ECONOMETRICS

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

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

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

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

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

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

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

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

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. . . . . . . . . .6 Bekker Asymptotics . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . Percentile Confidence Intervals . . . . . . . . . . . . . . . . 9. . . . . . . . . 9. . . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . .13 One-Sided Tests . . .7 Asymptotic Distribution .8 Conditional Moment Restrictions . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . .4 Estimation of the Efficient Weight Matrix . . . . 9. . . . . . . . . 12. . . .12 8. . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . .9 8. Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . 9. . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. 12. . . . . .4 Estimation . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . .5 GMM: The General Case .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . .3 Identification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . .8 Exercises . . . . . . . . . . 10. . . . . . . .2 GMM Estimator . . . . . . . . . .4 Lag Operator . . . . . 9. . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . .9 Trend Stationarity . . .1 Overidentified Linear Model . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 Exercises . .12Autoregressive Unit Roots .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . .11Model Selection . . . . . . . .7 Identification Failure . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identification Test . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . .11 8. . . . . . . . . . . 10. . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.4 Testing . . . . . . . . . . . 12. . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . .10 8. . . . . . 12. . . .5 Numerical Computation . . . . . . 9. .1 Instrumental Variables .2 Reduced Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

⎦ ⎣ . . . are said to be orthogonal if A0 A = Ir . The columns of a k × r matrix A. which has ones on the diagonal. For example. . An important diagonal matrix is the identity matrix.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. ⎥ . . then AIr = A and Ik A = A. for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . 0 0 ··· 1 2.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. . ⎤ ⎥ ⎥ ⎥ ⎦ AB = A1 A2 · · · Ar Br = A1 B1 + A2 B2 + · · · + Ar Br r X = Ar Br j=1 ¤⎢ ⎢ ⎢ ⎣ Important properties are that if A is k × r. . . We say that two vectors a and b are orthogonal if a0 b = 0. r ≤ k. A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . Also. ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . . A square matrix A is called orthogonal if A0 A = Ik .

7 Also.3) The matrix A− is not necessarily unique. we can still define a generalized inverse A− as a matrix which satisfies AA− A = A. . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. . The Moore-Penrose generalized inverse A− satisfies (2. This matrix is called the inverse of A and is denoted by A−1 . If A − BD−1 C and D − CA−1 B are non-singular. 2. or is nonsingular. . if there is no c 6= 0 such that Ac = 0. the Moore-Penrose generalized inverse A− exists and is unique. . then A−1 = A.4 Inverse A k × k matrix A has full rank.The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . For non-singular A and C. (2.2) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2. . then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . . if A is an orthogonal matrix. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . The following fact about inverting partitioned matrices is sometimes useful.1) . (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. In this case there exists a unique matrix B such that AB = BA = Ik .

X 0 X is symmetric and positive definite. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . Let λi and hi . A square matrix A is idempotent if AA = A. The matrix B need not be unique. This is written as A ≥ 0. We call B a matrix square root of A.) If A is positive definite. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. then A = HΛH 0 and H 0 AH = Λ. then A is positive semi-definite. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. which are not necessarily distinct and may be real or complex. k < n. They are called the latent roots or characteristic roots or eigenvalues of A. c0 Ac = α0 a ≥ 0 where α = Gc. • If A has distinct characteristic roots. 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. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. 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. then A is non-singular and A−1 exists. If A > 0 we can find a matrix B such that A = BB 0 .. λ−1 . . • The characteristic roots of A−1 are λ−1 . To see this. k denote the k eigenvalues and eigenvectors of a square matrix A. c0 Ac ≥ 0. then A > 0 if and only if all its characteristic roots are positive. We now state some useful properties. 2.. • If A is symmetric. We say that A is positive definite if for all non-zero c.. In this case. 8 . c0 Ac > 0. If A is symmetric. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. Furthermore. and let H = [h1 · · · hk ]. If A = G0 G.. λ−1 .. . (For any c 6= 0.6 Rank and Positive Definiteness The rank of a square matrix is the number of its non-zero characteristic roots. We say that a square matrix A is positive semi-definite if for all non-zero c. has full rank k if there is no non-zero c such that Xc = 0. and then set B = HΛ1/2 . One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal.5 Eigenvalues det (A − λIk ) = 0. A−1 > 0. We say that X is n × k. Q • det(A) = k λi i=1 Pk • tr(A) = i=1 λi • A is non-singular if and only if all its characteristic roots are non-zero.2. and the characteristic roots are all real. If λi is an eigenvalue of A. This is written as A > 0.. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one.

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

denoted by vec (A) . The Kronecker product of A and B. . 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 . am1 B am2 B · · · amn B Some important properties are now summarized. 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). . an Let B be any matrix. . • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n.• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. • If A is orthogonal. The vec of A. . . . is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . . denoted A ⊗ B. .9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. then det A = 2. . ⎟ . ⎠ ⎝ . ⎣ ⎦ . 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 =⎢ ⎥.

holding the other variables constant. the mean wage for men is $27. the mean is not necessarily a good summary of the central tendency. Figure 3. it is useful to have numerical measures of the difference.1 by the arrows drawn to the x-axis. In this context we partition the observations into the pair (yi .Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. Take a closer look at the density functions displayed in Figure 3. gender. and that for women is $20. We call xi alternatively the regressor. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. xi ) where yi is a scalar (real-valued) and xi is a vector. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.2) m(x) = E (yi | xi = x) = −∞ In general. (3. the conditional density of yi given xi .1) xi = ⎜ .1. You can see that the right tail of then density is much thicker than the left tail.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population.22. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. we can focus on f (y | x) .1. xki 3.1 displays the density1 of hourly wages for men and women. . These are conditional density functions — the density of hourly wages conditional on race. ⎟ . This is used when the goal is to quantify the impact of one set of variables on another variable. See Chapter 16. To illustrate. ⎠ ⎝ . The data are from the 2004 Current Population Survey 1 11 . education and experience. the conditioning variable. In the example presented in Figure 3. The two density curves show the effect of gender on the distribution of wages. While it is easy to observe that the two densities are unequal. or the covariates. When a distribution is skewed. We call yi the dependent variable. m(x) can take any form. which is a common feature of wage distributions. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. These are indicated in Figure 3.73. and exists so long as E |yi | < ∞. These are asymmetric (skewed) densities.

this yields the formula yi = m(xi ) + ei . This is a more robust measure of the typical wage gap between men and women than the difference in the untransformed wage means. When the distribution of the control variable is continuous.3) White non-military male wage earners with 10-15 years of potential work experience. Assuming for simplicity that this is the true joint distribution.3 displays a scatter plot2 of log wages against education levels. Figure 3.D.1 is facilitated by the fact that the control variable (gender) is discrete. Of particular interest to graduate students may be the observation that difference between a B. 12 . 2 (3.3 is how the conditional expectation describes an important feature of the conditional distribution.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. The comparison in Figure 3. degree in mean log hourly wages is 0.2 Regression Equation The regression error ei is defined to be the difference between yi and its conditional mean (3. The difference in the log mean wage between men and women is 0.2) evaluated at the observed value of xi : ei = yi − m(xi ). wage regressions typically use log wages as a dependent variable rather than the level of wages. 3.A. To illustrate. the dashed line is a linear projection approximation which will be discussed in the Section 3.30. the solid line displays the conditional expectation of log wages varying with education. which implies a 30% average wage difference for this population.5.Figure 3. By construction.36. then comparisons become more complicated. with mean log hourly wages drawn in with the arrows. Figure 3. The conditional expectation function is close to linear. For this reason. implying an average 36% difference in wage levels.2 shows the density of log hourly wages for the same population. The main point to be learned from Figure 3. and a Ph.

restrictions on the permissible class of regression functions m(x). E(ei ) = 0.1 Properties of the regression error ei 1.2. A regression model imposes further restrictions on the joint distribution. E(xi ei ) = 0. most typically. The remaining parts of the Theorem are left as an exercise. not a model. E (ei | xi ) = 0. To show the first statement. These equations hold true by definition. E (h(xi )ei ) = 0 for any function h (·) . 4.2: Log Wage Densities Theorem 3. 2. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. are often stated jointly as the regression framework. because no restrictions have been placed on the joint distribution of the data. It is important to understand that this is a framework. 13 . by the definition of ei and the linearity of conditional expectations.Figure 3. The equations yi = m(xi ) + ei E (ei | xi ) = 0. 3.

A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . the conditional variance of yi is σ 2 = σ 2 (xi ).3 Conditional Variance Generally. σ 2 (x) is a non-trivial function of x. Thus the mean squared error is minimized by the conditional mean.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . it does not provide information about the spread of the distribution. i .Figure 3. The right-hand-side is minimized by setting g(x) = m(x).2. The conditional standard deviation is its square root σ(x) = σ 2 (x). In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. when σ 2 (x) is a constant so that ¢ ¡ (3. 3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.1. in the sense of achieving the lowest mean squared error. let g(x) be an arbitrary predictor of yi given xi = x. To see this. and can take any form. 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. Given the random variable xi .3. subject to the restriction p that it is non-negative. In contrast.

we assume that x1i = 1.1) has been redefined as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. 15 .7) is a k × 1 parameter vector. they are also somewhat more dispersed. ⎟ β=⎝ . βk ⎛ (3.6) (3.8) (3. This concept is less helpful than defining heteroskedasticity as the dependence of the conditional variance on the observables xi . ⎟ . it is more realistic to view the linear specification (3. i (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. and the linear assumption of the previous section is empirically unlikely to accurate.we say that the error ei is homoskedastic. ⎝ .4 Linear Regression An important special case of (3. We call this the “constant” or “intercept”.5. 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). 3. which we derive in this section.1. ⎠ . xki When m(x) is linear in x. Equation (3. The conditional standard deviation for men is 12. Equivalently. So while men have higher average wages. ⎠ .1 and that for women is 10. Instead. take the conditional wage densities displayed in Figure 3. As an example. Thus (3.8) is called the linear regression model. In this case (3.5) xi = ⎜ . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.6) as an approximation.1).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 . it is convenient to augment the regressor vector xi by listing the number “1” as an element. Notationally. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .9) 3. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . its functional form is typically unknown.

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 .12) This completes the derivation of the linear projection model. Rewriting. It is invertible if and only if it is positive definite. i i (3. i 16 . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. i (3. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.10) It is worth taking the time to understand the notation involved in this expression. Equivalently.1. Observe i that for any non-zero α ∈ Rk . The best linear predictor is obtained by selecting β to minimize S(β). Given the definition of β in (3. xi contains an intercept. i which requires that for all non-zero α. E (x0 xi ) < ∞. 3. by “best” we mean the predictor function with lowest mean squared error. i (3.10). 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 . Therefore. The vector (3. In order for β to be uniquely defined. this situation must be excluded. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.7) is 0= Solving for β we find ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.1 1. 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.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . x0 β is the best linear predictor for yi . E (xi x0 ) is invertible. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) .5.5. As before. 2 2. otherwise they are distinct. α0 E (xi x0 ) α = E (α0 xi )2 > 0. written E (xi x0 ) > 0. The first-order condition for minimization (from Section 2.which is quadratic in β. Eyi < ∞. The error is i ei = yi − x0 β. i 4. Assumption 3.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.

1 is employed to guarantee that (3.4 is required to ensure that β is uniquely defined. E (xi ei ) = 0 and E (ei ) = 0.4 guarantees that the solution β exits.1.14) holds.2 and 3.1.1 Under Assumption 3.5.1. 17 .10) are defined.1. By definition.9).5.8)-(3. (3.1. Assumption 3.5. (3.1. Assumption 3. Since ei is mean zero by (3.14). Equation (3.5.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. Furthermore.11) and (3. Since from Theorem 3.1.3 are called regularity conditions. it follows that linear regression is a special case of the projection model.13) and Assumption 3.2. ¥ (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. For example. Assumption 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.3 ensure that the moments in (3.2 and 3.13) summarize the linear projection model.1.5. Let’s compare it with the linear regression model (3. Using the definitions (3.5.5.13) implies that xi and ei are uncorrelated. Figure 3. However. This means that the equation (3.1.1.12) can be alternatively interpreted as a projection decomposition.14) Proof. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1.5.10) and (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .13) The two equations (3.Theorem 3.5.10) ¡ ¡ ¢¢ 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. The finite variance Assumptions 3.14) follows from (3.11) are well defined.5.12) and (3. the orthogonality restriction (3.5.1 are weak. Assumption 3.4 we know that the regression error has the property E (xi ei ) = 0.

for those over 53 in age).12) is defined by projection and the associated coefficient definition (3. A projection of log wages on these two variables can be called a quadratic projection. It over-predicts wages for young and old workers. However. it is important to not misinterpret the generality of this statement. In other cases the two may be quite different. Most importantly.10). 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. the dashed line is the linear projection of log wages on eduction. This defect in linear projection can be partially corrected through a careful selection of regressors. The solid line is the conditional mean. In contrast. there are no changes in our methods or analysis. In this example it is a much better approximation to the conditional mean than the linear projection. we can augment the regressor vector xi to include both experience and experience2 . and under-predicts for the rest. In this example the linear projection is a close approximation to the conditional mean. We illustrate the issue in Figure 3. Returning to the joint distribution displayed in Figure 3.12) with the properties listed in Theorem 3. Other than the redefinition of the regressor vector. These structural models require alternative estimation methods.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. In this case the linear projection is a poor approximation to the conditional mean.10) may not hold and the implications of Theorem 3.1.1 may be false. for any pair (yi . In this case (3. No additional assumptions are required. Figure 3.3.5.5. xi ) we can define a linear projection equation (3.4 we display as well this quadratic projection. and are discussed in Chapter 11. In the example just presented. The linear equation (3. since the resulting function is quadratic in experience. Figure 3.We have shown that under mild regularity conditions. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. In Figure 1.4 displays the relationship3 between mean log hourly wages and labor market experience. and the straight dashed line is the linear projection. in many economic models the parameter β may be defined within the model.

The data are divided in two — Group 1 and Group 2 — which have different marginal distributions for the regressor xi . 1) and those in Group 2 are N(4.constructed4 joint distribution of yi and xi . A defect with linear projection is that it leads to the incorrect conclusion that the effect of xi on yi is different for individuals in the two Groups. 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. combined with different marginal distributions for the conditioning variables. and the conditional distriubtion of yi given xi is N(m(xi ). 1) where m(x) = 2x − x2 /6. The xi in Group 1 are N(2. and Group 1 has a lower mean value of xi than Group 2. This conclusion is incorrect because is fact there is no difference in the conditional mean between the two groups. 4 19 . The apparant difference is a by-product of a linear approximation to a non-linear mean. 1). The solid line is the non-linear conditional mean of yi given xi .

xi ∈ R. then E(x2 ei ) = 0. Are they different? Hint: If P (Y = j) = 5. 9. If yi = x0 β + ei .. e−λ λj j! . and have the following joint probability distribution X=0 X=1 Y =0 . taking values only on the non-negative integers.3. True or False. If yi = x0 β + ei and E(ei | xi ) = 0. Define µ ¶ ¢ ¡ x−µ 2 g x. then ei is i i independent of xi . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Define µy = Eyi . i 8.3 Find E(Y | X = x). and E(xi ei ) = 0.2. i 10. If yi = x0 β + ei and E(xi ei ) = 0. then ei is independent of xi . Suppose that Y and X only take the values 0 and 1. i 11. 2. 1. Compute the conditional mean m(x) = E (yi | xi = x) . Compute 2 the coefficients of the linear projection yi = β 0 + β 1 xi + ei . True or False. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j .6 Exercises 1. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. i 7. x 6.1 . If yi = xi β + ei . xi ∈ R. If yi = xi β + ei . 3 and 4 of Theorem 3. then E(x2 ei ) = 0. True or False. σ 2 = V ar(xi ). 3. E(ei | xi ) = 0. Prove parts 2. σ = . and E(e2 | xi ) = σ 2 . yi ). . j! 0 j = 0. ¡ ¢ 4. (x − µ)2 − σ 2 Show that Eg (X. and E(ei | xi ) = 0. a constant. µx = Exi .1. True or False. 0 ≤ y ≤ 1. Compute E(yi | xi = x) and V ar(yi | xi = x). 20 .4 . Let X be a random variable with µ = EX and σ 2 = V ar(X). Let xi and yi have the joint density f (x. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Suppose that yi is discrete-valued. µ. 2. then E(ei | xi ) = 0. m.. True or False.2 Y =1 . σ 2 = V ar(yi ) and σ xy = Cov(xi . E(Y 2 | X = x) and V ar(Y | X = x). s) = 0 if and only if m = µ and s = σ 2 .

1) (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.1 Estimation Equation (4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 . Observe that (4.7 and 4.4) i i=1 i=1 ˆ Another way to derive β is as follows.3) writes the projection coefficient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . but for most of the chapter we retain the broader focus on the projection model.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i à n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 à n !−1 n X X = xi x0 xi yi . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . we narrow the focus to the linear regression model. 4. i n i=1 n 21 .3) In Sections 4. (4. i It follows that the moment estimator of β replaces the population moments in (4.2) can be written in the parametric 0 β)) = 0.8.2) (4.

5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. An interpretation of the estimated equation is that each year of education is associated with an 11.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 205. Then µ ¶ n 1X 2. 4.83 ¶−1 µ ¶ . 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. This sample has 988 observations. 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 (4.117 1 14.30 + 0.117 Educationi .2 Least Squares There is another classic motivation for the estimator (4. consider the data used to generate Figure 3. These are white male wage earners from the March 2004 Current Population Survey.14 14. ¶ 2.7% increase in mean wages. 40 0. Let yi be log wages and xi be an intercept and years of education.4). 40 2. excluding military.3.95 xi yi = 42.95 42. 0. 30 = . To illustrate.37 µ ¶ 1. with 10-15 years of potential work experience.4).170 37. i 22 .71 = −2.40 µ ¶µ ¶ 34.14 205.ˆ This is a set of k equations which are linear in β.14 14. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.94 −2.

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 . we define the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. which can cause confusion. i ˆ ˆ Note that yi = yi + ei . Following convention we will call β the OLS estimator of β. Since the function Sn (β) is a quadratic function of β. To visualize the sum-of-squared errors function. Matrix calculus (see Appendix 2. while the residual is a by-product of estimation.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. Figure 4. the contour lines are ellipses. Figure 4. Figure 4.4).2 displays the contour lines of the same function — horizontal slices at equally spaced heights. These two ˆ variables are frequently mislabeled. 23 . The error is unobservable.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.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β).

ˆ n i=1 n Since xi contains a constant. The error variance σ 2 = Ee2 is also a parameter of interest. ˆ n−k 2 i=1 (4.6) An alternative estimator uses the formula n 1 X 2 s = ei . ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero.Figure 4. Its method of moments estimator is the sample average 1X 2 ei . 24 .2: Sum-of-Squared Error Function Contours Equation (4. and hold true for all linear regression estimates. ˆ σ = ˆ n 2 i=1 n (4. It measures the variation in the i “unexplained” part of the regression.7) A justification for the latter choice will be provided in Section 4.7. one implication is that n 1X ei = 0.5) implies that 1X xi ei = 0. These are algebraic results.

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

residual vector.Maximization with respect to σ 2 yields the first-order condition n X ∂ n 1 ˆ ˆ Ln (β. ⎠ . n or equivalently Y = Xβ + e. Sample sums can also be written in matrix notation. . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. and X is an n × k matrix.4). it is matrix notation. .8) . We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . σ 2 ) = − 2 + ¡ ¢2 e2 = 0.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. n X i=1 Thus the estimator (4. ⎟. including computation. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. . en ⎞ Observe that Y and e are n × 1 vectors. Due to this equivalence. The linear equation (3. For example n X i=1 For many purposes. 4.12) 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. We define ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . one for each observation. = β+ XX 26 (4. . ˆ ˆˆ ˆ A useful result is obtained by inserting Y = Xβ + e into the formula for β to obtain ¢ ¡ 0 ¢−1 ¡ 0 ˆ X (Xβ + e) β = XX ¡ ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 0 Xe X Xβ + X 0 X = XX ¡ 0 ¢−1 0 X e. . x0 n ⎞ ⎛ e1 e2 . yn = x0 β + en . . yn ⎟ ⎟ ⎟.6). Thus the MLE (β. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. ⎝ ⎝ . and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e.

4.5

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

obtain residuals Y . . Rather. ˆ ˜ ˜ ˆ 3. Regress X2 on X1 . ! Thus the OLS estimator for the slope coefficients is a regression with demeaned data. the FWL theorem can be used to speed computation. .13). obtain OLS estimates β 2 and residuals e. In some contexts. .1 (Frisch-Waugh-Lovell).6. Partition X = [X1 X2 ] where X1 = ι is a vector of ones.9). and X2 is the vector of observed regressors. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. A common application of the FWL theorem. ⎟ ⎜ ⎟ ⎜ (4. . . . In this section we derive the small sample conditional mean and variance of the OLS estimator.14) or via the ˆ following algorithm: ˜ 1. By the independence of the observations and (3.9). Regress Y on X2 . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . Regress Y on X1 . In the model (4. ¡ ¢−1 0 ι. observe that ⎞ ⎛ ⎞ ⎛ . . ˆ which are “demeaned”. 4. which you may have seen in an introductory econometrics course. obtain residuals X2 .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. 30 . but in most cases there is little computational advantage to using the two-step algorithm. 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) . M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. .8)(3. is the demeaning formula for regression.Theorem 4. ⎠ ⎝ ⎠ ⎝ . . In this case. ˜ 2.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. . the primary use is theoretical.

under the of ˆ ¢ 2 | x = σ 2 . . Next. Then given (4. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . From (4.19) ˆ and thus the OLS estimator β is unbiased for β. for any random vector Z define the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 .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 .. . .. σ 2 } = ⎜ . . 1 n .12). . and ³ ´ ¡ ¢−1 2 ˆ σ . the properties of conditional expectations. . and the trace operator observe that. 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). X 0 DX = X 0 Xσ 2 . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th off-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. σ 2 = σ 2 and we have the simplii fications D = In σ 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 = 0.18). 0 0 ··· 0 0 .20) .. and (4.. V ar β | X = X 0 X ⎟ ⎟ ⎟. σ2 n ⎞ We now calculate the finite sample bias of the method ¡ moments estimator σ 2 for σ 2 . ⎠ (4.Using (4. ⎝ . .

8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. By a calculation similar to those of the previous section. the estimator ˆ 2 defined (4.9) plus E e2 | xi = σ 2 . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .10).1 Gauss-Markov. Thus σ 2 is biased towards zero. says that the least-squares estimator is the best choice. which is (3.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 . It is important to remember.8. ³ ´ ˜ E β | X = A0 Xβ. 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. Theorem 4. In this case. Now consider the class of estimators of β which are linear functions of i the vector Y. This is the justification for the common s ˆ preference of s2 over σ 2 in empirical practice. ˜ so β is unbiased if (and only if) A0 X = Ik .8)¢ ¡ (3. is a famous statement of the solution. or in the projection model. known as the Gauss-Markov theorem. as it yields the smallest variance among all unbiased linear estimators.7) is unbiased for σ 2 by this calculation. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . 32 . and thus can be written as ˜ β = A0 Y where A is an n × k function of X. It is not unbiased in the absence of homoskedasticity. The following result. which we now present. = σ2 n the final equality by (4. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. Thus since V ar (e | X) = In σ 2 under homoskedasticity. 4. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. however. In the homoskedastic linear regression model. What is the best choice of A? The Gauss-Markov theorem. the best (minimumvariance) unbiased linear estimator is OLS. As an alternative.

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

1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 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 .4) is an asymptotically efficient estimator for the parameter β defined in (3.9). and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. (4.10) for the class of models satisfying Assumption 3. the maximum likelihood estimator is identical to the OLS estimator. Chamberlain (1987) extends this argument to the case of continuously-distributed data. and thus so is the OLS estimator. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .22) 34 . Since this is a regular parametric model the MLE is asymptotically efficient (see Appendix A.Substituting in the expressions for π j .5. He observes that the above argument holds for all multinomial distributions. if the data have a discrete distribution.1. He proves that generically the OLS estimator (4.10 Omitted Variables xi = µ x1i x2i ¶ . ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words.

22) is zero. the regression of x2i on x1i yields a set of zero coefficients (they are uncorrelated). this arises when sets of regressors are included which are identically related. 35 . there is some α such that Xα = 0. then β is not defined. This is one difficulty with the definition and interpretation of multicollinearity. and the error as ui rather than ei . log(p1 ). Thus the short and long regressions have the same coefficient on x1i only under one of two conditions. or second. log(p2 ) and log(p1 /p2 ). the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 .22) by least-squares. It is the consequence of omission of a relevant correlated variable.Now suppose that instead of estimating equation (4.22) the long regression and (4. In this case.23) the short regression to emphasize the distinction.. This definition is not precise. Typically there are limits. Most commonly.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . when the columns of X are close to linearly dependent. This happens when the columns of X are linearly dependent. This is called strict multicollinearity. First. if X includes both the logs of two prices and the log of the relative prices. In general. 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. 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 . For example. To see this. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. which is often called “multicollinearity” for brevity. The more relevant issue is near multicollinearity. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. Since the error is discovered quickly. 4. the coefficient on x2i in (4.22).23) where is the coefficient from a regression of x2i on x1i . When this happens. this is rarely a problem for applied econometric practice. This is the situation when the X 0 X matrix is near singular. By construction. the general model will be free of the omitted variables problem. i. least-squares estimation of (4. β 1 6= γ 1 . as many desired variables are not available in a given dataset.e. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. except in special cases. we regress yi on x1i only. Goldberger (1991) calls (4. Typically. This is because the model being estimated is different than (4. because we have not said what it means for a matrix to be “near singular”. The difference Γβ 2 is known as omitted variable bias.11 Multicollinearity ˆ If rank(X 0 X) < k + 1.

A more relevant implication of near multicollinearity is that individual coefficient estimates will be imprecise. 1] and sum to k. the OLS estimator based on the sample excluding the i’th observation. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. ˆ i A simple comparison yields that ˆ ei − ei. ˆ ˆ (4. We can also define the leave-one-out residual ˆ ˆ ei. the change in the coefficient estimate by deletion of the i’th observation depends critically on the magnitude of hi . As a consequence. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. it is statistically difficult to disentangle the impact of β 1 from that of β 2 . the worse the precision of the individual coefficient estimates.25) below. We can see the effect of collinearity on precision by observing that the asymptotic variance of a coefficient ¡ ¢−1 approaches infinity as ρ approaches 1.25) 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. The hi take values in [0. If the i’th observation 36 . What is happening is that when the regressors are highly dependent. the precision of individual estimates are reduced. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. that is. We derive expression (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 see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . In extreme cases it is possible that the reported calculations will be in error due to floating-point calculation difficulties.−i = (1 − hi )−1 hi ei .12 Influential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.27) (4.−i = yi − x0 β (−i) = (1 − hi )−1 ei . µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .26) As we can see. since as ρ approaches 1 the matrix becomes singular. define the leave-one-out least-squares estimator of β. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. To investigate the possibility of influential observations.

The key is equation (2. which is considerably more informative than plots of the uncorrected residuals ei .25).1) in Section 2.This implies has a large value of hi . ˆ We now derive equation (4. then this observation is a leverage point and has the potential to be an influential observation. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .27). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . Investigations into the presence of influential observations can plot the values of (4.

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

2. denoted Zn →p Z as n → ∞. The WLLN shows that sample averages converge in probability to the population average. Applying expectations. as stated. p p p q which is (5.3).Markov’s Inequality. ¥ 5. P (g(X) > α) ≤ α−1 Eg(X). So for all x.4) Proof of Jensen’s Inequality.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Let a + bx be the tangent line to g(x) at x = EX. Eg(X) ≥ a + bEX = g(EX). (5. Theorem 5. For any strictly increasing function g(X) ≥ 0. then as n → ∞ n 1X Xn = Xi →p E(X). Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Since g(x) is convex. We say that Zn converges in probability to Z as n → ∞. If Xi ∈ Rk is iid and E |Xi | < ∞. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. ¥ Proof of Holder’s Inequality. This is a probabilistic way of generalizing the mathematical definition of a limit. if for all δ > 0. =E U V p q p q Proof of Markov’s Inequality. Then Z ∞ −1 P (Y > α) = α αf (y)dy Zα∞ ≤ α−1 yf (y)dy α Z ∞ ≤ α−1 yf (y)dy = α−1 E(Y ) −∞ the second-to-last inequality using the region of integration {y > α}. Since 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 ) = + . Note EU = EV = 1. tangent lines lie below it. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. n→∞ lim P (|Zn − Z| > δ) = 0.1 Weak Law of Large Numbers (WLLN). n i=1 42 . Set Y = g(X) and let f denote the density function of Y.

Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . the triangle inequality. as needed. the fact that X n = W n + Z n . 43 .5). by Markov’s inequality (5.7). 5. we can set E(X) = 0 (by recentering Xi on its expectation). If Xi ∈ Rk is iid and E |Xi |2 < ∞.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞.1 Central Limit Theorem (CLT). We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. Set ε = δη/3. Theorem 5.7) the final inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .1).Proof: Without loss of generality. Define the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. Finally. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Fix δ and η. Fn (x) → F (x) as n → ∞.1) and (5. and the bound |Wi | ≤ 2C. denoted Zn →d Z. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. the fact that the Wi are iid and mean zero. where Z has distribution F (x) = P (Z ≤ x) . We say that Zn converges in distribution to Z as n → ∞. Jensen’s inequality (5.4). if for all x at which F (x) is continuous.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ¡¯ ¯ P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ δ δ δ the equality by the definition of ε. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. V ) . We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .6) By Jensen’s inequality (5.6) and (5. P ¯X n ¯ > δ ≤ η. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. (5.3. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η.

By a second-order Taylor series expansion of c(λ) about λ = 0.8) ⎞ ⎛ 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 . Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . the definition of c(λ) and (5. so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n .Proof: Without loss of generality. For ¡ ¢ λ ∈ Rk . it is sufficient to consider the case µ = 0 and V = Ik . By the properties of the exponential function. ∂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. the independence of the Xi . 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5.8) where λ∗ lies on the line segment joining 0 and λ.

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

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

8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . ·) is continuous at (Q. Equation (4. 0). 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 . we will use the methods of asymptotic approximation. (6.5.3). First.1). (6.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.1 and the WLLN (Theorem 5. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to infinity. (6. For a complete argument.1).1.2) i i n i=1 n From (6. To characterize the sampling distribution more fully. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1 by the fact that the sampling densities become more concentrated as n gets larger. Proof. Ã n ! n X 1X 0 1 ˆ xi xi .3) Ã where g(A. we can conclude ˆ that β →p β. n i=1 (6. using (6. and the continuous mapping theorem (Theorem 5.2 Consistency ˆ As discussed in Section 6.1.1).1 Under Assumption 3. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. ˆ Theorem 6. β →p β as n → ∞.1). 6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. As the sample size increases the density becomes more concentrated about the population coefficient.5. This is illustrated in Figure 6.4. Assumption 3. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .4. Assumption 3.2.From the figure we can see that the density functions are dispersed and highly non-normal.2).1. ˆ 47 .5. the OLS estimator β is has a statistical distribution which is unknown. xi ei →p g (Q. Hence by the continuous mapping theorem (Theorem 5.1) and ˆ We now deduce the consistency of β. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.2.4 implies that Q−1 exists and thus g(·.

i i Assumption 6.1 guarantees that the elements of Ω are finite.3.5. (6. ˆ Finally.6) n i=1 48 . Thus σ 2 is consistent for σ 2 . i Now define ¡ ¢ Ω = E xi x0 e2 . By the central limit theorem (Theorem 5. Assumption 6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.2 Under Assumption 3. ˆ Proof.5.3) and Theorem (6.1.2. We need a strengthening of the moment conditions.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n à ! à n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.1). it follows that s2 = ¥ n σ 2 →p σ 2 . by the Cauchy-Schwarz inequality (5.2. To see this. n 1 X √ xi ei →d N (0.1 In addition to Assumption 3. (6. Ee4 < ∞ and E |xi |4 < ∞. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.1. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. since n/(n − k) → 1 as n → ∞. Ω) .3. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . (6.1).2).Theorem 6.2). E ¯ei ¯ E ¯e4 ¯ i i i i (6.3. ˆ n−k 6.

after rescaling. 1 X √ xi ei n i=1 n ! the N (0. and (6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). ´ √ ³ ˆ n β−β = à 1X xi x0 i n i=1 n !−1 à Theorem 6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.1 is commonly used to approximate the finite of √ ³ˆ sample distribution of n β − β .2 we display the finite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . however. As α approaches 2. Theorem 6. 1). We illustrate this problem using a simulation. its variance diverges q ³ ´ ˆ to infinity. Let yi = β 0 + β 1 xi + εi where xi is N (0. for example.1 states that the sampling distribution of the least-squares estimator. The expression V = Q−1 ΩQ−1 is called a sandwich form.3.9) we define V 0 = Q−1 σ 2 whether (6.9) In (6. Under (6. We say that ei is a Homoskedastic Projection Error when (6. There is a special case where Ω and V simplify. otherwise V 6= V 0 .7) is true then V = V 0 . The approximation may be poor when n is small.1 Under Assumption 6.6).3. xi ) which satisfy the conditions of Assumption 6.Then using (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . The asymptotic distribution ´ Theorem 6. is approximately normal when the sample size n is sufficiently large. e2 ) = 0. This holds true for all joint distibutions of (yi .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.3.3. How large should n be in order for the approximation to be useful? Unfortunately. For α 49 .2). when xi and ei are independent. 1) asymptotic distibution. When (6. (6. Q−1 ΩQ−1 .7) holds. In´Figure 6. there is no simple answer to this reasonable question. V is often referred to as ˆ the asymptotic covariance matrix of β. The trouble is that no matter how large is the sample size.7) is true or false.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. but this is not a necessary condition.3. |ε| ≥ 1. setting n = 100 and varying the parameter α. However.1. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. V ) where V = Q−1 ΩQ−1 .1).7) Cov(xi x0 . Ω) ¡ ¢ = N 0. i i Condition (6. In Figure 6. for any ˆ fixed n the sampling distribution of β can be arbitrarily far from the normal distribution. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . We call V 0 the homoskedastic covariance matrix. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.1.

for k = 1. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.10) V 0 = Q−1 s2 . concentrating most of the probability mass around zero. 1) asymptotic approximation is never guaranteed to be accurate.2.2: Density of Normalized OLS estimator α = 3.Figure 6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.11) 50 . 6 and 8. 1). 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. the sampling distribution becomes highly skewed and non-normal. 6.0 the density is very close to the N (0.3. As k increases. The lesson from Figures 6.2 and 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 1) density. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.1) it is clear that V 0 →p V 0 . The estimator 2 2 in (6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. we need an estimate of Ω = E xi x0 e2 .3 is that the N (0. As α diminishes the density changes significantly. 4.10) without changing this result.2) and Theorem 6. Another example is shown in Figure 6. We show the sampling distribution of n β 1 − β 1 setting n = 100.

the “Huber formula”. ˆ ˆ When V is used rather than the traditional choice V 0 . the “Huber-White formula” or the “GMM covariance matrix”. these all mean the same thing. β j ..3: Sampling distribution where ei are the OLS residuals. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . standard errors are not unique. j = 0.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β.. In most cases. many authors will state that their “standard errors have been corrected for heteroskedasticity”. 1.4.. k. Generically. The methods switched during ˆ the late 1980s and early 1990s. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. This motivates the definition of a standard error. vis. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. and V is an estimator of the variance of n β − β . or that they use a “heteroskedasticity-robust covariance matrix estimator”. When β is a vector. A more easily interpretable measure of spread is its square root — the standard deviation. we focus on individual elements of β one-at-a-time. the “Eicker-White formula”. ˆ ˆ Definition 6. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator.. 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). . as there may be more than one estimator of the variance of the estimator. or that they use the “White formula”. as it is not always clear which has been computed. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. When reading and reporting applied work. It is therefore important to understand what formula and method is 51 . we set s(β) = n−1/2 V .Figure 6. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . and was still the standard choice for much empirical work done in the early 1980s.

First. Ω 2.1. i i i i n i=1 Second.20 = V 14. (. p ˆ In this case the two estimates are quite similar. then take the diagonal elements.14 6. n n i=1 52 . From a computational standpoint.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .14 205.30 + 0.2. the standard method to calculate the standard errors is to ˆ first calculate n−1 V .83 −0.80 40. we return to the log wage regression of Section 4.80 40.83 ¶−1 µ . but not under another set of assumptions. We calculate that s2 = 0. from which it follows that V →p V as n → ∞.35/988 = . Using (6.6 ¶µ 1 14.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.035 ¶ .80 . The standard errors for β 0 are 7.14 14. (6.98 −0. just as any other estimator.20 −0.020) 6.493 0.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.14 205.480 .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.14 205.80 2.4) 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 .039 and ˆ V = µ 1 14.83 ¶−1 = µ 7.5 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.085) (.117 Educationi .480 ˆ0 = 0.020.493 −0. by Holder’s inequality (5.199 2.used by an author when studying their work. To illustrate. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.20 and µ ¶ ˆ = 0.199 2. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. and then the square roots.085 p ˆ and that for β 1 is .5) and the WLLN (Theorem 5.2/988 = .12) in turn.14 14. (6.

n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. 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 i=1 1X |xi |4 →p E |xi |4 . Andrews (1991) suggested an similar estimator based on cross-validation. you can show that 1 Xˆ ¯ β= β (−i) .−i = (1 − hi )−1 ei ˆ presented in (4.12 the definition of β (−i) as the least-squares estimator with the i’th observation deleted.26). Recall from Section 4. 6.13) Using formula (4.11) with the leave-one-out estimator ei.25).13) of Efron (1982).¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. n i=1 n ˆ ˆ Theorem 6. ¯ ¯n ¯ n i=1 so Together. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. Ω →p Ω and V →p V. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . by the WLLN ¯ n ¯ à n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. From equation (3. ¯ 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 0.1 As n → ∞. is defined ˆ ˆ by replacing the OLS residual ei in (6. these establish consistency.14) à 1X (1 − hi )−1 xi ei ˆ n i=1 n !à 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . which. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. Using this substitution.5. i=1 Third.

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

and is therefore exactly free of unknowns. In special cases (such as the normal regression model. s(ˆ θ) (6. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. s(ˆ = n−1/2 H 0 V Hβ . the statistic tn has an exact t distribution. and θ = h(β) is some function of the parameter vector. Since the standard normal distribution does not depend on the parameters. 1) Proof. if R is a “selector matrix” R= so that if β = (β 1 . Consider the studentized statistic tn (θ) = Theorem 6. β 2 ). then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . 1) →d ˆ−θ θ .For example. θ) β 6. 55 .8 t tests Let θ = h(β) : Rk → R be any parameter of interest. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-specified value.8. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. In general. ˆ When q = 1q h(β) is real-valued). µ I 0 ¶ ˆ the upper-left block of V . however. Vθ ) √ Vθ = N (0.1 tn (θ) →d N (0. the standard error for ˆ is the square root of n−1 Vθ . we say that tn (θ) is asymptotically pivotal. By (6. that (so θ ˆ ˆ ˆ is. we say that tn is an exactly pivotal statistic. (For example.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. In this case. θ could be a single element of β). see Section X).

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

We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. and it is desired to test the joint restrictions simultaneously. ˆ + zα/2 s(ˆ .We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). This corresponds to selecting the confidence h i h ˆ ± 1.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. 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. or α = . θ The interval has been constructed so that as n → ∞. 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).18) . = n h(β) − θ0 Hβ V Hβ 57 (6. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. 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). 6. 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 .96s(ˆ ≈ ˆ ± 2s(ˆ . The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.16) and zα/2 is the upper α/2 quantile of the standard normal distribution.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% confidence interval. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). the most common professional choice isi95%. In this case the t-statistic approach does not work. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. θ θ) (6.05. A good method for construction of a confidence interval is the collection of parameter values which are not rejected by a statistical test.

˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . a chiq square random variable with q degrees of freedom. ˜˜ n ˜ e = Y − X1 β 1 .5. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. As before. For example.05) = 3. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. Vθ ). 6. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).1 showed θ ˆ that V →p V.19) σ2 ˆ where σ2 = ˜ 1 0 e e. 1] under H0 .2. ˆ Wn = n θ θ q θ θ Theorem 6. then Wn →d χ2 .When h is a linear function of β. χ2 (. the test rejects at the α% level iff pn < α.1. Hβ (β) is a continuous function of β. In this case.1 Under H0 and Assumption 6. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.3. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .10. θ = β 2 . Hβ (β) →p Hβ . Also h(β) = a selector matrix. The asymptotic p-value for Wn is pn = p(Wn ).15) showed that n ˆ − θ →d Z ∼ N (0. and there are q = k2 restrictions. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity.025 . Hence β β by Theorem A. if rank(Hβ ) = q. q and pn is asymptotically U[0. h(β) = R0 β. the upper-α quantile q 2 of the χ2 distribution. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.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 .84 = z.8. The null hypothesis is H0 : β 2 = 0. Furthermore. and Theorem 6.

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

Let u = σ −1 H 0 e ∼ N (0.where In many statistical packages. In σ 2 . when an OLS regression is reported. Since uncorrelated normal variables are independent. 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 . s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. σ 2 ) can be be used to calculate a set of exact distribution results. In ) .12 Normal Regression Model As an alternative to asymptotic distribution theory. This special F statistic is testing the hypothesis that all slope coefficients (other than the intercept) are zero. it follows ˆ that β is independent of any function of the OLS residuals. This is rarely an issue today. n−k 60 . In particular.4)) where H 0 H = In . This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . 6. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . This was a popular statistic in the early days of econometric reporting. Since linear functions of normals are also normal. including the estimated error variance 2.3. 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. an “F statistic” is reported. these cases are atypical. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . as sample sizes are typically sufficiently large that this F statistic is highly “significant”. While there are special cases where this F statistic is useful. there is an exact distribution theory available for the normal linear regression model. The modelling assumption that the error ei is independent of xi and N (0. introduced in Section 4. equivalently the residual variance from an intercept-only model. H 0 H) ∼ N (0.

The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .) Now let us partition β = (β 1 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ 2 ) = − log σ − log (2π) − . σ 2 ). which is twice the difference in the log-likelihood function evaluated under the null and alternative hypotheses. n−k • ∼ tn−k ˆ In Theorem 6. 0. The critical values are quite close if n − k ≥ 30. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . β 2 . 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.a chi-square distribution with n − k degrees of freedom.1 we showed that in large samples. so as a practical matter it does not matter which distribution is used. Theorem 6.12. a good testing procedure is based on the likelihood ratio statistic. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 .8. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ) discussed above. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.12. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .1 and Theorem 6.3. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ 2 ) − Ln (β 1 . β has an exact normal distribution and t has an exact t distribution.1 shows that under the strong assumption of ˆ normality. β 2 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . In contrast. and standard errors are calculated using the homoskedastic formula (6. the notable distinction is between the N (0.1 If ei is independent of xi and distributed N(0. if standard errors are calculated using the homoskedastic formula (6. 0. As inference (confidence intervals) are based on the t-ratio. 1) and tn−k distributions. σ ˆ ˆ βj − βj βj − βj N (0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . 0. We summarize these findings Theorem 6. β and t are approximately normally distributed. β 2 .10) then ´ ³ ˆ • β ∼ N 0. with residual variance σ . (Unless the sample size is unreasonably small. Furthermore. σ2 ˆ 61 .

and noting Hβ = sβ s−1 . In the present context of the Wald statistic. Through repetition. ˆ Let β and σ 2 be the sample mean and variance of yi . σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaffected by the choice of s. Letting h(β) = β s . This is an unfortunate feature of the Wald statistic. setting n/σ 2 = 10. while there are other values of s for which test test statistic is insignificant. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is significant relative to asymptotic critical values. The increasing solid line is for the case β = 0. 6. This produces random draws from the sampling distribution of interest. we find that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . To demonstrate this effect. The method uses random simulation to create an artificial dataset to apply the statistical tools of interest. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in finite samples.84 — the probability of a false rejection. features of this distribution can be calculated. the statistic Wn (s) varies with s. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s.By a first-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Take the model yi = β + ei ei ∼ N (0.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β.8. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. This can be seen by a simple example introduced by Lafontaine and White (1986). The decreasing dashed ˆ = 1. they can work quite poorly when the restrictions are nonlinear. we have plotted in Figure 6.7.4 the Wald statistic Wn (s) as a function ˆ of s. 62 . Our first-order asymptotic theory is not useful to help pick s. as Wn (s) →d χ2 under H0 for 1 any s. σ 2 ) and consider the hypothesis H0 : β = 1.

1 you can also see the impact of variation in sample size.84 | β = 1) . In Table 2. Test performance deteriorates as s increases. Rates above 20% are unexceptable. Table 4. so these probabilities are Type I error.4.000 random samples. There is. looking for tests for which rate rejection rates are close to 5%.Figure 6. When comparing statistical procedures. the Type I error probability improves towards 5% as the sample size n increases. this probability depends only on s. and σ is varied among 1 and 3. n is varied among 20. Table 4.1 reports the simulation estimate of the Type I error probability from 50.1 we report the results of a Monte Carlo simulation where we vary these three parameters. remember that the ideal Type I error probability is 5% (. The value of s is varied from 1 to 10. we compare the rates row by row.05) with deviations indicating+ distortion. and σ 2 . To interpret the table. however. The null hypothesis β s = 1 is true.000 simulated Wald statistics Wn (s) which are larger than 3. Typically. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . 100 and 500. no magic choice of n for which all tests perform uniformly well. Given the simplicity of the model.84. In Table 4. These probabilities are calculated as the percentage of the 50. and rarely fall outside of the 3%-8% range. Any other choice of s leads to a test with unacceptable Type I error probabilities. Each row of the table corresponds to a different value of s — and thus corresponds to a particular choice of test statistic. For this particular example.4: Wald Statistic as a function of s P (Wn (s) > 3. The second through seventh columns contain the Type I error probabilities for different combinations of n and σ. n. In each case. Type I error rates between 3% and 8% are considered reasonable. the only test which meets this criterion is the conventional Wn = Wn (1) test. Error rates avove 10% are considered excessive.

33 .06 .08 .14 . 64 .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 .30 .16 Rejection frequencies from 50.06 .22 .06 .10 .08 .25 .28 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. β 2 ) be the least-squares estimates of (6. In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.05 .10 .13 .24 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .08 .15 .07 .10 .07 .09 .13 .15 .15 .12 .12 .08 .06 .06 .06 .15 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.07 . This point can be illustrated through another example.05 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .11 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .05 .14 .18 .05 . Define θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . Other choices are arbitrary and would not be used in practice.06 .21 .20 . so the hypothesis can be stated as H0 : θ = r.20 .35 .17 .22 .07 .08 .34 .06 .23 .07 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at first. While this is clear in this particular example.19 .31 .26 .25 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. define θ = β 1 /β 2 .05 . Equivalently. β 1 .20).13 .05 .

05 β2 . ei be an independent N (0. The left tail probabilities P (t1n < −1. and are close to the ideal 5% rate for both sample sizes. If no linear formulation is feasible.00 The one-sided Type I error probabilities P (tn < −1.07 .75 1. The implication of Table 4.06 . 65 .645) P (tn < −1.05 .645) P (tn > 1.47 .06 .2. . This leaves β 2 as a free parameter.05 .645) are calculated from 50.50 . the rejection rates for the t1n statistic diverge greatly from this value. 6.00 .12 .25.00 .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.645) t1n t2n t1n t2n t1n t2n t1n t2n .05 . σ 2 ) draw with σ = 3.00 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .06 .645) P (tn > 1. Table 4. In contrast.06 . then the “most linear” formulation should be selected. 1) variables. and normalize β 0 = 0 and β 1 = 1.06 . especially for small values of β 2 . Ideally.00 .05 . and alternatives to asymptotic critical values should be considered. We let x1i and x2i be mutually independent N (0. . and 1. while the right tail probabilities P (t1n > 1.28 . In this section we describe the method in more detail.05 .00 .50.75. In all cases.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.645) are close to zero in most cases.06 .0 and n among 100 and 500.1. the entries in the table should be 0.06 .00 . It is also prudent to consider alternative tests to the Wald statistic.06 .05 .26 .000 simulated samples.15 .09 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .2 is that the two t-ratios have dramatically different sampling behavior. if the hypothesis can be expressed as a linear restriction on the model parameters. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.10 . We vary β 2 among .10 .05.02 .645) greatly exceed 5%.15 . this formulation should be used.00 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . The results are presented in Table 4.00 . However. along with sample size n. such as the GMM distance statistic which will be presented in Section 9.00 .645) and P (tn > 1.10 .05 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. .05 .05 .06 .25 .7.06 .

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

Generally. equalling 1 with probability P = E1 (Tnb ≥ 1.96) is iid Bernoulli. so that coefficients may be interpreted as semi-elasticities. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. the researcher must select the number of experiments. immigrant. where N = (B +1)α. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. In particular. for a selection of choices of n and F. union member. Hence the ³ ´ ˆ standard errors for B = 100.05) (. Often this is called the number of replications. B b=1 (6. hispanic. female. and 5000. we included a dummy 67 . As P is unknown. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. but requires more computational time. this may ˆ be approximated by replacing P with P or with an hypothesized value.007.22/ B. s P = . potential work experience. The α% sample quantile is a number qα such that α% of the sample are less than qα . potential work experience.15 Estimating a Wage Equation We again return to our wage equation.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. For example. Again our dependent variable is the natural log of wages. In practice. We now expand the sample all non-military wage earners. it is simple to make inferences about rejection probabilities from statistical tests. For example. are. 1000. the choice of B is often guided by the computational demands of the statistical procedure. and non-white. respectively. and hispanic.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. The average (6.022. In many cases. if we set B = 999. As discussed above. experience squared. the performance will depend on n and F.003. and therefore it is straightforward to calculate standard errors for any quantity of interest. and poorly for others. and estimate a multivariate regression. then we can set s P = (. and . Quite simply.96) . and 90% sample quantiles of the sample {Tnb }. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. . then B will have to be increased. We separately estimate equations for white and non-whites. It is therefore convenient to pick B so that N is an integer. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. Furthermore. We us the sample of wage earners from the March 2004 Current Population Survey.21). such as the percentage estimate reported in (6. Then qα is the N ’th number in this ordered sequence. an estimator or test may perform wonderfully for some values. a larger B results in more precise estimates of the features of interest of Gn . Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. and our regressors include years of education. experience squared. immigrant. union member.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. and dummy variable indicators for the following: married.95) /B ' .96) . therefore. For regressors we include years of education. excluding military. B. It is therefore useful to conduct a variety of experiments. 6. and dummy variable indicators for the following: married. The random variable 1 (Tnb ≥ 1. female. For the dependent variable we use the natural log of wages. If the standard error is too large to make a reliable inference.

001 . 2β 3 68 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. the restricted standard deviation estimate is σ = .070 .1. but not equal. Using either statistic the hypothesis is easily rejected.097 −. The F form of the Wald statistic (6. this adds 50 regressors).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.808 so the parameter estimates are quite precise and reported in Table 4. Wn = n 1 − 2 = 18.014 .18) that the state coefficients are jointly zero. 808 1 − .69. as the 1% critical value for the χ2 distribution is 76.101 .variable for state of residence (including the District of Columbia. we find Wn = 550.027 .010 .4877 18.48772 = 515. reestimating the model with the 50 state dummies excluded. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.013 .008 .34 ˆ s(β) .232 .49452 σ ˜ Notice that the two statistics are close.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.00002 .4945.102 −.808 . Table 4.102 −.007 . Computing the Wald statistic (6. 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.033 −.121 −.00057 .19) is ˜ µ ¶ µ ¶ σ2 ˆ . Ignoring the other coefficients. Alternatively.1 we find the point estimate ˆ ˆ = − β 2 = 28.002 .032 . excluding the coefficients on the state dummy variables. θ ˆ 2β 3 β2 . The available sample is 18.

there is not a simple expression for this set. 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. 69 .5]. In the present context we are interested in forming a confidence interval. Our desired confidence interval will be the set of parameter values θ which are not rejected by the hypothesis test.Using the Delta Method.96. Instead. but the lower end is substantially lower. However.5]. so we have to go one step further. 29. Since tn (θ) is a non-linear function of θ. This set is [27. 29. This is the set of θ such that |tn (θ)| ≤ 1. not testing a hypothesis.0. this is a poor choice. we found better Type I error rates by reformulating the hypothesis as a linear restriction.40. as the coverage probability of this confidence interval is one minus the Type I error of the hypothesis test based on the t-test. 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 ). we can calculate a standard error of s(ˆ = . implying a 95% confidence θ) interval of [27.9. In the previous section we discovered that such t-tests had very poor Type I error rates.

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

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

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

is the homoskedasticity-formula standard error.

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

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

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

E (xi ei ) = 0
∗ yi = yi + ui

71

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

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

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

• Qi • Di • Ci

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

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

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

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

73

2) E (ξ i | xi ) = 0. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . where z1i is some q × 1 function of xi . the least-squares estimator is inefficient.Chapter 7 Additional Regression Topics 7.1) infeasible since the matrix D is unknown. 74 . 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. .. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi .. Often the functional form is kept simple for parsimony. The theory of Chamberlain (1987) can be used to show that in this model the semiparametric efficiency bound is obtained by the Generalized Least Squares (GLS) estimator ¢−1 ¡ 0 −1 ¢ ¡ ˜ (7. The GLS estimator (7. we know that the least-squares estimator is semi-parametrically efficient for the projection coefficient.1 Generalized Least Squares In the projection model. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . However... Typically. z1i are squares (and perhaps levels) of some (or all) elements of xi .. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. . in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.. Let η i = e2 . σ 2 }. σ1 We now discuss this estimation problem.1) XD Y β = X 0 D−1 X ¡ ¢ 2 .

Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. Since there is not a unique specification for the conditional variance the FGLS estimator is not unique. Vα ) (7.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. If σ 2 < 0 for some i. ˜i Suppose that σ 2 > 0 for all i.. Then set ˜i ˜ D = diag{˜ 2 . 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. We have shown that α is consistently estimated by a simple procedure. 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 . and hence we can estimate 0 σ 2 = zi α by i ˜ (7. xi ). as it is estimating the conditional variance of the regression of yi on xi . We may call (7. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi .4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). then the FGLS ˜i estimator is not well defined. .4) the skedastic regression. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i specification. estimator of β. there is no guarantee that σ 2 > 0 for all i. or FGLS. This suggests 75 . and will depend on the model (and estimation method) for the skedastic regression. which is typically undesirable. then the FGLS estimator will force ˜i the regression equation through the point (yi . Vα = E zi zi (7. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi .3) ˆ ˆ While ei is not observed. Furthermore. This is the feasible GLS.Suppose ei (and thus η i ) were observed..6) σ 2 = α0 zi . if σ 2 ≈ 0 for some i..

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

and replaced E ξ 2 with 2σ 4 which holds when ei is N(0.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . and not a conditional mean.4). The main differences between popular “tests” is which transformations of xi enter zi .7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7.2. but the only difference is that they a ¢ allowed for general choice of zi . its squares. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. the estimated conditional variances may contain more noise than information about the true conditional variances.3) for α simplifies to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . If the equation of interest is a linear projection. In this case. This introduces an element of arbitrariness which is unsettling to empirical researchers. Theorem 7. It is consistent not only in the regression model. FGLS will do worse than OLS in practice. and this requires trimming to solve. on the other hand. and the cost is a reduction of robustness to misspecificatio 7. and all cross-products. as they will be estimating two different projections. Typically. We may therefore test this hypothesis by the estimation (7.5) and the asymptotic variance (7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. then the OLS and FGLS estimators will converge in probability to different limits. The GLS and FGLS estimators.1 Under H0 and ei independent of xi .2). OLS is a more robust estimator of the parameter vector.4) and constructing a Wald statistic. however. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. If i this simplification is replaced by the standard formula (under independence of the error). individual estimated conditional variances may be negative. Second. In the linear regression model the conditional mean of yi given xi = x is 77 . Third. but also under the assumptions of linear projection. The point is that the efficiency gains from FGLS are built on the stronger assumption of a correct conditional mean. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . And the FGLS probability limit will depend on the particular function selected for the skedastic regression. Vα = E zi zi (7. or equivalently that i H0 : α1 = 0 in the regression (7. require the assumption of a correct conditional mean.error. σ 2 ). The asymptotic distribution (7. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. 7. the two tests coincide. q Most tests for heteroskedasticity take this basic form. This hypothesis does not imply that ξ i is independent of xi . the Wald test of H0 is asymptotically χ2 .7) under independence show that this test has an asymptotic chi-square distribution.

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

θ) is differentiable. which alters some of the analysis. θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. θ))2 . ´ √ ³ n ˆ − θ0 →d N (0. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. estimator. When it exists. it must be shown that ˆ →p θ0 . ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. then the FOC for minimization are 0= n X i=1 mθ (xi . θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the first five examples. m is not differentiable with respect to θ3 . Since ˆ →p θ0 . 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 .8) Theorem 7.1 If the model is identified and m(x. we call this the nonlinear least squares (NLLS) θ). G known x2 − θ5 m(x. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. let ∂ m(x. θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. θ) = θ1 + θ2 exp(θ3 x) m(x. θ) is differentiable with respect to θ. θi 79 . θ)ˆ (7. In other cases. but we won’t cover that argument here. The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . θ) = θ1 + θ2 xθ3 m(x.Examples of nonlinear regression functions include x 1 + θ3 x m(x. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . V ) θ where mθi = mθ (xi . θ0 ). ˆ is close to θ θ θ0 for n large. Let 0 yi = ei + m0 θ0 . ˆ ei .4. θ) is suggested by an economic model. In the final two examples. θ). θ) is (generically) differentiable in the parameters θ. When m(x. θ) = G(x0 θ). See Appendix E. First. m(x. mθ (x. it is adopted as a flexible approximation to an unknown regression function. The NLLS residuals are ei = yi − m(xi . When the regression function is nonlinear. This can be done using arguments θ for optimization estimators. θ) = θ1 + θ2 m(x.

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

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

then there are many innovations near to the median. ∂β 0 so Third.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 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.Theorem 7. See Chapter 16. ∂ 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 ´ √ ³ˆ n β − β 0 →d N (0. and this improves estimation of the median. where V = and f (e | x) is the conditional density of ei given xi = x. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . the conditional density of the error at its median. Pn −1 0 β)) . When f (0 | x) is large. the height of the error density at its median. by a Taylor series expansion and the fact g(β 0 ) = 0 82 .5.10) is equivalent to g n (β) = 0.11) This simplification is similar to the simplification of the asymptotic covariance of the OLS estimator under homoskedasticity. ˆ Proof of Theorem 7. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . The main difficulty is the estimation of f (0). Let g(β) = Eg (β).1 is advanced. First.11). V ). (7. Second using the law of iterated expectations and the chain rule of i differentiation. we provide a sketch here for completeness. then f (0 | x) = f (0) and the asymptotic variance simplifies V = (Exi x0 )−1 i 4f (0)2 (7. by the central limit theorem (Theorm 5. This can be done with kernel estimation techniques.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . Computation of standard error for LAD estimates typically is based on equation (7. In the special case where the error is independent of xi . While a complete proof of Theorem 7.5.5.3.

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

E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). i By construction. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. 7. Fortunately. since it has discontinuous derivatives. ´ √ ³ˆ Theorem 7. then f (0 | xi ) = f (0) .1.5. Vτ ). and we have the simplification Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . it is useful to have a general test of the adequacy of the specification. Furthermore. if the model yi = x0 β + ei has i been fit by OLS. conventional Newton-type optimization methods are inappropriate.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) .12). otherwise its properties are unspecified without further restrictions. the unconditional density of ei at 0. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. Thus. n numerical methods are necessary for its minimization.13).where ei is the error defined to be the difference between yi and its τ ’th conditional quantile x0 β τ . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. and are widely available. The null model is yi = x0 β + εi i 84 . 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. and test their significance using a Wald test.1 n β τ − β τ →d N (0. ¡ ¡ ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ Exi x0 E xi x0 f (0 | xi ) Vτ = τ (1 − τ ) E xi x0 f (0 | xi ) i i i ¢ 1X ¡ ρτ yi − x0 β i n i=1 In general. fast linear programming methods have been developed for this problem. the τ ’th conditional quantile of ei is zero. Another popular approach is the RESET test proposed by Ramsey (1969).6. the asymptotic variance depends on the conditional density of the quantile regression error. and form a Wald statistic i for γ = 0. where and f (e | x) is the conditional density of ei given xi = x. ˆ Given the representation (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. When the error ei is independent of xi .

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

xK ) enters the regression function E(yi | x1i = x1 . X2 ) = 0 Note that M1 ⊂ M2 . One useful property is consistency. In the absence of the homoskedasticity assumption. In many cases the problem of model selection can be reduced to the comparison of two nested models. Y = X1 β 1 + X2 β 2 + ε. x2i = σ 2 .9 Model Selection In earlier sections we discussed the costs and benefits of inclusion/exclusion of variables. 7. This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. E (ε | X1 . take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0. To be concrete. that it selects the true model with probability one if the sample is sufficiently large.. when economic theory does not provide complete guidance? This is the question of model selection. models 1 and 2 are estimated by OLS.. there is no clear ranking of the efficiency of the ˜ restricted estimator β 1 versus the unrestricted estimator. respectively. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 . and β 1 0 (The least-squares estimate with the intercept omitted. we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . To simplify some of ¢ statistical discussion. Let β 1 be the ˜ be the estimate under the constraint β = 0.7). However. x Then under (6.. X2 ) = 0. There are many possible desirable properties for a model selection procedure.. the question: “What is the right model for y?” is not well posed.. we see that β 1 has a lower asymptotic variance.. we say that M2 is true if β 2 6= 0. E (ε | X1 . . xKi = xK )?” is well posed. We conclude that the inclusion of irrelevant variable reduces estimation efficiency if these variables are correlated with the relevant variables.˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . It is important that the model selection question be well-posed. i A model selection procedure is a data-dependent rule which selects one of the two models. with residual vectors e1 and e2 . etc. . “Which subset of (x1 . In contrast. Let Exi = µ. this result can be reversed when the error is conditionally heteroskedastic. How does a researcher go about selecting an econometric specification. estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 . n→∞ σx ˜ When µ 6= 0. because it does not make clear the conditioning set. To fix notation. as the larger problem can be written as a sequence of such comparisons.. σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 . where X1 is n × k1 and X2 is n × k2 . ˆ For example. We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε. and E (xi − µ)2 = σ 2 . estimate of β 1 from the unconstrained model. We c can write this as M. the question. For example.).

15) then where σ 2 is the variance estimate for model m.However. AIC selection is inconsistent. Another problem is that if α is held fixed. since under M1 . known as the BIC. this rule only makes sense when the true model is finite dimensional. One popular choice is the Akaike Information Criterion (AIC). If the truth is infinite dimensional. based on Bayesian arguments. In contrast to the AIC. The reasoning which helps guide the choice of α in hypothesis testing (controlling Type I error) is ´ not ³ c = M1 | M1 ≈ relevant for model selection. as the rule tends to overfit. BIC model selection is consistent. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . Indeed. the most popular to be one proposed by Schwarz. it is more appropriate to view model selection as determining the best finite sample approximation. if α is set to be a small number. as ³ ´ c P M = M1 | M1 → 1 − α < 1. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . depending on the sample size. For some critical level α. k ´ ³ c P M = M1 | M1 P (AIC1 < AIC2 | M1 ) µ ¶ k1 k1 + k2 2 2 σ | M1 = P log(ˆ 1 ) + 2 < log(ˆ 2 ) + 2 σ n n = P (LRn < 2k2 | M1 ) ¡ ¢ → P χ22 < 2k2 < 1. Indeed. ¢ ¡ ˆ1 ˆ2 (7. ˆm The AIC can be derived as an estimate of the KullbackLeibler information distance K(M) = E (log f (Y | X) − log f (Y | X. let cα satisfy ¢ ¡ P χ22 > cα . n (7. Another common approach to model selection is to to a selection criterion. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. log(n) 87 . then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. The rule is to select M1 if AIC1 < AIC2 . M)) between the true density and the model density. His criterion. k A major problem with this approach is that the critical level α is indeterminate. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . The model selection rule is as follows. k = While many modifications of the AIC have been proposed. Then select M1 if Wn ≤ cα . and km is the number of coefficients in the model. then this model selection procedure is inconsistent. since (7. else select M2 .16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . n (7. That is.17) Since log(n) > 2 (if n > 8). etc. else select M2 .16) holds under M1 . LRn →p 0.

In the latter case. stores the residual variance σ 2 for each model. . 576. MK : β 1 6= 0. However. which regressors enter the regression). selecting based on (7. β K 6= 0. There are two leading cases: ordered regressors and unordered. β 2 6= 0. xKi }. a model consists of any possible subset of the regressors {x1i . The methods extend readily to the issue of selection among multiple regressors. For example... . . 88 .so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive.. In the ordered case. which can be a very large number. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. We have discussed model selection between two models. β 3 = · · · = β K = 0 . which are nested.17). 210 = 1024. Also under M2 . The AIC selection criteria estimates the K models by OLS. 048. E (εi | xi ) = 0 and the question is which subset of the coefficients are non-zero (equivalently. and the AIC or BIC in principle can be implemented by estimating all possible subset models. and then selects the model with the lowest AIC (7. one can show that thus LRn →p ∞. . The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . Similarly for ˆ the BIC. and 220 = 1. . . the models are M1 : β 1 6= 0. In the unordered case. β 2 6= 0.15). log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. there are 2K such models.

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

Do you agree with this modification? (b) Now try a non-linear specification. Consider model (7. a7 ). and find the value of a7 for which the sum of squared errors is minimized. (iii) BIC criterion. This model is called a smooth threshold model. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . The model works best when a7 is selected so that several values (in this example. are both estimators consistent for β? (b) Are there conditions under which either estimator is efficient? 9. at least 10 to 15) of ln Qi are both below and above a7 . I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. (d) Calculate standard errors for all the parameters (a1 . Do so. calculate zi and estimate the model by OLS. Assess the merits of this new specification using (i) a hypothesis test. 90 . add the variable (ln Qi )2 to the regression. the variable ln Qi has a regression slope of a2 . n xi i=1 (a) Under the stated assumptions. 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 . (ii) AIC criterion. θ) + ei with E (ei | xi ) = 0. the regression slope is a2 + a6 . you estimated a cost function on a cross-section of electric companies. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. For values of ln Qi much below a7 . . In addition.. 8. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . and V is the = g(x estimate of V ar ˆ . Suppose that yi ³ ´ i . Exercise 13. and the model imposes a smooth transition between these regimes. (7. For each value of a7 . The model is non-linear because of the parameter a7 . For values much above a7 . You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x..18) plus the extra term a6 zi . Examine the data and pick an appropriate range for a7 . θ is the NLLS estimator. (c) Estimate the model by non-linear least squares. Record the sum of squared errors. In Chapter 6.18) (a) Following Nerlove..ˆ ˆ 7. Find an asymptotic 95% confidence interval for g(x). impose the restriction a3 + a4 + a5 = 1.

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

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

In general. . That is. x∗ ) with the i distribution Fn . 50. i = 1. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y.1). by the CLT (Theorem 5. Furthermore.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . The random draws are from the N (0.3. √ n (Fn (y. The EDF is a consistent estimator of the CDF. the EDF is only a crude approximation to the CDF.. This is a population moment. x). I have plotted the EDF and true CDF for three random samples of size n = 25. To see this. Recall that F (y. To see the effect of sample size on the EDF. x) − F (y. n.8. i 93 . x) = n i=1 Figure 8. x) (1 − F (y.. Fn is by construction a step function. Notationally. note that for any (y. Thus by the WLLN (Theorem 5.2. For n = 25. Fn is a nonparametric estimate of F. x) = P (yi ≤ y. x)) →d N (0. where 1(·) is the indicator function. Fn (y. 1) distribution.2 The Empirical Distribution Function Fn (y. x))) . The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . the EDF step function gets uniformly close to the true CDF. x). x∗ ≤ x) = Fn (y. F (y.. but the approximation appears to improve for the large n. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . in the Figure below. x) is called the empirical distribution function (EDF). and 100. x) →p F (y. ∗ P (yi ≤ y. Note that while F may be either discrete or continuous. as the sample size gets larger. x) .2) Fn (y.1). x). (8. xi ). it is helpful to think of a random pair (yi .

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

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

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

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

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

3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. F ) = Φ n→∞ v or ³x´ Gn (x. C4 is called the symmetric percentile-t interval.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. and a function h(x) is odd if h(−x) = −h(x).4) v ¡ ¢ While (8. The following notation will be helpful. Basically. Definition 8. We say that a function g(x) is even if g(−x) = g(x). and vice-versa. (8. Equivalently. Let Tn be a statistic such that (8.4) says that Gn converges to Φ x as n → ∞.1 an = o(1) if an → 0 as n → ∞ Definition 8. writing Tn ∼ Gn (x. about the rate v of convergence. v 2 ). F ) then ³x´ . not ˆ − θ0 . θ θ θ ˆ θ ∗ ∗ Computationally.8. 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.8 Asymptotic Expansions Tn →d N (0. lim Gn (x. the critical value qn (α) is found as the quantile from simulated values of W´ . 99 . The derivative of an even function is odd. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. Definition 8.8. it says nothing. 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. θ [This is a typical mistake made by practitioners. If θ is a vector. or the size of the divergence for any particular sample size n. F ) = Φ + o (1) . where qn (α) is the (1 − α)% quantile of the distribution of Wn . The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . an = O(n−r ) if it declines to zero like n−r .8. however. The ideal test rejects if Wn ≥ qn (α). Thus here Tn (θ) = Wn (θ).3 an = o(n−r ) if nr |an | → 0 as n → ∞.] 8.2 an = O(1) if |an | is uniformly bounded. Let an be a sequence. A better asymptotic approximation may be obtained through an asymptotic expansion.

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

5) where the simplifications are because g1 is even and g2 is odd.The “derivative” ∂ ∂F g1 (x. if Tn has exact distribution Gn (x. then |Tn | has the distribution function Gn (x. if Z ∼ N (0. F ) = Gn (x. Since Tn →d Z. = P (X ≤ x) − P (X ≤ −x) For example. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F ). 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. From Theorem 8. F ) + O(n−3/2 ). F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x.8. then |Tn | →d |Z| ∼ Φ. as F is a function. F ) − Gn (−x. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). Hence the difference between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. 101 2 g2 (x. and exact critical values are taken from the Gn (x. 1). F ) − Gn (−x. F0 ) = The order of the error is O(n−1 ). F ) is only heuristic. 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). F0 ) = O(n−1 ). Similarly. We conclude that G∗ (x) − Gn (x. F ). F0 ) + O(n−3/2 ) = O(n−1 ). 8.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). F ) + g2 (−x. F ) = Gn (x. n (8.1. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. we can calculate that Gn (x. Thus asymptotic critical values are taken from the Φ distribution. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). A two-sided hypothesis test rejects H0 for large values of |Tn | . n . F0 ) distribution. F ) + g2 (x.

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

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

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

you generate bootstrap samples. θ respectively. (a) Report the 95% Efron Percentile interval for θ. and the colonial dummy. Estimate a linear regression of price on the number of bedrooms. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).5% quantiles of the ˆ are . and thus reject H0 if ˆ ˆ > q ∗ (. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.75 and 1. What is wrong with this procedure? Tn = θ/s(θ) n 6. Using the non-parametric ∗ bootstrap.95).05) and qn (. Using the non-parametric bootstrap. Calculate 95% confidence intervals for the regression coefficients using both the asymptotic normal approximation and the percentile-t bootstrap.95) denote the 5% θ) ∗ and 95% quantiles of Tn . 105 .2 and s(ˆ = .pdf. size of house.95). with variables listed in the file hprice1. and the 2. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. ∗ ∗ ∗ Let qn (. You do this as follows. ˆ = 1. (b) Report the 95% Alternative Percentile interval for θ.3. (c) With the given information. can you report the 95% Percentile-t interval for θ? 7. Let qn (. Suppose that in an application. ∗ ∗ where s(ˆ is the standard error in the original data.dat contains data on house prices (sales).95) denote the 95% quantile of Tn .05) . You replace c with qn (.2.5% and 97. and define the bootstrap confidence interval h i C = ˆ − s(ˆ n (. The ˆ are sorted. lot size. and ˆ is calculated on each θ ∗ ∗ θ sample. You want to test H0 : θ = 0 against H1 : θ > 0. The datafile hprice1. ˆ − s(ˆ n (.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).95). The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.

where the dimensions of zi and xi are k × 1 and × 1 .Chapter 9 Generalized Method of Moments 9. In this case. as their are restrictions in E (xi ei ) = 0. β 0 ) = x(y − z 0 β) 106 (9.2) . This is a special case of a more general class of moment condition models. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . As an important special case we will devote special attention to linear moment condition models. x. zi . There are − k = r more moment restrictions than free parameters. Now suppose that we are given the information that β 2 = 0. but this is not required. This method. x.1) where β 0 is the true value of β. an asymptotically efficient estimator of β is the OLS estimator. these are known as estimating equations. This situation is called overidentified. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. In our previous example.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. z. We know that without further restrictions. g(y. In econometrics. is not necessarily efficient. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. while β 1 is of dimension k < .1) by setting g(y. with ≥ k. otherwise it is overidentified. If k = the model is just identified. β 0 ) = 0 (9. 1 this class of models are called moment condition models. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. In the statistics literature. Let g(y. however. β) = x(y − x0 β). x. We call r the number of overidentifying restrictions. xi . This model falls in the class (9. The variables zi may be components and functions of xi . z.

and the GMM estimator is the MME.1 β GMM = argmin Jn (β).9. The idea of the generalized method of moments (GMM) is to define an estimator which sets g n (β) “close” to zero. the square of the Euclidean length.2. β GMM does not change. gi (β) = xi yi − zi β = n n n i=1 i=1 Define the sample analog of (9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn .2) g n (β) = (9. Let and where gi = xi ei . ¡ ¢−1 0 ˆ Z XWn X 0 Y. The GMM estimator minimizes Jn (β).3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . let Jn (β) = n · g n (β)0 Wn g n (β). i i . ˆ Definition 9. This is a non-negative measure of the “length” of the vector g n (β). for if Wn is replaced ˆ by cWn for some c > 0. if Wn = I. 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 ˆ Note that if k = . then g n (β) = 0. For example. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . For some × weight matrix Wn > 0. Proposition 9. The first order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. but this is generally not possible when > k. then. the dependence is only up to scale.3) The method of moments estimator for β is defined as the parameter value which sets g n (β) = 0. β GMM = Z 0 XWn X 0 Z 9.2.

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

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

perhaps obtained by first ˆ setting Wn = I. and then β recomputed. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). and in this case it would be impossible to find a value of β 1 so that both E (x1i (yi − x0 β 1 )) = 0 and E (x2i (yi − x0 β 1 )) = 0 hold simultaneously. This estimator can be iterated if needed.5. ˆ J = J(β) →d χ2−k . take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. The general theory of GMM estimation and testing was exposited by L.Often. Theorem 9.1 Under general regularity conditions.1 (Sargan-Hansen). often the weight ˆ matrix Wn is updated. 110 . so that the linear equation may be written as yi = β 0 x1i + ei . However. Note that g n →p Egi . and is thus a natural test statistic for H0 : Egi = 0. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . For example. 9. ˆˆ n is a quadratic form in g n . this is all that is known.6. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. 1 it is possible that β 2 6= 0. n β − β →d N 0. Since the GMM estimator depends upon the first-stage estimator. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. Hansen (1982). and if the weight matrix is asymptotically efficient. Thus the model — the overidentifying restrictions — are testable. 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 . 1 2 It is possible that β 2 = 0. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. Under the hypothesis of correct specification. 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).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 . Identification requires l ≥ k = dim(β). The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = à 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. β) = 0 holds. G0 Ω−1 G .

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

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

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

V − V0 is positive semi-definite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the efficient weight matrix).g. we know that V − V0 is positive semi-definite if and only if V0−1 − V −1 = A is positive semi-definite. γ). ˆ ˆ Find the method of moments estimators (β. Show that Wn →p Ω i i i 4. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0. From matrix algebra. Letting H = CQ and G = C 0−1 W Q. 114 . (b) We want to show that for any W. Show that V0 = Q0 Ω−1 Q . Take the model E (zi ηi ) = 0. (c) Since Ω is positive definite. In the linear model estimated by GMM with general weight matrix W. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). 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 . Write out the matrix A. Take the model yi = zi β + ei with E (xi ei ) = 0.9. verify that A can be written as ³ ¡ ¢−1 0 ´ G H. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . i 0 0ˆ ˆ 3. 2. a GMM estimator with arbitrary weight matrix). Define the estimate of the optimal GMM weight matrix à n !−1 1X 0 2 xi xi ei ˆ . Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. Let ei = yi − zi β where β is consistent for ˆ β (e.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. there exists a nonsingular matrix C such that C 0 C = Ω−1 . γ ) for (β. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . and therefore positive semidefinite. A = H 0 I − G G0 G (d) Show that A is positive semidefinite.

xi . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. Show how to construct an efficient GMM estimator for β. Vn = X X i=1 ˜ and hence R0 β = r. VR ) where ¡ ¢−1 0 R V. β) + ei E (zi ei ) = 0. is defined as Jn (β) = ˜ β = argmin Jn (β). 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 . The equation of interest is yi = g(xi . The GMM estimator of β. the distance statistic D in (9.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). In the linear model Y = Xβ + e with E(xi ei ) = 0. Define the Lagrangian L(β. zi is l × 1 and β is k × 1. subject ˆ i ˆi i=1 to the restriction h(β) = 0. 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. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. h(β)=0 (9. VR = V − V R R0 V R (d) Show that in this setting. zi ). 115 . The observed data is (yi .6) equals the Wald statistic. Thus ˜ β = argmin Jn (β) R0 β−r à n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . 6. l ≥ k.6) (a) Show that you can rewrite Jn (β) in (9.5.

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

This is equivalent to maximizing à n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier. The idea is to construct a multinomial distribution F (p1 .. xi . pn ) are those which maximize the log-likelihood subject to the constraint (10.. . xi . pn ) = i=1 An alternative to GMM is empirical likelihood. The idea is due to Art Owen (1988.3) i=1 117 .1). To be a valid multinomial distribution. It is a non-parametric analog of likelihood estimation... . Now consider the case of an overidentified model with moment condition Egi (β 0 ) = 0 where g is × 1 and β is k × 1 and for simplicity we write gi (β) = g(yi .. the log-likelihood function for this multinomial distribution is n X ln(pi ). The multinomial distribution which places probability pi at each observation (yi .Chapter 10 Empirical Likelihood 10.. (10. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. β). Combined with i the constraint (10. In this case the moment condition places no additional restrictions on the multinomial distribution.. (10.1 Non-Parametric Likelihood Since each observation is observed once in the sample.2) Ln (p1 .1) we find that the MLE is pi = n−1 yielding the log-likelihood −n log(n). The n first order conditions are 0 = p−1 − µ... these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. pn ) which places probability pi at each observation. The maximum likelihood estimator of the probabilities (p1 . zi .1) i=1 First let us consider a just-identified model. . 2001) and has been extended to moment condition models by Qin and Lawless (1994).

Ln (β) = Rn (β. µ. summing over i. probabilities 1 ³ ´´ . pn . λ). (see section 6. .3)..5). pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we find n Rn (β. but must be obtained numerically (see section 6. λ ¡ ¢ ln 1 + λ0 gi (β) . (10.. we also obtain the Lagrange multiplier λ = λ(β). The solution (when it exists) is well defined since Rn (β. This yields the (profile) empirical log-likelihood function for β. λ.4) (10. λ) : λ(β) = argmin Rn (β.where λ and µ are Lagrange multipliers. p (10. p1 .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. we find µ = n and 1 ¢.7) 118 . The solution cannot be obtained explicitly. λ) is a convex function of λ. Multiplying the first equation by pi . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). the Lagrange multiplier λ(β) minimizes Rn (β.5) ˆ ˆ As a by-product of estimation. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .. and using the second and third equations.1) and (10. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .2) subject to the restrictions (10. The first-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. or equivalently minimizes its negative ˆ (10. λ) = −n ln (n) − n X i=1 For given β.5) This minimization problem is the dual of the constrained maximization problem. pi gi (β) = 0. The Lagrangian for this maximization problem is à n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β.

9) (10.10) ¡ Ω−1 N (0. β λ ∂ ³ ´. ˆ The asymptotic variance V for β is the same as for efficient GMM. and n β − β 0 and nλ are asymptotically independent.9) and (10.13) Premultiplying by G0 Ω−1 and using (10. i i Theorem 10.2 Define Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. λ) = − (10.2.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. n (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . 0 = Rn (β.1 Under regularity conditions. Gi (. β) = −xi zi . λ) = − (10.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . ˆ ˆ Proof. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are defined in (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .8) and ¢ 0 0 For example. and Ω = E xi x0 e2 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . in the linear model.10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.13) yields n n Expanding (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . (β. i=1 i=1 i=1i Expanding (10. Thus the EL estimator is asymptotically efficient. 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. G = −E (xi zi ).10).

and (10. and have the same interpretation.7) is n ³ ´´ ³ X ˆ ˆ0 (10.3.15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0.17) 2 ln 1 + λ gi β . This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Vλ ) Furthermore. 10.15) (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. ¥ Chamberlain (1987) showed that V is the semiparametric efficiency bound for β in the overidentified moment condition model. β 0 ) = 0 then LRn →d χ2−k . it is an asymptotically efficient estimator for β. LRn = i=1 Theorem 10. Proof.14) for λ and using (10.1 If Eg(wi . Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.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 (0.15). The same statistic can be constructed for empirical likelihood. tests are based on the difference in the log likelihood functions.16). Twice the difference between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.3 Overidentifying Restrictions In a parametric likelihood context. (10. Ω) GΩ G →d = N (0. The EL overidentification test is similar to the GMM overidentification test. First. They are asymptotically first-order equivalent. 120 . 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. by a Taylor expansion. Since the EL estimator achieves this bound. and it is advisable to report the statistic LRn whenever EL is the estimation method. V ) ˆ Solving (10. The overidentification test is a very useful by-product of EL estimation.

LRn →d χ2 .18). To test the hypothesis h(β) while maintaining (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. since ln(1 + x) ' x − x2 /2 for x small.wisc.prc 121 .18) Let the maintained model be where g is × 1 and β is k × 1.4. a The proof of this result is more challenging and is omitted. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).ssc. h(β)=0 ˜ Fundamentally.1 Under (10. the simple overidentifying restrictions test (10. Theorem 10. where h : Rk → Ra .4 Testing Egi (β) = 0 (10.Second. Instead we use the difference in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . By “maintained” we mean that the overidentfying restrictions contained in (10. This test statistic is a natural analog of the GMM distance statistic. 10. Vλ )0 Ω−1 N (0.edu/~bhansen/progs/elike. The hypothesis of interest is h(β) = 0. Vλ ) ¥ where the proof of the final equality is left as an exercise. 10.18) and H0 : h(β) = 0.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. so there is no fundamental change in the distribution theory for β relative to β. 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 (0.17) is not appropriate.

δ 1 = 1 and δ 2 = 1. λ) G∗ (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) = − gi (β. λ) G∗ (β. The starting value λ1 can be set to the zero vector. λj )) Rp = Rn (β. (10. The modified Newton method takes a quadratic approximation to Rn (β. λ) gi (β. λ) ∂λ i=1 n ∂ Rn (β. 1. set 2 λp = λj − δ p (Rλλ (β.19).4). δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.19) is continued until the gradient Rλ (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β.. Set δ 0 = 0. λj ))−1 Rλ (β. λj ))−1 Rλ (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. Efficient convergence requires a good choice of steplength δ. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λ)0 − ∂β∂β Rn (β. λ)0 − Rn (β. λ) = i The first derivatives of (10. λj ) is smaller than some prespecified tolerance. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. For p = 0.20) . λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. 2. i Rββ = Inner Loop The so-called “inner loop” solves (10.19) X ∂2 ∗ ∗ gi (β. λp ) A quadratic function can be fit exactly through these three points.5) for given β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) = − ∂β n X i=1 G∗ (β. One method uses the following quadratic approximation. λj ) . λ)0 0 Rn (β. Define ∗ gi (β. λ) = G∗ (β. λ) . The iteration (10.

where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. It is not guaranteed that Lββ > 0. If (10.6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. 123 . The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize.for all i. The Hessian for (10. The gradient for (10.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. the stepsize δ needs to be decreased. the eigenvalues of Lββ should be adjusted so that all are positive. and the rule is iterated until convergence. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. If not.20) fails. λ(β)) = 0.6). Outer Loop The outer loop is the minimization (10. λ(β)) + λ0 Rλ (β. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ . This can be done by the modified Newton method described in the previous section. λ) = 0 at λ = λ(β).

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

1) the structural equation. this can be written as Y = Zβ + e. In a typical set-up. so should be included in xi . 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. Thus we make the partition ¶ µ k1 z1i (11. 11.1 The × 1 random vector xi is an instrumental variable for (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. which does not equal either β 1 or β 2 . ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. In matrix notation. β →p β ∗ .1).1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. and assume that E(zi ei ) 6= 0 so there is endogeneity. That is x2i are variables which could be included in the equation for yi (in the sense 125 . This is called simultaneous equations bias. and x2i are the excluded exogenous variables. So we have the partition µ ¶ z1i k1 (11. at least the intercept). z1i is an instrumental variable for (11. (11.1. By the above definition.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) where zi is k × 1. some regressors in zi will be uncorrelated with ei (for example.1) if E (xi ei ) = 0. Definition 11.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we find

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

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

11.3

Identification

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

11.4

Estimation
0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

By the spectral decomposition of an idempotent matrix. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . the expression in (11. Let q = H 0 ξS −1/2 which satisfies Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases.7 Identification Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . l . the bias in the 2SLS estimator will be large. It is also close to zero when α = 0. Indeed as α → 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 . The consequences of identification failure for inference are quite severe.Let PX = X (X 0 X)−1 X 0 .14) approaches that in (11.12) and this result. except when S21 = 0 (when Z is exogenous). 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. 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 .14) is the probability limit of β 2SLS − β 11. 0). 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. 130 . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. P = HΛH 0 0 0 where Λ = diag(Il . n and (11.14) In general this is non-zero. The parameter β fails to be identified if Γ22 has deficient rank.13).

Take the simplest case where k = l = 1 (so there is no X1 ). meaning that inferences about parameters of interest can be misleading.15) is unaffected. In addition. Suppose this condition fails. and was examined by Phillips (1989) and Choi and Phillips (1992). This occurs when Γ22 is full rank. This can be handled in an asymptotic analysis by modeling it as local-to-zero. Then (11.16) 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 . To see the consequences. This result carries over to more general settings. Here. N2 since the ratio of two normals is Cauchy. so E (zi xi ) = 0. standard test statistics have non-standard asymptotic distribution of β distributions. as the Cauchy distribution does not have a finite mean. Thus identification hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. viz Γ22 = n−1/2 C. E x2 e2 i i n i=1 n (11. we find that β is inconsistent for β and the ˆ is non-normal. once again take the simple case k = l = 1. which occurs i when E (zi xi ) 6= 0. Qc + N2 ˆ As in the case of complete identification failure. where C is a full rank matrix. the instrument xi is weak for zi if γ = n−1/2 c. but (11. but small. E x2 u2 i i n n i=1 i=1 n n (11. 131 . The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. We see that β is identified if and only if Γ22 = γ 6= 0. This is particularly nasty. but is weak.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . Suppose that identification does not complete fail.

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

8 Exercises yi = zi β + ei . 1. and Γ is l × k. at ˆˆ If X is indeed endogeneous. 6. X is n × l. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). 2. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. l ≥ k. That is. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. in the sense that e ˜ ˜ least in large samples? 4.11. Explain why this is true. 5. Take the linear model Y = Zβ + e. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . u is n × k. The parameter Γ is defined by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . where xi and β are 1 × 1. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. 133 . Z is n × k. 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. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known.) 3. ˜ 0 e < e0 e. will IV “fit” better than OLS. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). (Find an expression for xi . show that if rank(Γ) < k then β cannot be identified. Find a simple expression for the IV estimator in this context. we claim that β is identified (can be recovered from the reduced form) if rank(Γ) = k. xi is l × 1. Take the linear model yi = xi β + ei E (ei | xi ) = 0.

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

we adopt new notation. and T to denote the number of observations.) is a random variable.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .1. .1.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. .... Yt−k ) is the autocorrelation function.. .4 (loose). γ(k) is called the autocovariance function. A stationary time series is ergodic if γ(k) → 0 as k → ∞. 135 . then Xt is strictly stationary and ergodic. we expect that Yt and Yt−1 are not independent.1. however. T . Definition 12. Theorem 12. 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. so classical assumptions are not valid. Yt−k ) is independent of t for all k... Definition 12.1. and Cov (Yt . Because of the sequential nature of time series. t = 1. Yt−k ) = γ(k) is independent of t for all k. To indicate the dependence on time.2 {Yt } is strictly stationary if the joint distribution of (Yt . We can separate time series into two categories: univariate (yt ∈ R is scalar). and multivariate (yt ∈ Rm is vector-valued). and use the subscript t to denote the individual observation. The primary model for univariate time series is autoregressions (ARs).1 If Yt is strictly stationary and ergodic and Xt = f (Yt . There proofs are rather difficult.1 Stationarity and Ergodicity Definition 12. Yt−1 .. The following two theorems are essential to the analysis of stationary time series.1. 12.. Definition 12.

then as T → ∞. Part (1) is a direct consequence of the Ergodic theorem. µ →p E(Yt ). the sequence Yt Yt−k is strictly stationary and ergodic. ˆ ˆ γ ¥ 136 . Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).Theorem 12. ˆ 3.1.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. For Part (2).1. ˆ 2. and it has a finite mean by the assumption that EYt2 < ∞. 1. T 1X Xt →p E(Xt ). ρ(k) →p ρ(k).1 above. γ (0) ˆ Theorem 12.2 (Ergodic Theorem). then as T → ∞. If Xt is strictly stationary and ergodic and E |Xt | < ∞. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). ˆ Proof.1. γ (k) →p γ(k). ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) .

. For example. the series {. k=0 Loosely speaking. A mean-zero AR(1) is Assume that et is iid.. In fact.. E(Yt−k et ) = 0. t By back-substitution.} are jointly random. some versions of the life-cycle hypothesis imply that either changes in consumption. A linear AR model (the most common type used in practice) specifies linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k .. Y1 . Yt−k ) . Yt−2 . 137 . 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. . Thus for k > 0. should be a MDS. . We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . it is even more important in the time-series context.. YT ..1 et is a martingale difference sequence (MDS) if E (et | It−1 ) = 0. This occurs when |ρ| < 1.3 Stationarity of AR(1) Process Yt = ρYt−1 + et .2 Autoregressions In time-series..12.. we find Yt = et + ρet−1 + ρ2 et−2 + . E(et ) = 0 and Ee2 = σ 2 < ∞.. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.2. Y2 ... . Letting et = Yt − E (Yt | It−1 ) .. Definition 12.. Some time-series processes may be a MDS as a consequence of optimizing behavior. ∞ X = ρk et−k . this series converges if the sequence ρk et−k gets small as k → ∞. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. Regression errors are naturally a MDS. as it is difficult to derive distribution theories without this property. The last property defines a special time-series process.} is the past history of the series. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . 12. . or consumption growth rates.. An autoregressive (AR) model specifies that only a finite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 ..

In general. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . Note that an equivalent way to say this is that an AR(1) is stationary iff the root of the autoregressive polynomial is larger than one (in absolute value).4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.1 The lag operator L satisfies LYt = Yt−1 .4. We can compute the moments of Yt using the infinite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 .Theorem 12. Definition 12.1. We call ρ(L) the autoregressive polynomial of Yt . Defining L2 = LL. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .3. 138 . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . 12.3. and solving for EYt = EYt−1 we find EYt = α/(1 − ρ). Lk Yt = Yt−k . We call ρ(L) the autoregressive polynomial of Yt .1 If |ρ| < 1 then Yt is strictly stationary and ergodic. We say that the root of the polynomial is 1/ρ. an AR(1) is stationary iff |ρ| < 1. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. ∞ X k=0 ρ2k V ar (et−k ) = 12. the above results are unchanged. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . we see that L2 Yt = LYt−1 = Yt−2 . since ρ(z) = 0 when z = 1/ρ. The AR(k) model is Using the lag operator. From Theorem 12.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .

the requirement is that all roots are larger than one. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. This is a special case of non-stationarity.1) Theorem 12. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. and by Theorem 12. and is of great interest in applied time series. Let |λ| denote the modulus of a complex number λ.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . so is xt x0 . it is helpful to define the process ut = xt et . . By Theorem 12.1.where the λ1 .” If one of the roots equals 1. t Yt−k ¢0 ρk . t t T t=1 ¥ Combined with (12. λk are the complex roots of ρ(z).1.1) and the continuous mapping theorem. We know that an AR(1) is stationary iff the absolute value of the root of its autoregressive polynomial is larger than one. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. “has a unit root”.1. then ˆ β →p β as T → ∞. it is also strictly stationary and ergodic. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. Theorem 12. One way of stating this is that “All roots lie outside the unit circle..1.. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. β = X 0X (12. and hence Yt .. Proof. which satisfy ρ(λj ) = 0. t T t=1 T t=1 139 . we see that à !−1 à ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. For an AR(k). The vector xt is strictly stationary and ergodic.5. Note that ut is a MDS. Thus t by the Ergodic Theorem.6. 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. we say that ρ(L).

This is identical in form to the asymptotic distribution of OLS in cross-section regression. this cannot work in a time-series application. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. ˆ 1.7.7. This creates an iid bootstrap sample. Ω) .. It also presumes that the AR(k) structure is the truth.7 Asymptotic Distribution Theorem 12.. t t Theorem 12. Q−1 ΩQ−1 . In particular. e ˆ 3. the asymptotic covariance matrix is estimated just as in the cross-section case.7. . i 4. 140 . T t=1 Since xt et is a MDS. Fix an initial condition (Y−k+1 . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. we constructed the bootstrap sample by randomly resampling from the data values {yt . which may be different than the i properties of the actual ei . eT }. there are two popular methods to implement bootstrap resampling for time-series data.1 MDS CLT. Y−k+2 .. T 1 X √ ut →d N (0.8 Bootstrap for Autoregressions In the non-parametric bootstrap. t This construction imposes homoskedasticity on the errors e∗ . 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∗ . Estimate β and residuals et . . then as T → ∞. we can apply Theorem 12. as this imposes inappropriate independence. Divide the sample into T /m blocks of length m. The implication is that asymptotic inference is the same. 12. Y0 ). Method 1: Model-Based (Parametric) Bootstrap.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. T t=1 where Ω = E(xt x0 e2 )...1 to see that T 1 X √ xt et →d N (0.. Briefly. ˆ 2. Clearly.12. xt }. t then as T → ∞. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Method 2: Block Resampling 1. Ω) .

. For each simulated sample.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . get the ˆ ˆ residual St . 5. • You can estimate (12. 3. and the way that the data are partitioned into blocks. Paste the blocks together to create the bootstrap time-series Yt∗ .3) sequentially by OLS. and for modelmisspecification. Seasonal Effects There are three popular methods to deal with seasonal data. If s is the number of seasons (typically s = 4 or s = 12). That is. also alters the time-series correlations of the data. Resample complete blocks.2) (12. first estimate (12. 12. The seasonal adjustment. 141 . (12.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . 6. • First apply a seasonal differencing operator.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . This presumes that “seasonality” does not change over the sample. This allows for arbitrary stationary serial correlation. Thus the seasonally adjusted data is a “filtered” series. and perhaps this was of relevance. • Include dummy variables for each season. or the season-to-season change.4) by OLS. • You can estimate (12. however. This is a flexible approach which can extract a wide range of seasonal factors. This procedure is sometimes called Detrending. May not work well in small samples.. draw T /m blocks..2)-(12.2. ρk ). ∆s Yt = Yt − Yt−s . heteroskedasticity. The series ∆s Yt is clearly free of seasonality. and then perform regression (12. (12. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. But the long-run trend is also eliminated.2). • Use “seasonally adjusted” data.3) replacing St with St . The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.. The results may be sensitive to the block length. 4.

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

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

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

. . and the m × (mk + 1) matrix A0 A1 A2 · · · 145 . Yt−k ) . A linear VAR specifies that this conditional mean is linear in the arguments: E (Yt | Yt−1 . defining the mk + 1 vector ⎜ Yt−1 ⎜ ⎜ xt = ⎜ Yt−2 ⎜ . Yt−2 .. The typical goal is to find the conditional expectation E (Yt | It−1 ) .Chapter 13 Multivariate Time Series A multivariate time series Yt is a vector process m × 1. . Yt−k ) = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k .) be all lagged information at time t. Yt−k A= ¡ ⎛ 1 ⎞ ⎟ ⎟ ⎟ ⎟ ⎟ ⎠ Ak ¢ .. Observe that A0 is m × 1. we have the VAR model Yt = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k + et E (et | It−1 ) = 0.1 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. Alternatively..and each of A1 through Ak are m × m matrices. this conditional expectation is also a vector. Let It−1 = (Yt−1 ... . ⎝ . Defining the m × 1 regression error et = Yt − E (Yt | It−1 ) . Note that since Yt is a vector...

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

and subtract off the equation once lagged multiplied by θ.2) is a special case of (13. t or yt = θyt−1 + x0 β + x0 γ + ut . Otherwise it is invalid. direct estimation of (13. j Often. and is still routinely reported by conventional regression packages. Another interesting fact is that (13. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i .4 Single Equation from a VAR Yjt = a0 xt + et . under the restriction γ = −βθ. (13. We see that an appropriate. In this case. which once was very popular. and simple way to test for omitted serial correlation is to test the significance of extra lagged values of the dependent variable and regressors. which is called a common factor restriction. This can be done by a Wald test. 147 . t t−1 (13. 1). and is typically rejected empirically. may be tested if desired. This restriction. You may have heard of the Durbin-Watson test for omitted serial correlation. Let yt = Yjt . t and xt = This is just a conventional regression. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. the model (13.3). t and et is iid N (0.1) yt = x0 β + et . we are only interested in a single equation out of a VAR system.) Since the common factor restriction appears arbitrary.2) is uncommon in recent applications. with time series data.13.1). 13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13.3) which is a valid regression model. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. (A simple version of this estimator is called Cochrane-Orcutt.2) Take the equation yt = x0 β + et . So testing H0 versus H1 is equivalent to testing for the significance of adding (yt−1 . Then the single equation takes the form (13. xt−1 ) to the regression. Let et = ejt and β = aj . 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 . it is convenient to re-define the variables. If valid. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). and Zt be the other variables.2) may be estimated by iterated GLS. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. Suppose that et is an AR(1). general.

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

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 . m × r. β is not consistent. it may be necessary to include a time trend in the estimated cointegrating regression. When the data have time trends. then β = (1 − 1)0 specifies that the spread (the difference in returns) is stationary. If Y = (log(Consumption) log(Income))0 . Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . yet under H1 zt is I(0). then Yt is I(0). so zt = β 0 Yt is known. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. as first shown by Stock (1987). For example. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. β may not be known. such that zt = β 0 Yt is I(0). 149 . however. If the series Yt is not cointegrated. 13. Suppose that β is known. it may be believed that β is known a priori. Under H0 . Their justification was Stock’s result that β is superˆ ˆ consistent under H1 . Whether or not the time trend is included. and was articulated in detail by Engle and Granger (1987). the asymptotic distribution of the test is affected by the presence of the time trend. then β = (1 − 1)0 specifies that log(Consumption/Income) is stationary.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β.13. so the ADF critical values are not appropriate. The r vectors in β are called the cointegrating vectors. If Yt is cointegrated with a single cointegrating vector (r = 1). For 0 < r < m. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1.8. Often. Yt is I(1) and cointegrated. If r = m. from OLS of Y1t on Y2t . of rank r. in general. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. Hansen (1992). then r = 0. Definition 13. if Yt is a pair of interest rates. This is not. When β is unknown. Then under H0 zt is I(1). The asymptotic distribution was worked out in B.8 Cointegration The idea of cointegration is due to Granger (1981). In other cases. Thus Yt = ˆ (Y1t . β = (1 − 1)0 . a good method to estimate β. Thus H0 can be tested using a univariate ADF test on zt . In some cases. but it is useful in the construction of alternative estimators and tests. The asymptotic distribution was worked out by Phillips and Ouliaris (1990).

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

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

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

i i i=1 ˆ The MLE is the value β which maximizes ln (β).. This may be considered restrictive. . 2. any known value can substitute. or it may be a by-product of economic constraints. Tobin observed that for many households.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β).}.14.1). In surveys. An example of a data collection censoring is top-coding of income. i If Y = {0. 1. . k! = exp(x0 β). He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. a typical approach is to employ Poisson regression. 1. 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. 2. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.. 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 censoring process may be explicit in data collection..1) yi = ∗ <0 . A generalization is the negative binomial. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. 14. The functional form for λi has been picked to ensure that λi > 0.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. incomes above a threshold are typically reported at the threshold. This model (now called the Tobit) specifies that the latent (or ideal) value of consumption may be negative (the household 153 .2 Count Data exp (−λi ) λk i . this motivates the label Poisson “regression.. the consumption level (purchases) in a particular period was zero. The first censored regression model was developed by Tobin (1958) to explain consumption of durable goods. 0 if yi (This is written for the case of the threshold being zero.) The observed data yi therefore come from a mixed continuous/discrete distribution. This model specifies that P (Yi = k | xi ) = λi k = 0. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. σ 2 ) with the observed variable yi generated by the censoring equation (14. Thus the model is that there is some latent process yi with unbounded support. The conditional density is the Poisson with parameter λi .

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

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

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

and most applied researchers try to avoid its use. An observation is the pair {yit . xit }. There are several derivations of the estimator.. then OLS is inconsistent. it The typical maintained assumptions are that the individuals i are mutually independent..Chapter 15 Panel Data A panel is a set of observations on individuals.1) If this condition fails. t = ti .1 Individual-Effects Model The standard panel data specification is that there is an individual-specific effect which enters linearly in the regression yit = x0 β + ui + eit . A panel may be balanced : {yit . This is often believed to be plausible if ui is an omitted variable. OLS of yit on xit is called pooled estimation... where the i subscript denotes the individual.. The motivation is to allow ui to be arbitrary. Condition (15. ti .2 Fixed Effects This is the most common technique for estimation of non-dynamic linear panel regressions. i = 1.. xit } : For i = 1. however. . n. . In either event. (15.. and the t subscript denotes time.. and thus achieve invariance. The goal is to eliminate ui from the estimator.1) fails if the individual-specific unobserved effect ui is correlated with the observed explanatory variables xit .. 15. that eit is iid across individuals and time. . or unbalanced : {yit . OLS appears a poor estimation choice. n. and have arbitrary correlated with xi . that ui and eit are independent.1) is called the random effects hypothesis. T . . collected over time.. It is a strong assumption. OLS can be improved upon via a GLS technique.. If (15. 15.1) is true. and that eit is uncorrelated with xit . xit } : t = 1.. It is consistent if E (xit ui ) = 0 (15. 157 .

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

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

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

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

Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . nh (x)2 dx is called the roughness of K. 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) . so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. The bias results from this smoothing. ˆ the greater the bias. the estimator f (x) smooths data local to Xi = x. The last expression shows that the expected value is an average of f (z) locally about x. and is larger the greater the curvature in f (x). which is valid as h → 0.16. Since it is an average of iid random variables. 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). The sharper the derivative. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . so is estimating a smoothed version of f (x). ˆ We now examine the variance of f (x). Intuitively. This integral (typically) is not analytically solvable. 162 .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.

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

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

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

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

and use lower case letters such as x for potential values and realized values. The probability function for X takes the form j = 1. τ r .. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx.. This induces a new sample space — the real line — and a new probability function on the real line.Theorem 2 (Bayes’ Rule). We say that the random variable X is continuous if F (x) is continuous in x. these cases are unusualRand are typically ignored..2) Sometimes we write this as FX (x) to denote that it is the CDF of X.3) P (X = τ j ) = π j . . F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. (A. Instead. In the latter case. A function F (x) is a CDF if and only if the following three properties hold: 1.. r (A. .3) is unavailable. A2 . While there are examples of continuous random variables which do not possess a PDF.. Typically. the range of X consists of a countable set of real numbers τ 1 . . we denote random variables by uppercase letters such as X. For a random variable X we define its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . a These expressions only make sense if F (x) is differentiable. of the sample space.. . then for each i = 1. 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.. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. F (x) is nondecreasing in x 3.. 167 . we represent the relative probabilities by the probability density function (PDF) f (x) = so that F (x) = and P (a ≤ X ≤ b) = Z d F (x) dx x f (u)du Z b −∞ f (x)dx. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.2 Random Variables A random variable X is a function from a sample space S into the real line.. 2.. For any set B and any partition A1 .

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

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

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

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

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

y) fX (x + ε) ∂2 ∂x∂y F (x. In particular. xk )0 . y) fX (x) The conditional density of Y given X = x is defined as fY |X (y | x) = if fX (x) > 0.... fX (x) 173 . .6 Conditional Distributions and Expectation f (x.A k × 1 random vector X = (X1 . y) . y) fX (x) f (x.. . ∂x1 · · · ∂xk For a measurable function g : Rk → Rs .. y) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε.. we define the expectation Z g(x)f (x)dx Eg(X) = Rk where the symbol dx denotes dx1 · · · dxk . 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. then Σ is a diagonal matrix and à k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A. y) − F (x. Letting x = (x1 . One way to derive this expression from the definition of conditional probability is fY |X (y | x) = = = = = = ∂ lim P (Y ≤ y | x ≤ X ≤ x + ε) ∂y ε→0 ∂ P ({Y ≤ y} ∩ {x ≤ X ≤ x + ε}) lim ∂y ε→0 P (x ≤ X ≤ x + ε) F (x + ε. it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x). Xk )0 is a function from S to Rk .

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

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

It is conventional to write X ∼ N (0. This shows that linear transformations of normals are also normal. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . denoted χ2 . If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. σ 2 ). For x ∈ Rk . then Z 0 A−1 Z ∼ χ2 .2 If Z ∼ N(0. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ.This density has all moments finite. A) with A > 0. x ∈ Rk . x ∈ Rk . respectively. Theorem A. (A. q 176 . By iterated integration by parts. Since it is symmetric about zero all odd moments are zero. In this case the density function can be written as j à à !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k à ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. X has density à ! (x − µ)2 1 exp − . −∞ < x < ∞. The mean and variance of the distribution are µ and σ 2 . f (x) = √ 2σ 2 2πσ which is the univariate normal density. The latter has no closed-form solution. Theorem A. and it is conventional to write X ∼ N (µ. Its mean and r variance are µ = r and σ 2 = 2r. Another useful fact is that if X ∼ N (µ. then Σ = diag{σ 2 } is a diagonal matrix. then by the change-of-variables formula. then they are mutually independent. Σ). This shows that if X is multivariate normal with uncorrelated elements. If Z is standard normal and X = µ + σZ. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . then using the change-of-variables formula. Σ) and Y = a + BX with B an invertible matrix. the density of Y is à ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = .8. q × q.8. 1).1 Let X ∼ N (0. we can also show that EX 2 = 1 and EX 4 = 3.11) and is known as the chi-square density with r degrees of freedom. Ir ) and set Q = X 0 X. and it is conventional to write X ∼ N(µ. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . ¢ ¡ 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 . y ≥ 0.

which can be found by applying change-of-variables to the gamma function. 1). Thus the density of Z 2 is (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .11) 2 with r = 1. tr has distribution 177 .8. Using the simple law of iterated expectations.2.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).13). Iq ). The fact that A > 0 means that we can write A = CC 0 where C is non-singular.8. 1) and Q ∼ χ2 be independent. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.1.8.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. (A. From (A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.13) is the MGF of the density (A.11).3. we see that the MGF of Z 2 is (1 − 2t)−1/2 . For Z ∼ N(0. Set r Z . C −1 CC 0 C −10 ) = N (0. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Proof of Theorem A. which we showed in (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 .3 Let Z ∼ N (0.12) E exp (tQ) = 0 Γ (A. q Proof of Theorem A.Theorem A.8. The MGF for the density (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. C −1 AC −10 ) = N (0.

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

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

θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . V ) . θ) is used to approximate the true unknown density f (y). θ). the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. Typically. ˆ ln f Yi . θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y. θ) = f (y) ln f (y.ˆ ˆ−1 θ We then set I0 = H −1 . θ) ¶ dy Thus in large samples. In this case there is not a “true” value of the parameter θ. θ) θ In this case. Instead we define the pseudo-true value θ0 as the maximizer of Z E ln f (Yi .18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. but has a different covariance matrix than in the pure MLE case. A minor adjustment to Theorem (A. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. but it is not literally believed that the model f (y. θ (A. Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . Therefore the MLE is called asymptotically efficient. ˆ elements of n 0 Sometimes a parametric density function f (y. θ) is necessarily the true density. Thus in large samples the MLE has approximately the best possible variance. Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance. 180 . ˆ . since the information matrix equality (A. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. The QMLE is consistent for the pseudo-true value.17) does not hold.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi .3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0.9. 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 .

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 = . V ar (S) nH so ¥ 181 . θ0 ) − f (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y.Proof of Theorem A. To see (A. θ0 )0 f (Yi . yn ).. θ0 )0 . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ0 )2 (Yi . θ) f (y. θ0 ) ¯ ∂ f (y. θ0 ) d˜ = E ˜ .9.. θ0 ) f (Yi . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. function of the data. θ0 ) (Yi .9. θ) d˜ = ˜ y ) ∂ ln f (˜.. θ0 ) ∂ ∂θ f ∂ (Yi . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 .17). ∂θ ¯θ=θ0 Z ! = 0. θ0 ) ∂θ f (Yi . θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y .9.1) has mean zero and variance nH. (Yi . θ) dy ¯ ∂θ f (y. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ0 = ln f (Yi . Since θ Z ˜ = ˜ y)f (˜. f (Yi . ¯ ¯ ∂ E ln f (Yi . Differentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜.1.2. we can show that E By direction computation.16). θ0 ) ln f (Yi . ∂2 ln f (Yi . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ) f (˜. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. Proof of Theorem A. θ0 ) ∂ ∂ − ln f (Yi . .

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

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

Then for ε small gj (θ) ' Similarly.. Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation. Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row).2 Gradient Methods Gradient Methods are iterative methods which produce a sequence θi : i = 1. 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 .B. Take the j 0 th element of g(θ). In this case the iteration rule takes the form (B. ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available. of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ). and all require the computation θ. numerical derivatives can work well but can be computationally costly relative to analytic derivatives. 2. . a one-dimensional optimization. In some cases. By a Taylor’s expansion for θ close to ˆ θ ³ ´ 0 = g(ˆ ' g(θ) + H(θ) ˆ − θ θ) θ gjk (θ) ' which implies ˆ = θ − H(θ)−1 g(θ). Q(θ + δ j ε + δ k ε) − Q(θ + δ k ε) − Q(θ + δ j ε) + Q(θ) ε2 In many cases. numerical derivatives can be quite unstable. One modification to prevent this possibility is quadratic hill-climbing which sets ˆi+1 = θi − (H(θi ) + αi Im )−1 g(θi ).2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(θ) . θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive definite. 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. To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 . however. they can be calculated numerically. Allowing the steplength to be a free parameter allows for a line search. 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 problem. Let ∆gi = gi − gi−1 ∆θi = θi − θi−1 and . These problems have motivated alternative choices for the weight matrix Di . As the iterations continue. At each iteration. A more recent innovation is the method of simulated annealing (SA). and it can be quite computationally costly if H(θ) is not analytically available.. it relies on an iterative sequence. The SA method is a sophisticated random search. 1/2. . the iterations continue until the sequence has converged in some sense. There are two common methods to perform a line search. 185 . If the criterion has improved over Q(θi ). this new value is accepted. 1/4. The SA algorithm stops when a large number of iterations is unable to improve the criterion. ¢2 0 ∆θ0 ∆gi ∆θ0 ∆gi ∆θ0 ∆gi ∆θi ∆gi i i i 0 ∆θi ∆θ0 Di−1 ∆gi ∆gi Di−1 i + . One example is the simplex method of Nelder-Mead (1965). 0 0 ∆gi Di−1 ∆gi ∆θi ∆gi For any of the gradient methods. Newton’s method does not perform well if Q(θ) is irregular. 1/8. otherwise move to the next element in the sequence. the methods are not well defined when Q(θ) is non-differentiable. Each value in the sequence is considered and the criterion Q(θi + Di gi λ) evaluated. In these cases. The downside is that it can take considerable computer time to execute.3 Derivative-Free Methods All gradient methods can be quite poor in locating the global minimum when Q(θ) has several local minima.. The half-step method considers the sequence λ = 1. and Rodgers (1994). Ferrier. Two popular methods are do to Davidson-Fletcher-Powell (DFP) and Broyden-Fletcher-Goldfarb-Shanno (BFGS). it may still be accepted depending on the extent of the increase and another randomization. The SA method has been found to be successful at locating global minima. If the criterion is increased. These methods are called Quasi-Newton methods. a random variable is drawn and added to the current value of the parameter. use this value. |Q (θi ) − Q (θi−1 )| or |g(θi )| has become small. Like the gradient methods. and picks λi as the value minimizing this approximation. This can be defined by examining whether |θi − θi−1 | . B. If the resulting criterion is decreased. Furthermore. . For a review see Goffe. alternative optimization methods are required. 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 + + . A quadratic approximation evaluates the first and second derivatives of Q(λ) with respect to λ. the variance of the random innovations is shrunk. The latter property is needed to keep the algorithm from selecting a local minimum.

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