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

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

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Contents

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

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

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

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

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

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

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ii

. . . . . . .6 Over-Identiﬁcation Test . . . . 12. . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . 12. . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 8.2 GMM Estimator . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . iii . . . . . . . . . 12. . . . . . . . . . . . . . . . . . 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. . 9. . . . 12. . . . . . . . . . . . . . . . . . .9 8. .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . 11. . . .4 Testing . .9 Trend Stationarity . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . . 9. 10. . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . .8 Bootstrap for Autoregressions . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . .10 Exercises .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . .12 8. . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . 10. . . .1 Overidentiﬁed Linear Model .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . 12. . . .10Testing for Omitted Serial Correlation 12. . . . . . .2 Reduced Form . . . . . 12. 11. . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . .3 Identiﬁcation . . . . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12.4 Estimation . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . .6 Estimation . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . .1 Stationarity and Ergodicity . . 9. . . . . .

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

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

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

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

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

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

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

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

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

.By the uniqueness of the characteristic roots... 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. jk ) denote a permutation of (1.. tr(A) = rank(A). then its determinant is det A = a11 a22 − a12 a21 . There are k! such permutations.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . k))... 2. . we deduce that Λ2 = Λ and λ2 = λi for i = 1. xk ) be k × 1 and g(x) = g(x1 . . Let π = (j1 . . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.. For a general k × k matrix A = [aij ] . i Hence they must equal either 0 or 1. we can deﬁne the determinant as follows. xk ) : Rk → R. Additionally.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. . k) .. If A is 2 × 2.. Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . k. . There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. ⎠ .... • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ ...4) H0 M =H 0 0 with H 0 H = In . ... The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ .. ..

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

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

36. 2 (3. For this reason. degree in mean log hourly wages is 0.A. and a Ph.1 is facilitated by the fact that the control variable (gender) is discrete. The comparison in Figure 3. When the distribution of the control variable is continuous. implying an average 36% diﬀerence in wage levels. 3. By construction. the solid line displays the conditional expectation of log wages varying with education. this yields the formula yi = m(xi ) + ei . The conditional expectation function is close to linear. with mean log hourly wages drawn in with the arrows.3 displays a scatter plot2 of log wages against education levels. Of particular interest to graduate students may be the observation that diﬀerence between a B. Assuming for simplicity that this is the true joint distribution. The diﬀerence in the log mean wage between men and women is 0.5. then comparisons become more complicated. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. Figure 3.2 shows the density of log hourly wages for the same population. wage regressions typically use log wages as a dependent variable rather than the level of wages.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3.2) evaluated at the observed value of xi : ei = yi − m(xi ). The main point to be learned from Figure 3. 12 . which implies a 30% average wage diﬀerence for this population.D. Figure 3.Figure 3.3) White non-military male wage earners with 10-15 years of potential work experience.3 is how the conditional expectation describes an important feature of the conditional distribution. the dashed line is a linear projection approximation which will be discussed in the Section 3.30. To illustrate.

are often stated jointly as the regression framework. The remaining parts of the Theorem are left as an exercise. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.2. by the deﬁnition of ei and the linearity of conditional expectations. E(ei ) = 0. most typically.Figure 3. The equations yi = m(xi ) + ei E (ei | xi ) = 0. To show the ﬁrst statement. E(xi ei ) = 0. not a model. E (h(xi )ei ) = 0 for any function h (·) . 4. These equations hold true by deﬁnition. A regression model imposes further restrictions on the joint distribution. restrictions on the permissible class of regression functions m(x). 2.2: Log Wage Densities Theorem 3. 3.1 Properties of the regression error ei 1. 13 . It is important to understand that this is a framework. because no restrictions have been placed on the joint distribution of the data. E (ei | xi ) = 0.

the conditional variance of yi is σ 2 = σ 2 (xi ). In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. i . it does not provide information about the spread of the distribution. in the sense of achieving the lowest mean squared error. σ 2 (x) is a non-trivial function of x. In contrast. The right-hand-side is minimized by setting g(x) = m(x).3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . when σ 2 (x) is a constant so that ¢ ¡ (3.3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. and can take any form.1.Figure 3. 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. let g(x) be an arbitrary predictor of yi given xi = x. subject to the restriction p that it is non-negative. The conditional standard deviation is its square root σ(x) = σ 2 (x).2. 3.3 Conditional Variance Generally. To see this. Given the random variable xi . A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . Thus the mean squared error is minimized by the conditional mean.

1 and that for women is 10.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). Thus (3. So while men have higher average wages. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. In this case (3.5) xi = ⎜ .9) 3.4 Linear Regression An important special case of (3. Equation (3. ⎟ . which we derive in this section. and the linear assumption of the previous section is empirically unlikely to accurate.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .we say that the error ei is homoskedastic. The conditional standard deviation for men is 12.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . Instead.6) as an approximation. where x1i is the ﬁrst element of the vector xi deﬁned in (3.7) is a k × 1 parameter vector. βk ⎛ (3. ⎠ . they are also somewhat more dispersed.8) is called the linear regression model. we assume that x1i = 1. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . it is convenient to augment the regressor vector xi by listing the number “1” as an element. As an example.1). xki When m(x) is linear in x. Equivalently.8) (3. take the conditional wage densities displayed in Figure 3.1. ⎟ β=⎝ . ⎝ .3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. We call this the “constant” or “intercept”. ⎠ . Notationally. 15 . 3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . i (3.6) (3.5. its functional form is typically unknown. it is more realistic to view the linear speciﬁcation (3.

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. written E (xi x0 ) > 0. 3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . 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 . α0 E (xi x0 ) α = E (α0 xi )2 > 0. i which requires that for all non-zero α. As before. otherwise they are distinct.1 1.12) This completes the derivation of the linear projection model. i i (3. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . xi contains an intercept.10) It is worth taking the time to understand the notation involved in this expression. The error is i ei = yi − x0 β. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. Rewriting. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.5. Given the deﬁnition of β in (3.5.which is quadratic in β. The best linear predictor is obtained by selecting β to minimize S(β). The vector (3. This occurs when redundant variables are included in xi .10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. i 4. i (3.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. Therefore. The ﬁrst-order condition for minimization (from Section 2.11) 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 . 2 2. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. Equivalently. this situation must be excluded. In order for β to be uniquely deﬁned. Eyi < ∞. by “best” we mean the predictor function with lowest mean squared error. i (3. Assumption 3. x0 β is the best linear predictor for yi .1. E (xi x0 ) is invertible. Observe i that for any non-zero α ∈ Rk . It is invertible if and only if it is positive deﬁnite. E (x0 xi ) < ∞. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.10). i 16 .

5. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Since from Theorem 3.1.1. Furthermore. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.14) holds.13) implies that xi and ei are uncorrelated.5. Figure 3.14) Proof.4 is required to ensure that β is uniquely deﬁned.12) and (3. the orthogonality restriction (3.13) summarize the linear projection model. The ﬁnite variance Assumptions 3.8)-(3.5.1 Under Assumption 3.5. Assumption 3.12) can be alternatively interpreted as a projection decomposition.1.11) and (3.1.5. (3.10) and (3.1 is employed to guarantee that (3.1.14). By deﬁnition.14) follows from (3.4 guarantees that the solution β exits.2 and 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. Assumption 3. Using the deﬁnitions (3.1. E (xi ei ) = 0 and E (ei ) = 0.5.3 are called regularity conditions. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . However.Theorem 3.4 we know that the regression error has the property E (xi ei ) = 0. Equation (3.1.1.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.13) The two equations (3. 17 .9).13) and Assumption 3. Let’s compare it with the linear regression model (3.1 are weak.1.2.1. Since ei is mean zero by (3.5.5.5. This means that the equation (3.11) are well deﬁned.5. it follows that linear regression is a special case of the projection model.10) are deﬁned.1.3 ensure that the moments in (3. ¥ (3. For example. Assumption 3.2 and 3. (3. Assumption 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.5.

12) with the properties listed in Theorem 3. A projection of log wages on these two variables can be called a quadratic projection.10) may not hold and the implications of Theorem 3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. Figure 3. In the example just presented. Returning to the joint distribution displayed in Figure 3. In this example it is a much better approximation to the conditional mean than the linear projection. In this case the linear projection is a poor approximation to the conditional mean. since the resulting function is quadratic in experience. for those over 53 in age). for any pair (yi . and the straight dashed line is the linear projection. it is important to not misinterpret the generality of this statement. We illustrate the issue in Figure 3.5. This defect in linear projection can be partially corrected through a careful selection of regressors.3. The linear equation (3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. in many economic models the parameter β may be deﬁned within the model. In this case (3.We have shown that under mild regularity conditions.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. 18 . the dashed line is the linear projection of log wages on eduction. we can augment the regressor vector xi to include both experience and experience2 . The solid line is the conditional mean.10).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.4 displays the relationship3 between mean log hourly wages and labor market experience. Other than the redeﬁnition of the regressor vector. No additional assumptions are required. In this example the linear projection is a close approximation to the conditional mean. and are discussed in Chapter 11.4 we display as well this quadratic projection.1. These structural models require alternative estimation methods. xi ) we can deﬁne a linear projection equation (3. In contrast. and under-predicts for the rest.1 may be false.5. Most importantly. In Figure 1. In other cases the two may be quite diﬀerent. there are no changes in our methods or analysis. However. Figure 3. It over-predicts wages for young and old workers.

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

Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . If yi = x0 β + ei and E(ei | xi ) = 0. Prove parts 2. a constant. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . µx = Exi . True or False.1.2. E(ei | xi ) = 0.4 . 2. Let xi and yi have the joint density f (x. i 8. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . Are they diﬀerent? Hint: If P (Y = j) = 5. e−λ λj j! . xi ∈ R. s) = 0 if and only if m = µ and s = σ 2 . µ. Compute E(yi | xi = x) and V ar(yi | xi = x).3 Find E(Y | X = x). then E(x2 ei ) = 0. 1. and E(ei | xi ) = 0. 2. True or False. and E(e2 | xi ) = σ 2 . E(Y 2 | X = x) and V ar(Y | X = x).3. If yi = xi β + ei . σ = . and E(xi ei ) = 0. True or False.2 Y =1 . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. True or False. yi ). i 11. 9. Compute the conditional mean m(x) = E (yi | xi = x) . x 6. Suppose that yi is discrete-valued. 0 ≤ y ≤ 1. σ 2 = V ar(yi ) and σ xy = Cov(xi . True or False.. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. m. Suppose that Y and X only take the values 0 and 1.1 . then E(ei | xi ) = 0. j! 0 j = 0. . If yi = xi β + ei . 20 .6 Exercises 1. xi ∈ R. i 10. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . ¡ ¢ 4. then E(x2 ei ) = 0. (x − µ)2 − σ 2 Show that Eg (X. then ei is independent of xi . and have the following joint probability distribution X=0 X=1 Y =0 . taking values only on the non-negative integers. then ei is i i independent of xi . If yi = x0 β + ei . 3. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. Let X be a random variable with µ = EX and σ 2 = V ar(X). i 7.. σ 2 = V ar(xi ). 3 and 4 of Theorem 3. If yi = x0 β + ei and E(xi ei ) = 0.

3) In Sections 4.1 Estimation Equation (4. 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 Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi . i n i=1 n 21 .8. Observe that (4. i It follows that the moment estimator of β replaces the population moments in (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .4) i i=1 i=1 ˆ Another way to derive β is as follows. 4. we narrow the focus to the linear regression model. 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 .1) (4. (4.7 and 4.2) can be written in the parametric 0 β)) = 0.2) (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .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.

170 37.40 µ ¶µ ¶ 34.95 xi yi = 42. 0. 30 = . ¶ 2.117 Educationi . i 22 . 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. excluding military. This sample has 988 observations.14 14. Then µ ¶ n 1X 2.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. 4.71 = −2. 40 0. To illustrate. 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 (4.2 Least Squares There is another classic motivation for the estimator (4.4).117 1 14.95 42.4). 40 2.30 + 0. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.7% increase in mean wages.14 205.83 ¶−1 µ ¶ .5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.37 µ ¶ 1. These are white male wage earners from the March 2004 Current Population Survey.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.14 205. consider the data used to generate Figure 3. Let yi be log wages and xi be an intercept and years of education. with 10-15 years of potential work experience.14 14.3.ˆ This is a set of k equations which are linear in β.94 −2. An interpretation of the estimated equation is that each year of education is associated with an 11.

Figure 4. To visualize the sum-of-squared errors function.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. i ˆ ˆ Note that yi = yi + ei . while the residual is a by-product of estimation. Figure 4. 23 . The error is unobservable. Following convention we will call β the OLS estimator of β.4). These two ˆ variables are frequently mislabeled. It is important to understand the distinction between the error ei and the residual ei . the contour lines are ellipses. Since the function Sn (β) is a quadratic function of β.1: Sum-of-Squared Errors Function As a by-product of OLS estimation.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. Figure 4. which can cause confusion. Matrix calculus (see Appendix 2.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β).

ˆ n−k 2 i=1 (4. 24 . Its method of moments estimator is the sample average 1X 2 ei .5) implies that 1X xi ei = 0.7. one implication is that n 1X ei = 0. and hold true for all linear regression estimates.Figure 4. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero.7) A justiﬁcation for the latter choice will be provided in Section 4. It measures the variation in the i “unexplained” part of the regression. The error variance σ 2 = Ee2 is also a parameter of interest. ˆ n i=1 n Since xi contains a constant.6) An alternative estimator uses the formula n 1 X 2 s = ei .2: Sum-of-Squared Error Function Contours Equation (4. These are algebraic results. ˆ σ = ˆ n 2 i=1 n (4.

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

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

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

observe that ⎞ ⎛ ⎞ ⎛ .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.9). obtain OLS estimates β 2 and residuals e. . Regress Y on X2 . . ⎟ ⎜ ⎟ ⎜ (4. In the model (4. obtain residuals Y .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. . but in most cases there is little computational advantage to using the two-step algorithm. In this case. 4. is the demeaning formula for regression. which you may have seen in an introductory econometrics course. 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. . . 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) . . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . and X2 is the vector of observed regressors. . Regress X2 on X1 . Rather. obtain residuals X2 . 30 .Theorem 4. . ˆ ˜ ˜ ˆ 3.14) or via the ˆ following algorithm: ˜ 1. the FWL theorem can be used to speed computation. ˆ which are “demeaned”. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. the primary use is theoretical. In some contexts. Partition X = [X1 X2 ] where X1 = ι is a vector of ones.6. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. By the independence of the observations and (3. Regress Y on X1 . . ⎠ ⎝ ⎠ ⎝ . .9). A common application of the FWL theorem.8)(3.13). In this section we derive the small sample conditional mean and variance of the OLS estimator. ¡ ¢−1 0 ι.1 (Frisch-Waugh-Lovell). ˜ 2.

. . and ³ ´ ¡ ¢−1 2 ˆ σ . Then given (4. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. ⎠ (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 . 0 0 ··· 0 0 . ⎝ . Next. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . under the of ˆ ¢ 2 | x = σ 2 .18). V ar β | X = X 0 X ⎟ ⎟ ⎟. From (4. .Using (4. X 0 DX = X 0 Xσ 2 . .8). 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.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 ..12). . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . . .19) ˆ and thus the OLS estimator β is unbiased for β. .20) . 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. the properties of conditional expectations. 1 n . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . and the trace operator observe that. σ 2 } = ⎜ .. and (4.

8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. Theorem 4. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. = σ2 n the ﬁnal equality by (4. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . As an alternative. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. Now consider the class of estimators of β which are linear functions of i the vector Y. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . By a calculation similar to those of the previous section. the estimator ˆ 2 deﬁned (4. which is (3. The following result. 32 . as it yields the smallest variance among all unbiased linear estimators. What is the best choice of A? The Gauss-Markov theorem.10). is a famous statement of the solution. Thus σ 2 is biased towards zero. ³ ´ ˜ E β | X = A0 Xβ.8)¢ ¡ (3. Thus since V ar (e | X) = In σ 2 under homoskedasticity. or in the projection model. the best (minimumvariance) unbiased linear estimator is OLS.9) plus E e2 | xi = σ 2 . and thus can be written as ˜ β = A0 Y where A is an n × k function of X. 4.1 Gauss-Markov. 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.7) is unbiased for σ 2 by this calculation. It is important to remember. known as the Gauss-Markov theorem. It is not unbiased in the absence of homoskedasticity.8.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 . that this estimator is only unbiased in the special case of the homoskedastic linear regression model. ˜ so β is unbiased if (and only if) A0 X = Ik . however. says that the least-squares estimator is the best choice. which we now present. In the homoskedastic linear regression model. In this case.

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

10 Omitted Variables xi = µ x1i x2i ¶ .22) 34 . (4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. 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 . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. He proves that generically the OLS estimator (4. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.9).10) for the class of models satisfying Assumption 3.Substituting in the expressions for π j . 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 . He observes that the above argument holds for all multinomial distributions.1.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words.5. the maximum likelihood estimator is identical to the OLS estimator. Chamberlain (1987) extends this argument to the case of continuously-distributed data. if the data have a discrete distribution. and thus so is the OLS estimator.

To see this. For example. β 1 6= γ 1 . This deﬁnition is not precise. the coeﬃcient on x2i in (4. then β is not deﬁned.11 Multicollinearity ˆ If rank(X 0 X) < k + 1.Now suppose that instead of estimating equation (4. The more relevant issue is near multicollinearity. the general model will be free of the omitted variables problem. By construction. 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 . Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.23) the short regression to emphasize the distinction. log(p2 ) and log(p1 /p2 ). To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. In this case. log(p1 ). When this happens. This is the situation when the X 0 X matrix is near singular. 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”. or second. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . Typically there are limits. i. we regress yi on x1i only. It is the consequence of omission of a relevant correlated variable.22) is zero. This is called strict multicollinearity. This happens when the columns of X are linearly dependent. 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. as many desired variables are not available in a given dataset. least-squares estimation of (4.22) by least-squares.. when the columns of X are close to linearly dependent. there is some α such that Xα = 0.23) where is the coeﬃcient from a regression of x2i on x1i . this arises when sets of regressors are included which are identically related. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). 4. which is often called “multicollinearity” for brevity. Goldberger (1991) calls (4. Typically.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. 35 .22) the long regression and (4. First. and the error as ui rather than ei . the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. this is rarely a problem for applied econometric practice. Most commonly. The diﬀerence Γβ 2 is known as omitted variable bias. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity.e. if X includes both the logs of two prices and the log of the relative prices.22). In general. except in special cases. Since the error is discovered quickly.

µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. We derive expression (4.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. the precision of individual estimates are reduced. ˆ ˆ (4. the OLS estimator based on the sample excluding the i’th observation. 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. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . that is. We can also deﬁne the leave-one-out residual ˆ ˆ ei. To investigate the possibility of inﬂuential observations.26) As we can see. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. If the i’th observation 36 . This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. 1] and sum to k. As a consequence. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. What is happening is that when the regressors are highly dependent. The hi take values in [0. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. since as ρ approaches 1 the matrix becomes singular.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.−i = yi − x0 β (−i) = (1 − hi )−1 ei . the worse the precision of the individual coeﬃcient estimates. ˆ i A simple comparison yields that ˆ ei − ei.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 .27) (4. deﬁne the leave-one-out least-squares estimator of β.25) below. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors.−i = (1 − hi )−1 hi ei . We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 .

which is considerably more informative than plots of the uncorrected residuals ei .27). The key is equation (2. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .This implies has a large value of hi . then this observation is a leverage point and has the potential to be an inﬂuential observation.1) in Section 2. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei . ˆ We now derive equation (4. Investigations into the presence of inﬂuential observations can plot the values of (4.25).

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

¥ 5. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. (5. So for all x. Let a + bx be the tangent line to g(x) at x = EX.1 Weak Law of Large Numbers (WLLN). =E U V p q p q Proof of Markov’s Inequality. If Xi ∈ Rk is iid and E |Xi | < ∞. n i=1 42 . denoted Zn →p Z as n → ∞. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q .2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. if for all δ > 0.3). The WLLN shows that sample averages converge in probability to the population average. We say that Zn converges in probability to Z as n → ∞. tangent lines lie below it. ¥ Proof of Holder’s Inequality. Eg(X) ≥ a + bEX = g(EX). 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}. then as n → ∞ n 1X Xn = Xi →p E(X).Markov’s Inequality. as stated. Applying expectations. Note EU = EV = 1. Set Y = g(X) and let f denote the density function of Y.2. P (g(X) > α) ≤ α−1 Eg(X). p p p q which is (5. Theorem 5.4) Proof of Jensen’s Inequality. Since g(x) is convex. 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 ) = + . n→∞ lim P (|Zn − Z| > δ) = 0. For any strictly increasing function g(X) ≥ 0.

4).6) By Jensen’s inequality (5. and the bound |Wi | ≤ 2C.6) and (5.5).Proof: Without loss of generality. where Z has distribution F (x) = P (Z ≤ x) .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. Fix δ and η. the fact that the Wi are iid and mean zero. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. if for all x at which F (x) is continuous. (5. Jensen’s inequality (5. as needed. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . the fact that X n = W n + Z n . P ¯X n ¯ > δ ≤ η.3.1). We say that Zn converges in distribution to Z as n → ∞. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .1 Central Limit Theorem (CLT). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . Theorem 5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) .3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . 5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. the triangle inequality. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. by Markov’s inequality (5. V ) . If Xi ∈ Rk is iid and E |Xi |2 < ∞. 43 . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. denoted Zn →d Z.7).1) and (5. Fn (x) → F (x) as n → ∞. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. we can set E(X) = 0 (by recentering Xi on its expectation). Finally. 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.

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

then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. gθ Σgθ . k ≤ m. If Zn →d Z as n → ∞ and g (·) is continuous. and g(θ) : Rm → Rk . 45 .4.√ where λn → 0 lies on the line segment joining 0 and λ/ n. then g(Zn ) →d g(Z) as n → ∞. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).4. ¥ 5. 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 . √ Theorem 5. Recall that A ⊂ B implies P (A) ≤ P (B). Stacking across elements of g. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0.3 Delta Method: If n (θn − θ0 ) →d N (0. Theorem 5. Ik ) distribution. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. If Zn →p c as n → ∞ and g (·) is continuous at c. where θ is m × 1 and Σ is m × m. Σ) .4 Asymptotic Transformations Theorem 5.1 Continuous Mapping Theorem 1 (CMT). Proof: Since g is continuous at c.2 Continuous Mapping Theorem 2. This is suﬃcient to establish the theorem.4. Σ) = N 0. Proof : By a vector Taylor series expansion. we see that as n → ∞. Hence g(Zn ) →p g(c) as n → ∞. for each element of g. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Since cλλ (λn ) → cλλ (0) = −Ik . then g(Zn ) →p g(c) as n → ∞. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.

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

1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.1).1. Hence by the continuous mapping theorem (Theorem 5.5. we will use the methods of asymptotic approximation.5. For a complete argument.1 by the fact that the sampling densities become more concentrated as n gets larger. the OLS estimator β is has a statistical distribution which is unknown. n i=1 (6. xi ei →p g (Q. 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 . and the continuous mapping theorem (Theorem 5.1 and the WLLN (Theorem 5.3). Proof. 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.1. Equation (4. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. This is illustrated in Figure 6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.5. using (6.4.1) and ˆ We now deduce the consistency of β.1 Under Assumption 3. ·) is continuous at (Q.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . First.2) i i n i=1 n From (6.1). 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. we can conclude ˆ that β →p β.4 implies that Q−1 exists and thus g(·. To characterize the sampling distribution more fully. 6.1).2. Assumption 3.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. (6.4.2). β →p β as n → ∞. Ã n ! n X 1X 0 1 ˆ xi xi .1).2 Consistency ˆ As discussed in Section 6. (6. ˆ 47 .3) Ã where g(A. ˆ Theorem 6.2. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . 0). As the sample size increases the density becomes more concentrated about the population coeﬃcient. Assumption 3. (6.1.

1 guarantees that the elements of Ω are ﬁnite. E ¯ei ¯ E ¯e4 ¯ i i i i (6. We need a strengthening of the moment conditions.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.1).1.2 Under Assumption 3. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .1).3. (6. it follows that s2 = ¥ n σ 2 →p σ 2 .5.6) n i=1 48 . ˆ n−k 6.3) and Theorem (6.1 In addition to Assumption 3. i i Assumption 6. (6. Thus σ 2 is consistent for σ 2 .2.Theorem 6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. Assumption 6. by the Cauchy-Schwarz inequality (5.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.3. n 1 X √ xi ei →d N (0. By the central limit theorem (Theorem 5.1. since n/(n − k) → 1 as n → ∞. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Ee4 < ∞ and E |xi |4 < ∞.2). To see this.2). Ω) .2. ˆ Finally. (6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .5. (6.3.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. ˆ Proof.

7) holds. Theorem 6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .Then using (6. As α approaches 2.3.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. Let yi = β 0 + β 1 xi + εi where xi is N (0.1 states that the sampling distribution of the least-squares estimator. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. We illustrate this problem using a simulation. However. but this is not a necessary condition.3. Ω) ¡ ¢ = N 0. xi ) which satisfy the conditions of Assumption 6. The expression V = Q−1 ΩQ−1 is called a sandwich form.3. How large should n be in order for the approximation to be useful? Unfortunately. The approximation may be poor when n is small. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. For α 49 . When (6. We say that ei is a Homoskedastic Projection Error when (6.1.7) is true or false. when xi and ei are independent. (6. setting n = 100 and varying the parameter α. V ) where V = Q−1 ΩQ−1 . 1 X √ xi ei n i=1 n ! the N (0.9) In (6. otherwise V 6= V 0 . e2 ) = 0.7) Cov(xi x0 . is approximately normal when the sample size n is suﬃciently large.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. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. In Figure 6.6).3. The trouble is that no matter how large is the sample size. for example.7) is true then V = V 0 .1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . There is a special case where Ω and V simplify. 1).9) we deﬁne V 0 = Q−1 σ 2 whether (6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). This holds true for all joint distibutions of (yi . i i Condition (6. Q−1 ΩQ−1 .1 Under Assumption 6. and (6. In´Figure 6. however. We call V 0 the homoskedastic covariance matrix. after rescaling. 1) asymptotic distibution. Under (6. |ε| ≥ 1.3. V is often referred to as ˆ the asymptotic covariance matrix of β.2).2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0. The asymptotic distribution ´ Theorem 6.1).1. there is no simple answer to this reasonable question. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . its variance diverges q ³ ´ ˆ to inﬁnity.

As α diminishes the density changes signiﬁcantly.11) 50 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . concentrating most of the probability mass around zero. we need an estimate of Ω = E xi x0 e2 .10) V 0 = Q−1 s2 .4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.3.0 the density is very close to the N (0. 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. 1).2. 4. for k = 1. 1) asymptotic approximation is never guaranteed to be accurate. 1) density. Another example is shown in Figure 6. 6. The estimator 2 2 in (6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.2) and Theorem 6.2 and 6. The lesson from Figures 6.1) it is clear that V 0 →p V 0 . We show the sampling distribution of n β 1 − β 1 setting n = 100.2: Density of Normalized OLS estimator α = 3. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. 6 and 8. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. As k increases. the sampling distribution becomes highly skewed and non-normal.Figure 6.10) without changing this result.3 is that the N (0.

ˆ ˆ Deﬁnition 6. The methods switched during ˆ the late 1980s and early 1990s. as it is not always clear which has been computed. . ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar.4. Generically. standard errors are not unique. the “Eicker-White formula”. k. we set s(β) = n−1/2 V . j = 0... ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . 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)...1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. we focus on individual elements of β one-at-a-time. When reading and reporting applied work. This motivates the deﬁnition of a standard error. many authors will state that their “standard errors have been corrected for heteroskedasticity”. the “Huber-White formula” or the “GMM covariance matrix”. or that they use a “heteroskedasticity-robust covariance matrix estimator”. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. ˆ ˆ When V is used rather than the traditional choice V 0 . In most cases. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . vis. and was still the standard choice for much empirical work done in the early 1980s. β j .Figure 6. as there may be more than one estimator of the variance of the estimator. these all mean the same thing. the “Huber formula”. It is therefore important to understand what formula and method is 51 . 1. A more easily interpretable measure of spread is its square root — the standard deviation. or that they use the “White formula”. ˆ The estimator V 0 was the dominate covariance estimator used before 1980.3: Sampling distribution where ei are the OLS residuals. When β is a vector. and V is an estimator of the variance of n β − β .

199 2.020. and then the square roots.6 ¶µ 1 14.2.14 205.493 0. just as any other estimator.20 = V 14. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.14 14. p ˆ In this case the two estimates are quite similar.199 2. i i i i n i=1 Second. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .14 14.30 + 0.5) and the WLLN (Theorem 5. Using (6.020) 6.039 and ˆ V = µ 1 14.83 −0.1.80 .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.14 205.493 −0.480 ˆ0 = 0.80 40.80 2.14 6.35/988 = . First. We calculate that s2 = 0.14 205.035 ¶ . n n i=1 52 .98 −0. Ω 2. we return to the log wage regression of Section 4.12) in turn.117 Educationi .80 40. by Holder’s inequality (5.480 . then take the diagonal elements. (6. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .085) (.used by an author when studying their work. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. from which it follows that V →p V as n → ∞.20 −0. From a computational standpoint.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 . (6.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. but not under another set of assumptions. To illustrate. The standard errors for β 0 are 7.085 p ˆ and that for β 1 is .12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.20 and µ ¶ ˆ = 0.83 ¶−1 µ .2/988 = . (.83 ¶−1 = µ 7.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.

From equation (3.25). ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . n i=1 n ˆ ˆ Theorem 6. ¯ ¯n ¯ n i=1 so Together. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . you can show that 1 Xˆ ¯ β= β (−i) .13) Using formula (4.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . 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 (6.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . these establish consistency. by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. Andrews (1991) suggested an similar estimator based on cross-validation.−i = (1 − hi )−1 ei ˆ presented in (4.1 As n → ∞.13) of Efron (1982).11) with the leave-one-out estimator ei.5.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. 6. Using this substitution. Recall from Section 4. Ω →p Ω and V →p V. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. i=1 Third.26). They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. ¯ 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. 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. which.

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

Vθ ) √ Vθ = N (0. θ) β 6. In this case. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . 55 . Since the standard normal distribution does not depend on the parameters. s(ˆ = n−1/2 H 0 V Hβ .For example.8. that (so θ ˆ ˆ ˆ is. (For example. if R is a “selector matrix” R= so that if β = (β 1 . A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. µ I 0 ¶ ˆ the upper-left block of V . the statistic tn has an exact t distribution. In general. see Section X). Consider the studentized statistic tn (θ) = Theorem 6. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. s(ˆ θ) (6. and is therefore exactly free of unknowns. ˆ When q = 1q h(β) is real-valued). ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. 1) Proof.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal.1 tn (θ) →d N (0. the standard error for ˆ is the square root of n−1 Vθ . 1) →d ˆ−θ θ . we say that tn (θ) is asymptotically pivotal. By (6.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. In special cases (such as the normal regression model. however. θ could be a single element of β). β 2 ).8 t tests Let θ = h(β) : Rk → R be any parameter of interest. we say that tn is an exactly pivotal statistic. and θ = h(β) is some function of the parameter vector.

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

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). 6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. This corresponds to selecting the conﬁdence h i h ˆ ± 1. 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. and it is desired to test the joint restrictions simultaneously. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6.96s(ˆ ≈ ˆ ± 2s(ˆ . θ The interval has been constructed so that as n → ∞.18) . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. or α = . ˆ + zα/2 s(ˆ . 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 . However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.16) and zα/2 is the upper α/2 quantile of the standard normal distribution.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). In this case the t-statistic approach does not work. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.05. θ θ) (6. the most common professional choice isi95%. 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). and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value.

˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . Also h(β) = a selector matrix. Furthermore. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.1. Hence β β by Theorem A. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . Hβ (β) →p Hβ .1 Under H0 and Assumption 6. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. Vθ ). and Theorem 6.10. θ = β 2 .2.5. ˜˜ n ˜ e = Y − X1 β 1 .1 showed θ ˆ that V →p V. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). 1] under H0 . Hβ (β) is a continuous function of β. χ2 (. 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 . 6. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . In this case. a chiq square random variable with q degrees of freedom. then Wn →d χ2 . The null hypothesis is H0 : β 2 = 0.15) showed that n ˆ − θ →d Z ∼ N (0. For example. and there are q = k2 restrictions.19) σ2 ˆ where σ2 = ˜ 1 0 e e.When h is a linear function of β. ˆ Wn = n θ θ q θ θ Theorem 6.84 = z.025 .3. if rank(Hβ ) = q. the test rejects at the α% level iﬀ pn < α. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.05) = 3. As before. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). 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. q and pn is asymptotically U[0. The asymptotic p-value for Wn is pn = p(Wn ). 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.8. the upper-α quantile q 2 of the χ2 distribution. h(β) = R0 β.

note that partitioned matrix inversion (2.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ .are from OLS of Y on X1 . = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. By the FWL theorem. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . X2 ). We now derive expression (6.19) the F form of the Wald statistic. The elegant feature about (6. Now consider the residual regression of e on X2 = M1 X2 . ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . First. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. Also. 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 σ ˆ To simplify this expression further.19) is that it is directly computable from the standard output from two simple OLS regressions.19). ˆˆ n ˆ e = Y − X β. Because of this connection we call (6. 2 2 2 or alternatively. note that if we regress Y on X1 alone. since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. as the sum of squared errors is a typical output from statistical packages. still this formula often ﬁnds good use in reading applied papers. Thus ¡ 0 ¢−1 R = X2 M1 X2 and ³ ¡ ´−1 ³ ¢−1 ´−1 ¡ 0 ¢ ˆ = σ −2 n−1 R0 X 0 X ˆ R = σ −2 n−1 X2 M1 X2 ˆ R0 V 0 R ³ ´−1 ˆ0 ˆ ˆ Wn = nβ 2 R0 V 0 R β2 = 0 ˆ ˆ0 β 2 (X2 M1 X2 ) β 2 .2) ¢−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 . and σ2 = ˆ 1 0 e e. 59 . the residual is ˜ ˜ e = M1 Y.

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

β 2 .8. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . so as a practical matter it does not matter which distribution is used. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ ˆ ˆ βj − βj βj − βj N (0. β 2 .1 and Theorem 6. σ 2 ) = − log σ − log (2π) − .) Now let us partition β = (β 1 .1 we showed that in large samples.10) then ´ ³ ˆ • β ∼ N 0. σ 2 ) discussed above.10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ 2 ) − Ln (β 1 . (Unless the sample size is unreasonably small.3. We summarize these ﬁndings Theorem 6. a good testing procedure is based on the likelihood ratio statistic.1 If ei is independent of xi and distributed N(0. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . As inference (conﬁdence intervals) are based on the t-ratio. Theorem 6. and standard errors are calculated using the homoskedastic formula (6. 0. In contrast. σ2 ˆ 61 . σ 2 ). β and t are approximately normally distributed. Furthermore.a chi-square distribution with n − k degrees of freedom. if standard errors are calculated using the homoskedastic formula (6. the notable distinction is between the N (0.12. 1) and tn−k distributions. β has an exact normal distribution and t has an exact t distribution. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . 0.1 shows that under the strong assumption of ˆ normality. The critical values are quite close if n − k ≥ 30. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. β 2 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . 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. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . n−k • ∼ tn−k ˆ In Theorem 6. with residual variance σ . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. 0.12.

In the present context of the Wald statistic. Letting h(β) = β s . Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . Take the model yi = β + ei ei ∼ N (0. setting n/σ 2 = 10. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. ˆ Let β and σ 2 be the sample mean and variance of yi . LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. This produces random draws from the sampling distribution of interest. 6. 62 . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. 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.4 the Wald statistic Wn (s) as a function ˆ of s. they can work quite poorly when the restrictions are nonlinear. σ 2 ) and consider the hypothesis H0 : β = 1. as Wn (s) →d χ2 under H0 for 1 any s.7. To demonstrate this eﬀect. The increasing solid line is for the case β = 0. while there are other values of s for which test test statistic is insigniﬁcant.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . This can be seen by a simple example introduced by Lafontaine and White (1986). σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. we have plotted in Figure 6. This is an unfortunate feature of the Wald statistic.84 — the probability of a false rejection. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. The decreasing dashed ˆ = 1. the statistic Wn (s) varies with s. and noting Hβ = sβ s−1 . features of this distribution can be calculated. Through repetition. Our ﬁrst-order asymptotic theory is not useful to help pick s. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 .8.

000 simulated Wald statistics Wn (s) which are larger than 3. remember that the ideal Type I error probability is 5% (. the Type I error probability improves towards 5% as the sample size n increases.84. and rarely fall outside of the 3%-8% range.000 random samples.1 reports the simulation estimate of the Type I error probability from 50. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. n. Type I error rates between 3% and 8% are considered reasonable. and σ 2 . Given the simplicity of the model. These probabilities are calculated as the percentage of the 50. Rates above 20% are unexceptable. In each case.05) with deviations indicating+ distortion. To interpret the table. The null hypothesis β s = 1 is true. n is varied among 20. Table 4. so these probabilities are Type I error.1 you can also see the impact of variation in sample size. The value of s is varied from 1 to 10.Figure 6. we compare the rates row by row. looking for tests for which rate rejection rates are close to 5%. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . For this particular example.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Test performance deteriorates as s increases.4. Table 4.84 | β = 1) .4: Wald Statistic as a function of s P (Wn (s) > 3. the only test which meets this criterion is the conventional Wn = Wn (1) test. this probability depends only on s. In Table 4. There is. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. Typically. however. and σ is varied among 1 and 3. When comparing statistical procedures. Any other choice of s leads to a test with unacceptable Type I error probabilities. no magic choice of n for which all tests perform uniformly well. 100 and 500. In Table 2. Error rates avove 10% are considered excessive.

12 .15 .06 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.09 . This point can be illustrated through another example.13 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.30 .22 .34 .22 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. deﬁne θ = β 1 /β 2 . β 1 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .15 .35 .11 .05 .10 .06 .18 .06 . so the hypothesis can be stated as H0 : θ = r.14 . Other choices are arbitrary and would not be used in practice.16 Rejection frequencies from 50.08 . 64 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . Equivalently.26 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .23 .10 .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 .05 .19 .21 .07 .10 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.13 .08 .06 . β 2 ) be the least-squares estimates of (6.05 .08 .24 .15 .08 .25 . While this is clear in this particular example.31 .20 .05 .07 .14 .07 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.17 .20).13 .25 .06 .05 .20 .06 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .15 .28 .07 .05 .12 .06 .06 .33 .07 .08 .

In this section we describe the method in more detail. .645) P (tn > 1. Ideally.00 .10 . if the hypothesis can be expressed as a linear restriction on the model parameters.15 .10 . .06 . and are close to the ideal 5% rate for both sample sizes. along with sample size n.28 .15 .25.00 The one-sided Type I error probabilities P (tn < −1.12 .645) and P (tn > 1. Table 4.06 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.06 . and 1.000 simulated samples.50.645) P (tn > 1. 65 .09 . 1) variables.05 .05 .2.7. and normalize β 0 = 0 and β 1 = 1. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .05 . 6. the entries in the table should be 0.645) P (tn < −1.10 . while the right tail probabilities P (t1n > 1. .00 . In contrast.00 .00 . then the “most linear” formulation should be selected. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. The results are presented in Table 4. the rejection rates for the t1n statistic diverge greatly from this value.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) are close to zero in most cases.00 . We vary β 2 among .06 . this formulation should be used.05 . and alternatives to asymptotic critical values should be considered. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . We let x1i and x2i be mutually independent N (0.645) are calculated from 50.06 .06 .26 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.75 1.00 .05 . If no linear formulation is feasible.05 β2 . ei be an independent N (0.47 .06 .50 . This leaves β 2 as a free parameter.02 .1. However.05 .00 .0 and n among 100 and 500.645) t1n t2n t1n t2n t1n t2n t1n t2n . The left tail probabilities P (t1n < −1.06 . especially for small values of β 2 .05 . such as the GMM distance statistic which will be presented in Section 9.07 . σ 2 ) draw with σ = 3.05 . It is also prudent to consider alternative tests to the Wald statistic. The implication of Table 4.645) greatly exceed 5%.06 .05 .00 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.06 .25 .05.00 . In all cases.75.

These results are stored. it is important that the statistic be evaluated at the “true” value of θ corresponding to the choice of F. where B is a large number. F ) = P (Tnb ≤ x) = P (Tn ≤ x | F ) . They constitute a random sample of size B from the distribution of Gn (x. F ) can be calculated numerically through simulation.Recall. ∗ ∗ • The statistic Tn = Tn (y1 . We then set Tn = ˆ − θ. A “true” value of θ is implied by this choice. The above experiment creates one random draw from the distribution Gn (x. 1) random numbers. x∗ . Let θ be a parameter and let Tn = Tn (y1 .. the distribution function Gn (x.. F ). F ) for selected choices of F. and from these most random variables can be constructed. which implies restrictions on F .. are drawn from the distribution F using i the computer’s random number generator. 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 .) For step 2. xn . a chi-square can be generated by sums of squares of normals. . Clearly. n. where games of chance are played. i = 1. The method of Monte Carlo is quite simple to describe. The basic idea is that for any given F. For example: Suppose we are interested in the bias. x∗ ... θ) is calculated on this pseudo data. The name Monte Carlo derives from the famous Mediterranean gambling resort. Typically. run the above experiment. So the researcher repeats the experiment B times. let the b0 th experiment result in the draw Tnb . While the asymptotic distribution of Tn might be known. 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. θ) be a statistic of interest.... This is useful to investigate the performance of the statistic Tn in reasonable situations and sample sizes.. from one observation very little can be said. . Monte Carlo simulation uses numerical simulation to compute Gn (x. mean-squared error (MSE)... Gn (x. xi ) which are random draws from a population distribution F.. (For example. or equivalently the value θ is selected directly by the researcher. n n For step 1. yn . we can estimate any feature of interest using (typically) a method of moments estimator. the exact (ﬁnite sample) distribution Gn is generally unknown. F ) = P (Tn ≤ x | F ) . our data consist of observations (yi . or variance of the distribution ˆ − θ. Then the following experiment is conducted ∗ • n independent random pairs (yi . Notationally. yn . 1] and N (0. From a random sample. x∗ ) . This is one observation from an unknown distribution. We will discuss this choice later. b = 1. most computer packages have built-in procedures for generating U [0. we set B = 1000 or B = 5000. B. x1 .

this may ˆ be approximated by replacing P with P or with an hypothesized value. experience squared. B. immigrant. and dummy variable indicators for the following: married.96) . a larger B results in more precise estimates of the features of interest of Gn . The α% sample quantile is a number qα such that α% of the sample are less than qα . B b=1 (6. It is therefore useful to conduct a variety of experiments. For regressors we include years of education. and non-white. and 5000.96) . union member. we included a dummy 67 . if we are ³ ´ p √ ˆ assessing an asymptotic 5% test.95) /B ' . and dummy variable indicators for the following: married. The random variable 1 (Tnb ≥ 1. union member. In many cases. Again our dependent variable is the natural log of wages. for a selection of choices of n and F. the performance will depend on n and F. We now expand the sample all non-military wage earners. For example. We us the sample of wage earners from the March 2004 Current Population Survey.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. Often this is called the number of replications. For the dependent variable we use the natural log of wages.15 Estimating a Wage Equation We again return to our wage equation.96) is iid Bernoulli. therefore. excluding military. if we set B = 999. 6. 1000. but requires more computational time. and poorly for others. For example.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. potential work experience. Hence the ³ ´ ˆ standard errors for B = 100. and therefore it is straightforward to calculate standard errors for any quantity of interest. We separately estimate equations for white and non-whites. Generally. such as the percentage estimate reported in (6. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. the choice of B is often guided by the computational demands of the statistical procedure. are. then we can set s P = (. respectively. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. potential work experience.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. an estimator or test may perform wonderfully for some values. and estimate a multivariate regression. Then qα is the N ’th number in this ordered sequence. It is therefore convenient to pick B so that N is an integer. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. where N = (B +1)α. female. and 90% sample quantiles of the sample {Tnb }. female.003. equalling 1 with probability P = E1 (Tnb ≥ 1. then B will have to be increased. . so that coeﬃcients may be interpreted as semi-elasticities.05) (. and our regressors include years of education. it is simple to make inferences about rejection probabilities from statistical tests. and hispanic. Quite simply. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. hispanic.22/ B. As discussed above. experience squared. In particular. As P is unknown.022. Furthermore. The average (6. immigrant. In practice. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. If the standard error is too large to make a reliable inference. the researcher must select the number of experiments.007. s P = .21). and .

reestimating the model with the 50 state dummies excluded.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.097 −.808 .4945.070 .014 .007 . Alternatively.032 . but not equal. Computing the Wald statistic (6.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. Using either statistic the hypothesis is easily rejected.69.48772 = 515.232 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.808 so the parameter estimates are quite precise and reported in Table 4.1. 2β 3 68 .00002 .101 . excluding the coeﬃcients on the state dummy variables. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. The F form of 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.4877 18.102 −.008 . Ignoring the other coeﬃcients. the restricted standard deviation estimate is σ = .variable for state of residence (including the District of Columbia.033 −. this adds 50 regressors).102 −. 808 1 − . we ﬁnd Wn = 550.34 ˆ s(β) .001 .002 . Table 4.013 .18) that the state coeﬃcients are jointly zero. The available sample is 18.121 −.49452 σ ˜ Notice that the two statistics are close.00057 .027 .010 . θ ˆ 2β 3 β2 . as the 1% critical value for the χ2 distribution is 76. Wn = n 1 − 2 = 18.19) is ˜ µ ¶ µ ¶ σ2 ˆ .

5]. In the present context we are interested in forming a conﬁdence interval. there is not a simple expression for this set.96.Using the Delta Method. 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 ).40. This set is [27. so we have to go one step further. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. implying a 95% conﬁdence θ) interval of [27. this is a poor choice. 29. but it can be found numerically quite easily. 29. Instead. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. 69 . we found better Type I error rates by reformulating the hypothesis as a linear restriction. However. This is the set of θ such that |tn (θ)| ≤ 1.9.5]. but the lower end is substantially lower. In the previous section we discovered that such t-tests had very poor Type I error rates.0. we can calculate a standard error of s(ˆ = . Since tn (θ) is a non-linear function of θ. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. not testing a hypothesis.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

. If σ 2 < 0 for some i. We may call (7. Furthermore. This is the feasible GLS.6) σ 2 = α0 zi . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7.. estimator of β. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . Then set ˜i ˜ D = diag{˜ 2 . which is typically undesirable. and hence we can estimate 0 σ 2 = zi α by i ˜ (7.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. This suggests 75 . Vα = E zi zi (7. and will depend on the model (and estimation method) for the skedastic regression. then the FGLS estimator will force ˜i the regression equation through the point (yi . One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . or FGLS. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0..4) the skedastic regression. then the FGLS ˜i estimator is not well deﬁned. ˜i Suppose that σ 2 > 0 for all i. as it is estimating the conditional variance of the regression of yi on xi .Suppose ei (and thus η i ) were observed. if σ 2 ≈ 0 for some i. Vα ) (7. there is no guarantee that σ 2 > 0 for all i. We have shown that α is consistently estimated by a simple procedure. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi . ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say.. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β).3) ˆ ˆ While ei is not observed. xi ).

1 If the skedastic regression is correctly speciﬁed. A trimming rule might make sense: σ 2 = max[˜ 2 . There are three reasons. This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞. similar to the covariance matrix of the OLS estimator. . Instead. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). In this case we interpret α0 zi as a linear projection of e2 on zi . FGLS estimation depends on speciﬁcation and estimation of the skedastic regression.. V ). It is possible to show that if the skedastic regression is correctly speciﬁed.1. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. β should perhaps be i i called a quasi-FGLS estimator of β. We just state the result without proof. the natural estimator of the asympˆ totic variance of β is Ã n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . V ˜ An appropriate solution is to use a White-type estimator in place of V 0 ..1. σ 2 ] σi i for some σ 2 > 0. ´´−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 . 1992). Unless σ 2 = α0 zi . and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. Since the form of the skedastic regression is unknown. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. then FGLS is asymptotically equivalent to GLS. Theorem 7.. e2 }. This estimator V 0 is appropriate when the skedastic regression (7. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . FGLS is asymptotically superior to OLS.that there is a need to bound the estimated variances away from zero. First. i ˜ 0 is inconsistent for V .1. In the linear regression model. and it may be estimated with considerable 76 V takes a sandwich form√. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. V n n i=1 . Its asymptotic variance is not that given in Theorem 7.1.2) is correctly speciﬁed.1. ¢¢−1 ¡ ¡ . but the proof of this can be tricky. Why then do we not exclusively estimate regression models by FGLS? This is a good question. and was proposed by Cragg (Journal of Econometrics.

3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. the Wald test of H0 is asymptotically χ2 .3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . We may therefore test this hypothesis by the estimation (7.error. Third. require the assumption of a correct conditional mean.4) and constructing a Wald statistic.4).2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . q Most tests for heteroskedasticity take this basic form. σ 2 ). And the FGLS probability limit will depend on the particular function selected for the skedastic regression. on the other hand. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . the estimated conditional variances may contain more noise than information about the true conditional variances. Vα = E zi zi (7. Second. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0.2. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. its squares. or equivalently that i H0 : α1 = 0 in the regression (7.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. This introduces an element of arbitrariness which is unsettling to empirical researchers. and not a conditional mean.5) and the asymptotic variance (7.1 Under H0 and ei independent of xi . but also under the assumptions of linear projection. The GLS and FGLS estimators. If the equation of interest is a linear projection. The asymptotic distribution (7. It is consistent not only in the regression model. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. Typically. In the linear regression model the conditional mean of yi given xi = x is 77 . but the only diﬀerence is that they a ¢ allowed for general choice of zi .7) under independence show that this test has an asymptotic chi-square distribution. however. individual estimated conditional variances may be negative. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . In this case. and the cost is a reduction of robustness to misspeciﬁcatio 7. Theorem 7. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.2). and this requires trimming to solve. The main diﬀerences between popular “tests” is which transformations of xi enter zi . as they will be estimating two diﬀerent projections. OLS is a more robust estimator of the parameter vector. and all cross-products. the two tests coincide. 7. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. FGLS will do worse than OLS in practice. This hypothesis does not imply that ξ i is independent of xi . If i this simpliﬁcation is replaced by the standard formula (under independence of the error).

the width of the conﬁdence set is dependent on x. For a given value of xi = x. but this turns out to be incorrect. In general. we see that m(x) = ˆ = x0 β and Hβ = x. Thus an asymptotic 95% conﬁdence interval for m(x) is θ) It is interesting to observe that if this is viewed as a function of x. σ 2 ).4 NonLinear Least Squares In some cases we might use a parametric regression function m(x. p h i ˆ ˆ x0 β ± 2 n−1 x0 V x . this has variance ³ ´³ ´0 ¡ ¢ ˆ ˆ Eˆ2 = E e2 | xi = x + x0 E β − β β − β x ei i = σ 2 (x) + n−1 x0 V x. we need to estimate the conditional distribution of ei given xi = x. Notice that this is diﬀerent from the standard ˆ ˆ error for the conditional mean. 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 validity of an asymptotic conﬁdence interval is based on the asymptotic normality of the studentized ratio. We would also like a measure of uncertainty for ˆ the forecast.6). which is a much more diﬃcult task. many applied forecasters focus h i ˆ on the simple approximate interval x0 β ± 2ˆ(x) . The only special exception is the case where ei has the exact distribution N (0. Letting h(β) = x0 β and θ = h(β). We describe this setting as non-linear regression. s 7. Notice that this is a (linear) ˆ ˆ θ function of β. In the present case. q 2 0 0 ˆ ˜ ˆ ˜ σ (x) = α z from (7. θ) = E (yi | xi = x) which is a non-linear function of the parameters θ.In some cases. which is generally invalid. so a standard ˆ i p ˆ error for the forecast is s(x) = σ 2 + n−1 x0 V x. ³ ´ ˆ ˆ The forecast error is ei = yi − m(x) = ei − x0 β − β . so p ˆ s(ˆ = n−1 x0 V x. As the out-of-sample error ei is ˆ ˆ independent of the in-sample estimate β. s(x) ˆ But no such asymptotic approximation can be made. 78 . the natural estimate of this variance is σ 2 + n−1 x0 V x. To get an accurate forecast interval. ¡ ¢ ˆ Assuming E e2 | xi = σ 2 . A reasonable rule is the conditional mean m(x) as it is the mean-square-minimizing forecast. we want to estimate m(x) at a particular point x. this would require the asymptotic normality of the ratio ³ ´ ˆ ei − x0 β − β . e. we may want to forecast (guess) yi out-of-sample. A point forecast ˆ is the estimated conditional mean m(x) = x0 β.g. If we have an estimate of the conditional variance function. Given the diﬃculty.

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

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

let Y be a continuous random variable. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . Now let’s consider the conditional median of Y given a random variable X. however.To recall the deﬁnition and properties of the median.5.10) The LAD estimator has the asymptotic distribution 81 . Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. Two useful facts about the median are that (7. and the substantive assumption is that the median function is linear in x. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. These distinctions are illusory. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. The second is the value which minimizes n n |yi − θ| . the linear function M ed (yi | xi = x) = x0 β is the conditional median function.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. i n n i=1 (7. as i=1 these estimators are indeed identical. These facts deﬁnitions motivate three estimators of θ. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. The ﬁrst deﬁnition is the 50th empirical 1 P quantile.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.

1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. Computation of standard error for LAD estimates typically is based on equation (7. Let g(β) = Eg (β). While a complete proof of Theorem 7.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) .1 ´ √ ³ˆ n β − β 0 →d N (0. and this improves estimation of the median. V ). ∂β 0 so Third.10) is equivalent to g n (β) = 0. the height of the error density at its median. the conditional density of the error at its median. where V = and f (e | x) is the conditional density of ei given xi = x. This can be done with kernel estimation techniques. (7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . ˆ Proof of Theorem 7. Pn −1 0 β)) . we provide a sketch here for completeness. ∂ 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 ) . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. by a Taylor series expansion and the fact g(β 0 ) = 0 82 .11).1 is advanced. then there are many innovations near to the median. In the special case where the error is independent of xi . When f (0 | x) is large. The main diﬃculty is the estimation of f (0). Second using the law of iterated expectations and the chain rule of i diﬀerentiation.5. First. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. by the central limit theorem (Theorm 5. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . See Chapter 16.5.3.5.

5. For the random variables (yi . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. If the random variable U has τ ’th quantile Qτ . so you can think of the quantile as the inverse of the distribution function. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). then (7. ¥ 7. For τ ∈ [0. the quantile regression functions can take any shape. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . Again. then F (Qτ ) = τ . (7. when F (y | x) is continuous and strictly monotonic in y. Exi x0 ) →d i 2 = N (0. 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.9) for the median to all quantiles. The median is the special case τ = . then F (Qτ (x) | x) = τ . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . For ﬁxed τ . 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)) .13) This generalizes representation (7.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 (0.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . As functions of x. The third line follows from an asymptotic empirical process argument.12) Qτ = argmin Eρτ (U − θ) . The following alternative representation is useful. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . V ).

ˆ Given the representation (7.1 n β τ − β τ →d N (0. fast linear programming methods have been developed for this problem. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . since it has discontinuous derivatives. otherwise its properties are unspeciﬁed without further restrictions. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. if the model yi = x0 β + ei has i been ﬁt by OLS. 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. where and f (e | x) is the conditional density of ei given xi = x. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression.1. The null model is yi = x0 β + εi i 84 . n numerical methods are necessary for its minimization.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Another popular approach is the RESET test proposed by Ramsey (1969). the τ ’th conditional quantile of ei is zero. then f (0 | xi ) = f (0) . the asymptotic variance depends on the conditional density of the quantile regression error. Vτ ). and test their signiﬁcance using a Wald test. 7. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7.5.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . and are widely available. Thus. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). and form a Wald statistic i for γ = 0. it is useful to have a general test of the adequacy of the speciﬁcation.13). Furthermore. i By construction. When the error ei is independent of xi . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. ¡ ¡ ¢¢−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.12). conventional Newton-type optimization methods are inappropriate. Fortunately. the unconditional density of ei at 0.6. ´ √ ³ˆ Theorem 7.

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

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

and km is the number of coeﬃcients in the model. 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. 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. For some critical level α. let cα satisfy ¢ ¡ P χ22 > cα . LRn →p 0. That is. k ´ ³ c P M = M1 | M1 P (AIC1 < AIC2 | M1 ) µ ¶ k1 k1 + k2 2 2 σ | M1 = P log(ˆ 1 ) + 2 < log(ˆ 2 ) + 2 σ n n = P (LRn < 2k2 | M1 ) ¡ ¢ → P χ22 < 2k2 < 1. Indeed. known as the BIC. Then select M1 if Wn ≤ cα . k A major problem with this approach is that the critical level α is indeterminate.16) holds under M1 . Another common approach to model selection is to to a selection criterion. etc. M)) between the true density and the model density.15) then where σ 2 is the variance estimate for model m. k = While many modiﬁcations of the AIC have been proposed. based on Bayesian arguments. One popular choice is the Akaike Information Criterion (AIC).However. BIC model selection is consistent. since (7. Another problem is that if α is held ﬁxed. His criterion. In contrast to the AIC. ¢ ¡ ˆ1 ˆ2 (7.17) Since log(n) > 2 (if n > 8). is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . since under M1 . log(n) 87 . n (7. The rule is to select M1 if AIC1 < AIC2 . as the rule tends to overﬁt. then this model selection procedure is inconsistent. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. the most popular to be one proposed by Schwarz. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. as ³ ´ c P M = M1 | M1 → 1 − α < 1. The model selection rule is as follows.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . n (7. depending on the sample size. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. else select M2 . Indeed. AIC selection is inconsistent. If the truth is inﬁnite dimensional. if α is set to be a small number. this rule only makes sense when the true model is ﬁnite dimensional. else select M2 .

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

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

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

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

. for example an estimator ˆ or a t-statistic ˆ − θ /s(ˆ Note that we θ θ θ). as it depends on the sample through the estimator Fn . we say that Tn is asymptotically pivotal and use the distribution function G(x) for inferential purposes. write Tn as possibly a function of F . When G(x. inference would be based on Gn (x. Fn ) constructed on n 1.1) We call G∗ the bootstrap distribution. The bootstrap distribution is itself random.. Efron (1979) proposed the bootstrap. n n ∗ Let (yi . x1. F ). The statistic Tn = Tn (y1 . F ) ³ ´ be a statistic of interest. 92 . Gn (x. We call T ∗ this sample is a random variable with distribution Gn n n n ∗ the bootstrap statistic. A random sample from this i ∗ ∗ ∗ distribution is call the bootstrap data. which makes a diﬀerent approximation.. Plugged into Gn (x. F ) = G(x) does not depend on F. Bootstrap inference is based on G∗ (x). In a seminal contribution. F ) = limn→∞ Gn (x. xn . For example. In the next sections we describe computation of the bootstrap distribution. x∗ ) denote random variables with the distribution Fn . the t-statistic is a function of the parameter θ which itself is a function of F. ∗ . Fn ). yn . This is generally impossible since F is unknown. xi ) .Chapter 8 The Bootstrap 8. F ). . F ) = P (Tn ≤ x | F ) In general.. The exact CDF of Tn when the data are sampled from the distribution F is Gn (x. F ) we obtain G∗ (x) = Gn (x. n (8. x∗ . F ) depends on F. yn . x∗ .. The distribution of Tn is identical to that of Tn when the true CDF of Fn rather than F. That is. Asymptotic inference is based on approximating Gn (x. F ) with G(x. Let Tn = Tn (y1 . meaning that G changes as F changes. The unknown F is replaced by a consistent estimate Fn (one choice is discussed in the next section). Ideally..1 Deﬁnition of the Bootstrap Let F denote a distribution function for the population of observations (yi . P (T ∗ ≤ x) = G∗ (x).

F (y.. in the Figure below. x) − F (y. Fn (y. but the approximation appears to improve for the large n. For n = 25. I have plotted the EDF and true CDF for three random samples of size n = 25. the EDF is only a crude approximation to the CDF. x). i 93 . x) →p F (y. That is. x∗ ) with the i distribution Fn . (8.2 The Empirical Distribution Function Fn (y. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x) = n i=1 Figure 8.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi .3. Thus by the WLLN (Theorem 5. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . This is a population moment. 50.8. where 1(·) is the indicator function. The EDF is a consistent estimator of the CDF. the EDF step function gets uniformly close to the true CDF. x). 1) distribution. Furthermore.. x) = P (yi ≤ y.1). by the CLT (Theorem 5. Recall that F (y. ∗ P (yi ≤ y. To see the eﬀect of sample size on the EDF. xi ). i = 1. x∗ ≤ x) = Fn (y. . In general. x))) . To see this. x) . and 100.2. x) is called the empirical distribution function (EDF). n. it is helpful to think of a random pair (yi . √ n (Fn (y. x)) →d N (0.1). note that for any (y. Note that while F may be either discrete or continuous. x). Fn is a nonparametric estimate of F. Fn is by construction a step function.. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. x) (1 − F (y. The random draws are from the N (0.2) Fn (y. as the sample size gets larger. Notationally.

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

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

the x’th sample quantile of the ∗ . F0 ) = (1 − Gn (qn (α/2). θ This is a bootstrap estimate of the “ideal” conﬁdence interval 0 θ C1 = [ˆ + qn (α/2). F0 ) − Gn (−qn (1 − α/2). T ∗ }. so ¡ ¢ 0 P θ0 ∈ C1 = Gn (−qn (α/2). ∗ ˆ∗ Computationally. qn (α. The latter has coverage probability ³ ´ ¢ ¡ 0 θ P θ0 ∈ C1 = P ˆ + qn (α/2) ≤ θ0 ≤ ˆ + qn (1 − α/2) θ ´ ³ θ = P −qn (1 − α/2) ≤ ˆ − θ0 ≤ −qn (α/2) = Gn (−qn (α/2). That is. Let Tn (θ) = ˆ − θ and let qn (α) be the quantile function of its distribution. θ. if we deﬁne φ = f (θ) as the parameter of interest for a monotonic function f. θ−θ then Gn (−x. ∗ qn (1 − α/2)]. simple to motivate.8.5 Percentile Intervals For a distribution function Gn (x. F0 ) = 1 − Gn (x.. F0 )) ³ ³ α ´´ α´ ³ − 1− 1− = 1− 2 2 = 1−α 96 . F ) is discrete.. then percentile method ∗ ∗ applied to this problem will produce the conﬁdence interval [f (qn (α/2)). as discussed in the section on Monte Carlo simulation. F0 ) which generally is not 1−α! There is one important exception. and qn (α) = qn (α. However. was popularized by Efron early in the history of the bootstrap. F ) = α. This is because it is easy to compute. θ n ˆ + qn (1 − α/2)]. as we show now. and also has the feature that it is translation invariant. qn (1 − α/2)]. F0 ) − Gn (−qn (1 − α/2). f (qn (1 − α/2))]. C1 is in a deep sense very poorly motivated. . F0 ) denote the quantile function of the true sampling distribution. F ) denote its quantile function.] ∗ Let qn (α) = qn (α.. F0 )) − (1 − Gn (qn (1 − α/2). The simulated statistics {Tn1 nB ˆ∗ (1 − α)% Efron percentile interval is then [ˆn (α/2). ˆ lies in the region [qn (α/2). with θ subtracted. This is the function which solves Gn (qn (α. In (1 − α)% of samples. θ Let Tn = ˆ an estimate of a parameter of interest. F0 ). (These are the original quantiles. F ) may be non-unique. ˆ + q ∗ (1 − α/2)]. which is a naturally good property. the quantile qn (x) is estimated by qn (x). q∗ The interval C1 is a popular bootstrap conﬁdence interval often used in empirical practice. Fn ) denote the quantile function of the bootstrap distribution.) Then C1 can alternatively be written as ∗ θ C1 = [ˆ + qn (α/2). let qn (α. If ˆ 0 has a symmetric distribution. but we will ignore such complications. This motivates a conﬁdence interval proposed by Efron: ∗ C1 = [qn (α/2). Note that this function will change depending on the underlying statistic Tn whose distribution is Gn . This is often called the percentile conﬁdence interval. θ It will be useful if we introduce an alternative deﬁnition C1 . F ). F ). qn (1 − α/2)]. [When Gn (x.

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

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

where qn (α) is the (1 − α)% quantile of the distribution of Wn . n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .3 an = o(n−r ) if nr |an | → 0 as n → ∞. Thus here Tn (θ) = Wn (θ).1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. The following notation will be helpful. v 2 ). The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). We say that a function g(x) is even if g(−x) = g(x). C4 is called the symmetric percentile-t interval. Deﬁnition 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. θ [This is a typical mistake made by practitioners. 99 . θ θ θ ˆ θ ∗ ∗ Computationally. Equivalently.] 8. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α. lim Gn (x.4) says that Gn converges to Φ x as n → ∞. writing Tn ∼ Gn (x. The ideal test rejects if Wn ≥ qn (α). Basically. F ) = Φ + o (1) .3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.8. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. Let Tn be a statistic such that (8. (8. F ) then ³x´ .8.4) v ¡ ¢ While (8. not ˆ − θ0 . The derivative of an even function is odd.2 an = O(1) if |an | is uniformly bounded.8. Let an be a sequence. A better asymptotic approximation may be obtained through an asymptotic expansion. and vice-versa.8 Asymptotic Expansions Tn →d N (0. F ) = Φ n→∞ v or ³x´ Gn (x.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . the critical value qn (α) is found as the quantile from simulated values of W´ . Deﬁnition 8. and a function h(x) is odd if h(−x) = −h(x). or the size of the divergence for any particular sample size n. If θ is a vector. about the rate v of convergence. however. an = O(n−r ) if it declines to zero like n−r . it says nothing.

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

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 | . F ) + O(n−3/2 ).The “derivative” ∂ ∂F g1 (x. F ). n (8. F ) − Gn (−x. 1). F ) + g2 (−x. 101 2 g2 (x. then |Tn | →d |Z| ∼ Φ. Thus asymptotic critical values are taken from the Φ distribution. Since Tn →d Z. From Theorem 8. F ) + g2 (x.8. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. Similarly. and exact critical values are taken from the Gn (x. we can calculate that Gn (x. F0 ) distribution. F ) is only heuristic. 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.1. 8. F ) = Gn (x. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). as F is a function. = P (X ≤ x) − P (X ≤ −x) For example. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F ) − Gn (−x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. if Z ∼ N (0. F ). then |Tn | has the distribution function Gn (x. n .5) where the simpliﬁcations are because g1 is even and g2 is odd. if Tn has exact distribution Gn (x.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). We conclude that G∗ (x) − Gn (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x). F0 ) = O(n−1 ). then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F0 ) + O(n−3/2 ) = O(n−1 ). F0 ) = The order of the error is O(n−1 ). F ) = Gn (x.

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

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

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

You replace c with qn (. and ˆ is calculated on each θ ∗ ∗ θ sample.75 and 1. θ respectively. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. The ˆ are sorted. with variables listed in the ﬁle hprice1. ∗ ∗ where s(ˆ is the standard error in the original data.95). You want to test H0 : θ = 0 against H1 : θ > 0.95). and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. and the colonial dummy.2 and s(ˆ = . θ θ) ∗ 1000 samples are generated from the bootstrap distribution.5% quantiles of the ˆ are .2.95). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.5% and 97.95) denote the 5% θ) ∗ and 95% quantiles of Tn .05) .05) and qn (. Using the non-parametric ∗ bootstrap. The dataﬁle hprice1. What is wrong with this procedure? Tn = θ/s(θ) n 6. (b) Report the 95% Alternative Percentile interval for θ. (c) With the given information. lot size. Estimate a linear regression of price on the number of bedrooms. size of house.95) denote the 95% quantile of Tn . can you report the 95% Percentile-t interval for θ? 7. and thus reject H0 if ˆ ˆ > q ∗ (. Let qn (. ˆ − s(ˆ n (. and the 2. You do this as follows. ˆ = 1. you generate bootstrap samples. 105 . Suppose that in an application. Using the non-parametric bootstrap. ∗ ∗ ∗ Let qn (.pdf.3.dat contains data on house prices (sales). (a) Report the 95% Efron Percentile interval for θ.

these are known as estimating equations. If k = the model is just identiﬁed. β 0 ) = x(y − z 0 β) 106 (9. This situation is called overidentiﬁed. In the statistics literature. with ≥ k. We call r the number of overidentifying restrictions. 1 this class of models are called moment condition models.2) . as their are restrictions in E (xi ei ) = 0. In this case. x. g(y. x. but this is not required.1) by setting g(y. β 0 ) = 0 (9.Chapter 9 Generalized Method of Moments 9. Let g(y. zi .1 Overidentiﬁed Linear Model yi = x0 β + ei i = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where x1i is k × 1 and x2 is r × 1 with = k + r. otherwise it is overidentiﬁed. This method. As an important special case we will devote special attention to linear moment condition models. β) = x(y − x0 β). how should β 1 be estimated? One method is OLS regression of yi on x1i alone. while β 1 is of dimension k < . The variables zi may be components and functions of xi . z. In econometrics. We know that without further restrictions. This is a special case of a more general class of moment condition models. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. where the dimensions of zi and xi are k × 1 and × 1 . however. an asymptotically eﬃcient estimator of β is the OLS estimator. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . z. In our previous example. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. is not necessarily eﬃcient. x. This model falls in the class (9. xi .1) where β 0 is the true value of β. Now suppose that we are given the information that β 2 = 0. There are − k = r more moment restrictions than free parameters.

This is a non-negative measure of the “length” of the vector g n (β). For some × weight matrix Wn > 0. the dependence is only up to scale. for if Wn is replaced ˆ by cWn for some c > 0. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Proposition 9. β GMM = Z 0 XWn X 0 Z 9. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. For example.9.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. β GMM does not change. then g n (β) = 0.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . i i . β ˆ Note that if k = .2.2) g n (β) = (9. and the GMM estimator is the MME. ¡ ¢−1 0 ˆ Z XWn X 0 Y. the square of the Euclidean length. but this is generally not possible when > k. 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 .2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . The GMM estimator minimizes Jn (β).3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. Let and where gi = xi ei . 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. let Jn (β) = n · g n (β)0 Wn g n (β).1 β GMM = argmin Jn (β). ˆ Deﬁnition 9. then.2.

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

when we say “GMM”. Egi 6= 0. we can let the weight matrix be considered as a function of β.5 GMM: The General Case In its most general form. set Wn = (X 0 X)−1 . 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. Hansen. Instead.4) which uses the uncentered moment conditions. i. but can be numerically tricky to obtain in some cases. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. This is a current area of research in econometrics.e. (9.4) above. First. A common alternative choice is to set Ã n !−1 1X 0 gi gi ˆˆ Wn = n i=1 1 X ∗ ∗0 gi gi ˆ ˆ n i=1 n !−1 = Ã 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . 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. Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. A simple solution is to use the centered moment conditions to construct the weight matrix. J(β) = n · g n (β) n i=1 In most cases. Heaton and Yaron (1996). we actually mean “eﬃcient GMM”. When constructing hypothesis tests. Then set gi = xi ei . The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). and was introduced by L. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. under the alternative hypothesis the moment conditions are violated. There is an important alternative to the two-step GMM estimator just described. 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 . and GMM using Wn as the weight matrix is asymptotically eﬃcient. as in (9. ∗ gi (β) = gi (β) − g n (β) 9. There is little point in using an ineﬃcient GMM estimator as it is easy to compute. The estimator appears to have some better properties than traditional GMM. Here is a simple way to compute the eﬃcient GMM estimator.and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . However. ˆ and let g be the associated n × matrix. and construct the residual ei = yi − zi β. GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. Since Egi = 0. 109 .

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

These may be used to construct Wald tests of statistical hypotheses. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. This reasoning is not compelling. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). 1. we can reject the model.The proof of the theorem is left as an exercise. then D equals the Wald statistic. 111 . If h is non-linear. it is customary to report the J statistic as a general test of model adequacy. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. This is sometimes called the GMM Distance statistic. D →d χ2 r 3. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. In contrast. as this ensures that D ≥ 0. and by L. 9. This result was established by Sargan (1958) for a specialized case. D ≥ 0 2. If the hypothesis is non-linear. current evidence suggests that the D statistic appears to have quite good sampling properties.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. The idea was ﬁrst put forward by Newey and West (1987). the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . Based on this information alone. and some current research suggests that this restriction is not necessary for good performance of the test. For a given weight matrix Wn . it is unclear what is wrong. the Wald statistic can work quite poorly. If h is linear in β. however. If the statistic J exceeds the chi-square critical value. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). and is the preferred test statistic. Proposition 9.1 If the same weight matrix Wn is used for both null and alternative. a better approach is to directly use the GMM criterion function. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology.7. Hansen (1982) for the general case. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). but it is typically cause for concern. the hypothesis is H0 : h(β) = 0. When over-identiﬁed models are estimated by GMM. and it is advisable to report the statistic J whenever GMM is the estimation method.

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

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

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

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

. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. 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. ˆ and consider the GMM estimator β of β. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix.7. 116 .

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

Ln (β) = Rn (β.1) and (10. and using the second and third equations. we also obtain the Lagrange multiplier λ = λ(β). λ) = −n ln (n) − n X i=1 For given β. λ) : λ(β) = argmin Rn (β. or equivalently minimizes its negative ˆ (10.5) This minimization problem is the dual of the constrained maximization problem..3). λ) is a convex function of λ. The solution cannot be obtained explicitly. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .4) (10. (10.7) 118 .where λ and µ are Lagrange multipliers.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. Multiplying the ﬁrst equation by pi . p (10. p1 . λ. but must be obtained numerically (see section 6. λ).. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . µ. we ﬁnd µ = n and 1 ¢.2) subject to the restrictions (10. pn . the Lagrange multiplier λ(β) minimizes Rn (β. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). probabilities 1 ³ ´´ . The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β.5) ˆ ˆ As a by-product of estimation. The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. (see section 6. The solution (when it exists) is well deﬁned since Rn (β.. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. summing over i. pi gi (β) = 0. This yields the (proﬁle) empirical log-likelihood function for β.5). λ ¡ ¢ ln 1 + λ0 gi (β) . .

ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. λ) = − (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.8) and ¢ 0 0 For example. i i Theorem 10. Gi (.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. and n β − β 0 and nλ are asymptotically independent.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . G = −E (xi zi ). β) = −xi zi . n (10. λ) = − (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .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 .10) ¡ Ω−1 N (0.9) and (10.13) Premultiplying by G0 Ω−1 and using (10. in the linear model. and Ω = E xi x0 e2 . ˆ ˆ Proof.13) yields n n Expanding (10.1 Under regularity conditions.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. Thus the EL estimator is asymptotically eﬃcient. (β. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10. β λ ∂ ³ ´.9) (10. i=1 i=1 i=1i Expanding (10.10). g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . 0 = Rn (β.2.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.

The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. (10. tests are based on the diﬀerence in the log likelihood functions.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. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Since the EL estimator achieves this bound. The overidentiﬁcation test is a very useful by-product of EL estimation. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.15).16).17) 2 ln 1 + λ gi β .3. The same statistic can be constructed for empirical likelihood. by a Taylor expansion. and it is advisable to report the statistic LRn whenever EL is the estimation method. They are asymptotically ﬁrst-order equivalent. LRn = i=1 Theorem 10. Proof.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. it is an asymptotically eﬃcient estimator for β. First. and (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.3 Overidentifying Restrictions In a parametric likelihood context. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .7) is n ³ ´´ ³ X ˆ ˆ0 (10. 10.15) (10.1 If Eg(wi .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. Ω) GΩ G →d = N (0. Vλ ) Furthermore. 120 . and have the same interpretation. β 0 ) = 0 then LRn →d χ2−k .14) for λ and using (10. V ) ˆ Solving (10.

so there is no fundamental change in the distribution theory for β relative to β.18) Let the maintained model be where g is × 1 and β is k × 1. Theorem 10. 10. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). h(β)=0 ˜ Fundamentally. the simple overidentifying restrictions test (10.17) is not appropriate.wisc.Second. Vλ )0 Ω−1 N (0.ssc.18). 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.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .1 Under (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.4 Testing Egi (β) = 0 (10. The hypothesis of interest is h(β) = 0. LRn →d χ2 .18) and H0 : h(β) = 0.4. where h : Rk → Ra . LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. 10. This test statistic is a natural analog of the GMM distance statistic.edu/~bhansen/progs/elike. To test the hypothesis h(β) while maintaining (10. By “maintained” we mean that the overidentfying restrictions contained in (10.prc 121 . a The proof of this result is more challenging and is omitted. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.

5) for given β. λj ))−1 Rλ (β. λ) gi (β.4). λp ) A quadratic function can be ﬁt exactly through these three points. λ)0 0 Rn (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. Deﬁne ∗ gi (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. Set δ 0 = 0. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. One method uses the following quadratic approximation.. λ) = G∗ (β. λ) G∗ (β. (10. λ) G∗ (β. Eﬃcient convergence requires a good choice of steplength δ. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λj )) Rp = Rn (β.19) X ∂2 ∗ ∗ gi (β. λ) . λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). 1. The iteration (10. λ) = − ∂β n X i=1 G∗ (β. λj ))−1 Rλ (β. λj ) is smaller than some prespeciﬁed tolerance. λ)0 − ∂β∂β Rn (β. 2. The starting value λ1 can be set to the zero vector. λj ) .19) is continued until the gradient Rλ (β.20) . λ)0 − Rn (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ) = − gi (β. set 2 λp = λj − δ p (Rλλ (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) ∂λ i=1 n ∂ Rn (β.19). δ 1 = 1 and δ 2 = 1.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. λ) = i The ﬁrst derivatives of (10. For p = 0.

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

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

1) the structural equation. So we have the partition µ ¶ z1i k1 (11.1. This is called simultaneous equations bias. By the above deﬁnition. so should be included in xi . z1i is an instrumental variable for (11. at least the intercept).4) xi = x2i 2 where z1i = x1i are the included exogenous variables. β →p β ∗ .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. In matrix notation.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 . some regressors in zi will be uncorrelated with ei (for example. and x2i are the excluded exogenous variables.1 The × 1 random vector xi is an instrumental variable for (11. (11. In a typical set-up. 11. and assume that E(zi ei ) 6= 0 so there is endogeneity.1) if E (xi ei ) = 0.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 ¶ . Deﬁnition 11. Thus we make the partition ¶ µ k1 z1i (11. We call z1i exogenous and z2i endogenous.1). We call (11. which does not equal either β 1 or β 2 .2) Any solution to the problem of endogeneity requires additional information which we call instruments. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. this can be written as Y = Zβ + e.1) where zi is k × 1.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 .14) approaches that in (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .12) and this result. 0). Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. 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 . P = HΛH 0 0 0 where Λ = diag(Il . It is also close to zero when α = 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.Let PX = X (X 0 X)−1 X 0 . The consequences of identiﬁcation failure for inference are quite severe. the bias in the 2SLS estimator will be large. 130 .14) is the probability limit of β 2SLS − β 11.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . n and (11. By the spectral decomposition of an idempotent matrix. except when S21 = 0 (when Z is exogenous).13). 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. l . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.14) In general this is non-zero. Indeed as α → 1.

Then (11. In addition. Suppose that identiﬁcation does not complete fail. E x2 e2 i i n i=1 n (11.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. This is particularly nasty. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0.15) is unaﬀected. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. E x2 u2 i i n n i=1 i=1 n n (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 . Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . where C is a full rank matrix. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. Here. This can be handled in an asymptotic analysis by modeling it as local-to-zero. standard test statistics have non-standard asymptotic distribution of β distributions. This result carries over to more general settings. To see the consequences. and was examined by Phillips (1989) and Choi and Phillips (1992). Suppose this condition fails. the instrument xi is weak for zi if γ = n−1/2 c. 131 . This occurs when Γ22 is full rank. so E (zi xi ) = 0. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. Qc + N2 ˆ As in the case of complete identiﬁcation failure. once again take the simple case k = l = 1. N2 since the ratio of two normals is Cauchy. meaning that inferences about parameters of interest can be misleading. but is weak. but small. but (11. as the Cauchy distribution does not have a ﬁnite mean.Take the simplest case where k = l = 1 (so there is no X1 ). which occurs i when E (zi xi ) 6= 0. viz Γ22 = n−1/2 C. We see that β is identiﬁed if and only if Γ22 = γ 6= 0.

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

l ≥ k. will IV “ﬁt” better than OLS. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. where xi and β are 1 × 1. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. in the sense that e ˜ ˜ least in large samples? 4. 133 . u is n × k. Z is n × k. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). 6. 5. Take the linear model yi = xi β + ei E (ei | xi ) = 0. X is n × l. Take the linear model Y = Zβ + e.) 3.8 Exercises yi = zi β + ei . and Γ is l × k. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . at ˆˆ If X is indeed endogeneous. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Find a simple expression for the IV estimator in this context. xi is l × 1. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. 2. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. show that if rank(Γ) < k then β cannot be identiﬁed. 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. That is. Explain why this is true.11. ˜ 0 e < e0 e. 1. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. (Find an expression for xi .

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

1 Stationarity and Ergodicity Deﬁnition 12. 135 . t = 1.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . and T to denote the number of observations. A stationary time series is ergodic if γ(k) → 0 as k → ∞..1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t..1.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. so classical assumptions are not valid. Deﬁnition 12.1 If Yt is strictly stationary and ergodic and Xt = f (Yt .. Theorem 12. .. we expect that Yt and Yt−1 are not independent. however. γ(k) is called the autocovariance function. and Cov (Yt . and multivariate (yt ∈ Rm is vector-valued).) is a random variable.. Deﬁnition 12. we adopt new notation. Yt−k ) = γ(k) is independent of t for all k. Yt−1 . Deﬁnition 12. Yt−k ) is the autocorrelation function. and use the subscript t to denote the individual observation. . The primary model for multivariate time series is vector autoregressions (VARs).1.2 {Yt } is strictly stationary if the joint distribution of (Yt . The primary model for univariate time series is autoregressions (ARs). Yt−k ) is independent of t for all k. . There proofs are rather diﬃcult.1. 12.1. We can separate time series into two categories: univariate (yt ∈ R is scalar).. Because of the sequential nature of time series. T ..4 (loose).1.. The following two theorems are essential to the analysis of stationary time series. then Xt is strictly stationary and ergodic. To indicate the dependence on time.

3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ρ(k) →p ρ(k).1. 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) . ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. µ →p E(Yt ). If Xt is strictly stationary and ergodic and E |Xt | < ∞. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . 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 . Part (1) is a direct consequence of the Ergodic theorem.1 above. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). then as T → ∞.1.Theorem 12. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k).1. γ (0) ˆ Theorem 12. then as T → ∞. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). ˆ ˆ γ ¥ 136 . 1.2 (Ergodic Theorem). ˆ 2. and it has a ﬁnite mean by the assumption that EYt2 < ∞. For Part (2). ˆ 3. T 1X Xt →p E(Xt ). ˆ Proof. γ (k) →p γ(k). the sequence Yt Yt−k is strictly stationary and ergodic.

some versions of the life-cycle hypothesis imply that either changes in consumption. or consumption growth rates. as it is diﬃcult to derive distribution theories without this property.. ..3 Stationarity of AR(1) Process Yt = ρYt−1 + et . . A linear AR model (the most common type used in practice) speciﬁes linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k . A mean-zero AR(1) is Assume that et is iid.... k=0 Loosely speaking. Regression errors are naturally a MDS. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. 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.} are jointly random. it is even more important in the time-series context.} is the past history of the series. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + .. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. t By back-substitution. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . In fact. 137 .. YT . Y2 .. Yt−2 .2. Some time-series processes may be a MDS as a consequence of optimizing behavior. Y1 .2 Autoregressions In time-series. E(et ) = 0 and Ee2 = σ 2 < ∞. Thus for k > 0... The last property deﬁnes a special time-series process.... the series {. Letting et = Yt − E (Yt | It−1 ) . . should be a MDS. this series converges if the sequence ρk et−k gets small as k → ∞. .1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. This occurs when |ρ| < 1. Deﬁnition 12. Yt−k ) . For example. 12. E(Yt−k et ) = 0.12.. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .. ∞ X = ρk et−k . A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 .

3. 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). or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . Deﬁning L2 = LL. We call ρ(L) the autoregressive polynomial of Yt .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. we see that L2 Yt = LYt−1 = Yt−2 .4.1 The lag operator L satisﬁes LYt = Yt−1 . The AR(k) model is Using the lag operator.Theorem 12. an AR(1) is stationary iﬀ |ρ| < 1.3. We say that the root of the polynomial is 1/ρ. since ρ(z) = 0 when z = 1/ρ. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . Lk Yt = Yt−k . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . ∞ X k=0 ρ2k V ar (et−k ) = 12. the above results are unchanged. 12. We call ρ(L) the autoregressive polynomial of Yt . 138 .1 If |ρ| < 1 then Yt is strictly stationary and ergodic. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). From Theorem 12. Deﬁnition 12.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 .1. In general.

β = X 0X (12. it is also strictly stationary and ergodic. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. it is helpful to deﬁne the process ut = xt et . The vector xt is strictly stationary and ergodic.1. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.where the λ1 . For an AR(k). we say that ρ(L). and by Theorem 12. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.1) Theorem 12. By Theorem 12. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.” If one of the roots equals 1. Thus t by the Ergodic Theorem. “has a unit root”.. . so is xt x0 .6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12.1. t Yt−k ¢0 ρk .1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.6.5. and is of great interest in applied time series. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. λk are the complex roots of ρ(z). This is a special case of non-stationarity. t t T t=1 ¥ Combined with (12. Note that ut is a MDS. then ˆ β →p β as T → ∞.1. Proof. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. Let |λ| denote the modulus of a complex number λ. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. the requirement is that all roots are larger than one. and hence Yt . One way of stating this is that “All roots lie outside the unit circle..1. which satisfy ρ(λj ) = 0. t T t=1 T t=1 139 . Theorem 12.1) and the continuous mapping theorem..

we can apply Theorem 12.12. It also presumes that the AR(k) structure is the truth. This is identical in form to the asymptotic distribution of OLS in cross-section regression..7. then as T → ∞.1 MDS CLT. i 4.. In particular. we constructed the bootstrap sample by randomly resampling from the data values {yt . T t=1 Since xt et is a MDS. Ω) . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Ω) . 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∗ . Y−k+2 . Y0 ). ˆ 2. this cannot work in a time-series application.7. as this imposes inappropriate independence. which may be diﬀerent than the i properties of the actual ei .. Estimate β and residuals et . T 1 X √ ut →d N (0. xt }. 12. 140 . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. Method 1: Model-Based (Parametric) Bootstrap. the asymptotic covariance matrix is estimated just as in the cross-section case. . there are two popular methods to implement bootstrap resampling for time-series data. t This construction imposes homoskedasticity on the errors e∗ .. t t Theorem 12. T t=1 where Ω = E(xt x0 e2 ).7 Asymptotic Distribution Theorem 12. e ˆ 3. .. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Brieﬂy. Fix an initial condition (Y−k+1 .1 to see that T 1 X √ xt et →d N (0. ˆ 1.8 Bootstrap for Autoregressions In the non-parametric bootstrap. Q−1 ΩQ−1 . Clearly. The implication is that asymptotic inference is the same.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. Divide the sample into T /m blocks of length m. This creates an iid bootstrap sample. Method 2: Block Resampling 1.. t then as T → ∞. eT }.7.

The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.2) (12. That is. ∆s Yt = Yt − Yt−s . • Use “seasonally adjusted” data. May not work well in small samples. (12. • You can estimate (12. But the long-run trend is also eliminated. 141 . This is a ﬂexible approach which can extract a wide range of seasonal factors.3) replacing St with St . heteroskedasticity. If s is the number of seasons (typically s = 4 or s = 12). 3..3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . and for modelmisspeciﬁcation. 6.2. ρk ).2)-(12. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. 5. The series ∆s Yt is clearly free of seasonality. and the way that the data are partitioned into blocks. however. • First apply a seasonal diﬀerencing operator. Thus the seasonally adjusted data is a “ﬁltered” series. The results may be sensitive to the block length. (12. Resample complete blocks.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . This procedure is sometimes called Detrending. or the season-to-season change. The seasonal adjustment.4) by OLS. draw T /m blocks. 12.2). 4. For each simulated sample. and then perform regression (12. This allows for arbitrary stationary serial correlation. • You can estimate (12. This presumes that “seasonality” does not change over the sample. and perhaps this was of relevance.3) sequentially by OLS.. get the ˆ ˆ residual St . also alters the time-series correlations of the data. Paste the blocks together to create the bootstrap time-series Yt∗ . ﬁrst estimate (12. • Include dummy variables for each season. Seasonal Eﬀects There are three popular methods to deal with seasonal data. ..

12. The best remedy is to ﬁx a upper value k. Yt is an AR(1). (12. we take (12.. and the alternative is that the error is an AR(m).5) We are interested in the question if the error ut is serially correlated. (12. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . We then multiply this by θ and subtract from (12. To combine (12. and then reserve the ﬁrst k as initial conditions.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . and then estimate the models AR(1). Another is to minimize the AIC or BIC information criterion.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. (If you increase k. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2).5) and (12. We want to test H0 against H1 .. (A simple exclusion test). if the null hypothesis is that Yt is an AR(k). and under H1 it is an AR(2). Thus under H0 ... you need more initial conditions. In general. this is the same as saying that under the alternative Yt is an AR(k+m). e. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . We model this as an AR(1): ut = θut−1 + et with et a MDS. An appropriate test is the Wald test of this restriction. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .g. 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. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. AR(k) on this (uniﬁed) sample.10 Testing for Omitted Serial Correlation For simplicity. One approach to model selection is to choose k based on a Wald tests..6) 12. AIC(k) = log σ 2 (k) + ˆ 2k . Yt−k−m are jointly zero.5).) This can induce strange behavior in the AIC. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. 142 . AR(2).. . . The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.6).

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

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

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

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

under the restriction γ = −βθ.1). the model (13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.2) is a special case of (13. direct estimation of (13. t t−1 (13. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). 13.13.3) which is a valid regression model. This restriction. which is called a common factor restriction. You may have heard of the Durbin-Watson test for omitted serial correlation. (A simple version of this estimator is called Cochrane-Orcutt. (13. we are only interested in a single equation out of a VAR system. and is still routinely reported by conventional regression packages.2) may be estimated by iterated GLS. If valid. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. This can be done by a Wald test. which once was very popular. general. j Often. 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 .3). In this case. 147 . and is typically rejected empirically. Let yt = Yjt . it is convenient to re-deﬁne the variables. t and xt = This is just a conventional regression. t or yt = θyt−1 + x0 β + x0 γ + ut .) Since the common factor restriction appears arbitrary.1) yt = x0 β + et . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. may be tested if desired. and Zt be the other variables. t and et is iid N (0. Suppose that et is an AR(1). Let et = ejt and β = aj .4 Single Equation from a VAR Yjt = a0 xt + et . So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i .2) is uncommon in recent applications. Then the single equation takes the form (13. Another interesting fact is that (13. with time series data. and subtract oﬀ the equation once lagged multiplied by θ.2) Take the equation yt = x0 β + et . 1). We see that an appropriate. Otherwise it is invalid. xt−1 ) to the regression. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s.

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

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

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

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

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

σ 2 ) with the observed variable yi generated by the censoring equation (14. In surveys.2 Count Data exp (−λi ) λk i . Tobin observed that for many households. incomes above a threshold are typically reported at the threshold. a typical approach is to employ Poisson regression. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. . An example of a data collection censoring is top-coding of income. 1. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. 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 !) .. This may be considered restrictive. 0 if yi (This is written for the case of the threshold being zero. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. any known value can substitute.1).” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). 14. or it may be a by-product of economic constraints. Thus the model is that there is some latent process yi with unbounded support. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. 1. A generalization is the negative binomial.}. The functional form for λi has been picked to ensure that λi > 0. this motivates the label Poisson “regression. the consumption level (purchases) in a particular period was zero..1) yi = ∗ <0 . 2.. The censoring process may be explicit in data collection.. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . 2.14. k! = exp(x0 β).) The observed data yi therefore come from a mixed continuous/discrete distribution. i If Y = {0.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. i i i=1 ˆ The MLE is the value β which maximizes ln (β). The conditional density is the Poisson with parameter λi . . 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.

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

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

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

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

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

there are more instruments available. Thus values of yit−k . the ﬁxed eﬀects estimator is inconsistent. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . 15. if eit is iid.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). it However. it it which is free of the individual-eﬀect ui . at least if T is held ﬁnite as n → ∞. A more sophisticated GMM estimator recognizes that for time-periods later in the sample. But if there are valid instruments. we use lags of the dependent variable.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . This is conveniently organized by the GMM principle. 159 (15. then IV or GMM can be used to estimate the equation.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. Alternatively. the dependent variable and regressors in deviationit from-mean form.4) . two periods back. as yt−2 is uncorrelated with ∆eit . GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. Taking ﬁrst-diﬀerences of (15. we ﬁnd y i = x0 β + ui + ei . it (15. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. k ≥ 2. 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 . are valid instruments. A simple application of GMM yields the parameter estimates and standard errors. Typically. so the instrument list should be diﬀerent for each equation. Unfortunately. Hence a valid estimator of α and β is to estimate (15. but loses a time-series observation). and the residual is the demean value ∗ yit = yit − yi .4) will be inconsistent. the predicted value from these regressions is the individual speciﬁc mean y i .3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . it and then take individual-speciﬁc means by taking the average for the i0 th individual: ti ti ti 1 X 1 X 0 1 X yit = x β + ui + eit Ti t=t Ti t=t it Ti t=t i i i or Subtracting. i ∗ yit = x∗0 β + e∗ . e So OLS on (15. This is because the sample mean of yit−1 is correlated with that of eit . as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions.

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

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

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

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

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

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

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

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

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

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

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

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

the variance of the sum is the sum of the variances. Another implication of (A. y) = g(x)h(y). then Cov(X. Y ). the marginal density of Y is fY (y) = Z ∞ f (x. free of units of measurement. then V ar (X + Y ) = V ar(X) + V ar(Y ). (A. X 2 ) = 0.6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y.5) if the expectations exist. then σ XY = 0 and ρXY = 0. is not true. If X and Y are independent. X and Y are independent if and only if there exist functions g(x) and h(y) such that 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). For example. The reverse. if EX = 0 and EX 3 = 0. The covariance between X and Y is Cov(X. Furthermore.Similarly. For example. 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 ) . y)dx. −∞ The random variables X and Y are deﬁned to be independent if f (x. An implication is that if X and Y are independent. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X. however. σxσY (A. Y ) = ρXY = σ XY .The correlation is a measure of linear dependence. if X and Y are independent then E(XY ) = EXEY. 172 . The correlation between X and Y is Corr(X.5) is that if X and Y are independent and Z = X + Y. y) = fX (x)fY (y).

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

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

The Jacobian is ¶ µ ∂ h(y) . . 1] and Y = − ln(X). J(y) = det ∂y 0 Consider the univariate case k = 1.10) shows that fY (y) = exp(−y). and invertible. but its justiﬁcation requires deeper results from analysis. diﬀerentiable. (A.10) d h(y). Let h(y) denote the inverse of g(x). If g(x) is an increasing function. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). 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)| . A. Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. As one example.10) holds for k > 1. dy dy If g(x) is a decreasing function. 0 ≤ y ≤ ∞. Let Y = g(X) where g(x) : Rk → Rk is one-to-one. This same formula (A. take the case X ∼ U [0.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). 1].∞). Here. an exponential density.A. then g(X) ≤ Y if and only if X ≤ h(Y ). so the distribution function of Y is FY (y) = P (g(X) ≤ y) = FX (h(Y )) = P (X ≤ h(Y )) so the density of Y is fY (y) = d d FY (y) = fX (h(Y )) h(y). As the range of X is [0. that for Y is [0. then g(X) ≤ Y if and only if X ≥ h(Y ).8 Normal and Related Distributions µ 2¶ 1 x . dy This is known as the change-of-variables formula.

The mean and variance of the distribution are µ and σ 2 . we can also show that EX 2 = 1 and EX 4 = 3. In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ.8. It is conventional to write X ∼ N (0. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. −∞ < x < ∞. x ∈ Rk . Since it is symmetric about zero all odd moments are zero. 1). If Z is standard normal and X = µ + σZ. then they are mutually independent.1 Let X ∼ N (0.8. By iterated integration by parts. Another useful fact is that if X ∼ N (µ. ¢ ¡ 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 . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . then Z 0 A−1 Z ∼ χ2 .This density has all moments ﬁnite. Ir ) and set Q = X 0 X. f (x) = √ 2σ 2 2πσ which is the univariate normal density. q 176 . the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . Theorem A. The latter has no closed-form solution. y ≥ 0. respectively. then Σ = diag{σ 2 } is a diagonal matrix. Theorem A. A) with A > 0. Its mean and r variance are µ = r and σ 2 = 2r. and it is conventional to write X ∼ N (µ. (A. For x ∈ Rk .11) and is known as the chi-square density with r degrees of freedom. then by the change-of-variables formula. This shows that if X is multivariate normal with uncorrelated elements. This shows that linear transformations of normals are also normal.2 If Z ∼ N(0. and it is conventional to write X ∼ N(µ. denoted χ2 . x ∈ Rk . X has density Ã ! (x − µ)2 1 exp − . Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . σ 2 ). then using the change-of-variables formula. q × q. Σ) and Y = a + BX with B an invertible matrix. Σ).

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). Set r Z . Iq ).13) is the MGF of the density (A. For Z ∼ N(0.12) E exp (tQ) = 0 Γ (A. C −1 CC 0 C −10 ) = N (0. 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 .3.8.13). Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. C −1 AC −10 ) = N (0. Proof of Theorem A. The MGF for the density (A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. which can be found by applying change-of-variables to the gamma function.8.8.11). we see that the MGF of Z 2 is (1 − 2t)−1/2 . The fact that A > 0 means that we can write A = CC 0 where C is non-singular. 1). q Proof of Theorem A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.1. Thus the density of Z 2 is (A.3 Let Z ∼ N (0. Using the simple law of iterated expectations.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. tr has distribution 177 .11) 2 with r = 1. (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.2. From (A.8. which we showed in (A. 1) and Q ∼ χ2 be independent. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.Theorem A.

the likelihood and log-likelihood are constructed by setting f (y.. θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector. 1+ √ r r rπΓ 2 ! Z P p ≤x Q/r ( r ) Q E Z≤x r !# " Ã r Q |Q E P Z≤x r Ã r ! Q EΦ x r Ã = ¥ A. The log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi .. θ) . θ) . θ) and the joint ˜ density of a random sample Y = (Y1 . θ) = P (Y = y.9 Maximum Likelihood If the distribution of Yi is F (y. In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ. If the distribution F is discrete. The space Θ is the set of permissible value for θ.. viewed as a function of θ. we say that the distribution is parametric and that θ is the parameter of the distribution F.θ = fn Y f (Yi . 178 .function F (x) = = = = Thus its density is f (x) = = = Ã r ! Q d E Φ x dx r Ã Ã r !r ! Q Q E φ x r r ! µ ¶¶ r Ã Z ∞µ qx2 1 q 1 r/2−1 ¡r¢ √ exp − q exp (−q/2) dq 2r r Γ 2 2r/2 2π 0 ¢ µ ¡ ¶− r+1 Γ r+1 x2 ( 2 ) 2¡ ¢ . θ) . Yn ) is n ³ ´ Y ˜. . 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 θ∈Θ ˆ In some simple cases. θ0 ) ln f (Yi .9. ˆ is consistent θ for this value.16) (A.15) Two important features of the likelihood are Theorem A.9. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.14) ¶ ∂ ∂ 0 ln f (Yi . the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. we can ﬁnd an explicit expression for θ as a function of the data.17) is often called the information matrix equality.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . However. θ0 ) . θ) ≡ L(θ). 179 . under conventional regularity conditions. ∂θ ∂θ (A.16). The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . then θ V ar(˜ ≥ (nI0 )−1 . θ0 ) ∂θ∂θ 0 (A. We can write this as ˆ = argmax Ln (θ). θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ) →p E ln f (Yi .9. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi .2 Cramer-Rao Lower Bound. In fact. we can see that it is an estimator of the maximizer θ of the right-hand-side.17) The matrix I0 is called the information.3 Under regularity conditions. which maximizes the log-likelihood). θ) The Cramer-Rao Theorem gives a lower bound for estimation. cases are rare. I0 . θ) ∂θ ∂θ which holds at θ = θ0 by (A. If ˜ is an unbiased estimator of θ ∈ R. n n i=1 n As the MLE ˆ maximizes the left-hand-side. ˆ →p θ0 as n → ∞. but these ˆ must be found by numerical methods.1 ¯ ¯ ∂ E ln f (Yi . ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. and the equality (A. Theorem A. More typically. θ Theorem A.

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

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

θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. Ω) = N 0.9. θ n ) θ − θ 0 . an application of the CLT yields 1 X ∂ √ ln f (Yi . θ) . θ0 ) + ' 0 ln f (Yi .) Rewriting this equation. ¥ 182 . ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θ0 ) . the speciﬁc value of θn varies by row in this expansion. we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi .9.3 Taking the ﬁrst-order condition for maximization of Ln (θ). and making a ﬁrst-order Taylor series expansion. ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . the ﬁnal equality using Theorem A. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . Ω) . θ0 ) →d N (0. then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . If it is continuous in θ. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi .1 . H −1 ΩH −1 = N 0. Together. θn ) = ln f (Yi .Proof of Theorem A. θ0 ) is mean-zero with covariance matrix Ω. − ln f (Yi . (Technically. H −1 . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi .

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

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

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

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