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

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Contents

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

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

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

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

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

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

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ii

. . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . .4 Lag Operator . . . . . . .4 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . .8 Bootstrap for Autoregressions .5 Stationarity of AR(k) . . . . . . . . . . . . 11. . . .6 Estimation . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . .11Model Selection . 12. . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 8. .8 Exercises . . . . . . . . . . . . . . . . . . . . . 10. . . . . . 9. . . . . . . . . . . . . . . . . . . . . . 9. . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . 12. . . . . . . . . . 9. . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . 9.13 One-Sided Tests . 12 Univariate Time Series 12. . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . iii . . . . . . . . . . . 12. . 9. . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . .2 Reduced Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . 12. . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . . .2 GMM Estimator .12 8. . . . . . . . . . . . . . . . . . . . 12. . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . 12. . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . .9 Trend Stationarity . . 12. . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

For example. Econometric theory concerns the study and development of tools and methods for applied econometric applications. This type of data is characterized by serial dependence.Chapter 1 Introduction Econometrics is the study of estimation and inference for economic models using economic data. Panel data combines elements of cross-section and time-series. experiments such as this are infeasible. We can measure the joint distribution of these variables. However. Time-series data is indexed by time. a concern in labor economics is the returns to schooling — the change in earnings induced by increasing a worker’s education. an experiment might randomly divide children into groups. household or corporation) is surveyed on multiple occasions. These data sets consist surveys of a set of individuals. To measure the returns to schooling. timeseries. most economic data is observational. 1.2 Observational Data A common econometric question is to quantify the impact of one set of variables on another variable. and assess the joint dependence. and then follow the children’s wage path as they mature and enter the labor force. we would use experimental data to answer these questions. Cross-sectional data sets are characterized by mutually independent observations. 1. Ideally. But we cannot infer causality. or corporations. prices and interest rates. as we are not able to manipulate one variable to see the direct eﬀect on the other. The diﬀerences between the groups could be attributed to the diﬀerent levels of education. mandate diﬀerent levels of education to the diﬀerent groups. even immoral! Instead. repeated over time. Surveys are a typical source for cross-sectional data. They are distinguished by the dependence structure across observations. The quality of the study will be largely determined by the data available. 1 . holding other variables constant.1 Economic Data An econometric study requires data for analysis. what we observe (through data collection) is the level of a person’s education and their wage. The individuals surveyed may be persons. To continue the above example. Each individual (person. and panel. households. Typical examples include macroeconomic aggregates. Another issue of interest is the earnings gap between men and women. Applied econometrics concerns the application of these tools to economic data. There are three major types of economic data sets: cross-sectional.

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

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

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

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

which has ones on the diagonal.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. then AIr = A and Ik A = A. We say that two vectors a and b are orthogonal if a0 b = 0. An important diagonal matrix is the identity matrix. Also. . The columns of a k × r matrix A. ⎤ ⎥ ⎥ ⎥ ⎦ AB = A1 A2 · · · Ar Br = A1 B1 + A2 B2 + · · · + Ar Br r X = Ar Br j=1 ¤⎢ ⎢ ⎢ ⎣ Important properties are that if A is k × r. . For example. ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . . ⎦ ⎣ . .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. r ≤ k. 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 . A square matrix A is called orthogonal if A0 A = Ik . A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . ⎥ . . . . are said to be orthogonal if A0 A = Ir .

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

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

8 Determinant The determinant is deﬁned for square matrices..... we deduce that Λ2 = Λ and λ2 = λi for i = 1. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ ... ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. xk ) be k × 1 and g(x) = g(x1 . jk ) denote a permutation of (1. then its determinant is det A = a11 a22 − a12 a21 .. . xk ) : Rk → R. ..By the uniqueness of the characteristic roots. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 .. . If A is 2 × 2. . It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2. i Hence they must equal either 0 or 1.. tr(A) = rank(A). (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2... we can deﬁne the determinant as follows. .. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . k)).4) H0 M =H 0 0 with H 0 H = In .. ⎠ .. Additionally.. k) . and let επ = +1 if this count is even and επ = −1 if the count is odd... . For a general k × k matrix A = [aij ] . Let π = (j1 . 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 . 2. . k. There are k! such permutations.

• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. The Kronecker product of A and B. . . denoted by vec (A) . . • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. det(A ⊗ B) = (det (A))n (det (B))m • (A ⊗ B)−1 = A−1 ⊗ B −1 • If A > 0 and B > 0 then A ⊗ B > 0 • vec (ABC) = (C 0 ⊗ A) vec (B) • tr (ABCD) = vec (D0 )0 (C 0 ⊗ A) vec (B) 10 . . ⎟ .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). ⎣ ⎦ . . These results hold for matrices for which all matrix multiplications are conformable. • If A is orthogonal. ⎠ ⎝ . is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. . denoted A ⊗ B. an Let B be any matrix. am1 B am2 B · · · amn B Some important properties are now summarized. is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . . then det A = 2. The vec of A. .

We call xi alternatively the regressor. the conditional density of yi given xi . The data are from the 2004 Current Population Survey 1 11 . To illustrate. This is used when the goal is to quantify the impact of one set of variables on another variable. We call yi the dependent variable. holding the other variables constant. These are asymmetric (skewed) densities.22. These are conditional density functions — the density of hourly wages conditional on race. In the example presented in Figure 3.1) xi = ⎜ .2) m(x) = E (yi | xi = x) = −∞ In general. xki 3. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. which is a common feature of wage distributions. 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. m(x) can take any form.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. .1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. xi ) where yi is a scalar (real-valued) and xi is a vector.1 by the arrows drawn to the x-axis. In this context we partition the observations into the pair (yi .1. the mean is not necessarily a good summary of the central tendency.1 displays the density1 of hourly wages for men and women. we can focus on f (y | x) . We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. Take a closer look at the density functions displayed in Figure 3. See Chapter 16. Figure 3. and that for women is $20. (3. ⎠ ⎝ . the mean wage for men is $27. gender. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. While it is easy to observe that the two densities are unequal. These are indicated in Figure 3. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. ⎟ . education and experience. the conditioning variable.1.73. or the covariates. The two density curves show the eﬀect of gender on the distribution of wages. and exists so long as E |yi | < ∞.

3 is how the conditional expectation describes an important feature of the conditional distribution.2) evaluated at the observed value of xi : ei = yi − m(xi ). the solid line displays the conditional expectation of log wages varying with education. implying an average 36% diﬀerence in wage levels. The comparison in Figure 3. and a Ph. Figure 3. which implies a 30% average wage diﬀerence for this population. For this reason.A. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.Figure 3.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. wage regressions typically use log wages as a dependent variable rather than the level of wages. Of particular interest to graduate students may be the observation that diﬀerence between a B. then comparisons become more complicated.2 shows the density of log hourly wages for the same population. By construction.3) White non-military male wage earners with 10-15 years of potential work experience. Assuming for simplicity that this is the true joint distribution. with mean log hourly wages drawn in with the arrows.36.3 displays a scatter plot2 of log wages against education levels. The diﬀerence in the log mean wage between men and women is 0. Figure 3. When the distribution of the control variable is continuous. this yields the formula yi = m(xi ) + ei . The conditional expectation function is close to linear.30. the dashed line is a linear projection approximation which will be discussed in the Section 3.1 is facilitated by the fact that the control variable (gender) is discrete.5.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. The main point to be learned from Figure 3. degree in mean log hourly wages is 0.D. 3. 2 (3. To illustrate. 12 .

E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. E(xi ei ) = 0. E (h(xi )ei ) = 0 for any function h (·) . 2. E (ei | xi ) = 0. E(ei ) = 0. 13 . The remaining parts of the Theorem are left as an exercise. The equations yi = m(xi ) + ei E (ei | xi ) = 0. 3. To show the ﬁrst statement. A regression model imposes further restrictions on the joint distribution. by the deﬁnition of ei and the linearity of conditional expectations.Figure 3. most typically.1 Properties of the regression error ei 1. not a model. 4.2: Log Wage Densities Theorem 3.2. It is important to understand that this is a framework. restrictions on the permissible class of regression functions m(x). because no restrictions have been placed on the joint distribution of the data. are often stated jointly as the regression framework. These equations hold true by deﬁnition.

Given the random variable xi . The right-hand-side is minimized by setting g(x) = m(x). it does not provide information about the spread of the distribution.Figure 3. 3. subject to the restriction p that it is non-negative.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. and can take any form. in the sense of achieving the lowest mean squared error. when σ 2 (x) is a constant so that ¢ ¡ (3.2. i . Thus the mean squared error is minimized by the conditional mean. The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. To see this. In contrast. let g(x) be an arbitrary predictor of yi given xi = x.1. The conditional standard deviation is its square root σ(x) = σ 2 (x).3. σ 2 (x) is a non-trivial function of x.3 Conditional Variance Generally. the conditional variance of yi is σ 2 = σ 2 (xi ).

i (3.5. Equivalently. Equation (3. it is more realistic to view the linear speciﬁcation (3. Instead.1).6) as an approximation. we assume that x1i = 1. In this case (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .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.5) xi = ⎜ . it is convenient to augment the regressor vector xi by listing the number “1” as an element. where x1i is the ﬁrst element of the vector xi deﬁned in (3.8) (3. We call this the “constant” or “intercept”. ⎟ .we say that the error ei is homoskedastic.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. Notationally.1. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . ⎝ . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. 3. its functional form is typically unknown. take the conditional wage densities displayed in Figure 3. So while men have higher average wages. ⎠ . xki When m(x) is linear in x.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 .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. they are also somewhat more dispersed.4 Linear Regression An important special case of (3. Thus (3. As an example.1 and that for women is 10. βk ⎛ (3. ⎟ β=⎝ . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . which we derive in this section. 15 .8) is called the linear regression model.9) 3. The conditional standard deviation for men is 12.7) is a k × 1 parameter vector. ⎠ .6) (3.

Assumption 3. xi contains an intercept. E (x0 xi ) < ∞. The best linear predictor is obtained by selecting β to minimize S(β). we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . this situation must be excluded. i (3. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite.5. i i (3.5. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. 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. E (xi x0 ) is invertible. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. x0 β is the best linear predictor for yi . Given the deﬁnition of β in (3. 3.which is quadratic in β. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . Therefore. Rewriting.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. The vector (3. i (3. by “best” we mean the predictor function with lowest mean squared error. written E (xi x0 ) > 0. Observe i that for any non-zero α ∈ Rk . The ﬁrst-order condition for minimization (from Section 2.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. 2 2. i which requires that for all non-zero α.10).12) This completes the derivation of the linear projection model. Eyi < ∞. otherwise they are distinct. It is invertible if and only if it is positive deﬁnite. This occurs when redundant variables are included in xi .1 1. In order for β to be uniquely deﬁned. As before.1.10) It is worth taking the time to understand the notation involved in this expression. Equivalently.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . i 16 . We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. α0 E (xi x0 ) α = E (α0 xi )2 > 0. 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 4. The error is i ei = yi − x0 β.

Assumption 3.11) and (3. 17 .5.5. it follows that linear regression is a special case of the projection model.1 are weak.1.1.14). suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Equation (3.5.2. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Since ei is mean zero by (3.1.1.5. The ﬁnite variance Assumptions 3.9). Let’s compare it with the linear regression model (3.1. Furthermore.2 and 3. Since from Theorem 3.5. (3. E (xi ei ) = 0 and E (ei ) = 0. Assumption 3.4 we know that the regression error has the property E (xi ei ) = 0.11) are well deﬁned. Figure 3.10) are deﬁned. This means that the equation (3.13) summarize the linear projection model.12) and (3.13) The two equations (3.4 is required to ensure that β is uniquely deﬁned.14) Proof.1 Under Assumption 3.1. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.5. (3.13) implies that xi and ei are uncorrelated.13) and Assumption 3.14) holds. Using the deﬁnitions (3. Assumption 3.4 guarantees that the solution β exits.8)-(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. Assumption 3.1. For example.5.5.1.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. ¥ (3. However. the orthogonality restriction (3.Theorem 3.3 ensure that the moments in (3.1.14) follows from (3.1 is employed to guarantee that (3.5.5.5.1.2 and 3. By deﬁnition.10) and (3.12) can be alternatively interpreted as a projection decomposition.1.3 are called regularity conditions. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.

Figure 3. The solid line is the conditional mean.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.4 displays the relationship3 between mean log hourly wages and labor market experience.1.5: 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. the dashed line is the linear projection of log wages on eduction. xi ) we can deﬁne a linear projection equation (3. However. for those over 53 in age).5. In the example just presented. In this example the linear projection is a close approximation to the conditional mean. These structural models require alternative estimation methods. in many economic models the parameter β may be deﬁned within the model. we can augment the regressor vector xi to include both experience and experience2 . for any pair (yi .12) with the properties listed in Theorem 3. Figure 3. Returning to the joint distribution displayed in Figure 3. It over-predicts wages for young and old workers. and the straight dashed line is the linear projection. In other cases the two may be quite diﬀerent. Other than the redeﬁnition of the regressor vector. In this case the linear projection is a poor approximation to the conditional mean.5. In contrast.10) may not hold and the implications of Theorem 3.1 may be false. This defect in linear projection can be partially corrected through a careful selection of regressors. Most importantly. In this case (3. there are no changes in our methods or analysis. it is important to not misinterpret the generality of this statement.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. In this example it is a much better approximation to the conditional mean than the linear projection. and under-predicts for the rest. and are discussed in Chapter 11. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.We have shown that under mild regularity conditions.3.10). The linear equation (3. No additional assumptions are required. 18 . A projection of log wages on these two variables can be called a quadratic projection. since the resulting function is quadratic in experience.4 we display as well this quadratic projection. In Figure 1. We illustrate the issue in Figure 3.

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

s) = 0 if and only if m = µ and s = σ 2 . then E(x2 ei ) = 0.3 Find E(Y | X = x). If yi = xi β + ei . x 6. Compute E(yi | xi = x) and V ar(yi | xi = x). 9. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Prove parts 2. σ = . and E(e2 | xi ) = σ 2 . then ei is independent of xi . If yi = x0 β + ei and E(ei | xi ) = 0. e−λ λj j! . 3 and 4 of Theorem 3. 1.2 Y =1 . i 8. (x − µ)2 − σ 2 Show that Eg (X. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. taking values only on the non-negative integers.3. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . µx = Exi . E(Y 2 | X = x) and V ar(Y | X = x). Suppose that yi is discrete-valued. If yi = x0 β + ei . σ 2 = V ar(xi ). m. 3. i 7. Let xi and yi have the joint density f (x. xi ∈ R.1 . and E(xi ei ) = 0. then ei is i i independent of xi . . True or False. and have the following joint probability distribution X=0 X=1 Y =0 . i 11. a constant. 2.2. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1..1. 2. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . If yi = x0 β + ei and E(xi ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi . 20 . If yi = xi β + ei . ¡ ¢ 4. i 10. Are they diﬀerent? Hint: If P (Y = j) = 5. and E(ei | xi ) = 0. True or False. j! 0 j = 0. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. yi ).. then E(x2 ei ) = 0. True or False. Let X be a random variable with µ = EX and σ 2 = V ar(X). µ.4 . 0 ≤ y ≤ 1.6 Exercises 1. E(ei | xi ) = 0. xi ∈ R. then E(ei | xi ) = 0. Compute the conditional mean m(x) = E (yi | xi = x) . True or False. True or False. Suppose that Y and X only take the values 0 and 1. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei .

1 Estimation Equation (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. we narrow the focus to the linear regression model. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .1) (4. Observe that (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 (4.7 and 4.2) (4. i It follows that the moment estimator of β replaces the population moments in (4. but for most of the chapter we retain the broader focus on the projection model.2) can be written in the parametric 0 β)) = 0.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .3) In Sections 4. (4. i n i=1 n 21 .8. 4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .

5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. 40 2.14 205. 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 (4.4). consider the data used to generate Figure 3. 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.117 Educationi .83 ¶−1 µ ¶ .117 1 14. To illustrate.3.14 14.94 −2. 40 0.2 Least Squares There is another classic motivation for the estimator (4.95 xi yi = 42.14 14. 30 = . 0.170 37. i 22 . ¶ 2.ˆ This is a set of k equations which are linear in β. Then µ ¶ n 1X 2.30 + 0. These are white male wage earners from the March 2004 Current Population Survey.4).83 µ We often write the estimated equation using the format \ log(W agei ) = 1.71 = −2. with 10-15 years of potential work experience. Let yi be log wages and xi be an intercept and years of education. This sample has 988 observations. 4. An interpretation of the estimated equation is that each year of education is associated with an 11.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 205. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.95 42.37 µ ¶ 1.7% increase in mean wages. excluding military.40 µ ¶µ ¶ 34.

Figure 4.1: Sum-of-Squared Errors Function As a by-product of OLS estimation.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. i ˆ ˆ Note that yi = yi + ei . Since the function Sn (β) is a quadratic function of β.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. These two ˆ variables are frequently mislabeled.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Matrix calculus (see Appendix 2. It is important to understand the distinction between the error ei and the residual ei . The error is unobservable. while the residual is a by-product of estimation.4). Following convention we will call β the OLS estimator of β.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Figure 4. the contour lines are ellipses. 23 . Figure 4. which can cause confusion. To visualize the sum-of-squared errors function.

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

maximizing the likelihood is identical to minimizing Sn (β). and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. This is a parametric model. σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. The R2 is frequently mislabeled as a measure of “ﬁt”. Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi . The log-likelihood function for the normal regression model is Ã ¶! µ n X ¢2 1 1 ¡ 2 0 log exp − 2 yi − xi β Ln (β. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 .where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. Since Ln (β. Hence the MLE for β equals the OLS estimator. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. and distribution theory. where likelihood methods can be used for estimation. This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. testing. σ 2 ).3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. 4. σ 2 ) is a function of β only through the sum of squared errors Sn (β). It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. σ 2 ) maximize Ln (β. An alternative estimator of ρ2 proposed by Theil called “R-bar-squared” is y R =1− where σ2 = ˜y 2 n 2 s2 σ2 ˜y 1 X (yi − y)2 . Instead. 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 ).

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

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

1 (Frisch-Waugh-Lovell). ˆ ˜ ˜ ˆ 3. which you may have seen in an introductory econometrics course. . ⎠ ⎝ ⎠ ⎝ . . . the FWL theorem can be used to speed computation. .9). . Regress X2 on X1 . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ⎟ ⎜ ⎟ ⎜ (4. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y.14) or via the ˆ following algorithm: ˜ 1. is the demeaning formula for regression. ˜ 2. observe that ⎞ ⎛ ⎞ ⎛ .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. In the model (4. 30 . . 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) . .8)(3. obtain residuals X2 . .9). A common application of the FWL theorem. Regress Y on X1 . obtain residuals Y .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.6. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . 4. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.13). the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. the primary use is theoretical. and X2 is the vector of observed regressors. obtain OLS estimates β 2 and residuals e. but in most cases there is little computational advantage to using the two-step algorithm. ¡ ¢−1 0 ι. In this section we derive the small sample conditional mean and variance of the OLS estimator. Regress Y on X2 . ˆ which are “demeaned”. In this case. In some contexts. . By the independence of the observations and (3.Theorem 4. . Rather.

.19) ˆ and thus the OLS estimator β is unbiased for β. From (4. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . . . the properties of conditional expectations.. . V ar β | X = X 0 X ⎟ ⎟ ⎟. under the of ˆ ¢ 2 | x = σ 2 . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. . 0 0 ··· 0 0 . σ 2 } = ⎜ . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . . 1 n . .. 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. ⎝ . ..18). X 0 DX = X 0 Xσ 2 . Then given (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 = 0.12). and (4.19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . and ³ ´ ¡ ¢−1 2 ˆ σ .8)..Using (4. and the trace operator observe that. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . ⎠ (4. Next.20) .

and thus can be written as ˜ β = A0 Y where A is an n × k function of X. 32 . Theorem 4.10). = σ2 n the ﬁnal equality by (4. which we now present. which is (3.7) is unbiased for σ 2 by this calculation. the best (minimumvariance) unbiased linear estimator is OLS. What is the best choice of A? The Gauss-Markov theorem. Thus since V ar (e | X) = In σ 2 under homoskedasticity. the estimator ˆ 2 deﬁned (4. In the homoskedastic linear regression model. or in the projection model.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model.8.8)¢ ¡ (3. is a famous statement of the solution. known as the Gauss-Markov theorem.9) plus E e2 | xi = σ 2 . It is not unbiased in the absence of homoskedasticity. By a calculation similar to those of the previous section. It is important to remember. 4. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. however. In this case. As an alternative. as it yields the smallest variance among all unbiased linear estimators. ˜ so β is unbiased if (and only if) A0 X = Ik .Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . ³ ´ ˜ E β | X = A0 Xβ. The following result. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. that this estimator is only unbiased in the special case of the homoskedastic linear regression model.1 Gauss-Markov. Now consider the class of estimators of β which are linear functions of i the vector Y. we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . Thus σ 2 is biased towards zero. says that the least-squares estimator is the best choice. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 .

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

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 . He proves that generically the OLS estimator (4.1.Substituting in the expressions for π j . He observes that the above argument holds for all multinomial distributions. the maximum likelihood estimator is identical to the OLS estimator.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. and thus so is the OLS estimator.10 Omitted Variables xi = µ x1i x2i ¶ .22) 34 . Chamberlain (1987) extends this argument to the case of continuously-distributed data. if the data have a discrete distribution.5.10) for the class of models satisfying Assumption 3. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. 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 . and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. (4. 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.9). 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.

Typically.23) where is the coeﬃcient from a regression of x2i on x1i .. log(p1 ). because we have not said what it means for a matrix to be “near singular”. This is called strict multicollinearity. the general model will be free of the omitted variables problem.Now suppose that instead of estimating equation (4. This is the situation when the X 0 X matrix is near singular.22) by least-squares. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. there is some α such that Xα = 0.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 .e. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . which is often called “multicollinearity” for brevity. The more relevant issue is near multicollinearity. as many desired variables are not available in a given dataset. or second. 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. Goldberger (1991) calls (4. this arises when sets of regressors are included which are identically related. the coeﬃcient on x2i in (4. Since the error is discovered quickly. least-squares estimation of (4. This happens when the columns of X are linearly dependent. we regress yi on x1i only. For example. Most commonly.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. In this case. i.22) is zero. Typically there are limits. 4. First. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.22). the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). It is the consequence of omission of a relevant correlated variable. This is because the model being estimated is diﬀerent than (4. This deﬁnition is not precise. β 1 6= γ 1 . log(p2 ) and log(p1 /p2 ). 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 . By construction. and the error as ui rather than ei . When this happens. except in special cases. if X includes both the logs of two prices and the log of the relative prices. this is rarely a problem for applied econometric practice. when the columns of X are close to linearly dependent.22) the long regression and (4. To see this. In general.23) the short regression to emphasize the distinction. then β is not deﬁned. 35 . The diﬀerence Γβ 2 is known as omitted variable bias.

If the i’th observation 36 . Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. We derive expression (4. As a consequence. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . To investigate the possibility of inﬂuential observations. since as ρ approaches 1 the matrix becomes singular. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. The hi take values in [0. the worse the precision of the individual coeﬃcient estimates. We can also deﬁne the leave-one-out residual ˆ ˆ ei. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. ˆ i A simple comparison yields that ˆ ei − ei. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . the OLS estimator based on the sample excluding the i’th observation. that is. deﬁne the leave-one-out least-squares estimator of β. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.−i = (1 − hi )−1 hi ei .12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.25) below. the precision of individual estimates are reduced. What is happening is that when the regressors are highly dependent. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.27) (4.−i = yi − x0 β (−i) = (1 − hi )−1 ei . ˆ ˆ (4.25) 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. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . 1] and sum to k.26) As we can see. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.

4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .25). then this observation is a leverage point and has the potential to be an inﬂuential observation. which is considerably more informative than plots of the uncorrected residuals ei . ˆ We now derive equation (4. The key is equation (2.This implies has a large value of hi .1) in Section 2.27). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei . Investigations into the presence of inﬂuential observations can plot the values of (4.

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

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

P (g(X) > α) ≤ α−1 Eg(X). Since g(x) is convex. Note EU = EV = 1. So for all x. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1.3). If Xi ∈ Rk is iid and E |Xi | < ∞. Eg(X) ≥ a + bEX = g(EX).4) Proof of Jensen’s Inequality.1 Weak Law of Large Numbers (WLLN). ¥ 5.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. tangent lines lie below it.2.Markov’s Inequality. p p p q which is (5. For any strictly increasing function g(X) ≥ 0. Set Y = g(X) and let f denote the density function of Y. n→∞ lim P (|Zn − Z| > 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 ) = + . The WLLN shows that sample averages converge in probability to the population average. as stated. if for all δ > 0. =E U V p q p q Proof of Markov’s Inequality. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Applying expectations. Let a + bx be the tangent line to g(x) at x = EX. We say that Zn converges in probability to Z as n → ∞. n i=1 42 . denoted Zn →p Z as n → ∞. Theorem 5. (5. ¥ Proof of Holder’s Inequality. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. then as n → ∞ n 1X Xn = Xi →p E(X). 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}. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit.

as needed. the triangle inequality. by Markov’s inequality (5.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.6) and (5. P ¯X n ¯ > δ ≤ η. if for all x at which F (x) is continuous. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. Fix δ and η.7). 43 . ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Theorem 5. the fact that the Wi are iid and mean zero. V ) . Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. Fn (x) → F (x) as n → ∞.5). and the bound |Wi | ≤ 2C. We say that Zn converges in distribution to Z as n → ∞.1).3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) .4). the fact that X n = W n + Z n . We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.6) By Jensen’s inequality (5.Proof: Without loss of generality. Jensen’s inequality (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . Set ε = δη/3. denoted Zn →d Z. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.3. we can set E(X) = 0 (by recentering Xi on its expectation).1) and (5. If Xi ∈ Rk is iid and E |Xi |2 < ∞. Finally.1 Central Limit Theorem (CLT). where Z has distribution F (x) = P (Z ≤ x) . 5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.

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

for each element of g. Since cλλ (λn ) → cλλ (0) = −Ik . then g(Zn ) →p g(c) as n → ∞. This is suﬃcient to establish the theorem. 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 . It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.4. √ Theorem 5.1 Continuous Mapping Theorem 1 (CMT). then g(Zn ) →d g(Z) as n → ∞. k ≤ m.√ where λn → 0 lies on the line segment joining 0 and λ/ n. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Theorem 5. and g(θ) : Rm → Rk . Recall that A ⊂ B implies P (A) ≤ P (B). Σ) .3 Delta Method: If n (θn − θ0 ) →d N (0. Hence g(Zn ) →p g(c) as n → ∞. Proof: Since g is continuous at c. If Zn →p c as n → ∞ and g (·) is continuous at c. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).2 Continuous Mapping Theorem 2. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Ik ) distribution. 45 .4. gθ Σgθ . ¥ 5. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. where θ is m × 1 and Σ is m × m. Stacking across elements of g.4. If Zn →d Z as n → ∞ and g (·) is continuous. we see that as n → ∞. Proof : By a vector Taylor series expansion. Σ) = N 0. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε.4 Asymptotic Transformations Theorem 5.

In general.Chapter 6 Inference 6.1 for sample sizes of n = 25.1 Sampling Distribution The least-squares estimator is a random vector. its distribution is a complicated function of the joint distribution of (yi . ˆ Figure 6. xi ) and the sample size n. and therefore has a sampling distribution. 46 .1: Sampling Density of β 2 To illustrate the possibilities in one example. Using ˆ simulation methods. since it is a function of the random data. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density. let yi and xi be drawn from the joint density µ ¶ µ ¶ 1 1 1 2 2 exp − (ln y − ln x) exp − (ln x) f (x. The verticle line marks the true value of the projection coeﬃcient. the density function of β 2 was computed and plotted in Figure 6. n = 100 and n = 800.

ˆ 47 . xi ei →p g (Q. (6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.5.1.1.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.1 by the fact that the sampling densities become more concentrated as n gets larger.1).3) Ã where g(A. n i=1 (6. (6. Ã n ! n X 1X 0 1 ˆ xi xi . ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .3).4.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. 6. 0). we can conclude ˆ that β →p β. β →p β as n → ∞. the OLS estimator β is has a statistical distribution which is unknown.2) i i n i=1 n From (6. Proof.2. and the continuous mapping theorem (Theorem 5. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.4.1) and ˆ We now deduce the consistency of β. using (6. As the sample size increases the density becomes more concentrated about the population coeﬃcient. Assumption 3.2). ·) is continuous at (Q. (6.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . Assumption 3.2 Consistency ˆ As discussed in Section 6.2.1 Under Assumption 3.4 implies that Q−1 exists and thus g(·. For a complete argument.5.1). Equation (4.1). we will use the methods of asymptotic approximation. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 .1 and the WLLN (Theorem 5. First.5.1.1). ˆ Theorem 6. This is illustrated in Figure 6. To characterize the sampling distribution more fully. Hence by the continuous mapping theorem (Theorem 5. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.

Ω) .1).5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6.2. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.2.3. (6.3. ˆ Proof.2). n 1 X √ xi ei →d N (0. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. To see this.6) n i=1 48 . by the Cauchy-Schwarz inequality (5. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. it follows that s2 = ¥ n σ 2 →p σ 2 .5. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . Thus σ 2 is consistent for σ 2 . Assumption 6. i i Assumption 6. ˆ Finally.1.3. E ¯ei ¯ E ¯e4 ¯ i i i i (6.1. (6.Theorem 6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .2 Under Assumption 3.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. We need a strengthening of the moment conditions.3) and Theorem (6.5.1). Ee4 < ∞ and E |xi |4 < ∞.2).1 In addition to Assumption 3.1 guarantees that the elements of Ω are ﬁnite. ˆ n−k 6. By the central limit theorem (Theorem 5. since n/(n − k) → 1 as n → ∞.

as n → ∞ ´ √ ³ ˆ n β − β →d N (0.Then using (6.3. We say that ei is a Homoskedastic Projection Error when (6. Ω) ¡ ¢ = N 0. V is often referred to as ˆ the asymptotic covariance matrix of β. The expression V = Q−1 ΩQ−1 is called a sandwich form. Theorem 6. However. when xi and ei are independent. after rescaling. We call V 0 the homoskedastic covariance matrix. for example. Q−1 ΩQ−1 . There is a special case where Ω and V simplify.3.6). This holds true for all joint distibutions of (yi .2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . 1) asymptotic distibution. xi ) which satisfy the conditions of Assumption 6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. The trouble is that no matter how large is the sample size. is approximately normal when the sample size n is suﬃciently large. e2 ) = 0. 1). i i Condition (6. In Figure 6.1.1 states that the sampling distribution of the least-squares estimator. We illustrate this problem using a simulation. (6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.1.7) is true then V = V 0 . and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1 Under Assumption 6. The asymptotic distribution ´ Theorem 6. Under (6. 1 X √ xi ei n i=1 n ! the N (0. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. its variance diverges q ³ ´ ˆ to inﬁnity. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).7) is true or false. Let yi = β 0 + β 1 xi + εi where xi is N (0.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. but this is not a necessary condition. The approximation may be poor when n is small. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.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. |ε| ≥ 1. When (6.3. As α approaches 2.7) Cov(xi x0 . For α 49 . however. there is no simple answer to this reasonable question. setting n = 100 and varying the parameter α.3. and (6. otherwise V 6= V 0 .9) we deﬁne V 0 = Q−1 σ 2 whether (6.3.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . In´Figure 6. V ) where V = Q−1 ΩQ−1 .1).2). ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.9) In (6.7) holds. How large should n be in order for the approximation to be useful? Unfortunately.

Figure 6. we need an estimate of Ω = E xi x0 e2 .2: Density of Normalized OLS estimator α = 3. 6.1) it is clear that V 0 →p V 0 . As k increases.2 and 6. 6 and 8.10) without changing this result.10) V 0 = Q−1 s2 . We show the sampling distribution of n β 1 − β 1 setting n = 100. The estimator 2 2 in (6. Another example is shown in Figure 6.0 the density is very close to the N (0. The lesson from Figures 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 1) asymptotic approximation is never guaranteed to be accurate.11) 50 .3. the sampling distribution becomes highly skewed and non-normal. 1) density.2. concentrating most of the probability mass around zero. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.3 is that the N (0.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (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 (0.2) and Theorem 6. As α diminishes the density changes signiﬁcantly. 1). for k = 1. 4.

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

199 2.117 Educationi .2/988 = . (6.2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .used by an author when studying their work. by Holder’s inequality (5.14 6. (.83 −0. From a computational standpoint.80 40. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .98 −0.020. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.480 .80 . First.085) (.83 ¶−1 µ .80 40.80 2.1.493 0.35/988 = .20 and µ ¶ ˆ = 0.30 + 0. To illustrate. Using (6.480 ˆ0 = 0. (6.039 and ˆ V = µ 1 14.14 14.14 14.83 ¶−1 = µ 7.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.5) and the WLLN (Theorem 5. n n i=1 52 . from which it follows that V →p V as n → ∞.035 ¶ .6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.20 −0.20 = V 14. i i i i n i=1 Second.199 2.085 p ˆ and that for β 1 is . but not under another set of assumptions.14 205. Ω 2.493 −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 . The standard errors for β 0 are 7. then take the diagonal elements. p ˆ In this case the two estimates are quite similar.6 ¶µ 1 14. just as any other estimator. and then the square roots. We calculate that s2 = 0. we return to the log wage regression of Section 4.020) 6.14 205.12) in turn.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω.14 205.

13) of Efron (1982). you can show that 1 Xˆ ¯ β= β (−i) .25). these establish consistency. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6.1 As n → ∞.26). which.−i = (1 − hi )−1 ei ˆ presented in (4. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.11) with the leave-one-out estimator ei. 6. by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0.5. From equation (3. Using this substitution. Andrews (1991) suggested an similar estimator based on cross-validation. ¯ 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. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . Ω →p Ω and V →p V. Recall from Section 4. n i=1 n ˆ ˆ Theorem 6.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. ¯ ¯n ¯ n i=1 so Together.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. i=1 Third.13) Using formula (4.

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

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

z. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. from which it follows that pn →d U [0.96 and z. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. An alternative approach. 1]. under H0 . Deﬁne the tail probability. Either θ ∈ Cn or θ ∈ Cn .05 = 1. The asymptotic p-value for the above statistic is constructed as follows. associated with Fisher. If the p-value pn is small (close to zero) then the evidence against H0 is strong. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. Otherwise the test does not reject.645.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. That is. s(ˆ θ) Under H0 . note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). however. tn →d N (0. 56 . or “accepts” H0 . The p-value is more general. In a sense. 1]. is to report an asymptotic p-value. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. if Z ∼ N (0. It is designed to cover θ with high probability. Then the asymptotic p-value of the statistic tn is pn = p(tn ). 1].The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . The coverage probability is P (θ ∈ Cn ). pn →d U [0. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. and is a function of the data and hence is / random. regardless of the complication of the distribution of the original test statistic. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . 1). 6. 1). That is. To see this fact. in that the reader is allowed to pick the level of signiﬁcance α. For example. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. Let zα/2 is the upper α/2 quantile of the standard normal distribution.025 = 1.

θ θ) (6.05. In this case the t-statistic approach does not work. 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). We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . and it is desired to test the joint restrictions simultaneously. 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%.18) . θ The interval has been constructed so that as n → ∞. 6. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. ˆ + zα/2 s(ˆ . This corresponds to selecting the conﬁdence h i h ˆ ± 1. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. or α = .We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. 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).96s(ˆ ≈ ˆ ± 2s(ˆ .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). 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.

Hence β β by Theorem A.When h is a linear function of β. 1] under H0 . For example. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . q and pn is asymptotically U[0. if rank(Hβ ) = q. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. The null hypothesis is H0 : β 2 = 0.15) showed that n ˆ − θ →d Z ∼ N (0. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Vθ ). and there are q = k2 restrictions. ˆ Wn = n θ θ q θ θ Theorem 6. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . The asymptotic p-value for Wn is pn = p(Wn ).19) σ2 ˆ where σ2 = ˜ 1 0 e e. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity. Hβ (β) is a continuous function of β. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.1.2. and Theorem 6.025 . Also h(β) = a selector matrix. the upper-α quantile q 2 of the χ2 distribution. In this case.1 Under H0 and Assumption 6. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2.8. 6.10. the test rejects at the α% level iﬀ pn < α. ˜˜ n ˜ e = Y − X1 β 1 . ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .05) = 3. θ = β 2 .5. a chiq square random variable with q degrees of freedom.1 showed θ ˆ that V →p V.3. Furthermore. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. χ2 (.84 = z. Hβ (β) →p Hβ . h(β) = R0 β. then Wn →d χ2 . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . As before.

The elegant feature about (6. since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. We now derive expression (6. ˆˆ n ˆ e = Y − X β.19). ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . Because of this connection we call (6. and σ2 = ˆ 1 0 e e.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . the residual is ˜ ˜ e = M1 Y. By the FWL theorem. still this formula often ﬁnds good use in reading applied papers. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6.2) ¢−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 . Also. 2 2 2 or alternatively. 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 . 59 . This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . 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 partitioned matrix inversion (2. Now consider the residual regression of e on X2 = M1 X2 . X2 ). note that if we regress Y on X1 alone. 2 σ ˆ To simplify this expression further. First.are from OLS of Y on X1 . as the sum of squared errors is a typical output from statistical packages. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.19) the F form of the Wald statistic.19) is that it is directly computable from the standard output from two simple OLS regressions.

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

β 2 .10) then ´ ³ ˆ • β ∼ N 0. 0. the notable distinction is between the N (0. σ 2 ). 1) and tn−k distributions. As inference (conﬁdence intervals) are based on the t-ratio. σ 2 ) discussed above. The critical values are quite close if n − k ≥ 30.1 If ei is independent of xi and distributed N(0. 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. β 2 . σ 2 ) − Ln (β 1 . β has an exact normal distribution and t has an exact t distribution.) Now let us partition β = (β 1 . σ ˆ ˆ βj − βj βj − βj N (0. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. with residual variance σ . In contrast. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. 0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 .1 we showed that in large samples.3.12. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . so as a practical matter it does not matter which distribution is used. Furthermore. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . and standard errors are calculated using the homoskedastic formula (6. σ 2 ) = − log σ − log (2π) − . a good testing procedure is based on the likelihood ratio statistic. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. β and t are approximately normally distributed. if standard errors are calculated using the homoskedastic formula (6.8.1 shows that under the strong assumption of ˆ normality.12.1 and Theorem 6. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . We summarize these ﬁndings Theorem 6.a chi-square distribution with n − k degrees of freedom. n−k • ∼ tn−k ˆ In Theorem 6. Theorem 6. 0. (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 . σ2 ˆ 61 . β 2 .10) µ h i ¶ 2 (X 0 X)−1 N 0.

7. while there are other values of s for which test test statistic is insigniﬁcant. setting n/σ 2 = 10. Take the model yi = β + ei ei ∼ N (0. To demonstrate this eﬀect. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. 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. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. Letting h(β) = β s .84 — the probability of a false rejection. and noting Hβ = sβ s−1 . we have plotted in Figure 6.8. Through repetition. as Wn (s) →d χ2 under H0 for 1 any s. the statistic Wn (s) varies with s. 6. This can be seen by a simple example introduced by Lafontaine and White (1986).13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. 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. they can work quite poorly when the restrictions are nonlinear.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . 62 . LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. The increasing solid line is for the case β = 0. ˆ Let β and σ 2 be the sample mean and variance of yi . In the present context of the Wald statistic. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.4 the Wald statistic Wn (s) as a function ˆ of s. This is an unfortunate feature of the Wald statistic. features of this distribution can be calculated. σ 2 ) and consider the hypothesis H0 : β = 1. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Our ﬁrst-order asymptotic theory is not useful to help pick s. This produces random draws from the sampling distribution of interest. The decreasing dashed ˆ = 1.

4. the Type I error probability improves towards 5% as the sample size n increases.1 reports the simulation estimate of the Type I error probability from 50. Test performance deteriorates as s increases. The null hypothesis β s = 1 is true. In Table 4. we compare the rates row by row.000 random samples. Table 4. Any other choice of s leads to a test with unacceptable Type I error probabilities. this probability depends only on s. remember that the ideal Type I error probability is 5% (. Typically. These probabilities are calculated as the percentage of the 50. The value of s is varied from 1 to 10. In Table 2. and rarely fall outside of the 3%-8% range. Type I error rates between 3% and 8% are considered reasonable.4: Wald Statistic as a function of s P (Wn (s) > 3. When comparing statistical procedures. In each case. and σ is varied among 1 and 3. however. For this particular example. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Given the simplicity of the model. and σ 2 .1 you can also see the impact of variation in sample size.Figure 6.1 we report the results of a Monte Carlo simulation where we vary these three parameters. no magic choice of n for which all tests perform uniformly well. Table 4. looking for tests for which rate rejection rates are close to 5%.84 | β = 1) .1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .05) with deviations indicating+ distortion. n. Error rates avove 10% are considered excessive. To interpret the table.000 simulated Wald statistics Wn (s) which are larger than 3. so these probabilities are Type I error. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. Rates above 20% are unexceptable. n is varied among 20. 100 and 500. There is. the only test which meets this criterion is the conventional Wn = Wn (1) test.84. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.

12 .20 .14 .24 .05 .06 .10 .07 .19 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.20 .13 .15 .16 Rejection frequencies from 50.10 .06 . 64 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.07 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .22 . This point can be illustrated through another example.05 .15 .08 .15 .33 .30 .05 .35 . While this is clear in this particular example.20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .31 .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 .34 . deﬁne θ = β 1 /β 2 .10 .23 .06 .13 .25 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 .06 .08 .17 .05 .08 . Other choices are arbitrary and would not be used in practice.13 . β 1 . β 2 ) be the least-squares estimates of (6.21 .07 .05 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.20).14 .06 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. so the hypothesis can be stated as H0 : θ = r.18 .11 .08 .26 . Equivalently.12 .06 .07 .25 .15 .08 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .28 .06 .22 .07 .09 .05 .

Table 4.10 . Ideally. and 1.05 . and alternatives to asymptotic critical values should be considered.00 .15 .06 .05 .06 .06 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . along with sample size n. this formulation should be used. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .05 .05 . and normalize β 0 = 0 and β 1 = 1.2 is that the two t-ratios have dramatically diﬀerent sampling behavior. 65 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.645) greatly exceed 5%.7.05 β2 .47 .00 The one-sided Type I error probabilities P (tn < −1.50 .000 simulated samples. It is also prudent to consider alternative tests to the Wald statistic. However.06 .645) are close to zero in most cases.0 and n among 100 and 500.1.05 .25 .07 . This leaves β 2 as a free parameter.06 . ei be an independent N (0. The left tail probabilities P (t1n < −1. such as the GMM distance statistic which will be presented in Section 9.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . We let x1i and x2i be mutually independent N (0. . The implication of Table 4.00 . In all cases. then the “most linear” formulation should be selected.2.02 .00 .75.14 Monte Carlo Simulation In the previous section we introduced the method of Monte Carlo simulation to illustrate the small sample problems with tests of nonlinear hypotheses.06 .05 .645) t1n t2n t1n t2n t1n t2n t1n t2n .00 .645) P (tn > 1.00 .645) P (tn > 1. . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.05 .06 . especially for small values of β 2 . If no linear formulation is feasible.28 .00 . . 6.06 . We vary β 2 among .09 .50.06 .645) are calculated from 50.06 .05.00 . if the hypothesis can be expressed as a linear restriction on the model parameters.10 . In contrast. The results are presented in Table 4.00 .75 1. In this section we describe the method in more detail. the entries in the table should be 0. the rejection rates for the t1n statistic diverge greatly from this value.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.05 .26 . while the right tail probabilities P (t1n > 1.645) P (tn < −1.05 .645) and P (tn > 1.25.12 . and are close to the ideal 5% rate for both sample sizes. σ 2 ) draw with σ = 3.00 .15 . 1) variables.10 .

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

B. the performance will depend on n and F. so that coeﬃcients may be interpreted as semi-elasticities.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. immigrant.96) . and 90% sample quantiles of the sample {Tnb }. a larger B results in more precise estimates of the features of interest of Gn . experience squared. and therefore it is straightforward to calculate standard errors for any quantity of interest. Hence the ³ ´ ˆ standard errors for B = 100. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.96) .21). Furthermore. Often this is called the number of replications. We separately estimate equations for white and non-whites.022. . then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. and estimate a multivariate regression. 1000. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. equalling 1 with probability P = E1 (Tnb ≥ 1. union member. female. It is therefore convenient to pick B so that N is an integer. The α% sample quantile is a number qα such that α% of the sample are less than qα . immigrant. the choice of B is often guided by the computational demands of the statistical procedure. if we set B = 999. In many cases. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. As discussed above. and poorly for others. are.96) is iid Bernoulli. For regressors we include years of education. We now expand the sample all non-military wage earners. and 5000. Generally.95) /B ' . and non-white. female. Again our dependent variable is the natural log of wages. 6. union member. For example. therefore. potential work experience.007. potential work experience. For example.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. for a selection of choices of n and F. experience squared. and our regressors include years of education. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. but requires more computational time.05) (. Then qα is the N ’th number in this ordered sequence. As P is unknown.003. the researcher must select the number of experiments.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. it is simple to make inferences about rejection probabilities from statistical tests. Quite simply. then B will have to be increased. B b=1 (6. and dummy variable indicators for the following: married. and hispanic. We us the sample of wage earners from the March 2004 Current Population Survey. we included a dummy 67 . respectively. s P = . If the standard error is too large to make a reliable inference. and dummy variable indicators for the following: married. then we can set s P = (. The average (6.15 Estimating a Wage Equation We again return to our wage equation. For the dependent variable we use the natural log of wages. excluding military. this may ˆ be approximated by replacing P with P or with an hypothesized value. such as the percentage estimate reported in (6. It is therefore useful to conduct a variety of experiments. where N = (B +1)α. In practice. The random variable 1 (Tnb ≥ 1. and . hispanic. In particular. an estimator or test may perform wonderfully for some values.22/ B. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.

001 . the restricted standard deviation estimate is σ = .102 −.808 so the parameter estimates are quite precise and reported in Table 4. but not equal.102 −.00002 .008 . The available sample is 18.34 ˆ s(β) . 808 1 − . we ﬁnd Wn = 550.808 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.014 .070 .4877 18. excluding the coeﬃcients on the state dummy variables.69. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.1. Computing the Wald statistic (6.101 .097 −.027 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .4945.18) that the state coeﬃcients are jointly zero. Alternatively. this adds 50 regressors). Wn = n 1 − 2 = 18. θ ˆ 2β 3 β2 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.010 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. 2β 3 68 .002 .010 .48772 = 515. Table 4.49452 σ ˜ Notice that the two statistics are close.033 −.variable for state of residence (including the District of Columbia. 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. as the 1% critical value for the χ2 distribution is 76. Ignoring the other coeﬃcients.007 . The F form of the Wald statistic (6.232 .121 −. Using either statistic the hypothesis is easily rejected.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.00057 .013 .032 . reestimating the model with the 50 state dummies excluded.

This set is [27.96. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ). 29. but the lower end is substantially lower. 29. Since tn (θ) is a non-linear function of θ. but it can be found numerically quite easily. we can calculate a standard error of s(ˆ = .Using the Delta Method.5].40. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. there is not a simple expression for this set. this is a poor choice. In the previous section we discovered that such t-tests had very poor Type I error rates.0.5]. not testing a hypothesis. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. However. we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further.9. This is the set of θ such that |tn (θ)| ≤ 1. 69 . Instead. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. In the present context we are interested in forming a conﬁdence interval. implying a 95% conﬁdence θ) interval of [27.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

the least-squares estimator is ineﬃcient.1 Generalized Least Squares In the projection model. Often the functional form is kept simple for parsimony. 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. Typically. z1i are squares (and perhaps levels) of some (or all) elements of xi .. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .Chapter 7 Additional Regression Topics 7. 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 . in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0. where z1i is some q × 1 function of xi . we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. . However.. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. Let η i = e2 ..1) XD Y β = X 0 D−1 X ¡ ¢ 2 . 74 .. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . σ1 We now discuss this estimation problem.. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi .2) E (ξ i | xi ) = 0.1) infeasible since the matrix D is unknown. The GLS estimator (7. σ 2 }. The theory of Chamberlain (1987) can be used to show that in this model the semiparametric eﬃciency bound is obtained by the Generalized Least Squares (GLS) estimator ¢−1 ¡ 0 −1 ¢ ¡ ˜ (7. ..

then the FGLS estimator will force ˜i the regression equation through the point (yi . Furthermore.6) σ 2 = α0 zi . which is typically undesirable. We may call (7... Then set ˜i ˜ D = diag{˜ 2 . estimator of β.3) ˆ ˆ While ei is not observed. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . or FGLS. if σ 2 ≈ 0 for some i. This is the feasible GLS.. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. If σ 2 < 0 for some i. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . and will depend on the model (and estimation method) for the skedastic regression. We have shown that α is consistently estimated by a simple procedure. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. This suggests 75 . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Vα = E zi zi (7.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. ˜i Suppose that σ 2 > 0 for all i. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β).4) the skedastic regression. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. 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. .Suppose ei (and thus η i ) were observed. as it is estimating the conditional variance of the regression of yi on xi . Vα ) (7. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. then the FGLS ˜i estimator is not well deﬁned. there is no guarantee that σ 2 > 0 for all i.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. 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 . xi ).

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

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

we need to estimate the conditional distribution of ei given xi = x. ³ ´ ˆ ˆ The forecast error is ei = yi − m(x) = ei − x0 β − β . s 7. A reasonable rule is the conditional mean m(x) as it is the mean-square-minimizing forecast. Notice that this is a (linear) ˆ ˆ θ function of β. we see that m(x) = ˆ = x0 β and Hβ = x. Notice that this is diﬀerent from the standard ˆ ˆ error for the conditional mean. this would require the asymptotic normality of the ratio ³ ´ ˆ ei − x0 β − β . In general. Letting h(β) = x0 β and θ = h(β). q 2 0 0 ˆ ˜ ˆ ˜ σ (x) = α z from (7.4 NonLinear Least Squares In some cases we might use a parametric regression function m(x. e. we want to estimate m(x) at a particular point x. the natural estimate of this variance is σ 2 + n−1 x0 V x. θ) = E (yi | xi = x) which is a non-linear function of the parameters θ. We describe this setting as non-linear regression. so p ˆ s(ˆ = n−1 x0 V x. the validity of an asymptotic conﬁdence interval is based on the asymptotic normality of the studentized ratio. many applied forecasters focus h i ˆ on the simple approximate interval x0 β ± 2ˆ(x) . the width of the conﬁdence set is dependent on x. ¡ ¢ ˆ Assuming E e2 | xi = σ 2 .g. We would also like a measure of uncertainty for ˆ the forecast. which is a much more diﬃcult task. For a given value of xi = x. σ 2 ). s(x) ˆ But no such asymptotic approximation can be made.In some cases. we may want to forecast (guess) yi out-of-sample. 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) . Given the diﬃculty. As the out-of-sample error ei is ˆ ˆ independent of the in-sample estimate β. In the present case. this has variance ³ ´³ ´0 ¡ ¢ ˆ ˆ Eˆ2 = E e2 | xi = x + x0 E β − β β − β x ei i = σ 2 (x) + n−1 x0 V x. Thus an asymptotic 95% conﬁdence interval for m(x) is θ) It is interesting to observe that if this is viewed as a function of x. so a standard ˆ i p ˆ error for the forecast is s(x) = σ 2 + n−1 x0 V x. To get an accurate forecast interval.6). A point forecast ˆ is the estimated conditional mean m(x) = x0 β. p h i ˆ ˆ x0 β ± 2 n−1 x0 V x . If we have an estimate of the conditional variance function. The only special exception is the case where ei has the exact distribution N (0. which is generally invalid. but this turns out to be incorrect. 78 .

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

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

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

V ).1 ´ √ ³ˆ n β − β 0 →d N (0.1 is advanced. where V = and f (e | x) is the conditional density of ei given xi = x.5. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . Second using the law of iterated expectations and the chain rule of i diﬀerentiation. When f (0 | x) is large. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . ˆ Proof of Theorem 7. This can be done with kernel estimation techniques.5. the conditional density of the error at its median. See Chapter 16. ∂β 0 so Third.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. (7. by the central limit theorem (Theorm 5. In the special case where the error is independent of xi .10) is equivalent to g n (β) = 0. we provide a sketch here for completeness. The main diﬃculty is the estimation of f (0). Let g(β) = Eg (β). While a complete proof of Theorem 7.3.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. then there are many innovations near to the median. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .Theorem 7. First. Pn −1 0 β)) .1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .11). Computation of standard error for LAD estimates typically is based on equation (7. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. the height of the error density at its median. and this improves estimation of the median.5.

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

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. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. the τ ’th conditional quantile of ei is zero. ´ √ ³ˆ Theorem 7. the unconditional density of ei at 0. ˆ Given the representation (7. it is useful to have a general test of the adequacy of the speciﬁcation. Furthermore. Fortunately.1 n β τ − β τ →d N (0. ¡ ¡ ¢¢−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. and test their signiﬁcance using a Wald test. where and f (e | x) is the conditional density of ei given xi = x. if the model yi = x0 β + ei has i been ﬁt by OLS.1. When the error ei is independent of xi . Another popular approach is the RESET test proposed by Ramsey (1969). conventional Newton-type optimization methods are inappropriate. otherwise its properties are unspeciﬁed without further restrictions. then f (0 | xi ) = f (0) .12).6. n numerical methods are necessary for its minimization.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . and form a Wald statistic i for γ = 0. the asymptotic variance depends on the conditional density of the quantile regression error. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. fast linear programming methods have been developed for this problem.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . 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. i By construction. Thus. and are widely available.5.13). 7. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . The null model is yi = x0 β + εi i 84 . Vτ ). A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. since it has discontinuous derivatives.

In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. 3. or 4 seem to work best. ⎠ . To see why this is the case. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . note that (7. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. ⎟ zi = ⎝ . yi ˆm (7. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. To implement the test. β 1 = (X1 X1 )−1 (X1 Y ) . and the two estimators have equal asymptotic eﬃciency. since Q12 Q−1 Q21 > 0. then 22 Q11 > Q11 − Q12 Q−1 Q21 . m must be selected in advance. they will (typically) have diﬀerence asymptotic variances.be an (m − 1)-vector of powers of yi . 7. and form the Wald statistic Wn for γ = 0. 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. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. Otherwise. 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 . It is easy (although somewhat tedious) to show that under the null hypothesis. yielding ˆ ˜ ˆ ˆ (β 1 . 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. small values such as m = 2.14) may be written as ³ ´3 ³ ´m ³ ´2 ˜ ˆ ˜ ˆ ˜ ˆ yi = x0 β + x0 β γ 1 + x0 β γ 2 + · · · x0 β γ m−1 + ei ˜ ˜ i i i i which has essentially approximated G(·) by a m’th order polynomial. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . Another is to regress yi on x1i and x2i jointly. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . and consequently 22 ¡ ¢−1 2 σ . and n→∞ say. 1i 2i 2i 1i 22 . β 2 ). In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . yielding predicted values yi = x0 β. Wn →d χ2 . However.14) by OLS.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. Typically. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone.

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

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

the models are M1 : β 1 6= 0. stores the residual variance σ 2 for each model. and the AIC or BIC in principle can be implemented by estimating all possible subset models. 88 . and then selects the model with the lowest AIC (7.. Also under M2 . xKi }. 210 = 1024. However. . . In the unordered case. which are nested. Similarly for ˆ the BIC. β 2 6= 0.17). The methods extend readily to the issue of selection among multiple regressors. β 2 6= 0. In the latter case.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. MK : β 1 6= 0. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . . β 3 = · · · = β K = 0 . which regressors enter the regression).. there are 2K such models. . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. 576. The AIC selection criteria estimates the K models by OLS. one can show that thus LRn →p ∞. . β K 6= 0. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0.15). 048. which can be a very large number. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. and 220 = 1. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1.. In the ordered case. selecting based on (7. . We have discussed model selection between two models. There are two leading cases: ordered regressors and unordered. a model consists of any possible subset of the regressors {x1i . For example. .

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

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

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

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

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

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

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

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

the bootstrap test rejects if Tn (θ0 ) > qn (1 − α). Computationally. and this is important. Therefore. θ sample. a bootstrap test replaces qn (α) with the bootstrap estimate ∗ ∗ qn (α). 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. The 95% conﬁdence interval is then [θ − ˆ to yield the quantile estimates qn ˆ ˆn ∗ (. it also follows that if there exists some monotonic transformation f (·) such that f (ˆ is symmetrically distributed about f (θ0 ).0 and this idealized conﬁdence interval is accurate. Then so an exact (1 − α)% conﬁdence interval for θ0 would be 0 C2 = [ˆ − qn (1 − α/2). 8.975). C1 and C1 are designed for the case that ˆ has a symmetric distribution about θ0 .025)]. θ) then the idealized percentile bootstrap method will be accurate. ∗ Similarly.025) and q ∗ (. this³interval can be estimated from a bootstrap simulation by sorting the ´ ∗ ∗ bootstrap statistics Tn = ˆ − ˆ . θ This motivates a bootstrap analog ∗ θ C2 = [ˆ − qn (1 − α/2). ˆ − q ∗ (. which are centered at the sample estimate ˆ These are sorted θ θ θ. Note. 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) . that the bootstrap test θ θ θ ∗ statistic is centered at the estimate ˆ and the standard error s(ˆ ) is calculated on the bootstrap θ. θ Let Tn (θ) = ˆ − θ. many argue that the percentile interval should not be used unless the sampling distribution is close to unbiased and symmetric. θ However. θ. by the translation invariance argument presented above. but is not widely used in practice. We would set Tn (θ) = ´ ³ ˆ − θ /s(ˆ and reject H0 in favor of H1 if Tn (θ0 ) < c. θ When ˆ does not have a symmetric distribution. C1 may perform quite poorly. The problems with the percentile method can be circumvented by an alternative method. ˆ∗ ˆ∗ 97 .6 Percentile-t Equal-Tailed Interval Suppose we want to test H0 : θ = θ0 against H1 : θ < θ0 at size α. Thus c = qn (α). These t-statistics are sorted to ﬁnd the estimated quantiles qn (α) and/or qn (1 − α). ∗ (. and the test rejects if Tn (θ0 ) < qn (α). if the alternative is H1 : θ > θ0 . Since this is unknown. these critical values can be estimated from a bootstrap simulation by sorting ³ ∗ ´ ∗ ∗ the bootstrap t-statistics Tn = ˆ − ˆ /s(ˆ ). θ ˆ − qn (α/2)].975). θ ˆn qn ˆ This conﬁdence interval is discussed in most theoretical treatments of the bootstrap. where c would be selected so that θ θ) P (Tn (θ0 ) < c) = α. n Computationally. Based on these arguments. ˆ − q ∗ (α/2)].

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

and a function h(x) is odd if h(−x) = −h(x). then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. v 2 ). however. F ) = Φ n→∞ v or ³x´ Gn (x. 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.4) says that Gn converges to Φ x as n → ∞. Basically. 99 .2 an = O(1) if |an | is uniformly bounded. about the rate v of convergence. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . an = O(n−r ) if it declines to zero like n−r . the critical value qn (α) is found as the quantile from simulated values of W´ . writing Tn ∼ Gn (x.3 an = o(n−r ) if nr |an | → 0 as n → ∞.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. where qn (α) is the (1 − α)% quantile of the distribution of Wn . (8.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. Thus here Tn (θ) = Wn (θ). 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. We say that a function g(x) is even if g(−x) = g(x). and vice-versa.] 8. not ˆ − θ0 . Let an be a sequence. θ [This is a typical mistake made by practitioners.4) v ¡ ¢ While (8. The ideal test rejects if Wn ≥ qn (α). it says nothing. F ) = Φ + o (1) .8. A better asymptotic approximation may be obtained through an asymptotic expansion. θ θ θ ˆ θ ∗ ∗ Computationally. The following notation will be helpful. Equivalently. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). F ) then ³x´ . lim Gn (x. C4 is called the symmetric percentile-t interval. Let Tn be a statistic such that (8.8.8.8 Asymptotic Expansions Tn →d N (0. If θ is a vector. Deﬁnition 8. The derivative of an even function is odd. or the size of the divergence for any particular sample size n.

F0 ) = n 1 n1/2 (g1 (x. F0 ) = Φ(x) + since v = 1. ³x´ Gn (x. the density function is skewed.1 as follows.8. g1 (x. which from Theorem 8. the exact distribution is P (Tn < x) = Gn (x. F ) + g2 (x. F ). The diﬀerence is Φ(x) − Gn (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. Fn ) − g1 (x. To a third order of approximation. F ) v which adds a symmetric non-normal component to the approximate density (for example. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F ) = Φ v n n 8. Fn ) − g1 (x. v Since the derivative of g1 is odd.uniformly over x. Fn ) = Φ(x) + n 1 g (x.9 One-Sided Tests Using the expansion of Theorem 8. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . F ) ≈ Φ + n−1/2 g1 (x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). adding leptokurtosis).8. √ Since Fn converges to F at rate n. An asymptotic test is based on Φ(x). F0 ) ≈ ∂ g1 (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). A bootstrap test is based on G∗ (x). To a second order of approximation. ³x´ Gn (x. Fn ) + O(n−1 ). We can interpret Theorem 8.3). and g2 is an odd function of x. F0 )) + O(n−1 ).8. 1/2 1 n Because Φ(x) appears in both expansions. First.1 has the expansion n G∗ (x) = Gn (x. the diﬀerence √ (g1 (x. and g1 is continuous with respect to F. F ) ≈ Φ + n−1/2 g1 (x.1.1 Under regularity conditions and (8. F ) + O(n−3/2 ) Gn (x. where g1 is an even function of x. Gn (x. ³x´ 1 1 + 1/2 g1 (x.8. Moreover. F0 ) = 1 g (x. F ) converges to the normal limit at rate n1/2 . so the order of the error is O(n−1/2 ). F ) + n−1 g2 (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. F0 )) converges to 0 at rate n. 100 . To the second order. Fn ) − g1 (x. Heuristically. Theorem 8.

if Z ∼ N (0.1. then |Tn | has the distribution function Gn (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. F ). F ) = Gn (x. as F is a function. F0 ) = The order of the error is O(n−1 ). F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. From Theorem 8. A two-sided hypothesis test rejects H0 for large values of |Tn | . and exact critical values are taken from the Gn (x. F ) − Gn (−x. F ) = Gn (x. F ). n . 101 2 g2 (x. F0 ) distribution. n (8.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). = P (X ≤ x) − P (X ≤ −x) For example. we can calculate that Gn (x. F ) + O(n−3/2 ). if Tn has exact distribution Gn (x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. This rate can be used to show that one-tailed bootstrap inference based on the tratio achieves a so-called asymptotic reﬁnement — the Type I error of the test converges at a faster rate than an analogous asymptotic test. then |Tn | →d |Z| ∼ Φ. F ) + g2 (x. F ) − Gn (−x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. Similarly. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). F ) + g2 (−x. 1). Since Tn →d Z.8. F0 ) = O(n−1 ). We conclude that G∗ (x) − Gn (x. then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x).5) where the simpliﬁcations are because g1 is even and g2 is odd. F0 ) + O(n−3/2 ) = O(n−1 ). F ) is only heuristic. Thus asymptotic critical values are taken from the Φ distribution.The “derivative” ∂ ∂F g1 (x. 8.

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

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

Let the statistic of interest be the sample mean Tn = y n . which is a valid statistical approach. and e = Y − X β ˆ (a) Draw a random vector (x∗ . Consider the following bootstrap procedure for a regression of yi on xi ..13 Exercises 1. calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). ˆi A conditional distribution with these features will preserve the main important features of the data. generate ∗ bootstrap samples.. Let ∗ ∗ ∗ {y1 . Consider the following bootstrap procedure. .. Find the bootstrap moments ETn and V ar(Tn ).. ˆ Draw (with replacement) n such vectors. ˆ 3. n} . OLS estimator from the regression of Y on X. Let β denote the ˆ the OLS residuals. Set y∗ = x∗0 β + e∗ . 2... Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. ei ) : i = 1. yielding OLS estimates β and any other statistic of interest. however. Let Fn (x) denote the EDF of a random sample.. This can be achieved using a two-point distribution of the form Ã Ã √ ! ! √ 1+ 5 5−1 ∗ √ ei ˆ = P εi = 2 2 5 Ã Ã √ ! ! √ 1− 5 5+1 ∗ √ P εi = = ei ˆ 2 2 5 For each xi . ˆ∗ (b) Regress Y ∗ on X ∗ . i 8. That is. .. draw a ˆ ˆ random integer i0 from [1. The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent.. yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. 2. creating a random bootstrap data set (Y ∗ . Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. whether or not the xi are really “ﬁxed” or random. Using the non-parametric bootstrap. and set x∗ = xi0 and e∗ = ei0 . 4. you sample ε∗ using this two-point distribution. Take a random sample {y1 . e∗ ) from the pair {(xi .. Tn = (ˆ − ˆ 104 . 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 . Unfortunately this is a harder problem.observed values of the regressors. . Show that √ n (Fn (x) − F0 (x)) →d N (0. . X ∗ ). It does not really matter. Find the population moments ETn and V ar(Tn ). yn } with µ = Eyi and σ 2 = V ar(yi ).. n]. F0 (x) (1 − F0 (x))) ..

What is wrong with this procedure? Tn = θ/s(θ) n 6.5% quantiles of the ˆ are . with variables listed in the ﬁle hprice1. ∗ ∗ where s(ˆ is the standard error in the original data.2. The ˆ are sorted.75 and 1.dat contains data on house prices (sales).pdf.5% and 97. you generate bootstrap samples. (b) Report the 95% Alternative Percentile interval for θ. Estimate a linear regression of price on the number of bedrooms.95) denote the 95% quantile of Tn . and the colonial dummy. lot size. The dataﬁle hprice1.95).95). ˆ − s(ˆ n (. Suppose that in an application. ˆ = 1. Using the non-parametric bootstrap. θ respectively.3. You want to test H0 : θ = 0 against H1 : θ > 0. and thus reject H0 if ˆ ˆ > q ∗ (. You do this as follows. size of house. You replace c with qn (. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. (a) Report the 95% Efron Percentile interval for θ. and ˆ is calculated on each θ ∗ ∗ θ sample. and the 2. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. Using the non-parametric ∗ bootstrap. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).95). (c) With the given information. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.05) and qn (.2 and s(ˆ = . Let qn (.95) denote the 5% θ) ∗ and 95% quantiles of Tn . Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. can you report the 95% Percentile-t interval for θ? 7. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.05) . ∗ ∗ ∗ Let qn (. 105 .Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).

z. 1 this class of models are called moment condition models. however. As an important special case we will devote special attention to linear moment condition models. an asymptotically eﬃcient estimator of β is the OLS estimator. x. as their are restrictions in E (xi ei ) = 0.2) . z. x. In this case. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0.1) where β 0 is the true value of β. β 0 ) = x(y − z 0 β) 106 (9. is not necessarily eﬃcient. g(y. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. This model falls in the class (9. but this is not required. In econometrics. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. β) = x(y − x0 β). We know that without further restrictions. these are known as estimating equations. In the statistics literature. There are − k = r more moment restrictions than free parameters. with ≥ k. zi . β 0 ) = 0 (9. xi . This method.Chapter 9 Generalized Method of Moments 9. x. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . Let g(y. This is a special case of a more general class of moment condition models.1) by setting g(y. This situation is called overidentiﬁed. If k = the model is just identiﬁed. where the dimensions of zi and xi are k × 1 and × 1 . We call r the number of overidentifying restrictions. The variables zi may be components and functions of xi . Now suppose that we are given the information that β 2 = 0.1 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. In our previous example. otherwise it is overidentiﬁed. while β 1 is of dimension k < .

β ˆ Note that if k = . Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .2) g n (β) = (9. the dependence is only up to scale. The GMM estimator minimizes Jn (β). i i . β GMM does not change.2. if Wn = I. Let and where gi = xi ei . ¡ ¢−1 0 ˆ Z XWn X 0 Y. then. the square of the Euclidean length. let Jn (β) = n · g n (β)0 Wn g n (β). but this is generally not possible when > k. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.2. for if Wn is replaced ˆ by cWn for some c > 0. For some × weight matrix Wn > 0. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. For example. 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. 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 . ˆ Deﬁnition 9. and the GMM estimator is the MME.1 β GMM = argmin Jn (β).1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . then g n (β) = 0.9. This is a non-negative measure of the “length” of the vector g n (β).3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. β GMM = Z 0 XWn X 0 Z 9. Proposition 9.

no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. ˆ∗ ˆ 108 .1 ´ √ ³ˆ n β − β →d N (0.3. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9.2 For the eﬃcient GMM estimator. This is a weak concept of optimality.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. as shown by Gary Chamberlain (1987). and this is all that is known. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . this is a semi-parametric problem. The optimal weight matrix W0 is one which minimizes V. as it has the same asymptotic distribution. This results shows that in the linear model. n β − β →d N 0. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. For any Wn →p W0 . Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. n n We conclude: Theorem 9. a better choice is Wn = (X 0 X)−1 . β). where In general. ˆ Construct n 1X ˆ g n = g n (β) = gi . For example. In the linear model. Chamberlain showed that in this context. If it is known that E (gi (β)) = 0. the GMM estimator β is consistent yet ineﬃcient. as the distribution of the data is unknown. The proof is left as an exercise. W0 = Ω−1 is not known in practice. but it can be estimated consistently. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. without imposing additional assumptions. ˆ n i=1 gi = gi − g n . 9. ˆ we still call β the eﬃcient GMM estimator. However. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . it is semiparametrically eﬃcient. it turns out that the GMM estimator is semiparametrically eﬃcient. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. as we are only considering alternative weight matrices Wn . No estimator can do better (in this ﬁrst-order asymptotic sense). This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. V ) . This turns out to be W0 = Ω−1 .3.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. Ω) . 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. we can set Wn = I .

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

110 . Under the hypothesis of correct speciﬁcation. 9. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not.Often. However. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. often the weight ˆ matrix Wn is updated. 1 it is possible that β 2 6= 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 . and if the weight matrix is asymptotically eﬃcient. and then β recomputed. Note that g n →p Egi .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 . perhaps obtained by ﬁrst ˆ setting Wn = I. this is all that is known. Hansen (1982). 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). In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. This estimator can be iterated if needed.5. and is thus a natural test statistic for H0 : Egi = 0. The general theory of GMM estimation and testing was exposited by L. ˆˆ n is a quadratic form in g n . ˆ J = J(β) →d χ2−k . Thus the model — the overidentifying restrictions — are testable.1 Under general regularity conditions. Theorem 9. For example. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9.6. so that the linear equation may be written as yi = β 0 x1i + ei . where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). 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. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . Identiﬁcation requires l ≥ k = dim(β). n β − β →d N 0. 1 2 It is possible that β 2 = 0. G0 Ω−1 G . Since the GMM estimator depends upon the ﬁrst-stage estimator. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. β) = 0 holds.

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

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

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

Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . (c) Since Ω is positive deﬁnite. Letting H = CQ and G = C 0−1 W Q. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). V − V0 is positive semi-deﬁnite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the eﬃcient weight matrix). we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. Take the model yi = zi β + ei with E (xi ei ) = 0. 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 . there exists a nonsingular matrix C such that C 0 C = Ω−1 . a GMM estimator with arbitrary weight matrix). Show that V0 = Q0 Ω−1 Q . Write out the matrix A. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 .9. Let ei = yi − zi β where β is consistent for ˆ β (e. γ ) for (β. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . γ). A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. From matrix algebra. 114 . Take the model E (zi ηi ) = 0. In the linear model estimated by GMM with general weight matrix W. i 0 0ˆ ˆ 3.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. and therefore positive semideﬁnite. Show that Wn →p Ω i i i 4. 2. (b) We want to show that for any W. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0.g. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . ˆ ˆ Find the method of moments estimators (β. verify that A can be written as ³ ¡ ¢−1 0 ´ G H.

zi is l × 1 and β is k × 1. xi . Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . In the linear model Y = Xβ + e with E(xi ei ) = 0. zi ). is deﬁned as Jn (β) = ˜ β = argmin Jn (β). The observed data is (yi . l ≥ k.6) equals the Wald statistic. 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. Show how to construct an eﬃcient GMM estimator for β. h(β)=0 (9.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . The equation of interest is yi = g(xi . The GMM estimator of β. subject ˆ i ˆi i=1 to the restriction h(β) = 0. 6. 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 . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. Vn = X X i=1 ˜ and hence R0 β = r. Deﬁne the Lagrangian L(β. the distance statistic D in (9. β) + ei E (zi ei ) = 0.5) 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.5. VR = V − V R R0 V R (d) Show that in this setting. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9.6) (a) Show that you can rewrite Jn (β) in (9.

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

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

5) This minimization problem is the dual of the constrained maximization problem. The solution (when it exists) is well deﬁned since Rn (β. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. λ. λ) : λ(β) = argmin Rn (β. the Lagrange multiplier λ(β) minimizes Rn (β. λ). (see section 6.5). λ) is a convex function of λ. λ) = −n ln (n) − n X i=1 For given β. pi gi (β) = 0.7) 118 . probabilities 1 ³ ´´ .2) subject to the restrictions (10. we also obtain the Lagrange multiplier λ = λ(β).1) and (10.where λ and µ are Lagrange multipliers.. Multiplying the ﬁrst equation by pi . and using the second and third equations. (10..4) (10. The solution cannot be obtained explicitly.3). µ. pn .. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .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. Ln (β) = Rn (β. but must be obtained numerically (see section 6. λ ¡ ¢ ln 1 + λ0 gi (β) . or equivalently minimizes its negative ˆ (10. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). p1 .5) ˆ ˆ As a by-product of estimation. 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. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. This yields the (proﬁle) empirical log-likelihood function for β. summing over i. . p (10. we ﬁnd µ = n and 1 ¢.

and Ω = E xi x0 e2 .12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . 0 = Rn (β. in the linear model. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10. i=1 i=1 i=1i Expanding (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . β) = −xi zi . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.13) Premultiplying by G0 Ω−1 and using (10.8) and ¢ 0 0 For example.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. λ) = − (10.9) (10. Gi (.10). (β.10) ¡ Ω−1 N (0. β λ ∂ ³ ´. and n β − β 0 and nλ are asymptotically independent. n (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.13) yields n n Expanding (10. Thus the EL estimator is asymptotically eﬃcient.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . ˆ ˆ Proof.10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. λ) = − (10. i i Theorem 10.9) and (10. G = −E (xi zi ).2.1 Under regularity conditions.

by a Taylor expansion. and it is advisable to report the statistic LRn whenever EL is the estimation method.15).3.15) 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. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. They are asymptotically ﬁrst-order equivalent. The overidentiﬁcation test is a very useful by-product of EL estimation. and have the same interpretation. (10. The same statistic can be constructed for empirical likelihood. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.14) for λ and using (10.17) 2 ln 1 + λ gi β . n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .3 Overidentifying Restrictions In a parametric likelihood context.16). 10. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Since the EL estimator achieves this bound. β 0 ) = 0 then LRn →d χ2−k . LRn = i=1 Theorem 10. 120 . V ) ˆ Solving (10. Proof. Ω) GΩ G →d = N (0. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.15) (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. it is an asymptotically eﬃcient estimator for β.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. First. Vλ ) Furthermore. tests are based on the diﬀerence in the log likelihood functions.1 If Eg(wi .7) is n ³ ´´ ³ X ˆ ˆ0 (10.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. and (10.

wisc.ssc. 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.edu/~bhansen/progs/elike. By “maintained” we mean that the overidentfying restrictions contained in (10. h(β)=0 ˜ Fundamentally. Theorem 10.4 Testing Egi (β) = 0 (10.prc 121 . 10. This test statistic is a natural analog of the GMM distance statistic. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . the simple overidentifying restrictions test (10. LRn →d χ2 .5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. The hypothesis of interest is h(β) = 0. so there is no fundamental change in the distribution theory for β relative to β.18) and H0 : h(β) = 0. a The proof of this result is more challenging and is omitted.18). Vλ )0 Ω−1 N (0.1 Under (10. To test the hypothesis h(β) while maintaining (10. where h : Rk → Ra . 10. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) Let the maintained model be where g is × 1 and β is k × 1. since ln(1 + x) ' x − x2 /2 for x small.17) is not appropriate.4.Second.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.

19) is continued until the gradient Rλ (β.19) X ∂2 ∗ ∗ gi (β. λ) = − gi (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. Set δ 0 = 0. λ)0 0 Rn (β.4). λj ))−1 Rλ (β. Eﬃcient convergence requires a good choice of steplength δ.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10.. Deﬁne ∗ gi (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). 1. 2. δ 1 = 1 and δ 2 = 1.20) .5) for given β. λ)0 − Rn (β. set 2 λp = λj − δ p (Rλλ (β. λj ) is smaller than some prespeciﬁed tolerance. λj ) . λ) gi (β. λj )) Rp = Rn (β. λ)0 − ∂β∂β Rn (β. λ) = i The ﬁrst derivatives of (10. One method uses the following quadratic approximation. λ) G∗ (β. The iteration (10.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. λ) = − ∂β n X i=1 G∗ (β. λ) ∂λ i=1 n ∂ Rn (β. λ) = G∗ (β. λ) . The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . i Rββ = Inner Loop The so-called “inner loop” solves (10. For p = 0. λ) G∗ (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λj ))−1 Rλ (β. (10. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. The starting value λ1 can be set to the zero vector. λp ) A quadratic function can be ﬁt exactly through these three points. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.19).

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

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

so should be included in xi . Thus we make the partition ¶ µ k1 z1i (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 . ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.1 The × 1 random vector xi is an instrumental variable for (11.1.1) if E (xi ei ) = 0.2) Any solution to the problem of endogeneity requires additional information which we call instruments. We call z1i exogenous and z2i endogenous. z1i is an instrumental variable for (11. 11. which does not equal either β 1 or β 2 . So we have the partition µ ¶ z1i k1 (11. In a typical set-up. In matrix notation. and x2i are the excluded exogenous variables.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. Deﬁnition 11. (11.1) where zi is k × 1.1) the structural equation. this can be written as Y = Zβ + e. We call (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1). β →p β ∗ .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). and assume that E(zi ei ) 6= 0 so there is endogeneity. This is called simultaneous equations bias. some regressors in zi will be uncorrelated with ei (for example. By the above deﬁnition.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

Z2 ] and X = [Z1 .6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. Using (11. In our notation.12) Z = XΓ + u ξ = (e. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . X2 ]. we regress Y on Z1 and Z2 . u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. First. Z2 = [PX Z1 . 129 . Thus in the second stage. 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. the model is Y = Zβ + e (11.ˆ It is useful to scrutinize the projection Z. Z2 . X is n × l so there are l instruments. ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) .11) (11. Z = [Z1 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . PX Z2 ] = [Z1 . Here we present a simpliﬁed version of one of his results. Recall. Then i h ˆ ˆ ˆ Z = Z1 . We now derive a similar result for the 2SLS estimator. ˆ since Z1 lies in the span of X.12). let’s analyze the approximate bias of OLS applied to (11. PX Z2 ] h i ˆ = Z1 .13) which is zero only when S21 = 0 (when Z is exogenous). 11.11).

Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.12) and this result. Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11.Let PX = X (X 0 X)−1 X 0 . By the spectral decomposition of an idempotent matrix.14) In general this is non-zero.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . 0).13). It is also close to zero when α = 0. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.14) approaches that in (11. n and (11.14) is the probability limit of β 2SLS − β 11. except when S21 = 0 (when Z is exogenous). the expression in (11. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. The consequences of identiﬁcation failure for inference are quite severe. P = HΛH 0 0 0 where Λ = diag(Il . l . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . Indeed as α → 1. 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. 130 . 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 . the bias in the 2SLS estimator will be large.

we ﬁnd that β is inconsistent for β and the ˆ is non-normal. E x2 e2 i i n i=1 n (11.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. but (11. This can be handled in an asymptotic analysis by modeling it as local-to-zero.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0.15) is unaﬀected. but is weak. This result carries over to more general settings. once again take the simple case k = l = 1. In addition. meaning that inferences about parameters of interest can be misleading. Qc + N2 ˆ As in the case of complete identiﬁcation failure. Suppose that identiﬁcation does not complete fail. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. Then (11. the instrument xi is weak for zi if γ = n−1/2 c. N2 since the ratio of two normals is Cauchy. so E (zi xi ) = 0. standard test statistics have non-standard asymptotic distribution of β distributions. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . Suppose this condition fails. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. and was examined by Phillips (1989) and Choi and Phillips (1992). but small. We see that β is identiﬁed if and only if Γ22 = γ 6= 0.16) instead takes the form 1 X √ xi zi n i=1 n = = 1 X 2 1 X √ xi γ + √ xi ui n n 1 n i=1 n X x2 c + i i=1 n n 1 √ n →d Qc + N2 therefore ˆ β − β →d i=1 n X i=1 xi ui N1 . This is particularly nasty. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. which occurs i when E (zi xi ) 6= 0. where C is a full rank matrix.Take the simplest case where k = l = 1 (so there is no X1 ). This occurs when Γ22 is full rank. E x2 u2 i i n n i=1 i=1 n n (11. 131 . Here. To see the consequences. viz Γ22 = n−1/2 C. as the Cauchy distribution does not have a ﬁnite mean.

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

X is n × l. 133 . Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). and Γ is l × k. 5. will IV “ﬁt” better than OLS. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. Find a simple expression for the IV estimator in this context. (Find an expression for xi . In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. 1. l ≥ k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. Explain why this is true.) 3.11. That is. The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. Z is n × k. Take the linear model Y = Zβ + e. ˜ 0 e < e0 e. xi is l × 1. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . in the sense that e ˜ ˜ least in large samples? 4. 2. u is n × k. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). Take the linear model yi = xi β + ei E (ei | xi ) = 0. where xi and β are 1 × 1. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. show that if rank(Γ) < k then β cannot be identiﬁed. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . at ˆˆ If X is indeed endogeneous. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. 6.8 Exercises yi = zi β + ei .

Report estimates and standard errors. listed in card.(b) Deﬁne the 2SLS estimator of β. using the instrument near4. and the remaining variables as exogenous. (d) Re-estimate the model by eﬃcient GMM. in years. Report the estimates and standard errors. are the parameters identiﬁed? 8. Report estimates and standard errors. 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. (e) Calculate and report the J statistic for overidentiﬁcation. There are 2215 observations with 19 variables. and South and Black are regional and racial dummy variables. (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). a dummy indicating that the observation lives near a 4-year college. 134 . and then calculate the GMM estimator from this weight matrix without further iteration. in years. f atheduc (the education. We want to estimate a wage equation log(W age) = β 0 + β 1 Educ + β 2 Exper + β 3 Exper2 + β 4 South + β 5 Black + e where Educ = Eduation (Years) Exper = Experience (Years). Does this diﬀer from 2SLS and/or OLS? 7. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. 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. of the father) and motheduc (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).. In this model. (a) Estimate the model by OLS. The data ﬁle card. using zi as an instrument for xi . of the mother). (f) Discuss your ﬁndings. Estimate the model by 2SLS. Suppose that price and quantity are determined by the intersection of the linear demand and supply curves Demand : Supply : Q = a0 + a1 P + a2 Y + e1 Q = b0 + b1 P + b2 W + e2 ¡ ¢ (a) Show that E (xi ei ) = 0 and E x2 ei = 0. (b) Now treat Education as endogenous.pdf.

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

and it has a ﬁnite mean by the assumption that EYt2 < ∞. 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) .Theorem 12. T 1X Xt →p E(Xt ). For Part (2). the sequence Yt Yt−k is strictly stationary and ergodic. then as T → ∞. γ (0) ˆ Theorem 12. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).1.1 above. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. ˆ 2.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).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 .2 (Ergodic Theorem).1. Part (1) is a direct consequence of the Ergodic theorem. ˆ ˆ γ ¥ 136 . γ (k) →p γ(k). If Xt is strictly stationary and ergodic and E |Xt | < ∞. µ →p E(Yt ). 1. ˆ Proof. ˆ 3. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ρ(k) →p ρ(k).

E(et ) = 0 and Ee2 = σ 2 < ∞. A mean-zero AR(1) is Assume that et is iid. Y2 . Some time-series processes may be a MDS as a consequence of optimizing behavior. For example.2.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . some versions of the life-cycle hypothesis imply that either changes in consumption. 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 . A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . Deﬁnition 12.. YT . In fact. . E(Yt−k et ) = 0.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. Regression errors are naturally a MDS.. ..} are jointly random. it is even more important in the time-series context..12..} is the past history of the series. Y1 . 137 .2 Autoregressions In time-series. . Letting et = Yt − E (Yt | It−1 ) . t By back-substitution. 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. k=0 Loosely speaking. the series {.... ∞ X = ρk et−k . Thus for k > 0. This occurs when |ρ| < 1.. should be a MDS.. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS.. or consumption growth rates. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 ... An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . The last property deﬁnes a special time-series process. as it is diﬃcult to derive distribution theories without this property. Yt−k ) . we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.. 12.. . this series converges if the sequence ρk et−k gets small as k → ∞. Yt−2 .

From Theorem 12.1.4. we see that L2 Yt = LYt−1 = Yt−2 . 12. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . 138 . since ρ(z) = 0 when z = 1/ρ.3. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . We call ρ(L) the autoregressive polynomial of Yt .1 If |ρ| < 1 then Yt is strictly stationary and ergodic. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . Lk Yt = Yt−k . an AR(1) is stationary iﬀ |ρ| < 1. We say that the root of the polynomial is 1/ρ.1 The lag operator L satisﬁes LYt = Yt−1 . or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. Deﬁnition 12.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.Theorem 12. 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).5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . In general. Deﬁning L2 = LL.3. the above results are unchanged. We call ρ(L) the autoregressive polynomial of Yt . The AR(k) model is Using the lag operator. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . ∞ X k=0 ρ2k V ar (et−k ) = 12.

β = X 0X (12.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . By Theorem 12. The vector xt is strictly stationary and ergodic.1.1. and is of great interest in applied time series. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. Note that ut is a MDS. “has a unit root”. Let |λ| denote the modulus of a complex number λ.where the λ1 . . we say that ρ(L).1) Theorem 12. For an AR(k). t Yt−k ¢0 ρk . Thus T T 1X 1X xt et = ut →p E (ut ) = 0. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. λk are the complex roots of ρ(z).1) and the continuous mapping theorem. it is also strictly stationary and ergodic. which satisfy ρ(λj ) = 0. it is helpful to deﬁne the process ut = xt et . One way of stating this is that “All roots lie outside the unit circle.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. the requirement is that all roots are larger than one..” If one of the roots equals 1. 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. so is xt x0 . This is a special case of non-stationarity. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.1.6.. Theorem 12. then ˆ β →p β as T → ∞. t t T t=1 ¥ Combined with (12. Proof.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞.5.1. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. Thus t by the Ergodic Theorem.. and hence Yt . and by Theorem 12. t T t=1 T t=1 139 . we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.

The implication is that asymptotic inference is the same. .7. Brieﬂy. Q−1 ΩQ−1 . In particular. then as T → ∞. t This construction imposes homoskedasticity on the errors e∗ . Divide the sample into T /m blocks of length m.8 Bootstrap for Autoregressions In the non-parametric bootstrap. . eT }.12... Method 2: Block Resampling 1. Y0 ).2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. 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∗ . T 1 X √ ut →d N (0.7. which may be diﬀerent than the i properties of the actual ei . 140 . Ω) . xt }. this cannot work in a time-series application. It also presumes that the AR(k) structure is the truth. T t=1 Since xt et is a MDS. we constructed the bootstrap sample by randomly resampling from the data values {yt .7 Asymptotic Distribution Theorem 12. ˆ 1. This creates an iid bootstrap sample. 12. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.1 MDS CLT. ˆ 2. Estimate β and residuals et . Method 1: Model-Based (Parametric) Bootstrap. Fix an initial condition (Y−k+1 . Y−k+2 .1 to see that T 1 X √ xt et →d N (0. T t=1 where Ω = E(xt x0 e2 ). t then as T → ∞. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.. e ˆ 3. we can apply Theorem 12. This is identical in form to the asymptotic distribution of OLS in cross-section regression. the asymptotic covariance matrix is estimated just as in the cross-section case. there are two popular methods to implement bootstrap resampling for time-series data.. i 4. t t Theorem 12. Clearly. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Ω) .7.. as this imposes inappropriate independence..

draw T /m blocks. Resample complete blocks.4) by OLS. (12.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . That is. The series ∆s Yt is clearly free of seasonality. get the ˆ ˆ residual St . Thus the seasonally adjusted data is a “ﬁltered” series. Paste the blocks together to create the bootstrap time-series Yt∗ . 6. This is a ﬂexible approach which can extract a wide range of seasonal factors.2). ρk ).4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . • Use “seasonally adjusted” data. Seasonal Eﬀects There are three popular methods to deal with seasonal data.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . • First apply a seasonal diﬀerencing operator. • You can estimate (12.2)-(12. • Include dummy variables for each season.. ﬁrst estimate (12. 5. and perhaps this was of relevance. If s is the number of seasons (typically s = 4 or s = 12). . The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. 4.. or the season-to-season change.3) sequentially by OLS. heteroskedasticity. also alters the time-series correlations of the data. 141 . May not work well in small samples.2) (12. 3. For each simulated sample. (12. This presumes that “seasonality” does not change over the sample. The results may be sensitive to the block length. and then perform regression (12.2. ∆s Yt = Yt − Yt−s . and the way that the data are partitioned into blocks. • You can estimate (12.. 12. This procedure is sometimes called Detrending. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. The seasonal adjustment. and for modelmisspeciﬁcation. This allows for arbitrary stationary serial correlation.3) replacing St with St . however. But the long-run trend is also eliminated.

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

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

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

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

ˆj ˆ And if we stack these to create the estimate A. The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj .. . ⎟ ⎝ . j Unrestricted VARs were introduced to econometrics by Sims (1980). ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt . we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ . each with the same set of regressors.2 Estimation E (xt ejt ) = 0. The VAR model is a system of m equations. These are implied by the VAR model. and was originally derived by Zellner (1962) ¢ 13. The GMM framework gives a convenient method to impose such restrictions on estimation. One way to write this is to let a0 be the jth row j of A. For example. Restrictions may be imposed on individual equations. Then the VAR system can be written as the equations Yjt = a0 xt + ejt .3 Restricted VARs The unrestricted VAR is a system of m equations. ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 .. A restricted VAR imposes restrictions on the system.then Yt = Axt + et . or as a linear projection. Consider the moment conditions j = 1.2 ⎟ X(X 0 X)−1 A ⎜ . either as a regression. m. or across equations. some regressors may be excluded from some of the equations. 146 . Note that a0 = Yj0 X(X 0 X)−1 .. This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator. ˆ An alternative way to compute this is as follows. 13.

Let yt = Yjt .5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. You may have heard of the Durbin-Watson test for omitted serial correlation.2) is uncommon in recent applications. t and et is iid N (0.2) is a special case of (13.1). general. Another interesting fact is that (13. Suppose that et is an AR(1). In this case. 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 . If valid. This restriction. and is still routinely reported by conventional regression packages. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). and Zt be the other variables. Then the single equation takes the form (13. (A simple version of this estimator is called Cochrane-Orcutt. (13. with time series data. Otherwise it is invalid. we are only interested in a single equation out of a VAR system. under the restriction γ = −βθ.2) Take the equation yt = x0 β + et . and subtract oﬀ the equation once lagged multiplied by θ.4 Single Equation from a VAR Yjt = a0 xt + et . j Often.13.3). t and xt = This is just a conventional regression. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. which once was very popular. We see that an appropriate. 147 .2) may be estimated by iterated GLS.1) yt = x0 β + et . may be tested if desired. 13. This can be done by a Wald test. and is typically rejected empirically.3) which is a valid regression model. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. xt−1 ) to the regression. Let et = ejt and β = aj . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. direct estimation of (13. it is convenient to re-deﬁne the variables. 1). t t−1 (13. the model (13.) Since the common factor restriction appears arbitrary. t or yt = θyt−1 + x0 β + x0 γ + ut . So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . which is called a common factor restriction.

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

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

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

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

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

any known value can substitute. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. The functional form for λi has been picked to ensure that λi > 0. 1. An example of a data collection censoring is top-coding of income. i If Y = {0. the consumption level (purchases) in a particular period was zero. σ 2 ) with the observed variable yi generated by the censoring equation (14.14.2 Count Data exp (−λi ) λk i .1) yi = ∗ <0 .. this motivates the label Poisson “regression. The censoring process may be explicit in data collection.1).) The observed data yi therefore come from a mixed continuous/discrete distribution.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. 14. i i i=1 ˆ The MLE is the value β which maximizes ln (β).” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). . 1. 2.. The conditional density is the Poisson with parameter λi . 2.. This may be considered restrictive. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. a typical approach is to employ Poisson regression. A generalization is the negative binomial. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. or it may be a by-product of economic constraints. 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 . k! = exp(x0 β).. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. In surveys. Tobin observed that for many households. 0 if yi (This is written for the case of the threshold being zero.}. 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 !) . Thus the model is that there is some latent process yi with unbounded support. . incomes above a threshold are typically reported at the threshold.

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

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

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

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

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

Taking ﬁrst-diﬀerences of (15. A simple application of GMM yields the parameter estimates and standard errors.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. A more sophisticated GMM estimator recognizes that for time-periods later in the sample. Alternatively. This is conveniently organized by the GMM principle. so the instrument list should be diﬀerent for each equation. the dependent variable and regressors in deviationit from-mean form. This is because the sample mean of yit−1 is correlated with that of eit . The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. But if there are valid instruments. i ∗ yit = x∗0 β + e∗ . 15. are valid instruments. it However.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). Thus values of yit−k . the ﬁxed eﬀects estimator is inconsistent. 159 (15. two periods back. Hence a valid estimator of α and β is to estimate (15.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit .4) . it (15. we use lags of the dependent variable. but loses a time-series observation). if eit is iid. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. and the residual is the demean value ∗ yit = yit − yi . k ≥ 2.4) will be inconsistent. Unfortunately. 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 . as yt−2 is uncorrelated with ∆eit . at least if T is held ﬁnite as n → ∞. there are more instruments available. the predicted value from these regressions is the individual speciﬁc mean y i . then IV or GMM can be used to estimate the equation.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . e So OLS on (15. we ﬁnd y i = x0 β + ui + ei . it it which is free of the individual-eﬀect ui . Typically. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . 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.

While we are typically interested in estimating the entire function f (x). Xn } While F (x) can be estimated by the f ˆ (x) = n−1 n 1 (Xi ≤ x) .Chapter 16 Nonparametrics 16.. The kernel functions are used to smooth the data. n i=1 n 160 . we cannot deﬁne d F (x) since F (x) is a step function. the choice between these three rarely makes a meaningful diﬀerence in the estimates. Deﬁnition 1 K(u) is a second-order kernel function if it is a symmetric zero-mean density function. The goal is to estimateP(x) from a random sample (X1 . and then see how the method generalizes to estimating the entire function. |x| ≤ 1 0 |x| > 1 ¡ ¢2 1 − x2 . The ˆ ˆ EDF F i=1 dx standard nonparametric method to estimate f (x) is based on smoothing using a kernel. Let 1 ³u´ . Kh (u) = K h h be the kernel K rescaled by the bandwidth h. The amount of smoothing is controlled by the bandwidth h > 0. we can simply focus on the problem where x is a speciﬁc ﬁxed number..1 Kernel Density Estimation d Let X be a random variable with continuous distribution F (x) and density f (x) = dx F (x).. The kernel density estimator of f (x) is 1X ˆ f (x) = Kh (Xi − x) . . Three common choices for kernels include the Gaussian µ 2¶ x 1 K(x) = √ exp − 2 2π the Epanechnikov K(x) = and the Biweight or Quartic K(x) = 15 16 3 4 ¡ ¢ 1 − x2 . |x| ≤ 1 0 |x| > 1 In practice.

This estimator is the average of a set of weights. 161 . ˆ(x) is small. then the weights are small and f ˆ ˆ Interestingly. and Z ∞ ˆ f (x)dx = −∞ Z ∞ −∞ 1X 1X Kh (Xi − x) dx = n n i=1 i=1 n n Z ∞ −∞ Kh (Xi − x) dx = 1X n i=1 n Z ∞ K (u) du = 1 −∞ where the second-to-last equality makes the change-of-variables u = (Xi − x)/h. If a large number of the observations Xi are near ˆ x. Conversely. The bandwidth h controls the meaning of “near”. The mean is Z ∞ ˆ xf (x)dx = = = = −∞ 1X n 1 n 1 n 1 n n i=1 −∞ n XZ ∞ Z ∞ xKh (Xi − x) dx (Xi + uh) K (u) du n i=1 −∞ n X Z ∞ Xi Xi i=1 n X i=1 1X K (u) du + h n −∞ i=1 Z ∞ uK (u) du −∞ the sample mean of the Xi . f (x) ≥ 0 for all x. ˆ We can also calculate the moments of the density f (x). then the weights are relatively large and f (x) is larger. It follows that the variance of the density f (x) is Ã n !2 ¶2 µZ ∞ Z ∞ n 1X 1X 2 ˆ ˆ x2 f (x)dx − xf (x)dx = Xi + h2 σ 2 − Xi K n n −∞ −∞ i=1 i=1 −∞ = σ ˆ 2 + h2 σ 2 K Thus the variance of the estimated density is inﬂated by the factor h2 σ 2 relative to the sample K moment. f (x) is a valid density. where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h. The second moment of the estimated density is Z ∞ n Z 1X ∞ 2 2ˆ x f (x)dx = x Kh (Xi − x) dx n −∞ i=1 −∞ n Z 1X ∞ = (Xi + uh)2 K (u) du n −∞ i=1 Z ∞ Z n n n X 2X 1X 2 ∞ 2 1 2 Xi + Xi h K(u)du + h u K (u) du = n n n −∞ −∞ = where σ2 = K 1 n i=1 n X i=1 i=1 i=1 Xi2 + h2 σ 2 K Z ∞ x2 K (x) dx ˆ is the variance of the kernel. That is. if only a few Xi are near x.

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

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

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

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

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

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

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

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

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

Uniform f (x) = EX = V ar(X) = Weibull µ γ¶ x γ γ−1 x . −∞ lim F (x. Eg(X. y) = P (X ≤ x. y)dxdy. Y ) is a function from the sample space into R2 . y) = For a Borel measurable set A ∈ R2 . Y ) is 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. y). the joint probability density function is f (x. exp − f (x) = β β µ ¶ 1 EX = β 1/γ Γ 1 + γ ¶ ¶¶ µ µ µ 2 1 2/γ 2 V ar(X) = β −Γ 1+ Γ 1+ γ γ γ > 0.5 Multivariate Random Variables A pair of bivariate random variables (X. y) f (x. β > 0 1 . −∞ 171 . Y ≤ y) . y)dydx −∞ f (x. y)dxdy A Z ∞ −∞ Z ∞ g(x. If F is continuous. ∂x∂y Z Z f (x. b−a a+b 2 (b − a)2 12 a≤x≤b A. P ((X < Y ) ∈ A) = For any measurable function g(x. 0 ≤ x < ∞. The joint CDF of (X. y)dy. y). y)f (x.

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

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

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

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

(A. X has density Ã ! (x − µ)2 1 exp − . Σ) and Y = a + BX with B an invertible matrix.8.2 If Z ∼ N(0. This shows that linear transformations of normals are also normal. Theorem A. x ∈ Rk . 1). It is conventional to write X ∼ N (0. By iterated integration by parts. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. Σ). and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). If Z is standard normal and X = µ + σZ.1 Let X ∼ N (0. x ∈ Rk . y ≥ 0. then Σ = diag{σ 2 } is a diagonal matrix.11) and is known as the chi-square density with r degrees of freedom. q × q. 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) . f (x) = √ 2σ 2 2πσ which is the univariate normal density. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 .8. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. q 176 . then by the change-of-variables formula. we can also show that EX 2 = 1 and EX 4 = 3. denoted χ2 . The latter has no closed-form solution. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . Theorem A. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ.This density has all moments ﬁnite. Since it is symmetric about zero all odd moments are zero. then they are mutually independent. ¢ ¡ 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 . Ir ) and set Q = X 0 X. and it is conventional to write X ∼ N (µ. A) with A > 0. σ 2 ). then using the change-of-variables formula. This shows that if X is multivariate normal with uncorrelated elements. −∞ < x < ∞. For x ∈ Rk . Its mean and r variance are µ = r and σ 2 = 2r. respectively. then Z 0 A−1 Z ∼ χ2 . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . Another useful fact is that if X ∼ N (µ. The mean and variance of the distribution are µ and σ 2 .

Thus the density of Z 2 is (A.11) 2 with r = 1. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. 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 . C −1 CC 0 C −10 ) = N (0. which we showed in (A.13).13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). which can be found by applying change-of-variables to the gamma function. Iq ).Theorem A. tr has distribution 177 . we see that the MGF of Z 2 is (1 − 2t)−1/2 . From (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . For Z ∼ N(0.3. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.11). Set r Z . C −1 AC −10 ) = N (0.8. Using the simple law of iterated expectations.8. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.13) is the MGF of the density (A. q Proof of Theorem A. 1).1.12) E exp (tQ) = 0 Γ (A.8. 1) and Q ∼ χ2 be independent. Proof of Theorem A.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.8. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.3 Let Z ∼ N (0.2. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. The MGF for the density (A. (A.

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

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

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

θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. we can show that E By direction computation. function of the data. θ0 = ln f (Yi . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ0 ) f (Yi . Since θ Z ˜ = ˜ y)f (˜.Proof of Theorem A. ∂θ ¯θ=θ0 Z ! = 0.. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.17). θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ0 ) ¯ ∂ f (y. V ar (S) nH so ¥ 181 . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 )2 (Yi . θ) f (˜. yn ). ∂2 ln f (Yi . θ0 ) ∂θ f (Yi . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y.1) has mean zero and variance nH. (Yi . θ) dy ¯ ∂θ f (y.16). θ) d˜ = ˜ y ) ∂ ln f (˜.. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 )0 f (Yi . Proof of Theorem A. θ0 ) − f (Yi . f (Yi . y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ0 )0 .9. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 ) ln f (Yi .. θ0 ) (Yi . θ0 ) ∂ ∂ − ln f (Yi . . θ0 ) d˜ = E ˜ . θ) f (y.2. θ0 ) ∂ ∂θ f ∂ (Yi . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A.9.9.1. To see (A. ¯ ¯ ∂ E ln f (Yi .

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

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

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

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

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