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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

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

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

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

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

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

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

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

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

If A − BD−1 C and D − CA−1 B are non-singular. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . The Moore-Penrose generalized inverse A− satisﬁes (2. .The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . or is nonsingular. if there is no c 6= 0 such that Ac = 0.1) .3) The matrix A− is not necessarily unique. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. (2. then A−1 = A. . 2. This matrix is called the inverse of A and is denoted by A−1 . 7 Also. The following fact about inverting partitioned matrices is sometimes useful. (2. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.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. In this case there exists a unique matrix B such that AB = BA = Ik . . For non-singular A and C. the Moore-Penrose generalized inverse A− exists and is unique. if A is an orthogonal matrix.4 Inverse A k × k matrix A has full rank. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . . . .

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

. ⎠ ..... k) .. jk ) denote a permutation of (1. tr(A) = rank(A). . The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ .. Additionally.. k. .. k)). • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . There are k! such permutations.. 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 .. If A is 2 × 2. . .4) H0 M =H 0 0 with H 0 H = In . 2. xk ) be k × 1 and g(x) = g(x1 . i Hence they must equal either 0 or 1..By the uniqueness of the characteristic roots. xk ) : Rk → R..7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . . For a general k × k matrix A = [aij ] .. (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2... and let επ = +1 if this count is even and επ = −1 if the count is odd.. then its determinant is det A = a11 a22 − a12 a21 . we deduce that Λ2 = Λ and λ2 = λi for i = 1. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2. Let π = (j1 . There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1.8 Determinant The determinant is deﬁned for square matrices. we can deﬁne the determinant as follows. ... ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.

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

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

The comparison in Figure 3.5. with mean log hourly wages drawn in with the arrows. the dashed line is a linear projection approximation which will be discussed in the Section 3.3 displays a scatter plot2 of log wages against education levels.A. which implies a 30% average wage diﬀerence for this population. The conditional expectation function is close to linear. Of particular interest to graduate students may be the observation that diﬀerence between a B. Assuming for simplicity that this is the true joint distribution.3 is how the conditional expectation describes an important feature of the conditional distribution. 2 (3.2) evaluated at the observed value of xi : ei = yi − m(xi ). This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. 12 . implying an average 36% diﬀerence in wage levels. By construction.1 is facilitated by the fact that the control variable (gender) is discrete. Figure 3. then comparisons become more complicated. the solid line displays the conditional expectation of log wages varying with education. The diﬀerence in the log mean wage between men and women is 0.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. When the distribution of the control variable is continuous. For this reason. 3.D.2 shows the density of log hourly wages for the same population.3) White non-military male wage earners with 10-15 years of potential work experience. Figure 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3.Figure 3. this yields the formula yi = m(xi ) + ei . degree in mean log hourly wages is 0. The main point to be learned from Figure 3.30.36. and a Ph. To illustrate. wage regressions typically use log wages as a dependent variable rather than the level of wages.

The equations yi = m(xi ) + ei E (ei | xi ) = 0. These equations hold true by deﬁnition. most typically. A regression model imposes further restrictions on the joint distribution. E(xi ei ) = 0. E(ei ) = 0. because no restrictions have been placed on the joint distribution of the data.Figure 3. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. by the deﬁnition of ei and the linearity of conditional expectations. To show the ﬁrst statement. The remaining parts of the Theorem are left as an exercise.1 Properties of the regression error ei 1.2. restrictions on the permissible class of regression functions m(x). It is important to understand that this is a framework. E (h(xi )ei ) = 0 for any function h (·) . 13 . are often stated jointly as the regression framework. 3. 2. not a model. E (ei | xi ) = 0.2: Log Wage Densities Theorem 3. 4.

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

15 .we say that the error ei is homoskedastic. which we derive in this section. it is convenient to augment the regressor vector xi by listing the number “1” as an element.6) as an approximation.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .5.5) xi = ⎜ . In this case (3. We call this the “constant” or “intercept”.1. Equation (3. Equivalently. The conditional standard deviation for men is 12. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. ⎠ . take the conditional wage densities displayed in Figure 3.4 Linear Regression An important special case of (3.8) (3. So while men have higher average wages. we assume that x1i = 1. they are also somewhat more dispersed. Notationally. and the linear assumption of the previous section is empirically unlikely to accurate. Instead. 3. i (3. it is more realistic to view the linear speciﬁcation (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.1). ⎝ . βk ⎛ (3.1 and that for women is 10.7) is a k × 1 parameter vector.6) (3. where x1i is the ﬁrst element of the vector xi deﬁned in (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 . ⎟ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . xki When m(x) is linear in x. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . its functional form is typically unknown. Thus (3.8) is called the linear regression model. As an example. ⎠ .9) 3.

The ﬁrst-order condition for minimization (from Section 2. by “best” we mean the predictor function with lowest mean squared error. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. otherwise they are distinct. 2 2. i 4. Rewriting. i which requires that for all non-zero α. i 16 . It is invertible if and only if it is positive deﬁnite. 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 .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 . α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. Equivalently. α0 E (xi x0 ) α = E (α0 xi )2 > 0.1. Given the deﬁnition of β in (3. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. This occurs when redundant variables are included in xi . Observe i that for any non-zero α ∈ Rk .10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. Eyi < ∞. The error is i ei = yi − x0 β. 3.5. written E (xi x0 ) > 0. x0 β is the best linear predictor for yi . i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . The best linear predictor is obtained by selecting β to minimize S(β). E (x0 xi ) < ∞. 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. Therefore. In order for β to be uniquely deﬁned.which is quadratic in β.10). we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.10) It is worth taking the time to understand the notation involved in this expression. The vector (3. E (xi x0 ) is invertible.1 1. i i (3. xi contains an intercept. i (3. i (3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.12) This completes the derivation of the linear projection model. this situation must be excluded.5. Assumption 3. As before.

By deﬁnition. Using the deﬁnitions (3.5.13) The two equations (3.1. (3. For example.1. the orthogonality restriction (3.5.1.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.14) Proof.9).4 is required to ensure that β is uniquely deﬁned.5. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . ¥ (3. However.1.3 ensure that the moments in (3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.5. The ﬁnite variance Assumptions 3.1.11) are well deﬁned.1.8)-(3.5.4 guarantees that the solution β exits. it follows that linear regression is a special case of the projection model.1.4 we know that the regression error has the property E (xi ei ) = 0. Assumption 3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. E (xi ei ) = 0 and E (ei ) = 0.11) and (3. Figure 3. Assumption 3.10) and (3.12) can be alternatively interpreted as a projection decomposition. Equation (3.2 and 3.1 are weak. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.12) and (3.13) implies that xi and ei are uncorrelated. Assumption 3.Theorem 3.2 and 3.5.13) and Assumption 3.2. (3.5.5.13) summarize the linear projection model.14) holds.1.5.10) are deﬁned.1. This means that the equation (3.5. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .14).1 Under Assumption 3.1.5. Assumption 3. Since from Theorem 3. Furthermore.1 is employed to guarantee that (3. 17 .14) follows from (3.1. Let’s compare it with the linear regression model (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.3 are called regularity conditions. Since ei is mean zero by (3.

we can augment the regressor vector xi to include both experience and experience2 . Returning to the joint distribution displayed in Figure 3. It over-predicts wages for young and old workers.1 may be false.4 displays the relationship3 between mean log hourly wages and labor market experience. In this case (3.5.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. for any pair (yi . In other cases the two may be quite diﬀerent. In the example just presented. Most importantly. A projection of log wages on these two variables can be called a quadratic projection. No additional assumptions are required. and under-predicts for the rest. the dashed line is the linear projection of log wages on eduction. in many economic models the parameter β may be deﬁned within the model.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. since the resulting function is quadratic in experience.We have shown that under mild regularity conditions. The linear equation (3. In this case the linear projection is a poor approximation to the conditional mean. Other than the redeﬁnition of the regressor vector. The solid line is the conditional mean. and are discussed in Chapter 11.10) may not hold and the implications of Theorem 3. and the straight dashed line is the linear projection. In contrast. xi ) we can deﬁne a linear projection equation (3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. In this example the linear projection is a close approximation to the conditional mean.5. These structural models require alternative estimation methods. We illustrate the issue in Figure 3. for those over 53 in age).4 we display as well this quadratic projection.3. In this example it is a much better approximation to the conditional mean than the linear projection. This defect in linear projection can be partially corrected through a careful selection of regressors.10). it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. Figure 3. there are no changes in our methods or analysis. 18 . Figure 3.1. In Figure 1. it is important to not misinterpret the generality of this statement.12) with the properties listed in Theorem 3. However.

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

3. µx = Exi . and E(ei | xi ) = 0.2. 3 and 4 of Theorem 3. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. then E(x2 ei ) = 0.3. If yi = xi β + ei .. True or False.4 . i 11. i 10. . yi ). then ei is independent of xi . and have the following joint probability distribution X=0 X=1 Y =0 . ¡ ¢ 4. σ 2 = V ar(yi ) and σ xy = Cov(xi . xi ∈ R. a constant. Let X be a random variable with µ = EX and σ 2 = V ar(X). i 8. then E(x2 ei ) = 0.1 . and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . and E(xi ei ) = 0. If yi = xi β + ei . Compute E(yi | xi = x) and V ar(yi | xi = x). then E(ei | xi ) = 0. Suppose that yi is discrete-valued. If yi = x0 β + ei and E(xi ei ) = 0. Suppose that Y and X only take the values 0 and 1. True or False. True or False. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. Compute the conditional mean m(x) = E (yi | xi = x) . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . 2. taking values only on the non-negative integers. If yi = x0 β + ei .1. True or False. Are they diﬀerent? Hint: If P (Y = j) = 5. 20 . e−λ λj j! . Prove parts 2. If yi = x0 β + ei and E(ei | xi ) = 0. and E(e2 | xi ) = σ 2 . E(Y 2 | X = x) and V ar(Y | X = x). E(ei | xi ) = 0.6 Exercises 1..3 Find E(Y | X = x). 2. µ. Let xi and yi have the joint density f (x. xi ∈ R. x 6. 9. (x − µ)2 − σ 2 Show that Eg (X. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ.2 Y =1 . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . i 7. m. then ei is i i independent of xi . s) = 0 if and only if m = µ and s = σ 2 . j! 0 j = 0. True or False. σ = . σ 2 = V ar(xi ). 1. 0 ≤ y ≤ 1.

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

Then µ ¶ n 1X 2. excluding military.94 −2. ¶ 2. An interpretation of the estimated equation is that each year of education is associated with an 11. 0. 40 2. 30 = .30 + 0.117 1 14.71 = −2. 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. Let yi be log wages and xi be an intercept and years of education.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.40 µ ¶µ ¶ 34.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 205. 4.37 µ ¶ 1.83 ¶−1 µ ¶ . These are white male wage earners from the March 2004 Current Population Survey.4).ˆ This is a set of k equations which are linear in β.14 205.14 14. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.2 Least Squares There is another classic motivation for the estimator (4. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4. 40 0. i 22 . with 10-15 years of potential work experience.95 xi yi = 42. This sample has 988 observations.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.7% increase in mean wages.4).117 Educationi .14 14.170 37.95 42. To illustrate.3.

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

2: Sum-of-Squared Error Function Contours Equation (4. one implication is that n 1X ei = 0. These are algebraic results. 24 .6) An alternative estimator uses the formula n 1 X 2 s = ei .7) A justiﬁcation for the latter choice will be provided in Section 4. The error variance σ 2 = Ee2 is also a parameter of interest. ˆ n i=1 n Since xi contains a constant. 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. and hold true for all linear regression estimates.Figure 4. ˆ σ = ˆ n 2 i=1 n (4.7. Its method of moments estimator is the sample average 1X 2 ei . It measures the variation in the i “unexplained” part of the regression.5) implies that 1X xi ei = 0. ˆ n−k 2 i=1 (4.

σ 2 ) is a function of β only through the sum of squared errors Sn (β). Instead.where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. σ 2 ). 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 ). 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 . 4. 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 ). This is a parametric model. where likelihood methods can be used for estimation. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . and distribution theory. 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 . This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. maximizing the likelihood is identical to minimizing Sn (β). σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . Since Ln (β. The R2 is frequently mislabeled as a measure of “ﬁt”. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β.3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. Hence the MLE for β equals the OLS estimator. 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 ) maximize Ln (β. testing.

⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. ⎟. 4. and X is an n × k matrix.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. including computation. The linear equation (3.12) is a system of n equations. . yn = x0 β + en . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. Thus the MLE (β. it is matrix notation. σ 2 ) = − 2 + ¡ ¢2 e2 = 0.8) . = β+ XX 26 (4. ⎠ . yn ⎟ ⎟ ⎟. one for each observation. For example n X i=1 For many purposes. Sample sums can also be written in matrix notation. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. ⎝ ⎝ . n X i=1 Thus the estimator (4. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ 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. . σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e.4). n or equivalently Y = Xβ + e. .6). residual vector. Due to this equivalence. .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . x0 n ⎞ ⎛ e1 e2 . en ⎞ Observe that Y and e are n × 1 vectors. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .

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

ˆ ˜ ˜ ˆ 3. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. obtain OLS estimates β 2 and residuals e.9). In this section we derive the small sample conditional mean and variance of the OLS estimator. ¡ ¢−1 0 ι. the FWL theorem can be used to speed computation. .6. . A common application of the FWL theorem. Regress Y on X2 . .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. but in most cases there is little computational advantage to using the two-step algorithm. Rather. In some contexts. . 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. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . obtain residuals Y . ⎠ ⎝ ⎠ ⎝ . By the independence of the observations and (3. . In the model (4. 30 . ˜ 2. obtain residuals X2 . and X2 is the vector of observed regressors. Partition X = [X1 X2 ] where X1 = ι is a vector of ones.13). .1 (Frisch-Waugh-Lovell). ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. which you may have seen in an introductory econometrics course. . is the demeaning formula for regression. ⎟ ⎜ ⎟ ⎜ (4. 4. .Theorem 4.8)(3. observe that ⎞ ⎛ ⎞ ⎛ . Regress X2 on X1 . or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . Regress Y on X1 . . . the primary use is theoretical.9). In this case.14) or via the ˆ following algorithm: ˜ 1. ˆ which are “demeaned”.

Then given (4. 1 n . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . X 0 DX = X 0 Xσ 2 . .8). and (4. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. . and the trace operator observe that. . . V ar β | X = X 0 X ⎟ ⎟ ⎟.Using (4.18). σ 2 } = ⎜ . and ³ ´ ¡ ¢−1 2 ˆ σ . 0 0 ··· 0 0 . 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.. . Next. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . .19) ˆ and thus the OLS estimator β is unbiased for β. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 ..20) . . 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.12). under the of ˆ ¢ 2 | x = σ 2 . From (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 . ⎝ . the properties of conditional expectations. ⎠ (4.. ¡ 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. . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 ..

By a calculation similar to those of the previous section.8. Thus σ 2 is biased towards zero. Theorem 4. The following result. ³ ´ ˜ E β | X = A0 Xβ. which is (3. however. the estimator ˆ 2 deﬁned (4. the best (minimumvariance) unbiased linear estimator is OLS. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model.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 . ˜ so β is unbiased if (and only if) A0 X = Ik .7) is unbiased for σ 2 by this calculation. It is important to remember.10). In this case. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. is a famous statement of the solution. What is the best choice of A? The Gauss-Markov theorem. As an alternative. ˜ β L = A0 Y = A (Xβ + e) = β + Ae.1 Gauss-Markov. which we now present. known as the Gauss-Markov theorem. as it yields the smallest variance among all unbiased linear estimators. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . Thus since V ar (e | X) = In σ 2 under homoskedasticity. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. = σ2 n the ﬁnal equality by (4. Now consider the class of estimators of β which are linear functions of i the vector Y. 32 . 4. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. 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.8)¢ ¡ (3. says that the least-squares estimator is the best choice. It is not unbiased in the absence of homoskedasticity. In the homoskedastic linear regression model.9) plus E e2 | xi = σ 2 . or in the projection model.

. Assume that the τ j and ξ j are known. This latter restriction is particularly unsatisfactory.. That is. and π j . ¡ ¢ P yi = τ j . 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.. . r for some constant vectors τ j . xi ) is discrete. Note that X 0 C = 0. Let A be any n×k function of X such that A0 X = Ik . but we don’t know the probabilities.. 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 2.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator..) In this discrete setting..5) as required. and is a strong justiﬁcation for the least-squares estimator. π j is the percentage of the observations ˆ ˆ which fall in each category. The MLE β mle for β is then the analog of (4. . (We know the values yi and xi can take. Not only has the class of models has been restricted to homoskedastic linear regressions. for ﬁnite r. A broader justiﬁcation is provided in Chamberlain (1987). 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 . r. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. As the data are multinomial.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 ⎠ . j = 1. That is.. where 1 (·) is the indicator function.21) j j=1 j=1 Thus β is a function of (π 1 . the class of potential estimators has been restricted to linear unbiased estimators. xi = ξ j = π j . Set C = A − X (X 0 X)−1 . the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4.. This property is called semiparametric eﬃciency. the deﬁnition (4. Suppose that the joint distribution of (yi . ˆ β mle = ⎝ j j=1 j=1 33 . It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite.. 4. but the π j are unknown. We discuss the intuition behind his result in this section. but it is quite limited in scope. π r ) .Proof..

Substituting in the expressions for π j . 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.22) 34 . and thus so is the OLS estimator.5. if the data have a discrete distribution. (4.9). 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 . and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. the maximum likelihood estimator is identical to the OLS estimator. Chamberlain (1987) extends this argument to the case of continuously-distributed data. He observes that the above argument holds for all multinomial distributions.10 Omitted Variables xi = µ x1i x2i ¶ . He proves that generically the OLS estimator (4.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.10) for the class of models satisfying Assumption 3. 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 .1. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.

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

ˆ i A simple comparison yields that ˆ ei − ei. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 .24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . We can also deﬁne the leave-one-out residual ˆ ˆ ei.25) β (−i) = β − (1 − hi )−1 X 0 X where ¢−1 ¡ xi hi = x0 X 0 X i The i’th observation is inﬂuential on the least-squares estimate if the deletion of the observation ˆ from the sample results in a meaningful change in β. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. As a consequence.−i = (1 − hi )−1 hi ei . since as ρ approaches 1 the matrix becomes singular. the precision of individual estimates are reduced. The hi take values in [0.−i = yi − x0 β (−i) = (1 − hi )−1 ei . A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. 1] and sum to k. If the i’th observation 36 . To investigate the possibility of inﬂuential observations. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi .26) As we can see. What is happening is that when the regressors are highly dependent. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. 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. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. deﬁne the leave-one-out least-squares estimator of β. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. that is. the worse the precision of the individual coeﬃcient estimates. ˆ ˆ (4.25) below. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. the OLS estimator based on the sample excluding the i’th observation.27) (4. We derive expression (4.

Investigations into the presence of inﬂuential observations can plot the values of (4.1) in Section 2. The key is equation (2. which is considerably more informative than plots of the uncorrected residuals ei .27). ˆ We now derive equation (4. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .This implies has a large value of hi . ¢−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 . then this observation is a leverage point and has the potential to be an inﬂuential observation.25).

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

2. Consider the OLS regression of the n × 1 vector y on the n × k matrix X. Consider an alternative set of regressors Z = XC, where C is a k × k non-singular matrix. Thus, each column of Z is a mixture of some of the columns of X. Compare the OLS estimates and residuals from the regression of Y on X to the OLS estimates from the regression of Y on Z.

0ˆ 3. Let e be the OLS residual from a regression of Y on X = [X1 X2 ]. Find X2 e. ˆ

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

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

5. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.7). the fact that the Wi are iid and mean zero.4). 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. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.5). by Markov’s inequality (5.Proof: Without loss of generality. We say that Zn converges in distribution to Z as n → ∞. Jensen’s inequality (5. If Xi ∈ Rk is iid and E |Xi |2 < ∞.1) and (5. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. Fn (x) → F (x) as n → ∞. the triangle inequality. V ) . Theorem 5.3.1 Central Limit Theorem (CLT). as needed. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. the fact that X n = W n + Z n . Set ε = δη/3. 43 . and the bound |Wi | ≤ 2C. where Z has distribution F (x) = P (Z ≤ x) .3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .6) By Jensen’s inequality (5. P ¯X n ¯ > δ ≤ η.6) and (5.1). (5. denoted Zn →d Z. if for all x at which F (x) is continuous. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Finally. we can set E(X) = 0 (by recentering Xi on its expectation).

the independence of the Xi . By the properties of the exponential function. 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 . let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n .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. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik .8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 . the deﬁnition of c(λ) and (5. For ¡ ¢ λ ∈ Rk . By a second-order Taylor series expansion of c(λ) about λ = 0.8) where λ∗ lies on the line segment joining 0 and λ. it is suﬃcient to consider the case µ = 0 and V = Ik .

Recall that A ⊂ B implies P (A) ≤ P (B). we see that as n → ∞. This is suﬃcient to establish the theorem. Theorem 5. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. 45 . for each element of g. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.√ where λn → 0 lies on the line segment joining 0 and λ/ n.3 Delta Method: If n (θn − θ0 ) →d N (0.4. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Since cλλ (λn ) → cλλ (0) = −Ik . Hence g(Zn ) →p g(c) as n → ∞. gθ Σgθ . Stacking across elements of g. ¥ 5. then g(Zn ) →d g(Z) as n → ∞. If Zn →d Z as n → ∞ and g (·) is continuous. Proof: Since g is continuous at c. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.1 Continuous Mapping Theorem 1 (CMT). 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 . Ik ) distribution. Proof : By a vector Taylor series expansion.2 Continuous Mapping Theorem 2. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. then g(Zn ) →p g(c) as n → ∞. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. k ≤ m. Σ) .4.4 Asymptotic Transformations Theorem 5. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). and g(θ) : Rm → Rk . If Zn →p c as n → ∞ and g (·) is continuous at c. where θ is m × 1 and Σ is m × m. √ Theorem 5.4. Σ) = N 0.

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

4.3). 6.1 and the WLLN (Theorem 5. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. For a complete argument. Assumption 3. we will use the methods of asymptotic approximation.5. Equation (4.2 Consistency ˆ As discussed in Section 6.1).1). and the continuous mapping theorem (Theorem 5. the OLS estimator β is has a statistical distribution which is unknown. (6. As the sample size increases the density becomes more concentrated about the population coeﬃcient. Hence by the continuous mapping theorem (Theorem 5.1 by the fact that the sampling densities become more concentrated as n gets larger. First. β →p β as n → ∞. (6. Proof.1).1 Under Assumption 3.1. Assumption 3. ·) is continuous at (Q.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. xi ei →p g (Q.5. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. To characterize the sampling distribution more fully. we can conclude ˆ that β →p β.2.1.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . This is illustrated in Figure 6. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.2. 0).1).2) i i n i=1 n From (6. (6. using (6. Ã n ! n X 1X 0 1 ˆ xi xi .2).4.3) Ã where g(A.5.1. ˆ Theorem 6. ˆ 47 .1) and ˆ We now deduce the consistency of β. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. we 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 . n i=1 (6.4 implies that Q−1 exists and thus g(·. 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.

it follows that s2 = ¥ n σ 2 →p σ 2 . since n/(n − k) → 1 as n → ∞.3) and Theorem (6.5.1 In addition to Assumption 3.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. To see this. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . n 1 X √ xi ei →d N (0.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6.2 Under Assumption 3.2). i i Assumption 6. ˆ Finally. E ¯ei ¯ E ¯e4 ¯ i i i i (6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. 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 . (6. by the Cauchy-Schwarz inequality (5.1 guarantees that the elements of Ω are ﬁnite. (6.2.3. Ee4 < ∞ and E |xi |4 < ∞.Theorem 6.3. By the central limit theorem (Theorem 5.1). We need a strengthening of the moment conditions.6) n i=1 48 . Assumption 6.5. (6.1.1. Ω) .3.1).2). ˆ Proof. ˆ n−k 6. Thus σ 2 is consistent for σ 2 .2. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.

Let yi = β 0 + β 1 xi + εi where xi is N (0.7) is true or false.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. xi ) which satisfy the conditions of Assumption 6. is approximately normal when the sample size n is suﬃciently large. setting n = 100 and varying the parameter α. We illustrate this problem using a simulation. however.1. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. (6. and (6.7) is true then V = V 0 . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. However.3.1). V ) where V = Q−1 ΩQ−1 . How large should n be in order for the approximation to be useful? Unfortunately. 1 X √ xi ei n i=1 n ! the N (0.Then using (6. This holds true for all joint distibutions of (yi . The asymptotic distribution ´ Theorem 6. The expression V = Q−1 ΩQ−1 is called a sandwich form. There is a special case where Ω and V simplify. but this is not a necessary condition.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β .2). there is no simple answer to this reasonable question. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. V is often referred to as ˆ the asymptotic covariance matrix of β. When (6. In´Figure 6. The approximation may be poor when n is small. The trouble is that no matter how large is the sample size.6). Theorem 6. Q−1 ΩQ−1 .7) holds. Ω) ¡ ¢ = N 0.3.9) we deﬁne V 0 = Q−1 σ 2 whether (6. 1).7) Cov(xi x0 . its variance diverges q ³ ´ ˆ to inﬁnity.1 states that the sampling distribution of the least-squares estimator.1 Under Assumption 6. after rescaling. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . Under (6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . For α 49 .9) In (6. for example. when xi and ei are independent.3. 1) asymptotic distibution. As α approaches 2. We call V 0 the homoskedastic covariance matrix. otherwise V 6= V 0 . |ε| ≥ 1.1. e2 ) = 0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .3.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. We say that ei is a Homoskedastic Projection Error when (6. i i Condition (6. In Figure 6.3.

3. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . Another example is shown in Figure 6. As k increases. 6. 4. As α diminishes the density changes signiﬁcantly. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. we need an estimate of Ω = E xi x0 e2 .10) V 0 = Q−1 s2 .Figure 6.2: Density of Normalized OLS estimator α = 3. the sampling distribution becomes highly skewed and non-normal.0 the density is very close to the N (0.11) 50 . 6 and 8. concentrating most of the probability mass around zero.1) it is clear that V 0 →p V 0 .3 is that the N (0. 1) asymptotic approximation is never guaranteed to be accurate. We show the sampling distribution of n β 1 − β 1 setting n = 100. 1).2) and Theorem 6.2 and 6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. 1) density.2. for k = 1. The lesson from Figures 6.10) without changing this result.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. The estimator 2 2 in (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.

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

It is also important to understand that a particular standard error may be relevant under one set of model assumptions. we return to the log wage regression of Section 4.2/988 = .5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. (6.199 2.14 14.020. We calculate that s2 = 0. by Holder’s inequality (5. Ω 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.035 ¶ .20 −0.98 −0. To illustrate.14 205.480 .12) in turn.83 ¶−1 = µ 7.35/988 = .1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.6 ¶µ 1 14.085) (.30 + 0.14 205.14 14.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.085 p ˆ and that for β 1 is . From a computational standpoint. and then the square roots.80 40.20 and µ ¶ ˆ = 0.493 0.020) 6.117 Educationi . just as any other estimator.80 40.83 ¶−1 µ .1.199 2.2. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .20 = V 14.14 205. Using (6. i i i i n i=1 Second. n n i=1 52 . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. The standard errors for β 0 are 7. First. but not under another set of assumptions.493 −0. (6. from which it follows that V →p V as n → ∞.80 2.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. then take the diagonal elements. (.80 .039 and ˆ V = µ 1 14.83 −0.used by an author when studying their work.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β .480 ˆ0 = 0.5) and the WLLN (Theorem 5. p ˆ In this case the two estimates are quite similar.14 6.

They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. 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. which.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.26).13) of Efron (1982). you can show that 1 Xˆ ¯ β= β (−i) . i=1 Third.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. ¯ ¯n ¯ n i=1 so Together. From equation (3.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6. Ω →p Ω and V →p V.13) Using formula (4. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . Recall from Section 4. Using this substitution. Andrews (1991) suggested an similar estimator based on cross-validation. these establish consistency.11) with the leave-one-out estimator ei. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0.25).1 As n → ∞. 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 (6.5.−i = (1 − hi )−1 ei ˆ presented in (4. n i=1 n ˆ ˆ Theorem 6. 6. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .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 .

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

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

from which it follows that pn →d U [0. 1]. An alternative approach. 1). associated with Fisher. in that the reader is allowed to pick the level of signiﬁcance α. For example. The asymptotic p-value for the above statistic is constructed as follows. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 .025 = 1. regardless of the complication of the distribution of the original test statistic. 6.96 and z. That is. If the p-value pn is small (close to zero) then the evidence against H0 is strong. under H0 . s(ˆ θ) Under H0 . This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. if Z ∼ N (0. Either θ ∈ Cn or θ ∈ Cn .9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. 1). and is a function of the data and hence is / random. The p-value is more general. z. 56 . 1].05 = 1. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level.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 ). Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. or “accepts” H0 . is to report an asymptotic p-value. 1]. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. It is designed to cover θ with high probability. In a sense. Otherwise the test does not reject. Then the asymptotic p-value of the statistic tn is pn = p(tn ). To see this fact. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . Let zα/2 is the upper α/2 quantile of the standard normal distribution.645. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . pn →d U [0. That is. tn →d N (0. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. however. Deﬁne the tail probability. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x).

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

˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . 1] under H0 . Hβ (β) →p Hβ .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 . Hβ (β) is a continuous function of β.1 Under H0 and Assumption 6. the test rejects at the α% level iﬀ pn < α. the upper-α quantile q 2 of the χ2 distribution. 6. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . if rank(Hβ ) = q. h(β) = R0 β. Also h(β) = a selector matrix.84 = z. For example.05) = 3. ˜˜ n ˜ e = Y − X1 β 1 .10. As before. a chiq square random variable with q degrees of freedom. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .025 . Furthermore. 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. and there are q = k2 restrictions.2. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. In this case. ˆ Wn = n θ θ q θ θ Theorem 6. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). χ2 (.19) σ2 ˆ where σ2 = ˜ 1 0 e e. Hence β β by Theorem A. q and pn is asymptotically U[0. θ = β 2 .When h is a linear function of β. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.8.1. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.1 showed θ ˆ that V →p V. The null hypothesis is H0 : β 2 = 0. and Theorem 6. then Wn →d χ2 . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. The asymptotic p-value for Wn is pn = p(Wn ). The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).5.3. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2. Vθ ).15) showed that n ˆ − θ →d Z ∼ N (0.

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

there is an exact distribution theory available for the normal linear regression model. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . In ) . n−k 60 . introduced in Section 4.where In many statistical packages. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. This is rarely an issue today. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. This was a popular statistic in the early days of econometric reporting. when an OLS regression is reported. including the estimated error variance 2. it follows ˆ that β is independent of any function of the OLS residuals. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . The modelling assumption that the error ei is independent of xi and N (0.3. In σ 2 . This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero.12 Normal Regression Model As an alternative to asymptotic distribution theory. equivalently the residual variance from an intercept-only model. 6. While there are special cases where this F statistic is useful.4)) where H 0 H = In . σ 2 ) can be be used to calculate a set of exact distribution results. Since uncorrelated normal variables are independent. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. these cases are atypical. an “F statistic” is reported. In particular. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0. Since linear functions of normals are also normal. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. Let u = σ −1 H 0 e ∼ N (0. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . H 0 H) ∼ N (0.

12.a chi-square distribution with n − k degrees of freedom.1 we showed that in large samples. a good testing procedure is based on the likelihood ratio statistic. The critical values are quite close if n − k ≥ 30.3. σ 2 ) = − log σ − log (2π) − . with residual variance σ . σ2 ˆ 61 .) Now let us partition β = (β 1 . β and t are approximately normally distributed. (Unless the sample size is unreasonably small.10) µ h i ¶ 2 (X 0 X)−1 N 0. β 2 . β 2 . Furthermore. and standard errors are calculated using the homoskedastic formula (6. In contrast. σ 2 ). so as a practical matter it does not matter which distribution is used. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models.1 shows that under the strong assumption of ˆ normality. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . β 2 . 0.12. σ ˆ ˆ βj − βj βj − βj N (0. Theorem 6. n−k • ∼ tn−k ˆ In Theorem 6. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ 2 ) − Ln (β 1 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. β has an exact normal distribution and t has an exact t distribution. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . 1) and tn−k distributions.1 If ei is independent of xi and distributed N(0. the notable distinction is between the N (0. if standard errors are calculated using the homoskedastic formula (6. 0.10) then ´ ³ ˆ • β ∼ N 0. σ 2 ) discussed above.1 and Theorem 6. 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. We summarize these ﬁndings Theorem 6.8. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . As inference (conﬁdence intervals) are based on the t-ratio.

This produces random draws from the sampling distribution of interest. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. In the present context of the Wald statistic. while there are other values of s for which test test statistic is insigniﬁcant.4 the Wald statistic Wn (s) as a function ˆ of s.8. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Our ﬁrst-order asymptotic theory is not useful to help pick s. This is an unfortunate feature of the Wald statistic. the statistic Wn (s) varies with s. Take the model yi = β + ei ei ∼ N (0. 6.7. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . σ 2 ) and consider the hypothesis H0 : β = 1. features of this distribution can be calculated. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. Letting h(β) = β s .84 — the probability of a false rejection. setting n/σ 2 = 10. Through repetition. as Wn (s) →d χ2 under H0 for 1 any s. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. To demonstrate this eﬀect. 62 . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. ˆ Let β and σ 2 be the sample mean and variance of yi . This can be seen by a simple example introduced by Lafontaine and White (1986). one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. and noting Hβ = sβ s−1 . The increasing solid line is for the case β = 0. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . we have plotted in Figure 6.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . The decreasing dashed ˆ = 1. they can work quite poorly when the restrictions are nonlinear.

When comparing statistical procedures. remember that the ideal Type I error probability is 5% (. and σ is varied among 1 and 3. and rarely fall outside of the 3%-8% range.000 random samples. Given the simplicity of the model.4. To interpret the table. In each case. Table 4.1 you can also see the impact of variation in sample size. These probabilities are calculated as the percentage of the 50. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.Figure 6. Type I error rates between 3% and 8% are considered reasonable. The null hypothesis β s = 1 is true. the only test which meets this criterion is the conventional Wn = Wn (1) test.000 simulated Wald statistics Wn (s) which are larger than 3. the Type I error probability improves towards 5% as the sample size n increases. looking for tests for which rate rejection rates are close to 5%.1 reports the simulation estimate of the Type I error probability from 50. Rates above 20% are unexceptable. Typically.4: Wald Statistic as a function of s P (Wn (s) > 3.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.05) with deviations indicating+ distortion. Table 4. so these probabilities are Type I error. 100 and 500.1 we report the results of a Monte Carlo simulation where we vary these three parameters. this probability depends only on s. In Table 4. and σ 2 . we compare the rates row by row. n is varied among 20.84.84 | β = 1) . There is. Any other choice of s leads to a test with unacceptable Type I error probabilities. no magic choice of n for which all tests perform uniformly well. In Table 2. Test performance deteriorates as s increases. Error rates avove 10% are considered excessive. however. The value of s is varied from 1 to 10. For this particular example. n.

20 .15 .13 .28 .33 .25 .15 .16 Rejection frequencies from 50.17 .05 .07 .24 .13 .08 .20 .08 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . While this is clear in this particular example.18 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.11 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.34 .35 . Equivalently.22 .06 .23 .21 .07 .06 .25 .08 .06 .06 .05 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .07 . β 1 .31 .05 .19 .09 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .20). An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.26 .30 . so the hypothesis can be stated as H0 : θ = r.14 . Other choices are arbitrary and would not be used in practice.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 .06 .10 .15 . This point can be illustrated through another example. ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .05 . β 2 ) be the least-squares estimates of (6.12 .10 .22 .15 .08 .05 . deﬁne θ = β 1 /β 2 . 64 .07 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.06 .14 .06 .13 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.08 .12 .05 .07 .06 .10 .

26 .05 . the rejection rates for the t1n statistic diverge greatly from this value. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. 65 .06 .14 Monte Carlo Simulation In the previous section we introduced the method of Monte Carlo simulation to illustrate the small sample problems with tests of nonlinear hypotheses.75 1. σ 2 ) draw with σ = 3.2. the entries in the table should be 0.05 . and normalize β 0 = 0 and β 1 = 1.05 . this formulation should be used. and 1. if the hypothesis can be expressed as a linear restriction on the model parameters.645) are close to zero in most cases. We let x1i and x2i be mutually independent N (0.06 .05 β2 .06 .00 .50 . In this section we describe the method in more detail.05 .0 and n among 100 and 500.00 . .06 .12 . such as the GMM distance statistic which will be presented in Section 9.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.05 .28 .06 .645) and P (tn > 1.00 The one-sided Type I error probabilities P (tn < −1. especially for small values of β 2 .00 .000 simulated samples.00 .7. If no linear formulation is feasible. We vary β 2 among .00 .645) P (tn > 1.25. Ideally. and alternatives to asymptotic critical values should be considered. and are close to the ideal 5% rate for both sample sizes.10 .00 .645) greatly exceed 5%.47 . 1) variables.00 . while the right tail probabilities P (t1n > 1.05 . However. In contrast.10 . then the “most linear” formulation should be selected.15 .10 . Table 4. 6.00 .15 .00 . It is also prudent to consider alternative tests to the Wald statistic.50.02 .05 .645) P (tn > 1.645) are calculated from 50.25 . The left tail probabilities P (t1n < −1.09 . In all cases. The results are presented in Table 4.06 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .05 .05 . The implication of Table 4.645) t1n t2n t1n t2n t1n t2n t1n t2n . ei be an independent N (0.75. This leaves β 2 as a free parameter.06 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.06 . along with sample size n. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.06 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . .07 .645) P (tn < −1.05.1.06 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . .

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

excluding military. immigrant. and . female. for a selection of choices of n and F. experience squared. As discussed above. and 90% sample quantiles of the sample {Tnb }.003.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value.022. respectively. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. The average (6. equalling 1 with probability P = E1 (Tnb ≥ 1. In practice. For the dependent variable we use the natural log of wages. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. union member.96) is iid Bernoulli. an estimator or test may perform wonderfully for some values. experience squared. it is simple to make inferences about rejection probabilities from statistical tests. Furthermore. As P is unknown. are. Hence the ³ ´ ˆ standard errors for B = 100. B. but requires more computational time. It is therefore useful to conduct a variety of experiments. and non-white. Often this is called the number of replications. potential work experience. and 5000. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. For regressors we include years of education. 6.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. Again our dependent variable is the natural log of wages. the researcher must select the number of experiments. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. In many cases. so that coeﬃcients may be interpreted as semi-elasticities. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test.22/ B. if we set B = 999. then we can set s P = (. We now expand the sample all non-military wage earners. s P = . this may ˆ be approximated by replacing P with P or with an hypothesized value.15 Estimating a Wage Equation We again return to our wage equation. we included a dummy 67 . the choice of B is often guided by the computational demands of the statistical procedure.007. For example. such as the percentage estimate reported in (6. where N = (B +1)α. Quite simply. and dummy variable indicators for the following: married.05) (. potential work experience.21). B b=1 (6. female. then B will have to be increased. Generally. and estimate a multivariate regression.96) . The α% sample quantile is a number qα such that α% of the sample are less than qα .Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. We us the sample of wage earners from the March 2004 Current Population Survey. The random variable 1 (Tnb ≥ 1. the performance will depend on n and F. and poorly for others. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. immigrant. and hispanic. In particular.96) . For example. 1000. If the standard error is too large to make a reliable inference. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. and therefore it is straightforward to calculate standard errors for any quantity of interest. a larger B results in more precise estimates of the features of interest of Gn . . hispanic. Then qα is the N ’th number in this ordered sequence. We separately estimate equations for white and non-whites. therefore. It is therefore convenient to pick B so that N is an integer. and our regressors include years of education.95) /B ' . and dummy variable indicators for the following: married. union member.

49452 σ ˜ Notice that the two statistics are close.014 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. Computing the Wald statistic (6.010 . Table 4. excluding the coeﬃcients on the state dummy variables.00057 .007 .002 .808 so the parameter estimates are quite precise and reported in Table 4. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. θ ˆ 2β 3 β2 . we ﬁnd Wn = 550.070 . Wn = n 1 − 2 = 18.18) that the state coeﬃcients are jointly zero.102 −.48772 = 515.121 −.4945. Using either statistic the hypothesis is easily rejected.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.001 .34 ˆ s(β) . reestimating the model with the 50 state dummies excluded.808 . The available sample is 18.232 . Ignoring the other coeﬃcients. The F form of the Wald statistic (6.00002 . the restricted standard deviation estimate is σ = .027 .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. Alternatively.1.variable for state of residence (including the District of Columbia.101 .097 −.4877 18.013 . 2β 3 68 . 808 1 − . this adds 50 regressors).033 −. 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. but not equal. as the 1% critical value for the χ2 distribution is 76.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.69.008 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .032 .102 −.

Using the Delta Method. this is a poor choice. However. 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 ). there is not a simple expression for this set. Instead. 69 . implying a 95% conﬁdence θ) interval of [27. but the lower end is substantially lower. 29. but it can be found numerically quite easily. This set is [27. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. we found better Type I error rates by reformulating the hypothesis as a linear restriction. we can calculate a standard error of s(ˆ = .5]. In the previous section we discovered that such t-tests had very poor Type I error rates.96.5]. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. This is the set of θ such that |tn (θ)| ≤ 1. In the present context we are interested in forming a conﬁdence interval.40. not testing a hypothesis.9. 29.0. so we have to go one step further. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. Since tn (θ) is a non-linear function of θ.

the following deﬁnition is used. Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix. show that the least-squares estimate of β = (β 1 . then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. show that the least-squares estimate of β = (β 1 . 0 < s < k. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. the least-squares estimate of β subject to the restriction h(β) = 0 is ˜ β = argmin Sn (β) h(β)=0 Sn (β) = (Y − Xβ)0 (Y − Xβ) . 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 . (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. In the model Y = X1 β 1 + X2 β 2 + e. β 2 ). ﬁnd the least-squares estimate of β = (β 1 . β 2 ). subject to the constraint that β 1 = −β 2 . (c) Show that if R0 β = r is true. (d) Under the ´ standard assumptions plus R0 β = r. and rank(R) = s. ˜ (b) Verify that R0 β = r. In the model Y = X1 β 1 + X2 β 2 + e. β − β = Ik − X 0 X 70 . 2. ˜ That is.16 Exercises For exercises 1-4. r ˜ is a known s × 1 vector. ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. In the model Y = X1 β 1 + X2 β 2 + e. 4.6. λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. In the model Y = Xβ + e. 1. ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. 3. β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 .

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1 Generalized Least Squares In the projection model.2) E (ξ i | xi ) = 0. Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7.. where z1i is some q × 1 function of xi . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 .. σ 2 }. Often the functional form is kept simple for parsimony. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi . we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. .1) XD Y β = X 0 D−1 X ¡ ¢ 2 .. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . However..1) infeasible since the matrix D is unknown. σ1 We now discuss this estimation problem... Let η i = e2 . Typically. 74 .Chapter 7 Additional Regression Topics 7. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . 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. The GLS estimator (7. z1i are squares (and perhaps levels) of some (or all) elements of xi . . the least-squares estimator is ineﬃcient.

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

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

but also under the assumptions of linear projection. the Wald test of H0 is asymptotically χ2 . In this case. on the other hand. Second.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . Motivated by the form of the asymptotic variance ˆ of the OLS estimator β.4). in which case ξ i is ˜ independent of xi and the asymptotic variance (7. Typically.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. but the only diﬀerence is that they a ¢ allowed for general choice of zi . q Most tests for heteroskedasticity take this basic form. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). The GLS and FGLS estimators. its squares. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. This hypothesis does not imply that ξ i is independent of xi .2. In the linear regression model the conditional mean of yi given xi = x is 77 . The main diﬀerences between popular “tests” is which transformations of xi enter zi .7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. and this requires trimming to solve. 7. however. individual estimated conditional variances may be negative. and all cross-products.error. OLS is a more robust estimator of the parameter vector. It is consistent not only in the regression model. or equivalently that i H0 : α1 = 0 in the regression (7. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . Third. Theorem 7. If the equation of interest is a linear projection. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.7) under independence show that this test has an asymptotic chi-square distribution. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . and not a conditional mean.4) and constructing a Wald statistic. σ 2 ).5) and the asymptotic variance (7. FGLS will do worse than OLS in practice. This introduces an element of arbitrariness which is unsettling to empirical researchers. as they will be estimating two diﬀerent projections. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. require the assumption of a correct conditional mean.1 Under H0 and ei independent of xi .2). Vα = E zi zi (7. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. The asymptotic distribution (7.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . the two tests coincide. and the cost is a reduction of robustness to misspeciﬁcatio 7. the estimated conditional variances may contain more noise than information about the true conditional variances. We may therefore test this hypothesis by the estimation (7.

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

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

θi Thus ¡ ¢ yi − m(xi . This renders the distribution theory presented in the previous section invalid. under H0 . The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. the parameter estimates are not asymptotically normally distributed. 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 . θ0 )) − m(xi .For θ close to the true value θ0 . the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. 1 2 The model is linear when β 2 = 0. ˆ ˆ θ) ˆ θ). Furthermore.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 .4. θ which is that stated in the theorem. We have discussed projections and conditional means. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. m(xi . θ) = β 0 zi + β 0 xi (γ). Thus when the truth is that β 2 = 0.1. tests of H0 do not have asymptotic normal or chi-square distributions. θ) ' m(xi . but these are not the only measures of central tendency. θ) ' (ei + m(xi . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ0 ) + m0 (θ − θ0 ) . Hansen (1996). 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. However. and this is often a useful hypothesis (sub-model) to consider. An alternative good measure is the conditional median. 7. Suppose that m(xi . In particular. Thus we want to test H0 : β 2 = 0. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . ¥ Based on Theorem 7. ˆ and ei = yi − m(xi . γ is not identiﬁed. by a ﬁrst-order Taylor series approximation. 80 . This means that under H0 .

it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. The second is the value which minimizes n n |yi − θ| . The ﬁrst deﬁnition is the 50th empirical 1 P quantile. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. These distinctions are illusory. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. and the substantive assumption is that the median function is linear in x. let Y be a continuous random variable. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model.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. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = .10) The LAD estimator has the asymptotic distribution 81 . Two useful facts about the median are that (7. Now let’s consider the conditional median of Y given a random variable X. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently.To recall the deﬁnition and properties of the median. as i=1 these estimators are indeed identical. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. however. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . i n n i=1 (7.9) 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. These facts deﬁnitions motivate three estimators of θ.5.

ˆ Proof of Theorem 7. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .5. by a Taylor series expansion and the fact g(β 0 ) = 0 82 .11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.1 is advanced. we provide a sketch here for completeness. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.11). 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 ) . the height of the error density at its median. In the special case where the error is independent of xi . the conditional density of the error at its median. First. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. When f (0 | x) is large.5.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . where V = and f (e | x) is the conditional density of ei given xi = x. ¢¢−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) . See Chapter 16.5. Let g(β) = Eg (β).3. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . ∂β 0 so Third.Theorem 7. V ). Computation of standard error for LAD estimates typically is based on equation (7. Pn −1 0 β)) . While a complete proof of Theorem 7. This can be done with kernel estimation techniques. and this improves estimation of the median.1 ´ √ ³ˆ n β − β 0 →d N (0. The main diﬃculty is the estimation of f (0). by the central limit theorem (Theorm 5. (7.10) is equivalent to g n (β) = 0.

5. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . The median is the special case τ = . (7. V ). then F (Qτ ) = τ .12) Qτ = argmin Eρτ (U − θ) . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. the quantile regression functions can take any shape. 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. then F (Qτ (x) | x) = τ . so you can think of the quantile as the inverse of the distribution function. For the random variables (yi . then (7.9) for the median to all quantiles. The following alternative representation is useful. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . The third line follows from an asymptotic empirical process argument. If the random variable U has τ ’th quantile Qτ .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. Exi x0 ) →d i 2 = N (0. when F (y | x) is continuous and strictly monotonic in y. Again. For τ ∈ [0. 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)) .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. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . For ﬁxed τ . The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . As functions of x.13) This generalizes representation (7. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). ¥ 7.

7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . The null model is yi = x0 β + εi i 84 . ˆ Given the representation (7. 7. and form a Wald statistic i for γ = 0. and are widely available. the τ ’th conditional quantile of ei is zero. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. Vτ ).1 n β τ − β τ →d N (0. otherwise its properties are unspeciﬁed without further restrictions. the asymptotic variance depends on the conditional density of the quantile regression error. n numerical methods are necessary for its minimization. since it has discontinuous derivatives.5.12). fast linear programming methods have been developed for this problem. Fortunately. and test their signiﬁcance using a Wald test.6. where and f (e | x) is the conditional density of ei given xi = x. conventional Newton-type optimization methods are inappropriate. i By construction. Furthermore. ´ √ ³ˆ Theorem 7. 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. then f (0 | xi ) = f (0) .13).1. it is useful to have a general test of the adequacy of the speciﬁcation. ¡ ¡ ¢¢−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. When the error ei is independent of xi . if the model yi = x0 β + ei has i been ﬁt by OLS. Thus.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . the unconditional density of ei at 0. Another popular approach is the RESET test proposed by Ramsey (1969). 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. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7.

8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. and form the Wald statistic Wn for γ = 0. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . Q−1 σ 2 < Q11 − Q12 Q−1 Q21 11 22 85 ¡ ¡ ¢ ¢−1 2 ¡ ¢−1 2 ˆ lim nV ar(β 1 ) = Ex1i x0 − Ex1i x0 Ex2i x0 Ex2i x0 σ = Q11 − Q12 Q−1 Q21 σ . ⎟ zi = ⎝ .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. yi ˆm (7. β 2 ). or 4 seem to work best. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . 3. However. small values such as m = 2. It is particularly powerful at detecting single-index models of the form yi = G(x0 β) + εi i where G(·) is a smooth “link” function. β 1 = (X1 X1 )−1 (X1 Y ) . To see why this is the case. 1i 2i 2i 1i 22 . 7. m must be selected in advance.14) by OLS. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. Wn →d χ2 . To implement the test. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 .be an (m − 1)-vector of powers of yi . note that (7. Typically. and the two estimators have equal asymptotic eﬃciency. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. Another is to regress yi on x1i and x2i jointly. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. since Q12 Q−1 Q21 > 0. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . they will (typically) have diﬀerence asymptotic variances. It is easy (although somewhat tedious) to show that under the null hypothesis. ⎠ . Thus the null is rejected at the α% level if Wn m−1 exceeds the upper α% tail critical value of the χ2 m−1 distribution. then 22 Q11 > Q11 − Q12 Q−1 Q21 . and consequently 22 ¡ ¢−1 2 σ . yielding predicted values yi = x0 β. Otherwise. and n→∞ say. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. yielding ˆ ˜ ˆ ˆ (β 1 . lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say.

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

k A major problem with this approach is that the critical level α is indeterminate. Another problem is that if α is held ﬁxed. then this model selection procedure is inconsistent. LRn →p 0. M)) between the true density and the model density. depending on the sample size.15) then where σ 2 is the variance estimate for model m. Then select M1 if Wn ≤ cα . BIC model selection is consistent. known as the BIC. as the rule tends to overﬁt. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . 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. AIC selection is inconsistent. n (7.17) Since log(n) > 2 (if n > 8). k = While many modiﬁcations of the AIC have been proposed. That is. One popular choice is the Akaike Information Criterion (AIC). Indeed. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. If the truth is inﬁnite dimensional. In contrast to the AIC. if α is set to be a small number. since (7. Another common approach to model selection is to to a selection criterion. n (7. let cα satisfy ¢ ¡ P χ22 > cα . His criterion. and km is the number of coeﬃcients in the model. this rule only makes sense when the true model is ﬁnite dimensional. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . it is more appropriate to view model selection as determining the best ﬁnite sample approximation. etc. ¢ ¡ ˆ1 ˆ2 (7. the most popular to be one proposed by Schwarz. log(n) 87 . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . else select M2 . as ³ ´ c P M = M1 | M1 → 1 − α < 1.16) holds under M1 . else select M2 . The model selection rule is as follows.However. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. based on Bayesian arguments. since under M1 . Indeed. The rule is to select M1 if AIC1 < AIC2 . For some critical level α. 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.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 .

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

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

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

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

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

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

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

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

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

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

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

the critical value qn (α) is found as the quantile from simulated values of W´ . however. not ˆ − θ0 . Let an be a sequence. Deﬁnition 8. Basically.8. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . Deﬁnition 8. θ θ θ ˆ θ ∗ ∗ Computationally. Let Tn be a statistic such that (8.2 an = O(1) if |an | is uniformly bounded. We say that a function g(x) is even if g(−x) = g(x). and a function h(x) is odd if h(−x) = −h(x). 99 .8 Asymptotic Expansions Tn →d N (0. (8. about the rate v of convergence. Equivalently. it says nothing. Thus here Tn (θ) = Wn (θ).4) says that Gn converges to Φ x as n → ∞. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic.4) v ¡ ¢ While (8. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. C4 is called the symmetric percentile-t interval. F ) = Φ n→∞ v or ³x´ Gn (x.] 8. or the size of the divergence for any particular sample size n. an = O(n−r ) if it declines to zero like n−r .8.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . θ [This is a typical mistake made by practitioners. writing Tn ∼ Gn (x. A better asymptotic approximation may be obtained through an asymptotic expansion. F ) = Φ + o (1) .3 an = o(n−r ) if nr |an | → 0 as n → ∞. The ideal test rejects if Wn ≥ qn (α). F ) then ³x´ . and vice-versa.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. where qn (α) is the (1 − α)% quantile of the distribution of Wn .∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. If θ is a vector. The following notation will be helpful.8. The derivative of an even function is odd. lim Gn (x. 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. v 2 ).

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

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

which is not pivotal. A reader might get confused between the two simultaneous eﬀects. G∗ (x) = Gn (x. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. V ). we ﬁnd Gn (x) = Gn (x. This is in contrast to the use of the asymptotic distribution.5) to the bootstrap distribution. 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 . 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. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. is an even function.Interestingly. 8. Theorem 8. g1 . √ the last equality because Fn converges to F0 at rate n. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. F0 ) = ∗ 2 (g2 (x.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). and bootstrap tests have better rates of convergence than asymptotic tests. and g2 is continuous in F. and needs to be determined on a case-by-case basis.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. Two-sided tests have better rates of convergence than the one-sided tests. F0 )) + O(n−3/2 ) n = O(n−3/2 ). the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. Twosided tests will have more accurate size (Reported Type I error). Fn ) + O(n−3/2 ). F ) = Φ v √ where v = V . We know that θ Tn →d N (0. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. and for the bootstrap ³x´ + O(n−1/2 ). This is because the ﬁrst term in the asymptotic expansion. Therefore. Fn ) − g2 (x. Applying (8.8. set Tn = n ˆ − θ0 . Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of 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 ). but one-sided tests might have more power against alternatives of interest. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. similar to a one-sided test. meaning that the errors in the two directions exactly cancel out. as it depends on the unknown V. Fn ) = Φ(x) + ∗ 2 g2 (x. whose error is O(n−1 ). Gn (x.

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

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

The dataﬁle hprice1.3. and the 2. You replace c with qn (. Using the non-parametric bootstrap. size of house. ˆ − s(ˆ n (. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. The ˆ are sorted.95). ∗ ∗ ∗ Let qn (. and the colonial dummy.95).dat contains data on house prices (sales). What is wrong with this procedure? Tn = θ/s(θ) n 6.75 and 1.05) . (b) Report the 95% Alternative Percentile interval for θ. (a) Report the 95% Efron Percentile interval for θ.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). θ respectively. You want to test H0 : θ = 0 against H1 : θ > 0. You do this as follows. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.pdf.95) denote the 95% quantile of Tn . θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. Using the non-parametric ∗ bootstrap. ∗ ∗ where s(ˆ is the standard error in the original data. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).05) and qn (. (c) With the given information.95) denote the 5% θ) ∗ and 95% quantiles of Tn .2. and thus reject H0 if ˆ ˆ > q ∗ (. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.2 and s(ˆ = . you generate bootstrap samples. 105 . can you report the 95% Percentile-t interval for θ? 7. with variables listed in the ﬁle hprice1.5% quantiles of the ˆ are . Suppose that in an application. Let qn (. lot size.5% and 97.95). Estimate a linear regression of price on the number of bedrooms. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. ˆ = 1. and ˆ is calculated on each θ ∗ ∗ θ sample.

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

ˆ Deﬁnition 9. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. the dependence is only up to scale.9. For example. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . 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.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . the square of the Euclidean length. The GMM estimator minimizes Jn (β). then. Let and where gi = xi ei .3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. This is a non-negative measure of the “length” of the vector g n (β). For some × weight matrix Wn > 0. if Wn = I.2. ¡ ¢−1 0 ˆ Z XWn X 0 Y. for if Wn is replaced ˆ by cWn for some c > 0. β ˆ Note that if k = . then g n (β) = 0. Proposition 9. β GMM does not change. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .1 β GMM = argmin Jn (β).2) g n (β) = (9. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. and the GMM estimator is the MME. but this is generally not possible when > k. i i .2.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . β GMM = Z 0 XWn X 0 Z 9. let Jn (β) = n · g n (β)0 Wn g n (β).

However. For example. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. without imposing additional assumptions. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. For any Wn →p W0 . β). ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. ˆ n i=1 gi = gi − g n . as we are only considering alternative weight matrices Wn . Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. n n We conclude: Theorem 9. V ) . ˆ∗ ˆ 108 . it is semiparametrically eﬃcient. it turns out that the GMM estimator is semiparametrically eﬃcient. Ω) . Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. n β − β →d N 0.2 For the eﬃcient GMM estimator. This turns out to be W0 = Ω−1 . Chamberlain showed that in this context. a better choice is Wn = (X 0 X)−1 . this is a semi-parametric problem.1 ´ √ ³ˆ n β − β →d N (0. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. The proof is left as an exercise. as the distribution of the data is unknown. 9. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . and this is all that is known. as it has the same asymptotic distribution. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . as shown by Gary Chamberlain (1987). the GMM estimator β is consistent yet ineﬃcient. W0 = Ω−1 is not known in practice.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . This results shows that in the linear model. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . No estimator can do better (in this ﬁrst-order asymptotic sense).3. we can set Wn = I . If it is known that E (gi (β)) = 0. This is a weak concept of optimality. where In general. ˆ Construct n 1X ˆ g n = g n (β) = gi . but it can be estimated consistently.3. In the linear model. The optimal weight matrix W0 is one which minimizes V. 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. ˆ we still call β the eﬃcient GMM estimator.

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

Under the hypothesis of correct speciﬁcation. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. The general theory of GMM estimation and testing was exposited by L. For example. ˆˆ n is a quadratic form in g n .6. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). ˆ J = J(β) →d χ2−k . Hansen (1982).1 (Sargan-Hansen).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. this is all that is known. Note that g n →p Egi . Identiﬁcation requires l ≥ k = dim(β). and is thus a natural test statistic for H0 : Egi = 0.5.1 Under general regularity conditions. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . 1 it is possible that β 2 6= 0. 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. 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). However. The criterion function at the parameter estimates is J = n g 0 Wn g n n ¡ ¢−1 2 0 = n g n g 0 g − ng n g 0 gn . 110 . 9. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. 1 2 It is possible that β 2 = 0. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. perhaps obtained by ﬁrst ˆ setting Wn = I. This estimator can be iterated if needed. n β − β →d N 0. Since the GMM estimator depends upon the ﬁrst-stage estimator. often the weight ˆ matrix Wn is updated. G0 Ω−1 G . so that the linear equation may be written as yi = β 0 x1i + ei . Thus the model — the overidentifying restrictions — are testable. β) = 0 holds. 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. Theorem 9. and then β recomputed.

and some current research suggests that this restriction is not necessary for good performance of the test. 1. When over-identiﬁed models are estimated by GMM. the Wald statistic can work quite poorly. Proposition 9.7. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β).7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. then D equals the Wald statistic. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). D →d χ2 r 3. and it is advisable to report the statistic J whenever GMM is the estimation method. The idea was ﬁrst put forward by Newey and West (1987). This result was established by Sargan (1958) for a specialized case. If the hypothesis is non-linear. This is sometimes called the GMM Distance statistic. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. Based on this information alone. however. current evidence suggests that the D statistic appears to have quite good sampling properties. 9.1 If the same weight matrix Wn is used for both null and alternative. D ≥ 0 2. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . we can reject the model. as this ensures that D ≥ 0. If h is non-linear. For a given weight matrix Wn . and is the preferred test statistic. it is customary to report the J statistic as a general test of model adequacy. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). In contrast. This reasoning is not compelling.The proof of the theorem is left as an exercise. and by L. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). it is unclear what is wrong. 111 . If the statistic J exceeds the chi-square critical value. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. the hypothesis is H0 : h(β) = 0. Hansen (1982) for the general case. If h is linear in β. These may be used to construct Wald tests of statistical hypotheses. but it is typically cause for concern. a better approach is to directly use the GMM criterion function. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology.

Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β). In many cases. Given a conditional moment restriction. Then ei (β) = yi − zi β.. How is k to be determined? This is an area of theory still under development. s = 1. in linear regression. and then use the ﬁrst k instruments. note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi .. while in a nonlinear i regression model ei (β) = yi − g(xi . i Ai = −σ −2 Ri i . then xi . the model implies more than an unconditional moment restriction of the form Egi (β) = 0. The form was uncovered by Chamberlain (1987).8 Conditional Moment Restrictions In many contexts. Another approach is to construct the optimal instrument. For example. . an unconditional moment restriction can always be constructed. The obvious problem is that the class of functions φ is inﬁnite. than the unconditional moment restriction discussed above. 0 Our linear model yi = zi β + ei with instruments xi falls into this class under the stronger 0 assumption E (ei | xi ) = 0. It is also helpful to realize that conventional regression models also fall into this class.. we can set gi (β) = φ(xi . It implies a conditional moment restriction of the form E (ei (β) | xi ) = 0 where ei (β) is some s × 1 function of the observation and the parameters.. In practice. except that in this case zi = xi . etc. β)ei (β) which satisﬁes Egi (β) = 0 and hence deﬁnes a GMM estimator. A recent study of this problem is Donald and Newey (2001). are all valid instruments. and restrictive. Which should be used? i i One solution is to construct an inﬁnite list of potent instruments. ei (β. 0 In the linear model ei (β) = yi − zi β. β). It turns out that this conditional moment restriction is much more powerful. β). so is just-identiﬁed) yields the best GMM estimator possible. In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i . ei (β) = yi − x0 β. x2 . but its form does help us think about construction of optimal instruments. x3 . Ai is unknown. Which should be selected? This is equivalent to the problem of selection of the best instruments. If xi is a valid instrument satisfying E (ei | xi ) = 0. Setting gi (β) to be this choice (which is k × 1. That is for any × 1 function φ(xi . γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2.9. Take the case s = 1.

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

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

λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. xi . λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1.6) (a) Show that you can rewrite Jn (β) in (9. The equation of interest is yi = g(xi . h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). zi is l × 1 and β is k × 1. h(β)=0 (9. 115 . 6. VR = V − V R R0 V R (d) Show that in this setting. 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 . VR ) where ¡ ¢−1 0 R V.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . is deﬁned as Jn (β) = ˜ β = argmin Jn (β). Vn = X X i=1 ˜ and hence R0 β = r. In the linear model Y = Xβ + e with E(xi 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. the distance statistic D in (9. β) + ei E (zi ei ) = 0. The GMM estimator of β. Show how to construct an eﬃcient GMM estimator for β. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . l ≥ k. Deﬁne the Lagrangian L(β. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9.5.6) equals the Wald statistic. zi ). The observed data is (yi . subject ˆ i ˆi i=1 to the restriction h(β) = 0.

Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0. ˆ and consider the GMM estimator β of β. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. 116 . 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 . Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions.7.. Deﬁne ¶µ ¶−1 µ 1 0 ˆ −1 1 0 1 0 ˆ −1 0−1 0 1 0 XZ Z XΩ XZ Z XΩ C Dn = Il − C n n n n 1 0 Xe g n (β 0 ) = n ¡ ¢ 0 R = C 0 E xi zi Show that Jn →d χ2 as n → ∞ by demonstrating each of the following: l−k (a) Since Ω > 0.

pn ) = i=1 An alternative to GMM is empirical likelihood. (10. zi . Combined with i the constraint (10. To be a valid multinomial distribution... β).1). these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. .. pn ) are those which maximize the log-likelihood subject to the constraint (10.2) Ln (p1 . This is equivalent to maximizing Ã n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier. The multinomial distribution which places probability pi at each observation (yi .. pn ) which places probability pi at each observation.1 Non-Parametric Likelihood Since each observation is observed once in the sample. The maximum likelihood estimator of the probabilities (p1 . In this case the moment condition places no additional restrictions on the multinomial distribution. xi .. (10. The idea is due to Art Owen (1988. . xi . zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (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 ... the log-likelihood function for this multinomial distribution is n X ln(pi ). The n ﬁrst order conditions are 0 = p−1 − µ.3) i=1 117 . The idea is to construct a multinomial distribution F (p1 .Chapter 10 Empirical Likelihood 10..1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n)..1) i=1 First let us consider a just-identiﬁed model. It is a non-parametric analog of likelihood estimation. 2001) and has been extended to moment condition models by Qin and Lawless (1994). .

λ). λ) : λ(β) = argmin Rn (β. Multiplying the ﬁrst equation by pi . summing over i.. µ.5) This minimization problem is the dual of the constrained maximization problem. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. p (10. pn .. λ. p1 . pi gi (β) = 0. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . we ﬁnd µ = n and 1 ¢. λ) = −n ln (n) − n X i=1 For given β.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. This yields the (proﬁle) empirical log-likelihood function for β.where λ and µ are Lagrange multipliers.2) subject to the restrictions (10.4) (10. probabilities 1 ³ ´´ . (see section 6. Ln (β) = Rn (β. 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. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β).5). or equivalently minimizes its negative ˆ (10. (10. λ) is a convex function of λ.7) 118 . and using the second and third equations. the Lagrange multiplier λ(β) minimizes Rn (β. .1) and (10.. we also obtain the Lagrange multiplier λ = λ(β). pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β.3). λ ¡ ¢ ln 1 + λ0 gi (β) . The solution (when it exists) is well deﬁned since Rn (β.5) ˆ ˆ As a by-product of estimation. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . The solution cannot be obtained explicitly. but must be obtained numerically (see section 6.

2. in the linear model. i i Theorem 10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . G = −E (xi zi ). g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . 0 = Rn (β. i=1 i=1 i=1i Expanding (10. β) = −xi zi . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.10) ¡ Ω−1 N (0. λ) = − (10. Gi (. and Ω = E xi x0 e2 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. Thus the EL estimator is asymptotically eﬃcient. and n β − β 0 and nλ are asymptotically independent. 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 (10.10.13) yields n n Expanding (10. n (10.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. λ) = − (10.8) and ¢ 0 0 For example.9) and (10.10). (β.9) (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. β λ ∂ ³ ´.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . ˆ ˆ Proof.13) Premultiplying by G0 Ω−1 and using (10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.1 Under regularity conditions.

16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. LRn = i=1 Theorem 10.3. it is an asymptotically eﬃcient estimator for β.17) 2 ln 1 + λ gi β . and have the same interpretation. 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. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. First.7) is n ³ ´´ ³ X ˆ ˆ0 (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.3 Overidentifying Restrictions In a parametric likelihood context. Ω) GΩ G →d = N (0. by a Taylor expansion. and (10. They are asymptotically ﬁrst-order equivalent. 120 . 10. The same statistic can be constructed for empirical likelihood. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. tests are based on the diﬀerence in the log likelihood functions. Since the EL estimator achieves this bound. β 0 ) = 0 then LRn →d χ2−k .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. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Proof. The overidentiﬁcation test is a very useful by-product of EL estimation.1 If Eg(wi .14) for λ and using (10.15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0. Vλ ) Furthermore. V ) ˆ Solving (10. and it is advisable to report the statistic LRn whenever EL is the estimation method. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.16). n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .15) (10. (10.15).

17) is not appropriate.1 Under (10.18). 10. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.4. This test statistic is a natural analog of the GMM distance statistic. To test the hypothesis h(β) while maintaining (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). Theorem 10.4 Testing Egi (β) = 0 (10.18) Let the maintained model be where g is × 1 and β is k × 1. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . LRn →d χ2 . By “maintained” we mean that the overidentfying restrictions contained in (10. a The proof of this result is more challenging and is omitted. The hypothesis of interest is h(β) = 0. the simple overidentifying restrictions test (10.Second. since ln(1 + x) ' x − x2 /2 for x small. where h : Rk → Ra . h(β)=0 ˜ Fundamentally.18) and H0 : h(β) = 0.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.edu/~bhansen/progs/elike. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).prc 121 . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. 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. 10.wisc. so there is no fundamental change in the distribution theory for β relative to β. Vλ )0 Ω−1 N (0.ssc.

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

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

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

z1i is an instrumental variable for (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. That is x2i are variables which could be included in the equation for yi (in the sense 125 . By the above deﬁnition. Deﬁnition 11. 11. so should be included in xi .1) where zi is k × 1. We call z1i exogenous and z2i endogenous. Thus we make the partition ¶ µ k1 z1i (11. at least the intercept).1) if E (xi ei ) = 0. (11. In matrix notation.1). So we have the partition µ ¶ z1i k1 (11. and x2i are the excluded exogenous variables. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. β →p β ∗ . this can be written as Y = Zβ + e.1) the structural equation. some regressors in zi will be uncorrelated with ei (for example. We call (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ .1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.1.1 The × 1 random vector xi is an instrumental variable for (11. which does not equal either β 1 or β 2 .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. and assume that E(zi ei ) 6= 0 so there is endogeneity. This is called simultaneous equations bias. In a typical set-up.

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

In our notation. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. 129 . Here we present a simpliﬁed version of one of his results. ¶ 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 ) . let’s analyze the approximate bias of OLS applied to (11.11) (11. Z = [Z1 . Z2 = [PX Z1 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . First. 11. PX Z2 ] = [Z1 .12). X is n × l so there are l instruments.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator.13) which is zero only when S21 = 0 (when Z is exogenous). PX Z2 ] h i ˆ = Z1 . Then i h ˆ ˆ ˆ Z = Z1 . Recall. X2 ].11). Z2 ] and X = [Z1 . we regress Y on Z1 and Z2 . Using (11. Hence by a ﬁrst-order approximation i µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ OLS − β E β ZZ Ze ≈ E E n n ¡ ¢−1 = Γ0 QΓ + S22 S21 (11.12) Z = XΓ + u ξ = (e. We now derive a similar result for the 2SLS estimator. Thus in the second stage. the model is Y = Zβ + e (11.ˆ It is useful to scrutinize the projection Z. ˆ since Z1 lies in the span of X. Z2 .

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

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

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

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

a dummy indicating that the observation lives near a 4-year college. There are 2215 observations with 19 variables. Report estimates and standard errors.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). and then calculate the GMM estimator from this weight matrix without further iteration. Report the estimates and standard errors. Estimate the model by 2SLS. (b) Now treat Education as endogenous. (d) Re-estimate the model by eﬃcient GMM. of the mother). I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. (a) Estimate the model by OLS. using zi as an instrument for xi .pdf. and the remaining variables as exogenous. using the instrument near4. f atheduc (the education. 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. are the parameters identiﬁed? 8. in years.. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. 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. (e) Calculate and report the J statistic for overidentiﬁcation. listed in card. Report estimates and standard errors.(b) Deﬁne the 2SLS estimator of β. (f) Discuss your ﬁndings. and South and Black are regional and racial dummy variables. The data ﬁle card. In this model. in years. Does this diﬀer from 2SLS and/or OLS? 7. 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). 134 . (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).

Deﬁnition 12. A stationary time series is ergodic if γ(k) → 0 as k → ∞. .Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. Deﬁnition 12. Because of the sequential nature of time series. we adopt new notation.1 If Yt is strictly stationary and ergodic and Xt = f (Yt ... The primary model for multivariate time series is vector autoregressions (VARs). Yt−k ) = γ(k) is independent of t for all k.1. so classical assumptions are not valid. we expect that Yt and Yt−1 are not independent... Yt−1 . and use the subscript t to denote the individual observation. T . There proofs are rather diﬃcult. Deﬁnition 12. 12. and T to denote the number of observations. Yt−k ) is independent of t for all k. and Cov (Yt . 135 . Yt−k ) is the autocorrelation function. To indicate the dependence on time. and multivariate (yt ∈ Rm is vector-valued). .. however.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .. γ(k) is called the autocovariance function.1.4 (loose). Theorem 12.) is a random variable.1. The following two theorems are essential to the analysis of stationary time series.1. The primary model for univariate time series is autoregressions (ARs).1 Stationarity and Ergodicity Deﬁnition 12. We can separate time series into two categories: univariate (yt ∈ R is scalar).1. t = 1. .. then Xt is strictly stationary and ergodic..2 {Yt } is strictly stationary if the joint distribution of (Yt .1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.

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

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

since ρ(z) = 0 when z = 1/ρ.1.3. 12. Lk Yt = Yt−k .1 The lag operator L satisﬁes LYt = Yt−1 . We call ρ(L) the autoregressive polynomial of Yt .3. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .4. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Deﬁnition 12.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . We say that the root of the polynomial is 1/ρ. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. 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). we see that L2 Yt = LYt−1 = Yt−2 . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. From Theorem 12. an AR(1) is stationary iﬀ |ρ| < 1. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . In general. We call ρ(L) the autoregressive polynomial of Yt . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . Deﬁning L2 = LL. 138 . ∞ X k=0 ρ2k V ar (et−k ) = 12.Theorem 12. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . The AR(k) model is Using the lag operator. the above results are unchanged.

t Yt−k ¢0 ρk . The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12.1) Theorem 12.5. “has a unit root”. This is a special case of non-stationarity. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.6.1) and the continuous mapping theorem.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. and hence Yt . then ˆ β →p β as T → ∞. and by Theorem 12. . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. For an AR(k).” If one of the roots equals 1. One way of stating this is that “All roots lie outside the unit circle. it is helpful to deﬁne the process ut = xt et . T ¢ ¡ 1X xt x0 →p E xt x0 = Q.. it is also strictly stationary and ergodic.. and is of great interest in applied time series. The vector xt is strictly stationary and ergodic. t T t=1 T t=1 139 . t t T t=1 ¥ Combined with (12. β = X 0X (12.1. which satisfy ρ(λj ) = 0. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. By Theorem 12.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. Let |λ| denote the modulus of a complex number λ.1. Note that ut is a MDS.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. Proof. we say that ρ(L).1. λk are the complex roots of ρ(z). Thus t by the Ergodic Theorem. so is xt x0 .. the requirement is that all roots are larger than one.1.where the λ1 . Theorem 12. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.

we constructed the bootstrap sample by randomly resampling from the data values {yt . 140 . t This construction imposes homoskedasticity on the errors e∗ . 12. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. we can apply Theorem 12. this cannot work in a time-series application. eT }.7 Asymptotic Distribution Theorem 12. T t=1 Since xt et is a MDS. Brieﬂy. Ω) .1 MDS CLT.8 Bootstrap for Autoregressions In the non-parametric bootstrap. T t=1 where Ω = E(xt x0 e2 ).2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. then as T → ∞. Fix an initial condition (Y−k+1 . Divide the sample into T /m blocks of length m.1 to see that T 1 X √ xt et →d N (0.. Q−1 ΩQ−1 . T 1 X √ ut →d N (0. which may be diﬀerent than the i properties of the actual ei .. as this imposes inappropriate independence. Method 1: Model-Based (Parametric) Bootstrap. Method 2: Block Resampling 1. It also presumes that the AR(k) structure is the truth.12. t t Theorem 12.. e ˆ 3. xt }.. t then as T → ∞. ˆ 2.7. . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . 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∗ . Clearly. ˆ 1. The implication is that asymptotic inference is the same.7.7. . i 4. Y−k+2 . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. the asymptotic covariance matrix is estimated just as in the cross-section case. This creates an iid bootstrap sample. Ω) .. Estimate β and residuals et . In particular. This is identical in form to the asymptotic distribution of OLS in cross-section regression. there are two popular methods to implement bootstrap resampling for time-series data. Y0 )..

get the ˆ ˆ residual St . and perhaps this was of relevance..9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . This procedure is sometimes called Detrending.. • First apply a seasonal diﬀerencing operator. • You can estimate (12. 3. Resample complete blocks. 12. 6. draw T /m blocks. 4. however. and then perform regression (12. If s is the number of seasons (typically s = 4 or s = 12). (12. heteroskedasticity. 141 . Thus the seasonally adjusted data is a “ﬁltered” series. Seasonal Eﬀects There are three popular methods to deal with seasonal data. The results may be sensitive to the block length. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years.3) replacing St with St . ρk ). This presumes that “seasonality” does not change over the sample. and for modelmisspeciﬁcation. This allows for arbitrary stationary serial correlation. or the season-to-season change. (12.3) sequentially by OLS. 5. ﬁrst estimate (12.4) by OLS. • You can estimate (12. That is.2. and the way that the data are partitioned into blocks. also alters the time-series correlations of the data.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . May not work well in small samples. . ∆s Yt = Yt − Yt−s . Paste the blocks together to create the bootstrap time-series Yt∗ . The series ∆s Yt is clearly free of seasonality. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.2).4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . • Use “seasonally adjusted” data.2) (12. For each simulated sample. The seasonal adjustment.. This is a ﬂexible approach which can extract a wide range of seasonal factors. • Include dummy variables for each season.2)-(12. But the long-run trend is also eliminated.

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

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

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

. Alternatively.and each of A1 through Ak are m × m matrices. Observe that A0 is m × 1. Note that since Yt is a vector.. 13. deﬁning the mk + 1 vector ⎜ Yt−1 ⎜ ⎜ xt = ⎜ Yt−2 ⎜ . we have the VAR model Yt = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k + et E (et | It−1 ) = 0.Chapter 13 Multivariate Time Series A multivariate time series Yt is a vector process m × 1.1 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 ) . Yt−k A= ¡ ⎛ 1 ⎞ ⎟ ⎟ ⎟ ⎟ ⎟ ⎠ Ak ¢ . . ⎝ . A linear VAR speciﬁes that this conditional mean is linear in the arguments: E (Yt | Yt−1 .. Deﬁning the m × 1 regression error et = Yt − E (Yt | It−1 ) ..) be all lagged information at time t... .. Let It−1 = (Yt−1 . and the m × (mk + 1) matrix A0 A1 A2 · · · 145 . Yt−2 . . this conditional expectation is also a vector. The typical goal is to ﬁnd the conditional expectation E (Yt | It−1 ) .. Yt−k ) = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k .

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

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

however. We say that Zt does not Granger-cause Yt if E (Yt | I1. Zt−1 . . then Zt may help to forecast Yt even though it does not “cause” Yt . This deﬁnition of causality was developed by Granger (1969) and Sims (1972). The latter has more information. conditional on information in lagged Yt . That is. 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.. If it is found that Zt does not Granger-cause Yt . and et (k) is the OLS residual vector from the ˆ model with k lags. The log determinant is the criterion from the multivariate normal likelihood. If Zt is some sort of forecast of the future. Yt−1 . Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0.13. The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure deﬁnition of causality. such as a futures price. 148 .t−1 ) = E (Yt | I2. 13.. In a linear VAR. This idea can be applied to blocks of variables.t−1 ) . Yt−2 . lagged Zt does not help to forecast Yt . That is. for example. the Wald statistic). If this condition does not hold. and the information set I2t is generated by both Yt and Zt . The hypothesis can be tested by using the appropriate multivariate Wald test. Zt−2 . In this equation. or an information criterion approach.6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR. Note. This may be tested using an exclusion (Wald) test. . Zt . . Deﬁne the two information sets I1t = (Yt . you may either use a testingbased approach (using. then we say that Zt Granger-causes Yt . Yt and/or Zt can be vectors.7 Granger Causality Partition the data vector into (Yt . Yt−2 . that Zt may still be useful to explain other features of 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 .. Yt−1 .) The information set I1t is generated only by the history of Yt . then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt .) I2t = (Yt . Zt ). such as the conditional variance..

of rank r. from OLS of Y1t on Y2t . a good method to estimate β. the asymptotic distribution of the test is aﬀected by the presence of the time trend. Hansen (1992). yet under H1 zt is I(0). For 0 < r < m. 13. If r = m. In some cases. Then under H0 zt is I(1). Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt .8 Cointegration The idea of cointegration is due to Granger (1981). such that zt = β 0 Yt is I(0). it may be believed that β is known a priori. The asymptotic distribution was worked out by Phillips and Ouliaris (1990).13. in general. 149 . If Yt is cointegrated with a single cointegrating vector (r = 1). Suppose that β is known. When β is unknown. as ﬁrst shown by Stock (1987). so the ADF critical values are not appropriate. The asymptotic distribution was worked out in B. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. β may not be known. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. so zt = β 0 Yt is known. it may be necessary to include a time trend in the estimated cointegrating regression. then r = 0. β is not consistent. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . In other cases. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . Thus H0 can be tested using a univariate ADF test on zt . however.8. The r vectors in β are called the cointegrating vectors. but it is useful in the construction of alternative estimators and tests. β = (1 − 1)0 . Often. Yt is I(1) and cointegrated. Thus Yt = ˆ (Y1t . and was articulated in detail by Engle and Granger (1987). Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. If Y = (log(Consumption) log(Income))0 .9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak .1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. if Yt is a pair of interest rates. If the series Yt is not cointegrated. m × r. Deﬁnition 13. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. When the data have time trends. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. Under H0 . Whether or not the time trend is included. then Yt is I(0). For example. This is not. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others.

Thus cointegration imposes a restriction upon the parameters of a VAR. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. One diﬃculty is that β is not identiﬁed without normalization. If β is unknown. they are typically called the “Johansen Max and Trace” tests. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. Their asymptotic distributions are non-standard. 1991. we typically just normalize one element to equal unity. As they were discovered by Johansen (1988. When r > 1. which is least-squares subject to the stated restriction.9. 1995). this is the MLE of the restricted parameters under the assumption that et is iid N (0.1 (Granger Representation Theorem). it is simple to test for cointegration by testing the rank of Π. Equivalently. If β is known. rank(α) = r. When r = 1. In the context of a cointegrated VAR estimated by reduced rank regression. this does not work. Ω). These tests are constructed as likelihood ratio (LR) tests. 150 . The restricted model can be written as ∆Yt = αβ 0 Yt−1 + D(L)∆Yt−1 + et ∆Yt = αzt−1 + D(L)∆Yt−1 + et . then estimation is done by “reduced rank regression”. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt .Theorem 13. and are similar to the Dickey-Fuller distributions.

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

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

2 Count Data exp (−λi ) λk i . or it may be a by-product of economic constraints.1). a typical approach is to employ Poisson regression.}. .) The observed data yi therefore come from a mixed continuous/discrete distribution. 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. 14. In surveys. incomes above a threshold are typically reported at the threshold. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. 0 if yi (This is written for the case of the threshold being zero.1) yi = ∗ <0 . The conditional density is the Poisson with parameter λi . This may be considered restrictive. the consumption level (purchases) in a particular period was zero.. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. any known value can substitute. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. σ 2 ) with the observed variable yi generated by the censoring equation (14.14. this motivates the label Poisson “regression. Thus the model is that there is some latent process yi with unbounded support. The functional form for λi has been picked to ensure that λi > 0. An example of a data collection censoring is top-coding of income. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods.. . A generalization is the negative binomial. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. The censoring process may be explicit in data collection. i i i=1 ˆ The MLE is the value β which maximizes ln (β).3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. k! = exp(x0 β). 1. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 .” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). i If Y = {0. 2. Tobin observed that for many households. 2.. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . 1..

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

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

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

This is often believed to be plausible if ui is an omitted variable. OLS appears a poor estimation choice. OLS can be improved upon via a GLS technique.. . however. t = ti . Condition (15. T . The motivation is to allow ui to be arbitrary. In either event. or unbalanced : {yit . xit } : For i = 1. it The typical maintained assumptions are that the individuals i are mutually independent.1) If this condition fails. n.Chapter 15 Panel Data A panel is a set of observations on individuals. where the i subscript denotes the individual. xit }.. 157 . and thus achieve invariance. 15.. and the t subscript denotes time. If (15. . and most applied researchers try to avoid its use. collected over time.1) is called the random eﬀects hypothesis. .. OLS of yit on xit is called pooled estimation...2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. i = 1. n. An observation is the pair {yit .. The goal is to eliminate ui from the estimator. ti . and have arbitrary correlated with xi . .. that ui and eit are independent. A panel may be balanced : {yit . It is a strong assumption.. xit } : t = 1.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . and that eit is uncorrelated with xit . 15. that eit is iid across individuals and time. There are several derivations of the estimator..1) is true. It is consistent if E (xit ui ) = 0 (15. then OLS is inconsistent.. (15.1 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 ..

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

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

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

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

ˆ the greater the bias. The sharper the derivative. 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) . Intuitively.16. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 .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. the estimator f (x) smooths data local to Xi = x. so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. The last expression shows that the expected value is an average of f (z) locally about x. so is estimating a smoothed version of f (x). Since it is an average of iid random variables. which is valid as h → 0. Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . nh (x)2 dx is called the roughness of K. This integral (typically) is not analytically solvable. 162 . ˆ We now examine the variance of f (x). The bias results from this smoothing. 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). and is larger the greater the curvature in f (x).

(16. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. h must tend to zero. but at a slower rate than n−1 .Together. Their K values for the three functions introduced in the previous section are given here.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . We thus say that the optimal bandwidth is of order O(n−1/5 ).2) depends on R(K). we need h → 0 but nh → ∞. but not of n. 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) . R∞ R∞ K σ 2 = −∞ x2 K (x) dx R(K) = −∞ K (x)2 dx K √ Gaussian 1 1/(2 π) Epanechnikov 1/5 1/5 Biweight 1/7 5/7 An obvious diﬃculty is that R(f 00 ) is unknown. The asymptotically optimal choice given in (16. but at a very slow rate. This choice for h gives an optimal rule when f (x) is ˆ normal. (16.1) is an asymptotic approximation to the MSE. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. how should the bandwidth be selected? This is a diﬃcult problem. Note that this h declines to zero. the rule-of-thumb h can be quite ineﬃcient. AM SEh (x) = f 00 (x)2 h4 σ 4 + K 4 nh A global measure of precision is the asymptotic mean integrated squared error (AMISE) Z h4 σ 4 R(f 00 ) R(K) K + . Thus for the AMISE to decline with n. The ﬁrst two are determined by the kernel function. Gaussian Kernel: hrule = 1. That is. ˆ It uses formula (16. and R(f 00 ). That is. we ﬁnd the reference rules for the three kernel functions introduced earlier. and there is a large and continuing literature on the subject. σ 2 . and gives a nearly optimal rule when f (x) is close to normal. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). where φ is the N (0. We can calculate that √ R(φ00 ) = 3/ (8 π) . The downside is that if the density is very far from normal.2) but replaces R(f 00 ) with σ −5 R(φ00 ).06n−1/5 163 . In practice. Equation (16. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. Together with the above table. 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 .

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

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

. as µ ¶ n n! = . 816.1) We say that the events A and B are statistically independent when (A. in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A. This selection is without replacement if you are not allowed to select the same number twice. the conditional probability function is a valid probability function where S has been replaced by B. r r! (n − r)! When counting the number of objects in a set... 2. 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. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. 49.. we say that the collection of events A1 . If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . Ã ! \ Y P Ai = P (Ai ) . it is useful to have simple rules to count the number of objects in a set. n ≥ r. . P (B) With Replacement nr ¡n+r−1¢ r For any B. Counting may be with replacement or without replacement.. These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r.1) holds. Rearranging the deﬁnition. Furthermore. we have four expressions for the number of objects (possible arrangements) of size r from n objects. i∈I i∈I 166 .• 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. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery. there are two important distinctions. ¢ counting is unordered and without replacement. and is with replacement if this is allowed. For example. consider a lottery where you pick six numbers from the set 1. Counting may be ordered or unordered. 983. Depending on these two distinctions. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. Ak are mutually independent when for any subset {Ai : i ∈ I}.

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

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

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

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

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

is not true. σxσY (A. y) = fX (x)fY (y). X 2 ) = 0. 172 . (A. x)dydx Z Z = g(x)h(y)fY (y)fX (x)dydx Z Z = g(x)fX (x)dx h(y)fY (y)dy = Eg (X) Eh (Y ) . The reverse. The covariance between X and Y is Cov(X. then MZ (λ) = E exp (λ (X + Y )) = E (exp (λX) exp (λY )) ¡ ¢ ¡ ¢ = E exp λ0 X E exp λ0 Y = MX (λ)MY (λ). −∞ The random variables X and Y are deﬁned to be independent if f (x. free of units of measurement. Another implication of (A. For example. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y.Similarly. if EX = 0 and EX 3 = 0.6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1.5) is that if X and Y are independent and Z = X + Y. then σ XY = 0 and ρXY = 0. however. For example. if X and Y are independent then E(XY ) = EXEY. the variance of the sum is the sum of the variances.5) if the expectations exist. Furthermore. If X and Y are independent. The correlation between X and Y is Corr(X. y)dx. An implication is that if X and Y are independent. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. Y ) = ρXY = σ XY . X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x. A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X. then V ar (X + Y ) = V ar(X) + V ar(Y ). the marginal density of Y is fY (y) = Z ∞ f (x. y) = g(x)h(y). then Cov(X. If X and Y are independent. Y ).The correlation is a measure of linear dependence.

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

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

dy This is known as the change-of-variables formula.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). and invertible. 1] and Y = − ln(X). diﬀerentiable. If g(x) is an increasing function. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). an exponential density. As one example. 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)| . As the range of X is [0.8 Normal and Related Distributions µ 2¶ 1 x . J(y) = det ∂y 0 Consider the univariate case k = 1.∞). but its justiﬁcation requires deeper results from analysis. Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. (A. that for Y is [0. This same formula (A.10) d h(y). then g(X) ≤ Y if and only if X ≤ h(Y ). take the case X ∼ U [0.10) holds for k > 1.10) shows that fY (y) = exp(−y). Here. A. Let h(y) denote the inverse of g(x). so the distribution function of Y is FY (y) = P (g(X) ≤ y) = FX (h(Y )) = P (X ≤ h(Y )) so the density of Y is fY (y) = d d FY (y) = fX (h(Y )) h(y). The Jacobian is ¶ µ ∂ h(y) . Let Y = g(X) where g(x) : Rk → Rk is one-to-one. dy dy If g(x) is a decreasing function. then g(X) ≤ Y if and only if X ≥ h(Y ). 1]. . φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. 0 ≤ y ≤ ∞.A.

−∞ < x < ∞. q 176 . This shows that linear transformations of normals are also normal.This density has all moments ﬁnite. then by the change-of-variables formula. we can also show that EX 2 = 1 and EX 4 = 3. Its mean and r variance are µ = r and σ 2 = 2r. denoted χ2 . Theorem A. then they are mutually independent. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . For x ∈ Rk . 1). Σ). x ∈ Rk . This shows that if X is multivariate normal with uncorrelated elements. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. σ 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. Another useful fact is that if X ∼ N (µ. y ≥ 0.2 If Z ∼ N(0. The mean and variance of the distribution are µ and σ 2 .8. then Σ = diag{σ 2 } is a diagonal matrix. The latter has no closed-form solution. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). Theorem A. If Z is standard normal and X = µ + σZ. Σ) and Y = a + BX with B an invertible matrix. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. x ∈ Rk . Since it is symmetric about zero all odd moments are zero. q × q.11) and is known as the chi-square density with r degrees of freedom. (A. Ir ) and set Q = X 0 X. then Z 0 A−1 Z ∼ χ2 . respectively. A) with A > 0. By iterated integration by parts. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . and it is conventional to write X ∼ N (µ.8. f (x) = √ 2σ 2 2πσ which is the univariate normal density. ¢ ¡ It useful to observe ¢ that the MGF and CF of the multivariate normal are exp λ0 µ + λ0 Σλ/2 ¡ 0 and exp iλ µ − λ0 Σλ/2 . and it is conventional to write X ∼ N(µ. It is conventional to write X ∼ N (0. then using the change-of-variables formula. X has density Ã ! (x − µ)2 1 exp − . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 .1 Let X ∼ N (0. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) .

we see that the MGF of Z 2 is (1 − 2t)−1/2 .3. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.2.11). Proof of Theorem A. Using the simple law of iterated expectations.8. 1) and Q ∼ χ2 be independent.3 Let Z ∼ N (0. Iq ).13).1. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . tr has distribution 177 . C −1 AC −10 ) = N (0. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.8.13) is the MGF of the density (A. Set r Z . From (A. 1).8. The MGF for the density (A.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.12) E exp (tQ) = 0 Γ (A. (A. Thus the density of Z 2 is (A. 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. q Proof of Theorem A. which can be found by applying change-of-variables to the gamma function. For Z ∼ N(0.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.11) 2 with r = 1.Theorem A. which we showed in (A.8. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.

9 Maximum Likelihood If the distribution of Yi is F (y. The space Θ is the set of permissible value for θ. 178 .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¡ ¢ . In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ.. θ) and the joint ˜ density of a random sample Y = (Y1 . i=1 The likelihood of the sample is this joint density evaluated at the observed sample values. 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) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector. Yn ) is n ³ ´ Y ˜. we say that the distribution is parametric and that θ is the parameter of the distribution F. viewed as a function of θ. θ) . The log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi . If the distribution F is discrete.. θ) . the likelihood and log-likelihood are constructed by setting f (y. θ) = P (Y = y. .. θ) . If the distribution F is continuous then the density of Yi can be written as f (y.θ = fn Y f (Yi .

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

θ) θ In this case. but has a diﬀerent covariance matrix than in the pure MLE case. θ) is necessarily the true density. The QMLE is consistent for the pseudo-true value. ˆ elements of n 0 Sometimes a parametric density function f (y. ˆ ln f Yi . θ) = f (y) ln f (y. Thus in large samples the MLE has approximately the best possible variance. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. θ) is used to approximate the true unknown density f (y).17) does not hold. Typically. Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . θ (A. but it is not literally believed that the model f (y. θ).ˆ ˆ−1 θ We then set I0 = H −1 . 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 .18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . θ) ¶ dy Thus in large samples. V ) . Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance. Therefore the MLE is called asymptotically eﬃcient. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A. A minor adjustment to Theorem (A. ˆ . since the information matrix equality (A.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0.18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi . to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A.9. 180 . In this case there is not a “true” value of the parameter θ.

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

and making a ﬁrst-order Taylor series expansion. Together. Ω) = N 0. ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . θ0 ) →d N (0. θn ) = ln f (Yi . θ0 ) is mean-zero with covariance matrix Ω. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . θ0 ) + ' 0 ln f (Yi . the ﬁnal equality using Theorem A.9. Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . θ n ) θ − θ 0 . ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . Ω) . we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . θ0 ) . H −1 . then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . ¥ 182 . ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . the speciﬁc value of θn varies by row in this expansion. θ) . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi .Proof of Theorem A. H −1 ΩH −1 = N 0. If it is continuous in θ. (Technically.3 Taking the ﬁrst-order condition for maximization of Ln (θ). − ln f (Yi .) Rewriting this equation. an application of the CLT yields 1 X ∂ √ ln f (Yi .9.1 .

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

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

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

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