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

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

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Contents

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

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

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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

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

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

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

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

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

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

denoted B = A0 . . . If a is a k × 1 vector. ⎦ ⎣ . The transpose of a matrix. a0 k ⎡ 0 ⎤ a1 b1 a0 b2 · · · a0 bs 1 1 ⎢ a0 b1 a0 b2 · · · a0 bs ⎥ 2 2 ⎢ 2 ⎥ = ⎢ . is obtained by ﬂipping the matrix on its diagonal. . . A square matrix is diagonal if the only non-zero elements appear on the diagonal. . A matrix is square if k = r. . . a1r a2r · · · akr £ aj1 aj2 · · · ajr ¤ Thus bij = aji for all i and j. Note that if A is k × r. are conformable. then A0 is r × k. Ak1 Ak2 · · · Akr where the Aij denote matrices. 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). then a0 is a 1 × k row vector. . A square matrix is symmetric if A = A0 . . . A square matrix is upper (lower) diagonal if all elements below (above) the diagonal equal zero. 2. ⎥ . . or the product AB. A partitioned matrix takes the form ⎤ ⎡ A11 A12 · · · A1r ⎢ A21 A22 · · · A2r ⎥ ⎥ ⎢ A=⎢ . .2 Matrix Multiplication k X j=1 If a and b are both k × 1. then their inner product is a0 b = a1 b1 + a2 b2 + · · · + ak bk = aj bj When the number of columns of A equals the number of rows of B. . .are column vectors and α0 = j are row vectors. . Then ⎡ 0 ⎤ a1 ⎢ a0 ⎥ £ ¤ ⎢ 2 ⎥ AB = ⎢ . which implies aij = aji . . If A is k × r and B is r × s. ⎦ ⎣ . . ⎤ ⎡ a11 a21 · · · ak1 ⎢ a12 a22 · · · ak2 ⎥ ⎥ ⎢ B = A0 = ⎢ . so that aij = 0 if i 6= j. ⎥ . we say that A and B. and this is the only case where this product is deﬁned. a0 b1 a0 b2 · · · k k a0 bs k . . ⎦ . vectors and/or scalars. 5 Note that a0 b = b0 a. ⎦ ⎣ . ⎥ . ⎥ b1 b2 · · · bs ⎣ .

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

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

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

2. Let π = (j1 . i Hence they must equal either 0 or 1. . For a general k × k matrix A = [aij ] . There are k! such permutations..4) H0 M =H 0 0 with H 0 H = In .. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ ..... .. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . and let επ = +1 if this count is even and επ = −1 if the count is odd. ⎠ .. k) . If A is 2 × 2.. k.. ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. . we can deﬁne the determinant as follows.. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.. Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. k)). xk ) be k × 1 and g(x) = g(x1 .... Additionally. . tr(A) = rank(A).. .By the uniqueness of the characteristic roots.8 Determinant The determinant is deﬁned for square matrices. .7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . jk ) denote a permutation of (1. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1.. . we deduce that Λ2 = Λ and λ2 = λi for i = 1. xk ) : Rk → R. then its determinant is det A = a11 a22 − a12 a21 ..

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

We call xi alternatively the regressor. We call yi the dependent variable. and that for women is $20. we can focus on f (y | x) . This is used when the goal is to quantify the impact of one set of variables on another variable. the mean is not necessarily a good summary of the central tendency. xki 3. The data are from the 2004 Current Population Survey 1 11 . Take a closer look at the density functions displayed in Figure 3. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. the conditional density of yi given xi . To illustrate. it is useful to have numerical measures of the diﬀerence. or the covariates. the mean wage for men is $27. Figure 3. m(x) can take any form. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. . education and experience. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. See Chapter 16. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. While it is easy to observe that the two densities are unequal. ⎠ ⎝ . (3. which is a common feature of wage distributions.2) m(x) = E (yi | xi = x) = −∞ In general. In this context we partition the observations into the pair (yi . and exists so long as E |yi | < ∞.1. These are indicated in Figure 3. gender.1.1) xi = ⎜ . These are conditional density functions — the density of hourly wages conditional on race.73. The two density curves show the eﬀect of gender on the distribution of wages.22. the conditioning variable. ⎟ .1 by the arrows drawn to the x-axis. In the example presented in Figure 3. xi ) where yi is a scalar (real-valued) and xi is a vector. When a distribution is skewed. These are asymmetric (skewed) densities. holding the other variables constant.1 displays the density1 of hourly wages for men and women. You can see that the right tail of then density is much thicker than the left tail.

36. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. When the distribution of the control variable is continuous. this yields the formula yi = m(xi ) + ei . Figure 3. the dashed line is a linear projection approximation which will be discussed in the Section 3.2) evaluated at the observed value of xi : ei = yi − m(xi ).5.3 displays a scatter plot2 of log wages against education levels.D. Of particular interest to graduate students may be the observation that diﬀerence between a B. To illustrate. For this reason. degree in mean log hourly wages is 0.3 is how the conditional expectation describes an important feature of the conditional distribution.A. By construction.30. then comparisons become more complicated.2 shows the density of log hourly wages for the same population. The conditional expectation function is close to linear. wage regressions typically use log wages as a dependent variable rather than the level of wages. which implies a 30% average wage diﬀerence for this population. and a Ph. 3.3) White non-military male wage earners with 10-15 years of potential work experience.1 is facilitated by the fact that the control variable (gender) is discrete. The diﬀerence in the log mean wage between men and women is 0. implying an average 36% diﬀerence in wage levels. with mean log hourly wages drawn in with the arrows. The main point to be learned from Figure 3. 2 (3. Assuming for simplicity that this is the true joint distribution. Figure 3.Figure 3. The comparison in Figure 3. the solid line displays the conditional expectation of log wages varying with education.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. 12 .1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.

not a model. E (ei | xi ) = 0. 4. 2.1 Properties of the regression error ei 1. 3. 13 .Figure 3. E (h(xi )ei ) = 0 for any function h (·) . by the deﬁnition of ei and the linearity of conditional expectations. most typically.2. A regression model imposes further restrictions on the joint distribution. To show the ﬁrst statement. are often stated jointly as the regression framework. restrictions on the permissible class of regression functions m(x). E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. because no restrictions have been placed on the joint distribution of the data. The remaining parts of the Theorem are left as an exercise. It is important to understand that this is a framework. The equations yi = m(xi ) + ei E (ei | xi ) = 0.2: Log Wage Densities Theorem 3. These equations hold true by deﬁnition. E(xi ei ) = 0. E(ei ) = 0.

A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. it does not provide information about the spread of the distribution. The right-hand-side is minimized by setting g(x) = m(x).3. In contrast. To see this.3 Conditional Variance Generally.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . i .4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. subject to the restriction p that it is non-negative. Thus the mean squared error is minimized by the conditional mean. The conditional standard deviation is its square root σ(x) = σ 2 (x). in the sense of achieving the lowest mean squared error. 3.Figure 3. the conditional variance of yi is σ 2 = σ 2 (xi ). The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. σ 2 (x) is a non-trivial function of x.2. and can take any form.1. when σ 2 (x) is a constant so that ¢ ¡ (3. Given the random variable xi . let g(x) be an arbitrary predictor of yi given xi = x.

This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . it is more realistic to view the linear speciﬁcation (3. where x1i is the ﬁrst element of the vector xi deﬁned in (3.6) (3.1). Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. Thus (3. and the linear assumption of the previous section is empirically unlikely to accurate.5.6) as an approximation.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). We call this the “constant” or “intercept”. which we derive in this section. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . xki When m(x) is linear in x. Equivalently.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. they are also somewhat more dispersed. ⎝ .5) xi = ⎜ . Notationally.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.we say that the error ei is homoskedastic. Instead. 3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . ⎠ . Equation (3.1 and that for women is 10.7) is a k × 1 parameter vector. The conditional standard deviation for men is 12. βk ⎛ (3. its functional form is typically unknown.4 Linear Regression An important special case of (3. i (3. ⎠ .8) is called the linear regression model. So while men have higher average wages.1. it is convenient to augment the regressor vector xi by listing the number “1” as an element.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 . ⎟ . As an example. take the conditional wage densities displayed in Figure 3. ⎟ β=⎝ . 15 .9) 3.8) (3. In this case (3. we assume that x1i = 1.

The best linear predictor is obtained by selecting β to minimize S(β). we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . 2 2. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . E (x0 xi ) < ∞. i (3. It is invertible if and only if it is positive deﬁnite. 3. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. As before. i i (3. this situation must be excluded. Rewriting. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . xi contains an intercept. Therefore. Eyi < ∞.which is quadratic in β.1. written E (xi x0 ) > 0. In order for β to be uniquely deﬁned.10) It is worth taking the time to understand the notation involved in this expression. This occurs when redundant variables are included in xi .5. The error is i ei = yi − x0 β. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. i which requires that for all non-zero α. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.10). i (3.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.12) This completes the derivation of the linear projection model. E (xi x0 ) is invertible. Given the deﬁnition of β in (3. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. α0 E (xi x0 ) α = E (α0 xi )2 > 0.5. The vector (3.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. i 4. x0 β is the best linear predictor for yi . i 16 . The ﬁrst-order condition for minimization (from Section 2. by “best” we mean the predictor function with lowest mean squared error.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 . Observe i that for any non-zero α ∈ Rk . Assumption 3. Equivalently. otherwise they are distinct. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite.1 1.

However.5. Furthermore.1. By deﬁnition.5. ¥ (3.8)-(3.2. Using the deﬁnitions (3.4 guarantees that the solution β exits.13) The two equations (3. E (xi ei ) = 0 and E (ei ) = 0.4 is required to ensure that β is uniquely deﬁned. The ﬁnite variance Assumptions 3.12) can be alternatively interpreted as a projection decomposition. Assumption 3. Since ei is mean zero by (3.5.1. Equation (3.14). i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1 Under Assumption 3. 17 .1 are weak. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Assumption 3. Let’s compare it with the linear regression model (3.Theorem 3. Assumption 3.3 are called regularity conditions.10) and (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 = 0.1. it follows that linear regression is a special case of the projection model.1 is employed to guarantee that (3. Since from Theorem 3.5.14) Proof.11) are well deﬁned.1. (3.1.5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.5. Assumption 3. (3.5.5. the orthogonality restriction (3.1.12) and (3. Figure 3.1.13) summarize the linear projection model.10) are deﬁned.9).1. This means that the equation (3.14) follows from (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.2 and 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. For example.5.1.5.13) implies that xi and ei are uncorrelated.1. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .11) and (3.14) holds.1.5.3 ensure that the moments in (3.4 we know that the regression error has the property E (xi ei ) = 0.2 and 3.13) and Assumption 3.

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

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

then E(x2 ei ) = 0.1. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. a constant. If yi = xi β + ei . E(Y 2 | X = x) and V ar(Y | X = x). Suppose that yi is discrete-valued. yi ). Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. and E(xi ei ) = 0. m..4 . 20 . 3. Let X be a random variable with µ = EX and σ 2 = V ar(X). then ei is i i independent of xi . Are they diﬀerent? Hint: If P (Y = j) = 5. µ. If yi = x0 β + ei and E(xi ei ) = 0. ¡ ¢ 4. If yi = x0 β + ei and E(ei | xi ) = 0. s) = 0 if and only if m = µ and s = σ 2 . then E(ei | xi ) = 0. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . True or False.2. 3 and 4 of Theorem 3. Compute E(yi | xi = x) and V ar(yi | xi = x).2 Y =1 . Suppose that Y and X only take the values 0 and 1. xi ∈ R. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. i 7. Let xi and yi have the joint density f (x. . 2. σ 2 = V ar(xi ). If yi = x0 β + ei . xi ∈ R. E(ei | xi ) = 0. 0 ≤ y ≤ 1. Prove parts 2. e−λ λj j! . True or False. and E(e2 | xi ) = σ 2 . True or False. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . then E(x2 ei ) = 0.6 Exercises 1. 9. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . then ei is independent of xi . True or False. i 10. Compute the conditional mean m(x) = E (yi | xi = x) . and E(ei | xi ) = 0. taking values only on the non-negative integers.1 .3. j! 0 j = 0. True or False. σ 2 = V ar(yi ) and σ xy = Cov(xi . (x − µ)2 − σ 2 Show that Eg (X. i 8. x 6. µx = Exi .3 Find E(Y | X = x). 2.. 1. If yi = xi β + ei . and have the following joint probability distribution X=0 X=1 Y =0 . i 11. σ = .

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 .2) can be written in the parametric 0 β)) = 0.1 Estimation Equation (4.7 and 4. but for most of the chapter we retain the broader focus on the projection model.3) In Sections 4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .1) (4. Observe that (4. i n i=1 n 21 .3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .4) i i=1 i=1 ˆ Another way to derive β is as follows.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4. (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 . we narrow the focus to the linear regression model. i It follows that the moment estimator of β replaces the population moments in (4.2) (4.8.

Then µ ¶ n 1X 2.4).14 14.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.37 µ ¶ 1. 4.3.ˆ This is a set of k equations which are linear in β. 0. Let yi be log wages and xi be an intercept and years of education.95 42. excluding military.170 37.95 xi yi = 42.7% increase in mean wages.30 + 0.4).14 205.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.40 µ ¶µ ¶ 34. with 10-15 years of potential work experience.117 Educationi . 40 0.117 1 14.14 205.94 −2. consider the data used to generate Figure 3.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.14 14. This sample has 988 observations. 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. 30 = .83 ¶−1 µ ¶ . These are white male wage earners from the March 2004 Current Population Survey. An interpretation of the estimated equation is that each year of education is associated with an 11.71 = −2. ¶ 2.2 Least Squares There is another classic motivation for the estimator (4. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. To illustrate. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4. i 22 . 40 2.

These two ˆ variables are frequently mislabeled. Since the function Sn (β) is a quadratic function of β.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Following convention we will call β the OLS estimator of β. It is important to understand the distinction between the error ei and the residual ei .2 displays the contour lines of the same function — horizontal slices at equally spaced heights. 23 .7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. Figure 4.4). the contour lines are ellipses. To visualize the sum-of-squared errors function. The error is unobservable. which can cause confusion. while the residual is a by-product of estimation. Figure 4. Figure 4.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. i ˆ ˆ Note that yi = yi + ei . Matrix calculus (see Appendix 2.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.

one implication is that n 1X ei = 0. ˆ σ = ˆ n 2 i=1 n (4. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero.7) A justiﬁcation for the latter choice will be provided in Section 4. These are algebraic results.Figure 4. ˆ n i=1 n Since xi contains a constant. It measures the variation in the i “unexplained” part of the regression. ˆ n−k 2 i=1 (4. The error variance σ 2 = Ee2 is also a parameter of interest.5) implies that 1X xi ei = 0.7.6) An alternative estimator uses the formula n 1 X 2 s = ei . and hold true for all linear regression estimates. Its method of moments estimator is the sample average 1X 2 ei .2: Sum-of-Squared Error Function Contours Equation (4. 24 .

σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . 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. testing. Instead. σ 2 ) is a function of β only through the sum of squared errors Sn (β). Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi .3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. An alternative estimator of ρ2 proposed by Theil called “R-bar-squared” is y R =1− where σ2 = ˜y 2 n 2 s2 σ2 ˜y 1 X (yi − y)2 . σ 2 ). maximizing the likelihood is identical to minimizing Sn (β). This is a parametric model. Since Ln (β. it should be viewed as an estimator of the population parameter ρ2 = σ2 V ar (x0 β) i =1− 2 V ar(yi ) σy where σ 2 = V ar(yi ). 4. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 .where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. Hence the MLE for β equals the OLS estimator. where likelihood methods can be used for estimation. and distribution theory. σ 2 ). This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. σ 2 ) maximize Ln (β. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. The R2 is frequently mislabeled as a measure of “ﬁt”.

We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . including computation. . ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. ⎠ .6). For example n X i=1 For many purposes. and X is an n × k matrix.12) is a system of n equations.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ⎠ xi x0 = X 0 X i xi yi = X 0 Y. Thus the MLE (β. x0 n ⎞ ⎛ e1 e2 . it is matrix notation. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. n X i=1 Thus the estimator (4. 4. The linear equation (3.4). 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. Due to this equivalence. = β+ XX 26 (4. . yn = x0 β + en .8) . σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. . ⎝ ⎝ . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. . ˆ ˆˆ ˆ A useful result is obtained by inserting Y = Xβ + e into the formula for β to obtain ¢ ¡ 0 ¢−1 ¡ 0 ˆ X (Xβ + e) β = XX ¡ ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 0 Xe X Xβ + X 0 X = XX ¡ 0 ¢−1 0 X e.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . n or equivalently Y = Xβ + e. . Sample sums can also be written in matrix notation. yn ⎟ ⎟ ⎟. . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. one for each observation. en ⎞ Observe that Y and e are n × 1 vectors. residual vector. ⎟.

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

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

19) ˆ and thus the OLS estimator β is unbiased for β... and ³ ´ ¡ ¢−1 2 ˆ σ . 1 n . 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. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. under the of ˆ ¢ 2 | x = σ 2 .8). and the trace operator observe that. 0 0 ··· 0 0 . . ⎝ . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for 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. Then given (4.20) . and (4. . . . .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 . From (4. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. ⎠ (4. . V ar β | X = X 0 X ⎟ ⎟ ⎟.. the properties of conditional expectations. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.. σ 2 } = ⎜ .Using (4. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . . X 0 DX = X 0 Xσ 2 . Next.12).

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. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . Now consider the class of estimators of β which are linear functions of i the vector Y.8)¢ ¡ (3. the estimator ˆ 2 deﬁned (4.7) is unbiased for σ 2 by this calculation. The following result. which is (3. It is not unbiased in the absence of homoskedasticity. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. As an alternative. What is the best choice of A? The Gauss-Markov theorem. ³ ´ ˜ E β | X = A0 Xβ.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. In this case. Theorem 4. however. By a calculation similar to those of the previous section. as it yields the smallest variance among all unbiased linear estimators. ˜ so β is unbiased if (and only if) A0 X = Ik .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 . is a famous statement of the solution. 32 . that this estimator is only unbiased in the special case of the homoskedastic linear regression model.9) plus E e2 | xi = σ 2 . = σ2 n the ﬁnal equality by (4. which we now present. or in the projection model. 4. In the homoskedastic linear regression model.1 Gauss-Markov. It is important to remember. says that the least-squares estimator is the best choice. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice.10). known as the Gauss-Markov theorem. 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. the best (minimumvariance) unbiased linear estimator is OLS. Thus σ 2 is biased towards zero. ˜ β L = A0 Y = A (Xβ + e) = β + Ae.

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

He proves that generically the OLS estimator (4. He observes that the above argument holds for all multinomial distributions. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. 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.10) for the class of models satisfying Assumption 3.22) 34 . if the data have a discrete distribution. Chamberlain (1987) extends this argument to the case of continuously-distributed data.1. and thus so is the OLS estimator. the maximum likelihood estimator is identical to the OLS estimator.5. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.Substituting in the expressions for π j . We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .10 Omitted Variables xi = µ x1i x2i ¶ . (4.9).

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

We can also deﬁne the leave-one-out residual ˆ ˆ ei. As a consequence.−i = yi − x0 β (−i) = (1 − hi )−1 ei . A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise.27) (4. that is. the precision of individual estimates are reduced. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.26) As we can see. ˆ ˆ (4.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced.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. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . ˆ i A simple comparison yields that ˆ ei − ei.−i = (1 − hi )−1 hi ei . We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . the worse the precision of the individual coeﬃcient estimates. If the i’th observation 36 . What is happening is that when the regressors are highly dependent. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. The hi take values in [0. the OLS estimator based on the sample excluding the i’th observation. 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. To investigate the possibility of inﬂuential observations.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 .25) below. deﬁne the leave-one-out least-squares estimator of β. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . since as ρ approaches 1 the matrix becomes singular. We derive expression (4. 1] and sum to k.

ˆ We now derive equation (4. Investigations into the presence of inﬂuential observations can plot the values of (4. The key is equation (2.25). then this observation is a leverage point and has the potential to be an inﬂuential observation.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .27). which is considerably more informative than plots of the uncorrected residuals ei .1) in Section 2. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .This implies has a large value of hi . ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality. Triangle inequality |X + Y | ≤ |X| + |Y | . then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory.1) (5. |a| = a a i i=1 If A is a m × n matrix. 5.1 Inequalities Asymptotic theory is based on a set of approximations. If g(·) : R → R is convex. Jensen’s Inequality. ij i=1 j=1 (5.2) + 1 q = 1. These approximations are bounded through the use of mathematical inequalities. then g(E(X)) ≤ E(g(X)). If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . 41 . Cauchy-Schwarz Inequality. We list here some of the most critical deﬁnitions and inequalities. The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 .Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . then (5.

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

the triangle inequality. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.4). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . Set ε = δη/3. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N.7). Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. the fact that the Wi are iid and mean zero. we can set E(X) = 0 (by recentering Xi on its expectation). Fix δ and η.1). ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . V ) . (5. and the bound |Wi | ≤ 2C. where Z has distribution F (x) = P (Z ≤ x) .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. Jensen’s inequality (5.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .6) By Jensen’s inequality (5. by Markov’s inequality (5.6) and (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Theorem 5.1) and (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.5). 5.3. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. We say that Zn converges in distribution to Z as n → ∞.1 Central Limit Theorem (CLT). Finally. if for all x at which F (x) is continuous.Proof: Without loss of generality. as needed. P ¯X n ¯ > δ ≤ η. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. If Xi ∈ Rk is iid and E |Xi |2 < ∞. Fn (x) → F (x) as n → ∞. denoted Zn →d Z. 43 . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. the fact that X n = W n + Z n . Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.

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

4. Σ) = N 0. Stacking across elements of g. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. k ≤ m.2 Continuous Mapping Theorem 2.1 Continuous Mapping Theorem 1 (CMT). we see that as n → ∞. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). and g(θ) : Rm → Rk . ¥ 5. Σ) . for each element of g. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.4 Asymptotic Transformations Theorem 5. then g(Zn ) →d g(Z) as n → ∞. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. This is suﬃcient to establish the theorem. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. gθ Σgθ . 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 .4. then g(Zn ) →p g(c) as n → ∞. If Zn →d Z as n → ∞ and g (·) is continuous. Hence g(Zn ) →p g(c) as n → ∞. Proof : By a vector Taylor series expansion. 45 . √ Theorem 5. Proof: Since g is continuous at c.√ where λn → 0 lies on the line segment joining 0 and λ/ n.3 Delta Method: If n (θn − θ0 ) →d N (0. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. where θ is m × 1 and Σ is m × m. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.4. If Zn →p c as n → ∞ and g (·) is continuous at c. Since cλλ (λn ) → cλλ (0) = −Ik . Theorem 5. Recall that A ⊂ B implies P (A) ≤ P (B). Ik ) distribution.

let yi and xi be drawn from the joint density µ ¶ µ ¶ 1 1 1 2 2 exp − (ln y − ln x) exp − (ln x) f (x. ˆ Figure 6.Chapter 6 Inference 6. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density. and therefore has a sampling distribution. In general. its distribution is a complicated function of the joint distribution of (yi . xi ) and the sample size n.1 Sampling Distribution The least-squares estimator is a random vector. since it is a function of the random data.1 for sample sizes of n = 25.1: Sampling Density of β 2 To illustrate the possibilities in one example. 46 . n = 100 and n = 800. the density function of β 2 was computed and plotted in Figure 6. Using ˆ simulation methods. The verticle line marks the true value of the projection coeﬃcient.

¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .From the ﬁgure we can see that the density functions are dispersed and highly non-normal.2) i i n i=1 n From (6. As the sample size increases the density becomes more concentrated about the population coeﬃcient. 0). and the continuous mapping theorem (Theorem 5.3) Ã where g(A.1) and ˆ We now deduce the consistency of β.3). A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. we will use the methods of asymptotic approximation. ·) is continuous at (Q.5. xi ei →p g (Q. using (6.1. n i=1 (6.5. (6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1 and the WLLN (Theorem 5. This is illustrated in Figure 6.5. First. To characterize the sampling distribution more fully.1. For a complete argument.4.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1).4. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.2). the OLS estimator β is has a statistical distribution which is unknown.4 implies that Q−1 exists and thus g(·. Ã n ! n X 1X 0 1 ˆ xi xi .1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. (6.2.1). β →p β as n → ∞. ˆ 47 . Equation (4. Hence by the continuous mapping theorem (Theorem 5. Proof.2. (6.1.1 Under Assumption 3.1 by the fact that the sampling densities become more concentrated as n gets larger.1). 6.2 Consistency ˆ As discussed in Section 6.1). Assumption 3. ˆ Theorem 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 . we can conclude ˆ that β →p β. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. Assumption 3.

6) n i=1 48 .3. We need a strengthening of the moment conditions. since n/(n − k) → 1 as n → ∞. Ee4 < ∞ and E |xi |4 < ∞.2.1 guarantees that the elements of Ω are ﬁnite.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. ˆ Finally.1.2. i i Assumption 6.1). by the Cauchy-Schwarz inequality (5. n 1 X √ xi ei →d N (0.3.3.5.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6. By the central limit theorem (Theorem 5.1.Theorem 6. ˆ n−k 6. (6.1). ˆ Proof. Assumption 6.5. E ¯ei ¯ E ¯e4 ¯ i i i i (6. it follows that s2 = ¥ n σ 2 →p σ 2 . (6.2). Ω) . σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.2). i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Thus σ 2 is consistent for σ 2 . To see this.2 Under Assumption 3.3) and Theorem (6.1 In addition to Assumption 3.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . (6.

1.9) we deﬁne V 0 = Q−1 σ 2 whether (6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.1).1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. The approximation may be poor when n is small. for example. after rescaling.3.3. There is a special case where Ω and V simplify. and (6.1 states that the sampling distribution of the least-squares estimator. is approximately normal when the sample size n is suﬃciently large. In´Figure 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0. Theorem 6. V is often referred to as ˆ the asymptotic covariance matrix of β. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). The asymptotic distribution ´ Theorem 6.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . We call V 0 the homoskedastic covariance matrix. The expression V = Q−1 ΩQ−1 is called a sandwich form.7) is true or false. |ε| ≥ 1.3. however.9) In (6. We say that ei is a Homoskedastic Projection Error when (6.3.3.Then using (6. its variance diverges q ³ ´ ˆ to inﬁnity. As α approaches 2.7) holds. e2 ) = 0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. 1) asymptotic distibution. How large should n be in order for the approximation to be useful? Unfortunately.7) is true then V = V 0 . there is no simple answer to this reasonable question. (6. However. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . Under (6.2).8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. but this is not a necessary condition. Let yi = β 0 + β 1 xi + εi where xi is N (0. 1 X √ xi ei n i=1 n ! the N (0. Ω) ¡ ¢ = N 0.6). setting n = 100 and varying the parameter α. In Figure 6. The trouble is that no matter how large is the sample size. i i Condition (6.7) Cov(xi x0 . when xi and ei are independent. 1). ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.1. For α 49 . V ) where V = Q−1 ΩQ−1 . This holds true for all joint distibutions of (yi .2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . xi ) which satisfy the conditions of Assumption 6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. Q−1 ΩQ−1 . When (6.1 Under Assumption 6. We illustrate this problem using a simulation. otherwise V 6= V 0 .

10) without changing this result.2 and 6. As α diminishes the density changes signiﬁcantly. We show the sampling distribution of n β 1 − β 1 setting n = 100.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 6. As k increases. 1). for k = 1. Another example is shown in Figure 6. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. The lesson from Figures 6.3 is that the N (0.1) it is clear that V 0 →p V 0 .2: Density of Normalized OLS estimator α = 3.2) and Theorem 6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.2. concentrating most of the probability mass around zero.3.10) V 0 = Q−1 s2 . the sampling distribution becomes highly skewed and non-normal. The estimator 2 2 in (6. 1) density. 6 and 8.Figure 6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. we need an estimate of Ω = E xi x0 e2 .0 the density is very close to the N (0. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.11) 50 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 1) asymptotic approximation is never guaranteed to be accurate. 4.

When reading and reporting applied work. 1. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . these all mean the same thing. the “Eicker-White formula”.. When β is a vector. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. ˆ ˆ When V is used rather than the traditional choice V 0 . ˆ The estimator V 0 was the dominate covariance estimator used before 1980. k. ˆ ˆ Deﬁnition 6.4. In most cases. β j . the “Huber-White formula” or the “GMM covariance matrix”.. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. The methods switched during ˆ the late 1980s and early 1990s. and V is an estimator of the variance of n β − β . and was still the standard choice for much empirical work done in the early 1980s.Figure 6. we focus on individual elements of β one-at-a-time. as there may be more than one estimator of the variance of the estimator. Generically. 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). the “Huber formula”. or that they use the “White formula”.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. vis. standard errors are not unique. many authors will state that their “standard errors have been corrected for heteroskedasticity”.. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. or that they use a “heteroskedasticity-robust covariance matrix estimator”. we set s(β) = n−1/2 V .. j = 0. . This motivates the deﬁnition of a standard error. A more easily interpretable measure of spread is its square root — the standard deviation. as it is not always clear which has been computed.3: Sampling distribution where ei are the OLS residuals. It is therefore important to understand what formula and method is 51 .

20 and µ ¶ ˆ = 0. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.14 6. (6. (.12) in turn.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.80 2.480 ˆ0 = 0. but not under another set of assumptions.14 14.6 ¶µ 1 14.80 40.83 ¶−1 = µ 7.020. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.085 p ˆ and that for β 1 is . we return to the log wage regression of Section 4.480 . then take the diagonal elements.2.20 −0.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.35/988 = .20 = V 14. i i i i n i=1 Second. n n i=1 52 . The standard errors for β 0 are 7. p ˆ In this case the two estimates are quite similar.98 −0. by Holder’s inequality (5.5) and the WLLN (Theorem 5.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω.199 2.30 + 0.80 . Using (6.14 205.80 40.14 14. just as any other estimator.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 .14 205. To illustrate.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. (6.493 −0. Ω 2.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.493 0.199 2. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . From a computational standpoint.83 ¶−1 µ .117 Educationi . E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .83 −0.085) (.1. We calculate that s2 = 0.039 and ˆ V = µ 1 14. and then the square roots.020) 6. from which it follows that V →p V as n → ∞.035 ¶ .2/988 = . First.used by an author when studying their work.14 205.

¯ 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.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. Andrews (1991) suggested an similar estimator based on cross-validation.1 As n → ∞. Ω →p Ω and V →p V. 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. Using this substitution. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.11) with the leave-one-out estimator ei.−i = (1 − hi )−1 ei ˆ presented in (4.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi .5. which.13) of Efron (1982). n i=1 n ˆ ˆ Theorem 6. i=1 Third. ¯ ¯n ¯ n i=1 so Together. Recall from Section 4. 6. 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. you can show that 1 Xˆ ¯ β= β (−i) . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.25). these establish consistency. 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 (6.13) Using formula (4. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . From equation (3.26). Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.

where ˆ It is similar to the MacKinnon-White estimator V ∗ .. . ˆ ˆ If V is the estimated covariance matrix for β. In these cases we can write the parameter of interest as a function of β. the function h(β) is linear: h(β) = R0 β ˆ ˆ ˆ for some k × q matrix R. Vθ ). 54 .7 Functions of Parameters Sometimes we are interested in some lower-dimensional function of the parameter vector β = (β 1 . Ω∗∗ = i ˆi n i=1 n 6.15) where 0 Vθ = Hβ V Hβ .. V ) where ∂ h(β) ∂β (k + 1) × q. Let h : Rk → Rq denote this function and let θ = h(β) denote the parameter of interest. Hβ = ∂β In many cases. For example.. β k+1 ). In this case. ˆ θ What is an appropriate standard error for ˆ Assume that h(β) is diﬀerentiable at the true θ? value of β. but omits the mean correction. so Vθ = R0 V R. 1X ˆ (1 − hi )−2 xi x0 e2 . we may be interested in a single coeﬃcient β j or a ratio β j /β l . then the natural estimate for the variance of ˆ is θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). By a ﬁrst-order Taylor series approximation: ³ ´ 0 ˆ ˆ h(β) ' h(β) + Hβ β − β . The estimate of θ is ˆ = h(β). Hβ = R and Hβ = R. (6. = N (0. Andrews ˆ ˆ (1991) argues that simulation evidence indicates that V ∗∗ is an improvement on V ∗ . Hβ = Thus ´ √ ³ ´ √ ³ ˆ n ˆ − θ = n h(β) − h(β) θ ³ ´ 0√ ˆ ' Hβ n β − β 0 →d Hβ N (0.

15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. In this case. if R is a “selector matrix” R= so that if β = (β 1 . the statistic tn has an exact t distribution. 1) →d ˆ−θ θ . pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. In special cases (such as the normal regression model. the standard error for ˆ is the square root of n−1 Vθ . see Section X). ˆ When q = 1q h(β) is real-valued). we say that tn (θ) is asymptotically pivotal. θ could be a single element of β).16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. Since the standard normal distribution does not depend on the parameters. Consider the studentized statistic tn (θ) = Theorem 6.8. we say that tn is an exactly pivotal statistic. 55 . then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . s(ˆ θ) (6. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. that (so θ ˆ ˆ ˆ is. In general. Vθ ) √ Vθ = N (0. however. µ I 0 ¶ ˆ the upper-left block of V . By (6. and is therefore exactly free of unknowns.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. θ) β 6.For example. (For example.1 tn (θ) →d N (0. s(ˆ = n−1/2 H 0 V Hβ . ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. and θ = h(β) is some function of the parameter vector. β 2 ). 1) Proof.

An alternative approach. however. For example. regardless of the complication of the distribution of the original test statistic. 1). z. tn →d N (0.96 and z.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. In a sense. The p-value is more general. It is designed to cover θ with high probability.025 = 1. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . That is. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . 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. Let zα/2 is the upper α/2 quantile of the standard normal distribution. 1). from which it follows that pn →d U [0.645. 1]. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. 1]. 1]. If the p-value pn is small (close to zero) then the evidence against H0 is strong. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. s(ˆ θ) Under H0 . note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. pn →d U [0. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . That is. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. 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. 6. if Z ∼ N (0. Then the asymptotic p-value of the statistic tn is pn = p(tn ). associated with Fisher. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. Either θ ∈ Cn or θ ∈ Cn .05 = 1. The coverage probability is P (θ ∈ Cn ). 56 . and is a function of the data and hence is / random. is to report an asymptotic p-value. To see this fact. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. in that the reader is allowed to pick the level of signiﬁcance α. under H0 . or “accepts” H0 .

6. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . the most common professional choice isi95%. This corresponds to selecting the conﬁdence h i h ˆ ± 1. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. and it is desired to test the joint restrictions simultaneously.18) . θ θ) (6. θ The interval has been constructed so that as n → ∞. 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.05. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. ˆ + zα/2 s(ˆ .96s(ˆ ≈ ˆ ± 2s(ˆ . = n h(β) − θ0 Hβ V Hβ 57 (6. 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). 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).16) and zα/2 is the upper α/2 quantile of the standard normal distribution. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). or α = .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. In this case the t-statistic approach does not work.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .

1] under H0 . h(β) = R0 β. ˆ Wn = n θ θ q θ θ Theorem 6. if rank(Hβ ) = q. The asymptotic p-value for Wn is pn = p(Wn ). the test rejects at the α% level iﬀ pn < α. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. Hence β β by Theorem A. 6. θ = β 2 .5. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. and there are q = k2 restrictions. Hβ (β) is a continuous function of β.1. a chiq square random variable with q degrees of freedom. 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. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . q and pn is asymptotically U[0. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.2. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .84 = z. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).025 .19) σ2 ˆ where σ2 = ˜ 1 0 e e. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. χ2 (. As before. then Wn →d χ2 . Furthermore. Vθ ). ˜˜ n ˜ e = Y − X1 β 1 . The null hypothesis is H0 : β 2 = 0. Hβ (β) →p Hβ .8.3. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . and Theorem 6. the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity.1 showed θ ˆ that V →p V. the upper-α quantile q 2 of the χ2 distribution. For example.When h is a linear function of β.10. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.05) = 3. Also h(β) = a selector matrix.15) showed that n ˆ − θ →d Z ∼ N (0. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).1 Under H0 and Assumption 6.11 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 . In this case.

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

In particular. equivalently the residual variance from an intercept-only model. In σ 2 . H 0 H) ∼ N (0. Let u = σ −1 H 0 e ∼ N (0. there is an exact distribution theory available for the normal linear regression model. The modelling assumption that the error ei is independent of xi and N (0. This was a popular statistic in the early days of econometric reporting. Since linear functions of normals are also normal. 6.3. introduced in Section 4. an “F statistic” is reported. Since uncorrelated normal variables are independent. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. including the estimated error variance 2.12 Normal Regression Model As an alternative to asymptotic distribution theory. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. it follows ˆ that β is independent of any function of the OLS residuals. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero.4)) where H 0 H = In . n−k 60 . This is rarely an issue today. these cases are atypical. 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 . In ) . this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0. σ 2 ) can be be used to calculate a set of exact distribution results. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2.where In many statistical packages. While there are special cases where this F statistic is useful. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . when an OLS regression is reported. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 .

In contrast.10) then ´ ³ ˆ • β ∼ N 0. with residual variance σ .1 we showed that in large samples. σ2 ˆ 61 .10) µ h i ¶ 2 (X 0 X)−1 N 0. β and t are approximately normally distributed. so as a practical matter it does not matter which distribution is used. 0. a good testing procedure is based on the likelihood ratio statistic. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .1 If ei is independent of xi and distributed N(0. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . β 2 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . We summarize these ﬁndings Theorem 6. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. n−k • ∼ tn−k ˆ In Theorem 6.1 and Theorem 6. σ 2 ) = − log σ − log (2π) − . σ 2 ) discussed above. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . As inference (conﬁdence intervals) are based on the t-ratio. σ ˆ ˆ βj − βj βj − βj N (0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . 0. β has an exact normal distribution and t has an exact t distribution. β 2 . and standard errors are calculated using the homoskedastic formula (6. Theorem 6.1 shows that under the strong assumption of ˆ normality. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. the notable distinction is between the N (0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . 1) and tn−k distributions. 0. The critical values are quite close if n − k ≥ 30.8.3. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .12. (Unless the sample size is unreasonably small. β 2 .a chi-square distribution with n − k degrees of freedom. if standard errors are calculated using the homoskedastic formula (6. Furthermore. 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 ).12.) Now let us partition β = (β 1 . σ 2 ) − Ln (β 1 .

we have plotted in Figure 6. as Wn (s) →d χ2 under H0 for 1 any s. features of this distribution can be calculated. while there are other values of s for which test test statistic is insigniﬁcant. they can work quite poorly when the restrictions are nonlinear. The decreasing dashed ˆ = 1. The increasing solid line is for the case β = 0. Through repetition. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. 62 . setting n/σ 2 = 10. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n .4 the Wald statistic Wn (s) as a function ˆ of s. 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.7. and noting Hβ = sβ s−1 . 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).By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . This produces random draws from the sampling distribution of interest. ˆ Let β and σ 2 be the sample mean and variance of yi . This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples. the statistic Wn (s) varies with s. Take the model yi = β + ei ei ∼ N (0. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. 6. 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. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Our ﬁrst-order asymptotic theory is not useful to help pick s. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β.8.84 — the probability of a false rejection. σ 2 ) and consider the hypothesis H0 : β = 1. This is an unfortunate feature of the Wald statistic. To demonstrate this eﬀect. In the present context of the Wald statistic.

Figure 6. Test performance deteriorates as s increases. n is varied among 20. the only test which meets this criterion is the conventional Wn = Wn (1) test. no magic choice of n for which all tests perform uniformly well. looking for tests for which rate rejection rates are close to 5%.000 simulated Wald statistics Wn (s) which are larger than 3. we compare the rates row by row. Type I error rates between 3% and 8% are considered reasonable.84 | β = 1) . To interpret the table. Table 4. In Table 2.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Typically.1 you can also see the impact of variation in sample size. When comparing statistical procedures.4: Wald Statistic as a function of s P (Wn (s) > 3. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.000 random samples. Any other choice of s leads to a test with unacceptable Type I error probabilities. however. These probabilities are calculated as the percentage of the 50. and rarely fall outside of the 3%-8% range. Given the simplicity of the model. this probability depends only on s. and σ is varied among 1 and 3. Table 4. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. In Table 4. There is. the Type I error probability improves towards 5% as the sample size n increases.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . Error rates avove 10% are considered excessive. so these probabilities are Type I error. The null hypothesis β s = 1 is true. remember that the ideal Type I error probability is 5% (.05) with deviations indicating+ distortion. In each case.84. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. 100 and 500. n.1 reports the simulation estimate of the Type I error probability from 50. and σ 2 . Rates above 20% are unexceptable. For this particular example.4. The value of s is varied from 1 to 10.

15 .10 .25 .26 .24 .20 .22 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. Other choices are arbitrary and would not be used in practice.15 .16 Rejection frequencies from 50.12 .25 .06 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .18 .14 .10 .08 .07 .05 .07 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. Equivalently.09 .05 .28 .08 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.23 .07 .15 .06 .21 .17 .20).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 .06 .08 . β 2 ) be the least-squares estimates of (6.33 .13 . β 1 .12 .11 . 64 .06 .07 .19 .05 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.06 .05 .05 .06 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.07 . While this is clear in this particular example. Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .22 .34 .20 .31 .13 .08 .10 .13 . This point can be illustrated through another example.05 .35 .08 .14 .15 .06 . deﬁne θ = β 1 /β 2 .30 .06 . so the hypothesis can be stated as H0 : θ = r.

05 β2 .645) P (tn > 1. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .12 . Table 4.06 . such as the GMM distance statistic which will be presented in Section 9.05 .10 . It is also prudent to consider alternative tests to the Wald statistic.28 .10 .0 and n among 100 and 500.05 . 65 . The results are presented in Table 4.06 . and are close to the ideal 5% rate for both sample sizes.7. However.00 . If no linear formulation is feasible. and normalize β 0 = 0 and β 1 = 1.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.05 .05 . . and alternatives to asymptotic critical values should be considered.06 .06 .47 .25. In all cases.06 . 6.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .06 .645) P (tn > 1. the entries in the table should be 0.06 . This leaves β 2 as a free parameter.645) are close to zero in most cases.645) P (tn < −1.05 .2.05. . In contrast. if the hypothesis can be expressed as a linear restriction on the model parameters. . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior. We let x1i and x2i be mutually independent N (0.1. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. σ 2 ) draw with σ = 3. In this section we describe the method in more detail.00 . and 1.50.14 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. the rejection rates for the t1n statistic diverge greatly from this value.05 . then the “most linear” formulation should be selected.00 .05 .00 The one-sided Type I error probabilities P (tn < −1.05 .06 .645) and P (tn > 1.000 simulated samples. especially for small values of β 2 .00 . The left tail probabilities P (t1n < −1.02 . The implication of Table 4.00 .00 .50 .75.06 .05 .645) t1n t2n t1n t2n t1n t2n t1n t2n .10 .75 1. while the right tail probabilities P (t1n > 1. this formulation should be used. along with sample size n.25 .09 . Ideally. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.645) are calculated from 50.00 . We vary β 2 among .15 .00 . ei be an independent N (0.15 .00 .07 . 1) variables.06 .645) greatly exceed 5%.26 .

x∗ . b = 1. B. or equivalently the value θ is selected directly by the researcher.. and from these most random variables can be constructed.. x∗ ) .. the exact (ﬁnite sample) distribution Gn is generally unknown.. This is one observation from an unknown distribution. (For example. F ) = P (Tnb ≤ x) = P (Tn ≤ x | F ) . xi ) which are random draws from a population distribution F. and calculate θ of θ \ ˆ Bias(θ) = B B 1 X 1 Xˆ Tnb = θb − θ B B b=1 b=1 B 1 X \θ) (Tnb )2 M SE(ˆ = B b=1 µ ¶2 \ = M SE(ˆ − Bias(ˆ \θ) \ ˆ V ar(θ) θ) 66 . We will discuss this choice later. They constitute a random sample of size B from the distribution of Gn (x.. ∗ ∗ • The statistic Tn = Tn (y1 . it is important that the statistic be evaluated at the “true” value of θ corresponding to the choice of F. The above experiment creates one random draw from the distribution Gn (x. . . our data consist of observations (yi . This is useful to investigate the performance of the statistic Tn in reasonable situations and sample sizes. θ) be a statistic of interest. 1] and N (0.. A “true” value of θ is implied by this choice. We then set Tn = ˆ − θ. let the b0 th experiment result in the draw Tnb . or variance of the distribution ˆ − θ... The researcher chooses F (the distribution of the data) and the sample size n. The basic idea is that for any given F. we set B = 1000 or B = 5000. run the above experiment. most computer packages have built-in procedures for generating U [0. Typically. Notationally. mean-squared error (MSE). Then the following experiment is conducted ∗ • n independent random pairs (yi .Recall. n. are drawn from the distribution F using i the computer’s random number generator. x∗ . the distribution function Gn (x. 1) random numbers... F ) for selected choices of F. xn . yn . yn . from one observation very little can be said. These results are stored. F ). For example: Suppose we are interested in the bias. Monte Carlo simulation uses numerical simulation to compute Gn (x. The method of Monte Carlo is quite simple to describe. The name Monte Carlo derives from the famous Mediterranean gambling resort. x1 . n n For step 1. Clearly. a chi-square can be generated by sums of squares of normals. θ) is calculated on this pseudo data. Gn (x..) For step 2. F ) can be calculated numerically through simulation. where games of chance are played. Let θ be a parameter and let Tn = Tn (y1 . where B is a large number. From a random sample. So the researcher repeats the experiment B times.. for example an estimator ˆ or a t-statistic (ˆ − θ)/s(ˆ The exact distribution of Tn is θ θ θ). F ) = P (Tn ≤ x | F ) . which implies restrictions on F . i = 1. While the asymptotic distribution of Tn might be known. we can estimate any feature of interest using (typically) a method of moments estimator.

In practice. and 5000.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. and non-white. a larger B results in more precise estimates of the features of interest of Gn . excluding military. immigrant. we included a dummy 67 .96) is iid Bernoulli. Generally. but requires more computational time. and hispanic. and therefore it is straightforward to calculate standard errors for any quantity of interest. For regressors we include years of education. and dummy variable indicators for the following: married. In many cases. potential work experience. s P = . then B will have to be increased. Then qα is the N ’th number in this ordered sequence. hispanic. We separately estimate equations for white and non-whites. therefore.022. 6. it is simple to make inferences about rejection probabilities from statistical tests. female. then we can set s P = (. potential work experience. Again our dependent variable is the natural log of wages. If the standard error is too large to make a reliable inference. and 90% sample quantiles of the sample {Tnb }. As P is unknown. As discussed above. female. We us the sample of wage earners from the March 2004 Current Population Survey. It is therefore convenient to pick B so that N is an integer.15 Estimating a Wage Equation We again return to our wage equation. for a selection of choices of n and F. Quite simply. respectively. 1000. an estimator or test may perform wonderfully for some values. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. B. experience squared. immigrant. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. such as the percentage estimate reported in (6.95) /B ' . and our regressors include years of education. so that coeﬃcients may be interpreted as semi-elasticities. It is therefore useful to conduct a variety of experiments. equalling 1 with probability P = E1 (Tnb ≥ 1. In particular. B b=1 (6. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. The α% sample quantile is a number qα such that α% of the sample are less than qα .22/ B. the performance will depend on n and F.05) (.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. and . the choice of B is often guided by the computational demands of the statistical procedure. this may ˆ be approximated by replacing P with P or with an hypothesized value. and dummy variable indicators for the following: married. and estimate a multivariate regression. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. the researcher must select the number of experiments.96) . union member. Furthermore.007. . Hence the ³ ´ ˆ standard errors for B = 100. experience squared. For the dependent variable we use the natural log of wages.21). are. if we set B = 999. The average (6. The random variable 1 (Tnb ≥ 1.003. where N = (B +1)α. For example. Often this is called the number of replications. union member. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1.96) . and poorly for others. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. For example.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. We now expand the sample all non-military wage earners.

001 .008 . excluding the coeﬃcients on the state dummy variables.232 .34 ˆ s(β) .070 .69. but not equal.002 .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.808 so the parameter estimates are quite precise and reported in Table 4. 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.00057 .808 .48772 = 515.4877 18.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. we ﬁnd Wn = 550.097 −.032 . Using either statistic the hypothesis is easily rejected. as the 1% critical value for the χ2 distribution is 76. 808 1 − . Ignoring the other coeﬃcients.010 .027 .033 −.19) is ˜ µ ¶ µ ¶ σ2 ˆ .00002 .18) that the state coeﬃcients are jointly zero. The F form of the Wald statistic (6. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.102 −.49452 σ ˜ Notice that the two statistics are close. The available sample is 18.1.007 . reestimating the model with the 50 state dummies excluded. Wn = n 1 − 2 = 18. 2β 3 68 .014 . Alternatively. this adds 50 regressors).variable for state of residence (including the District of Columbia.102 −. Computing the Wald statistic (6. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.121 −.101 .010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant. θ ˆ 2β 3 β2 .4945.013 . Table 4. the restricted standard deviation estimate is σ = .

69 . so we have to go one step further. 29. we can calculate a standard error of s(ˆ = . we found better Type I error rates by reformulating the hypothesis as a linear restriction. but the lower end is substantially lower.96. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. Since tn (θ) is a non-linear function of θ. there is not a simple expression for this set. Instead. In the previous section we discovered that such t-tests had very poor Type I error rates. this is a poor choice.0. 29. This is the set of θ such that |tn (θ)| ≤ 1.5]. In the present context we are interested in forming a conﬁdence interval.40. not testing a hypothesis. implying a 95% conﬁdence θ) interval of [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 ). This set is [27. but it can be found numerically quite easily.Using the Delta Method.5]. Notice that the upper end of the conﬁdence interval is the same as that from the delta method.9. However. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.

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

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

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

Suppose ei (and thus η i ) were observed. Furthermore. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi .4) the skedastic regression. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . If σ 2 < 0 for some i.. or FGLS. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. Then set ˜i ˜ D = diag{˜ 2 . Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0. This suggests 75 . ˜i Suppose that σ 2 > 0 for all i. then the FGLS estimator will force ˜i the regression equation through the point (yi . if σ 2 ≈ 0 for some i. which is typically undesirable.3) ˆ ˆ While ei is not observed. This is the feasible GLS. and will depend on the model (and estimation method) for the skedastic regression. estimator of β.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. as it is estimating the conditional variance of the regression of yi on xi . ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi .. then the FGLS ˜i estimator is not well deﬁned. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique.. Vα ) (7. there is no guarantee that σ 2 > 0 for all i. We may call (7. xi ).4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0.6) σ 2 = α0 zi . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Vα = E zi zi (7. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. . We have shown that α is consistently estimated by a simple procedure.

and was proposed by Cragg (Journal of Econometrics. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 .. and it may be estimated with considerable 76 V takes a sandwich form√.1. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . We just state the result without proof. It is possible to show that if the skedastic regression is correctly speciﬁed. σ 2 ] σi i for some σ 2 > 0. Why then do we not exclusively estimate regression models by FGLS? This is a good question. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression.1. e2 }. There are three reasons. ´´−1 ³ ³¡ ´´−1 ³ ³¡ ¢−1 ¢−2 2 0 ´´ ³ ³¡ 0 ¢−1 E α0 zi E α zi xi x0 σ i xi xi xi x0 . ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. similar to the covariance matrix of the OLS estimator.. This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞. ¢¢−1 ¡ ¡ . First. then FGLS is asymptotically equivalent to GLS. Its asymptotic variance is not that given in Theorem 7. This estimator V 0 is appropriate when the skedastic regression (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 ˜ = . i ˜ 0 is inconsistent for V .that there is a need to bound the estimated variances away from zero. Theorem 7.1. but the proof of this can be tricky. . FGLS is asymptotically superior to OLS. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). Since the form of the skedastic regression is unknown. V ). In the linear regression model. A trimming rule might make sense: σ 2 = max[˜ 2 . 1992).1. In this case we interpret α0 zi as a linear projection of e2 on zi ..1. β should perhaps be i i called a quasi-FGLS estimator of β. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. Instead. Unless σ 2 = α0 zi .1 If the skedastic regression is correctly speciﬁed.2) is correctly speciﬁed. V n n i=1 . and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.

5) and the asymptotic variance (7. σ 2 ). The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. the Wald test of H0 is asymptotically χ2 . the estimated conditional variances may contain more noise than information about the true conditional variances. or equivalently that i H0 : α1 = 0 in the regression (7. its squares. and this requires trimming to solve. Typically. on the other hand. however. individual estimated conditional variances may be negative.2). White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi .1 Under H0 and ei independent of xi . but the only diﬀerence is that they a ¢ allowed for general choice of zi . but also under the assumptions of linear projection. q Most tests for heteroskedasticity take this basic form.4).2. and the cost is a reduction of robustness to misspeciﬁcatio 7. The GLS and FGLS estimators.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . Theorem 7.7) under independence show that this test has an asymptotic chi-square distribution. require the assumption of a correct conditional mean. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β.error.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . If i this simpliﬁcation is replaced by the standard formula (under independence of the error). In the linear regression model the conditional mean of yi given xi = x is 77 . the two tests coincide. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . We may therefore test this hypothesis by the estimation (7. Vα = E zi zi (7. FGLS will do worse than OLS in practice. 7.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. and all cross-products. If the equation of interest is a linear projection. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.4) and constructing a Wald statistic. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. as they will be estimating two diﬀerent projections. OLS is a more robust estimator of the parameter vector. This hypothesis does not imply that ξ i is independent of xi . The main diﬀerences between popular “tests” is which transformations of xi enter zi . It is consistent not only in the regression model. The asymptotic distribution (7. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. In this case. Second. Third. This introduces an element of arbitrariness which is unsettling to empirical researchers. and not a conditional mean. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. in which case ξ i is ˜ independent of xi and the asymptotic variance (7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β.

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

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

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

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

5. Computation of standard error for LAD estimates typically is based on equation (7.3. When f (0 | x) is large. V ). then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. See Chapter 16. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.Theorem 7.5. the height of the error density at its median. First. by the central limit theorem (Theorm 5. In the special case where the error is independent of xi .5. then there are many innovations near to the median.11). and this improves estimation of the median. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . where V = and f (e | x) is the conditional density of ei given xi = x. ¢¢−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) . (7. While a complete proof of Theorem 7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . This can be done with kernel estimation techniques.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. ∂β 0 so Third.10) is equivalent to g n (β) = 0. we provide a sketch here for completeness. the conditional density of the error at its median.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.1 is advanced. ∂ 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 ) . ˆ Proof of Theorem 7. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . Let g(β) = Eg (β). The main diﬃculty is the estimation of f (0). Pn −1 0 β)) .1 ´ √ ³ˆ n β − β 0 →d N (0.

V ). then F (Qτ ) = τ . We then have the linear quantile regression model yi = x0 β τ + ei i 83 .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 (0.12) Qτ = argmin Eρτ (U − θ) .5. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. the quantile regression functions can take any shape. For τ ∈ [0. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). when F (y | x) is continuous and strictly monotonic in y. then F (Qτ (x) | x) = τ . If the random variable U has τ ’th quantile Qτ . 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. Exi x0 ) →d i 2 = N (0. As functions of x.9) for the median to all quantiles. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . (7. then (7. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. 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 = . ¥ 7. 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)) . For ﬁxed τ . Again. The third line follows from an asymptotic empirical process argument. so you can think of the quantile as the inverse of the distribution function.13) This generalizes representation (7. For the random variables (yi . The following alternative representation is useful.

Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. and are widely available. Another popular approach is the RESET test proposed by Ramsey (1969). Furthermore. Vτ ). the τ ’th conditional quantile of ei is zero.6. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7.5. then f (0 | xi ) = f (0) . conventional Newton-type optimization methods are inappropriate. 7. The null model is yi = x0 β + εi i 84 . One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. the asymptotic variance depends on the conditional density of the quantile regression error. 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. if the model yi = x0 β + ei has i been ﬁt by OLS. where and f (e | x) is the conditional density of ei given xi = x.13). and form a Wald statistic i for γ = 0. otherwise its properties are unspeciﬁed without further restrictions. fast linear programming methods have been developed for this problem. Thus. n numerical methods are necessary for its minimization. and test their signiﬁcance using a Wald test. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . ´ √ ³ˆ Theorem 7. Fortunately. i By construction.1 n β τ − β τ →d N (0. the unconditional density of ei at 0.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ .7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . since it has discontinuous derivatives. ˆ Given the representation (7.1.12). When the error ei is independent of xi . ¡ ¡ ¢¢−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. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. it is useful to have a general test of the adequacy of the speciﬁcation.

⎠ . since Q12 Q−1 Q21 > 0. yi ˆm (7. Wn →d χ2 . small values such as m = 2. To see why this is the case. then 22 Q11 > Q11 − Q12 Q−1 Q21 . m must be selected in advance. yielding ˆ ˜ ˆ ˆ (β 1 . or 4 seem to work best. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. It is easy (although somewhat tedious) to show that under the null hypothesis.be an (m − 1)-vector of powers of yi . β 1 = (X1 X1 )−1 (X1 Y ) . yielding predicted values yi = x0 β. 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. and the two estimators have equal asymptotic eﬃciency. To implement the test.14) by OLS. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. they will (typically) have diﬀerence asymptotic variances. 1i 2i 2i 1i 22 . β 2 ). ⎟ zi = ⎝ . and consequently 22 ¡ ¢−1 2 σ . One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. 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 . 7. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . Typically. 3. note that (7. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . Another is to regress yi on x1i and x2i jointly. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . However. Otherwise. 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. and n→∞ say. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. and form the Wald statistic Wn for γ = 0.14) may be written as ³ ´3 ³ ´m ³ ´2 ˜ ˆ ˜ ˆ ˜ ˆ yi = x0 β + x0 β γ 1 + x0 β γ 2 + · · · x0 β γ m−1 + ei ˜ ˜ i i i i which has essentially approximated G(·) by a m’th order polynomial. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 .

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

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

. However. 576. . and then selects the model with the lowest AIC (7. xKi }.15). 048. In the unordered case. . which regressors enter the regression). 88 . and 220 = 1. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . In the latter case. The methods extend readily to the issue of selection among multiple regressors. In the ordered case. the models are M1 : β 1 6= 0. Also under M2 . β 2 6= 0. . . . there are 2K such models. which are nested. The AIC selection criteria estimates the K models by OLS. one can show that thus LRn →p ∞. 210 = 1024. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. selecting based on (7.. β 2 6= 0. . log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1.17). which can be a very large number. Similarly for ˆ the BIC. For example. . MK : β 1 6= 0. We have discussed model selection between two models. β K 6= 0. and the AIC or BIC in principle can be implemented by estimating all possible subset models. a model consists of any possible subset of the regressors {x1i . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently..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. There are two leading cases: ordered regressors and unordered. β 3 = · · · = β K = 0 . β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. stores the residual variance σ 2 for each model.

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

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

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

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

∗ P (yi ≤ y. and 100.8. x) − F (y. x) .2) Fn (y. That is. by the CLT (Theorem 5.3. Note that while F may be either discrete or continuous. . To see this. as the sample size gets larger. the EDF step function gets uniformly close to the true CDF. √ n (Fn (y. The EDF is a consistent estimator of the CDF. x). x) = P (yi ≤ y. 1) distribution.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . Fn (y. The random draws are from the N (0. F (y. (8. where 1(·) is the indicator function. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x))) . x)) →d N (0. To see the eﬀect of sample size on the EDF. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . x) →p F (y.2. the EDF is only a crude approximation to the CDF. Fn is a nonparametric estimate of F.. x) = n i=1 Figure 8. in the Figure below. i 93 . Notationally. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. I have plotted the EDF and true CDF for three random samples of size n = 25. x) is called the empirical distribution function (EDF).. note that for any (y. Furthermore.. x). x∗ ≤ x) = Fn (y. In general. Thus by the WLLN (Theorem 5. x∗ ) with the i distribution Fn . it is helpful to think of a random pair (yi . This is a population moment.2 The Empirical Distribution Function Fn (y. x) (1 − F (y. For n = 25. n. i = 1. x). Recall that F (y. Fn is by construction a step function. but the approximation appears to improve for the large n.1). xi ).1). 50.

3 Nonparametric Bootstrap The nonparametric bootstrap is obtained when the bootstrap distribution (8. it similarly replaces θ with θn . the parameter ˆ estimate. a bootstrap ∗ ∗ sample {y1 . n 1 such a calculation is computationally infeasible. in principle the distribution G∗ n ∗ ∗ could be calculated by direct methods. As the bootstrap statistic replaces F with θ θ) ˆ Fn . with the following points of clariﬁcation: • The sample size n used for the simulation is the same as the sample size. This is i equivalent to sampling a pair (yi . 8.4 Bootstrap Estimation of Bias and Variance θ τ n = E(ˆ − θ0 )... the value of θ implied by Fn . A theory for the determination of the number of bootstrap replications B has been developed by Andrews and Buchinsky (2000). x∗ ) : i Z ∗ Eh (yi . Sampling from the EDF is particularly easy. When the statistic Tn³is a function of F. ∗ • The random vectors (yi . x∗ )}. (yn .. it is typically through dependence on a parameter. n X i=1 ∗ h (yi . x) i = = the empirical sample average. ∗ ∗ ∗ The bootstrap statistic Tn = Tn (y1 .. Since the EDF Fn is a multinomial (with n support points).1) is deﬁned using the EDF (8. x∗ = xi ) i n 1X h (yi . ..) at the sample estimate ˆ θ. 94 The bias of ˆ is θ . xi ) .. yn . x∗ ) are drawn randomly from the empirical distribution. xi ) P (yi = yi .. x∗ } will necessarily have some ties and multiple values. B = 1000 typically suﬃces. xi ) from the observed data with replacement. xi ) randomly from the sample.. Since Fn is a discrete probability distribution putting probability mass 1/n at each sample point. It is desireable for B to be large. sampling from the EDF is equivalent to random sampling a pair (yi . x)dFn (y. (When in doubt use θ. Typically θn = θ. which is generally n 1 not a problem. x∗ . the t-ratio ˆ − θ /s(ˆ depends on θ. n i=1 8. However. B is known as the number of bootstrap replications. n i This is repeated B times. x∗ )) = h(y. In consequence. . .2) as the estimate Fn of F. as there are 2n possible samples {(y1 . yn . x∗ . Fn ) is calculated for each bootstrap sample. ´ For example.∗ We can easily calculate the moments of functions of (yi . The algorithm is identical to our discussion of Monte Carlo simulation. x∗ ) . so long as the computational costs are reasonable. x∗ . The popular alternative is to use simulation to approximate the distribution..

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

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

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

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

or the size of the divergence for any particular sample size n. A better asymptotic approximation may be obtained through an asymptotic expansion. θ [This is a typical mistake made by practitioners. not ˆ − θ0 . The ideal test rejects if Wn ≥ qn (α). Basically. (8. C4 is called the symmetric percentile-t interval. however.4) v ¡ ¢ While (8.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.8. The derivative of an even function is odd. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . lim Gn (x. writing Tn ∼ Gn (x.8. If θ is a vector. the critical value qn (α) is found as the quantile from simulated values of W´ . about the rate v of convergence. Thus here Tn (θ) = Wn (θ).1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.3 an = o(n−r ) if nr |an | → 0 as n → ∞.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test.] 8. Let an be a sequence. and a function h(x) is odd if h(−x) = −h(x). The following notation will be helpful. θ θ θ ˆ θ ∗ ∗ Computationally. an = O(n−r ) if it declines to zero like n−r . Deﬁnition 8. Let Tn be a statistic such that (8. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . v 2 ). F ) = Φ n→∞ v or ³x´ Gn (x.8. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).2 an = O(1) if |an | is uniformly bounded. F ) then ³x´ . Deﬁnition 8. Equivalently. and vice-versa.8 Asymptotic Expansions Tn →d N (0. where qn (α) is the (1 − α)% quantile of the distribution of Wn .4) says that Gn converges to Φ x as n → ∞. F ) = Φ + o (1) . 99 . We say that a function g(x) is even if g(−x) = g(x). then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. 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. it says nothing.

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

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

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

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

It does not really matter.13 Exercises 1. Let β denote the ˆ the OLS residuals. you sample ε∗ using this two-point distribution. draw a ˆ ˆ random integer i0 from [1. . n} . yn } with µ = Eyi and σ 2 = V ar(yi ). 2. The idea is to construct a conditional distribution for ε∗ so that i E (ε∗ | xi ) = 0 i ¡ ∗2 ¢ E εi | xi = e2 ˆi ¡ ∗3 ¢ E εi | xi = e3 .. The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. Let ∗ ∗ ∗ {y1 . 2. OLS estimator from the regression of Y on X.. ˆi A conditional distribution with these features will preserve the main important features of the data. .. ˆ 3.... Let Fn (x) denote the EDF of a random sample. .. Take a random sample {y1 . Find the bootstrap moments ETn and V ar(Tn ).. Consider the following bootstrap procedure for a regression of yi on xi . . yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. 4.. n]. Unfortunately this is a harder problem. Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. generate ∗ bootstrap samples. ˆ∗ (b) Regress Y ∗ on X ∗ . Let the statistic of interest be the sample mean Tn = y n ... Using the non-parametric bootstrap. X ∗ ). creating a random bootstrap data set (Y ∗ . ei ) : i = 1. i 8. 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 . Set y∗ = x∗0 β + e∗ .. F0 (x) (1 − F0 (x))) . e∗ ) from the pair {(xi . ˆ Draw (with replacement) n such vectors. however. Show that √ n (Fn (x) − F0 (x)) →d N (0. calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). and e = Y − X β ˆ (a) Draw a random vector (x∗ . which is a valid statistical approach. One proposal which imposes the regression condition without independence is the Wild Bootstrap. Find the population moments ETn and V ar(Tn ). yielding OLS estimates β and any other statistic of interest. whether or not the xi are really “ﬁxed” or random. Consider the following bootstrap procedure.observed values of the regressors. and set x∗ = xi0 and e∗ = ei0 . That is. Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. Tn = (ˆ − ˆ 104 .

95) denote the 95% quantile of Tn . θ respectively. Estimate a linear regression of price on the number of bedrooms. You do this as follows. What is wrong with this procedure? Tn = θ/s(θ) n 6. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. ˆ − s(ˆ n (. and ˆ is calculated on each θ ∗ ∗ θ sample.05) . (c) With the given information. you generate bootstrap samples.95).2 and s(ˆ = .95). 105 .dat contains data on house prices (sales). You want to test H0 : θ = 0 against H1 : θ > 0. and the colonial dummy. can you report the 95% Percentile-t interval for θ? 7. size of house. ∗ ∗ ∗ Let qn (. (b) Report the 95% Alternative Percentile interval for θ. and the 2. The dataﬁle hprice1.2. and thus reject H0 if ˆ ˆ > q ∗ (. You replace c with qn (.5% quantiles of the ˆ are . θ θ) ∗ 1000 samples are generated from the bootstrap distribution. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).95). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.pdf. Using the non-parametric bootstrap.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). lot size. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.75 and 1.5% and 97.3. Using the non-parametric ∗ bootstrap. (a) Report the 95% Efron Percentile interval for θ.95) denote the 5% θ) ∗ and 95% quantiles of Tn .05) and qn (. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. Suppose that in an application. ˆ = 1. The ˆ are sorted. with variables listed in the ﬁle hprice1. Let qn (. ∗ ∗ where s(ˆ is the standard error in the original data.

Chapter 9 Generalized Method of Moments 9. an asymptotically eﬃcient estimator of β is the OLS estimator. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . If k = the model is just identiﬁed.1) where β 0 is the true value of β. There are − k = r more moment restrictions than free parameters. In our previous example. x. This method. In this case. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. Let g(y. where the dimensions of zi and xi are k × 1 and × 1 . 1 this class of models are called moment condition models. We know that without further restrictions. zi . x. β 0 ) = 0 (9.2) .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. β) = x(y − x0 β). This is a special case of a more general class of moment condition models. z. g(y. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. as their are restrictions in E (xi ei ) = 0. β 0 ) = x(y − z 0 β) 106 (9.1) by setting g(y. however. As an important special case we will devote special attention to linear moment condition models. In econometrics. In the statistics literature. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. x. with ≥ k. This situation is called overidentiﬁed. xi . We call r the number of overidentifying restrictions. is not necessarily eﬃcient. but this is not required. This model falls in the class (9. The variables zi may be components and functions of xi . these are known as estimating equations. while β 1 is of dimension k < . z. Now suppose that we are given the information that β 2 = 0. otherwise it is overidentiﬁed.

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

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

under the alternative hypothesis the moment conditions are violated. Egi 6= 0. we actually mean “eﬃcient GMM”. ˆ and let g be the associated n × matrix.e. 109 . Then the eﬃcient GMM estimator is ˆ ³ ¡ ¢−1 0 ´−1 0 ¡ 0 ¢−1 0 ˆ ˆˆ XZ Z X g g − ng n g 0 ˆˆ X Y. so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. and was introduced by L. Then set gi = xi ei . Hansen.4) above. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. ∗ gi (β) = gi (β) − g n (β) 9. as in (9. and GMM using Wn as the weight matrix is asymptotically eﬃcient. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. we can let the weight matrix be considered as a function of β. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. set Wn = (X 0 X)−1 . (9. 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. 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 . The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). when we say “GMM”. This is a current area of research in econometrics. GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0.and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 .4) which uses the uncentered moment conditions. There is little point in using an ineﬃcient GMM estimator as it is easy to compute. Here is a simple way to compute the eﬃcient GMM estimator. i. When constructing hypothesis tests. Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. J(β) = n · g n (β) n i=1 In most cases. First. The estimator appears to have some better properties than traditional GMM. Since Egi = 0.5 GMM: The General Case In its most general form. Instead. Heaton and Yaron (1996). A simple solution is to use the centered moment conditions to construct the weight matrix. There is an important alternative to the two-step GMM estimator just described. but can be numerically tricky to obtain in some cases. However. 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 .

Theorem 9. The criterion function at the parameter estimates is J = n g 0 Wn g n n ¡ ¢−1 2 0 = n g n g 0 g − ng n g 0 gn . n β − β →d N 0. 1 2 It is possible that β 2 = 0. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. Under the hypothesis of correct speciﬁcation. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . The general theory of GMM estimation and testing was exposited by L. and then β recomputed. ˆ J = J(β) →d χ2−k . take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. this is all that is known.1 (Sargan-Hansen). 9. Identiﬁcation requires l ≥ k = dim(β).Often. However. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. Thus the model — the overidentifying restrictions — are testable. For example. This estimator can be iterated if needed. often the weight ˆ matrix Wn is updated. 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). ˆˆ n is a quadratic form in g n .1 Under general regularity conditions. 1 it is possible that β 2 6= 0. so that the linear equation may be written as yi = β 0 x1i + ei .5.6 Over-Identiﬁcation Test Overidentiﬁed models ( > k) are special in the sense that there may not be a parameter value β such that the moment condition Eg(wi . Note that g n →p Egi . and is thus a natural test statistic for H0 : Egi = 0. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). 110 . 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. Hansen (1982). ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. 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. G0 Ω−1 G . Since the GMM estimator depends upon the ﬁrst-stage estimator. and if the weight matrix is asymptotically eﬃcient.6. β) = 0 holds.

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

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

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

a GMM estimator with arbitrary weight matrix). Let ei = yi − zi β where β is consistent for ˆ β (e. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 .10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. Show that Wn →p Ω i i i 4. From matrix algebra.g. verify that A can be written as ³ ¡ ¢−1 0 ´ G H. Letting H = CQ and G = C 0−1 W Q. Show that V0 = Q0 Ω−1 Q . Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . γ). (b) We want to show that for any W. Take the model E (zi ηi ) = 0. i 0 0ˆ ˆ 3. there exists a nonsingular matrix C such that C 0 C = Ω−1 . In the linear model estimated by GMM with general weight matrix W. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). 2.9. the asymptotic variˆ ance of β GMM is ¡ ¢−1 0 ¡ ¢−1 V = Q0 W Q Q W ΩW Q Q0 W Q ¡ ¢−1 (a) Let V0 be this matrix when W = Ω−1 . we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . and therefore positive semideﬁnite. ˆ ˆ Find the method of moments estimators (β. V − V0 is positive semi-deﬁnite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the eﬃcient weight matrix). A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0. 114 . γ ) for (β. Write out the matrix A. (c) Since Ω is positive deﬁnite. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . Take the model yi = zi β + ei with E (xi ei ) = 0. Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent.

Vn = X X i=1 ˜ and hence R0 β = r. l ≥ k. Deﬁne the Lagrangian L(β. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). 6. 115 .5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . is deﬁned as Jn (β) = ˜ β = argmin Jn (β).6) (a) Show that you can rewrite Jn (β) in (9.5.5) 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. the distance statistic D in (9. The GMM estimator of 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 . In the linear model Y = Xβ + e with E(xi ei ) = 0. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. subject ˆ i ˆi i=1 to the restriction h(β) = 0. The equation of interest is yi = g(xi .6) equals the Wald statistic. The observed data is (yi . β) + ei E (zi ei ) = 0. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. Show how to construct an eﬃcient GMM estimator for β. h(β)=0 (9. xi . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. zi is l × 1 and β is k × 1. zi ). VR ) where ¡ ¢−1 0 R V. VR = V − V R R0 V R (d) Show that in this setting.

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

1). 2001) and has been extended to moment condition models by Qin and Lawless (1994).2) Ln (p1 .. pn ) are those which maximize the log-likelihood subject to the constraint (10. It is a non-parametric analog of likelihood estimation. (10. .1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n).1 Non-Parametric Likelihood Since each observation is observed once in the sample.3) i=1 117 .. xi ..1) i=1 First let us consider a just-identiﬁed model... xi . To be a valid multinomial distribution. . these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. pn ) which places probability pi at each observation. In this case the moment condition places no additional restrictions on the multinomial distribution.. This is equivalent to maximizing Ã n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier. . zi ..Chapter 10 Empirical Likelihood 10. The maximum likelihood estimator of the probabilities (p1 . Combined with i the constraint (10. The idea is due to Art Owen (1988. The multinomial distribution which places probability pi at each observation (yi .. the log-likelihood function for this multinomial distribution is n X ln(pi ). The n ﬁrst order conditions are 0 = p−1 − µ.. The idea is to construct a multinomial distribution F (p1 . 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 . pn ) = i=1 An alternative to GMM is empirical likelihood. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. β). (10.

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

11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.10) ¡ Ω−1 N (0. i i Theorem 10.13) Premultiplying by G0 Ω−1 and using (10. λ) = − (10. i=1 i=1 i=1i Expanding (10. ˆ ˆ Proof. and Ω = E xi x0 e2 . (β. n (10.8) and ¢ 0 0 For example.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . in the linear model. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.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 . Gi (.2.10. λ) = − (10. Thus the EL estimator is asymptotically eﬃcient.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .10). β) = −xi zi . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . 0 = Rn (β.1 Under regularity conditions.9) and (10. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10.13) yields n n Expanding (10. and n β − β 0 and nλ are asymptotically independent. G = −E (xi zi ).9) (10. β λ ∂ ³ ´.

n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .1 If Eg(wi . and have the same interpretation. Vλ ) Furthermore. by a Taylor expansion. it is an asymptotically eﬃcient estimator for β.17) 2 ln 1 + λ gi β . Ω) GΩ G →d = N (0. 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. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. The same statistic can be constructed for empirical likelihood. 120 . First. 10. LRn = i=1 Theorem 10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.3.15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0.3 Overidentifying Restrictions In a parametric likelihood context. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. Proof. and it is advisable to report the statistic LRn whenever EL is the estimation method. V ) ˆ Solving (10.15).14) for λ and using (10. and (10. Since the EL estimator achieves this bound. They are asymptotically ﬁrst-order equivalent.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. β 0 ) = 0 then LRn →d χ2−k . tests are based on the diﬀerence in the log likelihood functions. (10.7) is n ³ ´´ ³ X ˆ ˆ0 (10. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. The overidentiﬁcation test is a very useful by-product of EL estimation.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. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .16).15) (10.

so there is no fundamental change in the distribution theory for β relative to β.wisc.ssc. h(β)=0 ˜ Fundamentally. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). 10.18). 10. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .edu/~bhansen/progs/elike. 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.Second. the simple overidentifying restrictions test (10. LRn →d χ2 . To test the hypothesis h(β) while maintaining (10.1 Under (10.18) and H0 : h(β) = 0. since ln(1 + x) ' x − x2 /2 for x small. This test statistic is a natural analog of the GMM distance statistic.18) Let the maintained model be where g is × 1 and β is k × 1. Theorem 10. The hypothesis of interest is h(β) = 0.4 Testing Egi (β) = 0 (10. a The proof of this result is more challenging and is omitted. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. Vλ )0 Ω−1 N (0.prc 121 .4.17) is not appropriate. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. where h : Rk → Ra . By “maintained” we mean that the overidentfying restrictions contained in (10.

λ)0 0 Rn (β. The iteration (10. set 2 λp = λj − δ p (Rλλ (β. λ) = − gi (β. Set δ 0 = 0. 2. λj ) is smaller than some prespeciﬁed tolerance. λ) = G∗ (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. One method uses the following quadratic approximation.20) . δ 1 = 1 and δ 2 = 1.19) X ∂2 ∗ ∗ gi (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λj ) . λ) . The modiﬁed Newton method takes a quadratic approximation to Rn (β.19) is continued until the gradient Rλ (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λj )) Rp = Rn (β. 1.4).. λj ))−1 Rλ (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. λ) gi (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ)0 − ∂β∂β Rn (β. λ) G∗ (β. λj ))−1 Rλ (β. λ) = − ∂β n X i=1 G∗ (β. Eﬃcient convergence requires a good choice of steplength δ.5) for given β. (10. λ) = i The ﬁrst derivatives of (10. λ) ∂λ i=1 n ∂ Rn (β. The starting value λ1 can be set to the zero vector. λ)0 − Rn (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. For p = 0. λp ) A quadratic function can be ﬁt exactly through these three points. λ) G∗ (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. Deﬁne ∗ gi (β.19).

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

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

¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. at least the intercept).1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. So we have the partition µ ¶ z1i k1 (11.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. In a typical set-up. This is called simultaneous equations bias. In matrix notation. some regressors in zi will be uncorrelated with ei (for example.1. 11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1) the structural equation.1) if E (xi ei ) = 0. Deﬁnition 11. (11. We call (11.1). this can be written as Y = Zβ + e. β →p β ∗ . which does not equal either β 1 or β 2 . and assume that E(zi ei ) 6= 0 so there is endogeneity. By the above deﬁnition.1 The × 1 random vector xi is an instrumental variable for (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 .1) where zi is k × 1. and x2i are the excluded exogenous variables. so should be included in xi . z1i is an instrumental variable for (11. Thus we make the partition ¶ µ k1 z1i (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. We call z1i exogenous and z2i endogenous.

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

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

P = HΛH 0 0 0 where Λ = diag(Il . n and (11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.13). It is also close to zero when α = 0. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 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. the expression in (11. l . n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . 130 .Let PX = X (X 0 X)−1 X 0 .14) is the probability limit of β 2SLS − β 11.14) approaches that in (11. except when S21 = 0 (when Z is exogenous). By the spectral decomposition of an idempotent matrix. 0). Indeed as α → 1. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .12) and this result. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. The consequences of identiﬁcation failure for inference are quite severe. the bias in the 2SLS estimator will be large.14) In general this is non-zero. 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.

This result carries over to more general settings. the instrument xi is weak for zi if γ = n−1/2 c. Then (11. and was examined by Phillips (1989) and Choi and Phillips (1992). Suppose this condition fails. but (11. E x2 u2 i i n n i=1 i=1 n n (11. E x2 e2 i i n i=1 n (11. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. viz Γ22 = n−1/2 C. Suppose that identiﬁcation does not complete fail. N2 since the ratio of two normals is Cauchy. which occurs i when E (zi xi ) 6= 0. To see the consequences.15) is unaﬀected. but is weak. This occurs when Γ22 is full rank. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . so E (zi xi ) = 0. In addition. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. Qc + N2 ˆ As in the case of complete identiﬁcation failure. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. once again take the simple case k = l = 1.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. where C is a full rank matrix. 131 . standard test statistics have non-standard asymptotic distribution of β distributions. as the Cauchy distribution does not have a ﬁnite mean. Here. This is particularly nasty. but small.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0.16) instead takes the form 1 X √ xi zi n i=1 n = = 1 X 2 1 X √ xi γ + √ xi ui n n 1 n i=1 n X x2 c + i i=1 n n 1 √ n →d Qc + N2 therefore ˆ β − β →d i=1 n X i=1 xi ui N1 . we ﬁnd that β is inconsistent for β and the ˆ is non-normal. meaning that inferences about parameters of interest can be misleading. This can be handled in an asymptotic analysis by modeling it as local-to-zero.Take the simplest case where k = l = 1 (so there is no X1 ).

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

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

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. and then calculate the GMM estimator from this weight matrix without further iteration. Report estimates and standard errors. in years.(b) Deﬁne the 2SLS estimator of β. using zi as an instrument for xi . (a) Estimate the model by OLS. 134 .. Estimate the model by 2SLS. (b) Now treat Education as endogenous. are the parameters identiﬁed? 8. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). using the instrument near4. and South and Black are regional and racial dummy variables. of the father) and motheduc (the education. of the mother). (d) Re-estimate the model by eﬃcient GMM. 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). 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. Report estimates and standard errors. (e) Calculate and report the J statistic for overidentiﬁcation. a dummy indicating that the observation lives near a 4-year college. in years.pdf.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995). and the remaining variables as exogenous. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. (f) Discuss your ﬁndings. There are 2215 observations with 19 variables. The data ﬁle card. In this model. 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. listed in card. f atheduc (the education. Report the estimates and standard errors. Does this diﬀer from 2SLS and/or OLS? 7.

Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.1. Deﬁnition 12.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . and T to denote the number of observations. We can separate time series into two categories: univariate (yt ∈ R is scalar).1. Yt−1 . however.. T .2 {Yt } is strictly stationary if the joint distribution of (Yt .1 Stationarity and Ergodicity Deﬁnition 12. Yt−k ) is the autocorrelation function. and multivariate (yt ∈ Rm is vector-valued). γ(k) is called the autocovariance function. A stationary time series is ergodic if γ(k) → 0 as k → ∞. . and use the subscript t to denote the individual observation.. Yt−k ) is independent of t for all k.1.. . we expect that Yt and Yt−1 are not independent. Theorem 12. The primary model for multivariate time series is vector autoregressions (VARs).1. Yt−k ) = γ(k) is independent of t for all k... Deﬁnition 12. The following two theorems are essential to the analysis of stationary time series.. Deﬁnition 12.) is a random variable. 135 . 12.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . There proofs are rather diﬃcult. . To indicate the dependence on time... and Cov (Yt . t = 1.1. Because of the sequential nature of time series. we adopt new notation. The primary model for univariate time series is autoregressions (ARs). so classical assumptions are not valid.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.4 (loose). then Xt is strictly stationary and ergodic.

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

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

1 The lag operator L satisﬁes LYt = Yt−1 . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. we see that L2 Yt = LYt−1 = Yt−2 . the above results are unchanged. 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). We say that the root of the polynomial is 1/ρ.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . ∞ X k=0 ρ2k V ar (et−k ) = 12.Theorem 12. In general. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . since ρ(z) = 0 when z = 1/ρ. Lk Yt = Yt−k . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).1 If |ρ| < 1 then Yt is strictly stationary and ergodic. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. From Theorem 12. We call ρ(L) the autoregressive polynomial of Yt .3.1. an AR(1) is stationary iﬀ |ρ| < 1. Deﬁnition 12. 12.4. We call ρ(L) the autoregressive polynomial of Yt . 138 . Deﬁning L2 = LL.3. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . The AR(k) model is Using the lag operator.

” If one of the roots equals 1. so is xt x0 . it is helpful to deﬁne the process ut = xt et . the requirement is that all roots are larger than one. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.1) Theorem 12. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. t t T t=1 ¥ Combined with (12. For an AR(k). This is a special case of non-stationarity. and hence Yt . Let |λ| denote the modulus of a complex number λ..1. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. Proof. β = X 0X (12. One way of stating this is that “All roots lie outside the unit circle.1. By Theorem 12.. t T t=1 T t=1 139 .1. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. Thus t by the Ergodic Theorem.6. then ˆ β →p β as T → ∞.1) and the continuous mapping theorem.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. The vector xt is strictly stationary and ergodic. “has a unit root”.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . we say that ρ(L). and is of great interest in applied time series.where the λ1 .1. Theorem 12. and by Theorem 12. λk are the complex roots of ρ(z). Note that ut is a MDS.. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.5. which satisfy ρ(λj ) = 0. it is also strictly stationary and ergodic. . t Yt−k ¢0 ρk . The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.

7. xt }. ˆ 1. t This construction imposes homoskedasticity on the errors e∗ . Ω) . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. eT }. Divide the sample into T /m blocks of length m. Method 1: Model-Based (Parametric) Bootstrap. Q−1 ΩQ−1 . 12.12. Method 2: Block Resampling 1. T t=1 where Ω = E(xt x0 e2 ).. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. . which may be diﬀerent than the i properties of the actual ei . ˆ 2..1 to see that T 1 X √ xt et →d N (0.7.. 140 . Y−k+2 . t then as T → ∞.. In particular. .2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. The implication is that asymptotic inference is the same. This is identical in form to the asymptotic distribution of OLS in cross-section regression. Fix an initial condition (Y−k+1 . This creates an iid bootstrap sample. Estimate β and residuals et . 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∗ .1 MDS CLT. t t Theorem 12.8 Bootstrap for Autoregressions In the non-parametric bootstrap. e ˆ 3. T 1 X √ ut →d N (0. the asymptotic covariance matrix is estimated just as in the cross-section case. there are two popular methods to implement bootstrap resampling for time-series data. It also presumes that the AR(k) structure is the truth. Y0 ). Ω) . as this imposes inappropriate independence.7 Asymptotic Distribution Theorem 12. we can apply Theorem 12..7. Clearly. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . T t=1 Since xt et is a MDS. then as T → ∞. Brieﬂy. this cannot work in a time-series application. i 4. we constructed the bootstrap sample by randomly resampling from the data values {yt ..

and for modelmisspeciﬁcation.4) by OLS. Resample complete blocks. That is. • Use “seasonally adjusted” data. heteroskedasticity. ρk ). If s is the number of seasons (typically s = 4 or s = 12). The seasonal adjustment.2) (12. or the season-to-season change.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . Seasonal Eﬀects There are three popular methods to deal with seasonal data. • First apply a seasonal diﬀerencing operator.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . and perhaps this was of relevance. • You can estimate (12. ﬁrst estimate (12. 4. May not work well in small samples.2). 141 . Paste the blocks together to create the bootstrap time-series Yt∗ .. Thus the seasonally adjusted data is a “ﬁltered” series. For each simulated sample. This allows for arbitrary stationary serial correlation. draw T /m blocks. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. (12. . But the long-run trend is also eliminated. (12. This procedure is sometimes called Detrending. also alters the time-series correlations of the data.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 5.3) replacing St with St . This presumes that “seasonality” does not change over the sample. and the way that the data are partitioned into blocks. get the ˆ ˆ residual St . and then perform regression (12.3) sequentially by OLS. This is a ﬂexible approach which can extract a wide range of seasonal factors.2)-(12.2.. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.. 3. however. The series ∆s Yt is clearly free of seasonality. 12. ∆s Yt = Yt − Yt−s . • You can estimate (12. 6. The results may be sensitive to the block length. • Include dummy variables for each season.

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

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

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

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

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

13. general. direct estimation of (13. which once was very popular. Let yt = Yjt . under the restriction γ = −βθ. In this case.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. t and et is iid N (0. This can be done by a Wald test. t t−1 (13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. xt−1 ) to the regression. t or yt = θyt−1 + x0 β + x0 γ + ut . Suppose that et is an AR(1).) Since the common factor restriction appears arbitrary. may be tested if desired.3). and subtract oﬀ the equation once lagged multiplied by θ. it is convenient to re-deﬁne the variables.1). Otherwise it is invalid. 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 . h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . 13. 1). and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors.2) Take the equation yt = x0 β + et . Another interesting fact is that (13. and Zt be the other variables. We see that an appropriate. the model (13. Then the single equation takes the form (13. which is called a common factor restriction. and is still routinely reported by conventional regression packages. (A simple version of this estimator is called Cochrane-Orcutt. with time series data. Let et = ejt and β = aj . This restriction. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).4 Single Equation from a VAR Yjt = a0 xt + et . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. If valid.1) yt = x0 β + et . This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. we are only interested in a single equation out of a VAR system.3) which is a valid regression model. (13.2) is uncommon in recent applications.2) may be estimated by iterated GLS. and is typically rejected empirically. j Often. t and xt = This is just a conventional regression. 147 . You may have heard of the Durbin-Watson test for omitted serial correlation. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 .2) is a special case of (13.

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

Then under H0 zt is I(1). The r vectors in β are called the cointegrating vectors. If the series Yt is not cointegrated. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. 149 . however. For example. β = (1 − 1)0 . The asymptotic distribution was worked out in B. β may not be known. a good method to estimate β. but it is useful in the construction of alternative estimators and tests.8. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. Suppose that β is known. In other cases. When β is unknown. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . then Yt is I(0). the asymptotic distribution of the test is aﬀected by the presence of the time trend. so the ADF critical values are not appropriate. Often. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). Hansen (1992). so zt = β 0 Yt is known. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . as ﬁrst shown by Stock (1987). from OLS of Y1t on Y2t .1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. 13.9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . Whether or not the time trend is included. yet under H1 zt is I(0). When the data have time trends. If r = m. Thus H0 can be tested using a univariate ADF test on zt . If Y = (log(Consumption) log(Income))0 . Thus Yt = ˆ (Y1t . and was articulated in detail by Engle and Granger (1987). Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . In some cases. Under H0 . it may be believed that β is known a priori. if Yt is a pair of interest rates.13. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Deﬁnition 13. If Yt is cointegrated with a single cointegrating vector (r = 1). Yt is I(1) and cointegrated. For 0 < r < m.8 Cointegration The idea of cointegration is due to Granger (1981). such that zt = β 0 Yt is I(0). This is not. of rank r. it may be necessary to include a time trend in the estimated cointegrating regression. β is not consistent. then r = 0. m × r. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. in general. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary.

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

A parametric model is constructed. you would be advised to consider employing a semi-parametric estimation approach. . i As P (Yi = 1 | xi ) = E (Yi | xi ) . eliminating the dependence on a parametric distributional assumption. estimation is by MLE..Chapter 14 Limited Dependent Variables A “limited dependent variable” Y is one which takes a “limited” set of values.} • Censored: Y = {x : x ≥ 0} The traditional approach to the estimation of limited dependent variable (LDV) models is parametric maximum likelihood. 1} • Multinomial: Y = {0. due to time constraints. allowing the construction of the likelihood function. you were to write a thesis involving LDV estimation. Given some regressors xi . this yields the regression: Yi = x0 β + ei which can be estimated by i OLS.. A major practical issue is construction of the likelihood function. 1}. 1. typically assumed to be symmetric about zero. The most common cases are • Binary: Y = {0. They still constitute the majority of LDV applications. 14.. 2. This represents a Yes/No outcome. However.. The two standard choices for F are 151 . 2.1 Binary Choice The dependent variable Yi = {0. so that F (z) = 1 − F (−z). Even so estimation of a linear probability model is a useful starting point for subsequent analysis. 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. If.. however. 1. For the parametric approach. the linear probability model does not impose the restriction that 0 ≤ P (Yi | xi ) ≤ 1. A more modern approach is semi-parametric. We will discuss only the ﬁrst (parametric) approach. . The linear probability model speciﬁes that P (Yi = 1 | xi ) = x0 β. k} • Integer: Y = {0. the goal is to describe P (Yi = 1 | xi ) . as this is the full conditional distribution.

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

1). 1. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) .1) yi = ∗ <0 . incomes above a threshold are typically reported at the threshold.) The observed data yi therefore come from a mixed continuous/discrete distribution..” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. This may be considered restrictive.. . 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. 14. 1. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . i i i=1 ˆ The MLE is the value β which maximizes ln (β). The censoring process may be explicit in data collection. i If Y = {0. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.14. . The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. any known value can substitute.. In surveys. An example of a data collection censoring is top-coding of income. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. 0 if yi (This is written for the case of the threshold being zero.. a typical approach is to employ Poisson regression. or it may be a by-product of economic constraints. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. σ 2 ) with the observed variable yi generated by the censoring equation (14.}. the consumption level (purchases) in a particular period was zero. 2. k! = exp(x0 β). This model speciﬁes that P (Yi = k | xi ) = λi k = 0.2 Count Data exp (−λi ) λk i .3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. this motivates the label Poisson “regression. 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. A generalization is the negative binomial. Tobin observed that for many households. The conditional density is the Poisson with parameter λi .

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

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

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

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

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

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

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

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

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

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

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

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

we have four expressions for the number of objects (possible arrangements) of size r from n objects. r r! (n − r)! When counting the number of objects in a set. Furthermore. we say that the collection of events A1 .. as µ ¶ n n! = . the number of ¡49 if potential combinations is 6 = 13. Counting may be with replacement or without replacement. the conditional probability function is a valid probability function where S has been replaced by B. These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r. For example. 49.1) We say that the events A and B are statistically independent when (A. in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A. Ak are mutually independent when for any subset {Ai : i ∈ I}. . there are two important distinctions. If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . 2.. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. consider a lottery where you pick six numbers from the set 1. Counting may be ordered or unordered. Depending on these two distinctions. Rearranging the deﬁnition.. Ã ! \ Y P Ai = P (Ai ) . . We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A)..• P (A) ≤ 1 • P (Ac ) = 1 − P (A) • P (B ∩ Ac ) = P (B) − P (A ∩ B) • P (A ∪ B) = P (A) + P (B) − P (A ∩ B) • If A ⊂ B then P (A) ≤ P (B) • Bonferroni’s Inequality: P (A ∩ B) ≥ P (A) + P (B) − 1 • Boole’s Inequality: P (A ∪ B) ≤ P (A) + P (B) For some elementary probability models. 816. i∈I i∈I 166 . 983. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery..1) holds. P (B) With Replacement nr ¡n+r−1¢ r For any B.. ¢ counting is unordered and without replacement. and is with replacement if this is allowed. This selection is without replacement if you are not allowed to select the same number twice. n ≥ r. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. it is useful to have simple rules to count the number of objects in a set.

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

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

1.. x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 . 0≤p≤1 V ar(X) = λ We now list some important continuous distributions.. x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx .. 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . m x1 !x2 ! · · · xm ! 1 2 = n. X2 = x2 . λ>0 x = 1. EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x . .A.. x! EX = λ x = 0. 2... 1.4 Common Distributions For reference.. 2. 0≤p≤1 x = 0.. Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . we now list some important discrete distribution function. .. . x = 1... 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 . 0≤p≤1 x = 0.. Bernoulli P (X = x) = px (1 − p)1−x . 169 . 2. n.. 1... . .

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

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

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

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

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

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

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

Set r Z . C −1 CC 0 C −10 ) = N (0. (A.2. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. 1) and Q ∼ χ2 be independent. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.8. which can be found by applying change-of-variables to the gamma function. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. From (A.3.8. tr has distribution 177 . Thus the density of Z 2 is (A.8. C −1 AC −10 ) = N (0. Using the simple law of iterated expectations. Proof of Theorem 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). Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .3 Let Z ∼ N (0. Iq ). we see that the MGF of Z 2 is (1 − 2t)−1/2 . For Z ∼ N(0.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.11). which we showed in (A.12) E exp (tQ) = 0 Γ (A. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. 1). ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.Theorem A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .13).6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. The MGF for the density (A.8.11) 2 with r = 1.13) is the MGF of the density (A.1. q Proof of Theorem A.

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

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

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

θ0 )0 . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 ) ∂ ∂θ f ∂ (Yi . (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. . θ0 ) ln f (Yi .9. f (Yi . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . ¯ ¯ ∂ E ln f (Yi .1. θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 ) (Yi . θ0 ) ∂θ f (Yi . θ0 )2 (Yi . function of the data.9.1) has mean zero and variance nH. To see (A. θ0 )0 f (Yi .. θ0 ) ¯ ∂ f (y.9. θ) f (˜.. θ0 = ln f (Yi . θ) dy ¯ ∂θ f (y. 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 = .17). ∂θ ¯θ=θ0 Z ! = 0.2. θ0 ) ∂ ∂ − ln f (Yi . we can show that E By direction computation.. θ) f (y. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0.Proof of Theorem A. θ0 ) − f (Yi . V ar (S) nH so ¥ 181 . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ0 ) d˜ = E ˜ . Since θ Z ˜ = ˜ y)f (˜. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. yn ). θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. Proof of Theorem A. θ0 ) f (Yi .16). ∂2 ln f (Yi .

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

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

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

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

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