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

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Contents

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

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

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i

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

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

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

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

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ii

. . . . . . . . . . . . . . . . 9.7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . .2 GMM Estimator . . . . . . . 9. . . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . . . . . . . . 12 Univariate Time Series 12. . . 10 Empirical Likelihood 10. . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . 11. . . 11. . . . .2 Reduced Form . . . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . .10 Exercises . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . iii . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . .12 8. . . . . . . 11. . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . 9. . . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . 10. . .3 Distribution of GMM Estimator . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 8.6 Bekker Asymptotics . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . 11. . . . 12. 12. . . .4 Testing . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . .3 Overidentifying Restrictions . . . . Percentile Conﬁdence Intervals . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . .6 Estimation . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9.

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

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

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

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

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

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

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

For non-singular A and C. . If A − BD−1 C and D − CA−1 B are non-singular. The Moore-Penrose generalized inverse A− satisﬁes (2.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = .1) .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. . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. or is nonsingular.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 . 7 Also. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . In this case there exists a unique matrix B such that AB = BA = Ik . . The following fact about inverting partitioned matrices is sometimes useful. 2.4 Inverse A k × k matrix A has full rank. if there is no c 6= 0 such that Ac = 0. (2.3) The matrix A− is not necessarily unique. (2. This matrix is called the inverse of A and is denoted by A−1 . . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . then A−1 = A. the Moore-Penrose generalized inverse A− exists and is unique. . if A is an orthogonal matrix. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. . .

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

i Hence they must equal either 0 or 1. ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. we can deﬁne the determinant as follows. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . Let π = (j1 . k)). It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1... k) .4) H0 M =H 0 0 with H 0 H = In . (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2... There are k! such permutations.. 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 .. If A is 2 × 2.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ .... . .. we deduce that Λ2 = Λ and λ2 = λi for i = 1. xk ) : Rk → R. ...By the uniqueness of the characteristic roots. then its determinant is det A = a11 a22 − a12 a21 . .. k. . xk ) be k × 1 and g(x) = g(x1 . Additionally.8 Determinant The determinant is deﬁned for square matrices. tr(A) = rank(A). jk ) denote a permutation of (1. . ⎠ ..... and let επ = +1 if this count is even and επ = −1 if the count is odd. For a general k × k matrix A = [aij ] .

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

xki 3. The two density curves show the eﬀect of gender on the distribution of wages. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. Take a closer look at the density functions displayed in Figure 3. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. This is used when the goal is to quantify the impact of one set of variables on another variable. In this context we partition the observations into the pair (yi . which is a common feature of wage distributions. . the mean is not necessarily a good summary of the central tendency. These are conditional density functions — the density of hourly wages conditional on race. See Chapter 16. education and experience.1. xi ) where yi is a scalar (real-valued) and xi is a vector. and exists so long as E |yi | < ∞. the mean wage for men is $27.1 by the arrows drawn to the x-axis. These are asymmetric (skewed) densities. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. You can see that the right tail of then density is much thicker than the left tail. We call xi alternatively the regressor.22. When a distribution is skewed. ⎟ . These are indicated in Figure 3. it is useful to have numerical measures of the diﬀerence.1) xi = ⎜ . To illustrate.2) m(x) = E (yi | xi = x) = −∞ In general. The data are from the 2004 Current Population Survey 1 11 . the conditional density of yi given xi . the conditioning variable. Figure 3. ⎠ ⎝ .1 displays the density1 of hourly wages for men and women. and that for women is $20. we can focus on f (y | x) . holding the other variables constant. In the example presented in Figure 3. While it is easy to observe that the two densities are unequal. (3. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.73. We call yi the dependent variable. gender. m(x) can take any form.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression.1. or the covariates.

When the distribution of the control variable is continuous.D. then comparisons become more complicated.36.1 is facilitated by the fact that the control variable (gender) is discrete. 3.2) evaluated at the observed value of xi : ei = yi − m(xi ).3 is how the conditional expectation describes an important feature of the conditional distribution. with mean log hourly wages drawn in with the arrows. To illustrate. The diﬀerence in the log mean wage between men and women is 0. 2 (3. By construction. Figure 3. 12 . The main point to be learned from Figure 3. For this reason. Of particular interest to graduate students may be the observation that diﬀerence between a B. implying an average 36% diﬀerence in wage levels.A. and a Ph. degree in mean log hourly wages is 0.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.Figure 3. Figure 3. the dashed line is a linear projection approximation which will be discussed in the Section 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. wage regressions typically use log wages as a dependent variable rather than the level of wages.2 shows the density of log hourly wages for the same population.3 displays a scatter plot2 of log wages against education levels. this yields the formula yi = m(xi ) + ei . This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. The conditional expectation function is close to linear. the solid line displays the conditional expectation of log wages varying with education. The comparison in Figure 3.3) White non-military male wage earners with 10-15 years of potential work experience. Assuming for simplicity that this is the true joint distribution.5.30. which implies a 30% average wage diﬀerence for this population.

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

In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. To see this. In contrast. when σ 2 (x) is a constant so that ¢ ¡ (3.1.3. The conditional standard deviation is its square root σ(x) = σ 2 (x). Thus the mean squared error is minimized by the conditional mean. let g(x) be an arbitrary predictor of yi given xi = x. The right-hand-side is minimized by setting g(x) = m(x). σ 2 (x) is a non-trivial function of x.2.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . 3.Figure 3. the conditional variance of yi is σ 2 = σ 2 (xi ). 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 3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. 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 . and can take any form. in the sense of achieving the lowest mean squared error. subject to the restriction p that it is non-negative. it does not provide information about the spread of the distribution.3 Conditional Variance Generally. i .

1). we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . xki When m(x) is linear in x. We call this the “constant” or “intercept”. they are also somewhat more dispersed.6) as an approximation.6) (3. Equation (3.1. ⎟ . we assume that x1i = 1.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). Instead.5. and the linear assumption of the previous section is empirically unlikely to accurate. which we derive in this section. Equivalently. its functional form is typically unknown. Notationally. 15 . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. ⎟ β=⎝ . βk ⎛ (3. ⎠ . This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .we say that the error ei is homoskedastic. it is more realistic to view the linear speciﬁcation (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. where x1i is the ﬁrst element of the vector xi deﬁned in (3. i (3. The conditional standard deviation for men is 12. In this case (3. So while men have higher average wages.4 Linear Regression An important special case of (3.8) is called the linear regression model. take the conditional wage densities displayed in Figure 3. As an example.7) is a k × 1 parameter vector.9) 3. 3. it is convenient to augment the regressor vector xi by listing the number “1” as an element. ⎠ . Thus (3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.5) xi = ⎜ .8) (3.1 and that for women is 10. ⎝ .

which is quadratic in β. this situation must be excluded. i (3. α0 E (xi x0 ) α = E (α0 xi )2 > 0. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.1.10). In order for β to be uniquely deﬁned. x0 β is the best linear predictor for yi . It is invertible if and only if it is positive deﬁnite. Rewriting. The error is i ei = yi − x0 β. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. Equivalently. xi contains an intercept. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.1 1. 2 2. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . i (3. by “best” we mean the predictor function with lowest mean squared error. i 4. This occurs when redundant variables are included in xi . We now summarize the assumptions necessary for its derivation and list the implications in Theorem 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. As before.10) It is worth taking the time to understand the notation involved in this expression. The vector (3. The best linear predictor is obtained by selecting β to minimize S(β). written E (xi x0 ) > 0.12) This completes the derivation of the linear projection model. Observe i that for any non-zero α ∈ Rk . i which requires that for all non-zero α. i 16 .5. Therefore. E (x0 xi ) < ∞.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. Assumption 3. i i (3.5. 3. The ﬁrst-order condition for minimization (from Section 2. Eyi < ∞. otherwise they are distinct. Given the deﬁnition of β in (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) .11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . E (xi x0 ) is invertible.

1.5. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.5. For example.13) implies that xi and ei are uncorrelated.2 and 3.5.5.1.5. Using the deﬁnitions (3.1 are weak.1.Theorem 3.5. Furthermore.10) are deﬁned.13) summarize the linear projection model.3 are called regularity conditions. Assumption 3.5.4 we know that the regression error has the property E (xi ei ) = 0. Assumption 3.2 and 3.13) and Assumption 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.2. Equation (3. Since ei is mean zero by (3.14) holds. 17 .1. Since from Theorem 3.14). Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. E (xi ei ) = 0 and E (ei ) = 0. the orthogonality restriction (3.8)-(3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .14) follows from (3.4 is required to ensure that β is uniquely deﬁned.1.13) The two equations (3.1.1. (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. it follows that linear regression is a special case of the projection model.1.11) are well deﬁned. The ﬁnite variance Assumptions 3. This means that the equation (3.1 Under Assumption 3.9).4 guarantees that the solution β exits. ¥ (3.5. However. Assumption 3.1. Figure 3.5.12) can be alternatively interpreted as a projection decomposition.1.3 ensure that the moments in (3.5.1.1 is employed to guarantee that (3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Assumption 3.5. (3.12) and (3.14) Proof. By deﬁnition.11) and (3. Let’s compare it with the linear regression model (3.10) and (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.

However. for those over 53 in age).3. In contrast. xi ) we can deﬁne a linear projection equation (3. there are no changes in our methods or analysis. since the resulting function is quadratic in experience. It over-predicts wages for young and old workers. These structural models require alternative estimation methods. In this example the linear projection is a close approximation to the conditional mean. and are discussed in Chapter 11. and under-predicts for the rest. Figure 3. The linear equation (3.We have shown that under mild regularity conditions. The solid line is the conditional mean. and the straight dashed line is the linear projection.1 may be false. it is important to not misinterpret the generality of this statement. In this case the linear projection is a poor approximation to the conditional mean. No additional assumptions are required.4 displays the relationship3 between mean log hourly wages and labor market experience. in many economic models the parameter β may be deﬁned within the model. In Figure 1.10). Figure 3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. In the example just presented. In this example it is a much better approximation to the conditional mean than the linear projection. A projection of log wages on these two variables can be called a quadratic projection. We illustrate the issue in Figure 3.5. In other cases the two may be quite diﬀerent.12) with the properties listed in Theorem 3.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. the dashed line is the linear projection of log wages on eduction. Returning to the joint distribution displayed in Figure 3. In this case (3. This defect in linear projection can be partially corrected through a careful selection of regressors. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. Other than the redeﬁnition of the regressor vector.5. 18 .1. we can augment the regressor vector xi to include both experience and experience2 . Most importantly. for any pair (yi .4 we display as well this quadratic projection.10) may not hold and the implications of Theorem 3.

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

2 Y =1 .6 Exercises 1. 2. x 6. and E(ei | xi ) = 0. taking values only on the non-negative integers. j! 0 j = 0. If yi = x0 β + ei and E(ei | xi ) = 0.1 . then ei is i i independent of xi . (x − µ)2 − σ 2 Show that Eg (X. 20 . σ 2 = V ar(yi ) and σ xy = Cov(xi . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. xi ∈ R. Compute E(yi | xi = x) and V ar(yi | xi = x). Let xi and yi have the joint density f (x. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . . 1.4 . then E(ei | xi ) = 0. then E(x2 ei ) = 0. yi ). Prove parts 2. a constant. s) = 0 if and only if m = µ and s = σ 2 . then E(x2 ei ) = 0. 0 ≤ y ≤ 1. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. 3 and 4 of Theorem 3. then ei is independent of xi . σ 2 = V ar(xi ). True or False. and have the following joint probability distribution X=0 X=1 Y =0 . σ = . If yi = x0 β + ei and E(xi ei ) = 0. i 10. i 8. Suppose that Y and X only take the values 0 and 1. If yi = x0 β + ei . True or False.3. m. and E(e2 | xi ) = σ 2 . If yi = xi β + ei . 3. Let X be a random variable with µ = EX and σ 2 = V ar(X). ¡ ¢ 4. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. If yi = xi β + ei . True or False. E(Y 2 | X = x) and V ar(Y | X = x). µ. 9.2. True or False. True or False. e−λ λj j! . i 7. µx = Exi .. xi ∈ R. i 11. Are they diﬀerent? Hint: If P (Y = j) = 5..1. and E(xi ei ) = 0. E(ei | xi ) = 0. 2. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . Compute the conditional mean m(x) = E (yi | xi = x) .3 Find E(Y | X = x). Suppose that yi is discrete-valued.

i n i=1 n 21 . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . (4.1 Estimation Equation (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4. i It follows that the moment estimator of β replaces the population moments in (4. but for most of the chapter we retain the broader focus on the projection model.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .2) can be written in the parametric 0 β)) = 0.7 and 4.4) i i=1 i=1 ˆ Another way to derive β is as follows.2) (4. 4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .8.3) In Sections 4. we narrow the focus to the linear regression model. Observe that (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .1) (4.

14 205.37 µ ¶ 1. This sample has 988 observations.4).40 µ ¶µ ¶ 34.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 14.14 205. These are white male wage earners from the March 2004 Current Population Survey.30 + 0. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β.14 14. 4. consider the data used to generate Figure 3.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. Then µ ¶ n 1X 2.83 ¶−1 µ ¶ .170 37.3.117 1 14. An interpretation of the estimated equation is that each year of education is associated with an 11.117 Educationi . excluding military. i 22 . 40 2.ˆ This is a set of k equations which are linear in β.7% increase in mean wages.94 −2.2 Least Squares There is another classic motivation for the estimator (4.71 = −2. 30 = . ¶ 2.95 42. Let yi be log wages and xi be an intercept and years of education. To illustrate. 40 0. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.4). The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4. 0.95 xi yi = 42. with 10-15 years of potential work experience.

Following convention we will call β the OLS estimator of β. Matrix calculus (see Appendix 2. To visualize the sum-of-squared errors function.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. It is important to understand the distinction between the error ei and the residual ei .1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. Figure 4. These two ˆ variables are frequently mislabeled.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Figure 4. i ˆ ˆ Note that yi = yi + ei . Figure 4. 23 . The error is unobservable.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4.4). we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). which can cause confusion. while the residual is a by-product of estimation. the contour lines are ellipses. Since the function Sn (β) is a quadratic function of β.

ˆ σ = ˆ n 2 i=1 n (4. and hold true for all linear regression estimates.6) An alternative estimator uses the formula n 1 X 2 s = ei . one implication is that n 1X ei = 0. These are algebraic results. ˆ n i=1 n Since xi contains a constant. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero.5) implies that 1X xi ei = 0.7) A justiﬁcation for the latter choice will be provided in Section 4.7.2: Sum-of-Squared Error Function Contours Equation (4.Figure 4. ˆ n−k 2 i=1 (4. The error variance σ 2 = Ee2 is also a parameter of interest. 24 . It measures the variation in the i “unexplained” part of the regression. Its method of moments estimator is the sample average 1X 2 ei .

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

. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. For example n X i=1 For many purposes. . en ⎞ Observe that Y and e are n × 1 vectors. 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.12) is a system of n equations. Sample sums can also be written in matrix notation. yn = x0 β + en . . one for each observation. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE.6). 4. n X i=1 Thus the estimator (4. ⎝ ⎝ . and X is an n × k matrix. ⎟. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. . .4). it is matrix notation. residual vector. = β+ XX 26 (4. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. yn ⎟ ⎟ ⎟. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ⎠ .8) . including computation. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. The linear equation (3. Due to this equivalence. Thus the MLE (β. . x0 n ⎞ ⎛ e1 e2 . n or equivalently Y = Xβ + e.

4.5

Projection Matrices

¢−1 0 ¡ X P = X X 0X M ¡ ¢−1 0 = In − X X 0 X X = In − P

Deﬁne the matrices and

where In is the n × n identity matrix. They are called projection matrices due to the property that for any matrix Z which can be written as Z = XΓ for some matrix Γ, (we say that Z lies in the range space of X) then ¢−1 0 ¡ X XΓ = XΓ = Z P Z = P XΓ = X X 0 X M Z = (In − P ) Z = Z − P Z = Z − Z = 0. As an important example of this property, partition the matrix X into two matrices X1 and X2 , so that X = [X1 X2 ] . Then P X1 = X1 and M X1 = 0. It follows that M X = 0 and M P = 0, so M and P are orthogonal. The matrices P and M are symmetric and idempotent1 . To see that P is symmetric, ³ ¡ ¢−1 0 ´0 P 0 = X X 0X X ³¡ ¡ ¢0 ¢−1 ´0 X 0X = X0 (X)0 ³¡ ¢0 ´−1 0 = X X 0X X ³ ¡ ¢0 ´−1 0 = X (X)0 X 0 X = P. To establish that it is idempotent, ³ ¡ ¢−1 0 ´ ³ ¡ 0 ¢−1 0 ´ X X 0X X XX X X ¡ 0 ¢−1 0 ¡ 0 ¢−1 0 = X XX XX XX X ¡ 0 ¢−1 0 = X XX X = P, and MM = M (In − P )

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

**since M P = 0. Another useful property is that tr P tr M where the trace operator tr A = = k = n−k
**

r X j=1

(4.9) (4.10)

ajj

is the sum of the diagonal elements of the matrix A. To show (4.9) and (4.10), ³ ¡ ¢−1 0 ´ X tr P = tr X X 0 X ³¡ ¢−1 0 ´ = tr X 0 X XX = tr (Ik ) = k, and tr M = tr (In − P ) = tr (In ) − tr (P ) = n − k. Given the deﬁnitions of P and M, observe that ¢−1 0 ¡ ˆ ˆ X Y = PY Y = X β = X X 0X ˆ e = Y − X β = Y − P Y = M Y. ˆ Furthermore, since Y = Xβ + e and M X = 0, then e = M (Xβ + e) = M e. ˆ Another way of writing (4.11) is ˆ ˆ Y = (P + M ) Y = P Y + M Y = Y + e. This decomposition is orthogonal, that is ˆ ˆ Y 0 e = (P Y )0 (M Y ) = Y 0 P M Y = 0. (4.12) (4.11)

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

Then the regression model can be rewritten as Y = X1 β 1 + X2 β 2 + e. 28 (4.13)

Observe that the OLS estimator of β = (β 0 , β 0 )0 can be obtained by regression of Y on X = [X1 1 2 X2 ]. OLS estimation can be written as ˆ ˆ Y = X1 β 1 + X2 β 2 + e. ˆ (4.14)

Suppose that we are primarily interested in β 2 , not in β 1 , so are only interested in obtaining ˆ ˆ the OLS sub-component β 2 . In this section we derive an alternative expression for β 2 which does not involve estimation of the full model. Deﬁne ¡ 0 ¢−1 0 X1 . M1 = In − X1 X1 X1

0 Recalling the deﬁnition M = I − X (X 0 X)−1 X 0 , observe that X1 M1 = 0 and thus ¡ 0 ¢−1 0 M1 M = M − X1 X1 X1 X1 M = M

It follows that

**M1 e = M1 M e = M e = e. ˆ ˆ Using this result, if we premultiply (4.14) by M1 we obtain M1 Y ˆ ˆ = M1 X1 β 1 + M1 X2 β 2 + M1 e ˆ ˆ = M1 X2 β + e ˆ
**

2

(4.15)

0 0ˆ the second equality since M1 X1 = 0. Premultiplying by X2 and recalling that X2 e = 0, we obtain 0 0 0 0 ˆ ˆ X2 M1 Y = X2 M1 X2 β 2 + X2 e = X2 M1 X2 β 2 . ˆ

Solving, ˆ an alternative expression for β 2 . Now, deﬁne

¡ 0 ¢ ¢−1 ¡ 0 ˆ β 2 = X2 M1 X2 X2 M1 Y ˜ X2 = M1 X2 ˜ Y = M1 Y, (4.16) (4.17)

ˆ ˜ ˜ This shows that β 2 can be calculated by the OLS regression of Y on X2 . This technique is called residual regression. Furthermore, using the deﬁnitions (4.16) and (4.17), expression (4.15) can be equivalently written as ˜ ˜ ˆ ˆ Y = X2 β 2 + e. ˆ ˜ ˜ Since β 2 is precisely the OLS coeﬃcient from a regression of Y on X2 , this shows that the residual from this regression is e, numerically the same residual as from the joint regression (4.14). We ˆ have proven the following theorem. 29

the least-squares residuals from the regression of X2 and Y, respectively, on the matrix X1 only. Since the matrix M1 is idempotent, M1 = M1 M1 and thus ¢−1 ¡ 0 ¡ 0 ¢ ˆ X2 M1 Y β 2 = X2 M1 X2 ¢ ¢−1 ¡ 0 ¡ 0 X2 M1 M1 Y = X2 M1 M1 X2 ´−1 ³ ³ ´ ˜0 ˜ ˜0 ˜ = X2 X2 X2 Y

The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . ⎠ ⎝ ⎠ ⎝ .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. 4.9). but in most cases there is little computational advantage to using the two-step algorithm. is the demeaning formula for regression. which you may have seen in an introductory econometrics course. obtain OLS estimates β 2 and residuals e. In this case. .13). Partition X = [X1 X2 ] where X1 = ι is a vector of ones.9). . the FWL theorem can be used to speed computation. . .Theorem 4. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. In this section we derive the small sample conditional mean and variance of the OLS estimator. ⎟ ⎜ ⎟ ⎜ (4. ˆ ˜ ˜ ˆ 3. 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) . obtain residuals X2 . . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. ˆ which are “demeaned”. the primary use is theoretical. By the independence of the observations and (3. In some contexts. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y.6. ˜ 2. Regress Y on X1 . In the model (4. Regress Y on X2 . . Regress X2 on X1 . A common application of the FWL theorem. . Rather. . obtain residuals Y .8)(3. observe that ⎞ ⎛ ⎞ ⎛ . 30 . ¡ ¢−1 0 ι.14) or via the ˆ following algorithm: ˜ 1. and X2 is the vector of observed regressors. .1 (Frisch-Waugh-Lovell). .

σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 .Using (4. under the of ˆ ¢ 2 | x = σ 2 . . . .. the properties of conditional expectations. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . X 0 DX = X 0 Xσ 2 .20) .. and (4. . 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. ⎝ .8).18). and ³ ´ ¡ ¢−1 2 ˆ σ . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . From (4. .19) ˆ and thus the OLS estimator β is unbiased for β. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. . V ar β | X = X 0 X ⎟ ⎟ ⎟. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . . . ⎠ (4. and the trace operator observe that.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 . 1 n . σ 2 } = ⎜ . Then given (4.. 0 0 ··· 0 0 .12). 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. 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. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4..

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

who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. ¡ ¢ P yi = τ j . the class of potential estimators has been restricted to linear unbiased estimators. j = 1. This property is called semiparametric eﬃciency.. r for some constant vectors τ j . where 1 (·) is the indicator function. but the π j are unknown. 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. . Not only has the class of models has been restricted to homoskedastic linear regressions.. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. the deﬁnition (4. xi = ξ j = π j ... The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 .3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. r. π r ) . The MLE β mle for β is then the analog of (4. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. This latter restriction is particularly unsatisfactory. That is. It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. and π j . Assume that the τ j and ξ j are known. .. ξ j . ˆ β mle = ⎝ j j=1 j=1 33 .) In this discrete setting.Proof. . Set C = A − X (X 0 X)−1 .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 ⎠ . π j is the percentage of the observations ˆ ˆ which fall in each category..5) as required. A broader justiﬁcation is provided in Chamberlain (1987). As the data are multinomial. but it is quite limited in scope. (We know the values yi and xi can take. but we don’t know the probabilities. and is a strong justiﬁcation for the least-squares estimator. xi ) is discrete.. Then we calculate that ³ ¡ ¡ ¢−1 ¡ ¢−1 ´0 ³ ¢−1∗ ´ ¡ 0 ¢−1 C + X X 0X − XX = C + X X 0X A0 A − X 0 X ¡ 0 ¢−1 ¡ 0 ¢−1 0 ¡ ¢−1 0 ¡ 0 ¢−1 ¡ 0 ¢−1 = C 0C + C 0X X X + XX X C + X 0X XX XX − XX = C 0C The matrix C 0 C is positive semi-deﬁnite (see Appendix 2. 4..21) j j=1 j=1 Thus β is a function of (π 1 . Suppose that the joint distribution of (yi . That is. Let A be any n×k function of X such that A0 X = Ik . We discuss the intuition behind his result in this section.. Note that X 0 C = 0. for ﬁnite r.

1.5.9). 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. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.10 Omitted Variables xi = µ x1i x2i ¶ .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. Chamberlain (1987) extends this argument to the case of continuously-distributed data.22) 34 . and thus so is the OLS estimator. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. the maximum likelihood estimator is identical to the OLS estimator. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi . (4. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. if the data have a discrete distribution.10) for the class of models satisfying Assumption 3.Substituting in the expressions for π j . He observes that the above argument holds for all multinomial distributions. He proves that generically the OLS estimator (4.

the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . this arises when sets of regressors are included which are identically related. there is some α such that Xα = 0. This is called strict multicollinearity. we regress yi on x1i only. When this happens. or second.23) where is the coeﬃcient from a regression of x2i on x1i . For example. Since the error is discovered quickly. then β is not deﬁned.. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. 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 . By construction. This happens when the columns of X are linearly dependent. 4. which is often called “multicollinearity” for brevity. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. To see this. 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. First. and the error as ui rather than ei .Now suppose that instead of estimating equation (4.22).22) the long regression and (4. 35 . if X includes both the logs of two prices and the log of the relative prices. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). This is the situation when the X 0 X matrix is near singular. the coeﬃcient on x2i in (4.11 Multicollinearity ˆ If rank(X 0 X) < k + 1.23) the short regression to emphasize the distinction. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. This deﬁnition is not precise. log(p1 ). In general. The more relevant issue is near multicollinearity. this is rarely a problem for applied econometric practice. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. when the columns of X are close to linearly dependent. Goldberger (1991) calls (4. In this case.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . β 1 6= γ 1 . Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. as many desired variables are not available in a given dataset.22) by least-squares. The diﬀerence Γβ 2 is known as omitted variable bias. least-squares estimation of (4. It is the consequence of omission of a relevant correlated variable. the general model will be free of the omitted variables problem. log(p2 ) and log(p1 /p2 ).22) is zero. This is because the model being estimated is diﬀerent than (4.e. Typically. i. Typically there are limits. except in special cases. because we have not said what it means for a matrix to be “near singular”. Most commonly.

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

¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .25). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . which is considerably more informative than plots of the uncorrected residuals ei .This implies has a large value of hi .1) in Section 2. ˆ We now derive equation (4.27). Investigations into the presence of inﬂuential observations can plot the values of (4. then this observation is a leverage point and has the potential to be an inﬂuential observation. The key is equation (2.

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

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

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

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

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

If Zn →p c as n → ∞ and g (·) is continuous at c. √ Theorem 5. Hence g(Zn ) →p g(c) as n → ∞. where θ is m × 1 and Σ is m × m. gθ Σgθ . This is suﬃcient to establish the theorem. Σ) .4. Theorem 5. Recall that A ⊂ B implies P (A) ≤ P (B). µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. we see that as n → ∞. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0.4. k ≤ m. Stacking across elements of g. Since cλλ (λn ) → cλλ (0) = −Ik .1 Continuous Mapping Theorem 1 (CMT). and g(θ) : Rm → Rk . Σ) = N 0.√ where λn → 0 lies on the line segment joining 0 and λ/ n. 45 . then g(Zn ) →d g(Z) as n → ∞. Ik ) distribution. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.2 Continuous Mapping Theorem 2. If Zn →d Z as n → ∞ and g (·) is continuous.3 Delta Method: If n (θn − θ0 ) →d N (0. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 . ¥ 5. then g(Zn ) →p g(c) as n → ∞.4 Asymptotic Transformations Theorem 5.4. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. for each element of g. Proof : By a vector Taylor series expansion. Proof: Since g is continuous at c.

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

5. (6.4 implies that Q−1 exists and thus g(·. Hence by the continuous mapping theorem (Theorem 5.3) Ã where g(A.1 and the WLLN (Theorem 5. ˆ Theorem 6.2. 6.2). First.4.1. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. the OLS estimator β is has a statistical distribution which is unknown. Assumption 3. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. 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 5.5.1 by the fact that the sampling densities become more concentrated as n gets larger.2. using (6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1).2 Consistency ˆ As discussed in Section 6. As the sample size increases the density becomes more concentrated about the population coeﬃcient. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.2) i i n i=1 n From (6.1.1) and ˆ We now deduce the consistency of β.3). A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. Ã n ! n X 1X 0 1 ˆ xi xi . To characterize the sampling distribution more fully.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . For a complete argument. Equation (4. we will use the methods of asymptotic approximation.5. β →p β as n → ∞. n i=1 (6. (6. ·) is continuous at (Q.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. xi ei →p g (Q.1 Under Assumption 3.1. Assumption 3.1). ˆ 47 .1). This is illustrated in Figure 6.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. (6.1). 0). Proof.4. we can conclude ˆ that β →p β.

(6.1. Ee4 < ∞ and E |xi |4 < ∞. it follows that s2 = ¥ n σ 2 →p σ 2 .5. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . 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 . Thus σ 2 is consistent for σ 2 . E ¯ei ¯ E ¯e4 ¯ i i i i (6.5. (6.3.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. ˆ n−k 6.1).2).2). ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. ˆ Finally.3. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.1.1 In addition to Assumption 3. By the central limit theorem (Theorem 5.2 Under Assumption 3.2.2.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.1 guarantees that the elements of Ω are ﬁnite. i i Assumption 6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. Ω) .3. Assumption 6.6) n i=1 48 .1). (6.3) and Theorem (6. n 1 X √ xi ei →d N (0.Theorem 6. We need a strengthening of the moment conditions. (6. since n/(n − k) → 1 as n → ∞. by the Cauchy-Schwarz inequality (5. ˆ Proof. To see this.

and (6. xi ) which satisfy the conditions of Assumption 6.7) Cov(xi x0 . Under (6. V is often referred to as ˆ the asymptotic covariance matrix of β.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .2). We say that ei is a Homoskedastic Projection Error when (6. e2 ) = 0. however. (6. there is no simple answer to this reasonable question. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1 Under Assumption 6.3.1. its variance diverges q ³ ´ ˆ to inﬁnity. |ε| ≥ 1. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. In Figure 6.Then using (6. When (6. Ω) ¡ ¢ = N 0. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. Q−1 ΩQ−1 . after rescaling. setting n = 100 and varying the parameter α. We illustrate this problem using a simulation. i i Condition (6. This holds true for all joint distibutions of (yi . 1 X √ xi ei n i=1 n ! the N (0.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. As α approaches 2.6).7) holds. Let yi = β 0 + β 1 xi + εi where xi is N (0. is approximately normal when the sample size n is suﬃciently large.3.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β .8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. but this is not a necessary condition.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. otherwise V 6= V 0 . when xi and ei are independent. The asymptotic distribution ´ Theorem 6. There is a special case where Ω and V simplify.1).3. 1) asymptotic distibution.1 states that the sampling distribution of the least-squares estimator.9) we deﬁne V 0 = Q−1 σ 2 whether (6.7) is true then V = V 0 . However. 1). If α > 2 the 2 error εi has zero mean and variance α/(α − 2). The trouble is that no matter how large is the sample size. Theorem 6. How large should n be in order for the approximation to be useful? Unfortunately.3. V ) where V = Q−1 ΩQ−1 . The approximation may be poor when n is small.9) In (6. For α 49 .1. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. In´Figure 6.7) is true or false. We call V 0 the homoskedastic covariance matrix. for example. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. The expression V = Q−1 ΩQ−1 is called a sandwich form.3.

1) asymptotic approximation is never guaranteed to be accurate. Another example is shown in Figure 6.Figure 6.3.2: Density of Normalized OLS estimator α = 3. the sampling distribution becomes highly skewed and non-normal.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. The estimator 2 2 in (6.2. 4.3 is that the N (0. concentrating most of the probability mass around zero. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . We show the sampling distribution of n β 1 − β 1 setting n = 100. 1). As k increases.10) V 0 = Q−1 s2 . 6 and 8. The lesson from Figures 6.10) without changing this result.1) it is clear that V 0 →p V 0 . 1) density. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.2) and Theorem 6. 6.2 and 6.11) 50 . we need an estimate of Ω = E xi x0 e2 . As α diminishes the density changes signiﬁcantly.0 the density is very close to the N (0. for k = 1. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.

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

80 40.83 ¶−1 µ . To illustrate. we return to the log wage regression of Section 4.20 and µ ¶ ˆ = 0. From a computational standpoint.14 205.199 2.80 2.20 = V 14.480 .14 14. We calculate that s2 = 0.98 −0.039 and ˆ V = µ 1 14.83 −0.14 205.4) 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 . Using (6. (6. First.used by an author when studying their work.14 14.085 p ˆ and that for β 1 is . the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .020) 6. then take the diagonal elements.035 ¶ .117 Educationi . (. Ω 2.493 −0.14 205.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.1.35/988 = . The standard errors for β 0 are 7.020.14 6. just as any other estimator. and then the square roots.80 40.5) and the WLLN (Theorem 5. from which it follows that V →p V as n → ∞.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. n n i=1 52 .30 + 0.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.20 −0.83 ¶−1 = µ 7. p ˆ In this case the two estimates are quite similar. by Holder’s inequality (5. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.12) in turn. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.2/988 = .80 . E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. i i i i n i=1 Second. but not under another set of assumptions.199 2.085) (.493 0.6 ¶µ 1 14. (6.2.480 ˆ0 = 0.

by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.13) of Efron (1982). n i=1 n ˆ ˆ Theorem 6. ¯ 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 0.13) Using formula (4. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .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 . Ω →p Ω and V →p V. 6.−i = (1 − hi )−1 ei ˆ presented in (4. i=1 Third.11) with the leave-one-out estimator ei. 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. Using this substitution. Recall from Section 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.5.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . these establish consistency.25). which. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6.26). you can show that 1 Xˆ ¯ β= β (−i) . From equation (3. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .1 As n → ∞. ¯ ¯n ¯ n i=1 so Together. Andrews (1991) suggested an similar estimator based on cross-validation.

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

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

The asymptotic p-value for the above statistic is constructed as follows. associated with Fisher. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. under H0 . or “accepts” H0 . That is. It is designed to cover θ with high probability. If the p-value pn is small (close to zero) then the evidence against H0 is strong. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. The coverage probability is P (θ ∈ Cn ). z. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . 1]. 1]. 56 . in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. For example. is to report an asymptotic p-value. Deﬁne the tail probability. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. To see this fact. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 .645. Let zα/2 is the upper α/2 quantile of the standard normal distribution. 1]. In a sense. regardless of the complication of the distribution of the original test statistic. 1). The p-value is more general. tn →d N (0.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ .05 = 1.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. and is a function of the data and hence is / random. in that the reader is allowed to pick the level of signiﬁcance α. 1). Either θ ∈ Cn or θ ∈ Cn . note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). An alternative approach. Otherwise the test does not reject. pn →d U [0. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. from which it follows that pn →d U [0. That is. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . if Z ∼ N (0.96 and z. 6. s(ˆ θ) Under H0 .025 = 1. however. Then the asymptotic p-value of the statistic tn is pn = p(tn ).

The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. θ The interval has been constructed so that as n → ∞. the most common professional choice isi95%.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). 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 . This corresponds to selecting the conﬁdence h i h ˆ ± 1.05. or α = . 6. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. = n h(β) − θ0 Hβ V Hβ 57 (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. In this case the t-statistic approach does not work. 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). However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. 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).17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. 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.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. ˆ + zα/2 s(ˆ . and it is desired to test the joint restrictions simultaneously.16) and zα/2 is the upper α/2 quantile of the standard normal distribution.96s(ˆ ≈ ˆ ± 2s(ˆ .18) . θ θ) (6.

As before. The asymptotic p-value for Wn is pn = p(Wn ). χ2 (.10. the upper-α quantile q 2 of the χ2 distribution. 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. In this case. if rank(Hβ ) = q. Hβ (β) is a continuous function of β. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).1 showed θ ˆ that V →p V. the test rejects at the α% level iﬀ pn < α.15) showed that n ˆ − θ →d Z ∼ N (0. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . The null hypothesis is H0 : β 2 = 0. h(β) = R0 β. a chiq square random variable with q degrees of freedom. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.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 . then Wn →d χ2 . q and pn is asymptotically U[0. Furthermore. 1] under H0 .19) σ2 ˆ where σ2 = ˜ 1 0 e e. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .2. Hβ (β) →p Hβ . Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. 6.When h is a linear function of β. ˜˜ n ˜ e = Y − X1 β 1 .1 Under H0 and Assumption 6. ˆ Wn = n θ θ q θ θ Theorem 6. Wn = n R0 β − θ0 ´ √ ³ The delta method (6.5. Vθ ).8. 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. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).3. and Theorem 6.05) = 3. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. θ = β 2 .84 = z. and there are q = k2 restrictions. For example. Hence β β by Theorem A.025 . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .1. Also h(β) = a selector matrix. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.

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

where In many statistical packages. 6. Let u = σ −1 H 0 e ∼ N (0. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. an “F statistic” is reported.3. Since uncorrelated normal variables are independent. there is an exact distribution theory available for the normal linear regression model. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . equivalently the residual variance from an intercept-only model. In ) . In σ 2 . This is rarely an issue today. when an OLS regression is reported. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. n−k 60 . While there are special cases where this F statistic is useful. it follows ˆ that β is independent of any function of the OLS residuals. introduced in Section 4. these cases are atypical. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0.4)) where H 0 H = In . In particular. Since linear functions of normals are also normal. 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 . H 0 H) ∼ N (0. This was a popular statistic in the early days of econometric reporting.12 Normal Regression Model As an alternative to asymptotic distribution theory. The modelling assumption that the error ei is independent of xi and N (0. including the estimated error variance 2. σ 2 ) can be be used to calculate a set of exact distribution results. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = .

β 2 . β 2 .8. 1) and tn−k distributions. σ 2 ) = − log σ − log (2π) − . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . n−k • ∼ tn−k ˆ In Theorem 6. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses.) Now let us partition β = (β 1 . As inference (conﬁdence intervals) are based on the t-ratio. if standard errors are calculated using the homoskedastic formula (6. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. We summarize these ﬁndings Theorem 6. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ ˆ ˆ βj − βj βj − βj N (0.a chi-square distribution with n − k degrees of freedom. a good testing procedure is based on the likelihood ratio statistic. β and t are approximately normally distributed. σ 2 ) − Ln (β 1 . 0. The critical values are quite close if n − k ≥ 30.1 we showed that in large samples. β 2 . and standard errors are calculated using the homoskedastic formula (6. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. 0. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 .3. 0. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . so as a practical matter it does not matter which distribution is used. β has an exact normal distribution and t has an exact t distribution. σ2 ˆ 61 .1 If ei is independent of xi and distributed N(0. the notable distinction is between the N (0. σ 2 ). Furthermore. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .10) then ´ ³ ˆ • β ∼ N 0.12.1 and Theorem 6. with residual variance σ . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . Theorem 6. In contrast. σ 2 ) discussed above. (Unless the sample size is unreasonably small.1 shows that under the strong assumption of ˆ normality.12.

Take the model yi = β + ei ei ∼ N (0. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. σ 2 ) and consider the hypothesis H0 : β = 1. Letting h(β) = β s .4 the Wald statistic Wn (s) as a function ˆ of s. 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. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. In the present context of the Wald statistic.84 — the probability of a false rejection. they can work quite poorly when the restrictions are nonlinear. To demonstrate this eﬀect.7. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. features of this distribution can be calculated. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. The decreasing dashed ˆ = 1.8. Through repetition. 6. the statistic Wn (s) varies with s. This can be seen by a simple example introduced by Lafontaine and White (1986). while there are other values of s for which test test statistic is insigniﬁcant. The increasing solid line is for the case β = 0. 62 . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. This is an unfortunate feature of the Wald statistic. we have plotted in Figure 6. and noting Hβ = sβ s−1 . This produces random draws from the sampling distribution of interest. Our ﬁrst-order asymptotic theory is not useful to help pick s. setting n/σ 2 = 10. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n .By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. as Wn (s) →d χ2 under H0 for 1 any s. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. ˆ Let β and σ 2 be the sample mean and variance of yi . we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 .

4: Wald Statistic as a function of s P (Wn (s) > 3. we compare the rates row by row. the only test which meets this criterion is the conventional Wn = Wn (1) test. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.1 we report the results of a Monte Carlo simulation where we vary these three parameters.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . 100 and 500. Given the simplicity of the model. Test performance deteriorates as s increases. To interpret the table. remember that the ideal Type I error probability is 5% (. so these probabilities are Type I error. and σ is varied among 1 and 3. and rarely fall outside of the 3%-8% range. For this particular example. These probabilities are calculated as the percentage of the 50. Table 4. Error rates avove 10% are considered excessive.4. The null hypothesis β s = 1 is true. n. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.1 you can also see the impact of variation in sample size. There is. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Any other choice of s leads to a test with unacceptable Type I error probabilities. Type I error rates between 3% and 8% are considered reasonable. In Table 2. When comparing statistical procedures. Rates above 20% are unexceptable.84 | β = 1) . this probability depends only on s. the Type I error probability improves towards 5% as the sample size n increases. Typically. In Table 4. and σ 2 .84. In each case.000 simulated Wald statistics Wn (s) which are larger than 3.05) with deviations indicating+ distortion.000 random samples.Figure 6. no magic choice of n for which all tests perform uniformly well. n is varied among 20. looking for tests for which rate rejection rates are close to 5%. Table 4. however.1 reports the simulation estimate of the Type I error probability from 50. The value of s is varied from 1 to 10.

05 .31 .06 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.14 .25 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .06 .13 . Other choices are arbitrary and would not be used in practice.22 .05 .05 .07 . This point can be illustrated through another example.12 .06 .09 .19 .15 .11 .34 .16 Rejection frequencies from 50.08 .06 .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 (6.28 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .22 . Equivalently.12 .06 .10 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . so the hypothesis can be stated as H0 : θ = r.07 . β 2 ) be the least-squares estimates of (6.05 .35 .18 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.10 .15 .14 .07 .05 .08 .33 . β 1 .24 .13 .05 .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 .20 .06 .20).000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. While this is clear in this particular example.15 .13 .30 .26 . 64 .20 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .25 .17 .08 .07 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.08 .10 .06 .15 .08 .07 .23 .21 . deﬁne θ = β 1 /β 2 .

along with sample size n.26 .15 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. In contrast. 65 . If no linear formulation is feasible.06 . In this section we describe the method in more detail.10 .06 . and are close to the ideal 5% rate for both sample sizes. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. 6. This leaves β 2 as a free parameter.06 .05 .00 .7. this formulation should be used.645) P (tn < −1.645) are close to zero in most cases. However. then the “most linear” formulation should be selected.25 .05 .00 .645) P (tn > 1.10 . Ideally.50 . .25.645) t1n t2n t1n t2n t1n t2n t1n t2n .00 .05 . The implication of Table 4. the rejection rates for the t1n statistic diverge greatly from this value. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.00 .02 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior. We vary β 2 among .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . the entries in the table should be 0.09 .06 .645) and P (tn > 1.05 .05 .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. Table 4.06 . and alternatives to asymptotic critical values should be considered.645) are calculated from 50. if the hypothesis can be expressed as a linear restriction on the model parameters.05 . ei be an independent N (0.0 and n among 100 and 500. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .05 . σ 2 ) draw with σ = 3. . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .10 .06 .00 .00 . especially for small values of β 2 . The results are presented in Table 4.06 .12 .05 β2 . In all cases.1. We let x1i and x2i be mutually independent N (0. The left tail probabilities P (t1n < −1.15 .28 .00 .2.00 The one-sided Type I error probabilities P (tn < −1.645) P (tn > 1.06 .000 simulated samples. .645) greatly exceed 5%.75 1.05.05 .50. and normalize β 0 = 0 and β 1 = 1.06 . such as the GMM distance statistic which will be presented in Section 9.07 . and 1. It is also prudent to consider alternative tests to the Wald statistic.47 .00 .06 .05 .75.00 . while the right tail probabilities P (t1n > 1. 1) variables.

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

a larger B results in more precise estimates of the features of interest of Gn . Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. It is therefore useful to conduct a variety of experiments. and hispanic. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.003. and our regressors include years of education. experience squared. hispanic. excluding military.007. We us the sample of wage earners from the March 2004 Current Population Survey. Hence the ³ ´ ˆ standard errors for B = 100. For regressors we include years of education. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. Quite simply. Again our dependent variable is the natural log of wages. Then qα is the N ’th number in this ordered sequence. and therefore it is straightforward to calculate standard errors for any quantity of interest. immigrant. and . For example. then B will have to be increased. s P = . the researcher must select the number of experiments. and non-white. It is therefore convenient to pick B so that N is an integer. In practice. and poorly for others.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. therefore. it is simple to make inferences about rejection probabilities from statistical tests. For the dependent variable we use the natural log of wages. If the standard error is too large to make a reliable inference. if we set B = 999. As discussed above. experience squared. an estimator or test may perform wonderfully for some values. female. and dummy variable indicators for the following: married. we included a dummy 67 . union member. respectively. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. immigrant. where N = (B +1)α.96) is iid Bernoulli. For example. The α% sample quantile is a number qα such that α% of the sample are less than qα .21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. Often this is called the number of replications. and 90% sample quantiles of the sample {Tnb }. so that coeﬃcients may be interpreted as semi-elasticities.96) . union member. Furthermore. We separately estimate equations for white and non-whites. potential work experience. then we can set s P = (. such as the percentage estimate reported in (6. potential work experience. are. B. As P is unknown. for a selection of choices of n and F. and dummy variable indicators for the following: married. The random variable 1 (Tnb ≥ 1.022. The average (6. In particular. . Generally. but requires more computational time. this may ˆ be approximated by replacing P with P or with an hypothesized value. the choice of B is often guided by the computational demands of the statistical procedure. and 5000.22/ B. the performance will depend on n and F. B b=1 (6. female.95) /B ' . equalling 1 with probability P = E1 (Tnb ≥ 1. In many cases.21). 1000.05) (.15 Estimating a Wage Equation We again return to our wage equation. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1.96) . if we are ³ ´ p √ ˆ assessing an asymptotic 5% test.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. and estimate a multivariate regression. We now expand the sample all non-military wage earners. 6.

Alternatively.00057 .102 −.121 −.00002 . excluding the coeﬃcients on the state dummy variables. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. Table 4.19) is ˜ µ ¶ µ ¶ σ2 ˆ .001 .48772 = 515.101 .013 . 2β 3 68 . reestimating the model with the 50 state dummies excluded. 808 1 − . The available sample is 18.variable for state of residence (including the District of Columbia.008 .69. the restricted standard deviation estimate is σ = . Wn = n 1 − 2 = 18. The F form of the Wald statistic (6.033 −.232 .070 . we ﬁnd Wn = 550.014 .34 ˆ s(β) . but not equal. 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.102 −.808 so the parameter estimates are quite precise and reported in Table 4.010 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. θ ˆ 2β 3 β2 . this adds 50 regressors).097 −.010 .007 .18) that the state coeﬃcients are jointly zero.4877 18. Using either statistic the hypothesis is easily rejected.027 . Computing the Wald statistic (6.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.002 .1.032 . Ignoring the other coeﬃcients.808 .4945.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.49452 σ ˜ Notice that the two statistics are close. as the 1% critical value for the χ2 distribution is 76.

Using the Delta Method. This set is [27. we can calculate a standard error of s(ˆ = .96. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test.5]. 69 . Instead. but it can be found numerically quite easily. Since tn (θ) is a non-linear function of θ.5]. we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further. In the previous section we discovered that such t-tests had very poor Type I error rates. Notice that the upper end of the conﬁdence interval is the same as that from the delta method.9. 29. not testing a hypothesis. In the present context we are interested in forming a conﬁdence interval. this is a poor choice. However. 29. but the lower end is substantially lower. implying a 95% conﬁdence θ) interval of [27. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.40. 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 ). This is the set of θ such that |tn (θ)| ≤ 1. there is not a simple expression for this set.0.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1) infeasible since the matrix D is unknown... 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. 74 . the least-squares estimator is ineﬃcient.2) E (ξ i | xi ) = 0.. Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7. σ 2 }. 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 . Often the functional form is kept simple for parsimony. z1i are squares (and perhaps levels) of some (or all) elements of xi . where z1i is some q × 1 function of xi . The GLS estimator (7.. Let η i = e2 . Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 .. However. . we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. σ1 We now discuss this estimation problem.. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .1) XD Y β = X 0 D−1 X ¡ ¢ 2 . . Typically. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator.Chapter 7 Additional Regression Topics 7.1 Generalized Least Squares In the projection model.

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

and was proposed by Cragg (Journal of Econometrics. Its asymptotic variance is not that given in Theorem 7. ´´−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 . ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0.1. First. 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 → ∞. .1. A trimming rule might make sense: σ 2 = max[˜ 2 . Instead.1 If the skedastic regression is correctly speciﬁed. Theorem 7. This estimator V 0 is appropriate when the skedastic regression (7. Why then do we not exclusively estimate regression models by FGLS? This is a good question.1. It is possible to show that if the skedastic regression is correctly speciﬁed. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 .1. FGLS is asymptotically superior to OLS..1. In this case we interpret α0 zi as a linear projection of e2 on zi . V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 .. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. V n n i=1 . i ˜ 0 is inconsistent for V . but the proof of this can be tricky. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. Unless σ 2 = α0 zi . e2 }. In the linear regression model. Since the form of the skedastic regression is unknown. σ 2 ] σi i for some σ 2 > 0. β should perhaps be i i called a quasi-FGLS estimator of β.2) is correctly speciﬁed. We just state the result without proof. ¢¢−1 ¡ ¡ .that there is a need to bound the estimated variances away from zero. V ). similar to the covariance matrix of the OLS estimator. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7.. and it may be estimated with considerable 76 V takes a sandwich form√. 1992). There are three reasons. 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 ˜ = . It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). then FGLS is asymptotically equivalent to GLS. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.

in which case ξ i is ˜ independent of xi and the asymptotic variance (7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. It is consistent not only in the regression model. but also under the assumptions of linear projection. Theorem 7. its squares. and this requires trimming to solve. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. as they will be estimating two diﬀerent projections. individual estimated conditional variances may be negative. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.1 Under H0 and ei independent of xi . Third. The asymptotic distribution (7. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . This introduces an element of arbitrariness which is unsettling to empirical researchers. q Most tests for heteroskedasticity take this basic form. In this case.7) under independence show that this test has an asymptotic chi-square distribution. We may therefore test this hypothesis by the estimation (7. require the assumption of a correct conditional mean. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. the Wald test of H0 is asymptotically χ2 . This hypothesis does not imply that ξ i is independent of xi .3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . Typically. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. Second. the two tests coincide. FGLS will do worse than OLS in practice. and not a conditional mean.4). In the linear regression model the conditional mean of yi given xi = x is 77 .error. on the other hand. 7.2.5) and the asymptotic variance (7. If the equation of interest is a linear projection. The main diﬀerences between popular “tests” is which transformations of xi enter zi . σ 2 ). and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. Vα = E zi zi (7. and all cross-products. the estimated conditional variances may contain more noise than information about the true conditional variances.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 .7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. The GLS and FGLS estimators. and the cost is a reduction of robustness to misspeciﬁcatio 7.4) and constructing a Wald statistic. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . however. or equivalently that i H0 : α1 = 0 in the regression (7. but the only diﬀerence is that they a ¢ allowed for general choice of zi . OLS is a more robust estimator of the parameter vector.2).

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

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

an estimate of the asymptotic variance V is ˆ V = Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 Ã 1X mθi m0 e2 ˆ ˆ θi ˆi n i=1 n !Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 where mθi = mθ (xi . Thus we want to test H0 : β 2 = 0. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. This renders the distribution theory presented in the previous section invalid. An alternative good measure is the conditional median. θ) ' (ei + m(xi .For θ close to the true value θ0 . 7. θi Thus ¡ ¢ yi − m(xi . Suppose that m(xi . θ))2 ' n X¡ ¢2 0 yi − m0 θ θi i=1 0 and the right-hand-side is the SSE function for a linear regression of yi on mθi . the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. θ) ' m(xi . under H0 . θ which is that stated in the theorem. Hansen (1996). Thus when the truth is that β 2 = 0. ˆ ˆ θ) ˆ θ). θ) = β 0 zi + β 0 xi (γ). ˆ and ei = yi − m(xi . However. by a ﬁrst-order Taylor series approximation. 1 2 The model is linear when β 2 = 0. the parameter estimates are not asymptotically normally distributed. m(xi . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . Furthermore. We have discussed projections and conditional means. and this is often a useful hypothesis (sub-model) to consider. 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. θ0 )) − m(xi . In particular. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application.4.1. γ is not identiﬁed.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 . tests of H0 do not have asymptotic normal or chi-square distributions. Identiﬁcation is often tricky in nonlinear regression models. This means that under H0 . θ0 ) + m0 (θ − θ0 ) . Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . 80 . ¥ Based on Theorem 7.

The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. i n n i=1 (7. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . and the substantive assumption is that the median function is linear in x. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. The second is the value which minimizes n n |yi − θ| . however. Two useful facts about the median are that (7. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . These distinctions are illusory. Now let’s consider the conditional median of Y given a random variable X.To recall the deﬁnition and properties of the median. let Y be a continuous random variable. as i=1 these estimators are indeed identical. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently.5. These facts deﬁnitions motivate three estimators of θ.5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. the linear function M ed (yi | xi = x) = x0 β is the conditional median function.10) The LAD estimator has the asymptotic distribution 81 .9) θ0 = argmin E |Y − θ| θ and E sgn (Y − θ0 ) = 0 where sgn (u) = ½ 1 −1 if u ≥ 0 if u < 0 is the sign function. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) .

¢¢−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) . by the central limit theorem (Theorm 5. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .3. Let g(β) = Eg (β). then there are many innovations near to the median.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. the height of the error density at its median. The main diﬃculty is the estimation of f (0). ∂ 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 ) . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . (7. First. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. See Chapter 16. Computation of standard error for LAD estimates typically is based on equation (7. Pn −1 0 β)) . ∂β 0 so Third. When f (0 | x) is large.5. In the special case where the error is independent of xi . While a complete proof of Theorem 7. This can be done with kernel estimation techniques. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . V ). the conditional density of the error at its median.Theorem 7.1 ´ √ ³ˆ n β − β 0 →d N (0.1 is advanced.5.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. ˆ Proof of Theorem 7.10) is equivalent to g n (β) = 0. and this improves estimation of the median. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. where V = and f (e | x) is the conditional density of ei given xi = x.11). we provide a sketch here for completeness.5.

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

then f (0 | xi ) = f (0) . Furthermore. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7.5.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . fast linear programming methods have been developed for this problem. Thus. ¡ ¡ ¢¢−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. Vτ ). Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. n numerical methods are necessary for its minimization. Another popular approach is the RESET test proposed by Ramsey (1969). and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. conventional Newton-type optimization methods are inappropriate. the asymptotic variance depends on the conditional density of the quantile regression error. When the error ei is independent of xi .1. the unconditional density of ei at 0.6. since it has discontinuous derivatives. otherwise its properties are unspeciﬁed without further restrictions. it is useful to have a general test of the adequacy of the speciﬁcation. and are widely available. Fortunately.13).1 n β τ − β τ →d N (0. i By construction. 7. if the model yi = x0 β + ei has i been ﬁt by OLS. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7. and form a Wald statistic i for γ = 0. the τ ’th conditional quantile of ei is zero.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . and test their signiﬁcance using a Wald test. where and f (e | x) is the conditional density of ei given xi = x. ˆ Given the representation (7. The null model is yi = x0 β + εi i 84 . 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.12). ´ √ ³ˆ Theorem 7. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005).

The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. ⎟ zi = ⎝ . 7. β 2 ). yielding ˆ ˜ ˆ ˆ (β 1 . To see why this is the case. ⎠ .8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. 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. 3. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . 1i 2i 2i 1i 22 . Typically. It is easy (although somewhat tedious) to show that under the null hypothesis. and the two estimators have equal asymptotic eﬃciency. Wn →d χ2 .be an (m − 1)-vector of powers of yi . Another is to regress yi on x1i and x2i jointly. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. since Q12 Q−1 Q21 > 0. Otherwise. and consequently 22 ¡ ¢−1 2 σ . m must be selected in advance. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . they will (typically) have diﬀerence asymptotic variances. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. 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 . In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . and form the Wald statistic Wn for γ = 0. yi ˆm (7. small values such as m = 2.14) by OLS. β 1 = (X1 X1 )−1 (X1 Y ) . In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. note that (7. 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. yielding predicted values yi = x0 β. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. and n→∞ say. To implement the test.14) may be written as ³ ´3 ³ ´m ³ ´2 ˜ ˆ ˜ ˆ ˜ ˆ yi = x0 β + x0 β γ 1 + x0 β γ 2 + · · · x0 β γ m−1 + ei ˜ ˜ i i i i which has essentially approximated G(·) by a m’th order polynomial. However. then 22 Q11 > Q11 − Q12 Q−1 Q21 . If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. or 4 seem to work best.

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

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. 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. For some critical level α. LRn →p 0. M)) between the true density and the model density. The rule is to select M1 if AIC1 < AIC2 . k = While many modiﬁcations of the AIC have been proposed. else select M2 . n (7. and km is the number of coeﬃcients in the model. Then select M1 if Wn ≤ cα . depending on the sample size. etc. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . That is. since under M1 . known as the BIC.15) then where σ 2 is the variance estimate for model m. the most popular to be one proposed by Schwarz. If the truth is inﬁnite dimensional. this rule only makes sense when the true model is ﬁnite dimensional. log(n) 87 . is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . n (7. since (7.16) holds under M1 . AIC selection is inconsistent. His criterion.17) Since log(n) > 2 (if n > 8). ¢ ¡ ˆ1 ˆ2 (7. Another common approach to model selection is to to a selection criterion. 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. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. One popular choice is the Akaike Information Criterion (AIC).However. if α is set to be a small number. The model selection rule is as follows.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. Indeed. let cα satisfy ¢ ¡ P χ22 > cα . then this model selection procedure is inconsistent. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . k A major problem with this approach is that the critical level α is indeterminate. Another problem is that if α is held ﬁxed. as the rule tends to overﬁt. BIC model selection is consistent. based on Bayesian arguments. In contrast to the AIC. Indeed. as ³ ´ c P M = M1 | M1 → 1 − α < 1. else select M2 . then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically.

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

Let θ satisfy Eg(Yi − θ) = 0.10 Exercises 1. . V ar(e | X) = σ 2 Ω with Ω known. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e.. 5. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . else equals zero). Is θ a quantile of the distribution of Yi ? 3. 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 . (b) Prove that e = M1 e. and the out-of-sample value of the regressors. where xji is one of the xi . ˆ ˆ n−k 6. based on a sample of size n. 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 . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. xi ) be a random sample with E(Y | X) = Xβ. Show that the function g(x) which minimizes the MAE is the conditional median M (x). In a linear model Y = Xβ + e. ˆ (a) Find a point forecast of y. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 .. 4. wn ) and wi = x−2 . V . ˜ the residual vector is e = Y − X β.7. (b) Find an estimate of the variance of this forecast. E(e | X) = 0. For any predictor g(xi ) for y.. Thus the available information is the sample (Y. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . Let (yi . x. 2. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . Verify equation (7. σ 2 ). the estimates (β. . the residuals e. the mean absolute error (MAE) is E |yi − g(xi )| .12). Let σ 2 be the estimate of σ 2 . X). You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x.

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

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

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

The random draws are from the N (0. ∗ P (yi ≤ y. x). Fn is by construction a step function. This is a population moment. To see the eﬀect of sample size on the EDF.2. 1) distribution. in the Figure below. x) (1 − F (y. √ n (Fn (y. F (y. For n = 25. by the CLT (Theorem 5. x) is called the empirical distribution function (EDF). x) = P (yi ≤ y. Recall that F (y. x) . The EDF is a consistent estimator of the CDF.1).. and 100. Thus by the WLLN (Theorem 5.2) Fn (y. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . That is. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. but the approximation appears to improve for the large n. 50. x))) . Fn is a nonparametric estimate of F. Fn (y. (8.3. as the sample size gets larger. x). i = 1. n. where 1(·) is the indicator function. x∗ ) with the i distribution Fn . To see this. In general.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . it is helpful to think of a random pair (yi . xi ).2 The Empirical Distribution Function Fn (y... . Note that while F may be either discrete or continuous. x) − F (y. the EDF is only a crude approximation to the CDF. the EDF step function gets uniformly close to the true CDF. x∗ ≤ x) = Fn (y. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) .8. i 93 . x) = n i=1 Figure 8. x)) →d N (0. Furthermore. Notationally. x). I have plotted the EDF and true CDF for three random samples of size n = 25.1). note that for any (y. x) →p F (y.

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

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

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

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

ˆ + s(ˆ n (α)]. qn (α) is the 1 − α quantile of the distribution of |Tn (θ0 )| . Computationally. The bootstrap test rejects if ∗ |Tn (θ0 )| > qn (α). or the number which solves the equation ∗ ∗ ∗ Gn (qn (α)) = G∗ (qn (α)) − G∗ (−qn (α)) = 1 − α. The ideal critical value c = qn (α) solves the equation Gn (qn (α)) = 1 − α. Let θ θ)q ∗ θ θ)q ∗ C4 = [ˆ − s(ˆ n (α). where c would be selected so that θ θ) P (|Tn (θ0 )| > c) = α. 1 − α = P (qn (α/2) ≤ Tn (θ0 ) ≤ qn (1 − α/2)) ´ ³ ´ ³ θ) θ = P qn (α/2) ≤ ˆ − θ0 /s(ˆ ≤ qn (1 − α/2) ³ ´ = P ˆ − s(ˆ n (1 − α/2) ≤ θ0 ≤ ˆ − s(ˆ n (α/2) . Let Tn (θ) = ˆ − θ /s(ˆ Then so an exact (1 − α)% conﬁdence interval for θ0 would be 0 θ θ)q C3 = [ˆ − s(ˆ n (1 − α/2). θ θ)qn This motivates a bootstrap analog θ θ)q ∗ C3 = [ˆ − s(ˆ n (1 − α/2).7 Symmetric Percentile-t Intervals Suppose we want to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. this is based on the critical values from the one-sided hypothesis tests.´ ³ θ θ). 8. This is often called a percentile-t conﬁdence interval. discussed above. each α/2. Equivalently. We would set Tn (θ) = ³ ´ ˆ − θ /s(ˆ and reject H0 in favor of H1 if |Tn (θ0 )| > c. which is a symmetric distribution function. and taking the upper α% quantile. qn¯ ¯ ∗ ∗ ¯ ¯ ∗ θ θ θ statistics |Tn | = ¯ˆ − ˆ¯ /s(ˆ ). 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. θ θ)q ˆ − s(ˆ ∗ (α/2)]. ∗ 98 . θ θ)q θ θ)q ˆ − s(ˆ n (α/2)]. n n ∗ (α) is estimated from a bootstrap simulation by sorting the bootstrap tComputationally. ∗ ∗ The bootstrap estimate is qn (α). Note that P (|Tn (θ0 )| < c) = P (−c < Tn (θ0 ) < c) = Gn (c) − Gn (−c) ≡ Gn (c). the 1 − α quantile of the distribution of |Tn | .

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. Let an be a sequence. lim Gn (x. writing Tn ∼ Gn (x. F ) = Φ + o (1) . and a function h(x) is odd if h(−x) = −h(x). and vice-versa. not ˆ − θ0 .1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.8 Asymptotic Expansions Tn →d N (0.2 an = O(1) if |an | is uniformly bounded. 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. C4 is called the symmetric percentile-t interval. (8. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. Basically. 99 . Deﬁnition 8. Equivalently. v 2 ). The following notation will be helpful.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test.4) v ¡ ¢ While (8. A better asymptotic approximation may be obtained through an asymptotic expansion. however. If θ is a vector.] 8. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . Deﬁnition 8. where qn (α) is the (1 − α)% quantile of the distribution of Wn .4) says that Gn converges to Φ x as n → ∞. the critical value qn (α) is found as the quantile from simulated values of W´ . The derivative of an even function is odd. Thus here Tn (θ) = Wn (θ). or the size of the divergence for any particular sample size n.3 an = o(n−r ) if nr |an | → 0 as n → ∞.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. We say that a function g(x) is even if g(−x) = g(x). F ) then ³x´ . an = O(n−r ) if it declines to zero like n−r . Let Tn be a statistic such that (8.8. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . θ θ θ ˆ θ ∗ ∗ Computationally.8. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).8. it says nothing. F ) = Φ n→∞ v or ³x´ Gn (x. θ [This is a typical mistake made by practitioners. about the rate v of convergence. The ideal test rejects if Wn ≥ qn (α).

Fn ) − g1 (x. F ). F ) + O(n−3/2 ) Gn (x. the exact distribution is P (Tn < x) = Gn (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. F0 ) ≈ ∂ g1 (x. Fn ) + O(n−1 ). F0 )) converges to 0 at rate n. the diﬀerence √ (g1 (x. F ) + n−1 g2 (x. and g2 is an odd function of x. F ) + g2 (x. adding leptokurtosis). F ) converges to the normal limit at rate n1/2 . Fn ) − g1 (x. Theorem 8. The diﬀerence is Φ(x) − Gn (x. where g1 is an even function of x.8.3). F0 ) = 1 g (x. ³x´ 1 1 + 1/2 g1 (x. so the order of the error is O(n−1/2 ). An asymptotic test is based on Φ(x).9 One-Sided Tests Using the expansion of Theorem 8. First. and g1 is continuous with respect to F. g1 (x. To a second order of approximation. Fn ) − g1 (x.1 Under regularity conditions and (8.1.1 as follows.8.8. F ) ≈ Φ + n−1/2 g1 (x. ³x´ Gn (x. Moreover. To a third order of approximation. We can interpret Theorem 8. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). F ) = Φ v n n 8.1 has the expansion n G∗ (x) = Gn (x. Fn ) = Φ(x) + n 1 g (x. the density function is skewed.8. F0 ) = Φ(x) + since v = 1. which from Theorem 8. To the second order.uniformly over x. Heuristically. 100 . F ) ≈ Φ + n−1/2 g1 (x. F0 )) + O(n−1 ). we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . Gn (x. √ Since Fn converges to F at rate n. ³x´ Gn (x. F0 ) = n 1 n1/2 (g1 (x. A bootstrap test is based on G∗ (x). F0 ) + O(n−1 ) 1/2 1 n 1 g (x. v Since the derivative of g1 is odd. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). 1/2 1 n Because Φ(x) appears in both expansions. F ) v which adds a symmetric non-normal component to the approximate density (for example.

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

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

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

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

Estimate a linear regression of price on the number of bedrooms.95) denote the 95% quantile of Tn . ∗ ∗ where s(ˆ is the standard error in the original data. ˆ = 1. Using the non-parametric ∗ bootstrap. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.5% and 97.2 and s(ˆ = .3.05) . The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.pdf. and ˆ is calculated on each θ ∗ ∗ θ sample.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). you generate bootstrap samples. ˆ − s(ˆ n (. Suppose that in an application. You replace c with qn (. Using the non-parametric bootstrap.95). (a) Report the 95% Efron Percentile interval for θ.95).95). can you report the 95% Percentile-t interval for θ? 7.5% quantiles of the ˆ are . and the colonial dummy. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. Let qn (. What is wrong with this procedure? Tn = θ/s(θ) n 6.95) denote the 5% θ) ∗ and 95% quantiles of Tn .dat contains data on house prices (sales).75 and 1. with variables listed in the ﬁle hprice1. 105 .05) and qn (. θ respectively. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. (b) Report the 95% Alternative Percentile interval for θ. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and thus reject H0 if ˆ ˆ > q ∗ (. size of house. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. and the 2. (c) With the given information. lot size. You do this as follows.2. The ˆ are sorted. ∗ ∗ ∗ Let qn (. You want to test H0 : θ = 0 against H1 : θ > 0. The dataﬁle hprice1.

x. g(y. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . β 0 ) = 0 (9. however. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0.1) by setting g(y. The variables zi may be components and functions of xi . while β 1 is of dimension k < . This situation is called overidentiﬁed. This is a special case of a more general class of moment condition models. zi . where the dimensions of zi and xi are k × 1 and × 1 . This model falls in the class (9. 1 this class of models are called moment condition models. We call r the number of overidentifying restrictions. β 0 ) = x(y − z 0 β) 106 (9. with ≥ k. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. but this is not required. an asymptotically eﬃcient estimator of β is the OLS estimator. Now suppose that we are given the information that β 2 = 0. We know that without further restrictions. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0.2) . x. β) = x(y − x0 β). In econometrics. In our previous example. There are − k = r more moment restrictions than free parameters. otherwise it is overidentiﬁed. z. This method. x.1 Overidentiﬁed Linear Model yi = x0 β + ei i = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where x1i is k × 1 and x2 is r × 1 with = k + r.Chapter 9 Generalized Method of Moments 9. As an important special case we will devote special attention to linear moment condition models. If k = the model is just identiﬁed. as their are restrictions in E (xi ei ) = 0. In the statistics literature. Let g(y. z. In this case. these are known as estimating equations.1) where β 0 is the true value of β. xi . is not necessarily eﬃcient.

2.2. then. but this is generally not possible when > k. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. i i . let Jn (β) = n · g n (β)0 Wn g n (β). then g n (β) = 0. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . and the GMM estimator is the MME. ¡ ¢−1 0 ˆ Z XWn X 0 Y.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.1 β GMM = argmin Jn (β). Let and where gi = xi ei .2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . β ˆ Note that if k = . The GMM estimator minimizes Jn (β). the dependence is only up to scale. β GMM does not change. This is a non-negative measure of the “length” of the vector g n (β). β GMM = Z 0 XWn X 0 Z 9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. 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 . for if Wn is replaced ˆ by cWn for some c > 0. ˆ Deﬁnition 9. For some × weight matrix Wn > 0.9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn .2) g n (β) = (9. 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. For example. Proposition 9. the square of the Euclidean length. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. if Wn = I.

The optimal weight matrix W0 is one which minimizes V. as the distribution of the data is unknown. V ) . W0 = Ω−1 is not known in practice. as shown by Gary Chamberlain (1987). This results shows that in the linear model. it turns out that the GMM estimator is semiparametrically eﬃcient. Ω) . ˆ n i=1 gi = gi − g n . we can set Wn = I . β).3. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance.2 For the eﬃcient GMM estimator. This is a weak concept of optimality. Chamberlain showed that in this context. The proof is left as an exercise. this is a semi-parametric problem. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. No estimator can do better (in this ﬁrst-order asymptotic sense). 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. However. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . a better choice is Wn = (X 0 X)−1 . ˆ we still call β the eﬃcient GMM estimator.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. as we are only considering alternative weight matrices Wn . as it has the same asymptotic distribution. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0.1 ´ √ ³ˆ n β − β →d N (0. For any Wn →p W0 . but it can be estimated consistently. it is semiparametrically eﬃcient. n β − β →d N 0. This turns out to be W0 = Ω−1 . and this is all that is known. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. ˆ∗ ˆ 108 . the GMM estimator β is consistent yet ineﬃcient. without imposing additional assumptions. ˆ Construct n 1X ˆ g n = g n (β) = gi .3. 9. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. For example. If it is known that E (gi (β)) = 0. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. where In general. n n We conclude: Theorem 9. In the linear model. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi .

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

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

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

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

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

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

The GMM estimator of β. zi is l × 1 and β is k × 1. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9.6) (a) Show that you can rewrite Jn (β) in (9. Show how to construct an eﬃcient GMM estimator for β. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). 6. h(β)=0 (9. 115 .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. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). subject ˆ i ˆi i=1 to the restriction h(β) = 0. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. The equation of interest is yi = g(xi . In the linear model Y = Xβ + e with E(xi ei ) = 0. The observed data is (yi .5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 .6) equals the Wald statistic. Vn = X X i=1 ˜ and hence R0 β = r. xi . Deﬁne the Lagrangian L(β. zi ). the distance statistic D in (9. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . VR ) where ¡ ¢−1 0 R V. β) + ei E (zi ei ) = 0. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. l ≥ k. VR = V − V R R0 V R (d) Show that in this setting.5.

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

xi . pn ) which places probability pi at each observation.. (10. Combined with i the constraint (10. The idea is to construct a multinomial distribution F (p1 . The maximum likelihood estimator of the probabilities (p1 . pn ) = i=1 An alternative to GMM is empirical likelihood. zi . β). 2001) and has been extended to moment condition models by Qin and Lawless (1994). these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. The multinomial distribution which places probability pi at each observation (yi . pn ) are those which maximize the log-likelihood subject to the constraint (10.3) i=1 117 .1) i=1 First let us consider a just-identiﬁed model. To be a valid multinomial distribution. This is equivalent to maximizing Ã n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier. The n ﬁrst order conditions are 0 = p−1 − µ. (10. . .. the log-likelihood function for this multinomial distribution is n X ln(pi ). zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10... Now consider the case of an overidentiﬁed model with moment condition Egi (β 0 ) = 0 where g is × 1 and β is k × 1 and for simplicity we write gi (β) = g(yi .. It is a non-parametric analog of likelihood estimation.2) Ln (p1 . The idea is due to Art Owen (1988.1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n). In this case the moment condition places no additional restrictions on the multinomial distribution.Chapter 10 Empirical Likelihood 10..1). xi ..1 Non-Parametric Likelihood Since each observation is observed once in the sample.. ..

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. we ﬁnd µ = n and 1 ¢.. p1 . λ) = −n ln (n) − n X i=1 For given β. This yields the (proﬁle) empirical log-likelihood function for β. λ ¡ ¢ ln 1 + λ0 gi (β) . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). but must be obtained numerically (see section 6. . we also obtain the Lagrange multiplier λ = λ(β). µ) = n i=1 i=1 i=1 L∗ n with respect to pi . µ. probabilities 1 ³ ´´ . λ) is a convex function of λ. λ) : λ(β) = argmin Rn (β.. pn .4) (10. The solution (when it exists) is well deﬁned since Rn (β. The solution cannot be obtained explicitly. (10.5) This minimization problem is the dual of the constrained maximization problem. the Lagrange multiplier λ(β) minimizes Rn (β.2) subject to the restrictions (10. 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. λ. or equivalently minimizes its negative ˆ (10.1) and (10.. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β.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.3).7) 118 . pi gi (β) = 0. Ln (β) = Rn (β. λ).5) ˆ ˆ As a by-product of estimation. and using the second and third equations. p (10. (see section 6. Multiplying the ﬁrst equation by pi . summing over i.5). pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .

and Ω = E xi x0 e2 .10). i i Theorem 10. (β. n (10. Gi (.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. 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. ˆ ˆ Proof.10) ¡ Ω−1 N (0.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 .13) Premultiplying by G0 Ω−1 and using (10. λ) = − (10.8) and ¢ 0 0 For example. G = −E (xi zi ). 0 = Rn (β. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.1 Under regularity conditions. λ) = − (10. i=1 i=1 i=1i Expanding (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. in the linear model.9) and (10. β) = −xi zi . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.9) (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Thus the EL estimator is asymptotically eﬃcient.10.13) yields n n Expanding (10.2.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. β λ ∂ ³ ´. and n β − β 0 and nλ are asymptotically independent.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .

10. Ω) GΩ G →d = N (0. V ) ˆ Solving (10. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .14) for λ and using (10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. it is an asymptotically eﬃcient estimator for β. Vλ ) Furthermore. and (10. Since the EL estimator achieves this bound.16). β 0 ) = 0 then LRn →d χ2−k .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 (0.15) (10. tests are based on the diﬀerence in the log likelihood functions.1 If Eg(wi . The overidentiﬁcation test is a very useful by-product of EL estimation. They are asymptotically ﬁrst-order equivalent. (10.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. 120 . since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. First.7) is n ³ ´´ ³ X ˆ ˆ0 (10. by a Taylor expansion. LRn = i=1 Theorem 10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. 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. and have the same interpretation.17) 2 ln 1 + λ gi β .3. Proof.3 Overidentifying Restrictions In a parametric likelihood context. The same statistic can be constructed for empirical likelihood. and it is advisable to report the statistic LRn whenever EL is the estimation method.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0.15).

This test statistic is a natural analog of the GMM distance statistic. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).18) and H0 : h(β) = 0. a The proof of this result is more challenging and is omitted.17) is not appropriate.18).18) are assumed to hold and are not being challenged (at least for the test discussed in this section).wisc. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. Vλ )0 Ω−1 N (0. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . 10. By “maintained” we mean that the overidentfying restrictions contained in (10.Second. since ln(1 + x) ' x − x2 /2 for x small. The hypothesis of interest is h(β) = 0. 10.4. so there is no fundamental change in the distribution theory for β relative to β.prc 121 . Theorem 10. where h : Rk → Ra . LRn →d χ2 .18) Let the maintained model be where g is × 1 and β is k × 1.1 Under (10. the simple overidentifying restrictions test (10.edu/~bhansen/progs/elike.4 Testing Egi (β) = 0 (10.ssc. 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. To test the hypothesis h(β) while maintaining (10. h(β)=0 ˜ Fundamentally. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.

λ) = − ∂β n X i=1 G∗ (β. λ)0 0 Rn (β. λ)0 − ∂β∂β Rn (β. λ)0 − Rn (β. λj )) Rp = Rn (β. δ 1 = 1 and δ 2 = 1. Deﬁne ∗ gi (β. λ) ∂λ i=1 n ∂ Rn (β. Set δ 0 = 0.4). set 2 λp = λj − δ p (Rλλ (β. One method uses the following quadratic approximation. λ) . λ) G∗ (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . 2. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) = − gi (β. λp ) A quadratic function can be ﬁt exactly through these three points.19) is continued until the gradient Rλ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λj ))−1 Rλ (β. λj ) .19).19) X ∂2 ∗ ∗ gi (β. 1.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.5) for given β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) gi (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10.4) 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. The iteration (10. (10. λ) G∗ (β. λ) = G∗ (β. The starting value λ1 can be set to the zero vector.20) . λj ))−1 Rλ (β. For p = 0. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λj ) is smaller than some prespeciﬁed tolerance.. λ) = i The ﬁrst derivatives of (10. Eﬃcient convergence requires a good choice of steplength δ.

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

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

and x2i are the excluded exogenous variables.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. So we have the partition µ ¶ z1i k1 (11. so should be included in xi .4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1.1) where zi is k × 1.2) Any solution to the problem of endogeneity requires additional information which we call instruments.1).1 The × 1 random vector xi is an instrumental variable for (11. some regressors in zi will be uncorrelated with ei (for example. Thus we make the partition ¶ µ k1 z1i (11.1) if E (xi ei ) = 0. at least the intercept).1) the structural equation. We call (11. this can be written as Y = Zβ + e. (11. z1i is an instrumental variable for (11.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. β →p β ∗ . ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. We call z1i exogenous and z2i endogenous. In matrix notation. In a typical set-up.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. and assume that E(zi ei ) 6= 0 so there is endogeneity. By the above deﬁnition. That is x2i are variables which could be included in the equation for yi (in the sense 125 . This is called simultaneous equations bias. which does not equal either β 1 or β 2 . 11.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

l . By the spectral decomposition of an idempotent matrix. 130 . Indeed as α → 1.13). 0). Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 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 (11.12) and this result.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11.14) approaches that in (11. P = HΛH 0 0 0 where Λ = diag(Il .14) In general this is non-zero. 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 . Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. n and (11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.14) is the probability limit of β 2SLS − β 11.Let PX = X (X 0 X)−1 X 0 . the bias in the 2SLS estimator will be large. The consequences of identiﬁcation failure for inference are quite severe. except when S21 = 0 (when Z is exogenous). It is also close to zero when α = 0. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . the expression in (11.

Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. To see the consequences. the instrument xi is weak for zi if γ = n−1/2 c. This result carries over to more general settings.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 . 131 . but small.15) is unaﬀected. but (11.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. which occurs i when E (zi xi ) 6= 0. E x2 e2 i i n i=1 n (11. In addition. Here. but is weak. Then (11. standard test statistics have non-standard asymptotic distribution of β distributions. once again take the simple case k = l = 1.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. E x2 u2 i i n n i=1 i=1 n n (11. Suppose this condition fails. so E (zi xi ) = 0. N2 since the ratio of two normals is Cauchy. meaning that inferences about parameters of interest can be misleading. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. This is particularly nasty. viz Γ22 = n−1/2 C. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. This can be handled in an asymptotic analysis by modeling it as local-to-zero. where C is a full rank matrix. Suppose that identiﬁcation does not complete fail.Take the simplest case where k = l = 1 (so there is no X1 ). Qc + N2 ˆ As in the case of complete identiﬁcation failure. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. as the Cauchy distribution does not have a ﬁnite mean. This occurs when Γ22 is full rank. and was examined by Phillips (1989) and Choi and Phillips (1992).

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

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

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

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

ˆ ˆ γ ¥ 136 . ˆ 2.1. Part (1) is a direct consequence of the Ergodic theorem. γ (0) ˆ Theorem 12.1. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. 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 3. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . then as T → ∞. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . For Part (2). then as T → ∞. If Xt is strictly stationary and ergodic and E |Xt | < ∞.1. µ →p E(Yt ).1 above.2 (Ergodic Theorem).Theorem 12. ˆ Proof. T 1X Xt →p E(Xt ). and it has a ﬁnite mean by the assumption that EYt2 < ∞.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. 1. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). ρ(k) →p ρ(k). γ (k) →p γ(k). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). the sequence Yt Yt−k is strictly stationary and ergodic.

some versions of the life-cycle hypothesis imply that either changes in consumption.} are jointly random. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. ∞ X = ρk et−k .. E(Yt−k et ) = 0.2. The last property deﬁnes a special time-series process. .} is the past history of the series. k=0 Loosely speaking.. or consumption growth rates. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . A mean-zero AR(1) is Assume that et is iid.12. Thus for k > 0. E(et ) = 0 and Ee2 = σ 2 < ∞.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0... 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 . should be a MDS. Some time-series processes may be a MDS as a consequence of optimizing behavior. For example. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . 12. .2 Autoregressions In time-series. Yt−k ) .. . the series {. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. this series converges if the sequence ρk et−k gets small as k → ∞. In fact. Y1 .3 Stationarity of AR(1) Process Yt = ρYt−1 + et . t By back-substitution.... Deﬁnition 12. YT . Yt−2 .. 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. it is even more important in the time-series context. ..... Letting et = Yt − E (Yt | It−1 ) ... This occurs when |ρ| < 1. Regression errors are naturally a MDS. as it is diﬃcult to derive distribution theories without this property. 137 . Y2 .

Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . 12. We call ρ(L) the autoregressive polynomial of Yt .1 If |ρ| < 1 then Yt is strictly stationary and ergodic. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . Lk Yt = Yt−k .1 The lag operator L satisﬁes LYt = Yt−1 . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).1. From Theorem 12. since ρ(z) = 0 when z = 1/ρ. We call ρ(L) the autoregressive polynomial of Yt . the above results are unchanged.3. an AR(1) is stationary iﬀ |ρ| < 1.4.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . We say that the root of the polynomial is 1/ρ. ∞ X k=0 ρ2k V ar (et−k ) = 12. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. In general. Deﬁning L2 = LL. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .Theorem 12.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .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). 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. The AR(k) model is Using the lag operator. we see that L2 Yt = LYt−1 = Yt−2 . Deﬁnition 12. 138 .

5. which satisfy ρ(λj ) = 0. and is of great interest in applied time series. t t T t=1 ¥ Combined with (12.1) Theorem 12. Proof.6.1. For an AR(k). β = X 0X (12. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. it is also strictly stationary and ergodic. t Yt−k ¢0 ρk .where the λ1 .1) and the continuous mapping theorem.. and hence Yt . Thus t by the Ergodic Theorem.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. Theorem 12. Let |λ| denote the modulus of a complex number λ.. the requirement is that all roots are larger than one. .1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. “has a unit root”. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. λk are the complex roots of ρ(z).1. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.1. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.” If one of the roots equals 1.. One way of stating this is that “All roots lie outside the unit circle. The vector xt is strictly stationary and ergodic. it is helpful to deﬁne the process ut = xt et . we say that ρ(L).6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . t T t=1 T t=1 139 . This is a special case of non-stationarity. and by Theorem 12. then ˆ β →p β as T → ∞. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. By Theorem 12. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. so is xt x0 . we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. Note that ut is a MDS.1.

In particular. Fix an initial condition (Y−k+1 .. T 1 X √ ut →d N (0.7... It also presumes that the AR(k) structure is the truth. eT }.7. Method 1: Model-Based (Parametric) Bootstrap. t This construction imposes homoskedasticity on the errors e∗ . 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. 12. .1 to see that T 1 X √ xt et →d N (0. 140 . Y−k+2 . ˆ 1. then as T → ∞. we can apply Theorem 12. t then as T → ∞.. Ω) . xt }.. Y0 ). Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . T t=1 Since xt et is a MDS. 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∗ .12. Divide the sample into T /m blocks of length m.. Q−1 ΩQ−1 . t t Theorem 12. ˆ 2. which may be diﬀerent than the i properties of the actual ei .7 Asymptotic Distribution Theorem 12. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. T t=1 where Ω = E(xt x0 e2 ). i 4.7. This creates an iid bootstrap sample.8 Bootstrap for Autoregressions In the non-parametric bootstrap. Ω) . e ˆ 3. as this imposes inappropriate independence. this cannot work in a time-series application.1 MDS CLT. we constructed the bootstrap sample by randomly resampling from the data values {yt . Clearly. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. The implication is that asymptotic inference is the same. Brieﬂy. . This is identical in form to the asymptotic distribution of OLS in cross-section regression. Method 2: Block Resampling 1.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. Estimate β and residuals et .

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

(If you increase k. we take (12.5) and (12. and the alternative is that the error is an AR(m). We want to test H0 against H1 . and then reserve the ﬁrst k as initial conditions. One approach to model selection is to choose k based on a Wald tests. We then multiply this by θ and subtract from (12.g. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero..6).. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. In general.. AR(2).12. and under H1 it is an AR(2). if the null hypothesis is that Yt is an AR(k).5). The best remedy is to ﬁx a upper value k.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . To combine (12. .10 Testing for Omitted Serial Correlation For simplicity. Another is to minimize the AIC or BIC information criterion.. . AR(k) on this (uniﬁed) sample. (12. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. (A simple exclusion test). e.. Yt−k−m are jointly zero. We model this as an AR(1): ut = θut−1 + et with et a MDS. (12. AIC(k) = log σ 2 (k) + ˆ 2k . and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 .. An appropriate test is the Wald test of this restriction.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. and then estimate the models AR(1). 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.6) 12. 142 . Yt is an AR(1). this is the same as saying that under the alternative Yt is an AR(k+m).) This can induce strange behavior in the AIC. you need more initial conditions.5) We are interested in the question if the error ut is serially correlated. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . Thus under H0 . or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .

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

If the test rejects H0 . The natural solution is to include a time trend in the ﬁtted OLS equation. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . GDP.Theorem 12. When conducting the ADF test. We have described the test for the setting of with an intercept.1 (Dickey-Fuller Theorem). This is not really a correct conclusion. Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error. All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. the test procedure is the same. where c is the critical value from the ADF table. This distribution has been extensively α tabulated. If a time trend is included. the ADF test rejects H0 in favor of H1 when ADF < c. 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 diﬀerent critical values are required.12. and have negative means. The ADF test has a diﬀerent distribution when the time trend has been included. This is called a “super-consistent” rate of convergence. These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal.8). Assume α0 = 0. rather than the ˆ 1/2 . and may be used for testing the hypothesis H0 . but it may be stationary around the linear time trend. This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . as the AR model cannot conceivably describe this data. They are skewed to the left.g. this means that it is computed as the t-ratio for α0 from OLS estimation of (12. but does not depend on the parameters α. Thus the Dickey-Fuller test is robust to heteroskedasticity. Another popular setting includes as well a linear time trend. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. Since the alternative hypothesis is one-sided. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. this means that the evidence points to Yt being stationary. Stock Prices). (12.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. however. But the theorem does not require an assumption of homoskedasticity. If the test does not reject H0 . In this context. a common conclusion is that the data suggests that Yt is non-stationary. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. and a diﬀerent table should be consulted. then the series itself is nonstationary. If the series has a linear trend (e. 144 . As T → ∞.

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

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

In this case.13. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . the model (13. (13. j Often. may be tested if desired. You may have heard of the Durbin-Watson test for omitted serial correlation. with time series data. Let yt = Yjt . xt−1 ) to the regression.) Since the common factor restriction appears arbitrary.2) is a special case of (13. This restriction. 13. and Zt be the other variables. Otherwise it is invalid. it is convenient to re-deﬁne the variables.2) Take the equation yt = x0 β + et . and subtract oﬀ the equation once lagged multiplied by θ. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). 147 .5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. we are only interested in a single equation out of a VAR system. If valid. general. t t−1 (13. 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 . 1). and is still routinely reported by conventional regression packages.4 Single Equation from a VAR Yjt = a0 xt + et . under the restriction γ = −βθ. Another interesting fact is that (13.3). Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. This can be done by a Wald test. direct estimation of (13.3) which is a valid regression model. which is called a common factor restriction.1) yt = x0 β + et . which once was very popular. Suppose that et is an AR(1). Let et = ejt and β = aj .2) is uncommon in recent applications. We see that an appropriate. t and et is iid N (0.1).2) may be estimated by iterated GLS. t and xt = This is just a conventional regression. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. t or yt = θyt−1 + x0 β + x0 γ + ut . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . Then the single equation takes the form (13. (A simple version of this estimator is called Cochrane-Orcutt. and is typically rejected empirically.

Zt−1 . . Yt and/or Zt can be vectors. Yt−1 . The formula for the AIC and BIC are ³ ´ p ˆ AIC(k) = log det Ω(k) + 2 T ³ ´ p log(T ) ˆ BIC(k) = log det Ω(k) + T T X 1 ˆ et (k)ˆt (k)0 ˆ e Ω(k) = T t=1 p = m(km + 1) where p is the number of parameters in the model. This deﬁnition of causality was developed by Granger (1969) and Sims (1972). If this condition does not hold. The hypothesis can be tested by using the appropriate multivariate Wald test. that Zt may still be useful to explain other features of Yt . then we say that Zt Granger-causes Yt . conditional on information in lagged Yt . If Zt is some sort of forecast of the future. lagged Zt does not help to forecast Yt . the Wald statistic). for example. the equation for Yt is 0 0 Yt = α + ρ1 Yt−1 + · · · + ρk Yt−k + Zt−1 γ 1 + · · · + Zt−k γ k + et . This idea can be applied to blocks of variables. . We say that Zt does not Granger-cause Yt if E (Yt | I1. Yt−2 . 13.13.. . This may be tested using an exclusion (Wald) test. In a linear VAR. and et (k) is the OLS residual vector from the ˆ model with k lags.. Zt . and the information set I2t is generated by both Yt and Zt . Yt−2 . Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0. such as the conditional variance.. or an information criterion approach. Zt ). however. That is. such as a futures price. Zt−2 . That is.6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR. Yt−1 .t−1 ) = E (Yt | I2. The log determinant is the criterion from the multivariate normal likelihood. The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure deﬁnition of causality. 148 .) I2t = (Yt . In this equation. then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt ..7 Granger Causality Partition the data vector into (Yt .) The information set I1t is generated only by the history of Yt . Note. If it is found that Zt does not Granger-cause Yt . The latter has more information.t−1 ) . Deﬁne the two information sets I1t = (Yt . you may either use a testingbased approach (using. then Zt may help to forecast Yt even though it does not “cause” Yt .

m × r. the asymptotic distribution of the test is aﬀected by the presence of the time trend. β may not be known. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. as ﬁrst shown by Stock (1987). Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . The asymptotic distribution was worked out by Phillips and Ouliaris (1990). and was articulated in detail by Engle and Granger (1987). If r = m. For example. Suppose that β is known. Deﬁnition 13.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. Thus H0 can be tested using a univariate ADF test on zt . When β is unknown. This is not.13. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . but it is useful in the construction of alternative estimators and tests. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. a good method to estimate β. If Yt is cointegrated with a single cointegrating vector (r = 1). of rank r. If the series Yt is not cointegrated. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. in general. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others.8 Cointegration The idea of cointegration is due to Granger (1981). it may be believed that β is known a priori.8. β is not consistent. such that zt = β 0 Yt is I(0). Yt is I(1) and cointegrated. Then under H0 zt is I(1). For 0 < r < m. β = (1 − 1)0 . If Y = (log(Consumption) log(Income))0 . The r vectors in β are called the cointegrating vectors. In other cases. then r = 0. so zt = β 0 Yt is known. then Yt is I(0). from OLS of Y1t on Y2t . 149 . When the data have time trends. it may be necessary to include a time trend in the estimated cointegrating regression. Hansen (1992). In some cases. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) 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. if Yt is a pair of interest rates. Under H0 . yet under H1 zt is I(0).9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . Whether or not the time trend is included. Often. The asymptotic distribution was worked out in B. Thus Yt = ˆ (Y1t . however. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . 13.

If β is known. 1991. Ω). When r > 1. If β is unknown. this is the MLE of the restricted parameters under the assumption that et is iid N (0. In the context of a cointegrated VAR estimated by reduced rank regression. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . As they were discovered by Johansen (1988. Their asymptotic distributions are non-standard. 150 . The restricted model can be written as ∆Yt = αβ 0 Yt−1 + D(L)∆Yt−1 + et ∆Yt = αzt−1 + D(L)∆Yt−1 + et .1 (Granger Representation Theorem). These tests are constructed as likelihood ratio (LR) tests. 1995). When r = 1.9. One diﬃculty is that β is not identiﬁed without normalization. which is least-squares subject to the stated restriction. Thus cointegration imposes a restriction upon the parameters of a VAR.Theorem 13. they are typically called the “Johansen Max and Trace” tests. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. then estimation is done by “reduced rank regression”. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. and are similar to the Dickey-Fuller distributions. it is simple to test for cointegration by testing the rank of Π. this does not work. rank(α) = r. Equivalently. we typically just normalize one element to equal unity.

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

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

He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. incomes above a threshold are typically reported at the threshold.1). any known value can substitute. This model speciﬁes that P (Yi = k | xi ) = λi k = 0.}. 1.14. . but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14... this motivates the label Poisson “regression. The censoring process may be explicit in data collection. 1. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. i If Y = {0.) The observed data yi therefore come from a mixed continuous/discrete distribution. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. a typical approach is to employ Poisson regression. k! = exp(x0 β). . 2. or it may be a by-product of economic constraints. This may be considered restrictive. 2. 14. σ 2 ) with the observed variable yi generated by the censoring equation (14. the consumption level (purchases) in a particular period was zero.2 Count Data exp (−λi ) λk i . In surveys. The conditional density is the Poisson with parameter λi ... i so the model imposes the restriction that the conditional mean and variance of Yi are the same. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. A generalization is the negative binomial.1) yi = ∗ <0 . 0 if yi (This is written for the case of the threshold being zero. Thus the model is that there is some latent process yi with unbounded support. An example of a data collection censoring is top-coding of income.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). i i i=1 ˆ The MLE is the value β which maximizes ln (β). Tobin observed that for many households. The functional form for λi has been picked to ensure that λi > 0.

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

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

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

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

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

Typically. we ﬁnd y i = x0 β + ui + ei . it (15. we use lags of the dependent variable. then it will be correlated with ∆yit−1 : E (∆yit−1 ∆eit ) = E ((yit−1 − yit−2 ) (eit − eit−1 )) = −E (yit−1 eit−1 ) = −σ 2 . GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. Another derivation of the estimator is to take the equation yit = 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.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. Unfortunately. the dependent variable and regressors in deviationit from-mean form. e So OLS on (15. it However. the predicted value from these regressions is the individual speciﬁc mean y i . at least if T is held ﬁnite as n → ∞. so the instrument list should be diﬀerent for each equation. it it which is free of the individual-eﬀect ui . two periods back. and the residual is the demean value ∗ yit = yit − yi . but loses a time-series observation). Hence a valid estimator of α and β is to estimate (15. 159 (15. Taking ﬁrst-diﬀerences of (15. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. there are more instruments available. if eit is iid. then IV or GMM can be used to estimate the equation. This is conveniently organized by the GMM principle.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. Alternatively. 15. But if there are valid instruments. Thus values of yit−k .4) . are valid instruments. as yt−2 is uncorrelated with ∆eit . i ∗ yit = x∗0 β + e∗ . ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . This is because the sample mean of yit−1 is correlated with that of eit . A more sophisticated GMM estimator recognizes that for time-periods later in the sample. A simple application of GMM yields the parameter estimates and standard errors. k ≥ 2.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit .4) will be inconsistent. the ﬁxed eﬀects estimator is inconsistent.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit .4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed).

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

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

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

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

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

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

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

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

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

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

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

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

If X and Y are independent. y)dx. (A. the marginal density of Y is fY (y) = Z ∞ f (x. Y ) = ρXY = σ XY . For example. then V ar (X + Y ) = V ar(X) + V ar(Y ). y) = g(x)h(y). then MZ (λ) = E exp (λ (X + Y )) = E (exp (λX) exp (λY )) ¡ ¢ ¡ ¢ = E exp λ0 X E exp λ0 Y = MX (λ)MY (λ). Y ).6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1.5) is that if X and Y are independent and Z = X + Y. then σ XY = 0 and ρXY = 0. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y. x)dydx Z Z = g(x)h(y)fY (y)fX (x)dydx Z Z = g(x)fX (x)dx h(y)fY (y)dy = Eg (X) Eh (Y ) . Another implication of (A. if X and Y are independent then E(XY ) = EXEY.The correlation is a measure of linear dependence. An implication is that if X and Y are independent. the variance of the sum is the sum of the variances. however. 172 . if EX = 0 and EX 3 = 0. 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. Furthermore.5) if the expectations exist. X 2 ) = 0.Similarly. σxσY (A. then Cov(X. For example. X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x. free of units of measurement. is not true. The reverse. y) = fX (x)fY (y). The correlation between X and Y is Corr(X. −∞ The random variables X and Y are deﬁned to be independent if f (x. The covariance between X and Y is Cov(X.

A k × 1 random vector X = (X1 .. .. .. In particular. y) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε. it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x). xk )0 .. Letting x = (x1 . then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A. y) fX (x + ε) ∂2 ∂x∂y F (x.. y) − F (x. we deﬁne the expectation Z g(x)f (x)dx Eg(X) = Rk where the symbol dx denotes dx1 · · · dxk . y) . 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. ∂x1 · · · ∂xk For a measurable function g : Rk → Rs .. y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0.6 Conditional Distributions and Expectation f (x. y) fX (x) f (x. fX (x) 173 . 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. Xk )0 is a function from S to Rk .

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

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

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

Theorem A.3 Let Z ∼ N (0.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Set r Z . The fact that A > 0 means that we can write A = CC 0 where C is non-singular. tr has distribution 177 . The MGF for the density (A. which can be found by applying change-of-variables to the gamma function. 1) and Q ∼ χ2 be independent.8.1. 1). (A.8.8. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. Using the simple law of iterated expectations. Iq ).12) E exp (tQ) = 0 Γ (A. C −1 AC −10 ) = N (0. C −1 CC 0 C −10 ) = N (0.2. we see that the MGF of Z 2 is (1 − 2t)−1/2 . which we showed in (A. q Proof of Theorem A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. For Z ∼ N(0. Proof of Theorem A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .3.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.13) is the MGF of the density (A.11) 2 with r = 1. Thus the density of Z 2 is (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.11). ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).13). Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .8. From (A.

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

In fact. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.9. θ) ≡ L(θ). I0 . we can ﬁnd an explicit expression for θ as a function of the data.17) is often called the information matrix equality.14) ¶ ∂ ∂ 0 ln f (Yi . We can write this as ˆ = argmax Ln (θ). but these ˆ must be found by numerical methods. under conventional regularity conditions.16) (A. However. then θ V ar(˜ ≥ (nI0 )−1 .1 ¯ ¯ ∂ E ln f (Yi . cases are rare. ˆ →p θ0 as n → ∞.15) Two important features of the likelihood are Theorem A. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. θ) ∂θ ∂θ which holds at θ = θ0 by (A.2 Cramer-Rao Lower Bound. θ) →p E ln f (Yi . ∂θ ∂θ (A.9. θ0 ) ln f (Yi . ˆ is consistent θ for this value. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. we can see that it is an estimator of the maximizer θ of the right-hand-side.16). n n i=1 n As the MLE ˆ maximizes the left-hand-side. and the equality (A. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . Theorem A. θ θ∈Θ ˆ In some simple cases.17) The matrix I0 is called the information. More typically. 179 . θ) The Cramer-Rao Theorem gives a lower bound for estimation.3 Under regularity conditions. θ0 ) ∂θ∂θ 0 (A. θ0 ) . θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ Theorem A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .9. which maximizes the log-likelihood). the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . If ˜ is an unbiased estimator of θ ∈ R.

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

θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. yn ). To see (A.1) has mean zero and variance nH. θ0 ) ∂ ∂ − ln f (Yi .17). θ) d˜ = ˜ y ) ∂ ln f (˜.. θ0 )2 (Yi . ∂θ ¯θ=θ0 Z ! = 0. θ0 )0 . Proof of Theorem A. θ0 ) (Yi . θ0 ) ¯ ∂ f (y. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. Since θ Z ˜ = ˜ y)f (˜. θ0 ) d˜ = E ˜ .16).9.9. θ0 ) ln f (Yi . θ0 ) ∂ ∂θ f ∂ (Yi . θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ) f (˜.9. θ0 ) − f (Yi . (Yi . θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y .1. θ0 ) f (Yi . θ) dy ¯ ∂θ f (y. function of the data. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. we can show that E By direction computation. ¯ ¯ ∂ E ln f (Yi .. θ0 = ln f (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0.2.. ∂2 ln f (Yi . θ) f (y. θ0 ) ∂θ f (Yi . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. V ar (S) nH so ¥ 181 . .Proof of Theorem A. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 )0 f (Yi . f (Yi .

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

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

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

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

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