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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

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

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Sample Selection . .7 Transformations . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 Multivariate Time Series 13. . .2 Count Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . B. . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . .7 Granger Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . .8 Cointegration . . . . . . . . . . . . . . . .5 Multivariate Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Restricted VARs . . . . . . . . . . . . . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . .3 Expectation . . . . . .1 Kernel Density Estimation . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Grid Search . . . . . . . . . . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Gradient Methods . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . .1 Foundations . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Random Variables . . . . . A. . . . . . . . . . A. . . . . . . . . 13. . . . . . . . . . 13.4 Single Equation from a VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 A Probability A. . . . . . . . . . . .1 Binary Choice . . . . . . . . . . . . . . . . . . . . . . .2 Fixed Eﬀects . . . . . . 14. . . . . . . . . . . . A. . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . 160 16. . . B. . . . . . . . . . . . . 157 15. .2 Estimation . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . .1 Individual-Eﬀects Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . iv . . . B Numerical Optimization B. . . . . .3 Censored Data . . . . . 13. . . . . . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . A. . . . A. . . .6 Conditional Distributions and Expectation . . . . . . . . . .4 Common Distributions . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . .9 Maximum Likelihood .

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

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

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

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

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

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

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

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

. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . we can deﬁne the determinant as follows... ⎠ . For a general k × k matrix A = [aij ] . i Hence they must equal either 0 or 1..4) H0 M =H 0 0 with H 0 H = In ...By the uniqueness of the characteristic roots. k. . Let π = (j1 . jk ) denote a permutation of (1. . (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. we deduce that Λ2 = Λ and λ2 = λi for i = 1.. There are k! such permutations. and let επ = +1 if this count is even and επ = −1 if the count is odd.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . tr(A) = rank(A).. xk ) be k × 1 and g(x) = g(x1 . Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . If A is 2 × 2. .. then its determinant is det A = a11 a22 − a12 a21 . There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. xk ) : Rk → R. ... 2.8 Determinant The determinant is deﬁned for square matrices.. ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . k)).. k) ... Additionally. .. . ..

denoted A ⊗ B.• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. . ⎣ ⎦ . an Let B be any matrix. . . am1 B am2 B · · · amn B Some important properties are now summarized. is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. det(A ⊗ B) = (det (A))n (det (B))m • (A ⊗ B)−1 = A−1 ⊗ B −1 • If A > 0 and B > 0 then A ⊗ B > 0 • vec (ABC) = (C 0 ⊗ A) vec (B) • tr (ABCD) = vec (D0 )0 (C 0 ⊗ A) vec (B) 10 . . . 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). • If A is orthogonal. The Kronecker product of A and B. ⎟ . . . denoted by vec (A) . These results hold for matrices for which all matrix multiplications are conformable.9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . . • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. ⎠ ⎝ . The vec of A. . then det A = 2.

1 by the arrows drawn to the x-axis. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. xki 3. xi ) where yi is a scalar (real-valued) and xi is a vector. When a distribution is skewed. Take a closer look at the density functions displayed in Figure 3. The data are from the 2004 Current Population Survey 1 11 . education and experience. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. the mean wage for men is $27. The two density curves show the eﬀect of gender on the distribution of wages. holding the other variables constant. (3.1) xi = ⎜ . See Chapter 16.22. .Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. we can focus on f (y | x) . the conditional density of yi given xi . You can see that the right tail of then density is much thicker than the left tail. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1. or the covariates. gender.1 displays the density1 of hourly wages for men and women. it is useful to have numerical measures of the diﬀerence. We call yi the dependent variable. These are indicated in Figure 3. and that for women is $20. m(x) can take any form.2) m(x) = E (yi | xi = x) = −∞ In general. and exists so long as E |yi | < ∞. which is a common feature of wage distributions. These are asymmetric (skewed) densities. ⎠ ⎝ . This is used when the goal is to quantify the impact of one set of variables on another variable.1.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. the conditioning variable. While it is easy to observe that the two densities are unequal. In this context we partition the observations into the pair (yi . To illustrate.73. We call xi alternatively the regressor. ⎟ . the mean is not necessarily a good summary of the central tendency. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. In the example presented in Figure 3. These are conditional density functions — the density of hourly wages conditional on race. Figure 3.

2 shows the density of log hourly wages for the same population.A. For this reason.2) evaluated at the observed value of xi : ei = yi − m(xi ). the solid line displays the conditional expectation of log wages varying with education. The diﬀerence in the log mean wage between men and women is 0. Assuming for simplicity that this is the true joint distribution. implying an average 36% diﬀerence in wage levels.D.Figure 3. the dashed line is a linear projection approximation which will be discussed in the Section 3. 12 . The conditional expectation function is close to linear. The main point to be learned from Figure 3.5. degree in mean log hourly wages is 0. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. Figure 3.3) White non-military male wage earners with 10-15 years of potential work experience. which implies a 30% average wage diﬀerence for this population. When the distribution of the control variable is continuous. 2 (3. with mean log hourly wages drawn in with the arrows. and a Ph.1 is facilitated by the fact that the control variable (gender) is discrete. The comparison in Figure 3. 3.30.36.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. By construction. Figure 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3.3 displays a scatter plot2 of log wages against education levels. To illustrate. this yields the formula yi = m(xi ) + ei . wage regressions typically use log wages as a dependent variable rather than the level of wages.3 is how the conditional expectation describes an important feature of the conditional distribution. then comparisons become more complicated. Of particular interest to graduate students may be the observation that diﬀerence between a B.

Figure 3.1 Properties of the regression error ei 1. It is important to understand that this is a framework. E(ei ) = 0. most typically. not a model. To show the ﬁrst statement. E (h(xi )ei ) = 0 for any function h (·) . A regression model imposes further restrictions on the joint distribution. The equations yi = m(xi ) + ei E (ei | xi ) = 0. These equations hold true by deﬁnition. The remaining parts of the Theorem are left as an exercise. because no restrictions have been placed on the joint distribution of the data. 13 . by the deﬁnition of ei and the linearity of conditional expectations.2: Log Wage Densities Theorem 3. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. 3. are often stated jointly as the regression framework. 2. E(xi ei ) = 0. 4. E (ei | xi ) = 0. restrictions on the permissible class of regression functions m(x).2.

The right-hand-side is minimized by setting g(x) = m(x). A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x .3.1. 3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. and can take any form.2. let g(x) be an arbitrary predictor of yi given xi = x. In contrast. when σ 2 (x) is a constant so that ¢ ¡ (3. Given the random variable xi . subject to the restriction p that it is non-negative. Thus the mean squared error is minimized by the conditional mean. the conditional variance of yi is σ 2 = σ 2 (xi ). In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .Figure 3. σ 2 (x) is a non-trivial function of x. The conditional standard deviation is its square root σ(x) = σ 2 (x). i . in the sense of achieving the lowest mean squared error. 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. it does not provide information about the spread of the distribution. To see this.3 Conditional Variance Generally.

we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . Thus (3. ⎠ . it is convenient to augment the regressor vector xi by listing the number “1” as an element. which we derive in this section.1. and the linear assumption of the previous section is empirically unlikely to accurate.5) xi = ⎜ . ⎟ β=⎝ .8) (3. Equivalently. We call this the “constant” or “intercept”.4 Linear Regression An important special case of (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .1). xki When m(x) is linear in x.9) 3. βk ⎛ (3. take the conditional wage densities displayed in Figure 3.6) as an approximation. it is more realistic to view the linear speciﬁcation (3. ⎟ . 3.7) is a k × 1 parameter vector. The conditional standard deviation for men is 12.1 and that for women is 10. we assume that x1i = 1. In this case (3.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . its functional form is typically unknown. where x1i is the ﬁrst element of the vector xi deﬁned in (3. As an example. Notationally. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .we say that the error ei is homoskedastic. i (3. Instead.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. So while men have higher average wages. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. Equation (3. 15 . ⎠ .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). ⎝ .6) (3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.8) is called the linear regression model.5. they are also somewhat more dispersed.

E (xi x0 ) is invertible.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. xi contains an intercept. The vector (3. otherwise they are distinct.5. The ﬁrst-order condition for minimization (from Section 2. i 16 . i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . It is invertible if and only if it is positive deﬁnite. i which requires that for all non-zero α. this situation must be excluded. i (3. Given the deﬁnition of β in (3. Rewriting. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .which is quadratic in β. i i (3.5. by “best” we mean the predictor function with lowest mean squared error. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.10). We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. Equivalently. This occurs when redundant variables are included in xi . Assumption 3.12) This completes the derivation of the linear projection model.10) It is worth taking the time to understand the notation involved in this expression. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.1. 2 2. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . α0 E (xi x0 ) α = E (α0 xi )2 > 0. The best linear predictor is obtained by selecting β to minimize S(β). The error is i ei = yi − x0 β.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. i 4.11) 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 . Eyi < ∞. As before. In order for β to be uniquely deﬁned.1 1. x0 β is the best linear predictor for yi . For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. written E (xi x0 ) > 0. Observe i that for any non-zero α ∈ Rk . Therefore. 3. i (3. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. E (x0 xi ) < ∞.

Using the deﬁnitions (3. it follows that linear regression is a special case of the projection model. Equation (3.1. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1 are weak.1 is employed to guarantee that (3.4 is required to ensure that β is uniquely deﬁned. Since from Theorem 3.4: Hourly Wage as a Function of Experience The conditions listed in 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 = 0.10) and (3. Figure 3.5.9).5. Furthermore. However.1. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.10) are deﬁned.5. Since ei is mean zero by (3.11) are well deﬁned.5.1. This means that the equation (3. Let’s compare it with the linear regression model (3.13) and Assumption 3. 17 .2 and 3. By deﬁnition. E (xi ei ) = 0 and E (ei ) = 0.3 ensure that the moments in (3.1.12) can be alternatively interpreted as a projection decomposition.14). ¥ (3. Assumption 3.Theorem 3. (3.1.1.14) holds.1.5.13) The two equations (3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .2 and 3.14) Proof. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . The ﬁnite variance Assumptions 3.5.1.1.14) follows from (3. the orthogonality restriction (3.13) implies that xi and ei are uncorrelated. For example.4 we know that the regression error has the property E (xi ei ) = 0.13) summarize the linear projection model. Assumption 3. Assumption 3.4 guarantees that the solution β exits.5.12) and (3.5.1.5.5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.3 are called regularity conditions. Assumption 3.11) and (3.5.1 Under Assumption 3.8)-(3.1. (3.2.

These structural models require alternative estimation methods. We illustrate the issue in Figure 3.3.1 may be false. for any pair (yi .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. In the example just presented. 18 . In other cases the two may be quite diﬀerent. In this example the linear projection is a close approximation to the conditional mean. Returning to the joint distribution displayed in Figure 3. and the straight dashed line is the linear projection. and under-predicts for the rest. In contrast. In Figure 1.We have shown that under mild regularity conditions.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. Other than the redeﬁnition of the regressor vector. No additional assumptions are required. we can augment the regressor vector xi to include both experience and experience2 . Figure 3. Figure 3. In this example it is a much better approximation to the conditional mean than the linear projection. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. The solid line is the conditional mean.4 displays the relationship3 between mean log hourly wages and labor market experience.4 we display as well this quadratic projection. xi ) we can deﬁne a linear projection equation (3.12) with the properties listed in Theorem 3. A projection of log wages on these two variables can be called a quadratic projection. It over-predicts wages for young and old workers. it is important to not misinterpret the generality of this statement.1. This defect in linear projection can be partially corrected through a careful selection of regressors. for those over 53 in age).5. there are no changes in our methods or analysis. the dashed line is the linear projection of log wages on eduction. However. Most importantly. in many economic models the parameter β may be deﬁned within the model.10). and are discussed in Chapter 11.5. In this case (3.10) may not hold and the implications of Theorem 3. The linear equation (3. In this case the linear projection is a poor approximation to the conditional mean. since the resulting function is quadratic in experience.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.

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

e−λ λj j! . E(Y 2 | X = x) and V ar(Y | X = x). then E(x2 ei ) = 0. If yi = xi β + ei . If yi = x0 β + ei and E(ei | xi ) = 0. 1.3 Find E(Y | X = x). and have the following joint probability distribution X=0 X=1 Y =0 . and E(e2 | xi ) = σ 2 . then ei is independent of xi . and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . i 10.. Compute the conditional mean m(x) = E (yi | xi = x) . True or False. i 11. then E(x2 ei ) = 0. s) = 0 if and only if m = µ and s = σ 2 . True or False. 2.. then E(ei | xi ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi . True or False. ¡ ¢ 4. i 7. Prove parts 2. Compute E(yi | xi = x) and V ar(yi | xi = x).1 . True or False. a constant. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . True or False. m.6 Exercises 1. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . taking values only on the non-negative integers. xi ∈ R. j! 0 j = 0. If yi = xi β + ei . 2.2. x 6. If yi = x0 β + ei . σ = . Suppose that yi is discrete-valued. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . Let X be a random variable with µ = EX and σ 2 = V ar(X). then ei is i i independent of xi . (x − µ)2 − σ 2 Show that Eg (X. Suppose that Y and X only take the values 0 and 1. and E(xi ei ) = 0. 0 ≤ y ≤ 1.4 . 3 and 4 of Theorem 3. Let xi and yi have the joint density f (x. and E(ei | xi ) = 0. i 8. µx = Exi . . 20 . 9. yi ). Are they diﬀerent? Hint: If P (Y = j) = 5. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. σ 2 = V ar(xi ). If yi = x0 β + ei and E(xi ei ) = 0.3. E(ei | xi ) = 0.2 Y =1 .1. µ. xi ∈ R. 3.

3) In Sections 4. (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .2) (4.8.2) can be written in the parametric 0 β)) = 0.1 Estimation Equation (4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .7 and 4. i It follows that the moment estimator of β replaces the population moments in (4.1) (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . but for most of the chapter we retain the broader focus on the projection model. Observe that (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. 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 . i n i=1 n 21 .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. we narrow the focus to the linear regression model.

83 µ We often write the estimated equation using the format \ log(W agei ) = 1.4).14 14.30 + 0. ¶ 2. excluding military.71 = −2.ˆ This is a set of k equations which are linear in β. Let yi be log wages and xi be an intercept and years of education. consider the data used to generate Figure 3.117 1 14.4).5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. 40 0.40 µ ¶µ ¶ 34. This sample has 988 observations.14 205.7% increase in mean wages.37 µ ¶ 1.83 ¶−1 µ ¶ . i 22 . Then µ ¶ n 1X 2.3. with 10-15 years of potential work experience. 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 (4.170 37.94 −2.2 Least Squares There is another classic motivation for the estimator (4. 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. To illustrate. 30 = . n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. 0. These are white male wage earners from the March 2004 Current Population Survey.117 Educationi .14 205. 40 2.14 14. An interpretation of the estimated equation is that each year of education is associated with an 11. 4.95 xi yi = 42.95 42.

the contour lines are ellipses. Since the function Sn (β) is a quadratic function of β. Figure 4. Figure 4. It is important to understand the distinction between the error ei and the residual ei . 23 . To visualize the sum-of-squared errors function. These two ˆ variables are frequently mislabeled. Following convention we will call β the OLS estimator of β. Matrix calculus (see Appendix 2.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. which can cause confusion. i ˆ ˆ Note that yi = yi + ei . The error is unobservable.2 displays the contour lines of the same function — horizontal slices at equally spaced heights.4). Figure 4. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4.1: Sum-of-Squared Errors Function As a by-product of OLS estimation.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). while the residual is a by-product of estimation.

2: Sum-of-Squared Error Function Contours Equation (4. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. 24 . ˆ n−k 2 i=1 (4.Figure 4. The error variance σ 2 = Ee2 is also a parameter of interest. These are algebraic results. It measures the variation in the i “unexplained” part of the regression. Its method of moments estimator is the sample average 1X 2 ei . one implication is that n 1X ei = 0. ˆ σ = ˆ n 2 i=1 n (4.6) An alternative estimator uses the formula n 1 X 2 s = ei .7. and hold true for all linear regression estimates.7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n i=1 n Since xi contains a constant.5) implies that 1X xi ei = 0.

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

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

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

⎟ ⎜ ⎟ ⎜ (4. . In the model (4.8)(3. obtain residuals X2 . .1 (Frisch-Waugh-Lovell). Rather. ˜ 2. 4.6. ˆ ˜ ˜ ˆ 3. In this section we derive the small sample conditional mean and variance of the OLS estimator. 30 . . is the demeaning formula for regression. but in most cases there is little computational advantage to using the two-step algorithm. and X2 is the vector of observed regressors. A common application of the FWL theorem. the FWL theorem can be used to speed computation. Regress X2 on X1 . ¡ ¢−1 0 ι.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. . ⎠ ⎝ ⎠ ⎝ . observe that ⎞ ⎛ ⎞ ⎛ . ˆ which are “demeaned”. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. . ! 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. 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. . . Regress Y on X1 . Regress Y on X2 . .9).Theorem 4. which you may have seen in an introductory econometrics course. 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) . By the independence of the observations and (3.9). In this case. . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. .14) or via the ˆ following algorithm: ˜ 1. obtain OLS estimates β 2 and residuals e. the primary use is theoretical. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 .13). obtain residuals Y . In some contexts.

and (4. σ 2 } = ⎜ . V ar β | X = X 0 X ⎟ ⎟ ⎟.19) ˆ and thus the OLS estimator β is unbiased for β. 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. 1 n . . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . .8). ⎠ (4. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 .Using (4. and the trace operator observe that. Then given (4. From (4.. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. . the properties of conditional expectations. ¡ 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. Next.20) . under the of ˆ ¢ 2 | x = σ 2 . we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0.. X 0 DX = X 0 Xσ 2 . 0 0 ··· 0 0 . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . and ³ ´ ¡ ¢−1 2 ˆ σ .12). .18).. . .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . .. ⎝ .

This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. 4. known as the Gauss-Markov theorem.7) is unbiased for σ 2 by this calculation. or in the projection model. as it yields the smallest variance among all unbiased linear estimators.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. Thus σ 2 is biased towards zero. By a calculation similar to those of the previous section. Now consider the class of estimators of β which are linear functions of i the vector Y.1 Gauss-Markov. Theorem 4.10).9) plus E e2 | xi = σ 2 . which is (3.8)¢ ¡ (3. It is important to remember. says that the least-squares estimator is the best choice.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 . In this case. which we now present. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . Thus since V ar (e | X) = In σ 2 under homoskedasticity. = σ2 n the ﬁnal equality by (4. In the homoskedastic linear regression model. however. 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.8. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. is a famous statement of the solution. As an alternative. What is the best choice of A? The Gauss-Markov theorem. the best (minimumvariance) unbiased linear estimator is OLS. ³ ´ ˜ E β | X = A0 Xβ. 32 . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . It is not unbiased in the absence of homoskedasticity. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. the estimator ˆ 2 deﬁned (4. ˜ so β is unbiased if (and only if) A0 X = Ik . The following result.

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

Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. and thus so is the OLS estimator.10 Omitted Variables xi = µ x1i x2i ¶ .22) 34 . the maximum likelihood estimator is identical to the OLS estimator.9). We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . He observes that the above argument holds for all multinomial distributions. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.5. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.Substituting in the expressions for π j . Chamberlain (1987) extends this argument to the case of continuously-distributed data.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.10) for the class of models satisfying Assumption 3.1. 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. if the data have a discrete distribution. (4. He proves that generically the OLS estimator (4.

if X includes both the logs of two prices and the log of the relative prices. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. This is estimation of the equation yi = x0 γ 1 + ui 1i E (x1i ui ) = 0 Notice that we have written the coeﬃcient on x1i as γ 1 rather than β 1 . For example. because we have not said what it means for a matrix to be “near singular”. In this case.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 .22). i. By construction.e. The diﬀerence Γβ 2 is known as omitted variable bias.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. as many desired variables are not available in a given dataset. or second. Typically there are limits. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. least-squares estimation of (4. this is rarely a problem for applied econometric practice. log(p1 ). log(p2 ) and log(p1 /p2 ). and the error as ui rather than ei . This is the situation when the X 0 X matrix is near singular. This is because the model being estimated is diﬀerent than (4.23) the short regression to emphasize the distinction. Goldberger (1991) calls (4. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. which is often called “multicollinearity” for brevity. 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. 35 . 4. This deﬁnition is not precise.23) where is the coeﬃcient from a regression of x2i on x1i . In general. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. except in special cases.Now suppose that instead of estimating equation (4. β 1 6= γ 1 . The more relevant issue is near multicollinearity. Typically. This happens when the columns of X are linearly dependent. To see this. When this happens.. then β is not deﬁned. It is the consequence of omission of a relevant correlated variable. First. Most commonly. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). the coeﬃcient on x2i in (4. Since the error is discovered quickly.22) the long regression and (4. when the columns of X are close to linearly dependent. we regress yi on x1i only.22) is zero. there is some α such that Xα = 0. the general model will be free of the omitted variables problem. This is called strict multicollinearity.22) by least-squares. this arises when sets of regressors are included which are identically related.

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. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . the worse the precision of the individual coeﬃcient estimates. As a consequence. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . since as ρ approaches 1 the matrix becomes singular.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. To investigate the possibility of inﬂuential observations. 1] and sum to k. We derive expression (4. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.26) As we can see.−i = (1 − hi )−1 hi ei . the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . the OLS estimator based on the sample excluding the i’th observation. that is. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. What is happening is that when the regressors are highly dependent. ˆ ˆ (4.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. If the i’th observation 36 . deﬁne the leave-one-out least-squares estimator of β. ˆ i A simple comparison yields that ˆ ei − ei. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise.25) below. We can also deﬁne the leave-one-out residual ˆ ˆ ei. the precision of individual estimates are reduced.27) (4. The hi take values in [0.−i = yi − x0 β (−i) = (1 − hi )−1 ei .

This implies has a large value of hi . The key is equation (2. 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 . then this observation is a leverage point and has the potential to be an inﬂuential observation. Investigations into the presence of inﬂuential observations can plot the values of (4.27).25).1) in Section 2.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . ˆ We now derive equation (4. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .

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

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

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

the fact that X n = W n + Z n . 5.7). where Z has distribution F (x) = P (Z ≤ x) . Finally.4). Theorem 5. Fn (x) → F (x) as n → ∞. we can set E(X) = 0 (by recentering Xi on its expectation).1 Central Limit Theorem (CLT). n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. Set ε = δη/3.3. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. if for all x at which F (x) is continuous.1) and (5. as needed.1). ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. If Xi ∈ Rk is iid and E |Xi |2 < ∞.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. 43 . ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . (5. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N.5). and the bound |Wi | ≤ 2C.Proof: Without loss of generality.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. the fact that the Wi are iid and mean zero. We say that Zn converges in distribution to Z as n → ∞. Fix δ and η. by Markov’s inequality (5. V ) .6) By Jensen’s inequality (5. denoted Zn →d Z. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. P ¯X n ¯ > δ ≤ η. Jensen’s inequality (5. the triangle inequality. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .6) and (5.

it is suﬃcient to consider the case µ = 0 and V = Ik . Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . the independence of the Xi . By the properties of the exponential function. By a second-order Taylor series expansion of c(λ) about λ = 0. let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). the deﬁnition of c(λ) and (5.8) where λ∗ lies on the line segment joining 0 and λ.Proof: Without loss of generality. ∂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. For ¡ ¢ λ ∈ Rk . ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik .8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 .

√ where λn → 0 lies on the line segment joining 0 and λ/ n. and g(θ) : Rm → Rk . then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. k ≤ m. Since cλλ (λn ) → cλλ (0) = −Ik . Σ) . then g(Zn ) →d g(Z) as n → ∞.4.4.3 Delta Method: If n (θn − θ0 ) →d N (0. If Zn →d Z as n → ∞ and g (·) is continuous. then g(Zn ) →p g(c) as n → ∞. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. This is suﬃcient to establish the theorem. √ Theorem 5. Proof : By a vector Taylor series expansion. gθ Σgθ . It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. for each element of g. Ik ) distribution. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Recall that A ⊂ B implies P (A) ≤ P (B). Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. where θ is m × 1 and Σ is m × m. If Zn →p c as n → ∞ and g (·) is continuous at c. ¥ 5. 45 .2 Continuous Mapping Theorem 2. Proof: Since g is continuous at c. Σ) = N 0. Theorem 5.4 Asymptotic Transformations Theorem 5. Hence g(Zn ) →p g(c) as n → ∞.1 Continuous Mapping Theorem 1 (CMT). for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. we see that as n → ∞.4. 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 . Stacking across elements of g.

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

1). the OLS estimator β is has a statistical distribution which is unknown. As the sample size increases the density becomes more concentrated about the population coeﬃcient. we will use the methods of asymptotic approximation.2.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. Proof. Assumption 3.2 Consistency ˆ As discussed in Section 6. ˆ Theorem 6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. using (6.4 implies that Q−1 exists and thus g(·. Equation (4. xi ei →p g (Q.2). we can conclude ˆ that β →p β.3).1 Under Assumption 3. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . (6.1 and the WLLN (Theorem 5. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.5. ·) is continuous at (Q.1).5. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.1. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1) and ˆ We now deduce the consistency of β. β →p β as n → ∞. ˆ 47 . To characterize the sampling distribution more fully. (6.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . (6. 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 . 0). First.3) Ã where g(A.1 by the fact that the sampling densities become more concentrated as n gets larger. Ã n ! n X 1X 0 1 ˆ xi xi .1).1.1.4.4. n i=1 (6. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.1).1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. This is illustrated in Figure 6.2. For a complete argument. Assumption 3. and the continuous mapping theorem (Theorem 5.2) i i n i=1 n From (6. 6. Hence by the continuous mapping theorem (Theorem 5.5.

(6. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .1 In addition to Assumption 3.3.2. ˆ Finally. n 1 X √ xi ei →d N (0.3. E ¯ei ¯ E ¯e4 ¯ i i i i (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. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.2 Under Assumption 3.1.5. Assumption 6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .6) n i=1 48 . To see this. since n/(n − k) → 1 as n → ∞. We need a strengthening of the moment conditions. ˆ n−k 6. (6. Ω) .1). (6. ˆ Proof. Ee4 < ∞ and E |xi |4 < ∞. it follows that s2 = ¥ n σ 2 →p σ 2 . by the Cauchy-Schwarz inequality (5.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.2.3. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.5. i i Assumption 6. (6.1.3) and Theorem (6.2).3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. By the central limit theorem (Theorem 5.2). Thus σ 2 is consistent for σ 2 .1 guarantees that the elements of Ω are ﬁnite.1).Theorem 6.

In Figure 6. V ) where V = Q−1 ΩQ−1 . xi ) which satisfy the conditions of Assumption 6.3. |ε| ≥ 1. and (6.7) Cov(xi x0 . Under (6. for example. Q−1 ΩQ−1 .1 states that the sampling distribution of the least-squares estimator. This holds true for all joint distibutions of (yi .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.9) we deﬁne V 0 = Q−1 σ 2 whether (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . 1). V is often referred to as ˆ the asymptotic covariance matrix of β. We call V 0 the homoskedastic covariance matrix. when xi and ei are independent. Let yi = β 0 + β 1 xi + εi where xi is N (0. The approximation may be poor when n is small.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . The expression V = Q−1 ΩQ−1 is called a sandwich form. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. after rescaling.1 Under Assumption 6.7) is true then V = V 0 . but this is not a necessary condition. 1 X √ xi ei n i=1 n ! the N (0. We illustrate this problem using a simulation. For α 49 . As α approaches 2. i i Condition (6.3. its variance diverges q ³ ´ ˆ to inﬁnity. however. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. In´Figure 6.1.7) holds. When (6. e2 ) = 0. However. setting n = 100 and varying the parameter α.3.1).3.2).6). as n → ∞ ´ √ ³ ˆ n β − β →d N (0.1. The asymptotic distribution ´ Theorem 6.3. otherwise V 6= V 0 . Ω) ¡ ¢ = N 0. Theorem 6. there is no simple answer to this reasonable question.7) is true or false. 1) asymptotic distibution. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. The trouble is that no matter how large is the sample size. (6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).9) In (6. We say that ei is a Homoskedastic Projection Error when (6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .Then using (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . There is a special case where Ω and V simplify. is approximately normal when the sample size n is suﬃciently large. How large should n be in order for the approximation to be useful? Unfortunately.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.

1) it is clear that V 0 →p V 0 . Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .10) without changing this result. Another example is shown in Figure 6. 1) density. 6. 1) asymptotic approximation is never guaranteed to be accurate. for k = 1.0 the density is very close to the N (0. the sampling distribution becomes highly skewed and non-normal.Figure 6.2: Density of Normalized OLS estimator α = 3.10) V 0 = Q−1 s2 .11) 50 . As k increases. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. 4. As α diminishes the density changes signiﬁcantly.2) and Theorem 6.2 and 6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. we need an estimate of Ω = E xi x0 e2 . The estimator 2 2 in (6. concentrating most of the probability mass around zero.3.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. We show the sampling distribution of n β 1 − β 1 setting n = 100. The lesson from Figures 6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. 6 and 8.2. 1).3 is that the N (0.

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

30 + 0. by Holder’s inequality (5.used by an author when studying their work.14 6.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. From a computational standpoint.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.83 −0. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. Using (6. (6. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. from which it follows that V →p V as n → ∞.14 205.80 2. n n i=1 52 .12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.14 14.2.035 ¶ .6 ¶µ 1 14.80 .199 2. p ˆ In this case the two estimates are quite similar.493 −0.98 −0.480 .83 ¶−1 = µ 7.5) and the WLLN (Theorem 5. To illustrate.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.80 40.83 ¶−1 µ . i i i i n i=1 Second.14 14. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . then take the diagonal elements.14 205.020. (6.493 0.020) 6.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. (.1.117 Educationi .20 = V 14.480 ˆ0 = 0. just as any other estimator.039 and ˆ V = µ 1 14. but not under another set of assumptions.80 40.4) 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 .20 and µ ¶ ˆ = 0. we return to the log wage regression of Section 4.12) in turn. First.35/988 = .2/988 = .20 −0.14 205. Ω 2.199 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . We calculate that s2 = 0. The standard errors for β 0 are 7. and then the square roots.085) (.085 p ˆ and that for β 1 is .

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. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . 6.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi .6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. i=1 Third.26). ¯ ¯n ¯ n i=1 so Together. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. Using this substitution.−i = (1 − hi )−1 ei ˆ presented in (4.1 As n → ∞. Recall from Section 4. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . 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. these establish consistency. From equation (3. Ω →p Ω and V →p V. you can show that 1 Xˆ ¯ β= β (−i) . n i=1 n ˆ ˆ Theorem 6. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . Andrews (1991) suggested an similar estimator based on cross-validation.5.25).13) of Efron (1982).12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.13) Using formula (4. 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. which.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.

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

For example. see Section X). (For example. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. the standard error for ˆ is the square root of n−1 Vθ . By (6. In general. In special cases (such as the normal regression model. the statistic tn has an exact t distribution. s(ˆ = n−1/2 H 0 V Hβ . however. if R is a “selector matrix” R= so that if β = (β 1 . Since the standard normal distribution does not depend on the parameters. Consider the studentized statistic tn (θ) = Theorem 6.8. θ) β 6.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. s(ˆ θ) (6. Vθ ) √ Vθ = N (0.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. we say that tn (θ) is asymptotically pivotal. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . In this case. and θ = h(β) is some function of the parameter vector. we say that tn is an exactly pivotal statistic.1 tn (θ) →d N (0. θ could be a single element of β).15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. ˆ When q = 1q h(β) is real-valued). ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. 55 . 1) →d ˆ−θ θ . and is therefore exactly free of unknowns. β 2 ). that (so θ ˆ ˆ ˆ is. µ I 0 ¶ ˆ the upper-left block of V . 1) Proof.

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

We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ).16) and zα/2 is the upper α/2 quantile of the standard normal distribution. ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). the most common professional choice isi95%.05. 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. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. This corresponds to selecting the conﬁdence h i h ˆ ± 1. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. θ θ) (6.96s(ˆ ≈ ˆ ± 2s(ˆ . or α = . ˆ + zα/2 s(ˆ . and it is desired to test the joint restrictions simultaneously. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. 6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.18) . = n h(β) − θ0 Hβ V Hβ 57 (6. In this case the t-statistic approach does not work. θ The interval has been constructed so that as n → ∞. 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 . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.

19) σ2 ˆ where σ2 = ˜ 1 0 e e. 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. 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. Hβ (β) is a continuous function of β. 1] under H0 . ˆ Wn = n θ θ q θ θ Theorem 6.10. θ = β 2 . Vθ ). = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .2.025 . For example. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . Wn = n R0 β − θ0 ´ √ ³ The delta method (6.05) = 3. Hβ (β) →p Hβ . and there are q = k2 restrictions. Furthermore. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.1 showed θ ˆ that V →p V. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.1 Under H0 and Assumption 6. if rank(Hβ ) = q. χ2 (. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.1.11 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 .15) showed that n ˆ − θ →d Z ∼ N (0. As before. ˜˜ n ˜ e = Y − X1 β 1 . 6. Also h(β) = a selector matrix. The null hypothesis is H0 : β 2 = 0. and Theorem 6. the test rejects at the α% level iﬀ pn < α. The asymptotic p-value for Wn is pn = p(Wn ).8. In this case. the upper-α quantile q 2 of the χ2 distribution.84 = z.When h is a linear function of β. Hence β β by Theorem A. then Wn →d χ2 . The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. h(β) = R0 β. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . a chiq square random variable with q degrees of freedom. q and pn is asymptotically U[0. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).3.5.

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

This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . there is an exact distribution theory available for the normal linear regression model. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . Since linear functions of normals are also normal. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. σ 2 ) can be be used to calculate a set of exact distribution results. it follows ˆ that β is independent of any function of the OLS residuals. While there are special cases where this F statistic is useful. equivalently the residual variance from an intercept-only model. In ) . This was a popular statistic in the early days of econometric reporting. an “F statistic” is reported. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2.3.12 Normal Regression Model As an alternative to asymptotic distribution theory. In σ 2 .4)) where H 0 H = In . when an OLS regression is reported. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . In particular. Let u = σ −1 H 0 e ∼ N (0. H 0 H) ∼ N (0. 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.where In many statistical packages. n−k 60 . 6. introduced in Section 4. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. This is rarely an issue today. 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 . Since uncorrelated normal variables are independent. these cases are atypical. including the estimated error variance 2. The modelling assumption that the error ei is independent of xi and N (0.

In contrast. 0.1 and Theorem 6.12. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. σ2 ˆ 61 . β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .1 we showed that in large samples.10) then ´ ³ ˆ • β ∼ N 0. with residual variance σ . β 2 . σ 2 ) = − log σ − log (2π) − .3. so as a practical matter it does not matter which distribution is used.8. The critical values are quite close if n − k ≥ 30. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . (Unless the sample size is unreasonably small. Furthermore. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .10) µ h i ¶ 2 (X 0 X)−1 N 0. if standard errors are calculated using the homoskedastic formula (6.1 If ei is independent of xi and distributed N(0. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .1 shows that under the strong assumption of ˆ normality.12. As inference (conﬁdence intervals) are based on the t-ratio. Theorem 6. and standard errors are calculated using the homoskedastic formula (6. n−k • ∼ tn−k ˆ In Theorem 6. β and t are approximately normally distributed. σ 2 ). which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. 0. β has an exact normal distribution and t has an exact t distribution. β 2 . 0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . a good testing procedure is based on the likelihood ratio statistic. 1) and tn−k distributions. σ ˆ ˆ βj − βj βj − βj N (0. We summarize these ﬁndings Theorem 6. σ 2 ) discussed above. 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. β 2 . σ 2 ) − Ln (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . the notable distinction is between the N (0.a chi-square distribution with n − k degrees of freedom.) Now let us partition β = (β 1 .

we have plotted in Figure 6. and noting Hβ = sβ s−1 . we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Take the model yi = β + ei ei ∼ N (0. Through repetition. Letting h(β) = β s . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. This is an unfortunate feature of the Wald statistic. To demonstrate this eﬀect. the statistic Wn (s) varies with s. Our ﬁrst-order asymptotic theory is not useful to help pick s. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. they can work quite poorly when the restrictions are nonlinear. The decreasing dashed ˆ = 1. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. This produces random draws from the sampling distribution of interest.4 the Wald statistic Wn (s) as a function ˆ of s. while there are other values of s for which test test statistic is insigniﬁcant. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. This can be seen by a simple example introduced by Lafontaine and White (1986). The increasing solid line is for the case β = 0.8. as Wn (s) →d χ2 under H0 for 1 any s.7. 62 . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. In the present context of the Wald statistic. setting n/σ 2 = 10. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.84 — the probability of a false rejection. ˆ Let β and σ 2 be the sample mean and variance of yi . σ 2 ) and consider the hypothesis H0 : β = 1. 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 . features of this distribution can be calculated. 6. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples.

1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . These probabilities are calculated as the percentage of the 50.Figure 6. Given the simplicity of the model. we compare the rates row by row. In Table 4. Error rates avove 10% are considered excessive. looking for tests for which rate rejection rates are close to 5%. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. and rarely fall outside of the 3%-8% range. In Table 2. Type I error rates between 3% and 8% are considered reasonable. so these probabilities are Type I error. 100 and 500. n is varied among 20. however. Test performance deteriorates as s increases. To interpret the table. The null hypothesis β s = 1 is true. remember that the ideal Type I error probability is 5% (. In each case. the only test which meets this criterion is the conventional Wn = Wn (1) test.000 random samples. the Type I error probability improves towards 5% as the sample size n increases.1 we report the results of a Monte Carlo simulation where we vary these three parameters.000 simulated Wald statistics Wn (s) which are larger than 3. Any other choice of s leads to a test with unacceptable Type I error probabilities. Table 4. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. no magic choice of n for which all tests perform uniformly well. Typically.4: Wald Statistic as a function of s P (Wn (s) > 3. For this particular example.84. and σ 2 . When comparing statistical procedures. The value of s is varied from 1 to 10.4. There is. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.05) with deviations indicating+ distortion.1 you can also see the impact of variation in sample size. Rates above 20% are unexceptable. and σ is varied among 1 and 3. this probability depends only on s. n. Table 4.84 | β = 1) .1 reports the simulation estimate of the Type I error probability from 50.

10 .05 .25 .22 .30 .20 .05 .15 .14 .08 . 64 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.35 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .19 .23 .06 .08 .10 .08 .07 .24 .06 .09 .06 . While this is clear in this particular example.13 . so the hypothesis can be stated as H0 : θ = r.16 Rejection frequencies from 50.15 .06 .06 .31 .07 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.26 .05 .08 .15 .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 .18 .05 .12 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .28 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.25 . β 1 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. β 2 ) be the least-squares estimates of (6.12 .11 .07 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .08 .21 .06 .14 .13 .06 .07 .15 .17 .07 .22 .05 .33 .06 .20 . Equivalently.13 . Other choices are arbitrary and would not be used in practice. in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.20).10 . deﬁne θ = β 1 /β 2 .34 .05 . This point can be illustrated through another example.

0 and n among 100 and 500. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.7.05 .00 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.00 .1. The implication of Table 4. while the right tail probabilities P (t1n > 1.50 .00 .05 . such as the GMM distance statistic which will be presented in Section 9. The left tail probabilities P (t1n < −1.645) are calculated from 50.05. .06 .00 . if the hypothesis can be expressed as a linear restriction on the model parameters.75 1.09 .12 .000 simulated samples.05 β2 . .10 . In contrast.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 4.645) are close to zero in most cases. We vary β 2 among . the rejection rates for the t1n statistic diverge greatly from this value. In all cases. and normalize β 0 = 0 and β 1 = 1. In this section we describe the method in more detail. this formulation should be used. Ideally. 65 .645) P (tn > 1.06 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .06 . . 1) variables.00 . σ 2 ) draw with σ = 3.26 .25 .06 . then the “most linear” formulation should be selected.10 . along with sample size n.00 .05 .50. This leaves β 2 as a free parameter.00 The one-sided Type I error probabilities P (tn < −1. The results are presented in Table 4.75. It is also prudent to consider alternative tests to the Wald statistic.645) P (tn > 1. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .06 .05 .02 . If no linear formulation is feasible. 6.645) and P (tn > 1.07 .05 . ei be an independent N (0.06 .06 .06 .25. especially for small values of β 2 . and are close to the ideal 5% rate for both sample sizes.06 . We let x1i and x2i be mutually independent N (0.10 .00 .05 .06 .15 .05 .15 .645) P (tn < −1.05 .28 .2.00 .00 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.47 .645) greatly exceed 5%.05 . and alternatives to asymptotic critical values should be considered.645) t1n t2n t1n t2n t1n t2n t1n t2n . the entries in the table should be 0. However. and 1.

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

and . We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. such as the percentage estimate reported in (6. For example. the researcher must select the number of experiments. but requires more computational time. and estimate a multivariate regression. It is therefore convenient to pick B so that N is an integer. an estimator or test may perform wonderfully for some values. if we set B = 999. the choice of B is often guided by the computational demands of the statistical procedure. As P is unknown. and therefore it is straightforward to calculate standard errors for any quantity of interest. s P = . female. In particular. and dummy variable indicators for the following: married. the performance will depend on n and F. respectively. are. then B will have to be increased. union member. therefore. It is therefore useful to conduct a variety of experiments.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value.96) is iid Bernoulli. If the standard error is too large to make a reliable inference. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. In practice. Again our dependent variable is the natural log of wages. 6. The α% sample quantile is a number qα such that α% of the sample are less than qα . potential work experience. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.003. equalling 1 with probability P = E1 (Tnb ≥ 1. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. We now expand the sample all non-military wage earners. for a selection of choices of n and F.22/ B. and dummy variable indicators for the following: married. and non-white.007. We separately estimate equations for white and non-whites. Hence the ³ ´ ˆ standard errors for B = 100. female. and our regressors include years of education. Generally. immigrant. For the dependent variable we use the natural log of wages. it is simple to make inferences about rejection probabilities from statistical tests. B b=1 (6. and poorly for others.95) /B ' . a larger B results in more precise estimates of the features of interest of Gn . immigrant. this may ˆ be approximated by replacing P with P or with an hypothesized value. union member. and 90% sample quantiles of the sample {Tnb }. For example. potential work experience.96) . 1000. In many cases. excluding military. As discussed above. For regressors we include years of education. . The random variable 1 (Tnb ≥ 1. where N = (B +1)α.96) . if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. experience squared. Quite simply.022. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.15 Estimating a Wage Equation We again return to our wage equation. Furthermore.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. We us the sample of wage earners from the March 2004 Current Population Survey. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. Then qα is the N ’th number in this ordered sequence. hispanic. so that coeﬃcients may be interpreted as semi-elasticities. The average (6. experience squared. and 5000. then we can set s P = (. and hispanic. Often this is called the number of replications.05) (. B.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. we included a dummy 67 .21).

The F form of the Wald statistic (6. Ignoring the other coeﬃcients. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. The available sample is 18.49452 σ ˜ Notice that the two statistics are close. we can write this eﬀect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model. reestimating the model with the 50 state dummies excluded.007 .027 . Wn = n 1 − 2 = 18.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.101 . we ﬁnd Wn = 550. θ ˆ 2β 3 β2 .014 .variable for state of residence (including the District of Columbia. this adds 50 regressors). 2β 3 68 .48772 = 515.4945.102 −.34 ˆ s(β) . 808 1 − .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.00057 .002 . the restricted standard deviation estimate is σ = .19) is ˜ µ ¶ µ ¶ σ2 ˆ .013 .001 . but not equal.232 . as the 1% critical value for the χ2 distribution is 76.033 −.070 .18) that the state coeﬃcients are jointly zero.121 −.1.4877 18.008 . Using either statistic the hypothesis is easily rejected.808 .032 .010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant.808 so the parameter estimates are quite precise and reported in Table 4. excluding the coeﬃcients on the state dummy variables.097 −. Alternatively.102 −. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. Computing the Wald statistic (6.010 .69. Table 4.00002 .

not testing a hypothesis.40. but the lower end is substantially lower. implying a 95% conﬁdence θ) interval of [27. but it can be found numerically quite easily. 29. 29. we can calculate a standard error of s(ˆ = . This is the set of θ such that |tn (θ)| ≤ 1. Instead. However. Notice that the upper end of the conﬁdence interval is the same as that from the delta method.0. Since tn (θ) is a non-linear function of θ. there is not a simple expression for this set. this is a poor choice.96. In the present context we are interested in forming a conﬁdence interval. 69 .9. In the previous section we discovered that such t-tests had very poor Type I error rates. so we have to go one step further.5]. This set is [27. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ). we found better Type I error rates by reformulating the hypothesis as a linear restriction.5]. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.Using the Delta Method.

In the model Y = X1 β 1 + X2 β 2 + e. (c) Show that if R0 β = r is true. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. ˜ (b) Verify that R0 β = r. 0 < s < k. show that the least-squares estimate of β = (β 1 . ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. (d) Under the ´ standard assumptions plus R0 β = r. subject to the constraint that β 1 = −β 2 . In the model Y = Xβ + e. the least-squares estimate of β subject to the restriction h(β) = 0 is ˜ β = argmin Sn (β) h(β)=0 Sn (β) = (Y − Xβ)0 (Y − Xβ) . β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . 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 . Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix. ﬁnd the least-squares estimate of β = (β 1 . β − β = Ik − X 0 X 70 . ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. (a) Show that the solution is ´ ¢−1 h 0 ¡ 0 ¢−1 i−1 ³ 0 ¡ ˆ ˜ ˆ Rβ−r R R XX R β = β − X 0X ´ h ¡ ¢−1 i−1 ³ 0 ˆ ˆ Rβ−r R λ = R0 X 0 X ¢−1 0 ¡ ˆ XY β = X 0X where is the unconstrained OLS estimator. β 2 ). λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. r ˜ is a known s × 1 vector. 2. 1. In the model Y = X1 β 1 + X2 β 2 + e. then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. show that the least-squares estimate of β = (β 1 . In the model Y = X1 β 1 + X2 β 2 + e. 4. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. ˜ That is.6. 3.16 Exercises For exercises 1-4. and rank(R) = s. β 2 ). the following deﬁnition is used.

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

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

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

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 ˜ = ..that there is a need to bound the estimated variances away from zero. ¢¢−1 ¡ ¡ . . Its asymptotic variance is not that given in Theorem 7.. Why then do we not exclusively estimate regression models by FGLS? This is a good question. In the linear regression model. β should perhaps be i i called a quasi-FGLS estimator of β. and it may be estimated with considerable 76 V takes a sandwich form√. V ). ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. Unless σ 2 = α0 zi . σ 2 ] σi i for some σ 2 > 0. similar to the covariance matrix of the OLS estimator. 1992).1 If the skedastic regression is correctly speciﬁed. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.1. V n n i=1 . V ˜ An appropriate solution is to use a White-type estimator in place of V 0 .1.2) is correctly speciﬁed.1. and was proposed by Cragg (Journal of Econometrics.1. ´´−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 . There are three reasons. Instead. i ˜ 0 is inconsistent for V . First. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . In this case we interpret α0 zi as a linear projection of e2 on zi . A trimming rule might make sense: σ 2 = max[˜ 2 .. 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 → ∞. e2 }. It is possible to show that if the skedastic regression is correctly speciﬁed. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. FGLS is asymptotically superior to OLS. Since the form of the skedastic regression is unknown. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. Theorem 7.1. then FGLS is asymptotically equivalent to GLS. This estimator V 0 is appropriate when the skedastic regression (7. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. but the proof of this can be tricky. We just state the result without proof.

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

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

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

θ) ' m(xi . 1 2 The model is linear when β 2 = 0.1. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . Suppose that m(xi . tests of H0 do not have asymptotic normal or chi-square distributions. by a ﬁrst-order Taylor series approximation. ˆ and ei = yi − m(xi . θ0 )) − m(xi . the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. Thus when the truth is that β 2 = 0. ¥ Based on Theorem 7. θi Thus ¡ ¢ yi − m(xi . θ0 ) + m0 (θ − θ0 ) . and this is often a useful hypothesis (sub-model) to consider.For θ close to the true value θ0 .5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi . 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 .4. Thus we want to test H0 : β 2 = 0. 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 . Hansen (1996). θ which is that stated in the theorem. ˆ ˆ θ) ˆ θ). We have discussed projections and conditional means. This renders the distribution theory presented in the previous section invalid. Identiﬁcation is often tricky in nonlinear regression models. 80 . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ) ' (ei + m(xi . but these are not the only measures of central tendency. θ) = β 0 zi + β 0 xi (γ). m(xi . 7. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. γ is not identiﬁed. under H0 . θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. In particular. Furthermore. the parameter estimates are not asymptotically normally distributed. However. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . This means that under H0 . An alternative good measure is the conditional median.

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

11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.11).10) is equivalent to g n (β) = 0.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.5. When f (0 | x) is large. In the special case where the error is independent of xi . ˆ Proof of Theorem 7. (7. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . V ).5. the height of the error density at its median. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .1 ´ √ ³ˆ n β − β 0 →d N (0.1 is advanced. by the central limit theorem (Theorm 5. and this improves estimation of the median. The main diﬃculty is the estimation of f (0). First. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.5. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. See Chapter 16.3. Let g(β) = Eg (β). the conditional density of the error at its median.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . where V = and f (e | x) is the conditional density of ei given xi = x. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . Pn −1 0 β)) . we provide a sketch here for completeness. Computation of standard error for LAD estimates typically is based on equation (7. While a complete proof of Theorem 7. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . ∂β 0 so Third. This can be done with kernel estimation techniques. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.Theorem 7. then there are many innovations near to the median.

V ). This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . The median is the special case τ = . The following alternative representation is useful. If the random variable U has τ ’th quantile Qτ . We then have the linear quantile regression model yi = x0 β τ + ei i 83 .13) This generalizes representation (7.9) for the median to all quantiles.12) Qτ = argmin Eρτ (U − θ) . the quantile regression functions can take any shape. then (7. For the random variables (yi . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . then F (Qτ (x) | x) = τ . As functions of x. then F (Qτ ) = τ . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . so you can think of the quantile as the inverse of the distribution function. Again. 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)) . The third line follows from an asymptotic empirical process argument. 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. For ﬁxed τ . For τ ∈ [0. (7.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. ¥ 7. when F (y | x) is continuous and strictly monotonic in y.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. Exi x0 ) →d i 2 = N (0. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors.5.

the τ ’th conditional quantile of ei is zero.13).12). E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). n numerical methods are necessary for its minimization. i By construction. the asymptotic variance depends on the conditional density of the quantile regression error. and test their signiﬁcance using a Wald test. When the error ei is independent of xi . and are widely available. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. if the model yi = x0 β + ei has i been ﬁt by OLS. Furthermore. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 .7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . ´ √ ³ˆ Theorem 7. otherwise its properties are unspeciﬁed without further restrictions.1 n β τ − β τ →d N (0.1. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. the unconditional density of ei at 0. and form a Wald statistic i for γ = 0. then f (0 | xi ) = f (0) . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. 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. Thus. 7. Fortunately. Vτ ). it is useful to have a general test of the adequacy of the speciﬁcation.6. fast linear programming methods have been developed for this problem. since it has discontinuous derivatives. Another popular approach is the RESET test proposed by Ramsey (1969). where and f (e | x) is the conditional density of ei given xi = x. ¡ ¡ ¢¢−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.5.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . The null model is yi = x0 β + εi i 84 . conventional Newton-type optimization methods are inappropriate. 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. ˆ Given the representation (7.

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

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

else select M2 . For some critical level α. That is. Another common approach to model selection is to to a selection criterion. LRn →p 0. since under M1 . let cα satisfy ¢ ¡ P χ22 > cα . as the rule tends to overﬁt. Indeed. and km is the number of coeﬃcients in the model. AIC selection is inconsistent. Indeed. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . since (7.15) then where σ 2 is the variance estimate for model m. M)) between the true density and the model density. etc. In contrast to the AIC. if α is set to be a small number. His criterion.16) holds under M1 . this rule only makes sense when the true model is ﬁnite dimensional. known as the BIC. based on Bayesian arguments. else select M2 .16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . as ³ ´ c P M = M1 | M1 → 1 − α < 1. 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. ¢ ¡ ˆ1 ˆ2 (7. Then select M1 if Wn ≤ cα . One popular choice is the Akaike Information Criterion (AIC). log(n) 87 . A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . The model selection rule is as follows. Another problem is that if α is held ﬁxed.17) Since log(n) > 2 (if n > 8). n (7. then this model selection procedure is inconsistent. The rule is to select M1 if AIC1 < AIC2 . k = While many modiﬁcations of the AIC have been proposed. k A major problem with this approach is that the critical level α is indeterminate. depending on the sample size. n (7. ˆm The AIC can be derived as an estimate of the KullbackLeibler information distance K(M) = E (log f (Y | X) − log f (Y | X. If the truth is inﬁnite dimensional. it is more appropriate to view model selection as determining the best ﬁnite sample approximation.However. BIC model selection is consistent. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. the most popular to be one proposed by Schwarz. 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.

β 3 = · · · = β K = 0 . one can show that thus LRn →p ∞. The AIC selection criteria estimates the K models by OLS. Also under M2 . which regressors enter the regression). In the unordered case. . However. 210 = 1024. and then selects the model with the lowest AIC (7.. There are two leading cases: ordered regressors and unordered. which are nested. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . and the AIC or BIC in principle can be implemented by estimating all possible subset models. . β 2 6= 0. 88 . stores the residual variance σ 2 for each model. . 048.17). log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. We have discussed model selection between two models.. For example. . In the ordered case. .. selecting based on (7. a model consists of any possible subset of the regressors {x1i .15). the models are M1 : β 1 6= 0. In the latter case. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. 576. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. xKi }. β 2 6= 0. β K 6= 0. MK : β 1 6= 0. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. and 220 = 1. Similarly for ˆ the BIC. there are 2K such models. The methods extend readily to the issue of selection among multiple regressors. 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.

and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. V . 5. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . . (b) Find an estimate of the variance of this forecast. wn ) and wi = x−2 .. the residuals e. Let (yi . else equals zero). Is θ a quantile of the distribution of Yi ? 3. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. and the out-of-sample value of the regressors. 2. based on a sample of size n. Show that the function g(x) which minimizes the MAE is the conditional median M (x). You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . ˜ the residual vector is e = Y − X β. Thus the available information is the sample (Y.. 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 . V ar(e | X) = σ 2 Ω with Ω known. 4. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . x. Let θ satisfy Eg(Yi − θ) = 0. X). Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 .. 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 . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. ˆ ˆ n−k 6. σ 2 ). Verify equation (7. ˆ (a) Find a point forecast of y. where xji is one of the xi .12). Let σ 2 be the estimate of σ 2 . the estimates (β. . For any predictor g(xi ) for y. xi ) be a random sample with E(Y | X) = Xβ. the mean absolute error (MAE) is E |yi − g(xi )| . In a linear model Y = Xβ + e. (b) Prove that e = M1 e.7.10 Exercises 1. E(e | X) = 0.

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

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

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

but the approximation appears to improve for the large n. x)) →d N (0. Fn is by construction a step function. Fn is a nonparametric estimate of F. x))) .2 The Empirical Distribution Function Fn (y. x) (1 − F (y. x) = n i=1 Figure 8. To see this.. Furthermore. ∗ P (yi ≤ y.1). Notationally. 50. Fn (y. note that for any (y. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . i 93 .3. (8. x) = P (yi ≤ y. x) . the EDF step function gets uniformly close to the true CDF. . the EDF is only a crude approximation to the CDF. F (y. in the Figure below. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. x). x) →p F (y.2) Fn (y. 1) distribution. by the CLT (Theorem 5.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . where 1(·) is the indicator function. The EDF is a consistent estimator of the CDF. This is a population moment. x) is called the empirical distribution function (EDF). Thus by the WLLN (Theorem 5. Recall that F (y. n. I have plotted the EDF and true CDF for three random samples of size n = 25. x∗ ≤ x) = Fn (y.1). it is helpful to think of a random pair (yi . xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . i = 1. The random draws are from the N (0.2.. x). To see the eﬀect of sample size on the EDF. x). xi ). x∗ ) with the i distribution Fn . For n = 25. as the sample size gets larger. Note that while F may be either discrete or continuous..8. and 100. x) − F (y. In general. √ n (Fn (y. That is.

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

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

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

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

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

99 . Deﬁnition 8.3 an = o(n−r ) if nr |an | → 0 as n → ∞. θ θ θ ˆ θ ∗ ∗ Computationally. θ [This is a typical mistake made by practitioners. not ˆ − θ0 . Let Tn be a statistic such that (8.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. however. v 2 ). where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ .8 Asymptotic Expansions Tn →d N (0. Thus here Tn (θ) = Wn (θ). about the rate v of convergence.] 8. We say that a function g(x) is even if g(−x) = g(x). A better asymptotic approximation may be obtained through an asymptotic expansion. 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. Deﬁnition 8. lim Gn (x. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . Equivalently. Let an be a sequence. Basically.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.8. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).8. writing Tn ∼ Gn (x. F ) then ³x´ . F ) = Φ + o (1) .2 an = O(1) if |an | is uniformly bounded. 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. C4 is called the symmetric percentile-t interval. and a function h(x) is odd if h(−x) = −h(x). (8. The following notation will be helpful. If θ is a vector. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. The derivative of an even function is odd. it says nothing. or the size of the divergence for any particular sample size n.4) v ¡ ¢ While (8.4) says that Gn converges to Φ x as n → ∞.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. where qn (α) is the (1 − α)% quantile of the distribution of Wn . the critical value qn (α) is found as the quantile from simulated values of W´ . an = O(n−r ) if it declines to zero like n−r . The ideal test rejects if Wn ≥ qn (α). and vice-versa.8. F ) = Φ n→∞ v or ³x´ Gn (x.

we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . F0 ) ≈ ∂ g1 (x.8. ³x´ 1 1 + 1/2 g1 (x. F0 )) converges to 0 at rate n. so the order of the error is O(n−1/2 ). F0 )) + O(n−1 ). F0 ) = Φ(x) + since v = 1. where g1 is an even function of x. Fn ) + O(n−1 ). 100 . To a second order of approximation. F ) + O(n−3/2 ) Gn (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. The diﬀerence is Φ(x) − Gn (x.1 as follows. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). F ) v which adds a symmetric non-normal component to the approximate density (for example. An asymptotic test is based on Φ(x). g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. g1 (x. F ) + g2 (x. F ) ≈ Φ + n−1/2 g1 (x. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. the exact distribution is P (Tn < x) = Gn (x. ³x´ Gn (x.9 One-Sided Tests Using the expansion of Theorem 8. and g1 is continuous with respect to F.uniformly over x. v Since the derivative of g1 is odd. 1/2 1 n Because Φ(x) appears in both expansions.8. Moreover. √ Since Fn converges to F at rate n. First. To the second order.3). and g2 is an odd function of x. A bootstrap test is based on G∗ (x). F0 ) = 1 g (x. We can interpret Theorem 8.8. F ) converges to the normal limit at rate n1/2 . which from Theorem 8. Gn (x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). Heuristically. F ) + n−1 g2 (x.8. F ) = Φ v n n 8. adding leptokurtosis). Fn ) − g1 (x. Fn ) − g1 (x. To a third order of approximation. Theorem 8. Fn ) − g1 (x. F0 ) = n 1 n1/2 (g1 (x. the density function is skewed.1.1 has the expansion n G∗ (x) = Gn (x.1 Under regularity conditions and (8. F ) ≈ Φ + n−1/2 g1 (x. F ). ³x´ Gn (x. Fn ) = Φ(x) + n 1 g (x. the diﬀerence √ (g1 (x.

if Tn has exact distribution Gn (x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). F0 ) = The order of the error is O(n−1 ). then |Tn | →d |Z| ∼ Φ. then |Tn | has the distribution function Gn (x. Similarly. F ) + g2 (x. F ) + g2 (−x. n (8. n . F ) = Gn (x.The “derivative” ∂ ∂F g1 (x. F0 ) + O(n−3/2 ) = O(n−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). F ). F0 ) = O(n−1 ). F ) + O(n−3/2 ). 1). F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. 8.8. 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.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). We conclude that G∗ (x) − Gn (x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F ) = Gn (x. Since Tn →d Z. F0 ) distribution. 101 2 g2 (x. F ). as F is a function. A two-sided hypothesis test rejects H0 for large values of |Tn | .5) where the simpliﬁcations are because g1 is even and g2 is odd. and exact critical values are taken from the Gn (x. Thus asymptotic critical values are taken from the Φ distribution. F ) is only heuristic. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. = P (X ≤ x) − P (X ≤ −x) For example. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). if Z ∼ N (0. we can calculate that Gn (x.1. F ) − Gn (−x. From Theorem 8.

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

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

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

95). The dataﬁle hprice1. θ respectively. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. with variables listed in the ﬁle hprice1. ∗ ∗ where s(ˆ is the standard error in the original data. ∗ ∗ ∗ Let qn (.2. (a) Report the 95% Efron Percentile interval for θ. Estimate a linear regression of price on the number of bedrooms. Using the non-parametric ∗ bootstrap.pdf. You do this as follows.95). (b) Report the 95% Alternative Percentile interval for θ. you generate bootstrap samples. ˆ = 1.95).5% quantiles of the ˆ are . θ θ) ∗ 1000 samples are generated from the bootstrap distribution.75 and 1.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). You want to test H0 : θ = 0 against H1 : θ > 0. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. can you report the 95% Percentile-t interval for θ? 7.05) and qn (. lot size. Let qn (.5% and 97. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.95) denote the 95% quantile of Tn .dat contains data on house prices (sales). Using the non-parametric bootstrap. (c) With the given information.95) denote the 5% θ) ∗ and 95% quantiles of Tn . You replace c with qn (. and the 2. 105 . The ˆ are sorted. ˆ − s(ˆ n (.3. and thus reject H0 if ˆ ˆ > q ∗ (. What is wrong with this procedure? Tn = θ/s(θ) n 6. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). size of house. and ˆ is calculated on each θ ∗ ∗ θ sample.05) . and the colonial dummy. Suppose that in an application.2 and s(ˆ = .

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

but this is generally not possible when > k. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . β ˆ Note that if k = .1 β GMM = argmin Jn (β).9. This is a non-negative measure of the “length” of the vector g n (β). For some × weight matrix Wn > 0. Proposition 9. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. the square of the Euclidean length. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . the dependence is only up to scale. Let and where gi = xi ei . ˆ Deﬁnition 9. β GMM = Z 0 XWn X 0 Z 9. for if Wn is replaced ˆ by cWn for some c > 0. let Jn (β) = n · g n (β)0 Wn g n (β). The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. The GMM estimator minimizes Jn (β). For example. if Wn = I. then g n (β) = 0.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. then. β GMM does not change. ¡ ¢−1 0 ˆ Z XWn X 0 Y.2) g n (β) = (9. i i .2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .2.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. and the GMM estimator is the MME.2.

Chamberlain showed that in this context. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. where In general. this is a semi-parametric problem. If it is known that E (gi (β)) = 0. In the linear model. but it can be estimated consistently. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance.3. and this is all that is known.3. as shown by Gary Chamberlain (1987). The optimal weight matrix W0 is one which minimizes V. as the distribution of the data is unknown. as it has the same asymptotic distribution. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . This turns out to be W0 = Ω−1 .and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. Ω) . ˆ n i=1 gi = gi − g n . no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . ˆ we still call β the eﬃcient GMM estimator. we can set Wn = I . Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator.1 ´ √ ³ˆ n β − β →d N (0. However. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. ˆ Construct n 1X ˆ g n = g n (β) = gi . β).4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. W0 = Ω−1 is not known in practice. it is semiparametrically eﬃcient. The proof is left as an exercise. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. n n We conclude: Theorem 9. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. it turns out that the GMM estimator is semiparametrically eﬃcient. without imposing additional assumptions. 9. This is a weak concept of optimality. n β − β →d N 0.2 For the eﬃcient GMM estimator. For any Wn →p W0 . V ) . This results shows that in the linear model. 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. ˆ∗ ˆ 108 . For example. a better choice is Wn = (X 0 X)−1 . as we are only considering alternative weight matrices Wn . the GMM estimator β is consistent yet ineﬃcient.

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

and is thus a natural test statistic for H0 : Egi = 0. perhaps obtained by ﬁrst ˆ setting Wn = I. 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). this is all that is known.1 (Sargan-Hansen). 1 it is possible that β 2 6= 0. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. Theorem 9. Thus the model — the overidentifying restrictions — are testable. 110 . β) = 0 holds. For example. 9. Identiﬁcation requires l ≥ k = dim(β).Often. and if the weight matrix is asymptotically eﬃcient. 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. The general theory of GMM estimation and testing was exposited by L. so that the linear equation may be written as yi = β 0 x1i + ei . The criterion function at the parameter estimates is J = n g 0 Wn g n n ¡ ¢−1 2 0 = n g n g 0 g − ng n g 0 gn . In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction.5.1 Under general regularity conditions. and then β recomputed. However. G0 Ω−1 G . i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Since the GMM estimator depends upon the ﬁrst-stage estimator.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 . Under the hypothesis of correct speciﬁcation. n β − β →d N 0. Hansen (1982).6. often the weight ˆ matrix Wn is updated. This estimator can be iterated if needed. ˆˆ n is a quadratic form in g n . 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. Note that g n →p Egi . 1 2 It is possible that β 2 = 0. ˆ J = J(β) →d χ2−k .

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

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

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

γ). 2. 114 . Show that Wn →p Ω i i i 4. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 .g. Write out the matrix A. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0. γ ) for (β. verify that A can be written as ³ ¡ ¢−1 0 ´ G H. Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. From matrix algebra. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . Letting H = CQ and G = C 0−1 W Q. and therefore positive semideﬁnite.9. A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. In the linear model estimated by GMM with general weight matrix W. 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 . Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . Show that V0 = Q0 Ω−1 Q . (b) We want to show that for any W. we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . Let ei = yi − zi β where β is consistent for ˆ β (e. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). a GMM estimator with arbitrary weight matrix). ˆ ˆ Find the method of moments estimators (β. Take the model E (zi ηi ) = 0. V − V0 is positive semi-deﬁnite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the eﬃcient weight matrix). (c) Since Ω is positive deﬁnite. i 0 0ˆ ˆ 3.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. Take the model yi = zi β + ei with E (xi ei ) = 0. there exists a nonsingular matrix C such that C 0 C = Ω−1 .

Show how to construct an eﬃcient GMM estimator for β.6) equals the Wald statistic. The GMM estimator of β. 115 . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. VR = V − V R R0 V R (d) Show that in this setting. l ≥ k. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . zi is l × 1 and β is k × 1. the distance statistic D in (9. The observed data is (yi . VR ) where ¡ ¢−1 0 R V. Vn = X X i=1 ˜ and hence R0 β = r. subject ˆ i ˆi i=1 to the restriction h(β) = 0. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). In the linear model Y = Xβ + e with E(xi ei ) = 0. xi . zi ).5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . 6. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. h(β)=0 (9.6) (a) Show that you can rewrite Jn (β) in (9. β) + ei E (zi ei ) = 0.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. Deﬁne the Lagrangian L(β. Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . The equation of interest is yi = g(xi .5.

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

the log-likelihood function for this multinomial distribution is n X ln(pi ). 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.. these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1.. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10.1) i=1 First let us consider a just-identiﬁed model. Combined with i the constraint (10.2) Ln (p1 .1). The n ﬁrst order conditions are 0 = p−1 − µ.. . pn ) are those which maximize the log-likelihood subject to the constraint (10. The maximum likelihood estimator of the probabilities (p1 . It is a non-parametric analog of likelihood estimation. pn ) which places probability pi at each observation. pn ) = i=1 An alternative to GMM is empirical likelihood....Chapter 10 Empirical Likelihood 10.1 Non-Parametric Likelihood Since each observation is observed once in the sample. (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 . β). In this case the moment condition places no additional restrictions on the multinomial distribution. zi . . The multinomial distribution which places probability pi at each observation (yi .. xi . The idea is due to Art Owen (1988. . xi .3) i=1 117 . To be a valid multinomial distribution..1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n). (10. 2001) and has been extended to moment condition models by Qin and Lawless (1994). The idea is to construct a multinomial distribution F (p1 .

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

8) and ¢ 0 0 For example. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . in the linear model. (β.13) yields n n Expanding (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .1 Under regularity conditions.10) ¡ Ω−1 N (0. β) = −xi zi . ˆ ˆ Proof.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 .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. Thus the EL estimator is asymptotically eﬃcient.10). n (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. G = −E (xi zi ). ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. Gi (.13) Premultiplying by G0 Ω−1 and using (10. i=1 i=1 i=1i Expanding (10. and Ω = E xi x0 e2 .2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.9) and (10. β λ ∂ ³ ´. 0 = Rn (β.9) (10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. λ) = − (10.10. i i Theorem 10. and n β − β 0 and nλ are asymptotically independent.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . λ) = − (10.2. 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.

The overidentiﬁcation test is a very useful by-product of EL estimation.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.3 Overidentifying Restrictions In a parametric likelihood context. it is an asymptotically eﬃcient estimator for β. and have the same interpretation. and (10. Ω) GΩ G →d = N (0. Vλ ) Furthermore. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. β 0 ) = 0 then LRn →d χ2−k .15). n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.16).1 If Eg(wi . V ) ˆ Solving (10. They are asymptotically ﬁrst-order equivalent. by a Taylor expansion. and it is advisable to report the statistic LRn whenever EL is the estimation method. tests are based on the diﬀerence in the log likelihood functions. The same statistic can be constructed for empirical likelihood. LRn = i=1 Theorem 10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.14) for λ and using (10.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .15) (10.15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0. Proof.3.7) is n ³ ´´ ³ X ˆ ˆ0 (10. First. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. Since the EL estimator achieves this bound. 120 . (10.17) 2 ln 1 + λ gi β . 10.

18).17) is not appropriate. 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. Theorem 10.4. where h : Rk → Ra .5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. By “maintained” we mean that the overidentfying restrictions contained in (10. Vλ )0 Ω−1 N (0. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) and H0 : h(β) = 0. 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).wisc. 10. the simple overidentifying restrictions test (10.18) Let the maintained model be where g is × 1 and β is k × 1. To test the hypothesis h(β) while maintaining (10. h(β)=0 ˜ Fundamentally. since ln(1 + x) ' x − x2 /2 for x small. LRn →d χ2 . Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .ssc.prc 121 .18) are assumed to hold and are not being challenged (at least for the test discussed in this section).4 Testing Egi (β) = 0 (10.edu/~bhansen/progs/elike. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. 10.1 Under (10. The hypothesis of interest is h(β) = 0. so there is no fundamental change in the distribution theory for β relative to β.Second. a The proof of this result is more challenging and is omitted.

λj )) Rp = Rn (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) = − gi (β. λj ) is smaller than some prespeciﬁed tolerance. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) G∗ (β. λ) = G∗ (β. 2.4) 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. λj ))−1 Rλ (β. λp ) A quadratic function can be ﬁt exactly through these three points. λj ) . Set δ 0 = 0.19). The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) . λ)0 − Rn (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λ) gi (β. λ)0 0 Rn (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β.5) for given β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ) = i The ﬁrst derivatives of (10. λ) = − ∂β n X i=1 G∗ (β.. The iteration (10.19) X ∂2 ∗ ∗ gi (β.20) . Deﬁne ∗ gi (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. set 2 λp = λj − δ p (Rλλ (β.19) is continued until the gradient Rλ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λ)0 − ∂β∂β Rn (β. One method uses the following quadratic approximation. 1. The starting value λ1 can be set to the zero vector. λj ))−1 Rλ (β. For p = 0. λ) G∗ (β. δ 1 = 1 and δ 2 = 1. λ) ∂λ i=1 n ∂ Rn (β.4). (10. Eﬃcient convergence requires a good choice of steplength δ.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next).

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

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

1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. 11. We call z1i exogenous and z2i endogenous.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. By the above deﬁnition. some regressors in zi will be uncorrelated with ei (for example. So we have the partition µ ¶ z1i k1 (11. β →p β ∗ .2) Any solution to the problem of endogeneity requires additional information which we call instruments. In matrix notation. and x2i are the excluded exogenous variables.1) where zi is k × 1. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.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 ¶ . We call (11.1 The × 1 random vector xi is an instrumental variable for (11. (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 . This is called simultaneous equations bias. In a typical set-up. so should be included in xi . Deﬁnition 11.1) the structural equation. at least the intercept). Thus we make the partition ¶ µ k1 z1i (11. this can be written as Y = Zβ + e.1.1). which does not equal either β 1 or β 2 . z1i is an instrumental variable for (11. and assume that E(zi ei ) 6= 0 so there is endogeneity.1) if E (xi ei ) = 0.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.

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

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

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. P = HΛH 0 0 0 where Λ = diag(Il . 0).13). By the spectral decomposition of an idempotent matrix.Let PX = X (X 0 X)−1 X 0 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. the bias in the 2SLS estimator will be large. 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 . It is also close to zero when α = 0. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . The consequences of identiﬁcation failure for inference are quite severe. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . the expression in (11. 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. l . except when S21 = 0 (when Z is exogenous).14) approaches that in (11.12) and this result.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . n and (11.14) In general this is non-zero. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 130 . Indeed as α → 1.14) is the probability limit of β 2SLS − β 11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.

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

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

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

and the remaining variables as exogenous. in years. Does this diﬀer from 2SLS and/or OLS? 7. 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. Report estimates and standard errors. and then calculate the GMM estimator from this weight matrix without further iteration. in years.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995).pdf. (b) Now treat Education as endogenous. listed in card.. In this model. (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). I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. The data ﬁle card.(b) Deﬁne the 2SLS estimator of β. Suppose that price and quantity are determined by the intersection of the linear demand and supply curves Demand : Supply : Q = a0 + a1 P + a2 Y + e1 Q = b0 + b1 P + b2 W + e2 ¡ ¢ (a) Show that E (xi ei ) = 0 and E x2 ei = 0. 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 mother). (e) Calculate and report the J statistic for overidentiﬁcation. of the father) and motheduc (the education. Report the estimates and standard errors. are the parameters identiﬁed? 8. a dummy indicating that the observation lives near a 4-year college. and South and Black are regional and racial dummy variables. 134 . 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. (d) Re-estimate the model by eﬃcient GMM. There are 2215 observations with 19 variables. Report estimates and standard errors. Estimate the model by 2SLS. f atheduc (the education. using zi as an instrument for xi . (a) Estimate the model by OLS. using the instrument near4.

Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. t = 1.1.1. Yt−k ) = γ(k) is independent of t for all k. then Xt is strictly stationary and ergodic. To indicate the dependence on time. 12.. Deﬁnition 12. . T . Because of the sequential nature of time series. 135 . We can separate time series into two categories: univariate (yt ∈ R is scalar).. and use the subscript t to denote the individual observation. .1.) is a random variable. however.4 (loose).. we expect that Yt and Yt−1 are not independent.. so classical assumptions are not valid. The following two theorems are essential to the analysis of stationary time series.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. A stationary time series is ergodic if γ(k) → 0 as k → ∞.2 {Yt } is strictly stationary if the joint distribution of (Yt . and Cov (Yt . Yt−k ) is the autocorrelation function. Yt−1 . Yt−k ) is independent of t for all k.. .. Deﬁnition 12.. γ(k) is called the autocovariance function.1 Stationarity and Ergodicity Deﬁnition 12. and multivariate (yt ∈ Rm is vector-valued). we adopt new notation.1. The primary model for univariate time series is autoregressions (ARs). The primary model for multivariate time series is vector autoregressions (VARs). Theorem 12.1. and T to denote the number of observations.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . Deﬁnition 12.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .. There proofs are rather diﬃcult.

ˆ 3.2 (Ergodic Theorem). γ (k) →p γ(k).1.1. and it has a ﬁnite mean by the assumption that EYt2 < ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).Theorem 12.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. 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) . then as T → ∞. T 1X Xt →p E(Xt ). ˆ Proof. ˆ 2. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . For Part (2). the sequence Yt Yt−k is strictly stationary and ergodic. γ (0) ˆ Theorem 12. ˆ ˆ γ ¥ 136 .1. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . then as T → ∞. Part (1) is a direct consequence of the Ergodic theorem. If Xt is strictly stationary and ergodic and E |Xt | < ∞.1 above. 1. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). µ →p E(Yt ). T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ρ(k) →p ρ(k).

. 137 . Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. . For example. Deﬁnition 12.12. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . or consumption growth rates.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. Thus for k > 0.. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . 12.. In fact.. 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. E(et ) = 0 and Ee2 = σ 2 < ∞. Letting et = Yt − E (Yt | It−1 ) . Yt−2 . ∞ X = ρk et−k . this series converges if the sequence ρk et−k gets small as k → ∞. Yt−k ) . Y2 . YT . .} are jointly random... some versions of the life-cycle hypothesis imply that either changes in consumption. The last property deﬁnes a special time-series process. This occurs when |ρ| < 1..} is the past history of the series.. as it is diﬃcult to derive distribution theories without this property.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . it is even more important in the time-series context.. . Some time-series processes may be a MDS as a consequence of optimizing behavior. A mean-zero AR(1) is Assume that et is iid. Regression errors are naturally a MDS. k=0 Loosely speaking. t By back-substitution. A linear AR model (the most common type used in practice) speciﬁes linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k .2 Autoregressions In time-series. ... the series {. Y1 . should be a MDS.. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.2.. E(Yt−k et ) = 0...

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

since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.6. Thus t by the Ergodic Theorem.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.” If one of the roots equals 1. so is xt x0 . and is of great interest in applied time series. β = X 0X (12. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. By Theorem 12.. “has a unit root”.1) and the continuous mapping theorem. Proof. λk are the complex roots of ρ(z). 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. t T t=1 T t=1 139 . then ˆ β →p β as T → ∞.. it is also strictly stationary and ergodic. which satisfy ρ(λj ) = 0. One way of stating this is that “All roots lie outside the unit circle. Let |λ| denote the modulus of a complex number λ.1. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. . and hence Yt .1. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. the requirement is that all roots are larger than one.1. it is helpful to deﬁne the process ut = xt et . Note that ut is a MDS. and by Theorem 12.where the λ1 . ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et .. The vector xt is strictly stationary and ergodic. t t T t=1 ¥ Combined with (12.1) Theorem 12. Theorem 12. we say that ρ(L).1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. This is a special case of non-stationarity.5. t Yt−k ¢0 ρk .1. For an AR(k).

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

But the long-run trend is also eliminated.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . • Include dummy variables for each season.. . and the way that the data are partitioned into blocks.2) (12. Resample complete blocks. 141 . get the ˆ ˆ residual St . Paste the blocks together to create the bootstrap time-series Yt∗ .2)-(12.. ρk ). ∆s Yt = Yt − Yt−s . • You can estimate (12.3) replacing St with St . The seasonal adjustment. 5.. This presumes that “seasonality” does not change over the sample. and for modelmisspeciﬁcation. The results may be sensitive to the block length. • First apply a seasonal diﬀerencing operator. That is. and then perform regression (12. 3. however. For each simulated sample. and perhaps this was of relevance. Seasonal Eﬀects There are three popular methods to deal with seasonal data. This procedure is sometimes called Detrending. also alters the time-series correlations of the data. The series ∆s Yt is clearly free of seasonality. or the season-to-season change. If s is the number of seasons (typically s = 4 or s = 12).3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . ﬁrst estimate (12. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. • Use “seasonally adjusted” data. (12.4) by OLS. (12. May not work well in small samples. This allows for arbitrary stationary serial correlation. 6. • You can estimate (12. 4.2. heteroskedasticity. Thus the seasonally adjusted data is a “ﬁltered” series.2). 12. This is a ﬂexible approach which can extract a wide range of seasonal factors. draw T /m blocks.3) sequentially by OLS.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

let dij = and ⎧ ⎨ 1 ⎩ 0 ⎛ if i = j . Observe that • This is generally consistent. ˆ ˆ OLS on (15.2) yields estimator (β. ⎟ u = ⎝ . you do not want to actually implement conventional OLS estimation. so will have to be omitted. • Any regressor in xit which is constant over time for all individuals (e. . ⎠. u). Computationally. so the intercept is typically omitted from xit . then by the FWL theorem. it i (15. i yit = x0 β + d0 u + eit . 158 . Stacking the observations together: Y = Xβ + Du + e. Let ⎛ ⎞ u1 ⎜ .g. as the parameter space is too large. OLS estimation of β proceeds by the FWL theorem. Conventional inference applies. their gender) will be collinear with di . din Observe that E (eit | xit . ˆ β = ¢−1 ¡ 0 ¢ ¡ 0 X (1 − PD ) Y X (1 − PD ) X ¡ ¢−1 ¡ ∗0 ∗ ¢ = X ∗0 X ∗ X Y . • There are n + k regression parameters.2) is a valid regression. un ui = d0 u. . which is quite large as typically n is very large. it will be collinear with di .First. else Then note that and an n × 1 dummy vector with a “1” in the i0 th place. • If xit contains an intercept. ⎟ di = ⎝ . di ) = 0. so (15. Y ∗ = Y − D(D0 D)−1 D0 Y where X ∗ = X − D(D0 D)−1 D0 X.. with di as a regressor along with xi . ⎠ .2) ⎞ di1 ⎜ .

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

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

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

ˆ We now examine the variance of f (x). Since it is an average of iid random variables. using ﬁrst-order Taylor approximations and the fact that n−1 is of smaller order than (nh)−1 V ar (x) = = ' = ' = where R(K) = R∞ −∞ K 1 V ar (Kh (Xi − x)) n 1 1 EKh (Xi − x)2 − (EKh (Xi − x))2 n n ¶ Z ∞ µ z−x 2 1 1 K f (z)dz − f (x)2 2 nh −∞ h n Z ∞ 1 K (u)2 f (x + hu) du nh −∞ Z f (x) ∞ K (u)2 du nh −∞ f (x) R(K) . The bias results from this smoothing. ˆ the greater the bias. so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . the estimator f (x) smooths data local to Xi = x.16. Intuitively. and is larger the greater the curvature in f (x). so is estimating a smoothed version of f (x). which is valid as h → 0. nh (x)2 dx is called the roughness of K.2 Asymptotic MSE for Kernel Estimates ∞ For ﬁxed x and bandwidth h observe that Z ∞ Z Kh (z − x) f (z)dz = EKh (X − x) = −∞ Kh (uh) f (x + hu)hdu = −∞ Z ∞ K (u) f (x + hu)du −∞ The second equality uses the change-of variables u = (z − x)/h. 162 . The last expression shows that the expected value is an average of f (z) locally about x. The sharper the derivative. This integral (typically) is not analytically solvable. 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).

2) but replaces R(f 00 ) with σ −5 R(φ00 ). we need h → 0 but nh → ∞. In practice. 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. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . and there is a large and continuing literature on the subject. but not of n. and gives a nearly optimal rule when f (x) is close to normal.2) depends on R(K). Together with the above table. and R(f 00 ).06n−1/5 163 . but at a very slow rate. Gaussian Kernel: hrule = 1. This choice for h gives an optimal rule when f (x) is ˆ normal. but at a slower rate than n−1 . where φ is the N (0. 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.Together. 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 + . The ﬁrst two are determined by the kernel function. 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 . That is. ˆ It uses formula (16. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). the rule-of-thumb h can be quite ineﬃcient. The asymptotically optimal choice given in (16. (16. Equation (16.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. Thus for the AMISE to decline with n. h must tend to zero. The downside is that if the density is very far from normal. we ﬁnd the reference rules for the three kernel functions introduced earlier. (16. Their K values for the three functions introduced in the previous section are given here. Note that this h declines to zero. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. We can calculate that √ R(φ00 ) = 3/ (8 π) . σ 2 . We thus say that the optimal bandwidth is of order O(n−1/5 ). how should the bandwidth be selected? This is a diﬃcult problem.1) is an asymptotic approximation to the MSE. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh.

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

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

in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A. . These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r.• 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. as µ ¶ n n! = . and is with replacement if this is allowed. Rearranging the deﬁnition. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. Counting may be ordered or unordered.. Furthermore. P (B) With Replacement nr ¡n+r−1¢ r For any B. Depending on these two distinctions. Ã ! \ Y P Ai = P (Ai ) . Ak are mutually independent when for any subset {Ai : i ∈ I}. it is useful to have simple rules to count the number of objects in a set. 983... n ≥ r. there are two important distinctions. the conditional probability function is a valid probability function where S has been replaced by B. we say that the collection of events A1 . the number of ¡49 if potential combinations is 6 = 13. For example. . consider a lottery where you pick six numbers from the set 1.. Counting may be with replacement or without replacement. ¢ counting is unordered and without replacement.. r r! (n − r)! When counting the number of objects in a set. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery.1) holds. If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . 2.1) We say that the events A and B are statistically independent when (A. This selection is without replacement if you are not allowed to select the same number twice. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. we have four expressions for the number of objects (possible arrangements) of size r from n objects.. i∈I i∈I 166 . 816. 49. We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A).

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

r X g(τ j )π j . We can also write σ 2 = V ar(X). If I1 < ∞ and I2 = ∞ then we deﬁne Eg(X) = −∞. Eg(X) = j=1 and if X is continuous Eg(X) = The latter is well deﬁned and ﬁnite if Z If (A. However. 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. For m > 0. we deﬁne the m0 th moment of X as EX m and the m0 th central moment as E (X − EX)m . evaluate I1 = Z Z ∞ g(x)f (x)dx. and when E |X|m < ∞ ¯ ¯ dm ¯ = im E (X m ) . (A. The MGF does not necessarily exist. this allows the convenient expression V ar(a + bX) = b2 V ar(X). the characteristic function (CF) of X is C(λ) = E exp (iλX) . m C(λ)¯ dλ λ=0 The Lp norm. √ where i = −1 is the imaginary unit. 168 . If both I1 = ∞ and I2 = ∞ then Eg(X) is undeﬁned. we deﬁne the mean or expectation Eg(X) as follows. The moment generating function (MGF) of X is M (λ) = E exp (λX) . Since E (a + bX) = a + bEX.A. p ≥ 1.4) 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) = ∞. If X is discrete. The CF always exists. −∞ ∞ −∞ |g(x)| f (x)dx < ∞. of the random variable X is kXkp = (E |X|p )1/p .3 Expectation For any measurable real function g. we say that expectation is a linear operator. We √ call σ = σ 2 the standard deviation of X. For example.4) does not hold. More generally. Two special moments are the mean µ = EX and variance σ 2 = E (X − µ)2 = EX 2 − µ2 .

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

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

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

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

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

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

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. If g(x) is an increasing function. Let h(y) denote the inverse of g(x). Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. dy This is known as the change-of-variables formula. Here. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). dy dy If g(x) is a decreasing function. (A.8 Normal and Related Distributions µ 2¶ 1 x . The Jacobian is ¶ µ ∂ h(y) . that for Y is [0.∞). 1]. take the case X ∼ U [0.10) shows that fY (y) = exp(−y).10) d h(y). an exponential density.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). As one example. diﬀerentiable. but its justiﬁcation requires deeper results from analysis. A.10) holds for k > 1. then g(X) ≤ Y if and only if X ≥ h(Y ). . 0 ≤ y ≤ ∞. As the range of X is [0. This same formula (A.A. 1] and Y = − ln(X). so FY (y) = P (g(X) ≤ y) = 1 − P (X ≥ h(Y )) = 1 − FX (h(Y )) and the density of Y is fY (y) = −fX (h(Y )) We can write these two cases jointly as fY (y) = fX (h(Y )) |J(y)| . and invertible. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. J(y) = det ∂y 0 Consider the univariate case k = 1. then g(X) ≤ Y if and only if X ≤ h(Y ).

Theorem A.11) and is known as the chi-square density with r degrees of freedom. then they are mutually independent. The latter has no closed-form solution. y ≥ 0. If Z is standard normal and X = µ + σZ. 1). x ∈ Rk . For x ∈ Rk . Ir ) and set Q = X 0 X. q 176 . Its mean and r variance are µ = r and σ 2 = 2r.1 Let X ∼ N (0. This shows that if X is multivariate normal with uncorrelated elements. then using the change-of-variables formula. Theorem A.8. (A. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Σ). then by the change-of-variables formula. ¢ ¡ It useful to observe ¢ that the MGF and CF of the multivariate normal are exp λ0 µ + λ0 Σλ/2 ¡ 0 and exp iλ µ − λ0 Σλ/2 . −∞ < x < ∞. σ 2 ). q × q. f (x) = √ 2σ 2 2πσ which is the univariate normal density. we can also show that EX 2 = 1 and EX 4 = 3.This density has all moments ﬁnite. 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.8. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). and it is conventional to write X ∼ N (µ. denoted χ2 . respectively. Another useful fact is that if X ∼ N (µ. This shows that linear transformations of normals are also normal. then Σ = diag{σ 2 } is a diagonal matrix. It is conventional to write X ∼ N (0. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. Σ) and Y = a + BX with B an invertible matrix. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . then Z 0 A−1 Z ∼ χ2 . By iterated integration by parts. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . Since it is symmetric about zero all odd moments are zero.2 If Z ∼ N(0. A) with A > 0. X has density Ã ! (x − µ)2 1 exp − . x ∈ Rk . The mean and variance of the distribution are µ and σ 2 . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . and it is conventional to write X ∼ N(µ.

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 .8.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Thus the density of Z 2 is (A. (A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. C −1 AC −10 ) = N (0. Proof of Theorem A. 1). which we showed in (A.3. 1) and Q ∼ χ2 be independent.3 Let Z ∼ N (0. q Proof of Theorem A. tr has distribution 177 . tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.13).8. Iq ).12) E exp (tQ) = 0 Γ (A.8. For Z ∼ N(0. Set r Z . ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. Using the simple law of iterated expectations. which can be found by applying change-of-variables to the gamma function. we see that the MGF of Z 2 is (1 − 2t)−1/2 .2.8.Theorem A. From (A. C −1 CC 0 C −10 ) = N (0.13) is the MGF of the density (A. The MGF for the density (A.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).11).11) 2 with r = 1.1. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .

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

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

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

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

an application of the CLT yields 1 X ∂ √ ln f (Yi . ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi .9.Proof of Theorem A. Ω) = N 0. θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. H −1 ΩH −1 = N 0.9.3 Taking the ﬁrst-order condition for maximization of Ln (θ). Together. θn ) = ln f (Yi . θ n ) θ − θ 0 .1 . θ0 ) →d N (0. Ω) . If it is continuous in θ. Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . ¥ 182 . the speciﬁc value of θn varies by row in this expansion. (Technically. we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . the ﬁnal equality using Theorem A. − ln f (Yi . ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. and making a ﬁrst-order Taylor series expansion. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θ0 ) . θ0 ) + ' 0 ln f (Yi . θ) . H −1 . θ0 ) is mean-zero with covariance matrix Ω.) Rewriting this equation.

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

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

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

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