ECONOMETRICS

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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. . . .2 Reduced Form . . . . . . . . 9. . . . . . . . . . . . . .1 Non-Parametric Likelihood . . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . .10 8. . . . 9. . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . .8 Conditional Moment Restrictions . .6 Estimation . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . .7 Identification Failure . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . . . . . . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . iii . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identification Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . Percentile Confidence Intervals . . . . . . . . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . 11. . . . . . . 12. . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 8. . . . . . . . . . . . . . 9. . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . .10 Exercises . . . 12. . . . . . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . 11. . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . .4 Testing . . . . . . 11. . . . . . . 12. . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . .4 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . .12 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . .9 Bootstrap GMM Inference . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . .1 Overidentified Linear Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . 12. 12. . . . . . . . . . . . . . . . .3 Identification . . . .4 Estimation of the Efficient Weight Matrix . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Binary Choice . .3 Derivative-Free Methods . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Grid Search . . . .1 Individual-Effects Model . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . .3 Expectation . . 13. . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv . . . . . . . . . . . . . . . . . . . . . . . .13 Multivariate Time Series 13.6 Conditional Distributions and Expectation . . . . . . . B. . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Single Equation from a VAR . . . . . . . . . . . . .2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . A. A. . . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . 160 16. . . .4 Sample Selection . . . . . . . . .2 Random Variables .7 Granger Causality . . . . . A. . . . . . . . . . .7 Transformations . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . 162 A Probability A. . . . . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . 13. . . . . . . .8 Cointegration . .9 Cointegrated VARs . .3 Censored Data . .9 Maximum Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Foundations . . . .1 Kernel Density Estimation . . . . . . . . . . . . . . . . . . . . . .2 Gradient Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Common Distributions . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . .3 Restricted VARs . . . . . . . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . 157 15. . 14. . . . . . . . . . . . . . . . . . . . . . . . . . .2 Fixed Effects . . . . . . 14. . . . . . . B Numerical Optimization B. . . . . A.5 Multivariate Random Variables . . . . . . . 13. . . . . . . B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

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

λ−1 . A−1 > 0. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 .. If A = G0 G. (For any c 6= 0. We now state some useful properties. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. 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. has full rank k if there is no non-zero c such that Xc = 0. We say that A is positive definite if for all non-zero c. If λi is an eigenvalue of A. • If A has distinct characteristic roots. then A is non-singular and A−1 exists. then A > 0 if and only if all its characteristic roots are positive. In this case.) If A is positive definite. then A is positive semi-definite. i = 1. • If A is symmetric. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix.. c0 Ac ≥ 0. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. k < n.. . We say that a square matrix A is positive semi-definite if for all non-zero c. X 0 X is symmetric and positive definite.. If A is symmetric. They are called the latent roots or characteristic roots or eigenvalues of A. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal. This is written as A > 0.2. which are not necessarily distinct and may be real or complex.. 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. We call B a matrix square root of A. To see this. Furthermore. λ−1 . and the characteristic roots are all real. Let λi and hi . note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. and let H = [h1 · · · hk ].. then A − λi Ik is singular so there exists a non-zero vector hi such that (A − λi Ik ) hi = 0 The vector hi is called a latent vector or characteristic vector or eigenvector of A corresponding to λi . If A > 0 we can find a matrix B such that A = BB 0 . The matrix B need not be unique. • The characteristic roots of A−1 are λ−1 . c0 Ac = α0 a ≥ 0 where α = Gc. then A = HΛH 0 and H 0 AH = Λ. c0 Ac > 0. A square matrix A is idempotent if AA = A.6 Rank and Positive Definiteness The rank of a square matrix is the number of its non-zero characteristic roots. 8 . We say that X is n × k. This is written as A ≥ 0. and then set B = HΛ1/2 . 2. k denote the k eigenvalues and eigenvectors of a square matrix A.5 Eigenvalues det (A − λIk ) = 0. . there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ.

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

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

⎠ ⎝ . ⎟ . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. While it is easy to observe that the two densities are unequal. These are asymmetric (skewed) densities.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. and that for women is $20.1. which is a common feature of wage distributions. In the example presented in Figure 3. The two density curves show the effect of gender on the distribution of wages. or the covariates. .2) m(x) = E (yi | xi = x) = −∞ In general. the conditioning variable. (3. When a distribution is skewed. the mean wage for men is $27. we can focus on f (y | x) . We call yi the dependent variable. Figure 3. See Chapter 16.1 displays the density1 of hourly wages for men and women. This is used when the goal is to quantify the impact of one set of variables on another variable. and exists so long as E |yi | < ∞. the conditional density of yi given xi . These are conditional density functions — the density of hourly wages conditional on race. xi ) where yi is a scalar (real-valued) and xi is a vector.73. it is useful to have numerical measures of the difference. gender.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. holding the other variables constant. We call xi alternatively the regressor. Take a closer look at the density functions displayed in Figure 3. education and experience. An important summary measure is the conditional mean Z ∞ yf (y | x) dy.22. These are indicated in Figure 3.1. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1 by the arrows drawn to the x-axis. The data are from the 2004 Current Population Survey 1 11 .1) xi = ⎜ . xki 3. In this context we partition the observations into the pair (yi . To illustrate. You can see that the right tail of then density is much thicker than the left tail. the mean is not necessarily a good summary of the central tendency. m(x) can take any form. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation.

D.5. The comparison in Figure 3. Figure 3. degree in mean log hourly wages is 0.3 is how the conditional expectation describes an important feature of the conditional distribution. and a Ph. the dashed line is a linear projection approximation which will be discussed in the Section 3. Figure 3.2 shows the density of log hourly wages for the same population. By construction.A. The difference in the log mean wage between men and women is 0. wage regressions typically use log wages as a dependent variable rather than the level of wages.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.3) White non-military male wage earners with 10-15 years of potential work experience.3 displays a scatter plot2 of log wages against education levels.36. 3. Assuming for simplicity that this is the true joint distribution. The conditional expectation function is close to linear. To illustrate. 12 . 2 (3. which implies a 30% average wage difference for this population. The main point to be learned from Figure 3. with mean log hourly wages drawn in with the arrows. Of particular interest to graduate students may be the observation that difference between a B. then comparisons become more complicated. implying an average 36% difference in wage levels.2 Regression Equation The regression error ei is defined to be the difference between yi and its conditional mean (3. For this reason.1 is facilitated by the fact that the control variable (gender) is discrete.2) evaluated at the observed value of xi : ei = yi − m(xi ).Figure 3. the solid line displays the conditional expectation of log wages varying with education.30. this yields the formula yi = m(xi ) + ei . This is a more robust measure of the typical wage gap between men and women than the difference in the untransformed wage means. When the distribution of the control variable is continuous.

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

it does not provide information about the spread of the distribution. subject to the restriction p that it is non-negative. σ 2 (x) is a non-trivial function of x.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. 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 3.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . The conditional standard deviation is its square root σ(x) = σ 2 (x).2. let g(x) be an arbitrary predictor of yi given xi = x. i . Given the random variable xi . In contrast. Thus the mean squared error is minimized by the conditional mean. To see this. the conditional variance of yi is σ 2 = σ 2 (xi ).Figure 3.3. in the sense of achieving the lowest mean squared error. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . The right-hand-side is minimized by setting g(x) = m(x). 3. when σ 2 (x) is a constant so that ¢ ¡ (3.1. and can take any form.3 Conditional Variance Generally. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic.

3.6) (3. ⎠ .1). ⎝ . βk ⎛ (3. where x1i is the first element of the vector xi defined in (3.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . The conditional standard deviation for men is 12. it is convenient to augment the regressor vector xi by listing the number “1” as an element. So while men have higher average wages. ⎟ β=⎝ . they are also somewhat more dispersed.6) as an approximation. 15 . Thus (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . xki When m(x) is linear in x. i (3. it is more realistic to view the linear specification (3.4 Linear Regression An important special case of (3. we assume that x1i = 1.7) is a k × 1 parameter vector.1) has been redefined as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. and the linear assumption of the previous section is empirically unlikely to accurate.5. In this case (3. which we derive in this section. Equation (3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). This concept is less helpful than defining heteroskedasticity as the dependence of the conditional variance on the observables xi . Notationally.5) xi = ⎜ .9) 3. Equivalently.8) is called the linear regression model. ⎟ . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. ⎠ . Instead.8) (3. take the conditional wage densities displayed in Figure 3.1 and that for women is 10.1. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . We call this the “constant” or “intercept”. its functional form is typically unknown.we say that the error ei is homoskedastic. As an example.

5.1. E (xi x0 ) is invertible. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. this situation must be excluded. In order for β to be uniquely defined. 2 2. i (3.10). Given the definition of β in (3. x0 β is the best linear predictor for yi . α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-definite. Therefore.10) It is worth taking the time to understand the notation involved in this expression. This occurs when redundant variables are included in xi . there cannot i exist a non-zero vector α such that α0 xi = 0 identically. 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 . by “best” we mean the predictor function with lowest mean squared error. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. 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. The first-order condition for minimization (from Section 2. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i 16 .12) This completes the derivation of the linear projection model. 3.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . Eyi < ∞. Observe i that for any non-zero α ∈ Rk . It is invertible if and only if it is positive definite. i (3. As before. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . Equivalently. xi contains an intercept. Rewriting. i i (3. E (x0 xi ) < ∞. Assumption 3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . The best linear predictor is obtained by selecting β to minimize S(β). i 4.5.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.7) is 0= Solving for β we find ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.1 1. written E (xi x0 ) > 0.which is quadratic in β. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. i which requires that for all non-zero α. The vector (3. otherwise they are distinct. The error is i ei = yi − x0 β.

1. Equation (3. This means that the equation (3.11) and (3. 17 .13) The two equations (3.5.1. For example.5.13) and Assumption 3.5.10) and (3. Let’s compare it with the linear regression model (3. Furthermore.12) can be alternatively interpreted as a projection decomposition. Since from Theorem 3. (3.3 ensure that the moments in (3.1 is employed to guarantee that (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Assumption 3. Assumption 3. The finite variance Assumptions 3. However.8)-(3. (3. Figure 3.1.1.1.5.4 we know that the regression error has the property E (xi ei ) = 0. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. E (xi ei ) = 0 and E (ei ) = 0.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.2 and 3. it follows that linear regression is a special case of the projection model. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.13) summarize the linear projection model. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. Assumption 3.13) implies that xi and ei are uncorrelated. the orthogonality restriction (3.14) Proof.1 are weak.14). Assumption 3.1.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.5.4 is required to ensure that β is uniquely defined.2.11) are well defined.5.5.5.1.1.4 guarantees that the solution β exits.14) holds. Using the definitions (3.Theorem 3.1.5. Since ei is mean zero by (3.5.14) follows from (3.1 Under Assumption 3. ¥ (3.10) are defined.1.9).1.12) and (3.2 and 3.5.3 are called regularity conditions. By definition.

We have shown that under mild regularity conditions. Figure 3. it is important to not misinterpret the generality of this statement. In other cases the two may be quite different. Other than the redefinition of the regressor vector. A projection of log wages on these two variables can be called a quadratic projection. since the resulting function is quadratic in experience. 18 .12) with the properties listed in Theorem 3. The linear equation (3. the dashed line is the linear projection of log wages on eduction. In this example the linear projection is a close approximation to the conditional mean.3. for any pair (yi .5. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. for those over 53 in age). and are discussed in Chapter 11. We illustrate the issue in Figure 3. and under-predicts for the rest.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.12) is defined by projection and the associated coefficient definition (3. In the example just presented. Returning to the joint distribution displayed in Figure 3. In this case the linear projection is a poor approximation to the conditional mean. in many economic models the parameter β may be defined within the model. It over-predicts wages for young and old workers. there are no changes in our methods or analysis.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. However. we can augment the regressor vector xi to include both experience and experience2 . and the straight dashed line is the linear projection. No additional assumptions are required.4 we display as well this quadratic projection. In contrast. In Figure 1. In this example it is a much better approximation to the conditional mean than the linear projection.10). Figure 3. This defect in linear projection can be partially corrected through a careful selection of regressors.5. These structural models require alternative estimation methods. xi ) we can define a linear projection equation (3. In this case (3.1 may be false. Most importantly. The solid line is the conditional mean.1.4 displays the relationship3 between mean log hourly wages and labor market experience.10) may not hold and the implications of Theorem 3.

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

xi ∈ R. True or False. σ 2 = V ar(xi ). (x − µ)2 − σ 2 Show that Eg (X. Define µ ¶ ¢ ¡ x−µ 2 g x.. Compute the conditional mean m(x) = E (yi | xi = x) . σ 2 = V ar(yi ) and σ xy = Cov(xi . i 8. 1. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. i 11. µ. If yi = xi β + ei . e−λ λj j! . a constant. Let xi and yi have the joint density f (x. and E(e2 | xi ) = σ 2 . 2. i 10. Are they different? Hint: If P (Y = j) = 5. ¡ ¢ 4. If yi = x0 β + ei and E(xi ei ) = 0. 2.2. µx = Exi . True or False. and E(ei | xi ) = 0. xi ∈ R. i 7. . True or False. Suppose that yi is discrete-valued. If yi = x0 β + ei and E(ei | xi ) = 0. 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).1 . True or False. 3 and 4 of Theorem 3. True or False. j! 0 j = 0. Let X be a random variable with µ = EX and σ 2 = V ar(X).4 . x 6.. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . and E(xi ei ) = 0. E(ei | xi ) = 0. s) = 0 if and only if m = µ and s = σ 2 . yi ). then ei is independent of xi .1. 9. then E(x2 ei ) = 0.6 Exercises 1. m. Compute E(yi | xi = x) and V ar(yi | xi = x). E(Y 2 | X = x) and V ar(Y | X = x). 20 . 0 ≤ y ≤ 1. then ei is i i independent of xi . Compute 2 the coefficients of the linear projection yi = β 0 + β 1 xi + ei . If yi = xi β + ei . then E(x2 ei ) = 0.2 Y =1 . and have the following joint probability distribution X=0 X=1 Y =0 . taking values only on the non-negative integers. then E(ei | xi ) = 0. Suppose that Y and X only take the values 0 and 1. Prove parts 2. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . 3.3. σ = . If yi = x0 β + ei . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ.

we narrow the focus to the linear regression model. (4. i It follows that the moment estimator of β replaces the population moments in (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. 4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .7 and 4.3) In Sections 4.8.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i à n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 à n !−1 n X X = xi x0 xi yi .1 Estimation Equation (4.2) (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. Observe that (4.1) (4.3) writes the projection coefficient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .2) can be written in the parametric 0 β)) = 0. but for most of the chapter we retain the broader focus on the projection model. i n i=1 n 21 .

3. 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 (4.7% increase in mean wages.95 42. 40 0. These are white male wage earners from the March 2004 Current Population Survey.30 + 0.2 Least Squares There is another classic motivation for the estimator (4.117 Educationi .37 µ ¶ 1. An interpretation of the estimated equation is that each year of education is associated with an 11. This sample has 988 observations.4).94 −2.71 = −2. consider the data used to generate Figure 3.14 205. 30 = .170 37.14 14. 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. To illustrate.117 1 14.ˆ This is a set of k equations which are linear in β. 40 2. 4. excluding military.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 14.4). Then µ ¶ n 1X 2. ¶ 2.40 µ ¶µ ¶ 34.14 205. Let yi be log wages and xi be an intercept and years of education. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. 0.83 ¶−1 µ ¶ .95 xi yi = 42.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. i 22 . Define the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β.

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

ˆ n−k 2 i=1 (4. ˆ n i=1 n Since xi contains a constant. one implication is that n 1X ei = 0.2: Sum-of-Squared Error Function Contours Equation (4. The error variance σ 2 = Ee2 is also a parameter of interest.5) implies that 1X xi ei = 0. ˆ σ = ˆ n 2 i=1 n (4.Figure 4. Its method of moments estimator is the sample average 1X 2 ei . and hold true for all linear regression estimates. It measures the variation in the i “unexplained” part of the regression. 24 . 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. These are algebraic results.6) An alternative estimator uses the formula n 1 X 2 s = ei .7.7) A justification for the latter choice will be provided in Section 4.

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

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

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

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. 4. . ⎠ ⎝ ⎠ ⎝ . the FWL theorem can be used to speed computation. In the model (4. Regress X2 on X1 . ¡ ¢−1 0 ι.13).1 (Frisch-Waugh-Lovell). ! Thus the OLS estimator for the slope coefficients is a regression with demeaned data. . 30 . obtain OLS estimates β 2 and residuals e.14) or via the ˆ following algorithm: ˜ 1. which you may have seen in an introductory econometrics course. By the independence of the observations and (3. or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . obtain residuals X2 .9). .9).7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. A common application of the FWL theorem. is the demeaning formula for regression. Regress Y on X2 . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. . . observe that ⎞ ⎛ ⎞ ⎛ . In this section we derive the small sample conditional mean and variance of the OLS estimator. ⎟ ⎜ ⎟ ⎜ (4. obtain residuals Y . . . ˆ ˜ ˜ ˆ 3. the primary use is theoretical. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ˆ which are “demeaned”.Theorem 4.6. but in most cases there is little computational advantage to using the two-step algorithm. . Regress Y on X1 .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. ˜ 2. Rather. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . . In some contexts.8)(3. and X2 is the vector of observed regressors. .

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

This is the justification for the common s ˆ preference of s2 over σ 2 in empirical practice. however. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . or in the projection model.7) is unbiased for σ 2 by this calculation. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. Thus since V ar (e | X) = In σ 2 under homoskedasticity. the best (minimumvariance) unbiased linear estimator is OLS.10). which we now present. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. is a famous statement of the solution. 4. Thus σ 2 is biased towards zero. as it yields the smallest variance among all unbiased linear estimators.8. ˜ so β is unbiased if (and only if) A0 X = Ik . ³ ´ ˜ E β | X = A0 Xβ. which is (3. In this case. Theorem 4. 32 .9) plus E e2 | xi = σ 2 .8)¢ ¡ (3. Now consider the class of estimators of β which are linear functions of i the vector Y. the estimator ˆ 2 defined (4. As an alternative. By a calculation similar to those of the previous section.1 Gauss-Markov. What is the best choice of A? The Gauss-Markov theorem. It is not unbiased in the absence of homoskedasticity. It is important to remember. The following result. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. known as the Gauss-Markov theorem. says that the least-squares estimator is the best choice.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . 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. = σ2 n the final equality by (4. In the homoskedastic linear regression model.

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

ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. if the data have a discrete distribution.4) is an asymptotically efficient estimator for the parameter β defined in (3. 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 . He observes that the above argument holds for all multinomial distributions. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.9).1. (4.5. and thus so is the OLS estimator. Chamberlain (1987) extends this argument to the case of continuously-distributed data.10 Omitted Variables xi = µ x1i x2i ¶ .22) 34 . He proves that generically the OLS estimator (4.Substituting in the expressions for π j .10) for the class of models satisfying Assumption 3. 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 . the maximum likelihood estimator is identical to the OLS estimator. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.

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

The hi take values in [0. 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.−i = yi − x0 β (−i) = (1 − hi )−1 ei .24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .25) below. We can also define the leave-one-out residual ˆ ˆ ei. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. it is statistically difficult to disentangle the impact of β 1 from that of β 2 .−i = (1 − hi )−1 hi ei . This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. the OLS estimator based on the sample excluding the i’th observation. 1] and sum to k. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. the precision of individual estimates are reduced.26) As we can see. ˆ i A simple comparison yields that ˆ ei − ei.12 Influential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. the worse the precision of the individual coefficient estimates. In extreme cases it is possible that the reported calculations will be in error due to floating-point calculation difficulties. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4.25) β (−i) = β − (1 − hi )−1 X 0 X where ¢−1 ¡ xi hi = x0 X 0 X i The i’th observation is influential on the least-squares estimate if the deletion of the observation ˆ from the sample results in a meaningful change in β. ˆ ˆ (4. define the leave-one-out least-squares estimator of β. since as ρ approaches 1 the matrix becomes singular. If the i’th observation 36 . What is happening is that when the regressors are highly dependent. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei .One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. the change in the coefficient estimate by deletion of the i’th observation depends critically on the magnitude of hi . A more relevant implication of near multicollinearity is that individual coefficient estimates will be imprecise. As a consequence. that is. To investigate the possibility of influential observations.27) (4. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. We derive expression (4.

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

4.13

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

41 .1 Inequalities Asymptotic theory is based on a set of approximations. Cauchy-Schwarz Inequality. ij i=1 j=1 (5.2) + 1 q = 1. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . The Euclidean norm of an m × 1 vector a is à m !1/2 X ¡ 0 ¢1/2 = a2 . then (5.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . If g(·) : R → R is convex. ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality. 5. Triangle inequality |X + Y | ≤ |X| + |Y | . These approximations are bounded through the use of mathematical inequalities. then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. |a| = a a i i=1 If A is a m × n matrix. then g(E(X)) ≤ E(g(X)).1) (5.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. Jensen’s Inequality. We list here some of the most critical definitions and inequalities.

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

3.6) and (5.1).3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . the triangle inequality. the fact that X n = W n + Z n . Fix δ and η.6) By Jensen’s inequality (5. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. 5. we can set E(X) = 0 (by recentering Xi on its expectation). Jensen’s inequality (5. where Z has distribution F (x) = P (Z ≤ x) . n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Theorem 5.1 Central Limit Theorem (CLT). as needed. (5. If Xi ∈ Rk is iid and E |Xi |2 < ∞. by Markov’s inequality (5.7) the final inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . 43 .4). if for all x at which F (x) is continuous. Fn (x) → F (x) as n → ∞. We say that Zn converges in distribution to Z as n → ∞. P ¯X n ¯ > δ ≤ η. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η.Proof: Without loss of generality. and the bound |Wi | ≤ 2C. Define the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . denoted Zn →d Z.1) and (5. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . P ¯X n ¯ > δ ≤ δ δ δ the equality by the definition of ε.7). V ) . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. Finally. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. the fact that the Wi are iid and mean zero. Set ε = δη/3.5).

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

gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).1 Continuous Mapping Theorem 1 (CMT). Ik ) distribution. Since cλλ (λn ) → cλλ (0) = −Ik . Theorem 5. ¥ 5. Stacking across elements of g. k ≤ m. Recall that A ⊂ B implies P (A) ≤ P (B). then g(Zn ) →p g(c) as n → ∞. √ Theorem 5. If Zn →d Z as n → ∞ and g (·) is continuous. This is sufficient to establish the theorem. we see that as n → ∞. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Hence g(Zn ) →p g(c) as n → ∞.4. where θ is m × 1 and Σ is m × m. for each element of g. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.3 Delta Method: If n (θn − θ0 ) →d N (0.4. Σ) . Proof : By a vector Taylor series expansion.4 Asymptotic Transformations Theorem 5. If Zn →p c as n → ∞ and g (·) is continuous at c. for all ε > 0 we can find a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε.4. we find jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Proof: Since g is continuous at c. gθ Σgθ . 45 .2 Continuous Mapping Theorem 2.√ where λn → 0 lies on the line segment joining 0 and λ/ n. then g(Zn ) →d g(Z) as n → ∞. 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 . Σ) = N 0. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. and g(θ) : Rm → Rk .

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

xi ei →p g (Q.1).2. 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 . Proof.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.1).1. To characterize the sampling distribution more fully. Ã n ! n X 1X 0 1 ˆ xi xi . Hence by the continuous mapping theorem (Theorem 5. First. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. 6.1).3). (6.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . This is illustrated in Figure 6.From the figure we can see that the density functions are dispersed and highly non-normal. (6.1) and ˆ We now deduce the consistency of β. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. Assumption 3.2 Consistency ˆ As discussed in Section 6. ·) is continuous at (Q. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. we can conclude ˆ that β →p β.1). ˆ Theorem 6. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . n i=1 (6. As the sample size increases the density becomes more concentrated about the population coefficient.5.4 implies that Q−1 exists and thus g(·.2) i i n i=1 n From (6. (6. and the continuous mapping theorem (Theorem 5. using (6.1.1.3) Ã where g(A.1 Under Assumption 3. we will use the methods of asymptotic approximation.2.2). Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to infinity.5. the OLS estimator β is has a statistical distribution which is unknown. ˆ 47 .4. 0).1 by the fact that the sampling densities become more concentrated as n gets larger. Assumption 3.4.5. Equation (4. β →p β as n → ∞.1 and the WLLN (Theorem 5. For a complete argument.

5.2.Theorem 6. (6.1 guarantees that the elements of Ω are finite. To see this. (6.1. since n/(n − k) → 1 as n → ∞. Thus σ 2 is consistent for σ 2 . ˆ n−k 6.1).2). E ¯ei ¯ E ¯e4 ¯ i i i i (6.3.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.1). n 1 X √ xi ei →d N (0. i Now define ¡ ¢ Ω = E xi x0 e2 .3. it follows that s2 = ¥ n σ 2 →p σ 2 .3) and Theorem (6. Ω) .5. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6.1.1 In addition to Assumption 3. i i Assumption 6.2 Under Assumption 3. Assumption 6. (6. ˆ Proof.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 à ! à 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. By the central limit theorem (Theorem 5.3. by the Cauchy-Schwarz inequality (5. Ee4 < ∞ and E |xi |4 < ∞. ˆ Finally. 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 .2.6) n i=1 48 . We need a strengthening of the moment conditions.2).

We say that ei is a Homoskedastic Projection Error when (6.9) In (6. Theorem 6.1 states that the sampling distribution of the least-squares estimator. for any ˆ fixed n the sampling distribution of β can be arbitrarily far from the normal distribution. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). for example. There is a special case where Ω and V simplify.3. The expression V = Q−1 ΩQ−1 is called a sandwich form. We illustrate this problem using a simulation. but this is not a necessary condition. Ω) ¡ ¢ = N 0. |ε| ≥ 1. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . Q−1 ΩQ−1 . its variance diverges q ³ ´ ˆ to infinity. otherwise V 6= V 0 . We call V 0 the homoskedastic covariance matrix. For α 49 .7) is true then V = V 0 . i i Condition (6.2 we display the finite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . setting n = 100 and varying the parameter α. however. ´ √ ³ ˆ n β−β = à 1X xi x0 i n i=1 n !−1 à Theorem 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. after rescaling. The trouble is that no matter how large is the sample size.3. xi ) which satisfy the conditions of Assumption 6. The approximation may be poor when n is small.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.1 Under Assumption 6. In´Figure 6.2).1). In Figure 6.3. As α approaches 2. Let yi = β 0 + β 1 xi + εi where xi is N (0.9) we define V 0 = Q−1 σ 2 whether (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . 1). the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. The asymptotic distribution ´ Theorem 6. (6. This holds true for all joint distibutions of (yi .7) holds.3. When (6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. and (6.3.7) is true or false. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.6).1. when xi and ei are independent. there is no simple answer to this reasonable question. 1) asymptotic distibution.1 is commonly used to approximate the finite of √ ³ˆ sample distribution of n β − β . How large should n be in order for the approximation to be useful? Unfortunately.Then using (6. 1 X √ xi ei n i=1 n ! the N (0. However. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.1. V is often referred to as ˆ the asymptotic covariance matrix of β. Under (6.7) Cov(xi x0 . e2 ) = 0. V ) where V = Q−1 ΩQ−1 . is approximately normal when the sample size n is sufficiently large.

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. As α diminishes the density changes significantly. The lesson from Figures 6. 6 and 8. 1).4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.3 is that the N (0.10) without changing this result.0 the density is very close to the N (0.Figure 6.2) and Theorem 6. 1) asymptotic approximation is never guaranteed to be accurate. 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.1) it is clear that V 0 →p V 0 . The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. 4.10) V 0 = Q−1 s2 . ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. we need an estimate of Ω = E xi x0 e2 .2. We show the sampling distribution of n β 1 − β 1 setting n = 100.2 and 6.2: Density of Normalized OLS estimator α = 3. Another example is shown in Figure 6. for k = 1. concentrating most of the probability mass around zero.3. 1) density. As k increases.11) 50 . The estimator 2 2 in (6. the sampling distribution becomes highly skewed and non-normal.

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

To illustrate. we return to the log wage regression of Section 4.020.80 40. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. then take the diagonal elements.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. We calculate that s2 = 0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. and then the square roots.12) in turn. just as any other estimator. (.480 ˆ0 = 0.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.035 ¶ .4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β .20 = V 14.20 −0. The standard errors for β 0 are 7. First.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.117 Educationi .98 −0.199 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .493 −0.30 + 0. n n i=1 52 . from which it follows that V →p V as n → ∞.493 0. (6.1.14 6. (6. but not under another set of assumptions.14 205.83 ¶−1 = µ 7.83 ¶−1 µ .199 2.5 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. by Holder’s inequality (5. Using (6. From a computational standpoint.2/988 = .used by an author when studying their work.14 205.14 205.480 .085 p ˆ and that for β 1 is .5) and the WLLN (Theorem 5. Ω 2.14 14.80 2.83 −0. the standard method to calculate the standard errors is to ˆ first calculate n−1 V . p ˆ In this case the two estimates are quite similar.20 and µ ¶ ˆ = 0.020) 6.35/988 = .80 .085) (.14 14. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.039 and ˆ V = µ 1 14.6 ¶µ 1 14. i i i i n i=1 Second.80 40.2.

12 the definition of β (−i) as the least-squares estimator with the i’th observation deleted.11) with the leave-one-out estimator ei. which. Recall from Section 4. Using this substitution. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6.13) Using formula (4. 6. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. i=1 Third. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . these establish consistency.5. Andrews (1991) suggested an similar estimator based on cross-validation.14) à 1X (1 − hi )−1 xi ei ˆ n i=1 n !à 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . 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.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .1 As n → ∞.−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. you can show that 1 Xˆ ¯ β= β (−i) . Ω →p Ω and V →p V. is defined ˆ ˆ by replacing the OLS residual ei in (6. ¯ ¯n ¯ n i=1 so Together.13) of Efron (1982). MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . From equation (3.25). by the WLLN ¯ n ¯ à n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0.26). ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. n i=1 n ˆ ˆ Theorem 6.

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

Consider the studentized statistic tn (θ) = Theorem 6.1 tn (θ) →d N (0.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. see Section X). θ could be a single element of β). and is therefore exactly free of unknowns. s(ˆ = n−1/2 H 0 V Hβ . 1) Proof.For example. In general. θ) β 6. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . Vθ ) √ Vθ = N (0. that (so θ ˆ ˆ ˆ is. 55 . pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. Since the standard normal distribution does not depend on the parameters. the standard error for ˆ is the square root of n−1 Vθ . By (6. the statistic tn has an exact t distribution. In special cases (such as the normal regression model. β 2 ). ˆ its estimate and s(ˆ its asymptotic θ θ) standard error.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. ˆ When q = 1q h(β) is real-valued). however. we say that tn is an exactly pivotal statistic. 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) →d ˆ−θ θ . In this case.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. µ I 0 ¶ ˆ the upper-left block of V . s(ˆ θ) (6. if R is a “selector matrix” R= so that if β = (β 1 . we say that tn (θ) is asymptotically pivotal.8. (For example.

1). and is a function of the data and hence is / random. It is designed to cover θ with high probability. regardless of the complication of the distribution of the original test statistic. if Z ∼ N (0. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. In a sense. associated with Fisher.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . That is. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). Let zα/2 is the upper α/2 quantile of the standard normal distribution. 1). tn →d N (0. Otherwise the test does not reject. 6. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. 1]. For example. from which it follows that pn →d U [0. A test of asymptotic significance α rejects H0 if |tn | > zα/2 . z. under H0 . That is. 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. 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. or “accepts” H0 . or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . 1].9 Confidence Intervals A confidence interval Cn is an interval estimate of θ. An alternative approach. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. 56 .96 and z. is to report an asymptotic p-value. 1]. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution.025 = 1.05 = 1. The p-value is more general. If the p-value pn is small (close to zero) then the evidence against H0 is strong. The asymptotic p-value for the above statistic is constructed as follows. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. The coverage probability is P (θ ∈ Cn ). however.645. Either θ ∈ Cn or θ ∈ Cn . in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. Define the tail probability. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . To see this fact. Then the asymptotic p-value of the statistic tn is pn = p(tn ). pn →d U [0.

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

2.5. Hence β β by Theorem A. Hβ (β) →p Hβ . h(β) = R0 β. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.05) = 3. χ2 (. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. Also h(β) = a selector matrix. and there are q = k2 restrictions. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.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 . ˆ Wn = n θ θ q θ θ Theorem 6.10.19) σ2 ˆ where σ2 = ˜ 1 0 e e. The null hypothesis is H0 : β 2 = 0.1 showed θ ˆ that V →p V. For example. 6.8.84 = z. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).1. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. ˜˜ n ˜ e = Y − X1 β 1 . Vθ ).When h is a linear function of β. q and pn is asymptotically U[0. θ = β 2 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .025 . As before. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.1 Under H0 and Assumption 6. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . and Theorem 6. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . the upper-α quantile q 2 of the χ2 distribution. In this case. Hβ (β) is a continuous function of β. a chiq square random variable with q degrees of freedom. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . then Wn →d χ2 . Furthermore.15) showed that n ˆ − θ →d Z ∼ N (0. if rank(Hβ ) = q. 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. 1] under H0 . 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.3. the test rejects at the α% level iff pn < α. The asymptotic p-value for Wn is pn = p(Wn ).

2 2 2 or alternatively. First. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. Also. 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.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . 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. ˆˆ n ˆ e = Y − X β. 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 . Now consider the residual regression of e on X2 = M1 X2 . This statistic is typically reported as an “F-statistic” which is defined as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . note that if we regress Y on X1 alone. The elegant feature about (6.2) ¢−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 .19). note that partitioned matrix inversion (2. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. 59 . = 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. and σ2 = ˆ 1 0 e e. as the sum of squared errors is a typical output from statistical packages. By the FWL theorem. since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e.are from OLS of Y on X1 .19) is that it is directly computable from the standard output from two simple OLS regressions. the residual is ˜ ˜ e = M1 Y.19) the F form of the Wald statistic. X2 ). We now derive expression (6.

The modelling assumption that the error ei is independent of xi and N (0. Let u = σ −1 H 0 e ∼ N (0.4)) where H 0 H = In . While there are special cases where this F statistic is useful. In σ 2 . 6. This is rarely an issue today. as sample sizes are typically sufficiently large that this F statistic is highly “significant”. introduced in Section 4. there is an exact distribution theory available for the normal linear regression model. This was a popular statistic in the early days of econometric reporting. 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 . including the estimated error variance 2. n−k 60 . σ 2 ) can be be used to calculate a set of exact distribution results. it follows ˆ that β is independent of any function of the OLS residuals. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = .3. In ) . equivalently the residual variance from an intercept-only model. Since uncorrelated normal variables are independent. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. In particular. Since linear functions of normals are also normal. an “F statistic” is reported. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2.where In many statistical packages. This special F statistic is testing the hypothesis that all slope coefficients (other than the intercept) are zero. H 0 H) ∼ N (0. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0.12 Normal Regression Model As an alternative to asymptotic distribution theory. these cases are atypical. 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. when an OLS regression is reported.

if standard errors are calculated using the homoskedastic formula (6. so as a practical matter it does not matter which distribution is used. 0. σ 2 ) − Ln (β 1 .1 we showed that in large samples. 1) and tn−k distributions.1 and Theorem 6. β and t are approximately normally distributed. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. the notable distinction is between the N (0.12. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 ). β has an exact normal distribution and t has an exact t distribution. n−k • ∼ tn−k ˆ In Theorem 6. (Unless the sample size is unreasonably small. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models.1 If ei is independent of xi and distributed N(0. and standard errors are calculated using the homoskedastic formula (6. The critical values are quite close if n − k ≥ 30. which is twice the difference in the log-likelihood function evaluated under the null and alternative hypotheses. a good testing procedure is based on the likelihood ratio statistic. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . Theorem 6.a chi-square distribution with n − k degrees of freedom. We summarize these findings Theorem 6.8. β 2 . with residual variance σ . As inference (confidence intervals) are based on the t-ratio. 0.3. σ2 ˆ 61 . σ ˆ ˆ βj − βj βj − βj N (0. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .10) then ´ ³ ˆ • β ∼ N 0. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. Furthermore. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . In contrast. β 2 . 0.10) µ h i ¶ 2 (X 0 X)−1 N 0.) Now let us partition β = (β 1 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ 2 ) = − log σ − log (2π) − . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . β 2 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .12. σ 2 ) discussed above.1 shows that under the strong assumption of ˆ normality.

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

In Table 2. For this particular example. and σ 2 . looking for tests for which rate rejection rates are close to 5%.05) with deviations indicating+ distortion. Test performance deteriorates as s increases. Any other choice of s leads to a test with unacceptable Type I error probabilities. Typically. n.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Given the simplicity of the model. this probability depends only on s. and rarely fall outside of the 3%-8% range. however. and σ is varied among 1 and 3. 100 and 500. Rates above 20% are unexceptable. n is varied among 20. There is. we compare the rates row by row.000 random samples. Each row of the table corresponds to a different value of s — and thus corresponds to a particular choice of test statistic. When comparing statistical procedures. no magic choice of n for which all tests perform uniformly well. The value of s is varied from 1 to 10. The second through seventh columns contain the Type I error probabilities for different combinations of n and σ. In Table 4. In each case.Figure 6. the Type I error probability improves towards 5% as the sample size n increases. These probabilities are calculated as the percentage of the 50. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.1 reports the simulation estimate of the Type I error probability from 50.84 | β = 1) . so these probabilities are Type I error. The null hypothesis β s = 1 is true. Table 4.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .4.84. remember that the ideal Type I error probability is 5% (.1 you can also see the impact of variation in sample size.000 simulated Wald statistics Wn (s) which are larger than 3. To interpret the table. Type I error rates between 3% and 8% are considered reasonable.4: Wald Statistic as a function of s P (Wn (s) > 3. Error rates avove 10% are considered excessive. the only test which meets this criterion is the conventional Wn = Wn (1) test. Table 4.

05 .31 .25 .08 .18 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .23 .10 .22 .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 .30 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.28 . so the hypothesis can be stated as H0 : θ = r.10 .06 .12 . Define θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . Equivalently.13 .05 .33 .06 .05 .16 Rejection frequencies from 50.13 .06 .15 .07 .05 . β 2 ) be the least-squares estimates of (6.000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.14 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .15 .08 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.11 .05 .20 .35 .07 .07 . 64 .06 .15 .09 .13 .06 .15 .19 .20 .08 .22 .08 . define θ = β 1 /β 2 . Other choices are arbitrary and would not be used in practice.20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . This point can be illustrated through another example.07 .25 .26 .05 .10 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at first. While this is clear in this particular example.07 .21 .14 .06 .06 .12 .08 .06 .17 .24 . β 1 .34 .20).

It is also prudent to consider alternative tests to the Wald statistic.00 . The implication of Table 4.645) t1n t2n t1n t2n t1n t2n t1n t2n . 65 .00 .645) greatly exceed 5%. then the “most linear” formulation should be selected. In contrast. Table 4. and are close to the ideal 5% rate for both sample sizes.25. The left tail probabilities P (t1n < −1.05 .15 .50. if the hypothesis can be expressed as a linear restriction on the model parameters. However.25 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .09 .05 .06 . and normalize β 0 = 0 and β 1 = 1.7.645) are calculated from 50.06 . σ 2 ) draw with σ = 3.000 simulated samples. and 1.05 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 . The results are presented in Table 4.47 .05 .00 .05 .06 . .10 .0 and n among 100 and 500.06 .00 .00 .00 . .10 . such as the GMM distance statistic which will be presented in Section 9.10 .645) are close to zero in most cases. 6.05 β2 .1.05 .05 .2 is that the two t-ratios have dramatically different sampling behavior.75 1.06 . We vary β 2 among . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.06 .06 . this formulation should be used.75.07 .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.05. In all cases. especially for small values of β 2 .06 .645) P (tn < −1.02 .00 .50 . the rejection rates for the t1n statistic diverge greatly from this value. and alternatives to asymptotic critical values should be considered.00 The one-sided Type I error probabilities P (tn < −1.05 . 1) variables.28 . while the right tail probabilities P (t1n > 1.05 . .2.15 . In this section we describe the method in more detail.26 .00 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.12 . the entries in the table should be 0.06 . If no linear formulation is feasible.00 .06 .645) P (tn > 1. We let x1i and x2i be mutually independent N (0.645) P (tn > 1. ei be an independent N (0. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. Ideally.645) and P (tn > 1. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . along with sample size n. This leaves β 2 as a free parameter.

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

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

we can write this effect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model.102 −. 2β 3 68 . we find Wn = 550.808 so the parameter estimates are quite precise and reported in Table 4.00002 . The available sample is 18.34 ˆ s(β) .4945.variable for state of residence (including the District of Columbia. Table 4.232 .101 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.18) that the state coefficients are jointly zero. the restricted standard deviation estimate is σ = .032 . reestimating the model with the 50 state dummies excluded.001 . this adds 50 regressors). excluding the coefficients on the state dummy variables.027 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. but not equal.4877 18.808 .013 . Wn = n 1 − 2 = 18. Alternatively.097 −.00057 .007 .49452 σ ˜ Notice that the two statistics are close.69.008 .102 −. The F form of the Wald statistic (6. Ignoring the other coefficients.010 . Computing the Wald statistic (6.033 −.014 . as the 1% critical value for the χ2 distribution is 76.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.1. Using either statistic the hypothesis is easily rejected.1 we find the point estimate ˆ ˆ = − β 2 = 28.48772 = 515. θ ˆ 2β 3 β2 .002 .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.19) is ˜ µ ¶ µ ¶ σ2 ˆ .121 −. 808 1 − .070 .

0. 29. This set is [27.9. this is a poor choice.40. Since tn (θ) is a non-linear function of θ.96. we can calculate a standard error of s(ˆ = .5]. 29. but the lower end is substantially lower. we found better Type I error rates by reformulating the hypothesis as a linear restriction. In the present context we are interested in forming a confidence interval. This is the set of θ such that |tn (θ)| ≤ 1. Our desired confidence interval will be the set of parameter values θ which are not rejected by the hypothesis test. as the coverage probability of this confidence interval is one minus the Type I error of the hypothesis test based on the t-test. there is not a simple expression for this set. Instead. not testing a hypothesis.Using the Delta Method. but it can be found numerically quite easily. However. In the previous section we discovered that such t-tests had very poor Type I error rates. Notice that the upper end of the confidence interval is the same as that from the delta method. 69 . 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 ). implying a 95% confidence θ) interval of [27. so we have to go one step further.5].

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

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

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

is the homoskedasticity-formula standard error.

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

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

there is no guarantee that σ 2 > 0 for all i. If σ 2 < 0 for some i. Since there is not a unique specification for the conditional variance the FGLS estimator is not unique. ˜i Suppose that σ 2 > 0 for all i..4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi . then the FGLS estimator will force ˜i the regression equation through the point (yi . We may call (7.3) ˆ ˆ While ei is not observed. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. or FGLS.Suppose ei (and thus η i ) were observed. 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. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . estimator of β.. then the FGLS ˜i estimator is not well defined. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. Then set ˜i ˜ D = diag{˜ 2 . We have shown that α is consistently estimated by a simple procedure. if σ 2 ≈ 0 for some i. .. as it is estimating the conditional variance of the regression of yi on xi . xi ). Vα = E zi zi (7.4) the skedastic regression. Vα ) (7. This suggests 75 . One typical problem with implementation of FGLS estimation is that in a linear regression ˜i specification. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi .5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. This is the feasible GLS. and will depend on the model (and estimation method) for the skedastic regression. which is typically undesirable.6) σ 2 = α0 zi .

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

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

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

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

θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ) ' (ei + m(xi . 80 . θ0 ) + m0 (θ − θ0 ) . ˆ ˆ θ) ˆ θ). However. 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 . 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 . ¥ Based on Theorem 7. This renders the distribution theory presented in the previous section invalid. An alternative good measure is the conditional median. Suppose that m(xi .For θ close to the true value θ0 . under H0 . Identification is often tricky in nonlinear regression models. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. 1 2 The model is linear when β 2 = 0. γ is not identified. In particular. tests of H0 do not have asymptotic normal or chi-square distributions. Thus we want to test H0 : β 2 = 0. 7.1. m(xi . This means that under H0 . θ0 )) − m(xi . Thus when the truth is that β 2 = 0. θi Thus ¡ ¢ yi − m(xi . by a first-order Taylor series approximation.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 . The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. the parameter estimates are not asymptotically normally distributed. θ) ' m(xi . Furthermore. θ which is that stated in the theorem. but these are not the only measures of central tendency. We have discussed projections and conditional means.4. Hansen (1996). Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . ˆ and ei = yi − m(xi . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . θ) = β 0 zi + β 0 xi (γ). and this is often a useful hypothesis (sub-model) to consider.

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

3. Pn −1 0 β)) . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . we provide a sketch here for completeness. then there are many innovations near to the median. When f (0 | x) is large. where V = and f (e | x) is the conditional density of ei given xi = x. Second using the law of iterated expectations and the chain rule of i differentiation.10) is equivalent to g n (β) = 0.5. (7. This can be done with kernel estimation techniques. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . the conditional density of the error at its median.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. the height of the error density at its median.1 ´ √ ³ˆ n β − β 0 →d N (0. First. The main difficulty is the estimation of f (0). by the central limit theorem (Theorm 5. In the special case where the error is independent of xi . ∂β 0 so Third.11) This simplification is similar to the simplification of the asymptotic covariance of the OLS estimator under homoskedasticity.11). Let g(β) = Eg (β). ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.5. While a complete proof of Theorem 7.Theorem 7. V ).1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . ˆ Proof of Theorem 7. Computation of standard error for LAD estimates typically is based on equation (7.5. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . See Chapter 16. then f (0 | x) = f (0) and the asymptotic variance simplifies V = (Exi x0 )−1 i 4f (0)2 (7.1 is advanced. ¢¢−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) . and this improves estimation of the median.

Exi x0 ) →d i 2 = N (0. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). V ). 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)) . As functions of x. The median is the special case τ = . the quantile regression functions can take any shape. The third line follows from an asymptotic empirical process argument. This linear specification assumes that Qτ (x) = β 0 x where the coefficients β τ τ vary across the quantiles τ . ¥ 7. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. then (7.12) Qτ = argmin Eρτ (U − θ) . We then have the linear quantile regression model yi = x0 β τ + ei i 83 .Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0.9) for the median to all quantiles. (7.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . then F (Qτ ) = τ . then F (Qτ (x) | x) = τ . when F (y | x) is continuous and strictly monotonic in y. Again. For the random variables (yi .5. If the random variable U has τ ’th quantile Qτ . For fixed τ . For τ ∈ [0. so you can think of the quantile as the inverse of the distribution function. 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.13) This generalizes representation (7. The following alternative representation is useful.

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

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

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

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

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

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

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

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

xi ) . Fn ). x1. This is generally impossible since F is unknown. write Tn as possibly a function of F . When G(x. n (8.1) We call G∗ the bootstrap distribution. F ) ³ ´ be a statistic of interest. Fn ) constructed on n 1. F ) we obtain G∗ (x) = Gn (x. That is. The unknown F is replaced by a consistent estimate Fn (one choice is discussed in the next section). which makes a different approximation. x∗ . inference would be based on Gn (x. 92 . n n ∗ Let (yi . Bootstrap inference is based on G∗ (x).1 Definition of the Bootstrap Let F denote a distribution function for the population of observations (yi . Efron (1979) proposed the bootstrap. In a seminal contribution. Let Tn = Tn (y1 . Ideally.. the t-statistic is a function of the parameter θ which itself is a function of F. . ∗ .Chapter 8 The Bootstrap 8. for example an estimator ˆ or a t-statistic ˆ − θ /s(ˆ Note that we θ θ θ). F ) = G(x) does not depend on F. The statistic Tn = Tn (y1 . A random sample from this i ∗ ∗ ∗ distribution is call the bootstrap data. For example.. xn . Plugged into Gn (x. F ) with G(x. The exact CDF of Tn when the data are sampled from the distribution F is Gn (x. We call T ∗ this sample is a random variable with distribution Gn n n n ∗ the bootstrap statistic. P (T ∗ ≤ x) = G∗ (x). yn . we say that Tn is asymptotically pivotal and use the distribution function G(x) for inferential purposes.. meaning that G changes as F changes. Asymptotic inference is based on approximating Gn (x.. Gn (x. x∗ ) denote random variables with the distribution Fn . F ) = limn→∞ Gn (x. In the next sections we describe computation of the bootstrap distribution. x∗ . The distribution of Tn is identical to that of Tn when the true CDF of Fn rather than F. F ). The bootstrap distribution is itself random.. F ). F ) = P (Tn ≤ x | F ) In general.. as it depends on the sample through the estimator Fn . F ) depends on F. yn .

Thus by the WLLN (Theorem 5. To see this. 1) distribution. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y.. x) = P (yi ≤ y. To see the effect of sample size on the EDF. x∗ ≤ x) = Fn (y. x)) →d N (0. 50. but the approximation appears to improve for the large n. it is helpful to think of a random pair (yi . √ n (Fn (y. xi ). x) = n i=1 Figure 8. i 93 . For n = 25. note that for any (y. x). Note that while F may be either discrete or continuous.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x). where 1(·) is the indicator function.1). Fn (y. x) . Fn is a nonparametric estimate of F. Notationally. The EDF is a consistent estimator of the CDF. This is a population moment. In general.8. x) − F (y. the EDF step function gets uniformly close to the true CDF. the EDF is only a crude approximation to the CDF. ∗ P (yi ≤ y. I have plotted the EDF and true CDF for three random samples of size n = 25.3. n. . x) →p F (y. as the sample size gets larger. x) is called the empirical distribution function (EDF). x) (1 − F (y.1). Recall that F (y. by the CLT (Theorem 5. x∗ ) with the i distribution Fn . Furthermore.. x))) . x). xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . Fn is by construction a step function.2 The Empirical Distribution Function Fn (y. i = 1. (8.2.2) Fn (y.. in the Figure below. The random draws are from the N (0. F (y. and 100. That is.

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

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

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

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

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

99 . and a function h(x) is odd if h(−x) = −h(x). where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ .8. it says nothing.8. The following notation will be helpful. writing Tn ∼ Gn (x. Equivalently. not ˆ − θ0 . Definition 8. A better asymptotic approximation may be obtained through an asymptotic expansion. Definition 8.4) says that Gn converges to Φ x as n → ∞.8. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). Let Tn be a statistic such that (8. and vice-versa. 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. about the rate v of convergence. If θ is a vector.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.2 an = O(1) if |an | is uniformly bounded.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. Basically. lim Gn (x. The derivative of an even function is odd. We say that a function g(x) is even if g(−x) = g(x). θ [This is a typical mistake made by practitioners. (8. Let an be a sequence. however. F ) then ³x´ . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. Thus here Tn (θ) = Wn (θ). or the size of the divergence for any particular sample size n. The ideal test rejects if Wn ≥ qn (α). F ) = Φ n→∞ v or ³x´ Gn (x. where qn (α) is the (1 − α)% quantile of the distribution of Wn .1 an = o(1) if an → 0 as n → ∞ Definition 8. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . C4 is called the symmetric percentile-t interval. an = O(n−r ) if it declines to zero like n−r .] 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. the critical value qn (α) is found as the quantile from simulated values of W´ . θ θ θ ˆ θ ∗ ∗ Computationally.3 an = o(n−r ) if nr |an | → 0 as n → ∞. F ) = Φ + o (1) . v 2 ).8 Asymptotic Expansions Tn →d N (0.4) v ¡ ¢ While (8.

1. First. We can interpret Theorem 8. √ Since Fn converges to F at rate n. the difference √ (g1 (x. ³x´ Gn (x.8. the density function is skewed. g1 (x.1 as follows. adding leptokurtosis). F ) + O(n−3/2 ) Gn (x. F ) converges to the normal limit at rate n1/2 . An asymptotic test is based on Φ(x). and g2 is an odd function of x. the exact distribution is P (Tn < x) = Gn (x. F0 ) = 1 g (x. we can assess the accuracy of one-sided hypothesis tests and confidence regions based on an asymptotically normal t-ratio Tn .1 Under regularity conditions and (8. Gn (x. F ) ≈ Φ + n−1/2 g1 (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). 100 . 1/2 1 n Because Φ(x) appears in both expansions. To a second order of approximation. F0 ) = n 1 n1/2 (g1 (x.8.8.3). ³x´ Gn (x. which from Theorem 8.1 has the expansion n G∗ (x) = Gn (x. v Since the derivative of g1 is odd. so the order of the error is O(n−1/2 ). F ) + g2 (x. The difference is Φ(x) − Gn (x. Fn ) − g1 (x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). F ). Fn ) + O(n−1 ). Moreover. F0 )) converges to 0 at rate n. A bootstrap test is based on G∗ (x). Fn ) − g1 (x. F ) + n−1 g2 (x. F0 ) = Φ(x) + since v = 1. the difference between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x.9 One-Sided Tests Using the expansion of Theorem 8. Fn ) = Φ(x) + n 1 g (x. F0 )) + O(n−1 ). To the second order. Theorem 8. F0 ) ≈ ∂ g1 (x. F ) = Φ v n n 8. F ) v which adds a symmetric non-normal component to the approximate density (for example. Fn ) − g1 (x. F ) ≈ Φ + n−1/2 g1 (x.8. ³x´ 1 1 + 1/2 g1 (x. Heuristically. To a third order of approximation. and g1 is continuous with respect to F. g1 and g2 are differentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. F0 ) + O(n−1 ) 1/2 1 n 1 g (x.uniformly over x. where g1 is an even function of x.

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

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

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

Consider the following bootstrap procedure. 2. Let Fn (x) denote the EDF of a random sample.. which is a valid statistical approach. ˆi A conditional distribution with these features will preserve the main important features of the data.. yielding OLS estimates β and any other statistic of interest. Unfortunately this is a harder problem. Take a random sample {y1 . .13 Exercises 1. creating a random bootstrap data set (Y ∗ . Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. The idea is to construct a conditional distribution for ε∗ so that i E (ε∗ | xi ) = 0 i ¡ ∗2 ¢ E εi | xi = e2 ˆi ¡ ∗3 ¢ E εi | xi = e3 . . Let β denote the ˆ the OLS residuals. Let ∗ ∗ ∗ {y1 . e∗ ) from the pair {(xi . ˆ Draw (with replacement) n such vectors... whether or not the xi are really “fixed” or random.. generate ∗ bootstrap samples. X ∗ ). Let the statistic of interest be the sample mean Tn = y n . Set y∗ = x∗0 β + e∗ . you sample ε∗ using this two-point distribution. ˆ∗ (b) Regress Y ∗ on X ∗ . It does not really matter.. Using the non-parametric bootstrap. yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. F0 (x) (1 − F0 (x))) . The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. That is. 2. ˆ 3. and e = Y − X β ˆ (a) Draw a random vector (x∗ . draw a ˆ ˆ random integer i0 from [1. 4. This can be achieved using a two-point distribution of the form à à √ ! ! √ 1+ 5 5−1 ∗ √ ei ˆ = P εi = 2 2 5 à à √ ! ! √ 1− 5 5+1 ∗ √ P εi = = ei ˆ 2 2 5 For each xi . Show that √ n (Fn (x) − F0 (x)) →d N (0. Find the bootstrap moments ETn and V ar(Tn ).. however.. i 8. Tn = (ˆ − ˆ 104 .. Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. n]. OLS estimator from the regression of Y on X. and set x∗ = xi0 and e∗ = ei0 .. . n} .. calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). One proposal which imposes the regression condition without independence is the Wild Bootstrap. . Consider the following bootstrap procedure for a regression of yi on xi ..observed values of the regressors. Find the population moments ETn and V ar(Tn ). yn } with µ = Eyi and σ 2 = V ar(yi ). ei ) : i = 1.

You want to test H0 : θ = 0 against H1 : θ > 0. θ respectively. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.95). size of house. (c) With the given information.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Let qn (.95) denote the 5% θ) ∗ and 95% quantiles of Tn . The datafile hprice1.2. ˆ − s(ˆ n (. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. ∗ ∗ ∗ Let qn (. Estimate a linear regression of price on the number of bedrooms. and the colonial dummy. Using the non-parametric bootstrap.95) denote the 95% quantile of Tn .3. Using the non-parametric ∗ bootstrap. (b) Report the 95% Alternative Percentile interval for θ.dat contains data on house prices (sales). The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. and define the bootstrap confidence interval h i C = ˆ − s(ˆ n (. ∗ ∗ where s(ˆ is the standard error in the original data.05) .05) and qn (.5% and 97. can you report the 95% Percentile-t interval for θ? 7.pdf. What is wrong with this procedure? Tn = θ/s(θ) n 6. lot size. You replace c with qn (.75 and 1.95). and the 2. you generate bootstrap samples. and thus reject H0 if ˆ ˆ > q ∗ (. Suppose that in an application. The ˆ are sorted. and ˆ is calculated on each θ ∗ ∗ θ sample.2 and s(ˆ = . ˆ = 1. Calculate 95% confidence intervals for the regression coefficients using both the asymptotic normal approximation and the percentile-t bootstrap. 105 .5% quantiles of the ˆ are . with variables listed in the file hprice1. (a) Report the 95% Efron Percentile interval for θ. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). You do this as follows.95).

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

the square of the Euclidean length. For example. This is a non-negative measure of the “length” of the vector g n (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 . then g n (β) = 0. gi (β) = xi yi − zi β = n n n i=1 i=1 Define the sample analog of (9. let Jn (β) = n · g n (β)0 Wn g n (β). Let and where gi = xi ei . The first order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. i i .2. The GMM estimator minimizes Jn (β). then. ˆ Definition 9. if Wn = I. for if Wn is replaced ˆ by cWn for some c > 0.2) g n (β) = (9. For some × weight matrix Wn > 0.1 β GMM = argmin Jn (β).2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . β ˆ Note that if k = . Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Proposition 9.2. and the GMM estimator is the MME. ¡ ¢−1 0 ˆ Z XWn X 0 Y.9. 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. the dependence is only up to scale. β GMM does not change.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. but this is generally not possible when > k.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . The idea of the generalized method of moments (GMM) is to define an estimator which sets g n (β) “close” to zero.

ˆ n i=1 gi = gi − g n . as we are only considering alternative weight matrices Wn . it is semiparametrically efficient. as the distribution of the data is unknown. For any Wn →p W0 . as shown by Gary Chamberlain (1987). β). This estimator is efficient only in the sense that it is the best (asymptotically) in the class of GMM estimators with this set of moment conditions.3. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . ˆ Construct n 1X ˆ g n = g n (β) = gi .4 Estimation of the Efficient Weight Matrix ˆ Given any weight matrix Wn > 0. This results shows that in the linear model. ˆ∗ ˆ 108 . Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . The optimal weight matrix W0 is one which minimizes V. but it can be estimated consistently.3.2 For the efficient GMM estimator. the GMM estimator β is consistent yet inefficient. The proof is left as an exercise. this is a semi-parametric problem. n n We conclude: Theorem 9. no estimator has greater asymptotic efficiency than the efficient linear GMM estimator. ˆ We have described the estimator β as “efficient GMM” if the optimal (variance minimizing) weight matrix is selected. ˆ we still call β the efficient GMM estimator. we can define the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . However. W0 = Ω−1 is not known in practice. Ω) . we can set Wn = I . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . No estimator can do better (in this first-order asymptotic sense). This is a weak concept of optimality. a better choice is Wn = (X 0 X)−1 .1 ´ √ ³ˆ n β − β →d N (0. n β − β →d N 0. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. Given any such first0ˆ ˆ ˆ ˆ step estimator. In the linear model.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. and this is all that is known. without imposing additional assumptions. 9. where In general. For example. V ) . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. This turns out to be W0 = Ω−1 . it turns out that the GMM estimator is semiparametrically efficient. Chamberlain showed that in this context. This yields the efficient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. as it has the same asymptotic distribution. If it is known that E (gi (β)) = 0.

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

G0 Ω−1 G . In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. 1 2 It is possible that β 2 = 0. and then β recomputed. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . perhaps obtained by first ˆ setting Wn = I. Theorem 9. and if the weight matrix is asymptotically efficient.5. ˆ J = J(β) →d χ2−k . 1 it is possible that β 2 6= 0. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). n β − β →d N 0.6 Over-Identification Test Overidentified models ( > k) are special in the sense that there may not be a parameter value β such that the moment condition Eg(wi . and 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. so that the linear equation may be written as yi = β 0 x1i + ei .6. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = à 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. Under the hypothesis of correct specification. The variance of β may be estimated by G0 Ω−1 G where P ∗ ∗0 P ∂ ˆ ˆ ˆ g g and G = n−1 ˆ ˆ Ω = n−1 0 gi (β). ˆˆ n is a quadratic form in g n . and is thus a natural test statistic for H0 : Egi = 0. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. Since the GMM estimator depends upon the first-stage estimator. Thus the model — the overidentifying restrictions — are testable. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9.Often.1 Under general regularity conditions. 9.1 (Sargan-Hansen). This estimator can be iterated if needed. this is all that is known. 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 . 110 . The general theory of GMM estimation and testing was exposited by L. often the weight ˆ matrix Wn is updated. Hansen (1982). However. Identification requires l ≥ k = dim(β). Note that g n →p Egi . For example. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. β) = 0 holds.

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

It turns out that this conditional moment restriction is much more powerful.. A recent study of this problem is Donald and Newey (2001). so is just-identified) yields the best GMM estimator possible. In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i . γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2. . Ai is unknown.9. 0 Our linear model yi = zi β + ei with instruments xi falls into this class under the stronger 0 assumption E (ei | xi ) = 0. in linear regression. and then use the first k instruments. etc. β). It is also helpful to realize that conventional regression models also fall into this class. In practice. the model implies more than an unconditional moment restriction of the form Egi (β) = 0. Setting gi (β) to be this choice (which is k × 1.8 Conditional Moment Restrictions In many contexts. In many cases. than the unconditional moment restriction discussed above. Which should be selected? This is equivalent to the problem of selection of the best instruments. x2 . The obvious problem is that the class of functions φ is infinite. but its form does help us think about construction of optimal instruments. β). That is for any × 1 function φ(xi . an unconditional moment restriction can always be constructed. Then ei (β) = yi − zi β. are all valid instruments. 0 In the linear model ei (β) = yi − zi β.. β)ei (β) which satisfies Egi (β) = 0 and hence defines a GMM estimator. ei (β) = yi − x0 β. note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi . 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. except that in this case zi = xi . For example. If xi is a valid instrument satisfying E (ei | xi ) = 0. The form was uncovered by Chamberlain (1987). Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β). Another approach is to construct the optimal instrument. s = 1. ei (β. Given a conditional moment restriction. x3 . How is k to be determined? This is an area of theory still under development.. while in a nonlinear i regression model ei (β) = yi − g(xi . Take the case s = 1. then xi . i Ai = −σ −2 Ri i .. Which should be used? i i One solution is to construct an infinite list of potent instruments. and restrictive. we can set gi (β) = φ(xi .

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

114 . A = H 0 I − G G0 G (d) Show that A is positive semidefinite. Write out the matrix A. Define the estimate of the optimal GMM weight matrix à n !−1 1X 0 2 xi xi ei ˆ . we know that V − V0 is positive semi-definite if and only if V0−1 − V −1 = A is positive semi-definite. 2. verify that A can be written as ³ ¡ ¢−1 0 ´ G H. Take the model E (zi ηi ) = 0.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. 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 . Show that V0 = Q0 Ω−1 Q .g. (c) Since Ω is positive definite. From matrix algebra.9. In the linear model estimated by GMM with general weight matrix W. ˆ ˆ Find the method of moments estimators (β. (b) We want to show that for any W. Take the model yi = zi β + ei with E (xi ei ) = 0. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . there exists a nonsingular matrix C such that C 0 C = Ω−1 . γ ) for (β. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). i 0 0ˆ ˆ 3. γ). 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. Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. Let ei = yi − zi β where β is consistent for ˆ β (e. Show that Wn →p Ω i i i 4. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . a GMM estimator with arbitrary weight matrix). and therefore positive semidefinite. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0.

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

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

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

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

12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . and Ω = E xi x0 e2 . (β. ˆ ˆ Proof.10) ¡ Ω−1 N (0. 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. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.9) (10. n (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .8) and ¢ 0 0 For example. Thus the EL estimator is asymptotically efficient.9) and (10. β) = −xi zi .11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .10). in the linear model. β λ ∂ ³ ´.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .13) Premultiplying by G0 Ω−1 and using (10.1 Under regularity conditions.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. G = −E (xi zi ). λ) = − (10.10. 0 = Rn (β. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are defined in (10. Gi (. i i Theorem 10. i=1 i=1 i=1i Expanding (10. and n β − β 0 and nλ are asymptotically independent.2 Define Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. λ) = − (10.14) 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 . ˆ The asymptotic variance V for β is the same as for efficient GMM.2.13) yields n n Expanding (10.

120 . Since the EL estimator achieves this bound. and (10. Proof. and have the same interpretation.17) 2 ln 1 + λ gi β . The EL overidentification test is similar to the GMM overidentification test.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 (0.14) for λ and using (10. The same statistic can be constructed for empirical likelihood.7) is n ³ ´´ ³ X ˆ ˆ0 (10. 10.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.3.1 If Eg(wi .15). Ω) GΩ G →d = N (0. it is an asymptotically efficient estimator for β.3 Overidentifying Restrictions In a parametric likelihood context. tests are based on the difference in the log likelihood functions. The overidentification test is a very useful by-product of EL estimation. LRn = i=1 Theorem 10. by a Taylor expansion. ¥ Chamberlain (1987) showed that V is the semiparametric efficiency bound for β in the overidentified moment condition model. First. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . β 0 ) = 0 then LRn →d χ2−k .15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0. They are asymptotically first-order equivalent. (10. Twice the difference between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.16). 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.15) (10. and it is advisable to report the statistic LRn whenever EL is the estimation method. Vλ ) Furthermore. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. V ) ˆ Solving (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.

10. a The proof of this result is more challenging and is omitted. LRn →d χ2 .17) is not appropriate.wisc.18).4.prc 121 .1 Under (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). h(β)=0 ˜ Fundamentally.Second. 10. Vλ ) ¥ where the proof of the final equality is left as an exercise. since ln(1 + x) ' x − x2 /2 for x small. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).edu/~bhansen/progs/elike. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. so there is no fundamental change in the distribution theory for β relative to β.18) and H0 : h(β) = 0. 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.ssc. To test the hypothesis h(β) while maintaining (10.18) Let the maintained model be where g is × 1 and β is k × 1. By “maintained” we mean that the overidentfying restrictions contained in (10. This test statistic is a natural analog of the GMM distance statistic. The hypothesis of interest is h(β) = 0. Theorem 10. the simple overidentifying restrictions test (10. Instead we use the difference in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .4 Testing Egi (β) = 0 (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. Vλ )0 Ω−1 N (0. where h : Rk → Ra .

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

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

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

at least the intercept).1) where zi is k × 1. and x2i are the excluded exogenous variables. Thus we make the partition ¶ µ k1 z1i (11. which does not equal either β 1 or β 2 .4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1. some regressors in zi will be uncorrelated with ei (for example.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. and assume that E(zi ei ) 6= 0 so there is endogeneity. 11. We call (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ .1) the structural equation.1 The × 1 random vector xi is an instrumental variable for (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. By the above definition. β →p β ∗ . In a typical set-up. We call z1i exogenous and z2i endogenous. so should be included in xi .1) if E (xi ei ) = 0. In matrix notation. (11. Definition 11. So we have the partition µ ¶ z1i k1 (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 .1). this can be written as Y = Zβ + e. z1i is an instrumental variable for (11. This is called simultaneous equations bias. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.

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

X2 ].13) which is zero only when S21 = 0 (when Z is exogenous). We now derive a similar result for the 2SLS estimator. ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . 11. So only the endogenous variables Z2 are replaced by their fitted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 .11). Z2 = [PX Z1 . ˆ since Z1 lies in the span of X. Thus in the second stage. First. Recall. PX Z2 ] = [Z1 . the model is Y = Zβ + e (11.11) (11. let’s analyze the approximate bias of OLS applied to (11. Here we present a simplified version of one of his results. ¶ 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 ) .6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the finite-sample bias in the 2SLS estimator. Z2 ] and X = [Z1 .ˆ It is useful to scrutinize the projection Z. Z2 . PX Z2 ] h i ˆ = Z1 . we regress Y on Z1 and Z2 .12) Z = XΓ + u ξ = (e. Then i h ˆ ˆ ˆ Z = Z1 . Hence by a first-order approximation i µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ OLS − β E β ZZ Ze ≈ E E n n ¡ ¢−1 = Γ0 QΓ + S22 S21 (11. Using (11. Z = [Z1 . In our notation. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. 129 .12). X is n × l so there are l instruments.

indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. The parameter β fails to be identified if Γ22 has deficient rank. 130 . l .7 Identification Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . 0). 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 .14) approaches that in (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. It is also close to zero when α = 0.14) is the probability limit of β 2SLS − β 11.14) In general this is non-zero. n and (11. P = HΛH 0 0 0 where Λ = diag(Il . the bias in the 2SLS estimator will be large. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . the expression in (11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. Indeed as α → 1. By the spectral decomposition of an idempotent matrix. 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 (11.12) and this result.Let PX = X (X 0 X)−1 X 0 . except when S21 = 0 (when Z is exogenous).13). The consequences of identification failure for inference are quite severe. Let q = H 0 ξS −1/2 which satisfies Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .

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

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

X is n × l. l ≥ k. ˜ 0 e < e0 e. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). and Γ is l × k. will IV “fit” better than OLS. u is n × k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. (Find an expression for xi .11. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. we claim that β is identified (can be recovered from the reduced form) if rank(Γ) = k. 1. 133 . Find a simple expression for the IV estimator in this context. in the sense that e ˜ ˜ least in large samples? 4. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. 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) . 6. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Take the linear model Y = Zβ + e. xi is l × 1. Z is n × k. 5.) 3. 2. Take the linear model yi = xi β + ei E (ei | xi ) = 0.8 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. at ˆˆ If X is indeed endogeneous. Explain why this is true. show that if rank(Γ) < k then β cannot be identified. where xi and β are 1 × 1. That is. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1).

f atheduc (the education.. The data file card. There are 2215 observations with 19 variables. are the parameters identified? 8. In this model. using zi as an instrument for xi . Report the estimates and standard errors.(b) Define the 2SLS estimator of β. and then calculate the GMM estimator from this weight matrix without further iteration. listed in card. of the father) and motheduc (the education. (d) Re-estimate the model by efficient GMM. 134 .dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995). and the remaining variables as exogenous. 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.pdf. 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. Report estimates and standard errors. in years. Estimate the model by 2SLS. a dummy indicating that the observation lives near a 4-year college. in years. Does this differ from 2SLS and/or OLS? 7. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market. (e) Calculate and report the J statistic for overidentification. using the instrument near4. (f) Discuss your findings. I suggest that you use the 2SLS estimates as the first-step to get the weight matrix. and South and Black are regional and racial dummy variables. 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). (a) Estimate the model by OLS. Report estimates and standard errors. (b) Now treat Education as endogenous. of the mother). (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).

then Xt is strictly stationary and ergodic. Yt−k ) is independent of t for all k.1. we adopt new notation. Because of the sequential nature of time series. 12. To indicate the dependence on time.1..1 Stationarity and Ergodicity Definition 12.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . 135 .1.2 {Yt } is strictly stationary if the joint distribution of (Yt . γ(k) is called the autocovariance function. t = 1.. Yt−1 . The primary model for univariate time series is autoregressions (ARs). . 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. We can separate time series into two categories: univariate (yt ∈ R is scalar).3 ρ(k) = γ(k)/γ(0) = Corr(Yt . we expect that Yt and Yt−1 are not independent. Definition 12.1.... however. The primary model for multivariate time series is vector autoregressions (VARs). Definition 12. Theorem 12. so classical assumptions are not valid. and Cov (Yt .. Yt−k ) is the autocorrelation function. and use the subscript t to denote the individual observation. There proofs are rather difficult.. and T to denote the number of observations.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.. T . Definition 12.) is a random variable. .4 (loose). and multivariate (yt ∈ Rm is vector-valued). . Yt−k ) = γ(k) is independent of t for all k.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.1.

µ →p E(Yt ). 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 . ˆ 2. 1.1.2 (Ergodic Theorem).1 above. T 1X Xt →p E(Xt ). ρ(k) →p ρ(k).Theorem 12. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . and it has a finite mean by the assumption that EYt2 < ∞.1. the sequence Yt Yt−k is strictly stationary and ergodic. γ (0) ˆ Theorem 12. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). For Part (2). ˆ Proof. 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 < ∞. then as T → ∞. γ (k) →p γ(k).1. If Xt is strictly stationary and ergodic and E |Xt | < ∞. ˆ 3. Part (1) is a direct consequence of the Ergodic theorem. then as T → ∞. ˆ ˆ γ ¥ 136 . Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).

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.. Y2 .. For example. Yt−k ) . An autoregressive (AR) model specifies that only a finite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 .. t By back-substitution. A linear AR model (the most common type used in practice) specifies linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k . . In fact. Definition 12. Regression errors are naturally a MDS. This occurs when |ρ| < 1.. . A mean-zero AR(1) is Assume that et is iid.. Some time-series processes may be a MDS as a consequence of optimizing behavior. Letting et = Yt − E (Yt | It−1 ) . The last property defines a special time-series process. E(Yt−k et ) = 0. should be a MDS. k=0 Loosely speaking..} are jointly random. we find Yt = et + ρet−1 + ρ2 et−2 + . E(et ) = 0 and Ee2 = σ 2 < ∞. 137 . ∞ X = ρk et−k . this series converges if the sequence ρk et−k gets small as k → ∞.. or consumption growth rates... then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.. it is even more important in the time-series context. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. some versions of the life-cycle hypothesis imply that either changes in consumption. Y1 .3 Stationarity of AR(1) Process Yt = ρYt−1 + et . Thus for k > 0. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 ..12. ..2.2 Autoregressions In time-series.1 et is a martingale difference sequence (MDS) if E (et | It−1 ) = 0. the series {. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 .. Yt−2 .} is the past history of the series. YT . as it is difficult to derive distribution theories without this property.. 12.. .

We say that the root of the polynomial is 1/ρ.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .3.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . We call ρ(L) the autoregressive polynomial of Yt . We call ρ(L) the autoregressive polynomial of Yt . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . we see that L2 Yt = LYt−1 = Yt−2 . and solving for EYt = EYt−1 we find EYt = α/(1 − ρ). 138 . the above results are unchanged. From Theorem 12. since ρ(z) = 0 when z = 1/ρ. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . an AR(1) is stationary iff |ρ| < 1. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. Definition 12.4.Theorem 12. ∞ X k=0 ρ2k V ar (et−k ) = 12. Lk Yt = Yt−k .1 If |ρ| < 1 then Yt is strictly stationary and ergodic.1 The lag operator L satisfies LYt = Yt−1 . Note that an equivalent way to say this is that an AR(1) is stationary iff the root of the autoregressive polynomial is larger than one (in absolute value). We can compute the moments of Yt using the infinite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 .1. Defining L2 = LL. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. 12. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . The AR(k) model is Using the lag operator. In general.3.

T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. t t T t=1 ¥ Combined with (12. t Yt−k ¢0 ρk .1. λk are the complex roots of ρ(z). ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. For an AR(k). the requirement is that all roots are larger than one.. so is xt x0 .1. Theorem 12. This is a special case of non-stationarity.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . Proof. Thus t by the Ergodic Theorem. “has a unit root”. We know that an AR(1) is stationary iff the absolute value of the root of its autoregressive polynomial is larger than one. Let |λ| denote the modulus of a complex number λ. 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. and hence Yt .1) Theorem 12. and by Theorem 12..where the λ1 . we see that à !−1 à ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. then ˆ β →p β as T → ∞. Note that ut is a MDS. One way of stating this is that “All roots lie outside the unit circle.5. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. t T t=1 T t=1 139 . . β = X 0X (12. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. we say that ρ(L). which satisfy ρ(λj ) = 0. and is of great interest in applied time series.1.1) and the continuous mapping theorem. The vector xt is strictly stationary and ergodic.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞..1. By Theorem 12.6.” If one of the roots equals 1. it is helpful to define the process ut = xt et . it is also strictly stationary and ergodic.

7. i 4. xt }. Method 2: Block Resampling 1. we constructed the bootstrap sample by randomly resampling from the data values {yt .. we can apply Theorem 12. . t This construction imposes homoskedasticity on the errors e∗ .7 Asymptotic Distribution Theorem 12. ˆ 2. T 1 X √ ut →d N (0. The implication is that asymptotic inference is the same. Create the bootstrap series Yt∗ by the recursive formula ˆ ˆ ∗ ˆ ∗ ˆ ∗ Yt∗ = α + ρ1 Yt−1 + ρ2 Yt−2 + · · · + ρk Yt−k + e∗ .1 to see that T 1 X √ xt et →d N (0.. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. as this imposes inappropriate independence. this cannot work in a time-series application. T t=1 Since xt et is a MDS. Estimate β and residuals et .8 Bootstrap for Autoregressions In the non-parametric bootstrap. ˆ 1. there are two popular methods to implement bootstrap resampling for time-series data. This creates an iid bootstrap sample.7.1 MDS CLT. then as T → ∞.7. Q−1 ΩQ−1 .. t t Theorem 12. It also presumes that the AR(k) structure is the truth. Ω) . e ˆ 3. In particular. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .. Clearly. Y0 ). Y−k+2 .2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.. 140 . Fix an initial condition (Y−k+1 .. which may be different than the i properties of the actual ei . Method 1: Model-Based (Parametric) Bootstrap. This is identical in form to the asymptotic distribution of OLS in cross-section regression. Divide the sample into T /m blocks of length m. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. t then as T → ∞.12. . T t=1 where Ω = E(xt x0 e2 ). eT }. the asymptotic covariance matrix is estimated just as in the cross-section case. Ω) . 12. Briefly.

first estimate (12. For each simulated sample. The seasonal adjustment. • First apply a seasonal differencing operator.2). also alters the time-series correlations of the data. If s is the number of seasons (typically s = 4 or s = 12). heteroskedasticity.. Seasonal Effects There are three popular methods to deal with seasonal data.. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. This is a flexible approach which can extract a wide range of seasonal factors.3) replacing St with St . 12. ∆s Yt = Yt − Yt−s . and perhaps this was of relevance. 3. 6. (12. This procedure is sometimes called Detrending. and the way that the data are partitioned into blocks. or the season-to-season change.. Thus the seasonally adjusted data is a “filtered” series.2) (12.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . Resample complete blocks. . But the long-run trend is also eliminated. and then perform regression (12. 4. 141 .2. The series ∆s Yt is clearly free of seasonality. This presumes that “seasonality” does not change over the sample. • Use “seasonally adjusted” data.4) by OLS. May not work well in small samples. and for modelmisspecification. • Include dummy variables for each season. That is. get the ˆ ˆ residual St . (12. 5.3) sequentially by OLS.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . however. • You can estimate (12. Paste the blocks together to create the bootstrap time-series Yt∗ . The results may be sensitive to the block length.2)-(12. draw T /m blocks. This allows for arbitrary stationary serial correlation. • You can estimate (12.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . ρk ).

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

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

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

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

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

1). Another interesting fact is that (13.) Since the common factor restriction appears arbitrary.1) yt = x0 β + et . t and et is iid N (0.2) may be estimated by iterated GLS. j Often. which once was very popular. under the restriction γ = −βθ. This restriction. In this case. Let yt = Yjt . and is typically rejected empirically. We see that an appropriate. we are only interested in a single equation out of a VAR system. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. Otherwise it is invalid. to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 .3). which is called a common factor restriction. and simple way to test for omitted serial correlation is to test the significance of extra lagged values of the dependent variable and regressors. the model (13. with time series data. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. t and xt = This is just a conventional regression.2) is a special case of (13. If valid. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . Suppose that et is an AR(1). general.2) Take the equation yt = x0 β + et . t t−1 (13.1). 13. This can be done by a Wald test. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). Then the single equation takes the form (13. So testing H0 versus H1 is equivalent to testing for the significance of adding (yt−1 .3) which is a valid regression model.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. it is convenient to re-define the variables.2) is uncommon in recent applications.13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. and subtract off the equation once lagged multiplied by θ. You may have heard of the Durbin-Watson test for omitted serial correlation. xt−1 ) to the regression.4 Single Equation from a VAR Yjt = a0 xt + et . may be tested if desired. and is still routinely reported by conventional regression packages. 147 . t or yt = θyt−1 + x0 β + x0 γ + ut . direct estimation of (13. (13. Let et = ejt and β = aj . and Zt be the other variables. (A simple version of this estimator is called Cochrane-Orcutt.

6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR. This idea can be applied to blocks of variables. If Zt is some sort of forecast of the future. and the information set I2t is generated by both Yt and Zt .) I2t = (Yt . If it is found that Zt does not Granger-cause Yt . for example.. The latter has more information. Zt−2 . or an information criterion approach. .7 Granger Causality Partition the data vector into (Yt . If this condition does not hold. 13. This may be tested using an exclusion (Wald) test. . you may either use a testingbased approach (using. Zt−1 . 148 .t−1 ) . the Wald statistic). that Zt may still be useful to explain other features of Yt . Yt and/or Zt can be vectors. Define the two information sets I1t = (Yt .) The information set I1t is generated only by the history of Yt . then we say that Zt Granger-causes Yt . We say that Zt does not Granger-cause Yt if E (Yt | I1..13. Yt−1 . The formula for the AIC and BIC are ³ ´ p ˆ AIC(k) = log det Ω(k) + 2 T ³ ´ p log(T ) ˆ BIC(k) = log det Ω(k) + T T X 1 ˆ et (k)ˆt (k)0 ˆ e Ω(k) = T t=1 p = m(km + 1) where p is the number of parameters in the model. lagged Zt does not help to forecast Yt . That is. Yt−2 . such as a futures price. The hypothesis can be tested by using the appropriate multivariate Wald test. Yt−2 . In this equation. Note. such as the conditional variance.. and et (k) is the OLS residual vector from the ˆ model with k lags. That is. the equation for Yt is 0 0 Yt = α + ρ1 Yt−1 + · · · + ρk Yt−k + Zt−1 γ 1 + · · · + Zt−k γ k + et . Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0. then Zt may help to forecast Yt even though it does not “cause” Yt .t−1 ) = E (Yt | I2. In a linear VAR.. The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure definition of causality. Zt ). The log determinant is the criterion from the multivariate normal likelihood. This definition of causality was developed by Granger (1969) and Sims (1972). however. then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt . . Yt−1 . conditional on information in lagged Yt . Zt .

Yt is I(1) and cointegrated. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. If r = m. it may be believed that β is known a priori. then r = 0.13. 13. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . and was articulated in detail by Engle and Granger (1987). then β = (1 − 1)0 specifies that the spread (the difference in returns) is stationary. β = (1 − 1)0 . If Y = (log(Consumption) log(Income))0 . Whether or not the time trend is included. Hansen (1992). β may not be known. The r vectors in β are called the cointegrating vectors.8.9 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 . Often. In some cases. Thus Yt = ˆ (Y1t . Definition 13. then β = (1 − 1)0 specifies that log(Consumption/Income) is stationary. it may be necessary to include a time trend in the estimated cointegrating regression. yet under H1 zt is I(0).8 Cointegration The idea of cointegration is due to Granger (1981). For example. Under H0 . If Yt is cointegrated with a single cointegrating vector (r = 1). the asymptotic distribution of the test is affected by the presence of the time trend. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. as first shown by Stock (1987). however. such that zt = β 0 Yt is I(0). in general. so the ADF critical values are not appropriate. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . β is not consistent. if Yt is a pair of interest rates. a good method to estimate β. The asymptotic distribution was worked out in B. Then under H0 zt is I(1). This is not. If the series Yt is not cointegrated. Their justification was Stock’s result that β is superˆ ˆ consistent under H1 . Suppose that β is known. then Yt is I(0). from OLS of Y1t on Y2t . of rank r. Thus H0 can be tested using a univariate ADF test on zt . 149 . When the data have time trends.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. When β is unknown. m × r. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. so zt = β 0 Yt is known. but it is useful in the construction of alternative estimators and tests. In other cases. For 0 < r < m.

it is simple to test for cointegration by testing the rank of Π. 1991. Their asymptotic distributions are non-standard.9. this does not work. When r > 1.Theorem 13. In the context of a cointegrated VAR estimated by reduced rank regression. this is the MLE of the restricted parameters under the assumption that et is iid N (0.1 (Granger Representation Theorem). rank(α) = r. and different authors have adopted different identification schemes. As they were discovered by Johansen (1988. If β is known. 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 . Ω). and are similar to the Dickey-Fuller distributions. Equivalently. which is least-squares subject to the stated restriction. If β is unknown. we typically just normalize one element to equal unity. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . Thus cointegration imposes a restriction upon the parameters of a VAR. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. When r = 1. These tests are constructed as likelihood ratio (LR) tests. they are typically called the “Johansen Max and Trace” tests. One difficulty is that β is not identified without normalization. then estimation is done by “reduced rank regression”. 1995). 150 .

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

we need the conditional distribution of an individual observation. 152 . i i yi =0 ˆ The MLE β is the value of β which maximizes ln (β). To construct the likelihood. we call this the probit model. Details of such calculations are left to more advanced courses. Standard errors and test statistics are computed by asymptotic approximations. y = 0. 1. This model is identical to the latent variable model Yi∗ = x0 β + ei i ei ∼ F (·) ½ 1 Yi = 0 For then P (Yi = 1 | xi ) = P (Yi∗ > 0 | xi ) ¡ ¢ = P x0 β + ei > 0 | xi i ¢ ¡ = P ei > −x0 β | xi i ¢ ¡ = 1 − F −x0 β i ¡ ¢ = F x0 β .• Logistic: F (u) = (1 + e−u ) • Normal: F (u) = Φ(u). Recall that if Y is Bernoulli. If F is logistic. we call this the logit model. and if F is normal. i if Yi∗ > 0 . 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 ). such that P (Y = 1) = p and P (Y = 0) = 1 − p. Yi is conditionally Bernoulli with P (Yi = 1 | xi ) = pi = F (x0 β) . In the Binary choice model. otherwise Estimation is by maximum likelihood. 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 . then we can write the density of Y as f (y) = py (1 − p)1−y . −1 .

He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.2 Count Data exp (−λi ) λk i . k! = exp(x0 β). This may be considered restrictive. This model specifies that P (Yi = k | xi ) = λi k = 0. 14.) The observed data yi therefore come from a mixed continuous/discrete distribution. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.14.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold.. The functional form for λi has been picked to ensure that λi > 0. An example of a data collection censoring is top-coding of income. The first censored regression model was developed by Tobin (1958) to explain consumption of durable goods.. A generalization is the negative binomial. any known value can substitute.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). Tobin observed that for many households. The conditional density is the Poisson with parameter λi . 2. σ 2 ) with the observed variable yi generated by the censoring equation (14. Thus the model is that there is some latent process yi with unbounded support. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.. 1. The censoring process may be explicit in data collection. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) .}. This model (now called the Tobit) specifies that the latent (or ideal) value of consumption may be negative (the household 153 . 2. a typical approach is to employ Poisson regression.. .1).1) yi = ∗ <0 . i i i=1 ˆ The MLE is the value β which maximizes ln (β). 0 if yi (This is written for the case of the threshold being zero. this motivates the label Poisson “regression. i If Y = {0. incomes above a threshold are typically reported at the threshold. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. the consumption level (purchases) in a particular period was zero. . In surveys. 1. 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. or it may be a by-product of economic constraints.

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

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

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

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

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

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

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

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

and is larger the greater the curvature in f (x). ˆ We now examine the variance of f (x). so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. The sharper the derivative. Intuitively. ˆ the greater the bias. This integral (typically) is not analytically solvable. The bias results from this smoothing. Since it is an average of iid random variables. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . so is estimating a smoothed version of f (x). the estimator f (x) smooths data local to Xi = x. nh (x)2 dx is called the roughness of K. Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . The last expression shows that the expected value is an average of f (z) locally about x. Bias(x) = E f (x) − f (x) = K n 2 i=1 n ˆ We see that the bias of f (x) at x depends on the second derivative f 00 (x). 162 .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. which is valid as h → 0.16. 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) .

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

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

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

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

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

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

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

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

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

5) if the expectations exist. the marginal density of Y is fY (y) = Z ∞ f (x. is not true. σxσY (A. 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. 172 . (A. For example. however. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. Furthermore. the variance of the sum is the sum of the variances. X 2 ) = 0. y)dx. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y. then V ar (X + Y ) = V ar(X) + V ar(Y ). The correlation between X and Y is Corr(X. Y ) = ρXY = σ XY . If X and Y are independent. A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X. then σ XY = 0 and ρXY = 0. The reverse. If X and Y are independent.6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1.5) is that if X and Y are independent and Z = X + Y. An implication is that if X and Y are independent. then Cov(X. For example. −∞ The random variables X and Y are defined to be independent if f (x. free of units of measurement. y) = g(x)h(y). if EX = 0 and EX 3 = 0. 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 ) .Similarly. Y ). y) = fX (x)fY (y). Another implication of (A. if X and Y are independent then E(XY ) = EXEY.The correlation is a measure of linear dependence. 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).

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

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

∞). 1]. differentiable. an exponential density.8 Normal and Related Distributions µ 2¶ 1 x . Let h(y) denote the inverse of g(x). take the case X ∼ U [0. Let Y = g(X) where g(x) : Rk → Rk is one-to-one.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). dy This is known as the change-of-variables formula. (A. but its justification requires deeper results from analysis. As the range of X is [0. 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). dy dy If g(x) is a decreasing function. A. If g(x) is an increasing function.10) d h(y). .10) holds for k > 1. then g(X) ≤ Y if and only if X ≥ h(Y ). so FY (y) = P (g(X) ≤ y) = 1 − P (X ≥ h(Y )) = 1 − FX (h(Y )) and the density of Y is fY (y) = −fX (h(Y )) We can write these two cases jointly as fY (y) = fX (h(Y )) |J(y)| . φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. then g(X) ≤ Y if and only if X ≤ h(Y ). The Jacobian is ¶ µ ∂ h(y) . This same formula (A. J(y) = det ∂y 0 Consider the univariate case k = 1.10) shows that fY (y) = exp(−y). As one example. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y).A. Here. 1] and Y = − ln(X). Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. that for Y is [0. 0 ≤ y ≤ ∞. and invertible.

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

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

9 Maximum Likelihood If the distribution of Yi is F (y. Yn ) is n ³ ´ Y ˜. θ) .function F (x) = = = = Thus its density is f (x) = = = à r ! Q d E Φ x dx r à à r !r ! Q Q E φ x r r ! µ ¶¶ r à Z ∞µ qx2 1 q 1 r/2−1 ¡r¢ √ exp − q exp (−q/2) dq 2r r Γ 2 2r/2 2π 0 ¢ µ ¡ ¶− r+1 Γ r+1 x2 ( 2 ) 2¡ ¢ . θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector. the likelihood and log-likelihood are constructed by setting f (y.. The log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi . In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ. we say that the distribution is parametric and that θ is the parameter of the distribution F. θ) = P (Y = y.. viewed as a function of θ. θ) .. If the distribution F is discrete. 178 .θ = fn Y f (Yi . θ) . If the distribution F is continuous then the density of Yi can be written as f (y. . The space Θ is the set of permissible value for θ. 1+ √ r r rπΓ 2 ! Z P p ≤x Q/r ( r ) Q E Z≤x r !# " à r Q |Q E P Z≤x r à r ! Q EΦ x r à = ¥ A. i=1 The likelihood of the sample is this joint density evaluated at the observed sample values. θ) and the joint ˜ density of a random sample Y = (Y1 .

θ0 ) .16) (A. ∂θ ∂θ (A.16). ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. In fact. then θ V ar(˜ ≥ (nI0 )−1 .9.9. θ) ∂θ ∂θ which holds at θ = θ0 by (A. we can find an explicit expression for θ as a function of the data. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . n n i=1 n As the MLE ˆ maximizes the left-hand-side.2 Cramer-Rao Lower Bound. θ0 ) ln f (Yi . and the equality (A. We can write this as ˆ = argmax Ln (θ). θ θ∈Θ ˆ In some simple cases.14) ¶ ∂ ∂ 0 ln f (Yi .1 ¯ ¯ ∂ E ln f (Yi . θ) ≡ L(θ). θ0 ) ∂θ∂θ 0 (A. ˆ →p θ0 as n → ∞. θ Theorem A. cases are rare. we can see that it is an estimator of the maximizer θ of the right-hand-side.Define the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . The first-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation.3 Under regularity conditions. More typically. θ) →p E ln f (Yi .9.15) Two important features of the likelihood are Theorem A. which maximizes the log-likelihood). ˆ is consistent θ for this value. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.17) The matrix I0 is called the information.17) is often called the information matrix equality. under conventional regularity conditions. I0 . If ˜ is an unbiased estimator of θ ∈ R. but these ˆ must be found by numerical methods. the restriction to unbiased estimators means that the theorem has little direct relevance for finite sample efficiency. 179 . Theorem A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. However. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A.

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

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

1 . an application of the CLT yields 1 X ∂ √ ln f (Yi . we find ´ ³ ˆ − θ0 = θ Since ∂ ∂θ à !−1 à n ! n X ∂2 X ∂ ln f (Yi . If it is continuous in θ. the final equality using Theorem A. Ω) . − ln f (Yi . H −1 ΩH −1 = N 0. ¥ 182 . (Technically. θn ) = ln f (Yi . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . θ0 ) is mean-zero with covariance matrix Ω. Ω) = N 0. θ n ) θ − θ 0 . H −1 . θ) . Together. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θ0 ) . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . θ0 ) + ' 0 ln f (Yi .) Rewriting this equation. θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. and making a first-order Taylor series expansion.Proof of Theorem A. the specific value of θn varies by row in this expansion.3 Taking the first-order condition for maximization of Ln (θ). ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . then since θn →p θ0 we find H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi .9. ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . θ0 ) →d N (0. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0.9.

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

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

Let ∆gi = gi − gi−1 ∆θi = θi − θi−1 and . This can be defined by examining whether |θi − θi−1 | . the variance of the random innovations is shrunk. There are two common methods to perform a line search. If the criterion has improved over Q(θi ). 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 + + . and picks λi as the value minimizing this approximation. These problems have motivated alternative choices for the weight matrix Di .. Like the gradient methods. the iterations continue until the sequence has converged in some sense. The downside is that it can take considerable computer time to execute. it relies on an iterative sequence. A quadratic approximation evaluates the first and second derivatives of Q(λ) with respect to λ. this new value is accepted. A more recent innovation is the method of simulated annealing (SA). 1/8. alternative optimization methods are required.a one-dimensional optimization problem. and Rodgers (1994). ¢2 0 ∆θ0 ∆gi ∆θ0 ∆gi ∆θ0 ∆gi ∆θi ∆gi i i i 0 ∆θi ∆θ0 Di−1 ∆gi ∆gi Di−1 i + . it may still be accepted depending on the extent of the increase and another randomization. Newton’s method does not perform well if Q(θ) is irregular. As the iterations continue. . and it can be quite computationally costly if H(θ) is not analytically available. B. 1/4. At each iteration. 1/2. The half-step method considers the sequence λ = 1.3 Derivative-Free Methods All gradient methods can be quite poor in locating the global minimum when Q(θ) has several local minima. Furthermore. The SA algorithm stops when a large number of iterations is unable to improve the criterion. use this value. The SA method is a sophisticated random search. 185 . If the criterion is increased. If the resulting criterion is decreased. 0 0 ∆gi Di−1 ∆gi ∆θi ∆gi For any of the gradient methods. Two popular methods are do to Davidson-Fletcher-Powell (DFP) and Broyden-Fletcher-Goldfarb-Shanno (BFGS).. Each value in the sequence is considered and the criterion Q(θi + Di gi λ) evaluated. a random variable is drawn and added to the current value of the parameter. The SA method has been found to be successful at locating global minima. |Q (θi ) − Q (θi−1 )| or |g(θi )| has become small. These methods are called Quasi-Newton methods. . In these cases. For a review see Goffe. One example is the simplex method of Nelder-Mead (1965). the methods are not well defined when Q(θ) is non-differentiable. otherwise move to the next element in the sequence. The latter property is needed to keep the algorithm from selecting a local minimum. Ferrier.

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