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

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Contents

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

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

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

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

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

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

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ii

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

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

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

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

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

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

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

A square matrix A is called orthogonal if A0 A = Ik . r ≤ k. for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . . ⎦ ⎣ . For example.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. ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . . . An important diagonal matrix is the identity matrix. then AIr = A and Ik A = A. . ⎤ ⎥ ⎥ ⎥ ⎦ AB = A1 A2 · · · Ar Br = A1 B1 + A2 B2 + · · · + Ar Br r X = Ar Br j=1 ¤⎢ ⎢ ⎢ ⎣ Important properties are that if A is k × r. The columns of a k × r matrix A. . are said to be orthogonal if A0 A = Ir .3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. Also. . We say that two vectors a and b are orthogonal if a0 b = 0. A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . ⎥ . . . which has ones on the diagonal.

a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. (2. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . . The following fact about inverting partitioned matrices is sometimes useful.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. the Moore-Penrose generalized inverse A− exists and is unique. . (2. This matrix is called the inverse of A and is denoted by A−1 . if there is no c 6= 0 such that Ac = 0.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 . 2. .1) . . . or is nonsingular. 7 Also.3) The matrix A− is not necessarily unique. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . . The Moore-Penrose generalized inverse A− satisﬁes (2.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. In this case there exists a unique matrix B such that AB = BA = Ik .4 Inverse A k × k matrix A has full rank. If A − BD−1 C and D − CA−1 B are non-singular. For non-singular A and C. if A is an orthogonal matrix. . then A−1 = A.

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

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

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

the conditioning variable. xki 3.1 displays the density1 of hourly wages for men and women. The data are from the 2004 Current Population Survey 1 11 . In this context we partition the observations into the pair (yi . the mean wage for men is $27. We call xi alternatively the regressor. it is useful to have numerical measures of the diﬀerence. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. Take a closer look at the density functions displayed in Figure 3. This is used when the goal is to quantify the impact of one set of variables on another variable. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. holding the other variables constant.1. (3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. ⎟ . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. These are asymmetric (skewed) densities. While it is easy to observe that the two densities are unequal. education and experience. m(x) can take any form. The two density curves show the eﬀect of gender on the distribution of wages. In the example presented in Figure 3. we can focus on f (y | x) . When a distribution is skewed. the conditional density of yi given xi . You can see that the right tail of then density is much thicker than the left tail. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. which is a common feature of wage distributions.73.1) xi = ⎜ .1 by the arrows drawn to the x-axis. ⎠ ⎝ . the mean is not necessarily a good summary of the central tendency.2) m(x) = E (yi | xi = x) = −∞ In general. See Chapter 16. To illustrate. gender.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. We call yi the dependent variable. xi ) where yi is a scalar (real-valued) and xi is a vector. . and exists so long as E |yi | < ∞. and that for women is $20.22. or the covariates. These are indicated in Figure 3.1. Figure 3. These are conditional density functions — the density of hourly wages conditional on race.

wage regressions typically use log wages as a dependent variable rather than the level of wages.3 displays a scatter plot2 of log wages against education levels. implying an average 36% diﬀerence in wage levels. and a Ph.3) White non-military male wage earners with 10-15 years of potential work experience. 3.2 shows the density of log hourly wages for the same population. Figure 3.36. The diﬀerence in the log mean wage between men and women is 0. this yields the formula yi = m(xi ) + ei .3 is how the conditional expectation describes an important feature of the conditional distribution. The conditional expectation function is close to linear. The main point to be learned from Figure 3. then comparisons become more complicated.2) evaluated at the observed value of xi : ei = yi − m(xi ). degree in mean log hourly wages is 0. When the distribution of the control variable is continuous.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. Of particular interest to graduate students may be the observation that diﬀerence between a B.D. 12 .5.1 is facilitated by the fact that the control variable (gender) is discrete. To illustrate.Figure 3. which implies a 30% average wage diﬀerence for this population. with mean log hourly wages drawn in with the arrows. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. For this reason. The comparison in Figure 3. 2 (3.30.A. the dashed line is a linear projection approximation which will be discussed in the Section 3. By construction. the solid line displays the conditional expectation of log wages varying with education. Assuming for simplicity that this is the true joint distribution. Figure 3.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.

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

it does not provide information about the spread of the distribution.1. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . in the sense of achieving the lowest mean squared error.2. σ 2 (x) is a non-trivial function of x. 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. In contrast.Figure 3. when σ 2 (x) is a constant so that ¢ ¡ (3. 3.3 Conditional Variance Generally. Given the random variable xi . The conditional standard deviation is its square root σ(x) = σ 2 (x). and can take any form. let g(x) be an arbitrary predictor of yi given xi = x. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. i . the conditional variance of yi is σ 2 = σ 2 (xi ). Thus the mean squared error is minimized by the conditional mean. subject to the restriction p that it is non-negative.3. The right-hand-side is minimized by setting g(x) = m(x). To see this.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .

In this case (3. ⎟ β=⎝ . and the linear assumption of the previous section is empirically unlikely to accurate. ⎟ . Thus (3.5.5) xi = ⎜ . We call this the “constant” or “intercept”. where x1i is the ﬁrst element of the vector xi deﬁned in (3. Equation (3. it is more realistic to view the linear speciﬁcation (3.we say that the error ei is homoskedastic. they are also somewhat more dispersed.9) 3. take the conditional wage densities displayed in Figure 3. So while men have higher average wages. its functional form is typically unknown. Equivalently. ⎝ . 3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.1. i (3. Notationally. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . The conditional standard deviation for men is 12. xki When m(x) is linear in x.1 and that for women is 10.6) (3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.8) (3. βk ⎛ (3.4 Linear Regression An important special case of (3. As an example. which we derive in this section. we assume that x1i = 1.7) is a k × 1 parameter vector. ⎠ .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 . ⎠ .6) as an approximation. it is convenient to augment the regressor vector xi by listing the number “1” as an element.8) is called the linear regression model. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . Instead.1). 15 .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x).

10) It is worth taking the time to understand the notation involved in this expression.1. The ﬁrst-order condition for minimization (from Section 2. α0 E (xi x0 ) α = E (α0 xi )2 > 0. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. i (3. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .which is quadratic in β. written E (xi x0 ) > 0. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. Equivalently.5. xi contains an intercept. x0 β is the best linear predictor for yi . i 4. Assumption 3. 2 2. i which requires that for all non-zero α. This occurs when redundant variables are included in xi .1 1.10).7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. by “best” we mean the predictor function with lowest mean squared error. The error is i ei = yi − x0 β. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. this situation must be excluded. i 16 . i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . Eyi < ∞. 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. In order for β to be uniquely deﬁned. Therefore.5. E (x0 xi ) < ∞.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 . 3. E (xi x0 ) is invertible. As before. The best linear predictor is obtained by selecting β to minimize S(β). i i (3. The vector (3.12) This completes the derivation of the linear projection model.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. otherwise they are distinct. Given the deﬁnition of β in (3. Rewriting. 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 . alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. It is invertible if and only if it is positive deﬁnite. i (3. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite.

i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .14).3 are called regularity conditions.5.4 we know that the regression error has the property E (xi ei ) = 0. However.1.1 Under Assumption 3. Assumption 3.13) summarize the linear projection model. For example. (3.14) follows from (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 = 0.13) The two equations (3.Theorem 3. it follows that linear regression is a special case of the projection model.1. E (xi ei ) = 0 and E (ei ) = 0. This means that the equation (3.10) and (3.9).5.11) and (3.1.1.4 is required to ensure that β is uniquely deﬁned.1.1. The ﬁnite variance Assumptions 3. Assumption 3.13) implies that xi and ei are uncorrelated.5. Since ei is mean zero by (3.5.1.3 ensure that the moments in (3. Let’s compare it with the linear regression model (3.2 and 3. the orthogonality restriction (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. Assumption 3.11) are well deﬁned.5. Figure 3.5.1. (3.12) can be alternatively interpreted as a projection decomposition.4 guarantees that the solution β exits. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Since from Theorem 3.1.5. By deﬁnition.1 is employed to guarantee that (3.8)-(3. Using the deﬁnitions (3. ¥ (3.10) are deﬁned.5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. 17 .2.13) and Assumption 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. Equation (3.12) and (3.5.5. Assumption 3.2 and 3. Furthermore.1.1 are weak.14) Proof.1.14) holds.5.

4 we display as well this quadratic projection.1. This defect in linear projection can be partially corrected through a careful selection of regressors.10) may not hold and the implications of Theorem 3. since the resulting function is quadratic in experience. Other than the redeﬁnition of the regressor vector. The linear equation (3. It over-predicts wages for young and old workers. In this example the linear projection is a close approximation to the conditional mean. and are discussed in Chapter 11. However. In this case the linear projection is a poor approximation to the conditional mean.We have shown that under mild regularity conditions. Returning to the joint distribution displayed in Figure 3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. In contrast. In other cases the two may be quite diﬀerent. In this example it is a much better approximation to the conditional mean than the linear projection.5.5 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. there are no changes in our methods or analysis. In the example just presented. Figure 3.1 may be false. for those over 53 in age). A projection of log wages on these two variables can be called a quadratic projection. for any pair (yi . The solid line is the conditional mean.5. Figure 3.4 displays the relationship3 between mean log hourly wages and labor market experience.12) with the properties listed in Theorem 3. xi ) we can deﬁne a linear projection equation (3. We illustrate the issue in Figure 3. Most importantly. In this case (3.10). it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. and the straight dashed line is the linear projection. These structural models require alternative estimation methods. No additional assumptions are required. and under-predicts for the rest. in many economic models the parameter β may be deﬁned within the model.3. 18 . In Figure 1. we can augment the regressor vector xi to include both experience and experience2 . the dashed line is the linear projection of log wages on eduction.

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

True or False. Let xi and yi have the joint density f (x. Suppose that yi is discrete-valued. and E(xi ei ) = 0. σ = .2.6 Exercises 1. and E(ei | xi ) = 0. a constant. If yi = xi β + ei . Suppose that Y and X only take the values 0 and 1.1 . σ 2 = V ar(yi ) and σ xy = Cov(xi . 20 . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . σ 2 = V ar(xi ). (x − µ)2 − σ 2 Show that Eg (X. Are they diﬀerent? Hint: If P (Y = j) = 5. 9.4 . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi .3 Find E(Y | X = x). yi ).3.1. taking values only on the non-negative integers. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. then ei is i i independent of xi . If yi = x0 β + ei and E(ei | xi ) = 0. then E(x2 ei ) = 0. i 11. 0 ≤ y ≤ 1.. ¡ ¢ 4. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . e−λ λj j! . True or False. xi ∈ R. then ei is independent of xi . j! 0 j = 0. Let X be a random variable with µ = EX and σ 2 = V ar(X). then E(ei | xi ) = 0. µ. Compute the conditional mean m(x) = E (yi | xi = x) . xi ∈ R. x 6. i 10. i 8. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . 1. Prove parts 2. and E(e2 | xi ) = σ 2 . 2. 3. µx = Exi . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. True or False. s) = 0 if and only if m = µ and s = σ 2 . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. m. If yi = x0 β + ei and E(xi ei ) = 0. True or False. If yi = x0 β + ei .2 Y =1 .. If yi = xi β + ei . then E(x2 ei ) = 0. i 7. and have the following joint probability distribution X=0 X=1 Y =0 . E(Y 2 | X = x) and V ar(Y | X = x). E(ei | xi ) = 0. . 2. 3 and 4 of Theorem 3. True or False. Compute E(yi | xi = x) and V ar(yi | xi = x).

(4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.2) can be written in the parametric 0 β)) = 0. i It follows that the moment estimator of β replaces the population moments in (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 ) . but for most of the chapter we retain the broader focus on the projection model.2) (4.3) In Sections 4.1) (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .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 .7 and 4. Observe that (4.4) i i=1 i=1 ˆ Another way to derive β is as follows.1 Estimation Equation (4. 4.8. we narrow the focus to the linear regression model. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .

i 22 . These are white male wage earners from the March 2004 Current Population Survey. with 10-15 years of potential work experience.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.14 14.3. Then µ ¶ n 1X 2. 40 0.7% increase in mean wages. consider the data used to generate Figure 3.14 14.170 37. An interpretation of the estimated equation is that each year of education is associated with an 11.117 1 14.117 Educationi . 30 = . 40 2.83 ¶−1 µ ¶ .71 = −2. excluding military.4).95 xi yi = 42.95 42. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4. 0.14 205.ˆ This is a set of k equations which are linear in β.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 205. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.4).83 µ We often write the estimated equation using the format \ log(W agei ) = 1.37 µ ¶ 1. Let yi be log wages and xi be an intercept and years of education.40 µ ¶µ ¶ 34. This sample has 988 observations. ¶ 2.30 + 0.94 −2. To illustrate. 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.2 Least Squares There is another classic motivation for the estimator (4. 4.

i ˆ ˆ Note that yi = yi + ei . To visualize the sum-of-squared errors function. Figure 4.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. while the residual is a by-product of estimation. Matrix calculus (see Appendix 2. The error is unobservable.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. 23 . It is important to understand the distinction between the error ei and the residual ei . Since the function Sn (β) is a quadratic function of β. Figure 4. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. Figure 4. Following convention we will call β the OLS estimator of β.4). which can cause confusion. These two ˆ variables are frequently mislabeled.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). the contour lines are ellipses.

ˆ n i=1 n Since xi contains a constant.2: Sum-of-Squared Error Function Contours Equation (4. ˆ n−k 2 i=1 (4. Its method of moments estimator is the sample average 1X 2 ei . 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.Figure 4. These are algebraic results. 24 .5) implies that 1X xi ei = 0. It measures the variation in the i “unexplained” part of the regression. The error variance σ 2 = Ee2 is also a parameter of interest. and hold true for all linear regression estimates.7) A justiﬁcation for the latter choice will be provided in Section 4.6) An alternative estimator uses the formula n 1 X 2 s = ei . one implication is that n 1X ei = 0.7.

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

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

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

By the independence of the observations and (3. and X2 is the vector of observed regressors.13).8)(3. ˆ ˜ ˜ ˆ 3. obtain residuals X2 . obtain OLS estimates β 2 and residuals e.1 (Frisch-Waugh-Lovell). . . ˆ which are “demeaned”. In this section we derive the small sample conditional mean and variance of the OLS estimator. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. the FWL theorem can be used to speed computation. A common application of the FWL theorem. Rather.9). Regress Y on X1 . which you may have seen in an introductory econometrics course.9). The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . . . . ¡ ¢−1 0 ι. Regress Y on X2 . In some contexts. ⎠ ⎝ ⎠ ⎝ . .14) or via the ˆ following algorithm: ˜ 1. observe that ⎞ ⎛ ⎞ ⎛ . 4.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ⎟ ⎜ ⎟ ⎜ (4. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4.6. . but in most cases there is little computational advantage to using the two-step algorithm. In the model (4. Regress X2 on X1 . ˜ 2. obtain residuals Y .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. . or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. . In this case. 30 . is the demeaning formula for regression. the primary use is theoretical. .Theorem 4.

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

˜ β L = A0 Y = A (Xβ + e) = β + Ae. By a calculation similar to those of the previous section.10). 32 . however.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 . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . says that the least-squares estimator is the best choice. the best (minimumvariance) unbiased linear estimator is OLS. What is the best choice of A? The Gauss-Markov theorem. which is (3.1 Gauss-Markov. 4. As an alternative.9) plus E e2 | xi = σ 2 . the estimator ˆ 2 deﬁned (4.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. Theorem 4. ³ ´ ˜ E β | X = A0 Xβ. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. Now consider the class of estimators of β which are linear functions of i the vector Y. which we now present. In the homoskedastic linear regression model. is a famous statement of the solution. It is not unbiased in the absence of homoskedasticity. It is important to remember. as it yields the smallest variance among all unbiased linear estimators. = σ2 n the ﬁnal equality by (4.8)¢ ¡ (3. In this case. ˜ so β is unbiased if (and only if) A0 X = Ik . we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense.7) is unbiased for σ 2 by this calculation. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . and thus can be written as ˜ β = A0 Y where A is an n × k function of X. Thus since V ar (e | X) = In σ 2 under homoskedasticity. or in the projection model. that this estimator is only unbiased in the special case of the homoskedastic linear regression model.8. Thus σ 2 is biased towards zero. known as the Gauss-Markov theorem. The following result.

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

1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. He observes that the above argument holds for all multinomial distributions. if the data have a discrete distribution.22) 34 .5.10 Omitted Variables xi = µ x1i x2i ¶ .1. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi . 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. Chamberlain (1987) extends this argument to the case of continuously-distributed data. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. 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 . and thus so is the OLS estimator. (4.Substituting in the expressions for π j .9). the maximum likelihood estimator is identical to the OLS estimator.10) for the class of models satisfying Assumption 3. He proves that generically the OLS estimator (4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.

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

the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.25) below. The hi take values in [0. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . As a consequence.−i = (1 − hi )−1 hi ei . the precision of individual estimates are reduced. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.26) As we can see. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. We can also deﬁne the leave-one-out residual ˆ ˆ ei. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . ˆ i A simple comparison yields that ˆ ei − ei. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.27) (4. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . since as ρ approaches 1 the matrix becomes singular. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. deﬁne the leave-one-out least-squares estimator of β. that is.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. 1] and sum to k. ˆ ˆ (4.−i = yi − x0 β (−i) = (1 − hi )−1 ei . A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. the worse the precision of the individual coeﬃcient estimates. We derive expression (4. the OLS estimator based on the sample excluding the i’th observation.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. If the i’th observation 36 . What is happening is that when the regressors are highly dependent. To investigate the possibility of inﬂuential observations. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 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 . then this observation is a leverage point and has the potential to be an inﬂuential observation.27).4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . ˆ We now derive equation (4.This implies has a large value of hi . The key is equation (2.1) in Section 2. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . which is considerably more informative than plots of the uncorrected residuals ei . Investigations into the presence of inﬂuential observations can plot the values of (4.25).

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

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

(5.6) By Jensen’s inequality (5. by Markov’s inequality (5.1).4). Theorem 5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . Fn (x) → F (x) as n → ∞. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. We say that Zn converges in distribution to Z as n → ∞. the fact that X n = W n + Z n . V ) .5). Finally.3.1) and (5.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. we can set E(X) = 0 (by recentering Xi on its expectation). if for all x at which F (x) is continuous.6) and (5. the fact that the Wi are iid and mean zero. Jensen’s inequality (5. as needed.Proof: Without loss of generality. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. denoted Zn →d Z.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.7).1 Central Limit Theorem (CLT). If Xi ∈ Rk is iid and E |Xi |2 < ∞. the triangle inequality. Set ε = δη/3. 43 . Fix δ and η. P ¯X n ¯ > δ ≤ η.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. and the bound |Wi | ≤ 2C. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. 5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . where Z has distribution F (x) = P (Z ≤ x) .

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

for each element of g.√ where λn → 0 lies on the line segment joining 0 and λ/ n. gθ Σgθ .2 Continuous Mapping Theorem 2. Recall that A ⊂ B implies P (A) ≤ P (B). where θ is m × 1 and Σ is m × m. If Zn →p c as n → ∞ and g (·) is continuous at c. Σ) . Since cλλ (λn ) → cλλ (0) = −Ik . 45 . Σ) = N 0. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Theorem 5. Stacking across elements of g.4. This is suﬃcient to establish the theorem.4.4 Asymptotic Transformations Theorem 5. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. then g(Zn ) →d g(Z) as n → ∞. k ≤ m. Hence g(Zn ) →p g(c) as n → ∞. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.4. ¥ 5. Proof : By a vector Taylor series expansion. and g(θ) : Rm → Rk . Proof: Since g is continuous at c. Ik ) distribution. then g(Zn ) →p g(c) as n → ∞. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). If Zn →d Z as n → ∞ and g (·) is continuous. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. √ Theorem 5.1 Continuous Mapping Theorem 1 (CMT). we see that as n → ∞.3 Delta Method: If n (θn − θ0 ) →d N (0. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 .

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

we can conclude ˆ that β →p β.2.1 by the fact that the sampling densities become more concentrated as n gets larger.2).1.2) i i n i=1 n From (6.4. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1). n i=1 (6.4.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. Ã n ! n X 1X 0 1 ˆ xi xi . 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 . (6. For a complete argument. ·) is continuous at (Q. xi ei →p g (Q. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. 0).2 Consistency ˆ As discussed in Section 6.5. ˆ Theorem 6.2. the OLS estimator β is has a statistical distribution which is unknown.1). Equation (4.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. we will use the methods of asymptotic approximation. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.1 and the WLLN (Theorem 5. using (6.1). ˆ 47 .1. This is illustrated in Figure 6. Assumption 3. 6.1. First.1) and ˆ We now deduce the consistency of β. Assumption 3. As the sample size increases the density becomes more concentrated about the population coeﬃcient. and the continuous mapping theorem (Theorem 5.5.5.3) Ã where g(A. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1 Under Assumption 3. To characterize the sampling distribution more fully. β →p β as n → ∞. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. Proof.3). (6.4 implies that Q−1 exists and thus g(·. Hence by the continuous mapping theorem (Theorem 5. (6. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.1).

ˆ Proof. since n/(n − k) → 1 as n → ∞.1.1 In addition to Assumption 3. To see this.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.2 Under Assumption 3. (6.2). i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .1.3. Assumption 6. (6.Theorem 6. (6. E ¯ei ¯ E ¯e4 ¯ i i i i (6. it follows that s2 = ¥ n σ 2 →p σ 2 .2. by the Cauchy-Schwarz inequality (5.6) n i=1 48 . Ee4 < ∞ and E |xi |4 < ∞. We need a strengthening of the moment conditions.1).5. i i Assumption 6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.3.1 guarantees that the elements of Ω are ﬁnite.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. ˆ n−k 6.1). n 1 X √ xi ei →d N (0.2. Ω) . (6.2). By the central limit theorem (Theorem 5. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .5. Thus σ 2 is consistent for σ 2 . ˆ Finally.3) and Theorem (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.3.

As α approaches 2.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. after rescaling.3.1.9) we deﬁne V 0 = Q−1 σ 2 whether (6.1). there is no simple answer to this reasonable question. 1). V is often referred to as ˆ the asymptotic covariance matrix of β.7) is true then V = V 0 . We call V 0 the homoskedastic covariance matrix. Under (6. is approximately normal when the sample size n is suﬃciently large.1 Under Assumption 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. When (6.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. There is a special case where Ω and V simplify.7) holds. 1) asymptotic distibution. otherwise V 6= V 0 . Q−1 ΩQ−1 . Theorem 6. when xi and ei are independent.3. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1. We say that ei is a Homoskedastic Projection Error when (6. i i Condition (6. In´Figure 6. |ε| ≥ 1. For α 49 . for example.6). Ω) ¡ ¢ = N 0. Let yi = β 0 + β 1 xi + εi where xi is N (0. and (6. The approximation may be poor when n is small.Then using (6. In Figure 6.7) is true or false. However. 1 X √ xi ei n i=1 n ! the N (0. The trouble is that no matter how large is the sample size. (6.3. The expression V = Q−1 ΩQ−1 is called a sandwich form.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.3. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . If α > 2 the 2 error εi has zero mean and variance α/(α − 2). xi ) which satisfy the conditions of Assumption 6.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . its variance diverges q ³ ´ ˆ to inﬁnity. The asymptotic distribution ´ Theorem 6. We illustrate this problem using a simulation. setting n = 100 and varying the parameter α. however.7) Cov(xi x0 . This holds true for all joint distibutions of (yi .2).3.1 states that the sampling distribution of the least-squares estimator. How large should n be in order for the approximation to be useful? Unfortunately. e2 ) = 0. V ) where V = Q−1 ΩQ−1 . but this is not a necessary condition.9) In (6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.

Another example is shown in Figure 6. we need an estimate of Ω = E xi x0 e2 . 1) asymptotic approximation is never guaranteed to be accurate.2: Density of Normalized OLS estimator α = 3. 1).0 the density is very close to the N (0. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.10) without changing this result.3. concentrating most of the probability mass around zero. As α diminishes the density changes signiﬁcantly.1) it is clear that V 0 →p V 0 .3 is that the N (0. 1) density.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. We show the sampling distribution of n β 1 − β 1 setting n = 100.11) 50 . for k = 1. 6.2. 4.Figure 6. As k increases. 6 and 8.10) V 0 = Q−1 s2 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . the sampling distribution becomes highly skewed and non-normal. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.2) and Theorem 6.2 and 6. The estimator 2 2 in (6. The lesson from Figures 6.

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

80 . i i i i n i=1 Second. and then the square roots. From a computational standpoint.1.83 ¶−1 µ .20 −0.020) 6.039 and ˆ V = µ 1 14.12) in turn.80 40.199 2. we return to the log wage regression of Section 4.480 . but not under another set of assumptions. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .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 .085 p ˆ and that for β 1 is . First.80 40. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.14 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.20 = V 14.14 205.80 2. then take the diagonal elements.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.14 205.5) and the WLLN (Theorem 5.035 ¶ . To illustrate.used by an author when studying their work.83 −0. (.14 6.2/988 = . p ˆ In this case the two estimates are quite similar.493 0. The standard errors for β 0 are 7. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . n n i=1 52 .493 −0.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.98 −0. Ω 2.14 205.2. from which it follows that V →p V as n → ∞. (6. (6.020. We calculate that s2 = 0.5 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. Using (6.35/988 = .12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.83 ¶−1 = µ 7.117 Educationi . just as any other estimator.14 14.6 ¶µ 1 14.480 ˆ0 = 0. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.30 + 0.199 2.085) (.20 and µ ¶ ˆ = 0. by Holder’s inequality (5.

¯ ¯n ¯ n i=1 so Together. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. Andrews (1991) suggested an similar estimator based on cross-validation. Ω →p Ω and V →p V.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. 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. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.−i = (1 − hi )−1 ei ˆ presented in (4.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.1 As n → ∞. i=1 Third. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . you can show that 1 Xˆ ¯ β= β (−i) . Using this substitution. From equation (3. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .25).11) with the leave-one-out estimator ei. n i=1 n ˆ ˆ Theorem 6. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6.26).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 . which. these establish consistency. 6.13) Using formula (4.13) of Efron (1982).5. Recall from Section 4.

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

however. and is therefore exactly free of unknowns. Vθ ) √ Vθ = N (0. ˆ When q = 1q h(β) is real-valued). pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. Since the standard normal distribution does not depend on the parameters.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. s(ˆ θ) (6.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . β 2 ). ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. that (so θ ˆ ˆ ˆ is. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. and θ = h(β) is some function of the parameter vector.1 tn (θ) →d N (0. 1) Proof.For example. we say that tn (θ) is asymptotically pivotal. Consider the studentized statistic tn (θ) = Theorem 6. In special cases (such as the normal regression model. we say that tn is an exactly pivotal statistic. In general. θ) β 6. the statistic tn has an exact t distribution. In this case. µ I 0 ¶ ˆ the upper-left block of V . the standard error for ˆ is the square root of n−1 Vθ . s(ˆ = n−1/2 H 0 V Hβ . (For example. see Section X). 55 . By (6.8. 1) →d ˆ−θ θ . θ could be a single element of β). if R is a “selector matrix” R= so that if β = (β 1 .

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

05. 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. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. 6. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. or α = . ˆ + zα/2 s(ˆ . 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). 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 . 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). and it is desired to test the joint restrictions simultaneously. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. In this case the t-statistic approach does not work. θ The interval has been constructed so that as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . the most common professional choice isi95%. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).18) .96s(ˆ ≈ ˆ ± 2s(ˆ . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). θ θ) (6. This corresponds to selecting the conﬁdence h i h ˆ ± 1.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval.

An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).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 . the test rejects at the α% level iﬀ pn < α.025 . and Theorem 6. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.1. For example.15) showed that n ˆ − θ →d Z ∼ N (0. a chiq square random variable with q degrees of freedom.When h is a linear function of β. Also h(β) = a selector matrix. The asymptotic p-value for Wn is pn = p(Wn ).84 = z. h(β) = R0 β. ˆ Wn = n θ θ q θ θ Theorem 6. the upper-α quantile q 2 of the χ2 distribution.8. ˜˜ n ˜ e = Y − X1 β 1 . if rank(Hβ ) = q. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.2. In this case.5. Vθ ). ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .3. 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.05) = 3.19) σ2 ˆ where σ2 = ˜ 1 0 e e. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. and there are q = k2 restrictions. Hence β β by Theorem A. As before. χ2 (. Furthermore. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. q and pn is asymptotically U[0. 1] under H0 . Hβ (β) →p Hβ . 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. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . θ = β 2 . 6. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).1 Under H0 and Assumption 6. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. then Wn →d χ2 . Hβ (β) is a continuous function of β. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .10. The null hypothesis is H0 : β 2 = 0.1 showed θ ˆ that V →p V.

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

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

0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . a good testing procedure is based on the likelihood ratio statistic. 0. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . Furthermore. As inference (conﬁdence intervals) are based on the t-ratio. so as a practical matter it does not matter which distribution is used. σ 2 ) − Ln (β 1 . n−k • ∼ tn−k ˆ In Theorem 6. β 2 . The critical values are quite close if n − k ≥ 30.8. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .1 and Theorem 6.10) then ´ ³ ˆ • β ∼ N 0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . 0. σ ˆ ˆ βj − βj βj − βj N (0. β has an exact normal distribution and t has an exact t distribution. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. Theorem 6. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. We summarize these ﬁndings Theorem 6. 1) and tn−k distributions.1 If ei is independent of xi and distributed N(0. β 2 . β and t are approximately normally distributed. if standard errors are calculated using the homoskedastic formula (6.12. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . and standard errors are calculated using the homoskedastic formula (6. σ 2 ). σ 2 ) = − log σ − log (2π) − . β 2 .a chi-square distribution with n − k degrees of freedom. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. (Unless the sample size is unreasonably small.3. In contrast.12.10) µ h i ¶ 2 (X 0 X)−1 N 0.) Now let us partition β = (β 1 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . σ 2 ) discussed above. σ2 ˆ 61 . the notable distinction is between the N (0. 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. with residual variance σ .1 shows that under the strong assumption of ˆ normality.1 we showed that in large samples.

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

1 you can also see the impact of variation in sample size. and rarely fall outside of the 3%-8% range. In Table 4. When comparing statistical procedures. and σ is varied among 1 and 3. Table 4. 100 and 500. n is varied among 20. Any other choice of s leads to a test with unacceptable Type I error probabilities. Typically. Test performance deteriorates as s increases. The value of s is varied from 1 to 10. and σ 2 . In Table 2.05) with deviations indicating+ distortion. however. There is. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.4. Type I error rates between 3% and 8% are considered reasonable. so these probabilities are Type I error. looking for tests for which rate rejection rates are close to 5%. For this particular example. To interpret the table. we compare the rates row by row. this probability depends only on s. The null hypothesis β s = 1 is true. In each case. remember that the ideal Type I error probability is 5% (.1 we report the results of a Monte Carlo simulation where we vary these three parameters.4: Wald Statistic as a function of s P (Wn (s) > 3.1 reports the simulation estimate of the Type I error probability from 50.84. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. n. no magic choice of n for which all tests perform uniformly well. Rates above 20% are unexceptable.000 random samples. Given the simplicity of the model. the Type I error probability improves towards 5% as the sample size n increases. Table 4. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.84 | β = 1) .1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . the only test which meets this criterion is the conventional Wn = Wn (1) test.Figure 6.000 simulated Wald statistics Wn (s) which are larger than 3. Error rates avove 10% are considered excessive. These probabilities are calculated as the percentage of the 50.

An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.08 .31 .05 .22 .13 .21 .12 .08 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.08 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .05 .06 .06 .11 .20 .07 .13 . 64 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.07 .12 .06 .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 .15 .06 .19 .05 .15 . β 1 .35 .05 .10 .28 . This point can be illustrated through another example.08 .10 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.09 .10 .26 .08 .33 . β 2 ) be the least-squares estimates of (6.30 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . so the hypothesis can be stated as H0 : θ = r.13 . deﬁne θ = β 1 /β 2 .24 . Equivalently.14 .25 .05 .16 Rejection frequencies from 50.23 .18 .06 .22 .34 .07 .06 .14 .06 .05 . While this is clear in this particular example.06 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . Other choices are arbitrary and would not be used in practice.25 .17 .15 .20). In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.15 .20 .07 .07 .

75 1.06 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . then the “most linear” formulation should be selected.06 .10 . The implication of Table 4.00 .28 .645) P (tn > 1. along with sample size n. and normalize β 0 = 0 and β 1 = 1.05 . this formulation should be used.00 .7. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .09 .0 and n among 100 and 500. In this section we describe the method in more detail.06 .645) are close to zero in most cases.00 .07 .000 simulated samples. while the right tail probabilities P (t1n > 1. However.10 .05 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. The left tail probabilities P (t1n < −1. It is also prudent to consider alternative tests to the Wald statistic. Table 4.645) P (tn > 1. and 1. the rejection rates for the t1n statistic diverge greatly from this value.06 .12 .645) are calculated from 50. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . 1) variables.06 .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.47 . We vary β 2 among . ei be an independent N (0.25.645) and P (tn > 1.00 .05 . In all cases.645) P (tn < −1. .05 .10 .06 .05 . and alternatives to asymptotic critical values should be considered.06 .06 .50 . In contrast.05 . such as the GMM distance statistic which will be presented in Section 9.645) greatly exceed 5%.00 . 6.06 . This leaves β 2 as a free parameter.00 .00 .05 . .06 . and are close to the ideal 5% rate for both sample sizes.00 .00 .02 . . if the hypothesis can be expressed as a linear restriction on the model parameters.26 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.50.05 β2 .05 . especially for small values of β 2 .05. σ 2 ) draw with σ = 3.25 .2. We let x1i and x2i be mutually independent N (0.15 .75.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.1. the entries in the table should be 0.645) t1n t2n t1n t2n t1n t2n t1n t2n .05 . Ideally. 65 .15 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior. If no linear formulation is feasible. The results are presented in Table 4.00 The one-sided Type I error probabilities P (tn < −1.

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

The average (6.96) . and dummy variable indicators for the following: married. Then qα is the N ’th number in this ordered sequence. if we set B = 999. The α% sample quantile is a number qα such that α% of the sample are less than qα . We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1.95) /B ' .022. For the dependent variable we use the natural log of wages. union member. Generally. for a selection of choices of n and F. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. and our regressors include years of education.96) . and hispanic. B. Again our dependent variable is the natural log of wages.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. such as the percentage estimate reported in (6. For example. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. For regressors we include years of education. potential work experience. and 90% sample quantiles of the sample {Tnb }. As discussed above. and therefore it is straightforward to calculate standard errors for any quantity of interest. As P is unknown. 1000. a larger B results in more precise estimates of the features of interest of Gn .22/ B. We separately estimate equations for white and non-whites. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. Quite simply. so that coeﬃcients may be interpreted as semi-elasticities.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. union member. Hence the ³ ´ ˆ standard errors for B = 100. We now expand the sample all non-military wage earners. For example. If the standard error is too large to make a reliable inference. Often this is called the number of replications. In particular. the researcher must select the number of experiments. then B will have to be increased. this may ˆ be approximated by replacing P with P or with an hypothesized value. female. . It is therefore convenient to pick B so that N is an integer. respectively. 6. an estimator or test may perform wonderfully for some values. Furthermore. we included a dummy 67 . It is therefore useful to conduct a variety of experiments. the choice of B is often guided by the computational demands of the statistical procedure. and . experience squared. but requires more computational time.05) (. therefore. it is simple to make inferences about rejection probabilities from statistical tests. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. immigrant. female. potential work experience.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. and poorly for others. s P = .96) is iid Bernoulli. equalling 1 with probability P = E1 (Tnb ≥ 1. the performance will depend on n and F. then we can set s P = (.003. In practice. immigrant. B b=1 (6. We us the sample of wage earners from the March 2004 Current Population Survey. and dummy variable indicators for the following: married. are. The random variable 1 (Tnb ≥ 1. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. excluding military. and non-white. and 5000. experience squared. hispanic. and estimate a multivariate regression.007. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test.15 Estimating a Wage Equation We again return to our wage equation.21). where N = (B +1)α. In many cases.

232 .48772 = 515.69.008 .002 .102 −.101 .1.013 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. Computing the Wald statistic (6.4945. we ﬁnd Wn = 550.49452 σ ˜ Notice that the two statistics are close. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. the restricted standard deviation estimate is σ = .001 . 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 . The available sample is 18.014 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. but not equal.102 −. Table 4. Alternatively.808 so the parameter estimates are quite precise and reported in Table 4.4877 18. Using either statistic the hypothesis is easily rejected. The F form of the Wald statistic (6.007 . this adds 50 regressors). 808 1 − . excluding the coeﬃcients on the state dummy variables. Ignoring the other coeﬃcients.34 ˆ s(β) . reestimating the model with the 50 state dummies excluded.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. 2β 3 68 .070 . θ ˆ 2β 3 β2 .033 −. as the 1% critical value for the χ2 distribution is 76.00002 .097 −.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.121 −.808 . Wn = n 1 − 2 = 18.027 .18) that the state coeﬃcients are jointly zero.variable for state of residence (including the District of Columbia.010 .032 .

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

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . Typically.1) infeasible since the matrix D is unknown.. Often the functional form is kept simple for parsimony. However.Chapter 7 Additional Regression Topics 7.1 Generalized Least Squares In the projection model. z1i are squares (and perhaps levels) of some (or all) elements of xi .. . the least-squares estimator is ineﬃcient. σ 2 }. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1) XD Y β = X 0 D−1 X ¡ ¢ 2 . The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. σ1 We now discuss this estimation problem. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . The GLS estimator (7.2) 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.... 74 . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . Let η i = e2 . where z1i is some q × 1 function of xi . 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 . . we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7.

Suppose ei (and thus η i ) were observed. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. Then set ˜i ˜ D = diag{˜ 2 . and will depend on the model (and estimation method) for the skedastic regression. This is the feasible GLS. Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi . and hence we can estimate 0 σ 2 = zi α by i ˜ (7. This suggests 75 . then the FGLS estimator will force ˜i the regression equation through the point (yi .4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. xi ). σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Vα = E zi zi (7.4) the skedastic regression.. ˜i Suppose that σ 2 > 0 for all i. or FGLS. then the FGLS ˜i estimator is not well deﬁned. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. which is typically undesirable. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi .3) ˆ ˆ While ei is not observed. We have shown that α is consistently estimated by a simple procedure. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. We may call (7. Vα ) (7. If σ 2 < 0 for some i. as it is estimating the conditional variance of the regression of yi on xi . if σ 2 ≈ 0 for some i. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Furthermore. 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. there is no guarantee that σ 2 > 0 for all i. estimator of β. ..6) σ 2 = α0 zi ..5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant.

This estimator V 0 is appropriate when the skedastic regression (7. . Unless σ 2 = α0 zi .. In the linear regression model. and it may be estimated with considerable 76 V takes a sandwich form√. ´´−1 ³ ³¡ ´´−1 ³ ³¡ ¢−1 ¢−2 2 0 ´´ ³ ³¡ 0 ¢−1 E α0 zi E α zi xi x0 σ i xi xi xi x0 .1. Instead. e2 }.1.1. There are three reasons. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.1.. Why then do we not exclusively estimate regression models by FGLS? This is a good question. 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 → ∞. and was proposed by Cragg (Journal of Econometrics. FGLS is asymptotically superior to OLS.1. First. similar to the covariance matrix of the OLS estimator. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. Theorem 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 ˜ = . V ). We just state the result without proof. i ˜ 0 is inconsistent for V . but the proof of this can be tricky. In this case we interpret α0 zi as a linear projection of e2 on zi . Its asymptotic variance is not that given in Theorem 7. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. β should perhaps be i i called a quasi-FGLS estimator of β. A trimming rule might make sense: σ 2 = max[˜ 2 . σ 2 ] σi i for some σ 2 > 0. ¢¢−1 ¡ ¡ . 1992).that there is a need to bound the estimated variances away from zero. then FGLS is asymptotically equivalent to GLS. Since the form of the skedastic regression is unknown. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 .2) is correctly speciﬁed. It is possible to show that if the skedastic regression is correctly speciﬁed. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). V ˜ An appropriate solution is to use a White-type estimator in place of V 0 ..1 If the skedastic regression is correctly speciﬁed. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. V n n i=1 .

in which case ξ i is ˜ independent of xi and the asymptotic variance (7. as they will be estimating two diﬀerent projections. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. In the linear regression model the conditional mean of yi given xi = x is 77 . on the other hand. Second. Vα = E zi zi (7. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). but also under the assumptions of linear projection. and this requires trimming to solve. FGLS will do worse than OLS in practice.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . or equivalently that i H0 : α1 = 0 in the regression (7. Typically. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . OLS is a more robust estimator of the parameter vector. and not a conditional mean. however.error.2).7) under independence show that this test has an asymptotic chi-square distribution. The main diﬀerences between popular “tests” is which transformations of xi enter zi . require the assumption of a correct conditional mean.4). The asymptotic distribution (7. and all cross-products. This introduces an element of arbitrariness which is unsettling to empirical researchers. This hypothesis does not imply that ξ i is independent of xi .5) and the asymptotic variance (7. individual estimated conditional variances may be negative.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . In this case. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. σ 2 ). but the only diﬀerence is that they a ¢ allowed for general choice of zi .1 Under H0 and ei independent of xi .2.4) and constructing a Wald statistic.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. its squares. It is consistent not only in the regression model. We may therefore test this hypothesis by the estimation (7. the estimated conditional variances may contain more noise than information about the true conditional variances. and the cost is a reduction of robustness to misspeciﬁcatio 7. If the equation of interest is a linear projection. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. Theorem 7. the Wald test of H0 is asymptotically χ2 . The GLS and FGLS estimators. q Most tests for heteroskedasticity take this basic form. 7. the two tests coincide. Third.

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

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

θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. Furthermore. Thus we want to test H0 : β 2 = 0. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . Thus when the truth is that β 2 = 0.5 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 . Suppose that m(xi . ¥ Based on Theorem 7. θ) ' (ei + m(xi .For θ close to the true value θ0 . ˆ ˆ θ) ˆ θ). 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 . We have discussed projections and conditional means. This means that under H0 . ˆ and ei = yi − m(xi .4. and this is often a useful hypothesis (sub-model) to consider. 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 . the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. This renders the distribution theory presented in the previous section invalid. under H0 . θ0 ) + m0 (θ − θ0 ) . tests of H0 do not have asymptotic normal or chi-square distributions. θ which is that stated in the theorem. the parameter estimates are not asymptotically normally distributed. by a ﬁrst-order Taylor series approximation. θ) ' m(xi . Hansen (1996). m(xi . However. 80 .1. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . 7. θ) = β 0 zi + β 0 xi (γ). In particular. 1 2 The model is linear when β 2 = 0. Identiﬁcation is often tricky in nonlinear regression models. θ0 )) − m(xi . γ is not identiﬁed. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θi Thus ¡ ¢ yi − m(xi . but these are not the only measures of central tendency. An alternative good measure is the conditional median.

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

Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . When f (0 | x) is large.5. ˆ Proof of Theorem 7. by the central limit theorem (Theorm 5. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. In the special case where the error is independent of xi . (7. where V = and f (e | x) is the conditional density of ei given xi = x. Computation of standard error for LAD estimates typically is based on equation (7. the conditional density of the error at its median. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . Second using the law of iterated expectations and the chain rule of i diﬀerentiation.10) is equivalent to g n (β) = 0. First. While a complete proof of Theorem 7.Theorem 7. V ). and this improves estimation of the median.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.1 ´ √ ³ˆ n β − β 0 →d N (0. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . This can be done with kernel estimation techniques.5. The main diﬃculty is the estimation of f (0).5.1 is advanced.11). the height of the error density at its median. See Chapter 16. Let g(β) = Eg (β). then there are many innovations near to the median. we provide a sketch here for completeness. Pn −1 0 β)) . ∂β 0 so Third. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . ¢¢−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) .3.

Exi x0 ) →d i 2 = N (0. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors.12) Qτ = argmin Eρτ (U − θ) .Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ .9) for the median to all quantiles.13) This generalizes representation (7. when F (y | x) is continuous and strictly monotonic in y. For the random variables (yi . We then have the linear quantile regression model yi = x0 β τ + ei i 83 . Again. For τ ∈ [0. V ). For ﬁxed τ . so you can think of the quantile as the inverse of the distribution function. The third line follows from an asymptotic empirical process argument. then F (Qτ ) = τ .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. As functions of x. then F (Qτ (x) | x) = τ . the quantile regression functions can take any shape. 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. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) . If the random variable U has τ ’th quantile Qτ . The median is the special case τ = . The following alternative representation is useful. (7. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ .5. then (7. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). ¥ 7.

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

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

xK ) enters the regression function E(yi | x1i = x1 . 7. take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0.9 Model Selection In earlier sections we discussed the costs and beneﬁts of inclusion/exclusion of variables. This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. Let β 1 be the ˜ be the estimate under the constraint β = 0. To ﬁx notation. n→∞ σx ˜ When µ 6= 0. E (ε | X1 .. and β 1 0 (The least-squares estimate with the intercept omitted. where X1 is n × k1 and X2 is n × k2 . the question: “What is the right model for y?” is not well posed.. when economic theory does not provide complete guidance? This is the question of model selection. with residual vectors e1 and e2 .. We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε. estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 . “Which subset of (x1 .. . In many cases the problem of model selection can be reduced to the comparison of two nested models. because it does not make clear the conditioning set. and E (xi − µ)2 = σ 2 . Y = X1 β 1 + X2 β 2 + ε.). respectively. i A model selection procedure is a data-dependent rule which selects one of the two models. However. we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . this result can be reversed when the error is conditionally heteroskedastic. estimate of β 1 from the unconstrained model. we say that M2 is true if β 2 6= 0. We conclude that the inclusion of irrelevant variable reduces estimation eﬃciency if these variables are correlated with the relevant variables. It is important that the model selection question be well-posed. etc.. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 . σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 . In contrast.. x Then under (6. To be concrete. In the absence of the homoskedasticity assumption. that it selects the true model with probability one if the sample is suﬃciently large.˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . .7). X2 ) = 0. models 1 and 2 are estimated by OLS. we see that β 1 has a lower asymptotic variance.. Let Exi = µ. We c can write this as M. One useful property is consistency. X2 ) = 0 Note that M1 ⊂ M2 . E (ε | X1 . there is no clear ranking of the eﬃciency of the ˜ restricted estimator β 1 versus the unrestricted estimator. x2i = σ 2 . xKi = xK )?” is well posed. ˆ For example. To simplify some of ¢ statistical discussion. For example. How does a researcher go about selecting an econometric speciﬁcation. There are many possible desirable properties for a model selection procedure. as the larger problem can be written as a sequence of such comparisons. the question.

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

. β 3 = · · · = β K = 0 . β K 6= 0. β 2 6= 0. a model consists of any possible subset of the regressors {x1i . We have discussed model selection between two models.. and then selects the model with the lowest AIC (7. .so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. xKi }. stores the residual variance σ 2 for each model. 576.15). log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0.. . In the latter case. 88 . and the AIC or BIC in principle can be implemented by estimating all possible subset models. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. The AIC selection criteria estimates the K models by OLS. Similarly for ˆ the BIC. However. . The methods extend readily to the issue of selection among multiple regressors. There are two leading cases: ordered regressors and unordered. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . the models are M1 : β 1 6= 0. which are nested. one can show that thus LRn →p ∞. selecting based on (7. . which can be a very large number. MK : β 1 6= 0. . 048. For example. β 2 6= 0. 210 = 1024. In the unordered case. and 220 = 1. . .17). which regressors enter the regression). Also under M2 . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. there are 2K such models. In the ordered case.

Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. and the out-of-sample value of the regressors. . ˆ ˆ n−k 6. ˜ the residual vector is e = Y − X β. Let θ satisfy Eg(Yi − θ) = 0. the estimates (β. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . else equals zero). Let σ 2 be the estimate of σ 2 . where M1 = I − X X 0 Ω−1 X ˆ ¡ 0 −1 ¢−1 0 −1 0 (c) Prove that M1 Ω−1 M1 = Ω−1 − Ω−1 X X Ω X XΩ . X). In a linear model Y = Xβ + e.10 Exercises 1. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . V ar(e | X) = σ 2 Ω with Ω known.7. based on a sample of size n.. 4. For any predictor g(xi ) for y. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . (b) Prove that e = M1 e.. 5. . i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . Let (yi . 2. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. ˆ (a) Find a point forecast of y. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. Show that the function g(x) which minimizes the MAE is the conditional median M (x).. the mean absolute error (MAE) is E |yi − g(xi )| . the residuals e. V . x. Verify equation (7.12). wn ) and wi = x−2 . Is θ a quantile of the distribution of Yi ? 3. where xji is one of the xi . E(e | X) = 0. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. σ 2 ). (b) Find an estimate of the variance of this forecast. xi ) be a random sample with E(Y | X) = Xβ. Thus the available information is the sample (Y.

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

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

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

. To see the eﬀect of sample size on the EDF. and 100. by the CLT (Theorem 5. x) − F (y. Thus by the WLLN (Theorem 5. 1) distribution.2) Fn (y. x)) →d N (0.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . as the sample size gets larger.. 50.. The EDF is a consistent estimator of the CDF. where 1(·) is the indicator function.2 The Empirical Distribution Function Fn (y. the EDF is only a crude approximation to the CDF. x).1). Fn is by construction a step function. ∗ P (yi ≤ y. The random draws are from the N (0. xi ). Notationally. the EDF step function gets uniformly close to the true CDF. To see this. Fn (y. x) = P (yi ≤ y. x∗ ) with the i distribution Fn . This is a population moment. Fn is a nonparametric estimate of F. Note that while F may be either discrete or continuous. F (y. I have plotted the EDF and true CDF for three random samples of size n = 25. √ n (Fn (y. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. in the Figure below. For n = 25. it is helpful to think of a random pair (yi . x). (8. x) . That is. i 93 .3. x) is called the empirical distribution function (EDF). x) = n i=1 Figure 8. Recall that F (y. x))) . In general. x).2. i = 1. x) →p F (y.1). Furthermore.8. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) .. but the approximation appears to improve for the large n. x) (1 − F (y. note that for any (y. x∗ ≤ x) = Fn (y. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . n.

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

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

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

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

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

where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . however. 99 .4) says that Gn converges to Φ x as n → ∞. θ θ θ ˆ θ ∗ ∗ Computationally. where qn (α) is the (1 − α)% quantile of the distribution of Wn . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. and a function h(x) is odd if h(−x) = −h(x).8 Asymptotic Expansions Tn →d N (0.8. Equivalently. Thus here Tn (θ) = Wn (θ). lim Gn (x. Deﬁnition 8. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic. A better asymptotic approximation may be obtained through an asymptotic expansion. The ideal test rejects if Wn ≥ qn (α). θ [This is a typical mistake made by practitioners. and vice-versa. F ) = Φ + o (1) . Basically. or the size of the divergence for any particular sample size n. We say that a function g(x) is even if g(−x) = g(x). The following notation will be helpful.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.2 an = O(1) if |an | is uniformly bounded.8.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. F ) = Φ n→∞ v or ³x´ Gn (x. F ) then ³x´ . about the rate v of convergence. Let Tn be a statistic such that (8. C4 is called the symmetric percentile-t interval. Deﬁnition 8.] 8.8. an = O(n−r ) if it declines to zero like n−r . 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. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). (8. not ˆ − θ0 . If θ is a vector.3 an = o(n−r ) if nr |an | → 0 as n → ∞. v 2 ). The derivative of an even function is odd.4) v ¡ ¢ While (8. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . Let an be a sequence. it says nothing. writing Tn ∼ Gn (x. the critical value qn (α) is found as the quantile from simulated values of W´ .

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

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

the choice between symmetric and equal-tailed conﬁdence intervals is unclear. 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. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. Two-sided tests have better rates of convergence than the one-sided tests. similar to a one-sided test. but one-sided tests might have more power against alternatives of interest. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. We know that θ Tn →d N (0. and g2 is continuous in F. is an even function. we ﬁnd Gn (x) = Gn (x. This is because the ﬁrst term in the asymptotic expansion.8.5) to the bootstrap distribution. This is in contrast to the use of the asymptotic distribution. Therefore. Theorem 8. G∗ (x) = Gn (x. set Tn = n ˆ − θ0 . meaning that the errors in the two directions exactly cancel out. and needs to be determined on a case-by-case basis. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. Applying (8. F ) = Φ v √ where v = V . as it depends on the unknown V. whose error is O(n−1 ). A reader might get confused between the two simultaneous eﬀects. which is not pivotal. Twosided tests will have more accurate size (Reported Type I error). 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 ) = ∗ 2 (g2 (x. and bootstrap tests have better rates of convergence than asymptotic tests.Interestingly. and for the bootstrap ³x´ + O(n−1/2 ). √ the last equality because Fn converges to F0 at rate n.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. g1 . F0 )) + O(n−3/2 ) n = O(n−3/2 ). The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. Fn ) + O(n−3/2 ). 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 ). the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). Gn (x. 8. Fn ) − g2 (x. Fn ) = Φ(x) + ∗ 2 g2 (x. V ).

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

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

and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. ˆ = 1. and thus reject H0 if ˆ ˆ > q ∗ (. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.5% quantiles of the ˆ are . You want to test H0 : θ = 0 against H1 : θ > 0.3. (b) Report the 95% Alternative Percentile interval for θ.pdf. You do this as follows.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).dat contains data on house prices (sales). ∗ ∗ where s(ˆ is the standard error in the original data.2. You replace c with qn (.05) . ˆ − s(ˆ n (. Using the non-parametric ∗ bootstrap. you generate bootstrap samples. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). The ˆ are sorted.05) and qn (. and the colonial dummy.95).95) denote the 95% quantile of Tn . (a) Report the 95% Efron Percentile interval for θ. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.95).95) denote the 5% θ) ∗ and 95% quantiles of Tn . ∗ ∗ ∗ Let qn (. Using the non-parametric bootstrap.75 and 1. Suppose that in an application. What is wrong with this procedure? Tn = θ/s(θ) n 6. 105 . Let qn (. and ˆ is calculated on each θ ∗ ∗ θ sample. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. can you report the 95% Percentile-t interval for θ? 7. and the 2. lot size.95). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. The dataﬁle hprice1.2 and s(ˆ = . size of house. with variables listed in the ﬁle hprice1. (c) With the given information. Estimate a linear regression of price on the number of bedrooms.5% and 97. θ respectively.

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

Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . the square of the Euclidean length. β ˆ Note that if k = . i i . The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. For some × weight matrix Wn > 0. ˆ Deﬁnition 9.1 β GMM = argmin Jn (β). the dependence is only up to scale.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . let Jn (β) = n · g n (β)0 Wn g n (β).2) g n (β) = (9. β GMM does not change.2. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . but this is generally not possible when > k. β GMM = Z 0 XWn X 0 Z 9.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. Let and where gi = xi ei . Proposition 9. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. then g n (β) = 0. This is a non-negative measure of the “length” of the vector g n (β). if Wn = I. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .9. ¡ ¢−1 0 ˆ Z XWn X 0 Y. For example. for if Wn is replaced ˆ by cWn for some c > 0.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. The GMM estimator minimizes Jn (β). then. and the GMM estimator is the MME.2.

2 For the eﬃcient GMM estimator.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. This results shows that in the linear model. without imposing additional assumptions. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. ˆ n i=1 gi = gi − g n . as the distribution of the data is unknown. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . it is semiparametrically eﬃcient. No estimator can do better (in this ﬁrst-order asymptotic sense). 9. n β − β →d N 0. This turns out to be W0 = Ω−1 . we can set Wn = I . In the linear model. ˆ we still call β the eﬃcient GMM estimator. For example. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . V ) . where In general. and this is all that is known. as shown by Gary Chamberlain (1987). This is a weak concept of optimality. However. as it has the same asymptotic distribution. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. the GMM estimator β is consistent yet ineﬃcient. For any Wn →p W0 . β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . The optimal weight matrix W0 is one which minimizes V.3.3. this is a semi-parametric problem. ˆ∗ ˆ 108 . ˆ Construct n 1X ˆ g n = g n (β) = gi . it turns out that the GMM estimator is semiparametrically eﬃcient. Ω) . as we are only considering alternative weight matrices Wn . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . The proof is left as an exercise. W0 = Ω−1 is not known in practice. Chamberlain showed that in this context. n n We conclude: Theorem 9. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. but it can be estimated consistently. β).1 ´ √ ³ˆ n β − β →d N (0. a better choice is Wn = (X 0 X)−1 . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. 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.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0.

Then set gi = xi ei . 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. There is an important alternative to the two-step GMM estimator just described. 109 . First. The estimator appears to have some better properties than traditional GMM. Hansen. and GMM using Wn as the weight matrix is asymptotically eﬃcient. as in (9. Instead. and was introduced by L. when we say “GMM”. There is little point in using an ineﬃcient GMM estimator as it is easy to compute. ˆ and let g be the associated n × matrix. Since Egi = 0.4) above. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. i. A common alternative choice is to set Ã n !−1 1X 0 gi gi ˆˆ Wn = n i=1 1 X ∗ ∗0 gi gi ˆ ˆ n i=1 n !−1 = Ã 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). Egi 6= 0. J(β) = n · g n (β) n i=1 In most cases. This is a current area of research in econometrics.4) which uses the uncentered moment conditions. A simple solution is to use the centered moment conditions to construct the weight matrix. under the alternative hypothesis the moment conditions are violated. V = n Z 0 X g 0 g − ng n g 0 n where ˆ The β which minimizes this function is called the continuously-updated GMM estimator.e.5 GMM: The General Case In its most general form. 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 . 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. Here is a simple way to compute the eﬃcient GMM estimator. (9. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. we can let the weight matrix be considered as a function of β. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. but can be numerically tricky to obtain in some cases. Heaton and Yaron (1996). and construct the residual ei = yi − zi β. ∗ gi (β) = gi (β) − g n (β) 9. Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . set Wn = (X 0 X)−1 .and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. However. When constructing hypothesis tests. we actually mean “eﬃcient GMM”.

β) = 0 holds. Hansen (1982).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 .Often. 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. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . Thus the model — the overidentifying restrictions — are testable. The variance of β may be estimated by G0 Ω−1 G where P ∗ ∗0 P ∂ ˆ ˆ ˆ g g and G = n−1 ˆ ˆ Ω = n−1 0 gi (β).6. The general theory of GMM estimation and testing was exposited by L. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. and then β recomputed. G0 Ω−1 G . so that the linear equation may be written as yi = β 0 x1i + ei . and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Under the hypothesis of correct speciﬁcation. and is thus a natural test statistic for H0 : Egi = 0. n β − β →d N 0.1 (Sargan-Hansen). 1 2 It is possible that β 2 = 0. For example. this is all that is known. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. 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 . take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. This estimator can be iterated if needed. Note that g n →p Egi . 110 . 1 it is possible that β 2 6= 0.5. However. Identiﬁcation requires l ≥ k = dim(β). and if the weight matrix is asymptotically eﬃcient. ˆ J = J(β) →d χ2−k . often the weight ˆ matrix Wn is updated. ˆˆ n is a quadratic form in g n .1 Under general regularity conditions. Since the GMM estimator depends upon the ﬁrst-stage estimator. Theorem 9. 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. perhaps obtained by ﬁrst ˆ setting Wn = I. 9.

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

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

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

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

h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). xi . Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . subject ˆ i ˆi i=1 to the restriction h(β) = 0. Vn = X X i=1 ˜ and hence R0 β = r. 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 .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. zi ). The observed data is (yi . Show how to construct an eﬃcient GMM estimator for β. Deﬁne the Lagrangian L(β. is deﬁned as Jn (β) = ˜ β = argmin Jn (β).6) (a) Show that you can rewrite Jn (β) in (9. zi is l × 1 and β is k × 1. The equation of interest is yi = g(xi . 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. h(β)=0 (9. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.6) equals the Wald statistic. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. The GMM estimator of β. β) + ei E (zi ei ) = 0. l ≥ k. 6.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 .5. VR ) where ¡ ¢−1 0 R V. 115 . the distance statistic D in (9. VR = V − V R R0 V R (d) Show that in this setting.

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

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

probabilities 1 ³ ´´ . the Lagrange multiplier λ(β) minimizes Rn (β. µ. Multiplying the ﬁrst equation by pi .2) subject to the restrictions (10. λ).5) This minimization problem is the dual of the constrained maximization problem.5). p (10. Ln (β) = Rn (β.where λ and µ are Lagrange multipliers. . The solution (when it exists) is well deﬁned since Rn (β.. λ) = −n ln (n) − n X i=1 For given β. we ﬁnd µ = n and 1 ¢. p1 . (10. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . λ. 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. 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 (10.4) (10. This yields the (proﬁle) empirical log-likelihood function for β. λ) is a convex function of λ... λ) : λ(β) = argmin Rn (β. but must be obtained numerically (see section 6. (see section 6. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .1) and (10. we also obtain the Lagrange multiplier λ = λ(β). λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β).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.7) 118 . λ ¡ ¢ ln 1 + λ0 gi (β) . pi gi (β) = 0. The solution cannot be obtained explicitly. or equivalently minimizes its negative ˆ (10. summing over i. pn .3). pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β.5) ˆ ˆ As a by-product of estimation. and using the second and third equations.

12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . 0 = Rn (β. λ) = − (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .9) and (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. λ) = − (10.8) and ¢ 0 0 For example. Thus the EL estimator is asymptotically eﬃcient.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.9) (10. (β.2. β) = −xi zi .13) Premultiplying by G0 Ω−1 and using (10. ˆ ˆ Proof. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. n (10.13) yields n n Expanding (10.10). i i Theorem 10. and n β − β 0 and nλ are asymptotically independent. G = −E (xi zi ). and Ω = E xi x0 e2 .1 Under regularity conditions. β λ ∂ ³ ´.10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . Gi (.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 . 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. in the linear model.10) ¡ Ω−1 N (0. i=1 i=1 i=1i Expanding (10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.

Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . 10. They are asymptotically ﬁrst-order equivalent.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. LRn = i=1 Theorem 10. Proof. The overidentiﬁcation test is a very useful by-product of EL estimation.16). Vλ ) Furthermore. it is an asymptotically eﬃcient estimator for β. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .7) is n ³ ´´ ³ X ˆ ˆ0 (10. (10. tests are based on the diﬀerence in the log likelihood functions. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. by a Taylor expansion. and (10. V ) ˆ Solving (10. Ω) GΩ G →d = N (0. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.15) (10. and it is advisable to report the statistic LRn whenever EL is the estimation method.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. First.3 Overidentifying Restrictions In a parametric likelihood context.15). 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.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. and have the same interpretation.14) for λ and using (10. β 0 ) = 0 then LRn →d χ2−k .3.17) 2 ln 1 + λ gi β . Since the EL estimator achieves this bound. 120 .1 If Eg(wi . The same statistic can be constructed for empirical likelihood.

The hypothesis of interest is h(β) = 0. h(β)=0 ˜ Fundamentally. This test statistic is a natural analog of the GMM distance statistic. LRn →d χ2 . 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).18) Let the maintained model be where g is × 1 and β is k × 1.18) and H0 : h(β) = 0.edu/~bhansen/progs/elike.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.17) is not appropriate. To test the hypothesis h(β) while maintaining (10. Theorem 10. 10.4 Testing Egi (β) = 0 (10. 10.prc 121 .18). The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). Vλ )0 Ω−1 N (0.wisc.4. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.Second. a The proof of this result is more challenging and is omitted. since ln(1 + x) ' x − x2 /2 for x small. so there is no fundamental change in the distribution theory for β relative to β.ssc. By “maintained” we mean that the overidentfying restrictions contained in (10. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .1 Under (10. the simple overidentifying restrictions test (10. 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. where h : Rk → Ra .

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

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

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

1).1) where zi is k × 1. Deﬁnition 11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. β →p β ∗ .so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ .1 The × 1 random vector xi is an instrumental variable for (11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. this can be written as Y = Zβ + e. In a typical set-up.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. some regressors in zi will be uncorrelated with ei (for example. We call (11. and x2i are the excluded exogenous variables. which does not equal either β 1 or β 2 . (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments.1.1) if E (xi ei ) = 0. This is called simultaneous equations bias. 11. So we have the partition µ ¶ z1i k1 (11. at least the intercept). That is x2i are variables which could be included in the equation for yi (in the sense 125 . z1i is an instrumental variable for (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. We call z1i exogenous and z2i endogenous. Thus we make the partition ¶ µ k1 z1i (11. so should be included in xi . and assume that E(zi ei ) 6= 0 so there is endogeneity. By the above deﬁnition. In matrix notation.1) the structural equation.

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

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

except when S21 = 0 (when Z is exogenous). The consequences of identiﬁcation failure for inference are quite severe.14) In general this is non-zero. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.13). l .14) approaches that in (11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. It is also close to zero when α = 0. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. 130 .Let PX = X (X 0 X)−1 X 0 . n and (11. 0).12) and this result. P = HΛH 0 0 0 where Λ = diag(Il . By the spectral decomposition of an idempotent matrix. 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 . Indeed as α → 1. 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. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .14) is the probability limit of β 2SLS − β 11. 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. the bias in the 2SLS estimator will be large. the expression in (11. 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 .

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

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

u is n × k. 2. will IV “ﬁt” better than OLS. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. Explain why this is true. That is. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. Find a simple expression for the IV estimator in this context. 133 . where xi and β are 1 × 1.8 Exercises yi = zi β + ei . 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.) 3. Take the linear model Y = Zβ + e. show that if rank(Γ) < k then β cannot be identiﬁed. Take the linear model yi = xi β + ei E (ei | xi ) = 0. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . in the sense that e ˜ ˜ least in large samples? 4. 1. 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) . In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. at ˆˆ If X is indeed endogeneous. 5. xi is l × 1. X is n × l. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. 6. and Γ is l × k. (Find an expression for xi . ˜ 0 e < e0 e. Z is n × k. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. l ≥ k.11.

(a) Estimate the model by OLS. in years. Does this diﬀer from 2SLS and/or OLS? 7. Report the estimates and standard errors. using the instrument near4. listed in card. 134 . using zi as an instrument for xi . (d) Re-estimate the model by eﬃcient GMM.(b) Deﬁne the 2SLS estimator of β. of the father) and motheduc (the education.pdf. a dummy indicating that the observation lives near a 4-year college. Report estimates and standard errors. of the mother). The data ﬁle card. 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. (f) Discuss your ﬁndings. (b) Now treat Education as endogenous. Report estimates and standard errors. and the remaining variables as exogenous. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. (e) Calculate and report the J statistic for overidentiﬁcation. in years. In this model. and South and Black are regional and racial dummy variables. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. (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). are the parameters identiﬁed? 8. 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). f atheduc (the education. Estimate the model by 2SLS. and then calculate the GMM estimator from this weight matrix without further iteration. There are 2215 observations with 19 variables. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market.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)..

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

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

12. . Deﬁnition 12..3 Stationarity of AR(1) Process Yt = ρYt−1 + et .. Yt−k ) . it is even more important in the time-series context. 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 . this series converges if the sequence ρk et−k gets small as k → ∞.. .} is the past history of the series.2.. The last property deﬁnes a special time-series process..} are jointly random. as it is diﬃcult to derive distribution theories without this property. Y1 . In fact. YT . We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. 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.. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 .. For example. t By back-substitution. Yt−2 . E(et ) = 0 and Ee2 = σ 2 < ∞. or consumption growth rates. . ∞ X = ρk et−k .. 137 ... A mean-zero AR(1) is Assume that et is iid. some versions of the life-cycle hypothesis imply that either changes in consumption.. Letting et = Yt − E (Yt | It−1 ) . An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . Y2 .. Regression errors are naturally a MDS. the series {. Thus for k > 0.. k=0 Loosely speaking. ... E(Yt−k et ) = 0.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. This occurs when |ρ| < 1. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS.12. Some time-series processes may be a MDS as a consequence of optimizing behavior. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + .2 Autoregressions In time-series. should be a MDS.

1 If |ρ| < 1 then Yt is strictly stationary and ergodic. The AR(k) model is Using the lag operator. since ρ(z) = 0 when z = 1/ρ. 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 . 12. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . Deﬁning L2 = LL.3. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . We say that the root of the polynomial is 1/ρ.1. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. From Theorem 12. Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value).4. the above results are unchanged.1 The lag operator L satisﬁes LYt = Yt−1 . 138 . In general. an AR(1) is stationary iﬀ |ρ| < 1. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . We call ρ(L) the autoregressive polynomial of Yt . Deﬁnition 12.3. ∞ X k=0 ρ2k V ar (et−k ) = 12. we see that L2 Yt = LYt−1 = Yt−2 .Theorem 12.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. We call ρ(L) the autoregressive polynomial of Yt .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Lk Yt = Yt−k .

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

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

3) replacing St with St . however. This procedure is sometimes called Detrending. That is. and the way that the data are partitioned into blocks. . and for modelmisspeciﬁcation. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. This allows for arbitrary stationary serial correlation.3) sequentially by OLS. (12. The series ∆s Yt is clearly free of seasonality.. and perhaps this was of relevance. Seasonal Eﬀects There are three popular methods to deal with seasonal data. ﬁrst estimate (12. 141 . • You can estimate (12. The seasonal adjustment.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . draw T /m blocks. For each simulated sample. also alters the time-series correlations of the data. or the season-to-season change. This presumes that “seasonality” does not change over the sample. If s is the number of seasons (typically s = 4 or s = 12). But the long-run trend is also eliminated. 12. • You can estimate (12. ρk ). and then perform regression (12. Thus the seasonally adjusted data is a “ﬁltered” series. Resample complete blocks.2)-(12. • Use “seasonally adjusted” data. The results may be sensitive to the block length. May not work well in small samples.2) (12. Paste the blocks together to create the bootstrap time-series Yt∗ . ∆s Yt = Yt − Yt−s . The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. • Include dummy variables for each season..9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . (12. get the ˆ ˆ residual St . This is a ﬂexible approach which can extract a wide range of seasonal factors.2.2). 3. 4.4) by OLS.. • First apply a seasonal diﬀerencing operator. heteroskedasticity.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . 5. 6.

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

Under H0 . and test statistics are asymptotically non-normal. Since α0 is the parameter of a linear regression. As we discussed before. Hence.12. (12.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . Yt is non-stationary.7). Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . We do not have the time to develop this theory in detail. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . under H0 .7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). or I(d). Indeed. To see this. this is the most popular unit root test. 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 . An alternative asymptotic framework has been developed to deal with non-stationary data. we say that if Yt is non-stationary but ∆d Yt is stationary. Because of this property. observe that the lag polynomial for the Yt computed from (12. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et .7) These models are equivalent linear transformations of one another. However. Thus if Yt has a (single) unit root. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. Yt has a unit root when ρ(1) = 0. so conventional normal asymptotics are invalid. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. but simply assert the main results. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. then Yt is “integrated of order d”. So the natural alternative is H1 : α0 < 0. 143 . the natural test statistic is the t-statistic for H0 from OLS estimation of (12. then ∆Yt is a stationary AR process. since ρ(1) = −α0 . and is called the Augmented Dickey-Fuller (ADF) test for a unit root. Yt is non-stationary. or ρ1 + ρ2 + · · · + ρk = 1. The ergodic theorem and MDS CLT do not apply. as the models are equivalent. Thus a time series with unit root is I(1). Note that the model is stationary if α0 < 0. In this case.

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

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

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

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

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

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

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

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

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

i i i=1 ˆ The MLE is the value β which maximizes ln (β). 2. 0 if yi (This is written for the case of the threshold being zero. An example of a data collection censoring is top-coding of income. The censoring process may be explicit in data collection. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.. the consumption level (purchases) in a particular period was zero..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. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. .2 Count Data exp (−λi ) λk i . 1. This model speciﬁes that P (Yi = k | xi ) = λi k = 0.. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . . 1. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods.. In surveys.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β).1) yi = ∗ <0 . A generalization is the negative binomial. 2. Thus the model is that there is some latent process yi with unbounded support. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 .14. incomes above a threshold are typically reported at the threshold. Tobin observed that for many households.}. 14.1). a typical approach is to employ Poisson regression. k! = exp(x0 β).) The observed data yi therefore come from a mixed continuous/discrete distribution. This may be considered restrictive. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. The conditional density is the Poisson with parameter λi . He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. any known value can substitute. σ 2 ) with the observed variable yi generated by the censoring equation (14. or it may be a by-product of economic constraints. i If Y = {0. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. The functional form for λi has been picked to ensure that λi > 0.

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

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

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

. xit }. T . i = 1. where the i subscript denotes the individual. The motivation is to allow ui to be arbitrary.. that ui and eit are independent. Condition (15.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . and have arbitrary correlated with xi . (15. In either event. . It is a strong assumption... then OLS is inconsistent.. t = ti . An observation is the pair {yit . xit } : t = 1.. This is often believed to be plausible if ui is an omitted variable. There are several derivations of the estimator. . and the t subscript denotes time. 157 ... OLS appears a poor estimation choice. ti .1) is true. . however. . If (15. and thus achieve invariance.. and most applied researchers try to avoid its use..1) If this condition fails. It is consistent if E (xit ui ) = 0 (15. it The typical maintained assumptions are that the individuals i are mutually independent.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 . n. collected over time. A panel may be balanced : {yit .. that eit is iid across individuals and time.1) is called the random eﬀects hypothesis. 15.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. OLS can be improved upon via a GLS technique. and that eit is uncorrelated with xit . xit } : For i = 1. 15.Chapter 15 Panel Data A panel is a set of observations on individuals. The goal is to eliminate ui from the estimator.. OLS of yit on xit is called pooled estimation. n. or unbalanced : {yit .

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

4) will be inconsistent. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ .Since the regression of yit on di is a regression onto individual-speciﬁc dummies. k ≥ 2.4) . A more sophisticated GMM estimator recognizes that for time-periods later in the sample. there are more instruments available. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. 15. This is conveniently organized by the GMM principle. A simple application of GMM yields the parameter estimates and standard errors. i ∗ yit = x∗0 β + e∗ . Alternatively. it However. so the instrument list should be diﬀerent for each equation. 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. Typically. if eit is iid. the dependent variable and regressors in deviationit from-mean form. e So OLS on (15. Taking ﬁrst-diﬀerences of (15. 159 (15. as yt−2 is uncorrelated with ∆eit . and the residual is the demean value ∗ yit = yit − yi . The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. the predicted value from these regressions is the individual speciﬁc mean y i .3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. But if there are valid instruments. Thus values of yit−k . but loses a time-series observation). Unfortunately. it it which is free of the individual-eﬀect ui . 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. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit .3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . at least if T is held ﬁnite as n → ∞. two periods back. 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 . we use lags of the dependent variable.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). are valid instruments. it (15. the ﬁxed eﬀects estimator is inconsistent. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . then IV or GMM can be used to estimate the equation. we ﬁnd y i = x0 β + ui + ei .

. n i=1 n 160 . . |x| ≤ 1 0 |x| > 1 In practice.. we can simply focus on the problem where x is a speciﬁc ﬁxed number. the choice between these three rarely makes a meaningful diﬀerence in the estimates. While we are typically interested in estimating the entire function f (x). Let 1 ³u´ . Deﬁnition 1 K(u) is a second-order kernel function if it is a symmetric zero-mean density function. The kernel functions are used to smooth the data.. and then see how the method generalizes to estimating the entire function. The ˆ ˆ EDF F i=1 dx standard nonparametric method to estimate f (x) is based on smoothing using a kernel. Xn } While F (x) can be estimated by the f ˆ (x) = n−1 n 1 (Xi ≤ x) .Chapter 16 Nonparametrics 16. we cannot deﬁne d F (x) since F (x) is a step function. Three common choices for kernels include the Gaussian µ 2¶ x 1 K(x) = √ exp − 2 2π the Epanechnikov K(x) = and the Biweight or Quartic K(x) = 15 16 3 4 ¡ ¢ 1 − x2 . The amount of smoothing is controlled by the bandwidth h > 0.1 Kernel Density Estimation d Let X be a random variable with continuous distribution F (x) and density f (x) = dx F (x). Kh (u) = K h h be the kernel K rescaled by the bandwidth h. The kernel density estimator of f (x) is 1X ˆ f (x) = Kh (Xi − x) . |x| ≤ 1 0 |x| > 1 ¡ ¢2 1 − x2 . The goal is to estimateP(x) from a random sample (X1 .

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

Intuitively. nh (x)2 dx is called the roughness of K. and is larger the greater the curvature in f (x). so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. so is estimating a smoothed version of f (x). Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . ˆ We now examine the variance of f (x). Bias(x) = E f (x) − f (x) = K n 2 i=1 n ˆ We see that the bias of f (x) at x depends on the second derivative f 00 (x). which is valid as h → 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) . The bias results from this smoothing. The last expression shows that the expected value is an average of f (z) locally about x. 162 . the estimator f (x) smooths data local to Xi = x. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . Since it is an average of iid random variables. This integral (typically) is not analytically solvable.16.2 Asymptotic MSE for Kernel Estimates ∞ For ﬁxed x and bandwidth h observe that Z ∞ Z Kh (z − x) f (z)dz = EKh (X − x) = −∞ Kh (uh) f (x + hu)hdu = −∞ Z ∞ K (u) f (x + hu)du −∞ The second equality uses the change-of variables u = (z − x)/h. The sharper the derivative. ˆ the greater the bias.

(16. We thus say that the optimal bandwidth is of order O(n−1/5 ).1) is an asymptotic approximation to the MSE. The asymptotically optimal choice given in (16. but at a slower rate than n−1 . 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 + . Thus for the AMISE to decline with n. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. 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. how should the bandwidth be selected? This is a diﬃcult problem. we ﬁnd the reference rules for the three kernel functions introduced earlier.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. but at a very slow rate. R∞ R∞ K σ 2 = −∞ x2 K (x) dx R(K) = −∞ K (x)2 dx K √ Gaussian 1 1/(2 π) Epanechnikov 1/5 1/5 Biweight 1/7 5/7 An obvious diﬃculty is that R(f 00 ) is unknown. Together with the above table. h0 = argmin AM ISEh h It can be found by solving the ﬁrst order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 . We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. That is. where φ is the N (0. That is. Equation (16. Their K values for the three functions introduced in the previous section are given here. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). 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) . We can calculate that √ R(φ00 ) = 3/ (8 π) . Gaussian Kernel: hrule = 1. This choice for h gives an optimal rule when f (x) is ˆ normal.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. and there is a large and continuing literature on the subject. (16. we need h → 0 but nh → ∞.2) depends on R(K). h must tend to zero.2) but replaces R(f 00 ) with σ −5 R(φ00 ).Together.06n−1/5 163 . The downside is that if the density is very far from normal. σ 2 . ˆ It uses formula (16. Note that this h declines to zero. and gives a nearly optimal rule when f (x) is close to normal. the rule-of-thumb h can be quite ineﬃcient. In practice. and R(f 00 ).

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

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

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

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

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

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

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

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

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

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

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

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

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

Proof of Theorem A. we see that the MGF of Z 2 is (1 − 2t)−1/2 . tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.8.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.11). Using the simple law of iterated expectations. which can be found by applying change-of-variables to the gamma function.3 Let Z ∼ N (0.Theorem A.8. C −1 CC 0 C −10 ) = N (0.1.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. 1) and Q ∼ χ2 be independent. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. 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) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.12) E exp (tQ) = 0 Γ (A. which we showed in (A.8. Thus the density of Z 2 is (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. C −1 AC −10 ) = N (0. The MGF for the density (A.8.13) is the MGF of the density (A. (A. 1). For Z ∼ N(0.11) 2 with r = 1.3. Set r Z . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . The fact that A > 0 means that we can write A = CC 0 where C is non-singular. q Proof of Theorem A. Iq ).2. tr has distribution 177 .13). From (A.

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

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

the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. since the information matrix equality (A. ˆ elements of n 0 Sometimes a parametric density function f (y.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) is used to approximate the true unknown density f (y). ˆ .14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi . Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . Thus in large samples the MLE has approximately the best possible variance. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. θ) is necessarily the true density.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. θ) ¶ dy Thus in large samples. but has a diﬀerent covariance matrix than in the pure MLE case. Therefore the MLE is called asymptotically eﬃcient. θ). ˆ ln f Yi . 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 . V ) . Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . A minor adjustment to Theorem (A. θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y.17) does not hold. The QMLE is consistent for the pseudo-true value. Typically.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0. θ (A. θ) = f (y) ln f (y. but it is not literally believed that the model f (y. In this case there is not a “true” value of the parameter θ.9.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . 180 . θ) θ In this case. Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance.

Proof of Theorem A. θ0 )0 . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ0 ) ∂ ∂θ f ∂ (Yi . θ0 ) d˜ = E ˜ . θ) f (y.. ∂2 ln f (Yi . we can show that E By direction computation. θ0 )2 (Yi . ¯ ¯ ∂ E ln f (Yi .17). function of the data. yn ).16). θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A.. V ar (S) nH so ¥ 181 . f (Yi . θ0 )0 f (Yi .2.1.Proof of Theorem A. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ) f (˜. (Yi . . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ.9. θ) d˜ = ˜ y ) ∂ ln f (˜. To see (A.9. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ) dy ¯ ∂θ f (y. ∂θ ¯θ=θ0 Z ! = 0. θ0 ) − f (Yi .1) has mean zero and variance nH. θ0 = ln f (Yi . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ0 ) f (Yi . θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 ) ln f (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 ) ∂ ∂ − ln f (Yi .. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 ) (Yi . θ0 ) ∂θ f (Yi .9. θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. Since θ Z ˜ = ˜ y)f (˜. θ0 ) ¯ ∂ f (y.

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

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

numerical derivatives can work well but can be computationally costly relative to analytic derivatives. Another productive modiﬁcation is to add a scalar steplength λi . they can be calculated numerically. numerical derivatives can be quite unstable. Q(θ + δ j ε + δ k ε) − Q(θ + δ k ε) − Q(θ + δ j ε) + Q(θ) ε2 In many cases. . Then for ε small gj (θ) ' Similarly. Allowing the steplength to be a free parameter allows for a line search. Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation. ε where gi = g(θi ) and Di = H(θi )−1 for Newton’s method and Di = (H(θi ) + αi Im )−1 for quadratic hill-climbing. By a Taylor’s expansion for θ close to ˆ θ ³ ´ 0 = g(ˆ ' g(θ) + H(θ) ˆ − θ θ) θ gjk (θ) ' which implies ˆ = θ − H(θ)−1 g(θ). of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). Take the j 0 th element of g(θ). In some cases. 2. however. To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 .. a one-dimensional optimization. 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.B.2 Gradient Methods Gradient Methods are iterative methods which produce a sequence θi : i = 1..2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(θ) . θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ). which are designed to converge to ˆ All require the choice of a starting value θ1 . ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available. θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive deﬁnite. One modiﬁcation to prevent this possibility is quadratic hill-climbing which sets ˆi+1 = θi − (H(θi ) + αi Im )−1 g(θi ). and all require the computation θ. Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row). In this case the iteration rule takes the form (B.

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

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