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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

. . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . .11Model Selection . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . . . . . 9. . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . .10Testing for Omitted Serial Correlation 12. . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . 11. . . . . . . . . . .7 Asymptotic Distribution . . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . 12. . . . . 11. . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . 12.8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . 11. .10 Exercises . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . 9. . . . .5 Stationarity of AR(k) . . . . . . . . . . 12. . . 9. . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . .3 Overidentifying Restrictions . . . . . . . . . . . .12 8. . . . 12. . .2 Reduced Form . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . 11 Endogeneity 11. . .6 Bekker Asymptotics . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . .4 Lag Operator . .4 Testing . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . 12. 10. . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . .8 Exercises . . . . . . . . . . . . 9. . . . . . . . . . .7 Identiﬁcation Failure . .13 One-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . .9 8. . . . . . . . . . . .2 Autoregressions . . iii . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . .

. . . . . . . . . . .2 Gradient Methods . . . . . . . . . . . . . . . . . . . . . . . .1 Individual-Eﬀects Model . . .13 Multivariate Time Series 13. . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . A. A. . .7 Granger Causality . . .2 Estimation . . . . . . . . . . . . . . . . . 13. . . . .7 Transformations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . .1 Foundations . . . . . . . . . . . . .1 Binary Choice . . . . . . . . . . . . . . . . . . . . . . .4 Sample Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . A. A. . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Kernel Density Estimation . . . . . . . A. . . .3 Censored Data . . . . . . . . . . . . . .3 Restricted VARs . . . . . . . . . . . . . A. . . . .5 Multivariate Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Grid Search . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . B. . . . . . .6 Conditional Distributions and Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . A. . . iv . .4 Single Equation from a VAR . . . . . .9 Cointegrated VARs . . . . . . .2 Fixed Eﬀects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . 14. . . . .8 Normal and Related Distributions . . B. . . . . . . . . . . . . . . . . . . . . . . . 13.9 Maximum Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . .8 Cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Common Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . A. .5 Testing for Omitted Serial Correlation 13. . .2 Count Data . . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . 157 15. . . . . . . . . . . . . . . . 13. . 14. . . . . . . B Numerical Optimization B. . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 A Probability A. . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Expectation . . . .2 Random Variables . . . . . . . . . . 13. . . . . .

To measure the returns to schooling. experiments such as this are infeasible. Typical examples include macroeconomic aggregates.Chapter 1 Introduction Econometrics is the study of estimation and inference for economic models using economic data. what we observe (through data collection) is the level of a person’s education and their wage. an experiment might randomly divide children into groups. Econometric theory concerns the study and development of tools and methods for applied econometric applications. To continue the above example. These data sets consist surveys of a set of individuals. The diﬀerences between the groups could be attributed to the diﬀerent levels of education. or corporations. We can measure the joint distribution of these variables. For example. households. Panel data combines elements of cross-section and time-series. and then follow the children’s wage path as they mature and enter the labor force. and assess the joint dependence. timeseries. Cross-sectional data sets are characterized by mutually independent observations.2 Observational Data A common econometric question is to quantify the impact of one set of variables on another variable. 1.1 Economic Data An econometric study requires data for analysis. The quality of the study will be largely determined by the data available. The individuals surveyed may be persons. Applied econometrics concerns the application of these tools to economic data. Another issue of interest is the earnings gap between men and women. mandate diﬀerent levels of education to the diﬀerent groups. 1. However. as we are not able to manipulate one variable to see the direct eﬀect on the other. There are three major types of economic data sets: cross-sectional. repeated over time. and panel. But we cannot infer causality. a concern in labor economics is the returns to schooling — the change in earnings induced by increasing a worker’s education. Ideally. prices and interest rates. They are distinguished by the dependence structure across observations. we would use experimental data to answer these questions. Time-series data is indexed by time. most economic data is observational. holding other variables constant. Surveys are a typical source for cross-sectional data. even immoral! Instead. This type of data is characterized by serial dependence. 1 . Each individual (person. household or corporation) is surveyed on multiple occasions.

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

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

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

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

r ≤ k. . ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . are said to be orthogonal if A0 A = Ir . . We say that two vectors a and b are orthogonal if a0 b = 0. 0 0 ··· 1 2. . ⎥ . The columns of a k × r matrix A. . . . An important diagonal matrix is the identity matrix. then AIr = A and Ik A = A. For example. A square matrix A is called orthogonal if A0 A = Ik . Also. which has ones on the diagonal. . ⎦ ⎣ . . A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ .An alternative way to write the matrix product is ∙ ¸∙ A11 A12 B11 AB = A21 A22 B21 ∙ A11 B11 + A12 B21 = A21 B11 + A22 B21 and £ to use matrix partitions.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. ⎤ ⎥ ⎥ ⎥ ⎦ 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.

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

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

.8 Determinant The determinant is deﬁned for square matrices.. . k) . k)). 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 . . then its determinant is det A = a11 a22 − a12 a21 .. xk ) be k × 1 and g(x) = g(x1 . Additionally. k.. xk ) : Rk → R. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. jk ) denote a permutation of (1. . There are k! such permutations. (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2... we can deﬁne the determinant as follows. we deduce that Λ2 = Λ and λ2 = λi for i = 1.4) H0 M =H 0 0 with H 0 H = In . i Hence they must equal either 0 or 1.. tr(A) = rank(A)... • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . Let π = (j1 .. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . . . For a general k × k matrix A = [aij ] . and let επ = +1 if this count is even and επ = −1 if the count is odd.. If A is 2 × 2.... ⎠ .By the uniqueness of the characteristic roots.... . 2. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized..

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

we can focus on f (y | x) . When a distribution is skewed. or the covariates. m(x) can take any form. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. In the example presented in Figure 3. This is used when the goal is to quantify the impact of one set of variables on another variable. it is useful to have numerical measures of the diﬀerence. which is a common feature of wage distributions.1) xi = ⎜ .1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population.22. gender. The two density curves show the eﬀect of gender on the distribution of wages. xi ) where yi is a scalar (real-valued) and xi is a vector. ⎟ .1. These are asymmetric (skewed) densities. You can see that the right tail of then density is much thicker than the left tail. The data are from the 2004 Current Population Survey 1 11 . In this context we partition the observations into the pair (yi . These are conditional density functions — the density of hourly wages conditional on race. ⎠ ⎝ . the conditional density of yi given xi .1 by the arrows drawn to the x-axis. education and experience. While it is easy to observe that the two densities are unequal. xki 3. the mean wage for men is $27.73. We call yi the dependent variable.1 displays the density1 of hourly wages for men and women. Take a closer look at the density functions displayed in Figure 3.2) m(x) = E (yi | xi = x) = −∞ In general. These are indicated in Figure 3. the conditioning variable. the mean is not necessarily a good summary of the central tendency. We call xi alternatively the regressor.1. See Chapter 16. . and exists so long as E |yi | < ∞. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. (3. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. holding the other variables constant.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. To illustrate. and that for women is $20. Figure 3.

this yields the formula yi = m(xi ) + ei . Figure 3. degree in mean log hourly wages is 0. Figure 3.5.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. Of particular interest to graduate students may be the observation that diﬀerence between a B. The diﬀerence in the log mean wage between men and women is 0. The main point to be learned from Figure 3.2 shows the density of log hourly wages for the same population.D.Figure 3. the solid line displays the conditional expectation of log wages varying with education.3 displays a scatter plot2 of log wages against education levels. 12 . 2 (3.2) evaluated at the observed value of xi : ei = yi − m(xi ). then comparisons become more complicated. 3.3) White non-military male wage earners with 10-15 years of potential work experience. Assuming for simplicity that this is the true joint distribution.A.3 is how the conditional expectation describes an important feature of the conditional distribution. implying an average 36% diﬀerence in wage levels.36. To illustrate. The comparison in Figure 3. The conditional expectation function is close to linear.30. which implies a 30% average wage diﬀerence for this population. wage regressions typically use log wages as a dependent variable rather than the level of wages. When the distribution of the control variable is continuous. with mean log hourly wages drawn in with the arrows. For this reason.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. the dashed line is a linear projection approximation which will be discussed in the Section 3. and a Ph.1 is facilitated by the fact that the control variable (gender) is discrete. By construction.

The remaining parts of the Theorem are left as an exercise. A regression model imposes further restrictions on the joint distribution.Figure 3. E(xi ei ) = 0. The equations yi = m(xi ) + ei E (ei | xi ) = 0. not a model. because no restrictions have been placed on the joint distribution of the data.2: Log Wage Densities Theorem 3.2. To show the ﬁrst statement. 3. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. restrictions on the permissible class of regression functions m(x). by the deﬁnition of ei and the linearity of conditional expectations. are often stated jointly as the regression framework. 13 . These equations hold true by deﬁnition. It is important to understand that this is a framework. 4. E (ei | xi ) = 0. E(ei ) = 0.1 Properties of the regression error ei 1. most typically. E (h(xi )ei ) = 0 for any function h (·) . 2.

Thus the mean squared error is minimized by the conditional mean. σ 2 (x) is a non-trivial function of x. Given the random variable xi .Figure 3. it does not provide information about the spread of the distribution. The right-hand-side is minimized by setting g(x) = m(x). i . To see this. The conditional standard deviation is its square root σ(x) = σ 2 (x). The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3.2. 3. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . subject to the restriction p that it is non-negative. and can take any form.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . when σ 2 (x) is a constant so that ¢ ¡ (3. the conditional variance of yi is σ 2 = σ 2 (xi ).3 Conditional Variance Generally. In contrast. in the sense of achieving the lowest mean squared error. let g(x) be an arbitrary predictor of yi given xi = x. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic.1.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.3.

we assume that x1i = 1. which we derive in this section. As an example.6) (3. take the conditional wage densities displayed in Figure 3. Equivalently. i (3. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .5. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .5) xi = ⎜ .5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .1 and that for women is 10. Instead. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. The conditional standard deviation for men is 12. Equation (3.we say that the error ei is homoskedastic. So while men have higher average wages. 15 .9) 3. In this case (3. and the linear assumption of the previous section is empirically unlikely to accurate.7) is a k × 1 parameter vector. ⎠ . ⎟ . it is convenient to augment the regressor vector xi by listing the number “1” as an element. We call this the “constant” or “intercept”. 3. βk ⎛ (3.1. they are also somewhat more dispersed. where x1i is the ﬁrst element of the vector xi deﬁned in (3.8) (3.6) as an approximation.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. its functional form is typically unknown.4 Linear Regression An important special case of (3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). ⎠ . Thus (3. it is more realistic to view the linear speciﬁcation (3.8) is called the linear regression model.1). xki When m(x) is linear in x. ⎝ . Notationally.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. ⎟ β=⎝ .

this situation must be excluded.which is quadratic in β. i (3.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.12) This completes the derivation of the linear projection model. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . i 16 . i which requires that for all non-zero α. It is invertible if and only if it is positive deﬁnite. Therefore. In order for β to be uniquely deﬁned. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. written E (xi x0 ) > 0. This occurs when redundant variables are included in xi .11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . The ﬁrst-order condition for minimization (from Section 2. The vector (3. Equivalently. i 4. 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. The error is i ei = yi − x0 β. i i (3.5. Rewriting. x0 β is the best linear predictor for yi . otherwise they are distinct. E (xi x0 ) is invertible.10) It is worth taking the time to understand the notation involved in this expression. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . 3. i (3. Eyi < ∞. by “best” we mean the predictor function with lowest mean squared error. E (x0 xi ) < ∞. α0 E (xi x0 ) α = E (α0 xi )2 > 0. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. As before. Given the deﬁnition of β in (3. Observe i that for any non-zero α ∈ Rk . 2 2.1 1.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . xi contains an intercept. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.1. The best linear predictor is obtained by selecting β to minimize S(β).10).5. Assumption 3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.

1.2 and 3.13) implies that xi and ei are uncorrelated. Assumption 3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .5. it follows that linear regression is a special case of the projection model.13) summarize the linear projection model. E (xi ei ) = 0 and E (ei ) = 0. Equation (3. Figure 3. Assumption 3.1. By deﬁnition. Since from Theorem 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.1 is employed to guarantee that (3. Assumption 3.5.13) and Assumption 3.5. (3.11) and (3.5.2. Let’s compare it with the linear regression model (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.1.13) The two equations (3.1. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.Theorem 3. (3.1.3 are called regularity conditions. For example.1. However.14) follows from (3.3 ensure that the moments in (3.4 we know that the regression error has the property E (xi ei ) = 0.11) are well deﬁned.10) and (3.9). ¥ (3.14) Proof.4 is required to ensure that β is uniquely deﬁned. Since ei is mean zero by (3.2 and 3.1 Under Assumption 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.1 are weak.1. Using the deﬁnitions (3.4 guarantees that the solution β exits.5.5. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . This means that the equation (3.5. Furthermore.10) are deﬁned. the orthogonality restriction (3.1.14) holds.5.5.5. 17 .5. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1.12) can be alternatively interpreted as a projection decomposition. Assumption 3.1.12) and (3.1.14). The ﬁnite variance Assumptions 3.8)-(3.

Returning to the joint distribution displayed in Figure 3. The solid line is the conditional mean. in many economic models the parameter β may be deﬁned within the model. Figure 3. since the resulting function is quadratic in experience. However. for those over 53 in age).1.4 we display as well this quadratic projection.12) with the properties listed in Theorem 3.5. It over-predicts wages for young and old workers. 18 . No additional assumptions are required. xi ) we can deﬁne a linear projection equation (3.3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. we can augment the regressor vector xi to include both experience and experience2 . In this case (3. We illustrate the issue in Figure 3. the dashed line is the linear projection of log wages on eduction. In the example just presented. A projection of log wages on these two variables can be called a quadratic projection. In Figure 1.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.1 may be false. In this example the linear projection is a close approximation to the conditional mean. and under-predicts for the rest.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. Most importantly.We have shown that under mild regularity conditions. Other than the redeﬁnition of the regressor vector.4 displays the relationship3 between mean log hourly wages and labor market experience. This defect in linear projection can be partially corrected through a careful selection of regressors. and the straight dashed line is the linear projection. for any pair (yi . In contrast.5. The linear equation (3.10). These structural models require alternative estimation methods. there are no changes in our methods or analysis. it is important to not misinterpret the generality of this statement. and are discussed in Chapter 11. In this case the linear projection is a poor approximation to the conditional mean. In other cases the two may be quite diﬀerent. Figure 3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. In this example it is a much better approximation to the conditional mean than the linear projection.10) may not hold and the implications of Theorem 3.

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

True or False. Compute E(yi | xi = x) and V ar(yi | xi = x). i 10.6 Exercises 1. If yi = xi β + ei . If yi = x0 β + ei and E(ei | xi ) = 0. If yi = x0 β + ei and E(xi ei ) = 0. ¡ ¢ 4.1. Compute the conditional mean m(x) = E (yi | xi = x) . a constant. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. Prove parts 2. If yi = xi β + ei .2. 1. e−λ λj j! . .2 Y =1 . then ei is i i independent of xi . 20 . σ = . then E(ei | xi ) = 0. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. 9. 3.3 Find E(Y | X = x). σ 2 = V ar(xi ).3. True or False. i 8. and have the following joint probability distribution X=0 X=1 Y =0 . If yi = x0 β + ei . then E(x2 ei ) = 0. E(ei | xi ) = 0.. µx = Exi . (x − µ)2 − σ 2 Show that Eg (X. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . σ 2 = V ar(yi ) and σ xy = Cov(xi . Suppose that yi is discrete-valued. xi ∈ R. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . True or False. and E(e2 | xi ) = σ 2 . Suppose that Y and X only take the values 0 and 1. yi ). i 7.1 . taking values only on the non-negative integers. True or False. 2. x 6. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. i 11. j! 0 j = 0. 2. µ. Let X be a random variable with µ = EX and σ 2 = V ar(X). xi ∈ R. m. then E(x2 ei ) = 0. s) = 0 if and only if m = µ and s = σ 2 . E(Y 2 | X = x) and V ar(Y | X = x). Let xi and yi have the joint density f (x. and E(ei | xi ) = 0.4 . 0 ≤ y ≤ 1. then ei is independent of xi .. 3 and 4 of Theorem 3. True or False. and E(xi ei ) = 0. Are they diﬀerent? Hint: If P (Y = j) = 5. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j .

but for most of the chapter we retain the broader focus on the projection model. i It follows that the moment estimator of β replaces the population moments in (4.7 and 4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4. Observe that (4.1) (4.2) (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . (4.2) can be written in the parametric 0 β)) = 0.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi . i n i=1 n 21 .8.3) In Sections 4.1 Estimation Equation (4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .4) i i=1 i=1 ˆ Another way to derive β is as follows.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . we narrow the focus to the linear regression model. 4.

40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.95 42.14 205.ˆ This is a set of k equations which are linear in β. These are white male wage earners from the March 2004 Current Population Survey. To illustrate.14 14. 30 = .7% increase in mean wages.3.83 ¶−1 µ ¶ .37 µ ¶ 1.2 Least Squares There is another classic motivation for the estimator (4. Let yi be log wages and xi be an intercept and years of education. An interpretation of the estimated equation is that each year of education is associated with an 11.40 µ ¶µ ¶ 34.4).71 = −2. i 22 . Then µ ¶ n 1X 2.117 1 14.14 14.14 205. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4.94 −2.170 37. ¶ 2. consider the data used to generate Figure 3. 4. This sample has 988 observations. 40 0. 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. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.30 + 0.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. 40 2. excluding military.95 xi yi = 42. with 10-15 years of potential work experience. 0.117 Educationi .4).

Figure 4. It is important to understand the distinction between the error ei and the residual ei . Matrix calculus (see Appendix 2.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Since the function Sn (β) is a quadratic function of β. i ˆ ˆ Note that yi = yi + ei .The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). while the residual is a by-product of estimation.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. which can cause confusion.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.4). Figure 4. 23 . we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. To visualize the sum-of-squared errors function. These two ˆ variables are frequently mislabeled. The error is unobservable. Figure 4. the contour lines are ellipses. Following convention we will call β the OLS estimator of β.

7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. These are algebraic results.6) An alternative estimator uses the formula n 1 X 2 s = ei .5) implies that 1X xi ei = 0. ˆ σ = ˆ n 2 i=1 n (4.Figure 4.2: Sum-of-Squared Error Function Contours Equation (4. It measures the variation in the i “unexplained” part of the regression. The error variance σ 2 = Ee2 is also a parameter of interest. ˆ n−k 2 i=1 (4. ˆ n i=1 n Since xi contains a constant. 24 . and hold true for all linear regression estimates. Its method of moments estimator is the sample average 1X 2 ei .7. one implication is that n 1X ei = 0.

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 . maximizing the likelihood is identical to minimizing Sn (β). Hence the MLE for β equals the OLS estimator. σ 2 ) is a function of β only through the sum of squared errors Sn (β). testing. Since Ln (β. σ 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. σ 2 ). ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. The R2 is frequently mislabeled as a measure of “ﬁt”. σ 2 ) maximize Ln (β. Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi . Instead. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . and distribution theory. where likelihood methods can be used for estimation. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . 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 ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. This is a parametric model.where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. 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. 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 ).3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. 4. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators.

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

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

14) or via the ˆ following algorithm: ˜ 1. 30 . By the independence of the observations and (3. . ˆ which are “demeaned”. and X2 is the vector of observed regressors. obtain residuals Y . obtain OLS estimates β 2 and residuals e. observe that ⎞ ⎛ ⎞ ⎛ .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. A common application of the FWL theorem. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. In the model (4. .6. Regress X2 on X1 .1 (Frisch-Waugh-Lovell). In this section we derive the small sample conditional mean and variance of the OLS estimator.8)(3. ˜ 2. Rather.Theorem 4. Regress Y on X1 .13). the FWL theorem can be used to speed computation. ¡ ¢−1 0 ι. ˆ ˜ ˜ ˆ 3. . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. 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. obtain residuals X2 . . Regress Y on X2 . 4. . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. . but in most cases there is little computational advantage to using the two-step algorithm. In some contexts. In this case. . . ⎠ ⎝ ⎠ ⎝ . . which you may have seen in an introductory econometrics course. the primary use is theoretical. or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) .9).18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.9). ⎟ ⎜ ⎟ ⎜ (4. . is the demeaning formula for regression. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 .

12). σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . Next.8).. . . . .20) .. σ 2 } = ⎜ . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. 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.Using (4. From (4. under the of ˆ ¢ 2 | x = σ 2 . 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. . Then given (4. and the trace operator observe that. 1 n . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. . ⎠ (4... X 0 DX = X 0 Xσ 2 . the properties of conditional expectations. . and ³ ´ ¡ ¢−1 2 ˆ σ .18). 0 0 ··· 0 0 . and (4. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . .19) ˆ and thus the OLS estimator β is unbiased for β.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 . ⎝ . ¡ 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 . V ar β | X = X 0 X ⎟ ⎟ ⎟.

known as the Gauss-Markov theorem.8. ³ ´ ˜ E β | X = A0 Xβ. It is not unbiased in the absence of homoskedasticity. It is important to remember. which we now present. 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.9) plus E e2 | xi = σ 2 . that this estimator is only unbiased in the special case of the homoskedastic linear regression model. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. Theorem 4. is a famous statement of the solution.8)¢ ¡ (3. In this case. Thus since V ar (e | X) = In σ 2 under homoskedasticity. the best (minimumvariance) unbiased linear estimator is OLS.1 Gauss-Markov. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. Now consider the class of estimators of β which are linear functions of i the vector Y. 32 . = σ2 n the ﬁnal equality by (4. which is (3.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model.10). What is the best choice of A? The Gauss-Markov theorem. however. or in the projection model. As an alternative. says that the least-squares estimator is the best choice. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .7) is unbiased for σ 2 by this calculation. as it yields the smallest variance among all unbiased linear estimators.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 . 4. the estimator ˆ 2 deﬁned (4. By a calculation similar to those of the previous section. Thus σ 2 is biased towards zero. The following result. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . ˜ so β is unbiased if (and only if) A0 X = Ik . In the homoskedastic linear regression model.

) In this discrete setting.5) as required. That is. 4..21) j j=1 j=1 Thus β is a function of (π 1 .Proof. . where 1 (·) is the indicator function. This latter restriction is particularly unsatisfactory. r for some constant vectors τ j . xi ) is discrete. but we don’t know the probabilities. r. Assume that the τ j and ξ j are known.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. Note that X 0 C = 0.21) 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 ⎠ . Set C = A − X (X 0 X)−1 . We discuss the intuition behind his result in this section.. for ﬁnite r.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. Let A be any n×k function of X such that A0 X = Ik ... It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. 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. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1.. As the data are multinomial. The MLE β mle for β is then the analog of (4. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. That is. the deﬁnition (4. π r ) . ¡ ¢ P yi = τ j . Suppose that the joint distribution of (yi .. Not only has the class of models has been restricted to homoskedastic linear regressions. (We know the values yi and xi can take. xi = ξ j = π j . ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. . ξ j . the class of potential estimators has been restricted to linear unbiased estimators. ˆ β mle = ⎝ j j=1 j=1 33 . j = 1... but it is quite limited in scope. but the π j are unknown. . A broader justiﬁcation is provided in Chamberlain (1987). The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . and is a strong justiﬁcation for the least-squares estimator. and π j . π j is the percentage of the observations ˆ ˆ which fall in each category. This property is called semiparametric eﬃciency. 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..

He observes that the above argument holds for all multinomial distributions. 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 .1.22) 34 .10 Omitted Variables xi = µ x1i x2i ¶ . He proves that generically the OLS estimator (4.9). (4. 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 . ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words.5. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. the maximum likelihood estimator is identical to the OLS estimator. and thus so is the OLS estimator. Chamberlain (1987) extends this argument to the case of continuously-distributed data.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.Substituting in the expressions for π j .10) for the class of models satisfying Assumption 3. if the data have a discrete distribution. 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.

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

In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. The hi take values in [0. ˆ ˆ (4. since as ρ approaches 1 the matrix becomes singular. the precision of individual estimates are reduced. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. the OLS estimator based on the sample excluding the i’th observation. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 .One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . We can also deﬁne the leave-one-out residual ˆ ˆ ei.26) As we can see. that is.27) (4.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . To investigate the possibility of inﬂuential observations. ˆ i A simple comparison yields that ˆ ei − ei.25) below. If the i’th observation 36 .−i = yi − x0 β (−i) = (1 − hi )−1 ei . deﬁne the leave-one-out least-squares estimator of β. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi .12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. We derive expression (4. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . the worse the precision of the individual coeﬃcient estimates. 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.−i = (1 − hi )−1 hi ei . What is happening is that when the regressors are highly dependent. As a consequence. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. 1] and sum to k.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.

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) in Section 2. which is considerably more informative than plots of the uncorrected residuals ei . Investigations into the presence of inﬂuential observations can plot the values of (4.25). ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .27). The key is equation (2. then this observation is a leverage point and has the potential to be an inﬂuential observation.

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

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

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

V ) .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. P ¯X n ¯ > δ ≤ η. Jensen’s inequality (5.6) and (5.Proof: Without loss of generality.1) and (5.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . the fact that X n = W n + Z n . denoted Zn →d Z.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . If Xi ∈ Rk is iid and E |Xi |2 < ∞. Fn (x) → F (x) as n → ∞.7).3. and the bound |Wi | ≤ 2C.1 Central Limit Theorem (CLT). Fix δ and η. as needed. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.4). 43 . ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. if for all x at which F (x) is continuous. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. the triangle inequality.6) By Jensen’s inequality (5. (5.5). the fact that the Wi are iid and mean zero. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. We say that Zn converges in distribution to Z as n → ∞. Theorem 5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . where Z has distribution F (x) = P (Z ≤ x) . We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. Set ε = δη/3. we can set E(X) = 0 (by recentering Xi on its expectation). 5. Finally. by Markov’s inequality (5.1). then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.

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

Σ) = N 0. ¥ 5. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).√ where λn → 0 lies on the line segment joining 0 and λ/ n. then g(Zn ) →p g(c) as n → ∞. Recall that A ⊂ B implies P (A) ≤ P (B). we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. 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 . then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Σ) .4. Ik ) distribution. Theorem 5. and g(θ) : Rm → Rk . we see that as n → ∞. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.1 Continuous Mapping Theorem 1 (CMT). Proof : By a vector Taylor series expansion. Proof: Since g is continuous at c. Hence g(Zn ) →p g(c) as n → ∞.4 Asymptotic Transformations Theorem 5.4. Since cλλ (λn ) → cλλ (0) = −Ik . for each element of g. 45 .3 Delta Method: If n (θn − θ0 ) →d N (0. If Zn →d Z as n → ∞ and g (·) is continuous. √ Theorem 5. If Zn →p c as n → ∞ and g (·) is continuous at c.4.2 Continuous Mapping Theorem 2. where θ is m × 1 and Σ is m × m. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. k ≤ m. gθ Σgθ . then g(Zn ) →d g(Z) as n → ∞. Stacking across elements of g. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. This is suﬃcient to establish the theorem.

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

1). using (6.1) and ˆ We now deduce the consistency of β. 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 . ·) is continuous at (Q.2 Consistency ˆ As discussed in Section 6. 6. Hence by the continuous mapping theorem (Theorem 5. 0).From the ﬁgure we can see that the density functions are dispersed and highly non-normal.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. For a complete argument. First. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. Equation (4.4. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. xi ei →p g (Q. ˆ 47 .5.4. the OLS estimator β is has a statistical distribution which is unknown.1).1. n i=1 (6.5.2).1 by the fact that the sampling densities become more concentrated as n gets larger.1. Proof. (6. we can conclude ˆ that β →p β. β →p β as n → ∞.1 Under Assumption 3. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.4 implies that Q−1 exists and thus g(·.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1. (6.5.2. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .2) i i n i=1 n From (6. and the continuous mapping theorem (Theorem 5. Ã n ! n X 1X 0 1 ˆ xi xi . we will use the methods of asymptotic approximation. (6. ˆ Theorem 6. To characterize the sampling distribution more fully.3). This is illustrated in Figure 6.3) Ã where g(A. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. Assumption 3. As the sample size increases the density becomes more concentrated about the population coeﬃcient. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.2.1).1).1 and the WLLN (Theorem 5. Assumption 3.

1 guarantees that the elements of Ω are ﬁnite.1 In addition to Assumption 3.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. (6.3.5. (6.1). ˆ Proof.6) n i=1 48 . (6. since n/(n − k) → 1 as n → ∞. Ω) .3. To see this.3) and Theorem (6.2). ˆ n−k 6. We need a strengthening of the moment conditions. Ee4 < ∞ and E |xi |4 < ∞.Theorem 6. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . n 1 X √ xi ei →d N (0. i i Assumption 6.3.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. By the central limit theorem (Theorem 5.1). it follows that s2 = ¥ n σ 2 →p σ 2 .1. (6. E ¯ei ¯ E ¯e4 ¯ i i i i (6. by the Cauchy-Schwarz inequality (5.5.2 Under Assumption 3. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. Thus σ 2 is consistent for σ 2 .2).1. Assumption 6.2.2. ˆ Finally.

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

As k increases.3. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. The estimator 2 2 in (6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.Figure 6.11) 50 . 4. As α diminishes the density changes signiﬁcantly. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . We show the sampling distribution of n β 1 − β 1 setting n = 100. The lesson from Figures 6. 6 and 8. 1).4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. for k = 1. 1) asymptotic approximation is never guaranteed to be accurate.2: Density of Normalized OLS estimator α = 3.10) V 0 = Q−1 s2 .3 is that the N (0.1) it is clear that V 0 →p V 0 . 1) density. we need an estimate of Ω = E xi x0 e2 . Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0.2) and Theorem 6. Another example is shown in Figure 6.0 the density is very close to the N (0.2. the sampling distribution becomes highly skewed and non-normal. concentrating most of the probability mass around zero.2 and 6.10) without changing this result.

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

20 = V 14.83 −0.98 −0.493 0.14 205.80 .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.035 ¶ .117 Educationi . From a computational standpoint.039 and ˆ V = µ 1 14.480 .14 6. then take the diagonal elements.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.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. i i i i n i=1 Second.83 ¶−1 = µ 7.20 and µ ¶ ˆ = 0.020.085 p ˆ and that for β 1 is .199 2.2.14 205.80 40.6 ¶µ 1 14.480 ˆ0 = 0. p ˆ In this case the two estimates are quite similar. The standard errors for β 0 are 7. but not under another set of assumptions.199 2.14 14. from which it follows that V →p V as n → ∞.14 205. To illustrate. We calculate that s2 = 0.12) in turn.80 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . First.5) and the WLLN (Theorem 5. (. we return to the log wage regression of Section 4.30 + 0.20 −0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. Using (6. (6. Ω 2.2/988 = .used by an author when studying their work.085) (.493 −0. just as any other estimator. (6.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β .14 14. n n i=1 52 . It is also important to understand that a particular standard error may be relevant under one set of model assumptions.1.83 ¶−1 µ .80 40. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . by Holder’s inequality (5. and then the square roots.35/988 = .020) 6.

Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .5.13) Using formula (4. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . you can show that 1 Xˆ ¯ β= β (−i) . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . i=1 Third. From equation (3.26). Andrews (1991) suggested an similar estimator based on cross-validation. 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. n i=1 n ˆ ˆ Theorem 6.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. Recall from Section 4.14) 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 . 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. which.13) of Efron (1982).1 As n → ∞. ¯ ¯n ¯ n i=1 so Together. these establish consistency. ¯ 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. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. 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.−i = (1 − hi )−1 ei ˆ presented in (4.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. 6. Using this substitution.11) with the leave-one-out estimator ei.25).

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

16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. we say that tn is an exactly pivotal statistic. (For example.8.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. In general. θ could be a single element of β).1 tn (θ) →d N (0. In this case. θ) β 6. Since the standard normal distribution does not depend on the parameters. 1) →d ˆ−θ θ . Consider the studentized statistic tn (θ) = Theorem 6. that (so θ ˆ ˆ ˆ is. and is therefore exactly free of unknowns. 1) Proof. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. if R is a “selector matrix” R= so that if β = (β 1 . s(ˆ θ) (6. Vθ ) √ Vθ = N (0. we say that tn (θ) is asymptotically pivotal. the standard error for ˆ is the square root of n−1 Vθ . In special cases (such as the normal regression model. By (6. µ I 0 ¶ ˆ the upper-left block of V . see Section X). ˆ When q = 1q h(β) is real-valued). ˆ its estimate and s(ˆ its asymptotic θ θ) standard error.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. β 2 ). the statistic tn has an exact t distribution. and θ = h(β) is some function of the parameter vector. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 .For example. however. 55 . s(ˆ = n−1/2 H 0 V Hβ .

1). or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . associated with Fisher. 1].645. Deﬁne the tail probability. if Z ∼ N (0. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. That is. For example. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. regardless of the complication of the distribution of the original test statistic. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. or “accepts” H0 . under H0 . The asymptotic p-value for the above statistic is constructed as follows. That is. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . Either θ ∈ Cn or θ ∈ Cn . so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. 6. from which it follows that pn →d U [0. z. tn →d N (0. Then the asymptotic p-value of the statistic tn is pn = p(tn ). s(ˆ θ) Under H0 . To see this fact. It is designed to cover θ with high probability.025 = 1. 1].96 and z. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . 1]. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. In a sense. An alternative approach. 1). however. If the p-value pn is small (close to zero) then the evidence against H0 is strong. 56 . The p-value is more general. The coverage probability is P (θ ∈ Cn ). Let zα/2 is the upper α/2 quantile of the standard normal distribution.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. Otherwise the test does not reject. is to report an asymptotic p-value. pn →d U [0.05 = 1. in that the reader is allowed to pick the level of signiﬁcance α. and is a function of the data and hence is / random. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level.

= n h(β) − θ0 Hβ V Hβ 57 (6. 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. 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).10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. 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). and it is desired to test the joint restrictions simultaneously.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.96s(ˆ ≈ ˆ ± 2s(ˆ . However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). ˆ + zα/2 s(ˆ . We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . This corresponds to selecting the conﬁdence h i h ˆ ± 1. 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 . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. θ θ) (6.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. or α = . We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. θ The interval has been constructed so that as n → ∞. 6.18) . In this case the t-statistic approach does not work. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.05. the most common professional choice isi95%.

1 Under H0 and Assumption 6. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).3.When h is a linear function of β. χ2 (.05) = 3. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. Also h(β) = a selector matrix.84 = z.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 . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. if rank(Hβ ) = q. and there are q = k2 restrictions. 6. the test rejects at the α% level iﬀ pn < α. Vθ ). ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Hβ (β) is a continuous function of β.19) σ2 ˆ where σ2 = ˜ 1 0 e e. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.1 showed θ ˆ that V →p V. The null hypothesis is H0 : β 2 = 0. The asymptotic p-value for Wn is pn = p(Wn ). a chiq square random variable with q degrees of freedom. 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. ˆ Wn = n θ θ q θ θ Theorem 6. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. Furthermore. h(β) = R0 β. As before.025 . where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. the upper-α quantile q 2 of the χ2 distribution. ˜˜ n ˜ e = Y − X1 β 1 .10. 1] under H0 .15) showed that n ˆ − θ →d Z ∼ N (0.5.1. Hence β β by Theorem A. q and pn is asymptotically U[0.2. In this case. θ = β 2 . then Wn →d χ2 . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . Hβ (β) →p Hβ .8. For example. and Theorem 6. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . 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.

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

as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . This is rarely an issue today. introduced in Section 4. this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0. In particular. σ 2 ) can be be used to calculate a set of exact distribution results.where In many statistical packages. Since uncorrelated normal variables are independent.12 Normal Regression Model As an alternative to asymptotic distribution theory. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. H 0 H) ∼ N (0. it follows ˆ that β is independent of any function of the OLS residuals. equivalently the residual variance from an intercept-only model. Since linear functions of normals are also normal. In σ 2 . n−k 60 . including the estimated error variance 2. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero.3. when an OLS regression is reported.4)) where H 0 H = In . This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . This was a popular statistic in the early days of econometric reporting. While there are special cases where this F statistic is useful. The modelling assumption that the error ei is independent of xi and N (0. Let u = σ −1 H 0 e ∼ N (0. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . In ) . an “F statistic” is reported. 6. these cases are atypical. there is an exact distribution theory available for the normal linear regression model.

β has an exact normal distribution and t has an exact t distribution. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. the notable distinction is between the N (0.10) then ´ ³ ˆ • β ∼ N 0. (Unless the sample size is unreasonably small.8. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ 2 ) − Ln (β 1 . 1) and tn−k distributions.12. 0.) Now let us partition β = (β 1 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .12.a chi-square distribution with n − k degrees of freedom.1 If ei is independent of xi and distributed N(0. We summarize these ﬁndings Theorem 6. with residual variance σ . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . β 2 . Theorem 6. σ 2 ). ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 .3. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ) discussed above. σ ˆ ˆ βj − βj βj − βj N (0. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . The critical values are quite close if n − k ≥ 30. if standard errors are calculated using the homoskedastic formula (6. and standard errors are calculated using the homoskedastic formula (6.1 shows that under the strong assumption of ˆ normality. In contrast. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. β 2 . so as a practical matter it does not matter which distribution is used. n−k • ∼ tn−k ˆ In Theorem 6. a good testing procedure is based on the likelihood ratio statistic. As inference (conﬁdence intervals) are based on the t-ratio. 0. Furthermore. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. β and t are approximately normally distributed. β 2 . 0. σ 2 ) = − log σ − log (2π) − . σ2 ˆ 61 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .1 and Theorem 6.1 we showed that in large samples.

they can work quite poorly when the restrictions are nonlinear. To demonstrate this eﬀect. σ 2 ) and consider the hypothesis H0 : β = 1. the statistic Wn (s) varies with s. Through repetition. 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. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples. This can be seen by a simple example introduced by Lafontaine and White (1986). The increasing solid line is for the case β = 0. while there are other values of s for which test test statistic is insigniﬁcant. features of this distribution can be calculated.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. setting n/σ 2 = 10. 6. This is an unfortunate feature of the Wald statistic.8. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . 62 .84 — the probability of a false rejection. as Wn (s) →d χ2 under H0 for 1 any s. Our ﬁrst-order asymptotic theory is not useful to help pick s. This produces random draws from the sampling distribution of interest. Letting h(β) = β s .4 the Wald statistic Wn (s) as a function ˆ of s. and noting Hβ = sβ s−1 . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.13 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. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. ˆ Let β and σ 2 be the sample mean and variance of yi . 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.7. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. In the present context of the Wald statistic. The decreasing dashed ˆ = 1. Take the model yi = β + ei ei ∼ N (0.

the Type I error probability improves towards 5% as the sample size n increases. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Table 4. n. Table 4. There is. To interpret the table.Figure 6.4. no magic choice of n for which all tests perform uniformly well. In Table 4. so these probabilities are Type I error.84 | β = 1) . Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. however.000 random samples. Test performance deteriorates as s increases. and σ is varied among 1 and 3. When comparing statistical procedures.84. In Table 2.1 reports the simulation estimate of the Type I error probability from 50.000 simulated Wald statistics Wn (s) which are larger than 3. The value of s is varied from 1 to 10. we compare the rates row by row.05) with deviations indicating+ distortion. Rates above 20% are unexceptable. this probability depends only on s. Any other choice of s leads to a test with unacceptable Type I error probabilities. looking for tests for which rate rejection rates are close to 5%. n is varied among 20.1 you can also see the impact of variation in sample size.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Error rates avove 10% are considered excessive.4: Wald Statistic as a function of s P (Wn (s) > 3. and σ 2 . These probabilities are calculated as the percentage of the 50. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. For this particular example. Given the simplicity of the model. The null hypothesis β s = 1 is true. and rarely fall outside of the 3%-8% range. Type I error rates between 3% and 8% are considered reasonable. 100 and 500. the only test which meets this criterion is the conventional Wn = Wn (1) test. In each case. Typically. remember that the ideal Type I error probability is 5% (.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .

13 . 64 .23 .05 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . β 2 ) be the least-squares estimates of (6.05 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.12 .20 . β 1 .06 .09 .15 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.20).24 .12 .20 .19 .08 .06 .25 .06 .10 .15 .30 .10 .22 .08 .08 .33 .25 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .16 Rejection frequencies from 50. Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .05 .07 .10 .08 .08 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. so the hypothesis can be stated as H0 : θ = r.21 .31 .11 .15 .06 . This point can be illustrated through another example.26 .07 .07 .22 . Other choices are arbitrary and would not be used in practice.05 .06 .14 . Equivalently.07 .17 .06 . While this is clear in this particular example.34 .13 .14 .06 .05 .18 .35 .15 .05 .07 . deﬁne θ = β 1 /β 2 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.13 .28 .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 . 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.

However.10 . and alternatives to asymptotic critical values should be considered.26 .00 .06 .09 . while the right tail probabilities P (t1n > 1. .05 .7.00 The one-sided Type I error probabilities P (tn < −1. such as the GMM distance statistic which will be presented in Section 9.645) P (tn > 1. σ 2 ) draw with σ = 3. . We let x1i and x2i be mutually independent N (0.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . if the hypothesis can be expressed as a linear restriction on the model parameters. We vary β 2 among .25 .06 . and normalize β 0 = 0 and β 1 = 1.75.00 . 65 . 6.06 .15 .05 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 . 1) variables.02 . .15 . In contrast. then the “most linear” formulation should be selected.645) are close to zero in most cases. In this section we describe the method in more detail.10 . this formulation should be used.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.05 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .06 .06 .50 .05 .75 1.00 .50.06 . the entries in the table should be 0. especially for small values of β 2 .10 . If no linear formulation is feasible.06 .00 .05 . The left tail probabilities P (t1n < −1.05 β2 . Table 4. along with sample size n.645) P (tn < −1.00 . In all cases. The implication of Table 4.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.06 .05.645) are calculated from 50.14 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. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.2.05 .12 .05 . the rejection rates for the t1n statistic diverge greatly from this value.00 . It is also prudent to consider alternative tests to the Wald statistic.28 .06 .00 . Ideally.645) P (tn > 1.00 .47 .05 .645) t1n t2n t1n t2n t1n t2n t1n t2n .645) greatly exceed 5%. and 1.06 . This leaves β 2 as a free parameter.25. and are close to the ideal 5% rate for both sample sizes.1.645) and P (tn > 1.07 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.0 and n among 100 and 500. ei be an independent N (0.05 .00 . The results are presented in Table 4.000 simulated samples.

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

and poorly for others.022.95) /B ' . . It is therefore convenient to pick B so that N is an integer. potential work experience. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. potential work experience. an estimator or test may perform wonderfully for some values. It is therefore useful to conduct a variety of experiments. In practice.22/ B. We now expand the sample all non-military wage earners.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. and . a larger B results in more precise estimates of the features of interest of Gn . where N = (B +1)α. female. and hispanic.21). Again our dependent variable is the natural log of wages. Quite simply. are. For example. excluding military. union member. and non-white.96) . The random variable 1 (Tnb ≥ 1. and therefore it is straightforward to calculate standard errors for any quantity of interest. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. 1000. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. then B will have to be increased. union member. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. Furthermore.05) (. it is simple to make inferences about rejection probabilities from statistical tests. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. and estimate a multivariate regression. Generally. If the standard error is too large to make a reliable inference. and dummy variable indicators for the following: married. equalling 1 with probability P = E1 (Tnb ≥ 1.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. we included a dummy 67 . In particular. the performance will depend on n and F. respectively. For example. The α% sample quantile is a number qα such that α% of the sample are less than qα .96) . immigrant. experience squared. and our regressors include years of education. therefore. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. and 5000. immigrant. The average (6. this may ˆ be approximated by replacing P with P or with an hypothesized value. female. For the dependent variable we use the natural log of wages. such as the percentage estimate reported in (6. We us the sample of wage earners from the March 2004 Current Population Survey. Often this is called the number of replications. Then qα is the N ’th number in this ordered sequence. B b=1 (6. but requires more computational time. experience squared. and 90% sample quantiles of the sample {Tnb }. 6. In many cases. so that coeﬃcients may be interpreted as semi-elasticities.007. B. As discussed above.96) is iid Bernoulli.15 Estimating a Wage Equation We again return to our wage equation. the choice of B is often guided by the computational demands of the statistical procedure. We separately estimate equations for white and non-whites.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. As P is unknown. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. For regressors we include years of education. Hence the ³ ´ ˆ standard errors for B = 100. the researcher must select the number of experiments.003. if we set B = 999. and dummy variable indicators for the following: married. hispanic. s P = . then we can set s P = (. for a selection of choices of n and F.

808 .34 ˆ s(β) .008 . this adds 50 regressors).121 −. reestimating the model with the 50 state dummies excluded.002 . θ ˆ 2β 3 β2 . Using either statistic the hypothesis is easily rejected.097 −. Computing the Wald statistic (6. The available sample is 18.001 . 2β 3 68 . Table 4. The F form of the Wald statistic (6. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. Alternatively.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.232 .00057 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .014 .808 so the parameter estimates are quite precise and reported in Table 4.102 −.032 . as the 1% critical value for the χ2 distribution is 76.00002 .1.070 .102 −. but not equal.variable for state of residence (including the District of Columbia.4877 18.18) that the state coeﬃcients are jointly zero.101 .033 −.48772 = 515.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. excluding the coeﬃcients on the state dummy variables.010 . 808 1 − .49452 σ ˜ Notice that the two statistics are close. 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. the restricted standard deviation estimate is σ = . Ignoring the other coeﬃcients.69.027 .013 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.007 . Wn = n 1 − 2 = 18.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. we ﬁnd Wn = 550.4945.

29. there is not a simple expression for this set. In the previous section we discovered that such t-tests had very poor Type I error rates. In the present context we are interested in forming a conﬁdence interval. implying a 95% conﬁdence θ) interval of [27. we found better Type I error rates by reformulating the hypothesis as a linear restriction.5]. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. so we have to go one step further. 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 ).0. we can calculate a standard error of s(ˆ = . However. not testing a hypothesis. 69 .9. but the lower end is substantially lower. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test.40. This set is [27.96.Using the Delta Method. This is the set of θ such that |tn (θ)| ≤ 1. this is a poor choice. Instead. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. 29. Since tn (θ) is a non-linear function of θ. but it can be found numerically quite easily.5].

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

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

. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi .Suppose ei (and thus η i ) were observed. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . This is the feasible GLS. If σ 2 < 0 for some i. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. or FGLS. which is typically undesirable. 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 . then the FGLS ˜i estimator is not well deﬁned.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. Then set ˜i ˜ D = diag{˜ 2 . We have shown that α is consistently estimated by a simple procedure.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Vα = E zi zi (7. Furthermore. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation.3) ˆ ˆ While ei is not observed. then the FGLS estimator will force ˜i the regression equation through the point (yi . This suggests 75 . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. We may call (7. xi ). as it is estimating the conditional variance of the regression of yi on xi . and hence we can estimate 0 σ 2 = zi α by i ˜ (7..6) σ 2 = α0 zi . ˜i Suppose that σ 2 > 0 for all i. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0. and will depend on the model (and estimation method) for the skedastic regression.4) the skedastic regression.. estimator of β. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). if σ 2 ≈ 0 for some i.. Vα ) (7.

Its asymptotic variance is not that given in Theorem 7. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . e2 }. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance.1.1. similar to the covariance matrix of the OLS estimator.2) is correctly speciﬁed. In this case we interpret α0 zi as a linear projection of e2 on zi .1 If the skedastic regression is correctly speciﬁed. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. 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. V ). β should perhaps be i i called a quasi-FGLS estimator of β. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. Unless σ 2 = α0 zi . ´´−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 . σ 2 ] σi i for some σ 2 > 0. and was proposed by Cragg (Journal of Econometrics. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7... It is possible to show that if the skedastic regression is correctly speciﬁed. and it may be estimated with considerable 76 V takes a sandwich form√. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . There are three reasons. Theorem 7. This estimator V 0 is appropriate when the skedastic regression (7. ¢¢−1 ¡ ¡ . 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 ˜ = . FGLS is asymptotically superior to OLS. i ˜ 0 is inconsistent for V . but the proof of this can be tricky. 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 → ∞. A trimming rule might make sense: σ 2 = max[˜ 2 .1. 1992).1. First.1. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. Instead. V n n i=1 .that there is a need to bound the estimated variances away from zero. In the linear regression model.. . Since the form of the skedastic regression is unknown. Why then do we not exclusively estimate regression models by FGLS? This is a good question. then FGLS is asymptotically equivalent to GLS.

The asymptotic distribution (7. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . however. Vα = E zi zi (7. OLS is a more robust estimator of the parameter vector. or equivalently that i H0 : α1 = 0 in the regression (7. Second. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . the two tests coincide.4) and constructing a Wald statistic. This hypothesis does not imply that ξ i is independent of xi .3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . BreuschPagan (1979) proposed what might appear to be ¡ distinct test.4). We may therefore test this hypothesis by the estimation (7. and not a conditional mean. In the linear regression model the conditional mean of yi given xi = x is 77 . but also under the assumptions of linear projection. individual estimated conditional variances may be negative. q Most tests for heteroskedasticity take this basic form. In this case. and this requires trimming to solve. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. The main diﬀerences between popular “tests” is which transformations of xi enter zi . on the other hand. Third. the Wald test of H0 is asymptotically χ2 .error. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). If the equation of interest is a linear projection.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. Theorem 7. and all cross-products.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. FGLS will do worse than OLS in practice.2). but the only diﬀerence is that they a ¢ allowed for general choice of zi . the estimated conditional variances may contain more noise than information about the true conditional variances. as they will be estimating two diﬀerent projections.5) and the asymptotic variance (7.2. its squares. 7. and the cost is a reduction of robustness to misspeciﬁcatio 7. This introduces an element of arbitrariness which is unsettling to empirical researchers. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. It is consistent not only in the regression model. σ 2 ). Typically. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . And the FGLS probability limit will depend on the particular function selected for the skedastic regression. then the OLS and FGLS estimators will converge in probability to diﬀerent limits.1 Under H0 and ei independent of xi . The GLS and FGLS estimators. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. require the assumption of a correct conditional mean.7) under independence show that this test has an asymptotic chi-square distribution.

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

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

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

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

by the central limit theorem (Theorm 5. First. and this improves estimation of the median. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.5. then there are many innovations near to the median. When f (0 | x) is large. This can be done with kernel estimation techniques.3. we provide a sketch here for completeness. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .10) is equivalent to g n (β) = 0. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . V ).1 is advanced. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. Computation of standard error for LAD estimates typically is based on equation (7. ¢¢−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) . the height of the error density at its median. In the special case where the error is independent of xi .11).5. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . (7. the conditional density of the error at its median. ∂β 0 so Third.Theorem 7.5.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .1 ´ √ ³ˆ n β − β 0 →d N (0. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. See Chapter 16. ˆ Proof of Theorem 7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. Let g(β) = Eg (β). The main diﬃculty is the estimation of f (0). While a complete proof of Theorem 7. where V = and f (e | x) is the conditional density of ei given xi = x. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . Pn −1 0 β)) .

Exi x0 ) →d i 2 = N (0. For ﬁxed τ . For the random variables (yi . The following alternative representation is useful. If the random variable U has τ ’th quantile Qτ . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . As functions of x. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors.9) for the median to all quantiles. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . ¥ 7. 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. (7. then F (Qτ ) = τ . V ). xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . Again. when F (y | x) is continuous and strictly monotonic in y. the quantile regression functions can take any shape.13) This generalizes representation (7. then F (Qτ (x) | x) = τ . The median is the special case τ = . For τ ∈ [0. then (7. θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. The third line follows from an asymptotic empirical process argument.5. so you can think of the quantile as the inverse of the distribution function.12) Qτ = argmin Eρτ (U − θ) .Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0.

then f (0 | xi ) = f (0) . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . Vτ ). n numerical methods are necessary for its minimization.1 n β τ − β τ →d N (0.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Another popular approach is the RESET test proposed by Ramsey (1969). When the error ei is independent of xi .12).5.13). Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. where and f (e | x) is the conditional density of ei given xi = x. the unconditional density of ei at 0. the τ ’th conditional quantile of ei is zero. and form a Wald statistic i for γ = 0. Thus. The null model is yi = x0 β + εi i 84 . conventional Newton-type optimization methods are inappropriate. ˆ Given the representation (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. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). ¡ ¡ ¢¢−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. fast linear programming methods have been developed for this problem. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. the asymptotic variance depends on the conditional density of the quantile regression error. i By construction. since it has discontinuous derivatives. 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.1. and test their signiﬁcance using a Wald test. if the model yi = x0 β + ei has i been ﬁt by OLS. ´ √ ³ˆ Theorem 7. Fortunately. otherwise its properties are unspeciﬁed without further restrictions.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . Furthermore. 7.6. it is useful to have a general test of the adequacy of the speciﬁcation. and are widely available.

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

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

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

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

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

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

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

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

3. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) .1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . it is helpful to think of a random pair (yi . 1) distribution.. To see the eﬀect of sample size on the EDF. (8.8. 50. This is a population moment. x). x) . as the sample size gets larger. in the Figure below. Fn is a nonparametric estimate of F. by the CLT (Theorem 5. Fn is by construction a step function.1). x) →p F (y. I have plotted the EDF and true CDF for three random samples of size n = 25.2) Fn (y.. x) = P (yi ≤ y.. That is. x)) →d N (0. To see this. x∗ ≤ x) = Fn (y. x). Note that while F may be either discrete or continuous. i = 1. The EDF is a consistent estimator of the CDF.2. i 93 . xi ). x))) . x∗ ) with the i distribution Fn . In general. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. but the approximation appears to improve for the large n.1). . and 100. where 1(·) is the indicator function. n. x) − F (y. √ n (Fn (y. Notationally.2 The Empirical Distribution Function Fn (y. Fn (y. x) = n i=1 Figure 8. For n = 25. the EDF is only a crude approximation to the CDF. Furthermore. The random draws are from the N (0. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . Thus by the WLLN (Theorem 5. note that for any (y. F (y. the EDF step function gets uniformly close to the true CDF. x) is called the empirical distribution function (EDF). ∗ P (yi ≤ y. Recall that F (y. x). x) (1 − F (y.

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

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

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

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

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

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

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

F ) = Gn (x. F0 ) = The order of the error is O(n−1 ). as F is a function. Thus asymptotic critical values are taken from the Φ distribution. F ). 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). we can calculate that Gn (x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F ) + g2 (−x. F ) − Gn (−x. = P (X ≤ x) − P (X ≤ −x) For example. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. A two-sided hypothesis test rejects H0 for large values of |Tn | . F ). F0 ) + O(n−3/2 ) = O(n−1 ). then |Tn | has the distribution function Gn (x. 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. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F0 ) distribution. n (8. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). 101 2 g2 (x. Similarly. We conclude that G∗ (x) − Gn (x. From Theorem 8. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x.1. F ) + g2 (x. n . F0 ) = O(n−1 ). which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x.The “derivative” ∂ ∂F g1 (x. F ) + O(n−3/2 ). F ) is only heuristic. if Tn has exact distribution Gn (x. F ) − Gn (−x.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). 8. and exact critical values are taken from the Gn (x. F ) = Gn (x. then |Tn | →d |Z| ∼ Φ.8.5) where the simpliﬁcations are because g1 is even and g2 is odd. if Z ∼ N (0. 1).

meaning that the errors in the two directions exactly cancel out. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. √ the last equality because Fn converges to F0 at rate n. G∗ (x) = Gn (x. A reader might get confused between the two simultaneous eﬀects. 8.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). Gn (x. Therefore.Interestingly. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. Fn ) + O(n−3/2 ).5) to the bootstrap distribution. whose error is O(n−1 ). F0 ) = ∗ 2 (g2 (x. F ) = Φ v √ where v = V . set Tn = n ˆ − θ0 . as it depends on the unknown V.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. but one-sided tests might have more power against alternatives of interest. similar to a one-sided test. Applying (8. which is not pivotal. and for the bootstrap ³x´ + O(n−1/2 ). the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. V ). we ﬁnd Gn (x) = Gn (x. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. This is in contrast to the use of the asymptotic distribution. Fn ) = Φ(x) + ∗ 2 g2 (x. 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 ). Theorem 8. and bootstrap tests have better rates of convergence than asymptotic tests. Conﬁdence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. and needs to be determined on a case-by-case basis. F0 )) + O(n−3/2 ) n = O(n−3/2 ). Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. Two-sided tests have better rates of convergence than the one-sided tests. is an even function. and g2 is continuous in F. Fn ) − g2 (x. Twosided tests will have more accurate size (Reported Type I error). g1 .8. This is because the ﬁrst term in the asymptotic expansion. We know that θ Tn →d N (0.

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

. i 8. n]. Show that √ n (Fn (x) − F0 (x)) →d N (0.. yielding OLS estimates β and any other statistic of interest. F0 (x) (1 − F0 (x))) . and e = Y − X β ˆ (a) Draw a random vector (x∗ . 2. It does not really matter. ... Consider the following bootstrap procedure for a regression of yi on xi . ˆi A conditional distribution with these features will preserve the main important features of the data. . Let the statistic of interest be the sample mean Tn = y n . you sample ε∗ using this two-point distribution. 4. Unfortunately this is a harder problem. creating a random bootstrap data set (Y ∗ . Tn = (ˆ − ˆ 104 . draw a ˆ ˆ random integer i0 from [1. generate ∗ bootstrap samples. 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 . Find the bootstrap moments ETn and V ar(Tn ). calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. Let β denote the ˆ the OLS residuals. e∗ ) from the pair {(xi . ei ) : i = 1.13 Exercises 1. n} . That is. ... The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0.. Let Fn (x) denote the EDF of a random sample. whether or not the xi are really “ﬁxed” or random.. Set y∗ = x∗0 β + e∗ . Take a random sample {y1 . One proposal which imposes the regression condition without independence is the Wild Bootstrap. ˆ 3. Using the non-parametric bootstrap. which is a valid statistical approach. ˆ∗ (b) Regress Y ∗ on X ∗ . 2.. X ∗ ). and set x∗ = xi0 and e∗ = ei0 . 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 . . yn } with µ = Eyi and σ 2 = V ar(yi ). Consider the following bootstrap procedure. Let ∗ ∗ ∗ {y1 . however.. Find the population moments ETn and V ar(Tn ).observed values of the regressors... ˆ Draw (with replacement) n such vectors. Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. OLS estimator from the regression of Y on X.

θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. (c) With the given information. ∗ ∗ where s(ˆ is the standard error in the original data. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. ˆ = 1.95). lot size. and ˆ is calculated on each θ ∗ ∗ θ sample. and the colonial dummy. Let qn (.2 and s(ˆ = .3. You replace c with qn (. The ˆ are sorted. with variables listed in the ﬁle hprice1. size of house. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. ˆ − s(ˆ n (. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. (b) Report the 95% Alternative Percentile interval for θ.05) . and thus reject H0 if ˆ ˆ > q ∗ (. You do this as follows.dat contains data on house prices (sales).05) and qn (.75 and 1. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.5% quantiles of the ˆ are .95).5% and 97. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and the 2.pdf. Using the non-parametric bootstrap.95) denote the 95% quantile of Tn .95) denote the 5% θ) ∗ and 95% quantiles of Tn .2. you generate bootstrap samples.95). (a) Report the 95% Efron Percentile interval for θ. θ respectively. What is wrong with this procedure? Tn = θ/s(θ) n 6.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). The dataﬁle hprice1. Estimate a linear regression of price on the number of bedrooms. You want to test H0 : θ = 0 against H1 : θ > 0. Using the non-parametric ∗ bootstrap. 105 . ∗ ∗ ∗ Let qn (. can you report the 95% Percentile-t interval for θ? 7. Suppose that in an application.

As an important special case we will devote special attention to linear moment condition models.Chapter 9 Generalized Method of Moments 9.1 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. β) = x(y − x0 β). however. We call r the number of overidentifying restrictions. but this is not required. x. z. There are − k = r more moment restrictions than free parameters. as their are restrictions in E (xi ei ) = 0. while β 1 is of dimension k < . The variables zi may be components and functions of xi . β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . zi . which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0.2) . is not necessarily eﬃcient. If k = the model is just identiﬁed. x. We know that without further restrictions.1) where β 0 is the true value of β. x. Let g(y.1) by setting g(y. This method. otherwise it is overidentiﬁed. these are known as estimating equations. β 0 ) = 0 (9. Now suppose that we are given the information that β 2 = 0. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. β 0 ) = x(y − z 0 β) 106 (9. 1 this class of models are called moment condition models. where the dimensions of zi and xi are k × 1 and × 1 . g(y. an asymptotically eﬃcient estimator of β is the OLS estimator. This is a special case of a more general class of moment condition models. xi . how should β 1 be estimated? One method is OLS regression of yi on x1i alone. In the statistics literature. z. In econometrics. This model falls in the class (9. In this case. This situation is called overidentiﬁed. with ≥ k. In our previous example.

β GMM = Z 0 XWn X 0 Z 9. for if Wn is replaced ˆ by cWn for some c > 0. For example. ¡ ¢−1 0 ˆ Z XWn X 0 Y. Let and where gi = xi ei . the square of the Euclidean length. Proposition 9.1 β GMM = argmin Jn (β).3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. ˆ Deﬁnition 9. then g n (β) = 0. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. and the GMM estimator is the MME.2. let Jn (β) = n · g n (β)0 Wn g n (β). This is a non-negative measure of the “length” of the vector g n (β). β GMM does not change. if Wn = I. For some × weight matrix Wn > 0. β ˆ Note that if k = . i i . the dependence is only up to scale. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. The GMM estimator minimizes Jn (β). then.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .2) g n (β) = (9. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . but this is generally not possible when > k.2.

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

but can be numerically tricky to obtain in some cases. There is an important alternative to the two-step GMM estimator just described. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. When constructing hypothesis tests. Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . ˆ and let g be the associated n × matrix. Then set gi = xi ei . There is little point in using an ineﬃcient GMM estimator as it is easy to compute. Heaton and Yaron (1996). we can let the weight matrix be considered as a function of β. β = Z 0 X g 0 g − ng n g 0 n n ˆ Asymptotic standard errors are given by the square roots of the diagonal elements of V .4) above. GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). A simple solution is to use the centered moment conditions to construct the weight matrix. This is a current area of research in econometrics. and GMM using Wn as the weight matrix is asymptotically eﬃcient. and was introduced by L. i. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. 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.and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . However.4) which uses the uncentered moment conditions. Instead. we actually mean “eﬃcient GMM”. 109 . so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. First. (9. 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. Here is a simple way to compute the eﬃcient GMM estimator. J(β) = n · g n (β) n i=1 In most cases. The estimator appears to have some better properties than traditional GMM. Since Egi = 0. Egi 6= 0. when we say “GMM”. set Wn = (X 0 X)−1 . as in (9. 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.e. ∗ gi (β) = gi (β) − g n (β) 9.5 GMM: The General Case In its most general form. Hansen. and construct the residual ei = yi − zi β.

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

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

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

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

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

subject ˆ i ˆi i=1 to the restriction h(β) = 0.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . Deﬁne the Lagrangian L(β. xi . β) + ei E (zi ei ) = 0. 115 .6) (a) Show that you can rewrite Jn (β) in (9. h(β)=0 (9. VR ) where ¡ ¢−1 0 R V. l ≥ k. zi is l × 1 and β is k × 1.6) equals the Wald statistic. Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. The equation of interest is yi = g(xi . The GMM estimator of β. Vn = X X i=1 ˜ and hence R0 β = r. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . VR = V − V R R0 V R (d) Show that in this setting. zi ).5. The observed data is (yi . Show how to construct an eﬃcient GMM estimator for β.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. the distance statistic D in (9. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). In the linear model Y = Xβ + e with E(xi ei ) = 0. 6. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β).

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

(10. 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. . (10..Chapter 10 Empirical Likelihood 10.2) Ln (p1 .... . the log-likelihood function for this multinomial distribution is n X ln(pi ). xi . The idea is due to Art Owen (1988.1) 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.1).. The idea is to construct a multinomial distribution F (p1 . these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. In this case the moment condition places no additional restrictions on the multinomial distribution. pn ) which places probability pi at each observation. 2001) and has been extended to moment condition models by Qin and Lawless (1994). xi . Combined with i the constraint (10. zi . β). 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 . pn ) = i=1 An alternative to GMM is empirical likelihood.3) i=1 117 . pn ) are those which maximize the log-likelihood subject to the constraint (10.1 Non-Parametric Likelihood Since each observation is observed once in the sample. The maximum likelihood estimator of the probabilities (p1 . It is a non-parametric analog of likelihood estimation. .. To be a valid multinomial distribution. The n ﬁrst order conditions are 0 = p−1 − µ... The multinomial distribution which places probability pi at each observation (yi .

1) and (10. λ).7) 118 . (see section 6. (10. This yields the (proﬁle) empirical log-likelihood function for β.3). p (10. The solution (when it exists) is well deﬁned since Rn (β. 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.. but must be obtained numerically (see section 6. we ﬁnd µ = n and 1 ¢. p1 . µ. pi gi (β) = 0. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β.5) ˆ ˆ As a by-product of estimation. summing over i. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .5).2) subject to the restrictions (10. λ) = −n ln (n) − n X i=1 For given β. probabilities 1 ³ ´´ . pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . the Lagrange multiplier λ(β) minimizes Rn (β. λ ¡ ¢ ln 1 + λ0 gi (β) . we also obtain the Lagrange multiplier λ = λ(β). . Ln (β) = Rn (β. pn . The solution cannot be obtained explicitly.5) This minimization problem is the dual of the constrained maximization problem.where λ and µ are Lagrange multipliers.4) (10. λ) is a convex function of λ.. or equivalently minimizes its negative ˆ (10. λ) : λ(β) = argmin 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). Multiplying the ﬁrst equation by pi . λ.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. and using the second and third equations..

9) and (10. λ) = − (10. λ) = − (10.13) yields n n Expanding (10. Gi (.13) Premultiplying by G0 Ω−1 and using (10. and Ω = E xi x0 e2 . i=1 i=1 i=1i Expanding (10. n (10.2. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. β λ ∂ ³ ´. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . G = −E (xi zi ).10. Thus the EL estimator is asymptotically eﬃcient. (β.8) and ¢ 0 0 For example. 0 = Rn (β.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. i i Theorem 10. and n β − β 0 and nλ are asymptotically independent. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. ˆ ˆ Proof.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.9) (10.10). λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.10) ¡ Ω−1 N (0.1 Under regularity conditions. in the linear model. β) = −xi zi . 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 (10.14) 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 .

V ) ˆ Solving (10.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. Vλ ) Furthermore. 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. The same statistic can be constructed for empirical likelihood. 10. LRn = i=1 Theorem 10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.15) (10. First. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.3. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . and have the same interpretation. Since the EL estimator achieves this bound. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. They are asymptotically ﬁrst-order equivalent.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. 120 .15).1 If Eg(wi .7) is n ³ ´´ ³ X ˆ ˆ0 (10. β 0 ) = 0 then LRn →d χ2−k . and (10. and it is advisable to report the statistic LRn whenever EL is the estimation method. (10.14) for λ and using (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. The overidentiﬁcation test is a very useful by-product of EL estimation.17) 2 ln 1 + λ gi β .16). Proof. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (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. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . it is an asymptotically eﬃcient estimator for β. tests are based on the diﬀerence in the log likelihood functions. by a Taylor expansion.

h(β)=0 ˜ Fundamentally. To test the hypothesis h(β) while maintaining (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. The hypothesis of interest is h(β) = 0. Vλ )0 Ω−1 N (0. LRn →d χ2 . 10. where h : Rk → Ra .prc 121 . the simple overidentifying restrictions test (10. LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. 10.1 Under (10.18). Theorem 10. since ln(1 + x) ' x − x2 /2 for x small. This test statistic is a natural analog of the GMM distance statistic. By “maintained” we mean that the overidentfying restrictions contained in (10.4 Testing Egi (β) = 0 (10.18) and H0 : h(β) = 0.wisc.edu/~bhansen/progs/elike. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. so there is no fundamental change in the distribution theory for β relative to β. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).4. a The proof of this result is more challenging and is omitted.ssc. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.Second.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).18) Let the maintained model be where g is × 1 and β is k × 1.17) is not appropriate.

i Rββ = Inner Loop The so-called “inner loop” solves (10. Deﬁne ∗ gi (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λ)0 − ∂β∂β Rn (β. λ)0 0 Rn (β. One method uses the following quadratic approximation. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. set 2 λp = λj − δ p (Rλλ (β.. Eﬃcient convergence requires a good choice of steplength δ. λ) . λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). The starting value λ1 can be set to the zero vector. (10. Set δ 0 = 0. For p = 0.4). λp ) A quadratic function can be ﬁt exactly through these three points.19) is continued until the gradient Rλ (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ) G∗ (β.5) for given β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β.19). 1. 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. λj ) is smaller than some prespeciﬁed tolerance. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) = G∗ (β. λ) gi (β. λ) G∗ (β. λ) = − gi (β. λj ))−1 Rλ (β. δ 1 = 1 and δ 2 = 1. λ)0 − Rn (β. λj )) Rp = Rn (β. 2.20) . λ) = i The ﬁrst derivatives of (10.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. The iteration (10. 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 ) . λj ))−1 Rλ (β. λ) ∂λ i=1 n ∂ Rn (β.19) X ∂2 ∗ ∗ gi (β.

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

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

2) Any solution to the problem of endogeneity requires additional information which we call instruments. this can be written as Y = Zβ + e. (11. By the above deﬁnition. We call z1i exogenous and z2i endogenous.1.1). In a typical set-up. and x2i are the excluded exogenous variables. at least the intercept). which does not equal either β 1 or β 2 .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 ¶ .4) xi = x2i 2 where z1i = x1i are the included exogenous variables. So we have the partition µ ¶ z1i k1 (11. This is called simultaneous equations bias.1) the structural equation. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. That is x2i are variables which could be included in the equation for yi (in the sense 125 . so should be included in xi . In matrix notation.1 The × 1 random vector xi is an instrumental variable for (11.1) where zi is k × 1.1) if E (xi ei ) = 0. some regressors in zi will be uncorrelated with ei (for example. Deﬁnition 11. 11. and assume that E(zi ei ) 6= 0 so there is endogeneity. β →p β ∗ .1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. z1i is an instrumental variable for (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. Thus we make the partition ¶ µ k1 z1i (11. We call (11.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

12). 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 (11.13) which is zero only when S21 = 0 (when Z is exogenous). 11. PX Z2 ] h i ˆ = Z1 . Then i h ˆ ˆ ˆ Z = Z1 . Here we present a simpliﬁed version of one of his results. Thus in the second stage.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. X is n × l so there are l instruments. Z2 = [PX Z1 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . let’s analyze the approximate bias of OLS applied to (11. Using (11.11). PX Z2 ] = [Z1 .ˆ It is useful to scrutinize the projection Z. we regress Y on Z1 and Z2 .12) Z = XΓ + u ξ = (e. ¶ 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 ) . Recall. the model is Y = Zβ + e (11.11) (11. First. Z = [Z1 . ˆ since Z1 lies in the span of X. Z2 ] and X = [Z1 . So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . X2 ]. We now derive a similar result for the 2SLS estimator. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. 129 . In our notation. Z2 .

Let PX = X (X 0 X)−1 X 0 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . n and (11. By the spectral decomposition of an idempotent matrix. l . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11. It is also close to zero when α = 0.14) is the probability limit of β 2SLS − β 11.12) and this result. 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 . The consequences of identiﬁcation failure for inference are quite severe.14) In general this is non-zero. 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). Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. 130 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 0). Indeed as α → 1. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. the expression in (11. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 .14) approaches that in (11.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . the bias in the 2SLS estimator will be large.13). P = HΛH 0 0 0 where Λ = diag(Il .

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

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

5. l ≥ k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. Z is n × k. 133 . Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. 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) . at ˆˆ If X is indeed endogeneous. Find a simple expression for the IV estimator in this context. and Γ is l × k. will IV “ﬁt” better than OLS. X is n × l. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β.8 Exercises yi = zi β + ei . xi is l × 1.) 3. 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 × 1.11. 2. 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. ˜ 0 e < e0 e. (Find an expression for xi . in the sense that e ˜ ˜ least in large samples? 4. 1. That is. Take the linear model Y = Zβ + e. u is n × k. 6. where xi and β are 1 × 1. Explain why this is true. Take the linear model yi = xi β + ei E (ei | xi ) = 0.

(a) Estimate the model by OLS. Estimate the model by 2SLS. using zi as an instrument for xi . 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. and then calculate the GMM estimator from this weight matrix without further iteration. In this model. using the instrument near4. We want to estimate a wage equation log(W age) = β 0 + β 1 Educ + β 2 Exper + β 3 Exper2 + β 4 South + β 5 Black + e where Educ = Eduation (Years) Exper = Experience (Years). a dummy indicating that the observation lives near a 4-year college. of the mother). Report estimates and standard errors. (f) Discuss your ﬁndings. Does this diﬀer from 2SLS and/or OLS? 7. and South and Black are regional and racial dummy variables.. listed in card. 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. Report the estimates and standard errors. (b) Now treat Education as endogenous. The data ﬁle card. in years.pdf. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix.(b) Deﬁne the 2SLS estimator of β. are the parameters identiﬁed? 8. There are 2215 observations with 19 variables. Report estimates and standard errors. 134 . f atheduc (the education.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995). (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). in years. of the father) and motheduc (the education. and the remaining variables as exogenous. (d) Re-estimate the model by eﬃcient GMM. (e) Calculate and report the J statistic for overidentiﬁcation. 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.

Because of the sequential nature of time series. A stationary time series is ergodic if γ(k) → 0 as k → ∞.2 {Yt } is strictly stationary if the joint distribution of (Yt .) is a random variable. The primary model for univariate time series is autoregressions (ARs). . To indicate the dependence on time. Yt−1 . t = 1. Deﬁnition 12.. We can separate time series into two categories: univariate (yt ∈ R is scalar). 12. so classical assumptions are not valid. T . we adopt new notation. then Xt is strictly stationary and ergodic. we expect that Yt and Yt−1 are not independent. and use the subscript t to denote the individual observation..1. Yt−k ) = γ(k) is independent of t for all k.. .1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. Deﬁnition 12.1...1. 135 .1. and multivariate (yt ∈ Rm is vector-valued). The primary model for multivariate time series is vector autoregressions (VARs). Yt−k ) is the autocorrelation function. Deﬁnition 12. γ(k) is called the autocovariance function.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . and Cov (Yt .1 If Yt is strictly stationary and ergodic and Xt = f (Yt .1 Stationarity and Ergodicity Deﬁnition 12. There proofs are rather diﬃcult. . Theorem 12. The following two theorems are essential to the analysis of stationary time series..Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.4 (loose). Yt−k ) is independent of t for all k. and T to denote the number of observations.. however.1..

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

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

We say that the root of the polynomial is 1/ρ. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). we see that L2 Yt = LYt−1 = Yt−2 . Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .3.4. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. In general. an AR(1) is stationary iﬀ |ρ| < 1. Deﬁnition 12. the above results are unchanged.3. Deﬁning L2 = LL. 138 . or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. The AR(k) model is Using the lag operator. ∞ X k=0 ρ2k V ar (et−k ) = 12. Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value).5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . since ρ(z) = 0 when z = 1/ρ. From Theorem 12. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .Theorem 12. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . We call ρ(L) the autoregressive polynomial of Yt . We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 .1 The lag operator L satisﬁes LYt = Yt−1 . We call ρ(L) the autoregressive polynomial of Yt . Lk Yt = Yt−k . 12.1.

then ˆ β →p β as T → ∞. λk are the complex roots of ρ(z). One way of stating this is that “All roots lie outside the unit circle. β = X 0X (12. Theorem 12.. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. Proof. This is a special case of non-stationarity.1) Theorem 12.. t Yt−k ¢0 ρk . the requirement is that all roots are larger than one. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. Note that ut is a MDS. it is also strictly stationary and ergodic.where the λ1 . which satisfy ρ(λj ) = 0.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. we say that ρ(L). and is of great interest in applied time series. . Let |λ| denote the modulus of a complex number λ.6. Thus t by the Ergodic Theorem. The vector xt is strictly stationary and ergodic.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . 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. By Theorem 12.1. and hence Yt . ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.1.1) and the continuous mapping theorem. it is helpful to deﬁne the process ut = xt et . t T t=1 T t=1 139 . and by Theorem 12. so is xt x0 . For an AR(k). t t T t=1 ¥ Combined with (12. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.5.1.1. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.” If one of the roots equals 1. “has a unit root”.. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.

as this imposes inappropriate independence.8 Bootstrap for Autoregressions In the non-parametric bootstrap. t This construction imposes homoskedasticity on the errors e∗ .2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. .1 to see that T 1 X √ xt et →d N (0.7. Estimate β and residuals et . T t=1 Since xt et is a MDS. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. T 1 X √ ut →d N (0. Q−1 ΩQ−1 . Method 2: Block Resampling 1. Method 1: Model-Based (Parametric) Bootstrap. It also presumes that the AR(k) structure is the truth. xt }. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .. i 4. then as T → ∞. t then as T → ∞...1 MDS CLT. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. ˆ 2. e ˆ 3. Divide the sample into T /m blocks of length m. 140 . This creates an iid bootstrap sample. 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∗ . eT }.7 Asymptotic Distribution Theorem 12. Brieﬂy. The implication is that asymptotic inference is the same. we constructed the bootstrap sample by randomly resampling from the data values {yt . there are two popular methods to implement bootstrap resampling for time-series data. . ˆ 1. which may be diﬀerent than the i properties of the actual ei . this cannot work in a time-series application.12. T t=1 where Ω = E(xt x0 e2 ).7. 12. This is identical in form to the asymptotic distribution of OLS in cross-section regression... Y0 ). Ω) .. the asymptotic covariance matrix is estimated just as in the cross-section case. we can apply Theorem 12. Ω) . Y−k+2 . t t Theorem 12.7. In particular. Clearly. Fix an initial condition (Y−k+1 .

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

. if the null hypothesis is that Yt is an AR(k). you need more initial conditions. and then reserve the ﬁrst k as initial conditions. We then multiply this by θ and subtract from (12.6) 12.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . Yt−k−m are jointly zero. and then estimate the models AR(1). Another is to minimize the AIC or BIC information criterion. (12. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero..10 Testing for Omitted Serial Correlation For simplicity. (If you increase k.. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.) This can induce strange behavior in the AIC.5). 142 . . to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .5) and (12. We model this as an AR(1): ut = θut−1 + et with et a MDS. and under H1 it is an AR(2). T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes.. (A simple exclusion test). In general. this is the same as saying that under the alternative Yt is an AR(k+m). we take (12. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). AR(2).. The best remedy is to ﬁx a upper value k. and the alternative is that the error is an AR(m). AIC(k) = log σ 2 (k) + ˆ 2k . (12. We want to test H0 against H1 . One approach to model selection is to choose k based on a Wald tests. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . e.g. Yt is an AR(1). .5) We are interested in the question if the error ut is serially correlated.. AR(k) on this (uniﬁed) sample. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . Thus under H0 .12. To combine (12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. An appropriate test is the Wald test of this restriction.6).

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

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

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

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

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

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

if Yt is a pair of interest rates. In some cases. β is not consistent. Whether or not the time trend is included. in general. The r vectors in β are called the cointegrating vectors. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). then r = 0.13. If the series Yt is not cointegrated. 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). so the ADF critical values are not appropriate. Under H0 . then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. the asymptotic distribution of the test is aﬀected by the presence of the time trend.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 . Thus Yt = ˆ (Y1t . When the data have time trends. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . yet under H1 zt is I(0). then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. β = (1 − 1)0 . Suppose that β is known. a good method to estimate β. If Y = (log(Consumption) log(Income))0 . of rank r. When β is unknown. then Yt is I(0). 149 . Then under H0 zt is I(1). Often. In other cases.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. Yt is I(1) and cointegrated. If Yt is cointegrated with a single cointegrating vector (r = 1). Deﬁnition 13. such that zt = β 0 Yt is I(0). Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . from OLS of Y1t on Y2t . Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. Thus H0 can be tested using a univariate ADF test on zt . it may be believed that β is known a priori. This is not. as ﬁrst shown by Stock (1987). If r = m. m × r. so zt = β 0 Yt is known. For example. but it is useful in the construction of alternative estimators and tests. For 0 < r < m. it may be necessary to include a time trend in the estimated cointegrating regression. however. and was articulated in detail by Engle and Granger (1987).8. β may not be known. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. Hansen (1992). 13. The asymptotic distribution was worked out in B.

which is least-squares subject to the stated restriction. they are typically called the “Johansen Max and Trace” tests. 1991. One diﬃculty is that β is not identiﬁed without normalization. These tests are constructed as likelihood ratio (LR) tests. If β is known. Thus cointegration imposes a restriction upon the parameters of a VAR.Theorem 13. it is simple to test for cointegration by testing the rank of Π. this is the MLE of the restricted parameters under the assumption that et is iid N (0.9. If β is unknown. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. 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 does not work. Equivalently. 1995). and are similar to the Dickey-Fuller distributions. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . When r = 1. Their asymptotic distributions are non-standard. When r > 1. we typically just normalize one element to equal unity. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r.1 (Granger Representation Theorem). Ω). In the context of a cointegrated VAR estimated by reduced rank regression. As they were discovered by Johansen (1988. rank(α) = r. 150 .

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

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

2 Count Data exp (−λi ) λk i . but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. i i i=1 ˆ The MLE is the value β which maximizes ln (β). any known value can substitute.. . a typical approach is to employ Poisson regression. An example of a data collection censoring is top-coding of income. This may be considered restrictive. In surveys.1). He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. k! = exp(x0 β).1) yi = ∗ <0 . i If Y = {0. 1.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β).) The observed data yi therefore come from a mixed continuous/discrete distribution. Tobin observed that for many households. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. the consumption level (purchases) in a particular period was zero.}.. this motivates the label Poisson “regression. 14. Thus the model is that there is some latent process yi with unbounded support.. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. The functional form for λi has been picked to ensure that λi > 0. 2. A generalization is the negative binomial. . Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) .14. 1.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. σ 2 ) with the observed variable yi generated by the censoring equation (14. The censoring process may be explicit in data collection. The conditional density is the Poisson with parameter λi . 2. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. incomes above a threshold are typically reported at the threshold. or it may be a by-product of economic constraints. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. 0 if yi (This is written for the case of the threshold being zero..

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

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

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

xit }. t = ti . 15.1) is called the random eﬀects hypothesis. .. In either event. It is consistent if E (xit ui ) = 0 (15.. i = 1. xit } : t = 1..1) is true. xit } : For i = 1. An observation is the pair {yit . . A panel may be balanced : {yit . and that eit is uncorrelated with xit . . it The typical maintained assumptions are that the individuals i are mutually independent.... OLS can be improved upon via a GLS technique. Condition (15. OLS of yit on xit is called pooled estimation. and thus achieve invariance. . then OLS is inconsistent. n. that ui and eit are independent. If (15. There are several derivations of the estimator. This is often believed to be plausible if ui is an omitted variable. The goal is to eliminate ui from the estimator. OLS appears a poor estimation choice.1) If this condition fails. 157 . collected over time. 15. n... It is a strong assumption. and most applied researchers try to avoid its use.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions.. and the t subscript denotes time. where the i subscript denotes the individual. (15.. or unbalanced : {yit . The motivation is to allow ui to be arbitrary..Chapter 15 Panel Data A panel is a set of observations on individuals.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . that eit is iid across individuals and time.. however. T . and have arbitrary correlated with xi . ti .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 ˆ OLS on (15. • If xit contains an intercept. un ui = d0 u. 158 . • Any regressor in xit which is constant over time for all individuals (e. as the parameter space is too large. OLS estimation of β proceeds by the FWL theorem. di ) = 0. then by the FWL theorem. din Observe that E (eit | xit . it i (15. ⎠ . Let ⎛ ⎞ u1 ⎜ . Observe that • This is generally consistent.2) ⎞ di1 ⎜ . Y ∗ = Y − D(D0 D)−1 D0 Y where X ∗ = X − D(D0 D)−1 D0 X. it will be collinear with di .2) yields estimator (β. Conventional inference applies. . ˆ β = ¢−1 ¡ 0 ¢ ¡ 0 X (1 − PD ) Y X (1 − PD ) X ¡ ¢−1 ¡ ∗0 ∗ ¢ = X ∗0 X ∗ X Y . you do not want to actually implement conventional OLS estimation. let dij = and ⎧ ⎨ 1 ⎩ 0 ⎛ if i = j . • There are n + k regression parameters. . Stacking the observations together: Y = Xβ + Du + e. ⎠. else Then note that and an n × 1 dummy vector with a “1” in the i0 th place.g. so the intercept is typically omitted from xit . so will have to be omitted. which is quite large as typically n is very large. i yit = x0 β + d0 u + eit .First. ⎟ di = ⎝ ..2) is a valid regression. Computationally. their gender) will be collinear with di . with di as a regressor along with xi . so (15. u). ⎟ u = ⎝ .

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

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

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

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

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

164 .Epanechnikov Kernel: hrule = 2.34n−1/5 Biweight (Quartic) Kernel: hrule = 2. This is more treacherous than may ﬁrst appear. as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x). They are also quite ill-behaved when the data has some discretization (as is common in economics). Another popular choice for selection of h is cross-validation. This works by constructing an estimate of the MISE using leave-one-out estimators. The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x). but implementation can be delicate. There are some desirable properties of cross-validation bandwidths. which are known as smoothed cross-validation which is a close cousin of the bootstrap. I now discuss some of these choices. in particular the iterative method of Sheather and Jones (1991). and then plug this estimate into the formula (16. Fortunately there are remedies. in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates. there are modern versions of this estimator work well. There are other approaches. However.2). but they are also known to converge very slowly to the optimal values.78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice.

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

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

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

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

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

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

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

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

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

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

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

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

11) 2 with r = 1.1. tr has distribution 177 . Proof of Theorem A. Set r Z . Thus the density of Z 2 is (A.11). Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .13).8.Theorem A. Iq ).13) is the MGF of the density (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.8.3 Let Z ∼ N (0. which we showed in (A.8. which can be found by applying change-of-variables to the gamma function. (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 . For Z ∼ N(0. The MGF for the density (A. we see that the MGF of Z 2 is (1 − 2t)−1/2 . From (A.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). C −1 CC 0 C −10 ) = N (0.12) E exp (tQ) = 0 Γ (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.2. C −1 AC −10 ) = N (0. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. 1) and Q ∼ χ2 be independent. Using the simple law of iterated expectations. q Proof of Theorem A. 1). tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.8.3.

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

cases are rare. θ θ∈Θ ˆ In some simple cases.9.16). ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. More typically. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.17) The matrix I0 is called the information. θ) ∂θ ∂θ which holds at θ = θ0 by (A. θ) ≡ L(θ).9. ˆ →p θ0 as n → ∞. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. which maximizes the log-likelihood). θ) →p E ln f (Yi .17) is often called the information matrix equality. we can see that it is an estimator of the maximizer θ of the right-hand-side. θ0 ) ∂θ∂θ 0 (A.16) (A. n n i=1 n As the MLE ˆ maximizes the left-hand-side. but these ˆ must be found by numerical methods. However.14) ¶ ∂ ∂ 0 ln f (Yi . Theorem A.3 Under regularity conditions. under conventional regularity conditions. we can ﬁnd an explicit expression for θ as a function of the data. and the equality (A.1 ¯ ¯ ∂ E ln f (Yi . θ Theorem A. 179 . θ0 ) . θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. then θ V ar(˜ ≥ (nI0 )−1 . In fact. ˆ is consistent θ for this value. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . If ˜ is an unbiased estimator of θ ∈ R.15) Two important features of the likelihood are Theorem A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .2 Cramer-Rao Lower Bound. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ0 ) ln f (Yi .9. ∂θ ∂θ (A. I0 . θ) The Cramer-Rao Theorem gives a lower bound for estimation. We can write this as ˆ = argmax Ln (θ). the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi .

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

function of the data. ∂θ ¯θ=θ0 Z ! = 0. θ0 ) ln f (Yi . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . we can show that E By direction computation. θ) d˜ = ˜ y ) ∂ ln f (˜..9. (Yi . θ0 ) (Yi ..16). To see (A.Proof of Theorem A. θ0 ) ¯ ∂ f (y. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. ¯ ¯ ∂ E ln f (Yi . ∂2 ln f (Yi . θ) f (˜. θ) f (y. yn ). θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ0 ) ∂ ∂θ f ∂ (Yi . θ0 ) ∂θ f (Yi . f (Yi . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜.1) has mean zero and variance nH. θ0 ) ∂ ∂ − ln f (Yi . .17). θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. Proof of Theorem A. θ0 )2 (Yi . θ) dy ¯ ∂θ f (y. θ0 ) − f (Yi .2.9.9. θ0 = ln f (Yi . θ0 ) d˜ = E ˜ . θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y.1. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. V ar (S) nH so ¥ 181 . Since θ Z ˜ = ˜ y)f (˜. θ0 )0 f (Yi . y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = .. θ0 )0 . θ0 ) f (Yi .

Ω) . θ) . θ0 ) . θ n ) θ − θ 0 . θ0 ) + ' 0 ln f (Yi . an application of the CLT yields 1 X ∂ √ ln f (Yi . Ω) = N 0. the speciﬁc value of θn varies by row in this expansion. θ0 ) →d N (0. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi .) Rewriting this equation. (Technically. then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi .3 Taking the ﬁrst-order condition for maximization of Ln (θ).9. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0.9. H −1 ΩH −1 = N 0. If it is continuous in θ. ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. ¥ 182 . θ0 ) is mean-zero with covariance matrix Ω. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . and making a ﬁrst-order Taylor series expansion. we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi .Proof of Theorem A. Together. θn ) = ln f (Yi . − ln f (Yi . H −1 . the ﬁnal equality using Theorem A.1 .

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

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

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

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