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

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

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

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

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

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

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

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

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

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

0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . If A − BD−1 C and D − CA−1 B are non-singular. if there is no c 6= 0 such that Ac = 0. This matrix is called the inverse of A and is denoted by A−1 . . the Moore-Penrose generalized inverse A− exists and is unique. 2.1) . In this case there exists a unique matrix B such that AB = BA = Ik .3) The matrix A− is not necessarily unique. then A−1 = A. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . For non-singular A and C. (2. . (2.4 Inverse A k × k matrix A has full rank. .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.2) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2.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 . . then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . or is nonsingular. if A is an orthogonal matrix. 7 Also. The following fact about inverting partitioned matrices is sometimes useful. The Moore-Penrose generalized inverse A− satisﬁes (2. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. . .

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

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

⎟ . am1 B am2 B · · · amn B Some important properties are now summarized. The vec of A. The Kronecker product of A and B. . . .9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. denoted A ⊗ B. . then det A = ±1 ¢ ¡ = (det D) det A − BD−1 C if det D 6= 0 Qk i=1 aii • If A is triangular (upper or lower).• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. . . . ⎠ ⎝ . 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 . . then det A = 2. is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. • If A is orthogonal. These results hold for matrices for which all matrix multiplications are conformable. is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. an Let B be any matrix. denoted by vec (A) . . ⎣ ⎦ .

This is used when the goal is to quantify the impact of one set of variables on another variable. Figure 3.1 displays the density1 of hourly wages for men and women. and exists so long as E |yi | < ∞. We call yi the dependent variable. These are asymmetric (skewed) densities. ⎟ . which is a common feature of wage distributions. (3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. . In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. While it is easy to observe that the two densities are unequal. xki 3. In this context we partition the observations into the pair (yi . An important summary measure is the conditional mean Z ∞ yf (y | x) dy. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. or the covariates. These are conditional density functions — the density of hourly wages conditional on race. The two density curves show the eﬀect of gender on the distribution of wages. The data are from the 2004 Current Population Survey 1 11 .73. When a distribution is skewed.22.1 by the arrows drawn to the x-axis. and that for women is $20. In the example presented in Figure 3. the conditioning variable. xi ) where yi is a scalar (real-valued) and xi is a vector. Take a closer look at the density functions displayed in Figure 3. the mean wage for men is $27.1. holding the other variables constant. ⎠ ⎝ .2) m(x) = E (yi | xi = x) = −∞ In general.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. education and experience. These are indicated in Figure 3. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. We call xi alternatively the regressor.1) xi = ⎜ . the conditional density of yi given xi . See Chapter 16. we can focus on f (y | x) .1. m(x) can take any form. it is useful to have numerical measures of the diﬀerence. gender. the mean is not necessarily a good summary of the central tendency. To illustrate. You can see that the right tail of then density is much thicker than the left tail.

Figure 3. The diﬀerence in the log mean wage between men and women is 0. To illustrate. this yields the formula yi = m(xi ) + ei . The main point to be learned from Figure 3. which implies a 30% average wage diﬀerence for this population. 2 (3.3 is how the conditional expectation describes an important feature of the conditional distribution.5.2) evaluated at the observed value of xi : ei = yi − m(xi ).3) White non-military male wage earners with 10-15 years of potential work experience. 3. When the distribution of the control variable is continuous. Figure 3. wage regressions typically use log wages as a dependent variable rather than the level of wages.Figure 3. with mean log hourly wages drawn in with the arrows.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. degree in mean log hourly wages is 0. Assuming for simplicity that this is the true joint distribution.A. then comparisons become more complicated. and a Ph. The comparison in Figure 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. The conditional expectation function is close to linear. For this reason. By construction. implying an average 36% diﬀerence in wage levels. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. the solid line displays the conditional expectation of log wages varying with education.D.3 displays a scatter plot2 of log wages against education levels. Of particular interest to graduate students may be the observation that diﬀerence between a B.1 is facilitated by the fact that the control variable (gender) is discrete.2 shows the density of log hourly wages for the same population.30. 12 .36. the dashed line is a linear projection approximation which will be discussed in the Section 3.

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

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

it is more realistic to view the linear speciﬁcation (3.4 Linear Regression An important special case of (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.we say that the error ei is homoskedastic.8) (3. Equivalently. ⎠ . where x1i is the ﬁrst element of the vector xi deﬁned in (3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). 15 .1 and that for women is 10.6) as an approximation. xki When m(x) is linear in x. As an example. βk ⎛ (3. which we derive in this section. Thus (3. take the conditional wage densities displayed in Figure 3. Instead.1. 3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. its functional form is typically unknown.6) (3. ⎝ .9) 3. and the linear assumption of the previous section is empirically unlikely to accurate.5. ⎟ .5) xi = ⎜ . Equation (3.8) is called the linear regression model. We call this the “constant” or “intercept”. i (3. they are also somewhat more dispersed. ⎠ . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .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 . This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . In this case (3.7) is a k × 1 parameter vector. ⎟ β=⎝ . it is convenient to augment the regressor vector xi by listing the number “1” as an element. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . The conditional standard deviation for men is 12. we assume that x1i = 1.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. So while men have higher average wages.1). Notationally.

by “best” we mean the predictor function with lowest mean squared error. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . E (xi x0 ) is invertible.12) This completes the derivation of the linear projection model. written E (xi x0 ) > 0. x0 β is the best linear predictor for yi .10). otherwise they are distinct. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . i (3. In order for β to be uniquely deﬁned. The best linear predictor is obtained by selecting β to minimize S(β). Therefore. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β.5.1. i (3. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. This occurs when redundant variables are included in xi . It is invertible if and only if it is positive deﬁnite. Equivalently.1 1. Observe i that for any non-zero α ∈ Rk . 2 2. 3. Rewriting. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. The ﬁrst-order condition for minimization (from Section 2. Assumption 3. As before. i 4. this situation must be excluded.which is quadratic in β. The error is i ei = yi − x0 β. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . i 16 .10) It is worth taking the time to understand the notation involved in this expression. xi contains an intercept. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i which requires that for all non-zero α. The vector (3.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. 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 . E (x0 xi ) < ∞. Given the deﬁnition of β in (3.5. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. i i (3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. Eyi < ∞.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.

3 ensure that the moments in (3.10) and (3. 17 . it follows that linear regression is a special case of the projection model.5.5.1. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .4 we know that the regression error has the property E (xi ei ) = 0.1 is employed to guarantee that (3. Let’s compare it with the linear regression model (3.1. The ﬁnite variance Assumptions 3.1.2 and 3. Assumption 3. This means that the equation (3.5. the orthogonality restriction (3.14) holds.12) and (3. Furthermore. Assumption 3. Equation (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. E (xi ei ) = 0 and E (ei ) = 0. (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.3 are called regularity conditions.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 = 0.13) and Assumption 3.1.4 guarantees that the solution β exits.1 Under Assumption 3.4 is required to ensure that β is uniquely deﬁned. (3.1. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .2 and 3.14) Proof.14) follows from (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. Since from Theorem 3.1.5. For example.13) The two equations (3.5.5.11) and (3. By deﬁnition.1. Assumption 3.1.13) summarize the linear projection model. Using the deﬁnitions (3.14).1.9).2.13) implies that xi and ei are uncorrelated.1. Since ei is mean zero by (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. Assumption 3.12) can be alternatively interpreted as a projection decomposition.Theorem 3.10) are deﬁned.8)-(3. However.5.5.11) are well deﬁned.1.5.5. Figure 3.1 are weak. ¥ (3.5.

4 we display as well this quadratic projection. and the straight dashed line is the linear projection.10) may not hold and the implications of Theorem 3. However. It over-predicts wages for young and old workers.We have shown that under mild regularity conditions. In other cases the two may be quite diﬀerent. and are discussed in Chapter 11. In this example it is a much better approximation to the conditional mean than the linear projection. it is important to not misinterpret the generality of this statement. In the example just presented. Figure 3. and under-predicts for the rest.3. we can augment the regressor vector xi to include both experience and experience2 . in many economic models the parameter β may be deﬁned within the model. there are no changes in our methods or analysis. the dashed line is the linear projection of log wages on eduction. A projection of log wages on these two variables can be called a quadratic projection.5. since the resulting function is quadratic in experience. In contrast.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. 18 .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. Returning to the joint distribution displayed in Figure 3.10). These structural models require alternative estimation methods. In this case the linear projection is a poor approximation to the conditional mean. Figure 3. The linear equation (3. In this case (3.1 may be false. Most importantly. Other than the redeﬁnition of the regressor vector. This defect in linear projection can be partially corrected through a careful selection of regressors. for those over 53 in age). it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.5. In this example the linear projection is a close approximation to the conditional mean. We illustrate the issue in Figure 3.12) with the properties listed in Theorem 3. xi ) we can deﬁne a linear projection equation (3. No additional assumptions are required.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.4 displays the relationship3 between mean log hourly wages and labor market experience.1. In Figure 1. The solid line is the conditional mean. for any pair (yi .

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

e−λ λj j! . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . j! 0 j = 0. then E(x2 ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi . i 8. If yi = x0 β + ei . 3. True or False. E(Y 2 | X = x) and V ar(Y | X = x). If yi = x0 β + ei and E(xi ei ) = 0.1. taking values only on the non-negative integers. Let X be a random variable with µ = EX and σ 2 = V ar(X).. s) = 0 if and only if m = µ and s = σ 2 . If yi = x0 β + ei and E(ei | xi ) = 0. then E(x2 ei ) = 0. then E(ei | xi ) = 0. i 7.3 Find E(Y | X = x). and have the following joint probability distribution X=0 X=1 Y =0 . Suppose that Y and X only take the values 0 and 1. µ. then ei is i i independent of xi . E(ei | xi ) = 0. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. Prove parts 2. True or False. and E(e2 | xi ) = σ 2 . 20 . 2. True or False. Let xi and yi have the joint density f (x.6 Exercises 1. yi ). 1. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . If yi = xi β + ei . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x.2 Y =1 . and E(ei | xi ) = 0. i 10.4 .3. Suppose that yi is discrete-valued. σ 2 = V ar(xi ). µx = Exi . ¡ ¢ 4. then ei is independent of xi . (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 .. 0 ≤ y ≤ 1. x 6. Compute E(yi | xi = x) and V ar(yi | xi = x). and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . m. and E(xi ei ) = 0. xi ∈ R. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. If yi = xi β + ei . 9. Are they diﬀerent? Hint: If P (Y = j) = 5. Compute the conditional mean m(x) = E (yi | xi = x) . σ = . a constant.2. 2. i 11. 3 and 4 of Theorem 3.1 . xi ∈ R. . True or False. True or False.

(4.4) i i=1 i=1 ˆ Another way to derive β is as follows.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 (4.2) (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .2) can be written in the parametric 0 β)) = 0. but for most of the chapter we retain the broader focus on the projection model. 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 .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 .3) In Sections 4.7 and 4. i It follows that the moment estimator of β replaces the population moments in (4.1 Estimation Equation (4. i n i=1 n 21 .3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .8. Observe that (4.1) (4. we narrow the focus to the linear regression model.

30 + 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. An interpretation of the estimated equation is that each year of education is associated with an 11. Let yi be log wages and xi be an intercept and years of education. This sample has 988 observations. To illustrate.4). ¶ 2.117 Educationi . Then µ ¶ n 1X 2. with 10-15 years of potential work experience.117 1 14.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.83 ¶−1 µ ¶ .7% increase in mean wages.95 42. i 22 .37 µ ¶ 1.14 205. 30 = . 4.2 Least Squares There is another classic motivation for the estimator (4.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. 40 0. These are white male wage earners from the March 2004 Current Population Survey.95 xi yi = 42.4).ˆ This is a set of k equations which are linear in β.40 µ ¶µ ¶ 34. 40 2.3. 0. consider the data used to generate Figure 3. excluding military.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.71 = −2.94 −2. 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. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.14 14.14 205.14 14.170 37.

These two ˆ variables are frequently mislabeled.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Following convention we will call β the OLS estimator of β. i ˆ ˆ Note that yi = yi + ei .2 displays the contour lines of the same function — horizontal slices at equally spaced heights.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. the contour lines are ellipses.4). Matrix calculus (see Appendix 2. 23 . Figure 4. Figure 4. which can cause confusion. Figure 4. To visualize the sum-of-squared errors function. while the residual is a by-product of estimation. The error is unobservable.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. It is important to understand the distinction between the error ei and the residual ei . Since the function Sn (β) is a quadratic function of β.

It measures the variation in the i “unexplained” part of the regression. 24 .6) An alternative estimator uses the formula n 1 X 2 s = ei .7) A justiﬁcation for the latter choice will be provided in Section 4.2: Sum-of-Squared Error Function Contours Equation (4. and hold true for all linear regression estimates.Figure 4. ˆ n i=1 n Since xi contains a constant. These are algebraic results. Its method of moments estimator is the sample average 1X 2 ei . The error variance σ 2 = Ee2 is also a parameter of interest. one implication is that n 1X ei = 0. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero.7. ˆ n−k 2 i=1 (4.5) implies that 1X xi ei = 0. ˆ σ = ˆ n 2 i=1 n (4.

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

and X is an n × k matrix. n X i=1 Thus the estimator (4. = β+ XX 26 (4. . . ⎟. For example n X i=1 For many purposes. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. The linear equation (3. ⎝ ⎝ . 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). . including computation. . and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. residual vector. yn = x0 β + en . 4. Due to this equivalence. it is matrix notation. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . ⎠ xi x0 = X 0 X i xi yi = X 0 Y. Sample sums can also be written in matrix notation.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . Thus the MLE (β. σ 2 ) = − 2 + ¡ ¢2 e2 = 0.12) is a system of n equations. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. one for each observation. yn ⎟ ⎟ ⎟. . en ⎞ Observe that Y and e are n × 1 vectors. x0 n ⎞ ⎛ e1 e2 . . σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. ⎠ . ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟.8) . n or equivalently Y = Xβ + e.4). We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ .

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

8)(3. but in most cases there is little computational advantage to using the two-step algorithm. .1 (Frisch-Waugh-Lovell). the FWL theorem can be used to speed computation. obtain residuals Y . By the independence of the observations and (3.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.Theorem 4. .6. obtain OLS estimates β 2 and residuals e.9). ⎠ ⎝ ⎠ ⎝ . A common application of the FWL theorem. In the model (4. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ¡ ¢−1 0 ι. is the demeaning formula for regression.13). .9). In some contexts. . 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) . In this case. obtain residuals X2 . . Regress Y on X1 . Regress Y on X2 . ˜ 2. . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. Regress X2 on X1 . . and X2 is the vector of observed regressors. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . ⎟ ⎜ ⎟ ⎜ (4.14) or via the ˆ following algorithm: ˜ 1. Rather. 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. which you may have seen in an introductory econometrics course. . ˆ which are “demeaned”. . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. the primary use is theoretical. In this section we derive the small sample conditional mean and variance of the OLS estimator.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. 4. 30 . observe that ⎞ ⎛ ⎞ ⎛ . . ˆ ˜ ˜ ˆ 3.

the properties of conditional expectations. X 0 DX = X 0 Xσ 2 . we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0. ⎝ . 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.8). .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . . From (4. 1 n . .12). We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 .. and (4.18). σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 .Using (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. . Then given (4. . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 .. . and the trace operator observe that. . under the of ˆ ¢ 2 | x = σ 2 .20) . and ³ ´ ¡ ¢−1 2 ˆ σ . ⎠ (4. ... Next. V ar β | X = X 0 X ⎟ ⎟ ⎟. 0 0 ··· 0 0 . σ 2 } = ⎜ .

Thus since V ar (e | X) = In σ 2 under homoskedasticity. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. It is not unbiased in the absence of homoskedasticity. 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.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 . and thus can be written as ˜ β = A0 Y where A is an n × k function of X. As an alternative.10). The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . however. which we now present. says that the least-squares estimator is the best choice. known as the Gauss-Markov theorem. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. Theorem 4. which is (3.1 Gauss-Markov. the estimator ˆ 2 deﬁned (4.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model.7) is unbiased for σ 2 by this calculation. The following result.8. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice.9) plus E e2 | xi = σ 2 . the best (minimumvariance) unbiased linear estimator is OLS. is a famous statement of the solution. 32 . 4. In this case. It is important to remember. What is the best choice of A? The Gauss-Markov theorem. Thus σ 2 is biased towards zero. or in the projection model. In the homoskedastic linear regression model. By a calculation similar to those of the previous section.8)¢ ¡ (3. ³ ´ ˜ E β | X = A0 Xβ. Now consider the class of estimators of β which are linear functions of i the vector Y. = σ2 n the ﬁnal equality by (4. as it yields the smallest variance among all unbiased linear estimators. ˜ so β is unbiased if (and only if) A0 X = Ik . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .

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

(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.9). 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. and thus so is the OLS estimator.22) 34 . and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. if the data have a discrete distribution.5.1. He observes that the above argument holds for all multinomial distributions.10) for the class of models satisfying Assumption 3.Substituting in the expressions for π j .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. He proves that generically the OLS estimator (4. the maximum likelihood estimator is identical to the OLS estimator.10 Omitted Variables xi = µ x1i x2i ¶ . 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 . Chamberlain (1987) extends this argument to the case of continuously-distributed data.

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

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

4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . Investigations into the presence of inﬂuential observations can plot the values of (4. ¢−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 . ˆ We now derive equation (4. which is considerably more informative than plots of the uncorrected residuals ei . ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . The key is equation (2.1) in Section 2.This implies has a large value of hi .27).25). 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) (5. 5.1 Inequalities Asymptotic theory is based on a set of approximations. Triangle inequality |X + Y | ≤ |X| + |Y | . The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 . 41 .3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q .2) + 1 q = 1. These approximations are bounded through the use of mathematical inequalities. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . |a| = a a i i=1 If A is a m × n matrix. then (5.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. Jensen’s Inequality. ij i=1 j=1 (5. If g(·) : R → R is convex. Cauchy-Schwarz Inequality. then g(E(X)) ≤ E(g(X)). We list here some of the most critical deﬁnitions and inequalities. then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality.

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

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

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

√ Theorem 5. Ik ) distribution. 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. Proof: Since g is continuous at c. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0.4.√ where λn → 0 lies on the line segment joining 0 and λ/ n. Since cλλ (λn ) → cλλ (0) = −Ik . then g(Zn ) →d g(Z) as n → ∞. Proof : By a vector Taylor series expansion. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. If Zn →d Z as n → ∞ and g (·) is continuous.4 Asymptotic Transformations Theorem 5.4. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. ¥ 5. and g(θ) : Rm → Rk . Theorem 5.3 Delta Method: If n (θn − θ0 ) →d N (0. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. then g(Zn ) →p g(c) as n → ∞. If Zn →p c as n → ∞ and g (·) is continuous at c. 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 . we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. we see that as n → ∞. where θ is m × 1 and Σ is m × m.2 Continuous Mapping Theorem 2.1 Continuous Mapping Theorem 1 (CMT). k ≤ m. for each element of g. Σ) . 45 . This is suﬃcient to establish the theorem. gθ Σgθ . Hence g(Zn ) →p g(c) as n → ∞. Recall that A ⊂ B implies P (A) ≤ P (B). Σ) = N 0.4.

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

ˆ Theorem 6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.2. we will use the methods of asymptotic approximation.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. Assumption 3.1 by the fact that the sampling densities become more concentrated as n gets larger. For a complete argument. (6.4.1 Under Assumption 3.2) i i n i=1 n From (6.1) and ˆ We now deduce the consistency of β. Hence by the continuous mapping theorem (Theorem 5. β →p β as n → ∞. As the sample size increases the density becomes more concentrated about the population coeﬃcient. we can conclude ˆ that β →p β.1). ˆ 47 . (6.1 and the WLLN (Theorem 5.1. 6.3) Ã where g(A. n i=1 (6.1). Proof. First. Ã n ! n X 1X 0 1 ˆ xi xi . ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. using (6.5.4 implies that Q−1 exists and thus g(·.2 Consistency ˆ As discussed in Section 6. Equation (4.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 .1).From the ﬁgure we can see that the density functions are dispersed and highly non-normal. 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. To characterize the sampling distribution more fully. and the continuous mapping theorem (Theorem 5. xi ei →p g (Q.1. the OLS estimator β is has a statistical distribution which is unknown.5.2).3).1. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.4. Assumption 3. 0). (6. This is illustrated in Figure 6. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.1).2.5. ·) is continuous at (Q.

i i Assumption 6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. since n/(n − k) → 1 as n → ∞. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .6) n i=1 48 . Ee4 < ∞ and E |xi |4 < ∞.3. To see this.1.3) and Theorem (6.Theorem 6. n 1 X √ xi ei →d N (0. (6. By the central limit theorem (Theorem 5. We need a strengthening of the moment conditions.3. (6. by the Cauchy-Schwarz inequality (5. ˆ Proof.2). ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. Ω) .2.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. ˆ n−k 6. ˆ Finally. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .5.1.1 In addition to Assumption 3.1). Assumption 6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6.1). it follows that s2 = ¥ n σ 2 →p σ 2 . E ¯ei ¯ E ¯e4 ¯ i i i i (6.2. (6.2 Under Assumption 3.1 guarantees that the elements of Ω are ﬁnite.5.2). Thus σ 2 is consistent for σ 2 .3.

7) is true or false. when xi and ei are independent. i i Condition (6. In´Figure 6. The approximation may be poor when n is small.6). 1 X √ xi ei n i=1 n ! the N (0. In Figure 6. (6.1 states that the sampling distribution of the least-squares estimator.3.9) In (6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).7) is true then V = V 0 . for example. xi ) which satisfy the conditions of Assumption 6.1 Under Assumption 6. e2 ) = 0. 1). We illustrate this problem using a simulation. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . We call V 0 the homoskedastic covariance matrix. We say that ei is a Homoskedastic Projection Error when (6.1.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . As α approaches 2. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. otherwise V 6= V 0 . Q−1 ΩQ−1 . there is no simple answer to this reasonable question.7) holds. When (6. The expression V = Q−1 ΩQ−1 is called a sandwich form.3. Under (6.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. Theorem 6.1. V ) where V = Q−1 ΩQ−1 . after rescaling. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. How large should n be in order for the approximation to be useful? Unfortunately.Then using (6. The trouble is that no matter how large is the sample size. and (6. V is often referred to as ˆ the asymptotic covariance matrix of β. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.3.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.7) Cov(xi x0 . ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . |ε| ≥ 1. For α 49 . The asymptotic distribution ´ Theorem 6.9) we deﬁne V 0 = Q−1 σ 2 whether (6.1).2). However. Let yi = β 0 + β 1 xi + εi where xi is N (0. This holds true for all joint distibutions of (yi . setting n = 100 and varying the parameter α. however. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. but this is not a necessary condition. 1) asymptotic distibution.3.3.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . its variance diverges q ³ ´ ˆ to inﬁnity. Ω) ¡ ¢ = N 0. There is a special case where Ω and V simplify. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. is approximately normal when the sample size n is suﬃciently large.

2. As k increases.10) V 0 = Q−1 s2 . As α diminishes the density changes signiﬁcantly. 1).3. Another example is shown in Figure 6. The estimator 2 2 in (6. we need an estimate of Ω = E xi x0 e2 . We show the sampling distribution of n β 1 − β 1 setting n = 100.2 and 6.2: Density of Normalized OLS estimator α = 3.10) without changing this result. 1) asymptotic approximation is never guaranteed to be accurate.11) 50 . the sampling distribution becomes highly skewed and non-normal. concentrating most of the probability mass around zero. 6 and 8. 6. 4. 1) density. for k = 1. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0.2) and Theorem 6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.0 the density is very close to the N (0. The lesson from Figures 6.3 is that the N (0. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .1) it is clear that V 0 →p V 0 .Figure 6.

or that they use the “White formula”. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. we set s(β) = n−1/2 V . The estimator of V is then ˆ ˆ ˆ ˆˆ V = Q−1 ΩQ−1 This estimator was introduced to the econometrics literature by White (1980). ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. as it is not always clear which has been computed.. ˆ ˆ Deﬁnition 6. Generically.. and was still the standard choice for much empirical work done in the early 1980s. the “Huber-White formula” or the “GMM covariance matrix”. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj .4. standard errors are not unique. The methods switched during ˆ the late 1980s and early 1990s. k. vis. the “Eicker-White formula”. When reading and reporting applied work.. It is therefore important to understand what formula and method is 51 . 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.Figure 6.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. β j . . ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . When β is a vector. ˆ ˆ When V is used rather than the traditional choice V 0 . we focus on individual elements of β one-at-a-time. 1. or that they use a “heteroskedasticity-robust covariance matrix estimator”. This motivates the deﬁnition of a standard error. and V is an estimator of the variance of n β − β . the “Huber formula”. j = 0. In most cases. A more easily interpretable measure of spread is its square root — the standard deviation. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. these all mean the same thing..3: Sampling distribution where ei are the OLS residuals.

020) 6.14 205.14 14. (6. and then the square roots.199 2.2/988 = .14 205.20 and µ ¶ ˆ = 0.14 14. We calculate that s2 = 0.35/988 = . from which it follows that V →p V as n → ∞.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.used by an author when studying their work.14 205.80 40.085) (. i i i i n i=1 Second.1.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. just as any other estimator.83 ¶−1 = µ 7.2.14 6.5 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.199 2. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.6 ¶µ 1 14.117 Educationi . From a computational standpoint.80 2. (6. Using (6.5) and the WLLN (Theorem 5. by Holder’s inequality (5.493 −0.039 and ˆ V = µ 1 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.20 −0.98 −0.80 . n n i=1 52 . p ˆ In this case the two estimates are quite similar. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . First.480 ˆ0 = 0.30 + 0.20 = V 14.12) in turn.80 40.020. we return to the log wage regression of Section 4.83 −0. (.035 ¶ .085 p ˆ and that for β 1 is . then take the diagonal elements.83 ¶−1 µ .493 0. Ω 2.480 . The standard errors for β 0 are 7.4) 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 . To illustrate. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . but not under another set of assumptions.

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. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. From equation (3. you can show that 1 Xˆ ¯ β= β (−i) . Ω →p Ω and V →p V. 6. n i=1 n ˆ ˆ Theorem 6.25). Using this substitution.11) with the leave-one-out estimator ei. Recall from Section 4.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. 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 0.5. 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. ¯ ¯n ¯ n i=1 so Together. i=1 Third. Andrews (1991) suggested an similar estimator based on cross-validation. 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 (6.26).6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.13) of Efron (1982).1 As n → ∞.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.−i = (1 − hi )−1 ei ˆ presented in (4.13) Using formula (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 . is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. which. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .

where ˆ It is similar to the MacKinnon-White estimator V ∗ . 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. = N (0.7 Functions of Parameters Sometimes we are interested in some lower-dimensional function of the parameter vector β = (β 1 . The estimate of θ is ˆ = h(β). By a ﬁrst-order Taylor series approximation: ³ ´ 0 ˆ ˆ h(β) ' h(β) + Hβ β − β . .. so Vθ = R0 V R. Hβ = ∂β In many cases. ˆ θ What is an appropriate standard error for ˆ Assume that h(β) is diﬀerentiable at the true θ? value of β. Vθ ). the function h(β) is linear: h(β) = R0 β ˆ ˆ ˆ for some k × q matrix R. Let h : Rk → Rq denote this function and let θ = h(β) denote the parameter of interest. then the natural estimate for the variance of ˆ is θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). In these cases we can write the parameter of interest as a function of β. In this case. Andrews ˆ ˆ (1991) argues that simulation evidence indicates that V ∗∗ is an improvement on V ∗ . 1X ˆ (1 − hi )−2 xi x0 e2 . Ω∗∗ = i ˆi n i=1 n 6.. ˆ ˆ If V is the estimated covariance matrix for β. 54 . V ) where ∂ h(β) ∂β (k + 1) × q. β k+1 ). Hβ = R and Hβ = R. (6. For example. we may be interested in a single coeﬃcient β j or a ratio β j /β l . but omits the mean correction..15) where 0 Vθ = Hβ V Hβ .

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

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

18) . and it is desired to test the joint restrictions simultaneously. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. θ θ) (6. In this case the t-statistic approach does not work.96s(ˆ ≈ ˆ ± 2s(ˆ .16) and zα/2 is the upper α/2 quantile of the standard normal distribution. 6. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. This corresponds to selecting the conﬁdence h i h ˆ ± 1.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (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. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . A 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). θ The interval has been constructed so that as n → ∞.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. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).05. = n h(β) − θ0 Hβ V Hβ 57 (6. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. ˆ + zα/2 s(ˆ . or α = . the most common professional choice isi95%. ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β).

Hβ (β) →p Hβ . The null hypothesis is H0 : β 2 = 0.1 Under H0 and Assumption 6. then Wn →d χ2 . and Theorem 6. h(β) = R0 β. q and pn is asymptotically U[0.84 = z.3.10. Hβ (β) is a continuous function of β. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).1. For example.8. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . χ2 (. Vθ ). the test rejects at the α% level iﬀ pn < α. Wn = n R0 β − θ0 ´ √ ³ The delta method (6.1 showed θ ˆ that V →p V. Hence β β by Theorem A. ˜˜ n ˜ e = Y − X1 β 1 . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. As before. In this case. 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. a chiq square random variable with q degrees of freedom. The asymptotic p-value for Wn is pn = p(Wn ).025 .19) σ2 ˆ where σ2 = ˜ 1 0 e e. 1] under H0 . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. Furthermore. 6. the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity. and there are q = k2 restrictions.5. θ = β 2 . ˆ Wn = n θ θ q θ θ Theorem 6. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).2.When h is a linear function of β. the upper-α quantile q 2 of the χ2 distribution.15) showed that n ˆ − θ →d Z ∼ N (0.05) = 3.11 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 . Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. if rank(Hβ ) = q. Also h(β) = a selector matrix. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .

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

it follows ˆ that β is independent of any function of the OLS residuals. an “F statistic” is reported. there is an exact distribution theory available for the normal linear regression model. Since uncorrelated normal variables are independent. Since linear functions of normals are also normal. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0.12 Normal Regression Model As an alternative to asymptotic distribution theory. In particular. 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 .where In many statistical packages.4)) where H 0 H = In . In σ 2 . introduced in Section 4. H 0 H) ∼ N (0. when an OLS regression is reported. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . σ 2 ) can be be used to calculate a set of exact distribution results. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. This was a popular statistic in the early days of econometric reporting. The modelling assumption that the error ei is independent of xi and N (0. In ) . equivalently the residual variance from an intercept-only model. 6. n−k 60 . 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. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . these cases are atypical. Let u = σ −1 H 0 e ∼ N (0. This is rarely an issue today. including the estimated error variance 2. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. While there are special cases where this F statistic is useful. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = .3.

(Unless the sample size is unreasonably small. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. Theorem 6. We summarize these ﬁndings Theorem 6.12.) Now let us partition β = (β 1 . n−k • ∼ tn−k ˆ In Theorem 6.12. β 2 . β 2 .10) µ h i ¶ 2 (X 0 X)−1 N 0.8. σ 2 ) = − log σ − log (2π) − . In contrast.10) then ´ ³ ˆ • β ∼ N 0. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ ˆ ˆ βj − βj βj − βj N (0. Furthermore. a good testing procedure is based on the likelihood ratio statistic. The critical values are quite close if n − k ≥ 30.a chi-square distribution with n − k degrees of freedom. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.3. σ 2 ) − Ln (β 1 . 0. β has an exact normal distribution and t has an exact t distribution. 0. 1) and tn−k distributions. 0. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . and standard errors are calculated using the homoskedastic formula (6. if standard errors are calculated using the homoskedastic formula (6. 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.1 we showed that in large samples.1 shows that under the strong assumption of ˆ normality. so as a practical matter it does not matter which distribution is used. with residual variance σ . σ2 ˆ 61 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ 2 ) discussed above. β and t are approximately normally distributed. the notable distinction is between the N (0. As inference (conﬁdence intervals) are based on the t-ratio.1 If ei is independent of xi and distributed N(0. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .1 and Theorem 6. β 2 . σ 2 ). The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .

By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . Letting h(β) = β s . Take the model yi = β + ei ei ∼ N (0. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. Our ﬁrst-order asymptotic theory is not useful to help pick s.4 the Wald statistic Wn (s) as a function ˆ of s. This can be seen by a simple example introduced by Lafontaine and White (1986). features of this distribution can be calculated. we have plotted in Figure 6.84 — the probability of a false rejection. they can work quite poorly when the restrictions are nonlinear. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. The increasing solid line is for the case β = 0. 62 . and noting Hβ = sβ s−1 . 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.7. 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. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. This is an unfortunate feature of the Wald statistic.8.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . This produces random draws from the sampling distribution of interest. while there are other values of s for which test test statistic is insigniﬁcant. ˆ Let β and σ 2 be the sample mean and variance of yi . The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. In the present context of the Wald statistic. σ 2 ) and consider the hypothesis H0 : β = 1. To demonstrate this eﬀect. setting n/σ 2 = 10. as Wn (s) →d χ2 under H0 for 1 any s. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. Through repetition. The decreasing dashed ˆ = 1. the statistic Wn (s) varies with s.

There is. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.05) with deviations indicating+ distortion. this probability depends only on s. the only test which meets this criterion is the conventional Wn = Wn (1) test.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .1 you can also see the impact of variation in sample size. Rates above 20% are unexceptable. In Table 2. In Table 4.Figure 6. n. The null hypothesis β s = 1 is true. so these probabilities are Type I error. and rarely fall outside of the 3%-8% range. no magic choice of n for which all tests perform uniformly well. 100 and 500. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. When comparing statistical procedures. looking for tests for which rate rejection rates are close to 5%. Any other choice of s leads to a test with unacceptable Type I error probabilities. n is varied among 20.4.1 we report the results of a Monte Carlo simulation where we vary these three parameters. In each case.000 random samples.1 reports the simulation estimate of the Type I error probability from 50. Type I error rates between 3% and 8% are considered reasonable.000 simulated Wald statistics Wn (s) which are larger than 3. Table 4. Typically. These probabilities are calculated as the percentage of the 50. we compare the rates row by row.84 | β = 1) .84.4: Wald Statistic as a function of s P (Wn (s) > 3. remember that the ideal Type I error probability is 5% (. and σ 2 . For this particular example. Table 4. however. Error rates avove 10% are considered excessive. Given the simplicity of the model. the Type I error probability improves towards 5% as the sample size n increases. The value of s is varied from 1 to 10. and σ is varied among 1 and 3. Test performance deteriorates as s increases. To interpret the table.

15 .08 .30 . Equivalently.13 . 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. In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.10 .05 .12 .06 .17 .24 .19 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. 64 .12 .06 .25 .31 .15 .08 .34 . β 1 . This point can be illustrated through another example. so the hypothesis can be stated as H0 : θ = r.06 .11 .09 .05 .20 .33 . deﬁne θ = β 1 /β 2 .06 .07 .08 .15 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. Other choices are arbitrary and would not be used in practice.06 .06 .07 .18 .13 .35 . β 2 ) be the least-squares estimates of (6.06 .26 .07 .05 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .25 .14 .08 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .28 .22 .10 .22 .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 .14 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .05 .08 .23 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .15 .16 Rejection frequencies from 50.13 .06 .05 .21 . While this is clear in this particular example.10 .07 .07 .20 .20).05 .

06 .05 β2 . If no linear formulation is feasible.05 .06 .25.75 1.645) are calculated from 50.05 .0 and n among 100 and 500.05 . 6. The left tail probabilities P (t1n < −1. along with sample size n. and normalize β 0 = 0 and β 1 = 1.14 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. In all cases. The implication of Table 4. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.645) P (tn > 1.05 .06 .15 . such as the GMM distance statistic which will be presented in Section 9.02 . It is also prudent to consider alternative tests to the Wald statistic. and alternatives to asymptotic critical values should be considered. while the right tail probabilities P (t1n > 1.00 . the entries in the table should be 0. Ideally.645) P (tn < −1.06 .645) P (tn > 1. ei be an independent N (0.10 .00 The one-sided Type I error probabilities P (tn < −1.00 .50 .2. The results are presented in Table 4.75.06 .645) t1n t2n t1n t2n t1n t2n t1n t2n . .25 . then the “most linear” formulation should be selected. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . this formulation should be used.645) and P (tn > 1.12 .7.09 .50.06 .00 . We vary β 2 among .05 .15 . We let x1i and x2i be mutually independent N (0.1. This leaves β 2 as a free parameter.00 .26 . if the hypothesis can be expressed as a linear restriction on the model parameters.05 .000 simulated samples. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .47 .00 . 1) variables.28 . the rejection rates for the t1n statistic diverge greatly from this value.05.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.00 .00 . In contrast.00 .645) greatly exceed 5%.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.05 . . 65 . especially for small values of β 2 . However.05 . and are close to the ideal 5% rate for both sample sizes. .06 .645) are close to zero in most cases. σ 2 ) draw with σ = 3. and 1.05 .00 .10 . Table 4.06 .07 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. In this section we describe the method in more detail.06 .10 .06 .

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

this may ˆ be approximated by replacing P with P or with an hypothesized value. and . such as the percentage estimate reported in (6. In particular.21). a larger B results in more precise estimates of the features of interest of Gn . B.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. We separately estimate equations for white and non-whites. 6. The average (6. As discussed above. B b=1 (6.95) /B ' . experience squared. The random variable 1 (Tnb ≥ 1. and 5000.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. then we can set s P = (. Quite simply. are. Furthermore. and dummy variable indicators for the following: married. immigrant. the performance will depend on n and F. and our regressors include years of education. and dummy variable indicators for the following: married. Again our dependent variable is the natural log of wages. Often this is called the number of replications. union member.22/ B. and estimate a multivariate regression. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings.15 Estimating a Wage Equation We again return to our wage equation. For the dependent variable we use the natural log of wages. for a selection of choices of n and F. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. We us the sample of wage earners from the March 2004 Current Population Survey. Then qα is the N ’th number in this ordered sequence. s P = . . an estimator or test may perform wonderfully for some values. and hispanic. the researcher must select the number of experiments. therefore. female. we included a dummy 67 .96) . and 90% sample quantiles of the sample {Tnb }. potential work experience. if we set B = 999. hispanic. excluding military. then B will have to be increased. the choice of B is often guided by the computational demands of the statistical procedure. For regressors we include years of education. and therefore it is straightforward to calculate standard errors for any quantity of interest. union member.05) (. For example. experience squared. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. immigrant. potential work experience.007. where N = (B +1)α. For example. and poorly for others. It is therefore convenient to pick B so that N is an integer. 1000. In practice. Generally. It is therefore useful to conduct a variety of experiments. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. female. equalling 1 with probability P = E1 (Tnb ≥ 1.003. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. We now expand the sample all non-military wage earners. Hence the ³ ´ ˆ standard errors for B = 100. As P is unknown. and non-white. respectively. If the standard error is too large to make a reliable inference. but requires more computational time.96) is iid Bernoulli. it is simple to make inferences about rejection probabilities from statistical tests.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test.022. In many cases.96) . The α% sample quantile is a number qα such that α% of the sample are less than qα . so that coeﬃcients may be interpreted as semi-elasticities.

Using either statistic the hypothesis is easily rejected.070 .033 −.1.007 . 808 1 − . Ignoring the other coeﬃcients. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.010 . Wn = n 1 − 2 = 18.49452 σ ˜ Notice that the two statistics are close.variable for state of residence (including the District of Columbia.102 −.002 . excluding the coeﬃcients on the state dummy variables.121 −. Computing the Wald statistic (6.032 .101 . we ﬁnd Wn = 550.014 .34 ˆ s(β) .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.001 . The available sample is 18.808 so the parameter estimates are quite precise and reported in Table 4. The F form of the Wald statistic (6.4945.102 −.48772 = 515.097 −. the restricted standard deviation estimate is σ = .18) that the state coeﬃcients are jointly zero. Alternatively.232 .00002 . θ ˆ 2β 3 β2 .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. Table 4.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.808 .69.00057 .008 .013 .027 . as the 1% critical value for the χ2 distribution is 76. but not equal. reestimating the model with the 50 state dummies excluded. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.4877 18. this adds 50 regressors). 2β 3 68 . 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.19) is ˜ µ ¶ µ ¶ σ2 ˆ .

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. 69 .9. 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 ). implying a 95% conﬁdence θ) interval of [27.40. However. so we have to go one step further. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.96.5]. 29. This is the set of θ such that |tn (θ)| ≤ 1.0. This set is [27. this is a poor choice. but the lower end is substantially lower. we found better Type I error rates by reformulating the hypothesis as a linear restriction. In the present context we are interested in forming a conﬁdence interval.5]. 29. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. but it can be found numerically quite easily. Instead. not testing a hypothesis. Since tn (θ) is a non-linear function of θ.Using the Delta Method. we can calculate a standard error of s(ˆ = .

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

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

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

2

is the homoskedasticity-formula standard error.

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

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

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

1... Theorem 7. First. FGLS is asymptotically superior to OLS. similar to the covariance matrix of the OLS estimator.that there is a need to bound the estimated variances away from zero. In the linear regression model.1.1 If the skedastic regression is correctly speciﬁed. This estimator V 0 is appropriate when the skedastic regression (7. We just state the result without proof. Instead. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. σ 2 ] σi i for some σ 2 > 0. There are three reasons. Unless σ 2 = α0 zi . then FGLS is asymptotically equivalent to GLS. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . . ´´−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 . Its asymptotic variance is not that given in Theorem 7. ¢¢−1 ¡ ¡ . It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). V ).. e2 }. but the proof of this can be tricky. V n n i=1 . and was proposed by Cragg (Journal of Econometrics. and it may be estimated with considerable 76 V takes a sandwich form√. 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 → ∞. Since the form of the skedastic regression is unknown. β should perhaps be i i called a quasi-FGLS estimator of β. 1992). the natural estimator of the asympˆ totic variance of β is Ã n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . A trimming rule might make sense: σ 2 = max[˜ 2 . Why then do we not exclusively estimate regression models by FGLS? This is a good question. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.2) is correctly speciﬁed. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. It is possible to show that if the skedastic regression is correctly speciﬁed. i ˜ 0 is inconsistent for V . In this case we interpret α0 zi as a linear projection of e2 on zi . ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0.1.1.1.

Theorem 7. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. The main diﬀerences between popular “tests” is which transformations of xi enter zi .2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . The asymptotic distribution (7. q Most tests for heteroskedasticity take this basic form.2. its squares. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. It is consistent not only in the regression model. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. In the linear regression model the conditional mean of yi given xi = x is 77 . or equivalently that i H0 : α1 = 0 in the regression (7.4). the estimated conditional variances may contain more noise than information about the true conditional variances. If the equation of interest is a linear projection. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.2). and not a conditional mean. OLS is a more robust estimator of the parameter vector. and the cost is a reduction of robustness to misspeciﬁcatio 7. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. The GLS and FGLS estimators. however. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . This introduces an element of arbitrariness which is unsettling to empirical researchers. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. and all cross-products. This hypothesis does not imply that ξ i is independent of xi .1 Under H0 and ei independent of xi .3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . and this requires trimming to solve. individual estimated conditional variances may be negative.7) under independence show that this test has an asymptotic chi-square distribution. We may therefore test this hypothesis by the estimation (7.5) and the asymptotic variance (7. but the only diﬀerence is that they a ¢ allowed for general choice of zi . 7. Second. σ 2 ). If i this simpliﬁcation is replaced by the standard formula (under independence of the error). In this case. but also under the assumptions of linear projection. Typically. the Wald test of H0 is asymptotically χ2 .error. Vα = E zi zi (7. FGLS will do worse than OLS in practice.4) and constructing a Wald statistic. Third.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. the two tests coincide. require the assumption of a correct conditional mean. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . as they will be estimating two diﬀerent projections. on the other hand.

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

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

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

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

See Chapter 16. the height of the error density at its median. Pn −1 0 β)) . then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . and this improves estimation of the median. When f (0 | x) is large. First. where V = and f (e | x) is the conditional density of ei given xi = x.10) is equivalent to g n (β) = 0. (7.1 is advanced.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . V ). by a Taylor series expansion and the fact g(β 0 ) = 0 82 .11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.Theorem 7.5. While a complete proof of Theorem 7. In the special case where the error is independent of xi . ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . ˆ Proof of Theorem 7. ∂β 0 so Third.5.1 ´ √ ³ˆ n β − β 0 →d N (0. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. The main diﬃculty is the estimation of f (0).11). Let g(β) = Eg (β). This can be done with kernel estimation techniques. then there are many innovations near to the median.3. ∂ 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 ) . ¢¢−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) .5. we provide a sketch here for completeness. Computation of standard error for LAD estimates typically is based on equation (7. the conditional density of the error at its median. by the central limit theorem (Theorm 5.

the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. the quantile regression functions can take any shape. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . when F (y | x) is continuous and strictly monotonic in y. The median is the special case τ = . The third line follows from an asymptotic empirical process argument. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). 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)) . As functions of x.5. ¥ 7.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice.12) Qτ = argmin Eρτ (U − θ) . We then have the linear quantile regression model yi = x0 β τ + ei i 83 . Exi x0 ) →d i 2 = N (0.Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. then F (Qτ ) = τ . For ﬁxed τ . If the random variable U has τ ’th quantile Qτ .9) for the median to all quantiles. 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. Again. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } .13) This generalizes representation (7. For the random variables (yi . This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . The following alternative representation is useful. then F (Qτ (x) | x) = τ . V ). so you can think of the quantile as the inverse of the distribution function. For τ ∈ [0. (7. then (7.

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. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. i By construction. conventional Newton-type optimization methods are inappropriate.1 n β τ − β τ →d N (0. 7.6.5.1. The null model is yi = x0 β + εi i 84 . and are widely available. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . Fortunately. and test their signiﬁcance using a Wald test. Another popular approach is the RESET test proposed by Ramsey (1969). E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005).12). ¡ ¡ ¢¢−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. the asymptotic variance depends on the conditional density of the quantile regression error. When the error ei is independent of xi . if the model yi = x0 β + ei has i been ﬁt by OLS. the τ ’th conditional quantile of ei is zero. the unconditional density of ei at 0. fast linear programming methods have been developed for this problem. it is useful to have a general test of the adequacy of the speciﬁcation. n numerical methods are necessary for its minimization. ˆ Given the representation (7. Vτ ). since it has discontinuous derivatives. 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. Thus. then f (0 | xi ) = f (0) . One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. where and f (e | x) is the conditional density of ei given xi = x. Furthermore.13). 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 ) . and form a Wald statistic i for γ = 0.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . ´ √ ³ˆ Theorem 7.

Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. and consequently 22 ¡ ¢−1 2 σ . lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. 7. and the two estimators have equal asymptotic eﬃciency. 1i 2i 2i 1i 22 . It is easy (although somewhat tedious) to show that under the null hypothesis. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . Another is to regress yi on x1i and x2i jointly. Wn →d χ2 . and n→∞ say. ⎟ zi = ⎝ . β 2 ). To implement the test. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. yielding predicted values yi = x0 β. 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 . To see why this is the case. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . ⎠ . In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. since Q12 Q−1 Q21 > 0.14) may be written as ³ ´3 ³ ´m ³ ´2 ˜ ˆ ˜ ˆ ˜ ˆ yi = x0 β + x0 β γ 1 + x0 β γ 2 + · · · x0 β γ m−1 + ei ˜ ˜ i i i i which has essentially approximated G(·) by a m’th order polynomial.be an (m − 1)-vector of powers of yi . 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. m must be selected in advance. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . However. Otherwise. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. β 1 = (X1 X1 )−1 (X1 Y ) . 3. then 22 Q11 > Q11 − Q12 Q−1 Q21 . yi ˆm (7. note that (7.14) by OLS.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. small values such as m = 2. yielding ˆ ˜ ˆ ˆ (β 1 . The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . 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. or 4 seem to work best. Typically. and form the Wald statistic Wn for γ = 0. they will (typically) have diﬀerence asymptotic variances.

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

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

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

ˆ ˆ n−k 6. wn ) and wi = x−2 . Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . Let (yi .. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . . and the out-of-sample value of the regressors. σ 2 ). 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 . In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. (b) Prove that e = M1 e. Let σ 2 be the estimate of σ 2 . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. the estimates (β. the residuals e. Is θ a quantile of the distribution of Yi ? 3.7. ˜ the residual vector is e = Y − X β. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. the mean absolute error (MAE) is E |yi − g(xi )| . X). . ˆ (a) Find a point forecast of y. E(e | X) = 0. Show that the function g(x) which minimizes the MAE is the conditional median M (x). 4. V ar(e | X) = σ 2 Ω with Ω known. Verify equation (7.. V . In a linear model Y = Xβ + e. (b) Find an estimate of the variance of this forecast. based on a sample of size n. Thus the available information is the sample (Y. For any predictor g(xi ) for y.. 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 .10 Exercises 1. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. 2. else equals zero). xi ) be a random sample with E(Y | X) = Xβ. where xji is one of the xi . i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V .12). Let θ satisfy Eg(Yi − θ) = 0. 5. x.

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

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

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

Note that while F may be either discrete or continuous. ∗ P (yi ≤ y. To see this. x) is called the empirical distribution function (EDF).1). x)) →d N (0. note that for any (y. x) (1 − F (y. F (y. the EDF is only a crude approximation to the CDF. . The EDF is a consistent estimator of the CDF. x) = n i=1 Figure 8. Thus by the WLLN (Theorem 5. (8. i 93 . xi ).1).3. Notationally. In general. x∗ ) with the i distribution Fn .2. x∗ ≤ x) = Fn (y. Fn (y.2 The Empirical Distribution Function Fn (y. I have plotted the EDF and true CDF for three random samples of size n = 25. i = 1. That is. This is a population moment. 50.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi .. For n = 25. by the CLT (Theorem 5.. The random draws are from the N (0.8. but the approximation appears to improve for the large n. √ n (Fn (y. as the sample size gets larger. x) = P (yi ≤ y. Recall that F (y. x). x) →p F (y. x). where 1(·) is the indicator function. x))) .. 1) distribution. in the Figure below. Furthermore. x). x) . Fn is a nonparametric estimate of F. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) .2) Fn (y. n. and 100. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. x) − F (y. To see the eﬀect of sample size on the EDF. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . it is helpful to think of a random pair (yi . the EDF step function gets uniformly close to the true CDF. Fn is by construction a step function.

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

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

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

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

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

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

Fn ) + O(n−1 ). F ) + g2 (x. F0 ) = Φ(x) + since v = 1.1 as follows. 1/2 1 n Because Φ(x) appears in both expansions. √ Since Fn converges to F at rate n. Fn ) = Φ(x) + n 1 g (x. F0 ) = n 1 n1/2 (g1 (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. 100 . Fn ) − g1 (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. F0 ) = 1 g (x. To a third order of approximation. ³x´ 1 1 + 1/2 g1 (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). the diﬀerence √ (g1 (x. F ) converges to the normal limit at rate n1/2 . where g1 is an even function of x. We can interpret Theorem 8. Heuristically. F ) ≈ Φ + n−1/2 g1 (x.8. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. which from Theorem 8. and g1 is continuous with respect to F. and g2 is an odd function of x.1 has the expansion n G∗ (x) = Gn (x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). the density function is skewed. An asymptotic test is based on Φ(x). F ) ≈ Φ + n−1/2 g1 (x. Gn (x. To the second order. F0 )) converges to 0 at rate n.8. Fn ) − g1 (x. ³x´ Gn (x. F0 )) + O(n−1 ).3). F ) v which adds a symmetric non-normal component to the approximate density (for example. g1 (x. The diﬀerence is Φ(x) − Gn (x.1.9 One-Sided Tests Using the expansion of Theorem 8.8. F ) = Φ v n n 8. First. Fn ) − g1 (x. F ) + n−1 g2 (x. Moreover.8. F0 ) ≈ ∂ g1 (x. F ). so the order of the error is O(n−1/2 ). Theorem 8. the exact distribution is P (Tn < x) = Gn (x. ³x´ Gn (x. adding leptokurtosis). we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn .uniformly over x. F ) + O(n−3/2 ) Gn (x. To a second order of approximation. v Since the derivative of g1 is odd. A bootstrap test is based on G∗ (x).1 Under regularity conditions and (8.

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

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

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

calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). 2. Tn = (ˆ − ˆ 104 . 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 ... . X ∗ ). .. Consider the following bootstrap procedure. Find the bootstrap moments ETn and V ar(Tn ). you sample ε∗ using this two-point distribution. Let ∗ ∗ ∗ {y1 . Take a random sample {y1 . 4.. . It does not really matter. ˆi A conditional distribution with these features will preserve the main important features of the data.observed values of the regressors.. .. creating a random bootstrap data set (Y ∗ . whether or not the xi are really “ﬁxed” or random. Let Fn (x) denote the EDF of a random sample. Using the non-parametric bootstrap. OLS estimator from the regression of Y on X. yn } with µ = Eyi and σ 2 = V ar(yi ). ei ) : i = 1. Let the statistic of interest be the sample mean Tn = y n .... yielding OLS estimates β and any other statistic of interest. n} . however. i 8.13 Exercises 1. That is. Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. which is a valid statistical approach. Let β denote the ˆ the OLS residuals. ˆ∗ (b) Regress Y ∗ on X ∗ . Unfortunately this is a harder problem. draw a ˆ ˆ random integer i0 from [1. Consider the following bootstrap procedure for a regression of yi on xi . yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. One proposal which imposes the regression condition without independence is the Wild Bootstrap.. ˆ 3. Find the population moments ETn and V ar(Tn ). Show that √ n (Fn (x) − F0 (x)) →d N (0. Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap.. and e = Y − X β ˆ (a) Draw a random vector (x∗ . Set y∗ = x∗0 β + e∗ . n]. 2. 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 . The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. and set x∗ = xi0 and e∗ = ei0 . F0 (x) (1 − F0 (x))) .. generate ∗ bootstrap samples. ˆ Draw (with replacement) n such vectors. e∗ ) from the pair {(xi .

The dataﬁle hprice1. size of house.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).5% and 97. can you report the 95% Percentile-t interval for θ? 7. (b) Report the 95% Alternative Percentile interval for θ. The ˆ are sorted.95). ∗ ∗ ∗ Let qn (. Let qn (.5% quantiles of the ˆ are . What is wrong with this procedure? Tn = θ/s(θ) n 6. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.95) denote the 5% θ) ∗ and 95% quantiles of Tn . Using the non-parametric ∗ bootstrap. lot size.2 and s(ˆ = . Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. 105 .dat contains data on house prices (sales). ∗ ∗ where s(ˆ is the standard error in the original data.95). (c) With the given information. and thus reject H0 if ˆ ˆ > q ∗ (. Estimate a linear regression of price on the number of bedrooms. (a) Report the 95% Efron Percentile interval for θ. You replace c with qn (.3. ˆ = 1.05) . with variables listed in the ﬁle hprice1. and the colonial dummy.pdf. You do this as follows.95) denote the 95% quantile of Tn . You want to test H0 : θ = 0 against H1 : θ > 0.95).2. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (.05) and qn (. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).75 and 1. and ˆ is calculated on each θ ∗ ∗ θ sample. Suppose that in an application. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. you generate bootstrap samples. and the 2. ˆ − s(ˆ n (. Using the non-parametric bootstrap. θ respectively.

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

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 . β GMM = Z 0 XWn X 0 Z 9.9.2. then g n (β) = 0.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.1 β GMM = argmin Jn (β). for if Wn is replaced ˆ by cWn for some c > 0.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.2) g n (β) = (9. β GMM does not change. the dependence is only up to scale. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. For some × weight matrix Wn > 0. β ˆ Note that if k = . if Wn = I. The GMM estimator minimizes Jn (β). i i . For example. Let and where gi = xi ei . but this is generally not possible when > k. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .2. and the GMM estimator is the MME. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. ¡ ¢−1 0 ˆ Z XWn X 0 Y. This is a non-negative measure of the “length” of the vector g n (β). gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. then. the square of the Euclidean length. let Jn (β) = n · g n (β)0 Wn g n (β). ˆ Deﬁnition 9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . Proposition 9.

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

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

this is all that is known. n β − β →d N 0.1 Under general regularity conditions. Since the GMM estimator depends upon the ﬁrst-stage estimator. 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 . and if the weight matrix is asymptotically eﬃcient. β) = 0 holds.5. G0 Ω−1 G . often the weight ˆ matrix Wn is updated. Thus the model — the overidentifying restrictions — are testable. ˆ J = J(β) →d χ2−k .6.1 (Sargan-Hansen). 1 2 It is possible that β 2 = 0. 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). so that the linear equation may be written as yi = β 0 x1i + ei . However. 110 . 9. This estimator can be iterated if needed. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction.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 . Note that g n →p Egi . The general theory of GMM estimation and testing was exposited by L. Theorem 9. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β.Often. perhaps obtained by ﬁrst ˆ setting Wn = I. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. and then β recomputed. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. ˆˆ n is a quadratic form in g n . and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. Under the hypothesis of correct speciﬁcation. Hansen (1982). where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). 1 it is possible that β 2 6= 0. and is thus a natural test statistic for H0 : Egi = 0. Identiﬁcation requires l ≥ k = dim(β). For example. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . and in this case it would be impossible to ﬁnd a value of β 1 so that both E (x1i (yi − x0 β 1 )) = 0 and E (x2i (yi − x0 β 1 )) = 0 hold simultaneously.

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

are all valid instruments. while in a nonlinear i regression model ei (β) = yi − g(xi . For example.... than the unconditional moment restriction discussed above. Setting gi (β) to be this choice (which is k × 1. How is k to be determined? This is an area of theory still under development. in linear regression. β). i Ai = −σ −2 Ri i . Which should be selected? This is equivalent to the problem of selection of the best instruments. the model implies more than an unconditional moment restriction of the form Egi (β) = 0.9. In practice. but its form does help us think about construction of optimal instruments. Ai is unknown. Which should be used? i i One solution is to construct an inﬁnite list of potent instruments. In many cases. except that in this case zi = xi . It implies a conditional moment restriction of the form E (ei (β) | xi ) = 0 where ei (β) is some s × 1 function of the observation and the parameters. note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi . It turns out that this conditional moment restriction is much more powerful. Take the case s = 1. Another approach is to construct the optimal instrument. Given a conditional moment restriction. Then ei (β) = yi − zi β. x3 . 0 Our linear model yi = zi β + ei with instruments xi falls into this class under the stronger 0 assumption E (ei | xi ) = 0. s = 1. If xi is a valid instrument satisfying E (ei | xi ) = 0. In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i . A recent study of this problem is Donald and Newey (2001). and restrictive. β). ei (β. we can set gi (β) = φ(xi . It is also helpful to realize that conventional regression models also fall into this class. Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β). ei (β) = yi − x0 β.8 Conditional Moment Restrictions In many contexts. so is just-identiﬁed) yields the best GMM estimator possible. γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2. and then use the ﬁrst k instruments. 0 In the linear model ei (β) = yi − zi β. an unconditional moment restriction can always be constructed. That is for any × 1 function φ(xi . The obvious problem is that the class of functions φ is inﬁnite. . x2 .. etc. then xi . The form was uncovered by Chamberlain (1987). β)ei (β) which satisﬁes Egi (β) = 0 and hence deﬁnes a GMM estimator.

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

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

In the linear model Y = Xβ + e with E(xi ei ) = 0. xi . The equation of interest is yi = g(xi . The GMM estimator of β. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. VR = V − V R R0 V R (d) Show that in this setting. 115 . Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . VR ) where ¡ ¢−1 0 R V. l ≥ k. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.5. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9.5) 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. h(β)=0 (9. Deﬁne the Lagrangian L(β.6) (a) Show that you can rewrite Jn (β) in (9. the distance statistic D in (9. 6. β) + ei E (zi ei ) = 0. zi ). is deﬁned as Jn (β) = ˜ β = argmin Jn (β).6) equals the Wald statistic. 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 . Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . The observed data is (yi . Show how to construct an eﬃcient GMM estimator for β. Vn = X X i=1 ˜ and hence R0 β = r. zi is l × 1 and β is k × 1.

Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . 116 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix.. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. ˆ and consider the GMM estimator β of β. 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. 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 > 0.7.

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

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. the Lagrange multiplier λ(β) minimizes Rn (β. λ) = −n ln (n) − n X i=1 For given β. λ.5) ˆ ˆ As a by-product of estimation. λ) : λ(β) = argmin Rn (β. pi gi (β) = 0.7) 118 .2) subject to the restrictions (10. (see section 6.5) This minimization problem is the dual of the constrained maximization problem. p1 . we also obtain the Lagrange multiplier λ = λ(β). λ ¡ ¢ ln 1 + λ0 gi (β) . we ﬁnd µ = n and 1 ¢. summing over i. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . or equivalently minimizes its negative ˆ (10. (10. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). but must be obtained numerically (see section 6.1) and (10.. pn . p (10. Ln (β) = Rn (β.3).6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β.. . pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . λ). 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. and using the second and third equations.. λ) is a convex function of λ. The solution cannot be obtained explicitly. The solution (when it exists) is well deﬁned since Rn (β. µ. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β.4) (10.where λ and µ are Lagrange multipliers. probabilities 1 ³ ´´ . Multiplying the ﬁrst equation by pi .5). This yields the (proﬁle) empirical log-likelihood function for β.

g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 .13) Premultiplying by G0 Ω−1 and using (10. n (10.8) and ¢ 0 0 For example. G = −E (xi zi ).10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.2. i i Theorem 10.9) (10. ˆ ˆ Proof. β λ ∂ ³ ´. in the linear model. 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 (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. Thus the EL estimator is asymptotically eﬃcient. λ) = − (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .13) yields n n Expanding (10.9) and (10. i=1 i=1 i=1i Expanding (10. λ) = − (10.1 Under regularity conditions. and n β − β 0 and nλ are asymptotically independent.10). and Ω = E xi x0 e2 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. β) = −xi zi .10) ¡ Ω−1 N (0. 0 = Rn (β. (β.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Gi (. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.

1 If Eg(wi . ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.3.17) 2 ln 1 + λ gi β . 10. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . and have the same interpretation.7) is n ³ ´´ ³ X ˆ ˆ0 (10.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. The overidentiﬁcation test is a very useful by-product of EL estimation. 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. V ) ˆ Solving (10. (10. Since the EL estimator achieves this bound. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.15). Vλ ) Furthermore.16). by a Taylor expansion. They are asymptotically ﬁrst-order equivalent. tests are based on the diﬀerence in the log likelihood functions. First. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. and (10.3 Overidentifying Restrictions In a parametric likelihood context.14) for λ and using (10.15) (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. LRn = i=1 Theorem 10. β 0 ) = 0 then LRn →d χ2−k . and it is advisable to report the statistic LRn whenever EL is the estimation method. Proof. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. it is an asymptotically eﬃcient estimator for β. Ω) GΩ G →d = N (0. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. 120 . The same statistic can be constructed for empirical likelihood.

18) and H0 : h(β) = 0.17) is not appropriate. The hypothesis of interest is h(β) = 0.Second. 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. h(β)=0 ˜ Fundamentally. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. Theorem 10. LRn →d χ2 . where h : Rk → Ra .prc 121 .18).ssc.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). since ln(1 + x) ' x − x2 /2 for x small. so there is no fundamental change in the distribution theory for β relative to β. To test the hypothesis h(β) while maintaining (10. 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.wisc.edu/~bhansen/progs/elike. the simple overidentifying restrictions test (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.1 Under (10. a The proof of this result is more challenging and is omitted. Vλ )0 Ω−1 N (0.4 Testing Egi (β) = 0 (10.18) Let the maintained model be where g is × 1 and β is k × 1. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. This test statistic is a natural analog of the GMM distance statistic. By “maintained” we mean that the overidentfying restrictions contained in (10.

2. The starting value λ1 can be set to the zero vector. λ) gi (β. λ) . For p = 0. λ) = i The ﬁrst derivatives of (10. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . Set δ 0 = 0. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λj ) is smaller than some prespeciﬁed tolerance. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. 1.19).4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. set 2 λp = λj − δ p (Rλλ (β. The iteration (10. λ) G∗ (β. λj )) Rp = Rn (β. One method uses the following quadratic approximation. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λj ))−1 Rλ (β. λ) = G∗ (β. λj ) . (10.20) . λ)0 − ∂β∂β Rn (β. λ) G∗ (β.19) X ∂2 ∗ ∗ gi (β. λ) = − ∂β n X i=1 G∗ (β. i Rββ = Inner Loop The so-called “inner loop” solves (10.4).5) for given β. λ) ∂λ i=1 n ∂ Rn (β. δ 1 = 1 and δ 2 = 1. Deﬁne ∗ gi (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.. λ)0 0 Rn (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λj ))−1 Rλ (β. Eﬃcient convergence requires a good choice of steplength δ.19) is continued until the gradient Rλ (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λp ) A quadratic function can be ﬁt exactly through these three points. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λ)0 − Rn (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λ) = − gi (β.

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

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

1). this can be written as Y = Zβ + e. 11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. So we have the partition µ ¶ z1i k1 (11. β →p β ∗ . (11. z1i is an instrumental variable for (11. In a typical set-up. In matrix notation.1) the structural equation. By the above deﬁnition. and assume that E(zi ei ) 6= 0 so there is endogeneity. We call (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. We call z1i exogenous and z2i endogenous.2) Any solution to the problem of endogeneity requires additional information which we call instruments. Deﬁnition 11. ¶ 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 . This is called simultaneous equations bias.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ .1. which does not equal either β 1 or β 2 . some regressors in zi will be uncorrelated with ei (for example. Thus we make the partition ¶ µ k1 z1i (11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.1) if E (xi ei ) = 0.1 The × 1 random vector xi is an instrumental variable for (11. so should be included in xi . at least the intercept). and x2i are the excluded exogenous variables.1) where zi is k × 1.

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

Hence by a ﬁrst-order approximation i µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ OLS − β E β ZZ Ze ≈ E E n n ¡ ¢−1 = Γ0 QΓ + S22 S21 (11.11). ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . the model is Y = Zβ + e (11. Z2 ] and X = [Z1 . PX Z2 ] = [Z1 . ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) . Then i h ˆ ˆ ˆ Z = Z1 . X is n × l so there are l instruments. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Z = [Z1 .13) which is zero only when S21 = 0 (when Z is exogenous). we regress Y on Z1 and Z2 . 129 . Here we present a simpliﬁed version of one of his results. Thus in the second stage. 11. We now derive a similar result for the 2SLS estimator. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . let’s analyze the approximate bias of OLS applied to (11. Z2 = [PX Z1 . First.11) (11. Using (11. In our notation.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. Recall.12). X2 ]. ˆ since Z1 lies in the span of X. Z2 .ˆ It is useful to scrutinize the projection Z.12) Z = XΓ + u ξ = (e. PX Z2 ] h i ˆ = Z1 .

The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.13). the bias in the 2SLS estimator will be large. The consequences of identiﬁcation failure for inference are quite severe. P = HΛH 0 0 0 where Λ = diag(Il . n and (11. By the spectral decomposition of an idempotent matrix.Let PX = X (X 0 X)−1 X 0 . 0). Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.14) In general this is non-zero.14) approaches that in (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . l . 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 (11.14) is the probability limit of β 2SLS − β 11. 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 . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 130 . 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. Indeed as α → 1. the expression in (11. except when S21 = 0 (when Z is exogenous).7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 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 . It is also close to zero when α = 0.12) and this result.

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

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

ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. and Γ is l × k. Explain why this is true. 6. xi is l × 1. at ˆˆ If X is indeed endogeneous.8 Exercises yi = zi β + ei . 1. The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. Take the linear model yi = xi β + ei E (ei | xi ) = 0. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. will IV “ﬁt” better than OLS.) 3. That is. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). ˜ 0 e < e0 e. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. in the sense that e ˜ ˜ least in large samples? 4. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). show that if rank(Γ) < k then β cannot be identiﬁed. Z is n × k. where xi and β are 1 × 1. X is n × l. 5. l ≥ k. 2. Find a simple expression for the IV estimator in this context.11. Take the linear model Y = Zβ + e. u is n × k. (Find an expression for xi . 133 .

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. of the father) and motheduc (the education.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995). listed in card. in years. and the remaining variables as exogenous. Estimate the model by 2SLS. and then calculate the GMM estimator from this weight matrix without further iteration. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. In this model. of the mother). Report estimates and standard errors. (b) Now treat Education as endogenous. a dummy indicating that the observation lives near a 4-year college. (d) Re-estimate the model by eﬃcient GMM. The data ﬁle card. 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. (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). using zi as an instrument for xi . There are 2215 observations with 19 variables. and South and Black are regional and racial dummy variables. (e) Calculate and report the J statistic for overidentiﬁcation. Report estimates and standard errors. 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). (f) Discuss your ﬁndings. f atheduc (the education. are the parameters identiﬁed? 8. Does this diﬀer from 2SLS and/or OLS? 7. (a) Estimate the model by OLS. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix.(b) Deﬁne the 2SLS estimator of β.pdf. in years. using the instrument near4.. 134 . Report the estimates and standard errors.

.) is a random variable. We can separate time series into two categories: univariate (yt ∈ R is scalar). and Cov (Yt . The primary model for multivariate time series is vector autoregressions (VARs).Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. Yt−1 . . and T to denote the number of observations. 135 . . so classical assumptions are not valid. Deﬁnition 12. Yt−k ) is the autocorrelation function.. The following two theorems are essential to the analysis of stationary time series.1. we adopt new notation. t = 1..3 ρ(k) = γ(k)/γ(0) = Corr(Yt .1.2 {Yt } is strictly stationary if the joint distribution of (Yt .1 If Yt is strictly stationary and ergodic and Xt = f (Yt . Yt−k ) = γ(k) is independent of t for all k.1.4 (loose). To indicate the dependence on time.. then Xt is strictly stationary and ergodic. Theorem 12.. γ(k) is called the autocovariance function. Because of the sequential nature of time series.1 Stationarity and Ergodicity Deﬁnition 12.1. Deﬁnition 12. . T .. There proofs are rather diﬃcult. we expect that Yt and Yt−1 are not independent.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. 12.. A stationary time series is ergodic if γ(k) → 0 as k → ∞. Deﬁnition 12.. The primary model for univariate time series is autoregressions (ARs). Yt−k ) is independent of t for all k. however. and multivariate (yt ∈ Rm is vector-valued). and use the subscript t to denote the individual observation.1.

the sequence Yt Yt−k is strictly stationary and ergodic. Part (1) is a direct consequence of the Ergodic theorem. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ ˆ γ ¥ 136 . T 1X Xt →p E(Xt ). ρ(k) →p ρ(k). For Part (2). ˆ 3. If Xt is strictly stationary and ergodic and E |Xt | < ∞.3 If Yt is strictly stationary and ergodic and EYt2 < ∞.1.1.2 (Ergodic Theorem). ˆ Proof. 1. ˆ 2. then as T → ∞.Theorem 12. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). then as T → ∞.1 above. and it has a ﬁnite mean by the assumption that EYt2 < ∞. µ →p E(Yt ). 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 . γ (k) →p γ(k). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . T t=1 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) . γ (0) ˆ Theorem 12.1.

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

Theorem 12.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . We say that the root of the polynomial is 1/ρ.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Deﬁnition 12. From Theorem 12. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . 138 . Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value). Lk Yt = Yt−k .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. an AR(1) is stationary iﬀ |ρ| < 1. the above results are unchanged.4. since ρ(z) = 0 when z = 1/ρ. Deﬁning L2 = LL. We call ρ(L) the autoregressive polynomial of Yt . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et .1 The lag operator L satisﬁes LYt = Yt−1 . ∞ X k=0 ρ2k V ar (et−k ) = 12.3. 12.3. We call ρ(L) the autoregressive polynomial of Yt . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. In general. we see that L2 Yt = LYt−1 = Yt−2 .1. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . The AR(k) model is Using the lag operator.

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

we constructed the bootstrap sample by randomly resampling from the data values {yt . we can apply Theorem 12. T t=1 where Ω = E(xt x0 e2 ). t This construction imposes homoskedasticity on the errors e∗ . the asymptotic covariance matrix is estimated just as in the cross-section case. It also presumes that the AR(k) structure is the truth. Q−1 ΩQ−1 . there are two popular methods to implement bootstrap resampling for time-series data. The implication is that asymptotic inference is the same. 12..1 to see that T 1 X √ xt et →d N (0. T 1 X √ ut →d N (0. Y0 )..7 Asymptotic Distribution Theorem 12.. e ˆ 3.. T t=1 Since xt et is a MDS. then as T → ∞. eT }. i 4. Divide the sample into T /m blocks of length m. Estimate β and residuals et . ˆ 1..1 MDS CLT. ˆ 2. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.7. Fix an initial condition (Y−k+1 . t then as T → ∞. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. this cannot work in a time-series application. 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∗ . Ω) . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Method 1: Model-Based (Parametric) Bootstrap.. Ω) . This creates an iid bootstrap sample. This is identical in form to the asymptotic distribution of OLS in cross-section regression.12. which may be diﬀerent than the i properties of the actual ei . Method 2: Block Resampling 1.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. xt }. .8 Bootstrap for Autoregressions In the non-parametric bootstrap. 140 . t t Theorem 12.7. Clearly. Y−k+2 . as this imposes inappropriate independence.7. Brieﬂy. . In particular.

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

6).g.. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). We then multiply this by θ and subtract from (12. you need more initial conditions. and under H1 it is an AR(2).5). 142 . (12. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . AIC(k) = log σ 2 (k) + ˆ 2k . this is the same as saying that under the alternative Yt is an AR(k+m). (If you increase k. and then reserve the ﬁrst k as initial conditions. and then estimate the models AR(1).6) 12. In general. To combine (12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero.. (12. Another is to minimize the AIC or BIC information criterion. We model this as an AR(1): ut = θut−1 + et with et a MDS. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. . e. Thus under H0 . The best remedy is to ﬁx a upper value k... we take (12. and the alternative is that the error is an AR(m).. AR(k) on this (uniﬁed) sample. AR(2). We want to test H0 against H1 . Yt is an AR(1). if the null hypothesis is that Yt is an AR(k). Yt−k−m are jointly zero.12.10 Testing for Omitted Serial Correlation For simplicity. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 .5) We are interested in the question if the error ut is serially correlated. One approach to model selection is to choose k based on a Wald tests.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 .) This can induce strange behavior in the AIC. (A simple exclusion test).. An appropriate test is the Wald test of this restriction.5) and (12. . T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero.

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

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

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

Restrictions may be imposed on individual equations. 146 . some regressors may be excluded from some of the equations. These are implied by the VAR model. 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). ˆj ˆ And if we stack these to create the estimate A. ..then Yt = Axt + et . each with the same set of regressors. One way to write this is to let a0 be the jth row j of A. m. This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator.2 Estimation E (xt ejt ) = 0. Consider the moment conditions j = 1.3 Restricted VARs The unrestricted VAR is a system of m equations. ˆ An alternative way to compute this is as follows. Note that a0 = Yj0 X(X 0 X)−1 . either as a regression. For example. The VAR model is a system of m equations. we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ . The GMM framework gives a convenient method to impose such restrictions on estimation. ⎟ ⎝ .. ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 . 13.. Then the VAR system can be written as the equations Yjt = a0 xt + ejt .2 ⎟ X(X 0 X)−1 A ⎜ . A restricted VAR imposes restrictions on the system. or as a linear projection. or across equations. ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt . and was originally derived by Zellner (1962) ¢ 13.

2) Take the equation yt = x0 β + et . and is still routinely reported by conventional regression packages.3).3) which is a valid regression model. general. and subtract oﬀ the equation once lagged multiplied by θ.1) yt = x0 β + et .2) is a special case of (13. xt−1 ) to the regression.4 Single Equation from a VAR Yjt = a0 xt + et .2) may be estimated by iterated GLS. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. Then the single equation takes the form (13. 1). which is called a common factor restriction. (13.1). and Zt be the other variables.13. and is typically rejected empirically. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. Let et = ejt and β = aj . This can be done by a Wald test. If valid. We see that an appropriate. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13.) Since the common factor restriction appears arbitrary. it is convenient to re-deﬁne the variables. we are only interested in a single equation out of a VAR system. Another interesting fact is that (13. j Often. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . 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 . t and et is iid N (0. which once was very popular. Otherwise it is invalid. 13. In this case. Suppose that et is an AR(1). So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . may be tested if desired. You may have heard of the Durbin-Watson test for omitted serial correlation. with time series data. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).2) is uncommon in recent applications. 147 . t or yt = θyt−1 + x0 β + x0 γ + ut . t t−1 (13. (A simple version of this estimator is called Cochrane-Orcutt. t and xt = This is just a conventional regression. the model (13. This restriction. direct estimation of (13. under the restriction γ = −βθ. Let yt = Yjt .

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

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

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

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

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

Thus the model is that there is some latent process yi with unbounded support. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. 1.1).. this motivates the label Poisson “regression. 14. . The conditional density is the Poisson with parameter λi . Tobin observed that for many households. incomes above a threshold are typically reported at the threshold.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. 1. 0 if yi (This is written for the case of the threshold being zero. σ 2 ) with the observed variable yi generated by the censoring equation (14. In surveys. 2. the consumption level (purchases) in a particular period was zero. or it may be a by-product of economic constraints.2 Count Data exp (−λi ) λk i . He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.. The functional form for λi has been picked to ensure that λi > 0.. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . This model speciﬁes that P (Yi = k | xi ) = λi k = 0. An example of a data collection censoring is top-coding of income. This may be considered restrictive.}.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). k! = exp(x0 β). 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 !) .) The observed data yi therefore come from a mixed continuous/discrete distribution. . i If Y = {0. The censoring process may be explicit in data collection. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods.. 2.1) yi = ∗ <0 .14. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. any known value can substitute. a typical approach is to employ Poisson regression. A generalization is the negative binomial. i i i=1 ˆ The MLE is the value β which maximizes ln (β). i so the model imposes the restriction that the conditional mean and variance of Yi are the same.

P (yi = y | xi ) = σ φ σ 0 Therefore. if you ask for volunteers for an experiment. that the parameter of β is deﬁned by an alternative statistical structure. Hence the log-likelihood is a mixture of the probit and the normal: ln (β) = n X i=1 ¶¸ µ 0 ¶ X ∙ µ xi β yi − x0 β −1 i + . 154 . [Note: it is still possible to estimate E (Yi | xi ) by LS techniques. 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 . 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). This occurs when the observed data is systematically diﬀerent from the population of interest. The naive approach to estimate β is to regress yi on xi . To construct the likelihood. and the latter is of interest. 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 − . σ φ σ σ where 1 (·) is the indicator function. the density function can be written as y > 0. For example. Thus OLS will be biased i for the parameter of interest β. This has great relevance for the evaluation of anti-poverty and job-training programs.] Consistent estimation will be achieved by the MLE. 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. σ The conditional distribution function above zero is Gaussian: ¶ µ Z y z − x0 β −1 i dz. and they wish to extrapolate the eﬀects of the experiment on a general population. where the goal is to assess the eﬀect of “training” on the general population. This does not work because regression estimates E (Yi | xi ) . All that is reported is that the household purchased zero units of the good. 14.4 Sample Selection The problem of sample selection arises when the sample is a non-random selection of potential observations.would prefer to sell than buy). not just on the volunteers.

155 . by viewing the Probit/OLS estimation equations as a large joint GMM problem. if γ were known. as this is a two-step estimator. However. The naive estimator of β is OLS regression of yi on xi for those observations for which yi is available. Heckman (1979) observed that we could consistently estimate β and ρ from this equation. using regressors zi . The binary dependent variable is Ti . Ti } for all observations. Zi ¢ ¡ ¢ ¡ 0 0 = ρE e0i | {e0i > −zi γ}. Or. where Hence ¡ 0 ¢ e1i = ρλ zi γ + ui . The model is often completed by specifying that the errors are jointly normal ¶ µ µ ¶¶ µ 1 ρ e0i ∼ N 0. It is unknown. A useful fact about the standard normal distribution is that φ(x) . E (e0i | e0i > −x) = λ(x) = Φ(x) and the function λ(x) is called the inverse Mills ratio. The “Heckit” estimator is thus calculated as follows • Estimate γ from a Probit. e1i = ρe0i + vi . . ¡ 0 ¢ yi = x0 β + ρλ zi γ + ui i (14. Under the normality assumption. i • The OLS standard errors will be incorrect. ¡ ¢ 0 E (e1i | Ti = 1. where vi is independent of e0i ∼ N (0. They can be corrected using a more complicated formula. The dependent variable yi is observed if (and only if) Ti = 1.2) is a valid regression equation for the observations for which Ti = 1.A simple sample selection model can be written as the latent model yi = x0 β + e1i i ¡ 0 ¢ Ti = 1 zi γ + e0i > 0 where 1 (·) is the indicator function. Thus E (ui | Ti = 1. e1i ρ σ2 It is presumed that we observe {xi . For example. The equation for Ti is an equation specifying the probability that the person is employed. Else it is unobserved. 1). ρ from OLS of yi on xi and λ(z 0 γ ). which is non-zero. Zi ) = E e1i | {e0i > −zi γ}. but also can be consistently estimated by a Probit model for selection. zi . The problem is that this is equivalent to conditioning on the event {Ti = 1}. Zi ¡ 0 ¢ = ρλ zi γ . yi could be a wage. Zi ) = 0. Zi + E vi | {e0i > −zi γ}. alternatively. ˆ ³ ´ ˆ ˆ ˆ • Estimate β. which can be observed only if a person is employed.

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

. then OLS is inconsistent. . ti .. 157 . and that eit is uncorrelated with xit . or unbalanced : {yit . . collected over time. OLS of yit on xit is called pooled estimation.. where the i subscript denotes the individual. t = ti . that eit is iid across individuals and time.Chapter 15 Panel Data A panel is a set of observations on individuals. OLS can be improved upon via a GLS technique. . The goal is to eliminate ui from the estimator. however.. n.. n. xit }. Condition (15. If (15.. In either event.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . This is often believed to be plausible if ui is an omitted variable. 15. it The typical maintained assumptions are that the individuals i are mutually independent. .. xit } : t = 1. xit } : For i = 1.1 Individual-Eﬀects Model The standard panel data speciﬁcation is that there is an individual-speciﬁc eﬀect which enters linearly in the regression yit = x0 β + ui + eit .1) is true.. and most applied researchers try to avoid its use. and thus achieve invariance. It is a strong assumption. and have arbitrary correlated with xi . 15. and the t subscript denotes time.1) If this condition fails. i = 1. It is consistent if E (xit ui ) = 0 (15.. T . The motivation is to allow ui to be arbitrary. An observation is the pair {yit .1) is called the random eﬀects hypothesis. (15. OLS appears a poor estimation choice.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. that ui and eit are independent.. A panel may be balanced : {yit .. There are several derivations of the estimator..

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

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

we cannot deﬁne d F (x) since F (x) is a step function. n i=1 n 160 . and then see how the method generalizes to estimating the entire function. The kernel functions are used to smooth the data. |x| ≤ 1 0 |x| > 1 In practice. |x| ≤ 1 0 |x| > 1 ¡ ¢2 1 − x2 . The goal is to estimateP(x) from a random sample (X1 . Let 1 ³u´ . The ˆ ˆ EDF F i=1 dx standard nonparametric method to estimate f (x) is based on smoothing using a kernel.. . The amount of smoothing is controlled by the bandwidth h > 0. the choice between these three rarely makes a meaningful diﬀerence in the estimates.1 Kernel Density Estimation d Let X be a random variable with continuous distribution F (x) and density f (x) = dx F (x). Xn } While F (x) can be estimated by the f ˆ (x) = n−1 n 1 (Xi ≤ x) .. While we are typically interested in estimating the entire function f (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 . The kernel density estimator of f (x) is 1X ˆ f (x) = Kh (Xi − x) .. Deﬁnition 1 K(u) is a second-order kernel function if it is a symmetric zero-mean density function. we can simply focus on the problem where x is a speciﬁc ﬁxed number.Chapter 16 Nonparametrics 16. Kh (u) = K h h be the kernel K rescaled by the bandwidth 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. f (x) ≥ 0 for all x. ˆ We can also calculate the moments of the density f (x). 161 . ˆ(x) is small. The bandwidth h controls the meaning of “near”. If a large number of the observations Xi are near ˆ x. where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h. if only a few Xi are near x. It follows that the variance of the density f (x) is Ã n !2 ¶2 µZ ∞ Z ∞ n 1X 1X 2 ˆ ˆ x2 f (x)dx − xf (x)dx = Xi + h2 σ 2 − Xi K n n −∞ −∞ i=1 i=1 −∞ = σ ˆ 2 + h2 σ 2 K Thus the variance of the estimated density is inﬂated by the factor h2 σ 2 relative to the sample K moment. Conversely.This estimator is the average of a set of weights. then the weights are small and f ˆ ˆ Interestingly. f (x) is a valid density. The mean is Z ∞ ˆ xf (x)dx = = = = −∞ 1X n 1 n 1 n 1 n n i=1 −∞ n XZ ∞ Z ∞ xKh (Xi − x) dx (Xi + uh) K (u) du n i=1 −∞ n X Z ∞ Xi Xi i=1 n X i=1 1X K (u) du + h n −∞ i=1 Z ∞ uK (u) du −∞ the sample mean of the Xi . 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 sharper the derivative.16. so is estimating a smoothed version of f (x). 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . Since it is an average of iid random variables.2 Asymptotic MSE for Kernel Estimates ∞ For ﬁxed x and bandwidth h observe that Z ∞ Z Kh (z − x) f (z)dz = EKh (X − x) = −∞ Kh (uh) f (x + hu)hdu = −∞ Z ∞ K (u) f (x + hu)du −∞ The second equality uses the change-of variables u = (z − x)/h. the estimator f (x) smooths data local to Xi = x. Intuitively. 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 . ˆ We now examine the variance of f (x). 162 . 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). which is valid as h → 0. The last expression shows that the expected value is an average of f (z) locally about x. This integral (typically) is not analytically solvable. and is larger the greater the curvature in f (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. 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 bias results from this smoothing. ˆ the greater the bias.

h must tend to zero. and gives a nearly optimal rule when f (x) is close to normal.2) depends on R(K). we need h → 0 but nh → ∞. where φ is the N (0. h0 = argmin AM ISEh h It can be found by solving the ﬁrst order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 .06n−1/5 163 . 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). σ 2 . (16. We thus say that the optimal bandwidth is of order O(n−1/5 ). Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. The asymptotically optimal choice given in (16.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . In practice. The downside is that if the density is very far from normal. but not of n. That is. AM SEh (x) = f 00 (x)2 h4 σ 4 + K 4 nh A global measure of precision is the asymptotic mean integrated squared error (AMISE) Z h4 σ 4 R(f 00 ) R(K) K + . how should the bandwidth be selected? This is a diﬃcult problem. Gaussian Kernel: hrule = 1. 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. Note that this h declines to zero. we ﬁnd the reference rules for the three kernel functions introduced earlier. but at a very slow rate.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. We can calculate that √ R(φ00 ) = 3/ (8 π) . and there is a large and continuing literature on the subject. Equation (16. (16. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. Together with the above table. 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) . Thus for the AMISE to decline with n. but at a slower rate than n−1 . That is. ˆ It uses formula (16. This choice for h gives an optimal rule when f (x) is ˆ normal. Their K values for the three functions introduced in the previous section are given here. and R(f 00 ). the rule-of-thumb h can be quite ineﬃcient.Together. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE.1) is an asymptotic approximation to the MSE. The ﬁrst two are determined by the kernel function.2) but replaces R(f 00 ) with σ −5 R(φ00 ).

there are modern versions of this estimator work well. in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates. There are some desirable properties of cross-validation bandwidths.Epanechnikov Kernel: hrule = 2.2). Another popular choice for selection of h is cross-validation. and then plug this estimate into the formula (16. There are other approaches. This works by constructing an estimate of the MISE using leave-one-out estimators.34n−1/5 Biweight (Quartic) Kernel: hrule = 2. which are known as smoothed cross-validation which is a close cousin of the bootstrap. in particular the iterative method of Sheather and Jones (1991). as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x). 164 .78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice. Fortunately there are remedies. I now discuss some of these choices. They are also quite ill-behaved when the data has some discretization (as is common in economics). This is more treacherous than may ﬁrst appear. However. but implementation can be delicate. The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. but they are also known to converge very slowly to the optimal values. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x).

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

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

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

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

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

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

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

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

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

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

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

−∞ < x < ∞. Σ) and Y = a + BX with B an invertible matrix. For x ∈ Rk . exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. (A. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . This shows that if X is multivariate normal with uncorrelated elements.2 If Z ∼ N(0. and it is conventional to write X ∼ N (µ. denoted χ2 . If Z is standard normal and X = µ + σZ. y ≥ 0. Its mean and r variance are µ = r and σ 2 = 2r. σ 2 ). Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . then Σ = diag{σ 2 } is a diagonal matrix.This density has all moments ﬁnite. respectively. q × q. x ∈ Rk . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . Ir ) and set Q = X 0 X. Since it is symmetric about zero all odd moments are zero. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). then Z 0 A−1 Z ∼ χ2 . Σ). By iterated integration by parts.8. then by the change-of-variables formula. then they are mutually independent.11) and is known as the chi-square density with r degrees of freedom. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . f (x) = √ 2σ 2 2πσ which is the univariate normal density. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. and it is conventional to write X ∼ N(µ. 1). X has density Ã ! (x − µ)2 1 exp − . q 176 . The mean and variance of the distribution are µ and σ 2 .8. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . The latter has no closed-form solution. ¢ ¡ It useful to observe ¢ that the MGF and CF of the multivariate normal are exp λ0 µ + λ0 Σλ/2 ¡ 0 and exp iλ µ − λ0 Σλ/2 . x ∈ Rk . Another useful fact is that if X ∼ N (µ. 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. then using the change-of-variables formula. Theorem A.1 Let X ∼ N (0. It is conventional to write X ∼ N (0. This shows that linear transformations of normals are also normal. we can also show that EX 2 = 1 and EX 4 = 3. A) with A > 0. Theorem 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 . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . Proof of Theorem A. 1) and Q ∼ χ2 be independent.1. which can be found by applying change-of-variables to the gamma function.3. C −1 CC 0 C −10 ) = N (0. 1). From (A.3 Let Z ∼ N (0.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.11) 2 with r = 1. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. C −1 AC −10 ) = N (0.13) is the MGF of the density (A. For Z ∼ N(0. q Proof of Theorem A. Set r Z . Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). Thus the density of Z 2 is (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Using the simple law of iterated expectations. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.11).11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.8. which we showed in (A. we see that the MGF of Z 2 is (1 − 2t)−1/2 .8. The MGF for the density (A.13).2.8. Iq ).Theorem A.8. (A. tr has distribution 177 .12) E exp (tQ) = 0 Γ (A.

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

9. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. under conventional regularity conditions. cases are rare. θ θ∈Θ ˆ In some simple cases. However. ˆ is consistent θ for this value. We can write this as ˆ = argmax Ln (θ). θ Theorem A.9.3 Under regularity conditions.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . If ˜ is an unbiased estimator of θ ∈ R. ∂θ ∂θ (A.14) ¶ ∂ ∂ 0 ln f (Yi .9. 179 . which maximizes the log-likelihood).15) Two important features of the likelihood are Theorem A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. we can see that it is an estimator of the maximizer θ of the right-hand-side. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. θ0 ) ln f (Yi . we can ﬁnd an explicit expression for θ as a function of the data. and the equality (A. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . In fact. ˆ →p θ0 as n → ∞. but these ˆ must be found by numerical methods. θ) The Cramer-Rao Theorem gives a lower bound for estimation. More typically.2 Cramer-Rao Lower Bound.17) The matrix I0 is called the information.16). the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . n n i=1 n As the MLE ˆ maximizes the left-hand-side. θ) ≡ L(θ). Theorem A.17) is often called the information matrix equality. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. θ) →p E ln f (Yi . θ) ∂θ ∂θ which holds at θ = θ0 by (A.1 ¯ ¯ ∂ E ln f (Yi .16) (A. θ0 ) . then θ V ar(˜ ≥ (nI0 )−1 . I0 . θ0 ) ∂θ∂θ 0 (A.

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

9. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ) f (y. ∂θ ¯θ=θ0 Z ! = 0. (Yi . yn ).. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y.9. θ0 ) ∂ ∂ − ln f (Yi . θ) dy ¯ ∂θ f (y. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A.1. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 )2 (Yi . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ.. θ0 ) ∂θ f (Yi . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0.Proof of Theorem A. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . To see (A.1) has mean zero and variance nH. θ0 )0 f (Yi . V ar (S) nH so ¥ 181 . ¯ ¯ ∂ E ln f (Yi . ∂2 ln f (Yi . θ0 )0 .9.2. 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 ) − f (Yi . we can show that E By direction computation. θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ0 ) d˜ = E ˜ . θ0 ) ln f (Yi . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.17). Since θ Z ˜ = ˜ y)f (˜. θ0 ) (Yi . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 ) f (Yi . function of the data.16). Proof of Theorem A. θ0 ) ¯ ∂ f (y. θ0 ) ∂ ∂θ f ∂ (Yi . θ) f (˜. . θ0 = ln f (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. f (Yi ..

and making a ﬁrst-order Taylor series expansion. Together. H −1 . the speciﬁc value of θn varies by row in this expansion. we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. the ﬁnal equality using Theorem A. − ln f (Yi . θ0 ) .9.3 Taking the ﬁrst-order condition for maximization of Ln (θ). ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . θ0 ) is mean-zero with covariance matrix Ω. an application of the CLT yields 1 X ∂ √ ln f (Yi .Proof of Theorem A. Ω) . ¥ 182 . θ0 ) →d N (0. θ n ) θ − θ 0 . ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi .1 . θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θn ) = 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. θ0 ) + ' 0 ln f (Yi .) Rewriting this equation. Ω) = N 0. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . H −1 ΩH −1 = N 0. θ) .9. (Technically. If it is continuous in θ.

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

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

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

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