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# ECONOMETRICS

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

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

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Contents

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

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

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

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

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

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

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ii

. . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . 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. . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . .2 Reduced Form . . . . . . . . . 12. . . 11. . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . .4 Lag Operator . . . . . 9. . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . 12. . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. 9. . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . .9 8. . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . 11. . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . .4 Estimation . . . . . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . . 10. . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . .6 Over-Identiﬁcation Test . .6 Bekker Asymptotics . . . . . . . . . . .8. . . . . . . . . . . . .7 Asymptotic Distribution . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . iii . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . .5 Numerical Computation . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation .11 8. . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . 12.3 Distribution of GMM Estimator . . . . . . . . . . . . . . . .12 8. . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . 9. . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . .

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

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

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

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

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

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

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

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

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

... (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. . ... There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. . 2.. ⎠ .. Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2. k) . The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ .... we deduce that Λ2 = Λ and λ2 = λi for i = 1.4) H0 M =H 0 0 with H 0 H = In .. There are k! such permutations. xk ) : Rk → R. jk ) denote a permutation of (1. .. i Hence they must equal either 0 or 1. If A is 2 × 2. k))... k. tr(A) = rank(A). ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . then its determinant is det A = a11 a22 − a12 a21 .8 Determinant The determinant is deﬁned for square matrices.. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . ... Additionally.. Let π = (j1 . and let επ = +1 if this count is even and επ = −1 if the count is odd.By the uniqueness of the characteristic roots. we can deﬁne the determinant as follows. . For a general k × k matrix A = [aij ] .. xk ) be k × 1 and g(x) = g(x1 .

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

Take a closer look at the density functions displayed in Figure 3. m(x) can take any form. education and experience. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. While it is easy to observe that the two densities are unequal. xi ) where yi is a scalar (real-valued) and xi is a vector. ⎠ ⎝ .1 displays the density1 of hourly wages for men and women. In this context we partition the observations into the pair (yi . To illustrate. and that for women is $20.2) m(x) = E (yi | xi = x) = −∞ In general. (3.1) xi = ⎜ . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience.73. These are conditional density functions — the density of hourly wages conditional on race.1. . We call yi the dependent variable.1. When a distribution is skewed. The two density curves show the eﬀect of gender on the distribution of wages. Figure 3. holding the other variables constant. We call xi alternatively the regressor. the conditional density of yi given xi . it is useful to have numerical measures of the diﬀerence.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. the mean is not necessarily a good summary of the central tendency. These are asymmetric (skewed) densities. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. which is a common feature of wage distributions. we can focus on f (y | x) . ⎟ . the conditioning variable. These are indicated in Figure 3. the mean wage for men is $27. You can see that the right tail of then density is much thicker than the left tail.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. In the example presented in Figure 3. The data are from the 2004 Current Population Survey 1 11 .1 by the arrows drawn to the x-axis. See Chapter 16.22. or the covariates. and exists so long as E |yi | < ∞. gender. This is used when the goal is to quantify the impact of one set of variables on another variable. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. xki 3.

D. and a Ph. Assuming for simplicity that this is the true joint distribution. To illustrate. degree in mean log hourly wages is 0. The diﬀerence in the log mean wage between men and women is 0.2 shows the density of log hourly wages for the same population. The conditional expectation function is close to linear. By construction. which implies a 30% average wage diﬀerence for this population. 12 .1 is facilitated by the fact that the control variable (gender) is discrete. Of particular interest to graduate students may be the observation that diﬀerence between a B.2) evaluated at the observed value of xi : ei = yi − m(xi ). Figure 3.Figure 3. with mean log hourly wages drawn in with the arrows.3 is how the conditional expectation describes an important feature of the conditional distribution. wage regressions typically use log wages as a dependent variable rather than the level of wages. the solid line displays the conditional expectation of log wages varying with education. The main point to be learned from Figure 3. When the distribution of the control variable is continuous. this yields the formula yi = m(xi ) + ei . implying an average 36% diﬀerence in wage levels.3 displays a scatter plot2 of log wages against education levels. Figure 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. then comparisons become more complicated.5. 3.36. For this reason.A.30.3) White non-military male wage earners with 10-15 years of potential work experience.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. 2 (3. The comparison in Figure 3. the dashed line is a linear projection approximation which will be discussed in the Section 3. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.

The remaining parts of the Theorem are left as an exercise. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. A regression model imposes further restrictions on the joint distribution.2: Log Wage Densities Theorem 3. E(ei ) = 0. because no restrictions have been placed on the joint distribution of the data. These equations hold true by deﬁnition. E (ei | xi ) = 0. restrictions on the permissible class of regression functions m(x). 2.2. E(xi ei ) = 0. 4. not a model.Figure 3. are often stated jointly as the regression framework. by the deﬁnition of ei and the linearity of conditional expectations. It is important to understand that this is a framework. E (h(xi )ei ) = 0 for any function h (·) . most typically.1 Properties of the regression error ei 1. 13 . 3. To show the ﬁrst statement. The equations yi = m(xi ) + ei E (ei | xi ) = 0.

Figure 3. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. when σ 2 (x) is a constant so that ¢ ¡ (3. To see this. The conditional standard deviation is its square root σ(x) = σ 2 (x). In contrast. subject to the restriction p that it is non-negative. Given the random variable xi . it does not provide information about the spread of the distribution.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. Thus the mean squared error is minimized by the conditional mean. i .2.1. σ 2 (x) is a non-trivial function of x. and can take any form. the conditional variance of yi is σ 2 = σ 2 (xi ).3. 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). in the sense of achieving the lowest mean squared error.3 Conditional Variance Generally. 3. 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 . let g(x) be an arbitrary predictor of yi given xi = x.

1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.4 Linear Regression An important special case of (3.5. 3. Equivalently.7) is a k × 1 parameter vector. i (3. 15 . In this case (3.1).5) xi = ⎜ .3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . ⎠ . and the linear assumption of the previous section is empirically unlikely to accurate. As an example. which we derive in this section.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). Thus (3. Equation (3. ⎟ . it is more realistic to view the linear speciﬁcation (3. Instead. they are also somewhat more dispersed. where x1i is the ﬁrst element of the vector xi deﬁned in (3.we say that the error ei is homoskedastic. We call this the “constant” or “intercept”.9) 3.1 and that for women is 10. its functional form is typically unknown. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .8) is called the linear regression model.6) (3. Notationally.6) as an approximation. we assume that x1i = 1. ⎠ . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . The conditional standard deviation for men is 12. ⎟ β=⎝ . βk ⎛ (3. ⎝ .1. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .8) (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. take the conditional wage densities displayed in Figure 3. xki When m(x) is linear in x. So while men have higher average wages. it is convenient to augment the regressor vector xi by listing the number “1” as an element.

α0 E (xi x0 ) α = E (α0 xi )2 > 0.5. written E (xi x0 ) > 0. by “best” we mean the predictor function with lowest mean squared error. The error is i ei = yi − x0 β.12) This completes the derivation of the linear projection model. Observe i that for any non-zero α ∈ Rk . Eyi < ∞. 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 .1. Given the deﬁnition of β in (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . The best linear predictor is obtained by selecting β to minimize S(β). i (3. otherwise they are distinct. Therefore. 3. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.1 1. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. E (xi x0 ) is invertible. 2 2.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. i 4.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.10) It is worth taking the time to understand the notation involved in this expression. x0 β is the best linear predictor for yi . E (x0 xi ) < ∞. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. i which requires that for all non-zero α. Rewriting.10). Assumption 3. In order for β to be uniquely deﬁned. This occurs when redundant variables are included in xi . It is invertible if and only if it is positive deﬁnite. i i (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 . xi contains an intercept. 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.which is quadratic in β. i (3. The ﬁrst-order condition for minimization (from Section 2. this situation must be excluded. i 16 . As before.5. The vector (3. Equivalently. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite.

12) can be alternatively interpreted as a projection decomposition.5. Equation (3.1. ¥ (3.13) summarize the linear projection model.1.8)-(3. Since ei is mean zero by (3. it follows that linear regression is a special case of the projection model. (3.1 are weak.13) The two equations (3.11) are well deﬁned. E (xi ei ) = 0 and E (ei ) = 0. 17 .5.3 are called regularity conditions.10) are deﬁned.5.1.5. Furthermore. Figure 3.14) follows from (3.13) and Assumption 3. However.5.4 guarantees that the solution β exits. (3.5.4 is required to ensure that β is uniquely deﬁned.1. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Using the deﬁnitions (3.3 ensure that the moments in (3.14) Proof. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1 Under Assumption 3.1.Theorem 3.14).13) implies that xi and ei are uncorrelated. For example.2.1.1 is employed to guarantee that (3. the orthogonality restriction (3.2 and 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .9).10) and (3. Assumption 3.1.1. Assumption 3. The ﬁnite variance Assumptions 3.5.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0. Let’s compare it with the linear regression model (3. This means that the equation (3. Since from Theorem 3.5. By deﬁnition.2 and 3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.1.4 we know that the regression error has the property E (xi ei ) = 0.14) holds.1.5.11) and (3.5.1. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. Assumption 3.5.12) and (3. Assumption 3.

This defect in linear projection can be partially corrected through a careful selection of regressors. In the example just presented. the dashed line is the linear projection of log wages on eduction. In this example it is a much better approximation to the conditional mean than the linear projection.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. In this case (3. The linear equation (3.10) may not hold and the implications of Theorem 3. Returning to the joint distribution displayed in Figure 3.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear.5. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. there are no changes in our methods or analysis. and under-predicts for the rest. We illustrate the issue in Figure 3. In this example the linear projection is a close approximation to the conditional mean.4 displays the relationship3 between mean log hourly wages and labor market experience. Other than the redeﬁnition of the regressor vector. In contrast. and the straight dashed line is the linear projection. No additional assumptions are required. The solid line is the conditional mean.1.We have shown that under mild regularity conditions. These structural models require alternative estimation methods. in many economic models the parameter β may be deﬁned within the model. 18 . Figure 3. It over-predicts wages for young and old workers. for those over 53 in age).4 we display as well this quadratic projection. Most importantly.10). However. it is important to not misinterpret the generality of this statement.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.12) with the properties listed in Theorem 3. In Figure 1.5. Figure 3. In other cases the two may be quite diﬀerent. since the resulting function is quadratic in experience. xi ) we can deﬁne a linear projection equation (3. for any pair (yi .1 may be false.3. and are discussed in Chapter 11. In this case the linear projection is a poor approximation to the conditional mean. we can augment the regressor vector xi to include both experience and experience2 . A projection of log wages on these two variables can be called a quadratic projection.

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

Compute the conditional mean m(x) = E (yi | xi = x) . then ei is i i independent of xi .2 Y =1 . . x 6.2. 0 ≤ y ≤ 1. True or False. E(ei | xi ) = 0. σ 2 = V ar(xi ). j! 0 j = 0. i 7. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . 3 and 4 of Theorem 3. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. Prove parts 2. Are they diﬀerent? Hint: If P (Y = j) = 5. True or False.1 . i 11. then E(x2 ei ) = 0. If yi = x0 β + ei and E(ei | xi ) = 0.. Let X be a random variable with µ = EX and σ 2 = V ar(X). then E(x2 ei ) = 0. m. taking values only on the non-negative integers. then ei is independent of xi .3 Find E(Y | X = x). xi ∈ R.6 Exercises 1. Let xi and yi have the joint density f (x. e−λ λj j! . s) = 0 if and only if m = µ and s = σ 2 . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. Compute E(yi | xi = x) and V ar(yi | xi = x). and have the following joint probability distribution X=0 X=1 Y =0 .4 . 2. 2.. then E(ei | xi ) = 0.1. 9. If yi = xi β + ei . E(Y 2 | X = x) and V ar(Y | X = x). Suppose that yi is discrete-valued. If yi = x0 β + ei . Suppose that Y and X only take the values 0 and 1. yi ). i 8. 1. 20 . xi ∈ R. If yi = x0 β + ei and E(xi ei ) = 0. µ. True or False. (x − µ)2 − σ 2 Show that Eg (X. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . 3. True or False. ¡ ¢ 4. and E(ei | xi ) = 0. a constant. and E(xi ei ) = 0. True or False.3. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. σ = . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . µx = Exi . σ 2 = V ar(yi ) and σ xy = Cov(xi . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . If yi = xi β + ei . i 10. and E(e2 | xi ) = σ 2 .

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.2) (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .3) In Sections 4.1 Estimation Equation (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.1) (4. we narrow the focus to the linear regression model. Observe that (4. but for most of the chapter we retain the broader focus on the projection model.8. i n i=1 n 21 . 4.2) can be written in the parametric 0 β)) = 0. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .7 and 4. (4.

n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. 40 2. consider the data used to generate Figure 3. ¶ 2.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.117 1 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. i 22 .37 µ ¶ 1.40 µ ¶µ ¶ 34.117 Educationi .83 ¶−1 µ ¶ .2 Least Squares There is another classic motivation for the estimator (4.4).170 37. 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.95 42. with 10-15 years of potential work experience. Let yi be log wages and xi be an intercept and years of education.14 205. An interpretation of the estimated equation is that each year of education is associated with an 11. 4. To illustrate.30 + 0. Then µ ¶ n 1X 2.14 14. 30 = .14 205. These are white male wage earners from the March 2004 Current Population Survey.94 −2.7% increase in mean wages.71 = −2. This sample has 988 observations.ˆ This is a set of k equations which are linear in β. excluding military. 40 0.4).3.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. 0.95 xi yi = 42.14 14.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.

i ˆ ˆ Note that yi = yi + ei . It is important to understand the distinction between the error ei and the residual ei . Matrix calculus (see Appendix 2. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β).1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Figure 4. Figure 4.7) 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. while the residual is a by-product of estimation.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. These two ˆ variables are frequently mislabeled.4). 23 . the contour lines are ellipses. Since the function Sn (β) is a quadratic function of β. To visualize the sum-of-squared errors function.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. The error is unobservable. which can cause confusion. Figure 4. Following convention we will call β the OLS estimator of β.

one implication is that n 1X ei = 0. ˆ n i=1 n Since xi contains a constant. Its method of moments estimator is the sample average 1X 2 ei .Figure 4.7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. It measures the variation in the i “unexplained” part of the regression. The error variance σ 2 = Ee2 is also a parameter of interest. and hold true for all linear regression estimates. ˆ n−k 2 i=1 (4.2: Sum-of-Squared Error Function Contours Equation (4.7. ˆ σ = ˆ n 2 i=1 n (4.5) implies that 1X xi ei = 0. These are algebraic results.6) An alternative estimator uses the formula n 1 X 2 s = ei . 24 .

Since Ln (β. This is a parametric model. maximizing the likelihood is identical to minimizing Sn (β).3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. 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 . The R2 is frequently mislabeled as a measure of “ﬁt”. σ 2 ) maximize Ln (β.where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. The log-likelihood function for the normal regression model is Ã ¶! µ n X ¢2 1 1 ¡ 2 0 log exp − 2 yi − xi β Ln (β. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. 4. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . σ 2 ) is a function of β only through the sum of squared errors Sn (β). σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . Hence the MLE for β equals the OLS estimator. 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 2 ). This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. and distribution theory. testing. σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. σ 2 ). 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. 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 ). Instead.

6). . including computation. For example n X i=1 For many purposes. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. The linear equation (3. . yn ⎟ ⎟ ⎟. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. residual vector. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . ⎟. ⎝ ⎝ . σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. = β+ XX 26 (4. and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e. . Thus the MLE (β. Due to this equivalence.8) . x0 n ⎞ ⎛ e1 e2 . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. n X i=1 Thus the estimator (4.4).12) is a system of n equations. n or equivalently Y = Xβ + e. . . en ⎞ Observe that Y and e are n × 1 vectors. ⎠ . one for each observation. Sample sums can also be written in matrix notation. and X is an n × k matrix. it is matrix notation.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . . We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . 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. yn = x0 β + en . 4.

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

In this section we derive the small sample conditional mean and variance of the OLS estimator. obtain residuals Y .8)(3. A common application of the FWL theorem. . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. ¡ ¢−1 0 ι. ⎟ ⎜ ⎟ ⎜ (4.13). ˆ which are “demeaned”. 4. obtain residuals X2 . observe that ⎞ ⎛ ⎞ ⎛ .14) or via the ˆ following algorithm: ˜ 1. or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. In this case. is the demeaning formula for regression. ⎠ ⎝ ⎠ ⎝ . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. the primary use is theoretical. Regress Y on X1 . 30 .6. . In some contexts. which you may have seen in an introductory econometrics course. . . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 .9). . and X2 is the vector of observed regressors. ˆ ˜ ˜ ˆ 3.Theorem 4. . Regress Y on X2 . but in most cases there is little computational advantage to using the two-step algorithm. ˜ 2. . the FWL theorem can be used to speed computation. In the model (4. . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.1 (Frisch-Waugh-Lovell). . .9). obtain OLS estimates β 2 and residuals e. Rather. By the independence of the observations and (3. Regress X2 on X1 .

. . . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. and (4. . . 1 n . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . ⎝ . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . From (4. . ⎠ (4.19) ˆ and thus the OLS estimator β is unbiased for β. 0 0 ··· 0 0 .20) . V ar β | X = X 0 X ⎟ ⎟ ⎟.19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X .. X 0 DX = X 0 Xσ 2 .12).18). Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 .8). the properties of conditional expectations. 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. . .. and ³ ´ ¡ ¢−1 2 ˆ σ .Using (4. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model. under the of ˆ ¢ 2 | x = σ 2 . σ 2 } = ⎜ . and the trace operator observe that. . Then given (4.. Next. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 .

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

r for some constant vectors τ j . The MLE β mle for β is then the analog of (4. ˆ β mle = ⎝ j j=1 j=1 33 .. but we don’t know the probabilities. ¡ ¢ P yi = τ j . Set C = A − X (X 0 X)−1 . who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. r. xi = ξ j = π j . xi ) is discrete. . . π r ) ..3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. Suppose that the joint distribution of (yi . . and π j . Note that X 0 C = 0..9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. the deﬁnition (4. Not only has the class of models has been restricted to homoskedastic linear regressions. Let A be any n×k function of X such that A0 X = Ik . 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.5) as required..Proof. That is. This latter restriction is particularly unsatisfactory.. j = 1.21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ . ξ 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. Assume that the τ j and ξ j are known. π j is the percentage of the observations ˆ ˆ which fall in each category. for ﬁnite r. and is a strong justiﬁcation for the least-squares estimator. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator..21) j j=1 j=1 Thus β is a function of (π 1 . where 1 (·) is the indicator function. We discuss the intuition behind his result in this section.. (We know the values yi and xi can take. 4..) In this discrete setting. but the π j are unknown. A broader justiﬁcation is provided in Chamberlain (1987). the class of potential estimators has been restricted to linear unbiased estimators. As the data are multinomial. This property is called semiparametric eﬃciency. 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.. That is. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . but it is quite limited in scope.

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 .9). He observes that the above argument holds for all multinomial distributions.5.22) 34 .10) for the class of models satisfying Assumption 3. (4.Substituting in the expressions for π j .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. 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. 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 . if the data have a discrete distribution.10 Omitted Variables xi = µ x1i x2i ¶ . and thus so is the OLS estimator. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. He proves that generically the OLS estimator (4. the maximum likelihood estimator is identical to the OLS estimator. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.1. Chamberlain (1987) extends this argument to the case of continuously-distributed data.

The more relevant issue is near multicollinearity. This is because the model being estimated is diﬀerent than (4. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. 4.22).e. This is called strict multicollinearity.22) the long regression and (4. For example. log(p2 ) and log(p1 /p2 ). then β is not deﬁned. When this happens. This happens when the columns of X are linearly dependent. Goldberger (1991) calls (4. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. In this case. 35 .11 Multicollinearity ˆ If rank(X 0 X) < k + 1. if X includes both the logs of two prices and the log of the relative prices. there is some α such that Xα = 0. which is often called “multicollinearity” for brevity. The diﬀerence Γβ 2 is known as omitted variable bias. This is estimation of the equation yi = x0 γ 1 + ui 1i E (x1i ui ) = 0 Notice that we have written the coeﬃcient on x1i as γ 1 rather than β 1 . except in special cases.23) where is the coeﬃcient from a regression of x2i on x1i .23) the short regression to emphasize the distinction. this is rarely a problem for applied econometric practice.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . log(p1 ). It is the consequence of omission of a relevant correlated variable. when the columns of X are close to linearly dependent. β 1 6= γ 1 . In general. Typically there are limits. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . 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. and the error as ui rather than ei . as many desired variables are not available in a given dataset. we regress yi on x1i only. First. This is the situation when the X 0 X matrix is near singular. By construction. the general model will be free of the omitted variables problem. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. or second..22) by least-squares.22) is zero. To see this. This deﬁnition is not precise.Now suppose that instead of estimating equation (4. least-squares estimation of (4. the coeﬃcient on x2i in (4. Since the error is discovered quickly. i. Most commonly. because we have not said what it means for a matrix to be “near singular”. this arises when sets of regressors are included which are identically related. Typically. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model.

25) below. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi .24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . ˆ i A simple comparison yields that ˆ ei − ei. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.26) As we can see. If the i’th observation 36 . ˆ ˆ (4. deﬁne the leave-one-out least-squares estimator of β. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . 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 . since as ρ approaches 1 the matrix becomes singular. that is. the precision of individual estimates are reduced. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.27) (4. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4.−i = yi − x0 β (−i) = (1 − hi )−1 ei . the OLS estimator based on the sample excluding the i’th observation. To investigate the possibility of inﬂuential observations. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. the worse the precision of the individual coeﬃcient estimates. The hi take values in [0. We can also deﬁne the leave-one-out residual ˆ ˆ ei. We derive expression (4.−i = (1 − hi )−1 hi ei .One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. 1] and sum to k. As a consequence.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. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.

ˆ We now derive equation (4.This implies has a large value of hi .1) in Section 2. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .25).4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . then this observation is a leverage point and has the potential to be an inﬂuential observation. which is considerably more informative than plots of the uncorrected residuals ei . ¢−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 . The key is equation (2.27). Investigations into the presence of inﬂuential observations can plot the values of (4.

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

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

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

if for all x at which F (x) is continuous. Fn (x) → F (x) as n → ∞.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .1 Central Limit Theorem (CLT). n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . If Xi ∈ Rk is iid and E |Xi |2 < ∞.Proof: Without loss of generality. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. as needed. (5. 5. the fact that X n = W n + Z n . Jensen’s inequality (5. We say that Zn converges in distribution to Z as n → ∞.5). ¡¯ ¯ P ¯X n ¯ > δ ≤ η.6) and (5.4). ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η.1). and the bound |Wi | ≤ 2C. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. 43 . Finally. where Z has distribution F (x) = P (Z ≤ x) . the triangle inequality.3. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . we can set E(X) = 0 (by recentering Xi on its expectation). denoted Zn →d Z. P ¯X n ¯ > δ ≤ η. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.6) By Jensen’s inequality (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N.1) and (5. Fix δ and η.7).3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . the fact that the Wi are iid and mean zero. by Markov’s inequality (5. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. V ) . Set ε = δη/3. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. Theorem 5.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞.

it is suﬃcient to consider the case µ = 0 and V = Ik . the independence of the Xi . so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . By a second-order Taylor series expansion of c(λ) about λ = 0. By the properties of the exponential function.Proof: Without loss of generality.8) where λ∗ lies on the line segment joining 0 and λ. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5.8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 . For ¡ ¢ λ ∈ Rk . let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). the deﬁnition of c(λ) and (5. ∂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.

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

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

1).1.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .2.5. (6.1 and the WLLN (Theorem 5.4. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. (6. To characterize the sampling distribution more fully. we will use the methods of asymptotic approximation.1).1. ·) is continuous at (Q. Equation (4. the OLS estimator β is has a statistical distribution which is unknown. Assumption 3. 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 . 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.2) i i n i=1 n From (6.3).1) and ˆ We now deduce the consistency of β.1 by the fact that the sampling densities become more concentrated as n gets larger. Ã n ! n X 1X 0 1 ˆ xi xi . β →p β as n → ∞.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.2. and the continuous mapping theorem (Theorem 5.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.1. 6.4. n i=1 (6. This is illustrated in Figure 6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. using (6. Assumption 3. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.5. xi ei →p g (Q. we can conclude ˆ that β →p β.1). For a complete argument. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . Proof. As the sample size increases the density becomes more concentrated about the population coeﬃcient.2 Consistency ˆ As discussed in Section 6.2). Hence by the continuous mapping theorem (Theorem 5. 0). First.1). ˆ Theorem 6.4 implies that Q−1 exists and thus g(·. ˆ 47 .1 Under Assumption 3.5.3) Ã where g(A. (6.

2). since n/(n − k) → 1 as n → ∞. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .1 guarantees that the elements of Ω are ﬁnite. Ee4 < ∞ and E |xi |4 < ∞.1.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.6) n i=1 48 .5) Thus xi ei is iid with mean zero and has covariance matrix Ω. by the Cauchy-Schwarz inequality (5. it follows that s2 = ¥ n σ 2 →p σ 2 .1 In addition to Assumption 3.1).3. i i Assumption 6.3. We need a strengthening of the moment conditions.Theorem 6. Thus σ 2 is consistent for σ 2 .3) and Theorem (6.2). Ω) . ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.5. ˆ Finally. E ¯ei ¯ E ¯e4 ¯ i i i i (6. (6.2. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. n 1 X √ xi ei →d N (0.2. By the central limit theorem (Theorem 5.2 Under Assumption 3.1. To see this.1). ˆ Proof. ˆ n−k 6.5.3. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . (6. Assumption 6. (6. (6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.

xi ) which satisfy the conditions of Assumption 6. but this is not a necessary condition. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. Let yi = β 0 + β 1 xi + εi where xi is N (0.7) holds.7) is true or false.9) we deﬁne V 0 = Q−1 σ 2 whether (6. The asymptotic distribution ´ Theorem 6. is approximately normal when the sample size n is suﬃciently large. |ε| ≥ 1. For α 49 . 1) asymptotic distibution.6). In Figure 6.1 Under Assumption 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. Under (6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. 1).1 states that the sampling distribution of the least-squares estimator.3.3. there is no simple answer to this reasonable question. however.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . V is often referred to as ˆ the asymptotic covariance matrix of β.3. i i Condition (6. when xi and ei are independent. We call V 0 the homoskedastic covariance matrix.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . The expression V = Q−1 ΩQ−1 is called a sandwich form. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .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.3. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. In´Figure 6. Theorem 6. However. for example. (6. setting n = 100 and varying the parameter α. We illustrate this problem using a simulation. and (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . We say that ei is a Homoskedastic Projection Error when (6. The trouble is that no matter how large is the sample size. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.7) Cov(xi x0 . The approximation may be poor when n is small. As α approaches 2.1. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). This holds true for all joint distibutions of (yi . 1 X √ xi ei n i=1 n ! the N (0. How large should n be in order for the approximation to be useful? Unfortunately.2).1).9) In (6. otherwise V 6= V 0 . There is a special case where Ω and V simplify. Q−1 ΩQ−1 . its variance diverges q ³ ´ ˆ to inﬁnity.1.Then using (6. When (6. e2 ) = 0. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. V ) where V = Q−1 ΩQ−1 .3. after rescaling.7) is true then V = V 0 . Ω) ¡ ¢ = N 0.

Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. The lesson from Figures 6. Another example is shown in Figure 6. 1) asymptotic approximation is never guaranteed to be accurate.10) V 0 = Q−1 s2 .2. We show the sampling distribution of n β 1 − β 1 setting n = 100. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.11) 50 .1) it is clear that V 0 →p V 0 . the sampling distribution becomes highly skewed and non-normal.2 and 6. As α diminishes the density changes signiﬁcantly. for k = 1. we need an estimate of Ω = E xi x0 e2 .2: Density of Normalized OLS estimator α = 3.3 is that the N (0. 1) density.0 the density is very close to the N (0. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. 6 and 8. 4. The estimator 2 2 in (6. As k increases. 6.2) and Theorem 6.10) without changing this result.3.Figure 6. concentrating most of the probability mass around zero.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. 1).

and was still the standard choice for much empirical work done in the early 1980s... . and V is an estimator of the variance of n β − β . these all mean the same thing.4.. When β is a vector. j = 0. or that they use a “heteroskedasticity-robust covariance matrix estimator”. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. This motivates the deﬁnition of a standard error.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. we focus on individual elements of β one-at-a-time. many authors will state that their “standard errors have been corrected for heteroskedasticity”. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. the “Huber formula”. as there may be more than one estimator of the variance of the estimator. the “Huber-White formula” or the “GMM covariance matrix”. ˆ ˆ When V is used rather than the traditional choice V 0 . as it is not always clear which has been computed. It is therefore important to understand what formula and method is 51 . it is important to pay ˆ ˆ attention to the distinction between V 0 and V . Generically. we set s(β) = n−1/2 V . vis. When reading and reporting applied work. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. standard errors are not unique. The methods switched during ˆ the late 1980s and early 1990s. the “Eicker-White formula”.. ˆ ˆ Deﬁnition 6. A more easily interpretable measure of spread is its square root — the standard deviation. 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).Figure 6. β j . In most cases. 1.3: Sampling distribution where ei are the OLS residuals. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . k. or that they use the “White formula”.

80 .480 .039 and ˆ V = µ 1 14.199 2.020) 6.6 ¶µ 1 14. but not under another set of assumptions. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .1. We calculate that s2 = 0.085 p ˆ and that for β 1 is .117 Educationi .14 205.020.80 2.4) 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 .493 0. The standard errors for β 0 are 7. i i i i n i=1 Second. from which it follows that V →p V as n → ∞.83 −0.used by an author when studying their work. From a computational standpoint. (6.14 205.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.035 ¶ .80 40.83 ¶−1 µ . First.085) (.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω.199 2. we return to the log wage regression of Section 4. To illustrate. and then the square roots.83 ¶−1 = µ 7.20 and µ ¶ ˆ = 0. p ˆ In this case the two estimates are quite similar.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.14 14. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.2.14 14.80 40. then take the diagonal elements. Ω 2. (. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .35/988 = .20 −0.480 ˆ0 = 0.493 −0.98 −0. n n i=1 52 .14 6. by Holder’s inequality (5. (6.2/988 = . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.30 + 0.14 205. just as any other estimator.5) and the WLLN (Theorem 5.12) in turn.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.20 = V 14. Using (6.

which. n i=1 n ˆ ˆ Theorem 6. you can show that 1 Xˆ ¯ β= β (−i) . Ω →p Ω and V →p V.5.13) of Efron (1982). ¯ 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.−i = (1 − hi )−1 ei ˆ presented in (4.13) Using formula (4. 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. Using this substitution. Recall from Section 4.11) with the leave-one-out estimator ei. 6. these establish consistency.1 As n → ∞. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. Andrews (1991) suggested an similar estimator based on cross-validation. ¯ ¯n ¯ n i=1 so Together. i=1 Third.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. From equation (3.25). 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 (6.26).12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.

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

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

from which it follows that pn →d U [0. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). regardless of the complication of the distribution of the original test statistic. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. z. or “accepts” H0 . Then the asymptotic p-value of the statistic tn is pn = p(tn ). in that the reader is allowed to pick the level of signiﬁcance α. The p-value is more general. 1). in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . If the p-value pn is small (close to zero) then the evidence against H0 is strong.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . The coverage probability is P (θ ∈ Cn ). s(ˆ θ) Under H0 . Either θ ∈ Cn or θ ∈ Cn . To see this fact. 56 . Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. 6.645. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0.96 and z. For example.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. Let zα/2 is the upper α/2 quantile of the standard normal distribution. pn →d U [0. In a sense. 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. An alternative approach. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α.025 = 1. That is. tn →d N (0. 1]. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . however. 1]. Otherwise the test does not reject. Deﬁne the tail probability.05 = 1. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. 1]. is to report an asymptotic p-value. associated with Fisher. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . if Z ∼ N (0. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. It is designed to cover θ with high probability. That is. and is a function of the data and hence is / random. under H0 . 1).

ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). and it is desired to test the joint restrictions simultaneously.96s(ˆ ≈ ˆ ± 2s(ˆ . or α = . θ θ) (6. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. θ The interval has been constructed so that as n → ∞. the most common professional choice isi95%. ˆ + zα/2 s(ˆ .16) and zα/2 is the upper α/2 quantile of the standard normal distribution. 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. This corresponds to selecting the conﬁdence h i h ˆ ± 1. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.18) . 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). 6.05. = n h(β) − θ0 Hβ V Hβ 57 (6. In this case the t-statistic approach does not work. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .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. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).

15) showed that n ˆ − θ →d Z ∼ N (0. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Vθ ). and there are q = k2 restrictions.8. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). 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. q and pn is asymptotically U[0. h(β) = R0 β. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. Furthermore. The asymptotic p-value for Wn is pn = p(Wn ). = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.19) σ2 ˆ where σ2 = ˜ 1 0 e e. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity.05) = 3. Hence β β by Theorem A.84 = z. Hβ (β) →p Hβ . For example. the upper-α quantile q 2 of the χ2 distribution. Hβ (β) is a continuous function of β. θ = β 2 . ˆ Wn = n θ θ q θ θ Theorem 6.1 showed θ ˆ that V →p V.2. As before. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. a chiq square random variable with q degrees of freedom.10. In this case. Also h(β) = a selector matrix. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . then Wn →d χ2 .5. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .1 Under H0 and Assumption 6.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . ˜˜ n ˜ e = Y − X1 β 1 . if rank(Hβ ) = q. The null hypothesis is H0 : β 2 = 0. the test rejects at the α% level iﬀ pn < α. and Theorem 6.1.025 .When h is a linear function of β. χ2 (. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . 1] under H0 . 6.3.

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

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 . n−k 60 . σ 2 ) can be be used to calculate a set of exact distribution results. an “F statistic” is reported.4)) where H 0 H = In . e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . when an OLS regression is reported. This is rarely an issue today.where In many statistical packages. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. equivalently the residual variance from an intercept-only model. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. introduced in Section 4. In σ 2 . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. 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. including the estimated error variance 2. In particular. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. This was a popular statistic in the early days of econometric reporting. The modelling assumption that the error ei is independent of xi and N (0. In ) . these cases are atypical. While there are special cases where this F statistic is useful. there is an exact distribution theory available for the normal linear regression model. Since linear functions of normals are also normal. it follows ˆ that β is independent of any function of the OLS residuals.3.12 Normal Regression Model As an alternative to asymptotic distribution theory. 6. Let u = σ −1 H 0 e ∼ N (0. H 0 H) ∼ N (0. Since uncorrelated normal variables are independent. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi .

β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. β has an exact normal distribution and t has an exact t distribution. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . The critical values are quite close if n − k ≥ 30. (Unless the sample size is unreasonably small. Furthermore. 0. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ) − Ln (β 1 .12. Theorem 6.10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ) = − log σ − log (2π) − . 0. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.a chi-square distribution with n − k degrees of freedom. We summarize these ﬁndings Theorem 6. β 2 . if standard errors are calculated using the homoskedastic formula (6. with residual variance σ .1 and Theorem 6. σ2 ˆ 61 . n−k • ∼ tn−k ˆ In Theorem 6. the notable distinction is between the N (0. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .3. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .1 shows that under the strong assumption of ˆ normality. σ 2 ). In contrast. As inference (conﬁdence intervals) are based on the t-ratio.10) then ´ ³ ˆ • β ∼ N 0.1 we showed that in large samples.12. β and t are approximately normally distributed. and standard errors are calculated using the homoskedastic formula (6. σ 2 ) discussed above. 1) and tn−k distributions. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. so as a practical matter it does not matter which distribution is used. σ ˆ ˆ βj − βj βj − βj N (0. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom.1 If ei is independent of xi and distributed N(0. β 2 . a good testing procedure is based on the likelihood ratio statistic. β 2 . 0. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .8.) Now let us partition β = (β 1 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .

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

the Type I error probability improves towards 5% as the sample size n increases. however. looking for tests for which rate rejection rates are close to 5%.Figure 6.000 simulated Wald statistics Wn (s) which are larger than 3. Test performance deteriorates as s increases.4.84 | β = 1) . There is. 100 and 500. so these probabilities are Type I error. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Typically.05) with deviations indicating+ distortion. no magic choice of n for which all tests perform uniformly well. n is varied among 20. and σ 2 . These probabilities are calculated as the percentage of the 50. the only test which meets this criterion is the conventional Wn = Wn (1) test. we compare the rates row by row. and σ is varied among 1 and 3. In Table 4. Error rates avove 10% are considered excessive.1 you can also see the impact of variation in sample size.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Any other choice of s leads to a test with unacceptable Type I error probabilities. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. The null hypothesis β s = 1 is true. n.1 reports the simulation estimate of the Type I error probability from 50. The value of s is varied from 1 to 10. this probability depends only on s. When comparing statistical procedures. Table 4. remember that the ideal Type I error probability is 5% (.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .84. In Table 2. Table 4. Given the simplicity of the model. Rates above 20% are unexceptable. Type I error rates between 3% and 8% are considered reasonable.4: Wald Statistic as a function of s P (Wn (s) > 3. For this particular example. To interpret the table. and rarely fall outside of the 3%-8% range. In each case.000 random samples.

14 .07 .08 .09 .25 .12 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .05 . β 2 ) be the least-squares estimates of (6.22 .20 .15 .s 1 2 3 4 5 6 7 8 9 10 Note: σ=1 σ=3 n = 20 n = 100 n = 500 n = 20 n = 100 n = 500 .21 .07 .06 .15 .19 .08 .11 . 64 .25 .23 .15 . deﬁne θ = β 1 /β 2 . β 1 .10 .05 .06 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.05 .07 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.08 .08 .15 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.30 .12 .06 .06 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.13 .13 .35 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .10 . While this is clear in this particular example.06 .24 . so the hypothesis can be stated as H0 : θ = r.07 .05 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .07 .26 .13 .08 . This point can be illustrated through another example.33 .31 .14 .10 . Other choices are arbitrary and would not be used in practice.20). Equivalently.16 Rejection frequencies from 50.05 .06 .18 .22 .05 .34 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .17 .20 .06 .28 .06 .

00 . The results are presented in Table 4.47 . this formulation should be used.2. Ideally. σ 2 ) draw with σ = 3. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . It is also prudent to consider alternative tests to the Wald statistic.05.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.15 .75.645) t1n t2n t1n t2n t1n t2n t1n t2n . 6.00 . the entries in the table should be 0.0 and n among 100 and 500. We vary β 2 among . and are close to the ideal 5% rate for both sample sizes.05 .00 . while the right tail probabilities P (t1n > 1.26 .05 .05 . the rejection rates for the t1n statistic diverge greatly from this value.05 .00 .09 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.15 .05 β2 . if the hypothesis can be expressed as a linear restriction on the model parameters. .28 .000 simulated samples. . and 1.05 . In contrast. along with sample size n.12 . If no linear formulation is feasible.00 . In this section we describe the method in more detail.05 .06 .10 . then the “most linear” formulation should be selected.25 .06 .06 .14 Monte Carlo Simulation In the previous section we introduced the method of Monte Carlo simulation to illustrate the small sample problems with tests of nonlinear hypotheses. ei be an independent N (0. This leaves β 2 as a free parameter. such as the GMM distance statistic which will be presented in Section 9.10 .10 . 65 .645) P (tn > 1.645) and P (tn > 1. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.06 .06 .05 .1.645) are calculated from 50.06 .25.645) greatly exceed 5%. The left tail probabilities P (t1n < −1. We let x1i and x2i be mutually independent N (0. and normalize β 0 = 0 and β 1 = 1. especially for small values of β 2 .06 .06 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . and alternatives to asymptotic critical values should be considered.645) P (tn < −1.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . Table 4.645) P (tn > 1.07 . 1) variables.05 .06 .06 .7.50. However.00 The one-sided Type I error probabilities P (tn < −1. The implication of Table 4.645) are close to zero in most cases.00 . . In all cases.05 .00 .75 1.02 .00 .50 .00 .

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

then we can set s P = (. In many cases.96) is iid Bernoulli. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. It is therefore useful to conduct a variety of experiments. For the dependent variable we use the natural log of wages. where N = (B +1)α. and hispanic. union member.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. 1000.95) /B ' . Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. the performance will depend on n and F. and 90% sample quantiles of the sample {Tnb }. For regressors we include years of education. potential work experience. are. a larger B results in more precise estimates of the features of interest of Gn .003. The random variable 1 (Tnb ≥ 1. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. therefore. and poorly for others. so that coeﬃcients may be interpreted as semi-elasticities. it is simple to make inferences about rejection probabilities from statistical tests. It is therefore convenient to pick B so that N is an integer. We now expand the sample all non-military wage earners. s P = . if we set B = 999. an estimator or test may perform wonderfully for some values. equalling 1 with probability P = E1 (Tnb ≥ 1. and our regressors include years of education. and 5000. Often this is called the number of replications. and therefore it is straightforward to calculate standard errors for any quantity of interest.15 Estimating a Wage Equation We again return to our wage equation. hispanic. We us the sample of wage earners from the March 2004 Current Population Survey. the choice of B is often guided by the computational demands of the statistical procedure. Again our dependent variable is the natural log of wages. immigrant. The average (6. immigrant.96) . Quite simply.007. and non-white. As discussed above. potential work experience.96) . and estimate a multivariate regression. we included a dummy 67 . union member. For example. and dummy variable indicators for the following: married. such as the percentage estimate reported in (6. The α% sample quantile is a number qα such that α% of the sample are less than qα .Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. 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. B. Hence the ³ ´ ˆ standard errors for B = 100. excluding military.022. Generally. experience squared. then B will have to be increased. experience squared. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1.21).21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. 6. If the standard error is too large to make a reliable inference. and . As P is unknown. In practice. Then qα is the N ’th number in this ordered sequence. female.22/ B. but requires more computational time. For example. B b=1 (6. In particular. the researcher must select the number of experiments. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. for a selection of choices of n and F. We separately estimate equations for white and non-whites.05) (. respectively. female. . Furthermore. this may ˆ be approximated by replacing P with P or with an hypothesized value.

033 −.121 −.070 . 808 1 − .007 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.19) is ˜ µ ¶ µ ¶ σ2 ˆ . Computing the Wald statistic (6. as the 1% critical value for the χ2 distribution is 76. excluding the coeﬃcients on the state dummy variables. The available sample is 18.032 .49452 σ ˜ Notice that the two statistics are close. Ignoring the other coeﬃcients. 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.097 −.1.808 .4877 18.014 .00057 .002 .00002 .232 . The F form of the Wald statistic (6.48772 = 515.808 so the parameter estimates are quite precise and reported in Table 4.013 . the restricted standard deviation estimate is σ = . we ﬁnd Wn = 550.4945.010 . θ ˆ 2β 3 β2 .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.34 ˆ s(β) .18) that the state coeﬃcients are jointly zero.008 . but not equal.027 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. 2β 3 68 .101 .010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant. Using either statistic the hypothesis is easily rejected. Table 4.001 . this adds 50 regressors).variable for state of residence (including the District of Columbia. Alternatively. Wn = n 1 − 2 = 18. reestimating the model with the 50 state dummies excluded.102 −.102 −.69.

96. we can calculate a standard error of s(ˆ = . However. Instead. 69 . but the lower end is substantially lower.5].9. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.40. but it can be found numerically quite easily. This is the set of θ such that |tn (θ)| ≤ 1. In the present context we are interested in forming a conﬁdence interval. This set is [27.0. not testing a hypothesis. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further.Using the Delta Method. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. implying a 95% conﬁdence θ) interval of [27. this is a poor choice.5]. 29. Since tn (θ) is a non-linear function of θ. 29. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ). In the previous section we discovered that such t-tests had very poor Type I error rates. there is not a simple expression for this set.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

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

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

but the only diﬀerence is that they a ¢ allowed for general choice of zi . require the assumption of a correct conditional mean. OLS is a more robust estimator of the parameter vector. In this case. 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 (7.4). BreuschPagan (1979) proposed what might appear to be ¡ distinct test.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. Third. Typically. and this requires trimming to solve. The asymptotic distribution (7. If the equation of interest is a linear projection. the Wald test of H0 is asymptotically χ2 . the estimated conditional variances may contain more noise than information about the true conditional variances. It is consistent not only in the regression model. σ 2 ). but also under the assumptions of linear projection. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . And the FGLS probability limit will depend on the particular function selected for the skedastic regression. the two tests coincide.4) and constructing a Wald statistic. Theorem 7.1 Under H0 and ei independent of xi . The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . Motivated by the form of the asymptotic variance ˆ of the OLS estimator β.error.5) and the asymptotic variance (7. its squares.7) under independence show that this test has an asymptotic chi-square distribution. individual estimated conditional variances may be negative. and the cost is a reduction of robustness to misspeciﬁcatio 7.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . If i this simpliﬁcation is replaced by the standard formula (under independence of the error). The GLS and FGLS estimators.2).2. or equivalently that i H0 : α1 = 0 in the regression (7. Second. FGLS will do worse than OLS in practice. q Most tests for heteroskedasticity take this basic form. and not a conditional mean. We may therefore test this hypothesis by the estimation (7. The main diﬀerences between popular “tests” is which transformations of xi enter zi . In the linear regression model the conditional mean of yi given xi = x is 77 . Vα = E zi zi (7. 7. and all cross-products. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. as they will be estimating two diﬀerent projections. This introduces an element of arbitrariness which is unsettling to empirical researchers. on the other hand. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . however.

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

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

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

Two useful facts about the median are that (7. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. as i=1 these estimators are indeed identical.To recall the deﬁnition and properties of the median. These distinctions are illusory. The second is the value which minimizes n n |yi − θ| .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 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. Now let’s consider the conditional median of Y given a random variable X. The ﬁrst deﬁnition is the 50th empirical 1 P quantile.10) The LAD estimator has the asymptotic distribution 81 . Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. and the substantive assumption is that the median function is linear in x. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. These facts deﬁnitions motivate three estimators of θ. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. however. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. i n n i=1 (7.5. let Y be a continuous random variable. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = .

This can be done with kernel estimation techniques. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .1 ´ √ ³ˆ n β − β 0 →d N (0. and this improves estimation of the median. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. then there are many innovations near to the median.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.3.10) is equivalent to g n (β) = 0. See Chapter 16. V ).1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .Theorem 7. While a complete proof of Theorem 7. ˆ Proof of Theorem 7. where V = and f (e | x) is the conditional density of ei given xi = x. (7. the height of the error density at its median. we provide a sketch here for completeness. Computation of standard error for LAD estimates typically is based on equation (7. In the special case where the error is independent of xi . Pn −1 0 β)) . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. ¢¢−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) . Second using the law of iterated expectations and the chain rule of i diﬀerentiation. The main diﬃculty is the estimation of f (0). ∂β 0 so Third. the conditional density of the error at its median. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . When f (0 | x) is large.5. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . by a Taylor series expansion and the fact g(β 0 ) = 0 82 .1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. Let g(β) = Eg (β). First. by the central limit theorem (Theorm 5.1 is advanced.5.11).5.

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

the τ ’th conditional quantile of ei is zero. and are widely available. 7.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ .1 n β τ − β τ →d N (0. ´ √ ³ˆ Theorem 7.12). ¡ ¡ ¢¢−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. Another popular approach is the RESET test proposed by Ramsey (1969).7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . and test their signiﬁcance using a Wald test. Vτ ). fast linear programming methods have been developed for this problem.5.13). otherwise its properties are unspeciﬁed without further restrictions. When the error ei is independent of xi . and form a Wald statistic i for γ = 0. i By construction. Furthermore. 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. 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 (7.1. Fortunately. Thus. then f (0 | xi ) = f (0) . E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005).6. it is useful to have a general test of the adequacy of the speciﬁcation. the unconditional density of ei at 0. ˆ Given the representation (7. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . where and f (e | x) is the conditional density of ei given xi = x. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. since it has discontinuous derivatives. n numerical methods are necessary for its minimization. The null model is yi = x0 β + εi i 84 . the asymptotic variance depends on the conditional density of the quantile regression error. if the model yi = x0 β + ei has i been ﬁt by OLS. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. conventional Newton-type optimization methods are inappropriate.

small values such as m = 2. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. or 4 seem to work best. However. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . then 22 Q11 > Q11 − Q12 Q−1 Q21 . and n→∞ say. 7.be an (m − 1)-vector of powers of yi . In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. Otherwise. To implement the test. β 2 ). Wn →d χ2 .14) by OLS. β 1 = (X1 X1 )−1 (X1 Y ) . lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. m must be selected in advance. ⎟ zi = ⎝ .8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. Thus the null is rejected at the α% level if Wn m−1 exceeds the upper α% tail critical value of the χ2 m−1 distribution. and form the Wald statistic Wn for γ = 0. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 .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. 1i 2i 2i 1i 22 . 3. note that (7. ⎠ . they will (typically) have diﬀerence asymptotic variances. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . Another is to regress yi on x1i and x2i jointly. since Q12 Q−1 Q21 > 0. yielding ˆ ˜ ˆ ˆ (β 1 . Q−1 σ 2 < Q11 − Q12 Q−1 Q21 11 22 85 ¡ ¡ ¢ ¢−1 2 ¡ ¢−1 2 ˆ lim nV ar(β 1 ) = Ex1i x0 − Ex1i x0 Ex2i x0 Ex2i x0 σ = Q11 − Q12 Q−1 Q21 σ . It is easy (although somewhat tedious) to show that under the null hypothesis. and consequently 22 ¡ ¢−1 2 σ . and the two estimators have equal asymptotic eﬃciency. yi ˆm (7. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. 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. To see why this is the case. Typically. yielding predicted values yi = x0 β. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives.

A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 . How does a researcher go about selecting an econometric speciﬁcation. this result can be reversed when the error is conditionally heteroskedastic. when economic theory does not provide complete guidance? This is the question of model selection. “Which subset of (x1 . E (ε | X1 . We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε..). One useful property is consistency. with residual vectors e1 and e2 . estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 . there is no clear ranking of the eﬃciency of the ˜ restricted estimator β 1 versus the unrestricted estimator. To simplify some of ¢ statistical discussion. as the larger problem can be written as a sequence of such comparisons. There are many possible desirable properties for a model selection procedure.˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . respectively. To ﬁx notation. We c can write this as M. X2 ) = 0. we see that β 1 has a lower asymptotic variance. It is important that the model selection question be well-posed.. x Then under (6. For example. xK ) enters the regression function E(yi | x1i = x1 . the question: “What is the right model for y?” is not well posed. . etc. and β 1 0 (The least-squares estimate with the intercept omitted. This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. We conclude that the inclusion of irrelevant variable reduces estimation eﬃciency if these variables are correlated with the relevant variables. σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 .9 Model Selection In earlier sections we discussed the costs and beneﬁts of inclusion/exclusion of variables.... i A model selection procedure is a data-dependent rule which selects one of the two models. 7. take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0. x2i = σ 2 . and E (xi − µ)2 = σ 2 . we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . ˆ For example. Let Exi = µ. estimate of β 1 from the unconstrained model. Y = X1 β 1 + X2 β 2 + ε. that it selects the true model with probability one if the sample is suﬃciently large. models 1 and 2 are estimated by OLS. because it does not make clear the conditioning set. where X1 is n × k1 and X2 is n × k2 . the question. In many cases the problem of model selection can be reduced to the comparison of two nested models. In the absence of the homoskedasticity assumption. n→∞ σx ˜ When µ 6= 0.. E (ε | X1 . In contrast. we say that M2 is true if β 2 6= 0.7). To be concrete. However. Let β 1 be the ˜ be the estimate under the constraint β = 0.. . X2 ) = 0 Note that M1 ⊂ M2 . xKi = xK )?” is well posed.

k A major problem with this approach is that the critical level α is indeterminate. That is. The model selection rule is as follows. In contrast to the AIC. if α is set to be a small number. Another common approach to model selection is to to a selection criterion.17) Since log(n) > 2 (if n > 8). Then select M1 if Wn ≤ cα . A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . else select M2 . His criterion. as the rule tends to overﬁt. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . n (7. If the truth is inﬁnite dimensional. Another problem is that if α is held ﬁxed. this rule only makes sense when the true model is ﬁnite dimensional. Indeed. 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. and km is the number of coeﬃcients in the model. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. Indeed. let cα satisfy ¢ ¡ P χ22 > cα . One popular choice is the Akaike Information Criterion (AIC). n (7.However. else select M2 . the most popular to be one proposed by Schwarz. as ³ ´ c P M = M1 | M1 → 1 − α < 1. known as the BIC. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . For some critical level α. then this model selection procedure is inconsistent. 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. 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. BIC model selection is consistent. ¢ ¡ ˆ1 ˆ2 (7. AIC selection is inconsistent. log(n) 87 . since under M1 . then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious.16) holds under M1 . M)) between the true density and the model density. The rule is to select M1 if AIC1 < AIC2 .15) then where σ 2 is the variance estimate for model m. k = While many modiﬁcations of the AIC have been proposed. since (7. depending on the sample size. LRn →p 0.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . based on Bayesian arguments. etc.

β K 6= 0. which regressors enter the regression). The methods extend readily to the issue of selection among multiple regressors. selecting based on (7. In the unordered case. Also under M2 . . . β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. 88 . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. which can be a very large number. and then selects the model with the lowest AIC (7. . β 3 = · · · = β K = 0 .. In the latter case. . There are two leading cases: ordered regressors and unordered. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. However. . The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . β 2 6= 0. For example. stores the residual variance σ 2 for each model.. . 048. 210 = 1024. We have discussed model selection between two models. and the AIC or BIC in principle can be implemented by estimating all possible subset models.15). . xKi }. MK : β 1 6= 0. β 2 6= 0.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. one can show that thus LRn →p ∞. the models are M1 : β 1 6= 0.17). and 220 = 1. Similarly for ˆ the BIC. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. which are nested. The AIC selection criteria estimates the K models by OLS. In the ordered case. a model consists of any possible subset of the regressors {x1i . there are 2K such models. 576..

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

Do so. In addition. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. Consider model (7. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . Exercise 13. 90 . and ﬁnd the value of a7 for which the sum of squared errors is minimized.18) (a) Following Nerlove. Examine the data and pick an appropriate range for a7 . Assess the merits of this new speciﬁcation using (i) a hypothesis test. and V is the = g(x estimate of V ar ˆ . (ii) AIC criterion. at least 10 to 15) of ln Qi are both below and above a7 . θ is the NLLS estimator. (c) Estimate the model by non-linear least squares. the regression slope is a2 + a6 .. are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9. impose the restriction a3 + a4 + a5 = 1.18) plus the extra term a6 zi . a7 ). In Chapter 6. . For each value of a7 .. (d) Calculate standard errors for all the parameters (a1 . n xi i=1 (a) Under the stated assumptions. Record the sum of squared errors. For values of ln Qi much below a7 . add the variable (ln Qi )2 to the regression. Find an asymptotic 95% conﬁdence interval for g(x). and the model imposes a smooth transition between these regimes. 8. The equation you estimated was ln T Ci = β 1 + β 2 ln Qi + β 3 ln P Li + β 4 ln P Ki + β 5 ln P Fi + ei . Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . Suppose that yi ³ ´ i . This model is called a smooth threshold model. θ) + ei with E (ei | xi ) = 0. The model works best when a7 is selected so that several values (in this example.ˆ ˆ 7. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. The model is non-linear because of the parameter a7 . you estimated a cost function on a cross-section of electric companies. For values much above a7 . (7.. (iii) BIC criterion. calculate zi and estimate the model by OLS. the variable ln Qi has a regression slope of a2 .

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

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

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

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

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

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

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

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

Thus here Tn (θ) = Wn (θ). where qn (α) is the (1 − α)% quantile of the distribution of Wn .3 an = o(n−r ) if nr |an | → 0 as n → ∞. an = O(n−r ) if it declines to zero like n−r .2 an = O(1) if |an | is uniformly bounded. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). F ) = Φ + o (1) . and vice-versa. Deﬁnition 8.8. lim Gn (x. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . We say that a function g(x) is even if g(−x) = g(x).4) v ¡ ¢ While (8. it says nothing. 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.] 8. The ideal test rejects if Wn ≥ qn (α).4) says that Gn converges to Φ x as n → ∞. not ˆ − θ0 . however. 99 .8. The following notation will be helpful. 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. θ θ θ ˆ θ ∗ ∗ Computationally. Deﬁnition 8. The derivative of an even function is odd. C4 is called the symmetric percentile-t interval. Equivalently. F ) then ³x´ . or the size of the divergence for any particular sample size n. and a function h(x) is odd if h(−x) = −h(x).8 Asymptotic Expansions Tn →d N (0. about the rate v of convergence. Let Tn be a statistic such that (8. Let an be a sequence. F ) = Φ n→∞ v or ³x´ Gn (x. the critical value qn (α) is found as the quantile from simulated values of W´ . (8.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. θ [This is a typical mistake made by practitioners. A better asymptotic approximation may be obtained through an asymptotic expansion. v 2 ). then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. writing Tn ∼ Gn (x.8.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. Basically. If θ is a vector. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ .

To a second order of approximation. We can interpret Theorem 8.8. and g1 is continuous with respect to F. First. the density function is skewed. A bootstrap test is based on G∗ (x). 1/2 1 n Because Φ(x) appears in both expansions.1 as follows. the exact distribution is P (Tn < x) = Gn (x. ³x´ Gn (x. Fn ) − g1 (x. F0 )) converges to 0 at rate n. F ) ≈ Φ + n−1/2 g1 (x. √ Since Fn converges to F at rate n. 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. F ) + g2 (x. Gn (x. v Since the derivative of g1 is odd. the diﬀerence √ (g1 (x. F ) ≈ Φ + n−1/2 g1 (x. F ) converges to the normal limit at rate n1/2 . F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. To a third order of approximation. Fn ) − g1 (x.1 has the expansion n G∗ (x) = Gn (x. ³x´ 1 1 + 1/2 g1 (x. F ). F ) + O(n−3/2 ) Gn (x.1 Under regularity conditions and (8. Fn ) − g1 (x.8. F0 ) = n 1 n1/2 (g1 (x. adding leptokurtosis). where g1 is an even function of x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). which from Theorem 8. F ) v which adds a symmetric non-normal component to the approximate density (for example. The diﬀerence is Φ(x) − Gn (x.8. 100 . F ) = Φ v n n 8. F0 )) + O(n−1 ). An asymptotic test is based on Φ(x). we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . Fn ) = Φ(x) + n 1 g (x. F0 ) = Φ(x) + since v = 1. Fn ) + O(n−1 ). g1 (x. To the second order. Heuristically.1.8. F ) + n−1 g2 (x. and g2 is an odd function of x.3).uniformly over x. so the order of the error is O(n−1/2 ). Theorem 8. ³x´ Gn (x. F0 ) = 1 g (x. Moreover. F0 ) ≈ ∂ g1 (x.

8.The “derivative” ∂ ∂F g1 (x. F ) + g2 (x. F ) is only heuristic. 101 2 g2 (x. n . A two-sided hypothesis test rejects H0 for large values of |Tn | .8.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). Thus asymptotic critical values are taken from the Φ distribution. F0 ) + O(n−3/2 ) = O(n−1 ). and exact critical values are taken from the Gn (x. F0 ) = The order of the error is O(n−1 ). then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x). we can calculate that Gn (x. This rate can be used to show that one-tailed bootstrap inference based on the tratio achieves a so-called asymptotic reﬁnement — the Type I error of the test converges at a faster rate than an analogous asymptotic test. F ). 1). From Theorem 8. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. F0 ) = O(n−1 ). then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F ) − Gn (−x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F ) = Gn (x. Similarly. if Z ∼ N (0. if Tn has exact distribution Gn (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. then |Tn | →d |Z| ∼ Φ. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )).1. F ) − Gn (−x. F ) + g2 (−x. We conclude that G∗ (x) − Gn (x. F ) = Gn (x. F ) + O(n−3/2 ).5) where the simpliﬁcations are because g1 is even and g2 is odd. F ). = P (X ≤ x) − P (X ≤ −x) For example. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). Since Tn →d Z. then |Tn | has the distribution function Gn (x. n (8. as F is a function. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F0 ) distribution.

Therefore. A reader might get confused between the two simultaneous eﬀects. This is in contrast to the use of the asymptotic distribution. Theorem 8.8. 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 ). 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.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). We know that θ Tn →d N (0. G∗ (x) = Gn (x. g1 . Two-sided tests have better rates of convergence than the one-sided tests.5) to the bootstrap distribution. we ﬁnd Gn (x) = Gn (x.Interestingly. whose error is O(n−1 ). This is because the ﬁrst term in the asymptotic expansion. and for the bootstrap ³x´ + O(n−1/2 ). F0 )) + O(n−3/2 ) n = O(n−3/2 ). as it depends on the unknown V. Fn ) = Φ(x) + ∗ 2 g2 (x. Fn ) + O(n−3/2 ). Twosided tests will have more accurate size (Reported Type I error). F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. and needs to be determined on a case-by-case basis. Fn ) − g2 (x. similar to a one-sided test. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. and g2 is continuous in F.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. and bootstrap tests have better rates of convergence than asymptotic tests. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. 8. which is not pivotal. F ) = Φ v √ where v = V . is an even function. Applying (8. F0 ) = ∗ 2 (g2 (x. √ the last equality because Fn converges to F0 at rate n. meaning that the errors in the two directions exactly cancel out. Gn (x. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. but one-sided tests might have more power against alternatives of interest. set Tn = n ˆ − θ0 . V ).

where Fn is the EDF. i For the regressors x∗ . i which implies ∗ ˆ yi = x∗0 β + ε∗ i i E (x∗ ε∗ ) = 0 i i but generally E (ε∗ | x∗ ) 6= 0. .. This is equivalent to treating the regressors as ﬁxed i in repeated samples. A parametric method is to sample x∗ from an estimated parametric i distribution. σ 2 ). Therefore if standard errors are available. .. it is unclear if there are any beneﬁts from using the percentile bootstrap over simple asymptotic methods. a nonparametric method is to sample the x∗ randomly from the EDF i i or sample values {x1 . ∗ The non-parametric bootstrap distribution resamples the observations (yi . A third approach sets x∗ = xi . Based on these arguments. The disadvantage is that the bootstrap distribution may be a poor approximation when the error is not independent of the regressors.. But since it is fully nonparametric. Hall. Horowitz. We discuss some bootstrap methods appropriate for the case of a regression model where yi = x0 β + εi i E (ei | xi ) = 0.Hence the order of the error is O(n−1/2 ). n Any other consistent estimate of F0 may be used to deﬁne a feasible bootstrap estimator. xn }. The advantage is that in this case it is straightforward to construct bootstrap distributions.g. and works in nearly any context. the percentile bootstrap methods provide an attractive inference method.. then all inferential statements are made conditionally on the 103 .. and then create i i ∗ = x∗0 β + ε∗ . To impose independence. It is no better than the rate obtained from an asymptotic one-sided conﬁdence region. the theoretical literature (e.) One approach to this problem is to impose the very strong assumption that the error εi is independent of the regressor xi . A non-parametric method is ˆ yi i i e ˆ to sample the bootstrap errors ε∗ randomly from the OLS residuals {ˆ1 . i i The the bootstrap distribution does not impose the regression assumption. If this is done. 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. x∗ ) from the EDF. and is thus an ineﬃcient estimator of the true distribution (when in fact the regression assumption is true. Yet these methods do not require the calculation of standard errors! This means that in contexts where standard errors are not available or are diﬃcult to calculate. The advantage of the EDF is that it is fully nonparametric.. en }. such as the normal i ˆ ε∗ ∼ N (0.12 Bootstrap Methods for Regression Models The bootstrap methods we have discussed have set G∗ (x) = Gn (x. 1992. it may be ineﬃcient in contexts where more is known about F. The bad news is that the rate of convergence is disappointing. A parametric i method is to generate the bootstrap errors ε∗ from a parametric distribution. it is suﬃcient to sample the x∗ and ε∗ independently. it imposes no conditions. Fn ). 8. There are diﬀerent ways to impose independence.

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

∗ ∗ where s(ˆ is the standard error in the original data. You replace c with qn (. Suppose that in an application. (c) With the given information. ˆ − s(ˆ n (. and thus reject H0 if ˆ ˆ > q ∗ (. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.95) denote the 95% quantile of Tn . and the 2.95).95).75 and 1. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. θ respectively. and ˆ is calculated on each θ ∗ ∗ θ sample. Using the non-parametric ∗ bootstrap. ˆ = 1. Using the non-parametric bootstrap. you generate bootstrap samples. 105 . ∗ ∗ ∗ Let qn (. and the colonial dummy.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).05) . Let qn (. You do this as follows.05) and qn (. with variables listed in the ﬁle hprice1. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). What is wrong with this procedure? Tn = θ/s(θ) n 6.pdf.5% and 97.3. can you report the 95% Percentile-t interval for θ? 7. You want to test H0 : θ = 0 against H1 : θ > 0. Estimate a linear regression of price on the number of bedrooms. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. lot size. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (.2 and s(ˆ = .2. The ˆ are sorted. (a) Report the 95% Efron Percentile interval for θ.95). The dataﬁle hprice1.95) denote the 5% θ) ∗ and 95% quantiles of Tn .5% quantiles of the ˆ are . (b) Report the 95% Alternative Percentile interval for θ.dat contains data on house prices (sales). size of house.

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

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

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

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

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

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

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

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

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

h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). zi ). Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . l ≥ k.6) (a) Show that you can rewrite Jn (β) in (9. zi is l × 1 and β is k × 1. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1.6) equals the Wald statistic. Vn = X X i=1 ˜ and hence R0 β = r. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. the distance statistic D in (9.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . β) + ei E (zi ei ) = 0. The observed data is (yi . VR = V − V R R0 V R (d) Show that in this setting. Deﬁne the Lagrangian L(β. Show how to construct an eﬃcient GMM estimator for β. The GMM estimator of β. subject ˆ i ˆi i=1 to the restriction h(β) = 0. 115 .5. 6. 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 . The equation of interest is yi = g(xi . the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9.5) 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. In the linear model Y = Xβ + e with E(xi ei ) = 0. h(β)=0 (9. VR ) where ¡ ¢−1 0 R V. is deﬁned as Jn (β) = ˜ β = argmin Jn (β).

Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions.7. ˆ and consider the GMM estimator β of β. 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.. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . 116 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. 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.

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

. λ) : λ(β) = argmin Rn (β. λ ¡ ¢ ln 1 + λ0 gi (β) .5). pi gi (β) = 0. λ). λ) is a convex function of λ.. λ. the Lagrange multiplier λ(β) minimizes Rn (β.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. µ. we also obtain the Lagrange multiplier λ = λ(β). The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. (10.4) (10.5) This minimization problem is the dual of the constrained maximization problem. summing over i. (see section 6. we ﬁnd µ = n and 1 ¢.3). This yields the (proﬁle) empirical log-likelihood function for β. probabilities 1 ³ ´´ . pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .5) ˆ ˆ As a by-product of estimation. but must be obtained numerically (see section 6.7) 118 . p1 . and using the second and third equations.1) and (10. The solution cannot be obtained explicitly. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. The solution (when it exists) is well deﬁned since Rn (β. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). µ) = n i=1 i=1 i=1 L∗ n with respect to pi . Multiplying the ﬁrst equation by pi .2) subject to the restrictions (10. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. or equivalently minimizes its negative ˆ (10.. pn . Ln (β) = Rn (β.where λ and µ are Lagrange multipliers. . λ) = −n ln (n) − n X i=1 For given β. p (10.

13) yields n n Expanding (10. β λ ∂ ³ ´.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.9) and (10. λ) = − (10. and n β − β 0 and nλ are asymptotically independent. Thus the EL estimator is asymptotically eﬃcient. β) = −xi zi .1 Under regularity conditions.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . i=1 i=1 i=1i Expanding (10.2. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . i i Theorem 10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.10. (β.13) Premultiplying by G0 Ω−1 and using (10.8) and ¢ 0 0 For example.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 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 (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. and Ω = E xi x0 e2 . G = −E (xi zi ).9) (10.10). in the linear model.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. Gi (. 0 = Rn (β. ˆ ˆ Proof. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.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 .10) ¡ Ω−1 N (0. λ) = − (10. n (10.

by a Taylor expansion. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.3 Overidentifying Restrictions In a parametric likelihood context. Proof.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. Since the EL estimator achieves this bound. Ω) GΩ G →d = N (0. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. and (10. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .15). (10. 120 .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. it is an asymptotically eﬃcient estimator for β. β 0 ) = 0 then LRn →d χ2−k . They are asymptotically ﬁrst-order equivalent. Vλ ) Furthermore. The overidentiﬁcation test is a very useful by-product of EL estimation. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .7) is n ³ ´´ ³ X ˆ ˆ0 (10.14) for λ and using (10.16). and have the same interpretation.3. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. tests are based on the diﬀerence in the log likelihood functions.15) (10. LRn = i=1 Theorem 10.1 If Eg(wi . V ) ˆ Solving (10. and it is advisable to report the statistic LRn whenever EL is the estimation method. The same statistic can be constructed for empirical likelihood.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 (0.17) 2 ln 1 + λ gi β . 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. 10. First.

so there is no fundamental change in the distribution theory for β relative to β. Vλ )0 Ω−1 N (0.wisc. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).Second. To test the hypothesis h(β) while maintaining (10.17) is not appropriate.1 Under (10. This test statistic is a natural analog of the GMM distance statistic.prc 121 . 10. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.18). 10.4. Theorem 10. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. where h : Rk → Ra . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.edu/~bhansen/progs/elike.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. the simple overidentifying restrictions test (10. The hypothesis of interest is h(β) = 0. LRn →d χ2 . since ln(1 + x) ' x − x2 /2 for x small.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). By “maintained” we mean that the overidentfying restrictions contained in (10.18) and H0 : h(β) = 0. a The proof of this result is more challenging and is omitted.ssc. h(β)=0 ˜ Fundamentally.4 Testing Egi (β) = 0 (10.18) Let the maintained model be where g is × 1 and β is k × 1.

The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 ..4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. λ) gi (β.20) .5) for given β. λ) = − ∂β n X i=1 G∗ (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λj )) Rp = Rn (β. 2. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β.19) is continued until the gradient Rλ (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10.19) X ∂2 ∗ ∗ gi (β. λ) = i The ﬁrst derivatives of (10. λ) = G∗ (β. (10. set 2 λp = λj − δ p (Rλλ (β. Deﬁne ∗ gi (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λj ))−1 Rλ (β. The starting value λ1 can be set to the zero vector. λp ) A quadratic function can be ﬁt exactly through these three points. λj ) is smaller than some prespeciﬁed tolerance. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λ) = − gi (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λ) ∂λ i=1 n ∂ Rn (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ) G∗ (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.4). δ 1 = 1 and δ 2 = 1.19). λ)0 − Rn (β. λj ) . λ)0 0 Rn (β. The iteration (10. λj ))−1 Rλ (β. λ) G∗ (β. λ)0 − ∂β∂β Rn (β. Set δ 0 = 0. λ) . 1. One method uses the following quadratic approximation. Eﬃcient convergence requires a good choice of steplength δ. For p = 0.

for all i. the stepsize δ needs to be decreased. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize. the eigenvalues of Lββ should be adjusted so that all are positive. The gradient for (10. and the rule is iterated until convergence. The Hessian for (10. It is not guaranteed that Lββ > 0.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. If (10.6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. Outer Loop The outer loop is the minimization (10. λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ .20) fails.6). This can be done by the modiﬁed Newton method described in the previous section. λ) = 0 at λ = λ(β). 123 . where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. λ(β)) = 0. If not. λ(β)) + λ0 Rλ (β.

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

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

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

PX Z2 ] = [Z1 . Recall. Z2 = [PX Z1 . let’s analyze the approximate bias of OLS applied to (11.13) which is zero only when S21 = 0 (when Z is exogenous). Using (11. we regress Y on Z1 and Z2 .12) Z = XΓ + u ξ = (e. 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. Then i h ˆ ˆ ˆ Z = Z1 . We now derive a similar result for the 2SLS estimator. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . First. PX Z2 ] h i ˆ = Z1 . Z2 ] and X = [Z1 . Here we present a simpliﬁed version of one of his results. In our notation. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) . X is n × l so there are l instruments. the model is Y = Zβ + e (11.12). X2 ].ˆ It is useful to scrutinize the projection Z. 129 .11). Thus in the second stage.11) (11. Z = [Z1 .6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. Z2 . ˆ since Z1 lies in the span of X. ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . 11.

the expression in (11. Indeed as α → 1. P = HΛH 0 0 0 where Λ = diag(Il .12) and this result. 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 . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. 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. By the spectral decomposition of an idempotent matrix. 130 .7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .Let PX = X (X 0 X)−1 X 0 . the bias in the 2SLS estimator will be large. except when S21 = 0 (when Z is exogenous). indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 0). It is also close to zero when α = 0. l . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .14) is the probability limit of β 2SLS − β 11.14) approaches that in (11.14) In general this is non-zero. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 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 . n and (11. The consequences of identiﬁcation failure for inference are quite severe.13). 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.

Here. but is weak. To see the consequences.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. Then (11. once again take the simple case k = l = 1. Qc + N2 ˆ As in the case of complete identiﬁcation failure.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 . Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . This result carries over to more general settings. Suppose that identiﬁcation does not complete fail. as the Cauchy distribution does not have a ﬁnite mean. This can be handled in an asymptotic analysis by modeling it as local-to-zero. Suppose this condition fails. standard test statistics have non-standard asymptotic distribution of β distributions. In addition.Take the simplest case where k = l = 1 (so there is no X1 ). E x2 u2 i i n n i=1 i=1 n n (11. but (11. which occurs i when E (zi xi ) 6= 0.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. This occurs when Γ22 is full rank. so E (zi xi ) = 0. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. and was examined by Phillips (1989) and Choi and Phillips (1992). but small. E x2 e2 i i n i=1 n (11. meaning that inferences about parameters of interest can be misleading. This is particularly nasty. N2 since the ratio of two normals is Cauchy. 131 .15) is unaﬀected. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. where C is a full rank matrix. viz Γ22 = n−1/2 C. the instrument xi is weak for zi if γ = n−1/2 c. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory.

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

xi is l × 1. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . 2. That is. Explain why this is true.) 3. 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. 5. show that if rank(Γ) < k then β cannot be identiﬁed. (Find an expression for xi . in the sense that e ˜ ˜ least in large samples? 4. X is n × l. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. ˜ 0 e < e0 e. u is n × k. 1. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). 6. 133 . Take the linear model Y = Zβ + e. at ˆˆ If X is indeed endogeneous. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). will IV “ﬁt” better than OLS. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. Z is n × k. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . Find a simple expression for the IV estimator in this context. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. Take the linear model yi = xi β + ei E (ei | xi ) = 0. l ≥ k. where xi and β are 1 × 1.11. and Γ is l × k.8 Exercises yi = zi β + ei .

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

.1.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. Deﬁnition 12.1 Stationarity and Ergodicity Deﬁnition 12.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . Theorem 12. Yt−k ) = γ(k) is independent of t for all k. A stationary time series is ergodic if γ(k) → 0 as k → ∞.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.1.2 {Yt } is strictly stationary if the joint distribution of (Yt . t = 1. The following two theorems are essential to the analysis of stationary time series. . 135 ... Yt−k ) is independent of t for all k.. we expect that Yt and Yt−1 are not independent.. Because of the sequential nature of time series. γ(k) is called the autocovariance function. We can separate time series into two categories: univariate (yt ∈ R is scalar). The primary model for univariate time series is autoregressions (ARs).. Yt−1 . .1 If Yt is strictly stationary and ergodic and Xt = f (Yt . so classical assumptions are not valid. T .4 (loose). Yt−k ) is the autocorrelation function. and multivariate (yt ∈ Rm is vector-valued). Deﬁnition 12.) is a random variable.1. .1. 12. To indicate the dependence on time. and Cov (Yt .1.. and T to denote the number of observations. and use the subscript t to denote the individual observation. we adopt new notation. however. Deﬁnition 12. There proofs are rather diﬃcult. The primary model for multivariate time series is vector autoregressions (VARs).. then Xt is strictly stationary and ergodic.

1. ρ(k) →p ρ(k). then as T → ∞. 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 .3 If Yt is strictly stationary and ergodic and EYt2 < ∞. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k).2 (Ergodic Theorem). ˆ 3. and it has a ﬁnite mean by the assumption that EYt2 < ∞. Part (1) is a direct consequence of the Ergodic theorem. γ (0) ˆ Theorem 12. 1.1.Theorem 12. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). γ (k) →p γ(k). the sequence Yt Yt−k is strictly stationary and ergodic. T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) . ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. If Xt is strictly stationary and ergodic and E |Xt | < ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). T 1X Xt →p E(Xt ). ˆ 2.1. ˆ Proof. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ˆ ˆ γ ¥ 136 .1 above. then as T → ∞. For Part (2).

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

Lk Yt = Yt−k . an AR(1) is stationary iﬀ |ρ| < 1.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. We call ρ(L) the autoregressive polynomial of Yt .Theorem 12.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . In general. We call ρ(L) the autoregressive polynomial of Yt . ∞ X k=0 ρ2k V ar (et−k ) = 12.4. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . Deﬁning L2 = LL. we see that L2 Yt = LYt−1 = Yt−2 . since ρ(z) = 0 when z = 1/ρ. Deﬁnition 12. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. From Theorem 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.3. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . the above results are unchanged. 138 . The AR(k) model is Using the lag operator. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . 12. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .1. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value). 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept.1 The lag operator L satisﬁes LYt = Yt−1 .3. We say that the root of the polynomial is 1/ρ.

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

7. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. then as T → ∞. It also presumes that the AR(k) structure is the truth. t This construction imposes homoskedasticity on the errors e∗ . xt }..1 to see that T 1 X √ xt et →d N (0. we constructed the bootstrap sample by randomly resampling from the data values {yt .. Q−1 ΩQ−1 . i 4. ˆ 2. as this imposes inappropriate independence. Y−k+2 . T t=1 Since xt et is a MDS. we can apply Theorem 12.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .7.. The implication is that asymptotic inference is the same. the asymptotic covariance matrix is estimated just as in the cross-section case. ˆ 1.7 Asymptotic Distribution Theorem 12. Method 2: Block Resampling 1. Fix an initial condition (Y−k+1 . eT }.. which may be diﬀerent than the i properties of the actual ei . Y0 ). there are two popular methods to implement bootstrap resampling for time-series data. This creates an iid bootstrap sample. 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∗ . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Divide the sample into T /m blocks of length m. t then as T → ∞. T 1 X √ ut →d N (0.7.1 MDS CLT.8 Bootstrap for Autoregressions In the non-parametric bootstrap. 12. Method 1: Model-Based (Parametric) Bootstrap. This is identical in form to the asymptotic distribution of OLS in cross-section regression. . 140 . Ω) . t t Theorem 12.12. T t=1 where Ω = E(xt x0 e2 ). Brieﬂy.. this cannot work in a time-series application.. Estimate β and residuals et . Clearly. Ω) . e ˆ 3. In particular.

Paste the blocks together to create the bootstrap time-series Yt∗ . and perhaps this was of relevance. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. Seasonal Eﬀects There are three popular methods to deal with seasonal data.3) sequentially by OLS. That is.2. The seasonal adjustment. (12. • Use “seasonally adjusted” data. ﬁrst estimate (12. The series ∆s Yt is clearly free of seasonality. 3.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . draw T /m blocks. also alters the time-series correlations of the data.. If s is the number of seasons (typically s = 4 or s = 12). This is a ﬂexible approach which can extract a wide range of seasonal factors. .4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . Resample complete blocks. however. heteroskedasticity.2)-(12. 5. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. get the ˆ ˆ residual St . (12.. For each simulated sample. 141 . or the season-to-season change.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .2) (12. 6. This presumes that “seasonality” does not change over the sample. and then perform regression (12. • You can estimate (12. • First apply a seasonal diﬀerencing operator. and the way that the data are partitioned into blocks.3) replacing St with St . This allows for arbitrary stationary serial correlation. • Include dummy variables for each season. and for modelmisspeciﬁcation.. The results may be sensitive to the block length. ∆s Yt = Yt − Yt−s . But the long-run trend is also eliminated. • You can estimate (12.2). Thus the seasonally adjusted data is a “ﬁltered” series. This procedure is sometimes called Detrending. May not work well in small samples.4) by OLS. 4. 12. ρk ).

(12.5) and (12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero.g. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 .10 Testing for Omitted Serial Correlation For simplicity. Thus under H0 . we take (12. this is the same as saying that under the alternative Yt is an AR(k+m).. 142 .) This can induce strange behavior in the AIC. The best remedy is to ﬁx a upper value k. An appropriate test is the Wald test of this restriction. Another is to minimize the AIC or BIC information criterion. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . and under H1 it is an AR(2). In general..6). AIC(k) = log σ 2 (k) + ˆ 2k .5) We are interested in the question if the error ut is serially correlated.5). To combine (12. and the alternative is that the error is an AR(m). (If you increase k.. We model this as an AR(1): ut = θut−1 + et with et a MDS.6) 12. e. One approach to model selection is to choose k based on a Wald tests. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. and then estimate the models AR(1). or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2).. Yt is an AR(1). T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes. . . (A simple exclusion test). (12.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 .. Yt−k−m are jointly zero. We then multiply this by θ and subtract from (12. and then reserve the ﬁrst k as initial conditions. you need more initial conditions. AR(2).12. AR(k) on this (uniﬁed) sample. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero.. if the null hypothesis is that Yt is an AR(k). We want to test H0 against H1 .

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

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

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

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

t or yt = θyt−1 + x0 β + x0 γ + ut . If valid.13. t t−1 (13. and is typically rejected empirically. 147 . and is still routinely reported by conventional regression packages.2) is uncommon in recent applications.3) which is a valid regression model. In this case. You may have heard of the Durbin-Watson test for omitted serial correlation. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. which is called a common factor restriction.) Since the common factor restriction appears arbitrary.2) may be estimated by iterated GLS. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. Another interesting fact is that (13. j Often. (13.2) Take the equation yt = x0 β + et . direct estimation of (13. under the restriction γ = −βθ. xt−1 ) to the regression. We see that an appropriate. it is convenient to re-deﬁne the variables. This restriction. we are only interested in a single equation out of a VAR system. (A simple version of this estimator is called Cochrane-Orcutt. Then the single equation takes the form (13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13.2) is a special case of (13. t and et is iid N (0. and subtract oﬀ the equation once lagged multiplied by θ. Suppose that et is an AR(1). t and xt = This is just a conventional regression. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. general. This can be done by a Wald test. with time series data. 13. Let yt = Yjt . and Zt be the other variables. Let et = ejt and β = aj . may be tested if desired.4 Single Equation from a VAR Yjt = a0 xt + et . 1).1). the model (13. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).1) yt = x0 β + et .3). Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . 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 . which once was very popular.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

the estimator f (x) smooths data local to Xi = x. nh (x)2 dx is called the roughness of K. 162 . The bias results from this smoothing. This integral (typically) is not analytically solvable. which is valid as h → 0. using ﬁrst-order Taylor approximations and the fact that n−1 is of smaller order than (nh)−1 V ar (x) = = ' = ' = where R(K) = R∞ −∞ K 1 V ar (Kh (Xi − x)) n 1 1 EKh (Xi − x)2 − (EKh (Xi − x))2 n n ¶ Z ∞ µ z−x 2 1 1 K f (z)dz − f (x)2 2 nh −∞ h n Z ∞ 1 K (u)2 f (x + hu) du nh −∞ Z f (x) ∞ K (u)2 du nh −∞ f (x) R(K) . The 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).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. so is estimating a smoothed version of f (x). Since it is an average of iid random variables. ˆ We now examine the variance of f (x). Intuitively. Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . The sharper the derivative. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . ˆ the greater the bias. and is larger the greater the curvature in f (x). so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0.16.

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

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

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

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

Typically.. these cases are unusualRand are typically ignored.. In the latter case. . ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. 167 . (A.. a These expressions only make sense if F (x) is diﬀerentiable.3) is unavailable..2 Random Variables A random variable X is a function from a sample space S into the real line. 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.. The probability function for X takes the form j = 1. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.Theorem 2 (Bayes’ Rule). In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . A function F (x) is a CDF if and only if the following three properties hold: 1. For any set B and any partition A1 . This induces a new sample space — the real line — and a new probability function on the real line. r (A.3) P (X = τ j ) = π j . We say that the random variable X is continuous if F (x) is continuous in x. F (x) is nondecreasing in x 3. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. ... of the sample space. Instead.. . τ r . P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. A2 . While there are examples of continuous random variables which do not possess a PDF.. we denote random variables by uppercase letters such as X. then for each i = 1. . the range of X consists of a countable set of real numbers τ 1 . Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. and use lower case letters such as x for potential values and realized values. 2..

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

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

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

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

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

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

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

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

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

3 Let Z ∼ N (0. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. (A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .3.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. Iq ). q Proof of Theorem A. The MGF for the density (A.8.13). Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . The fact that A > 0 means that we can write A = CC 0 where C is non-singular. Proof of Theorem A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.1. C −1 AC −10 ) = N (0.11) 2 with r = 1.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. which we showed in (A.2. C −1 CC 0 C −10 ) = N (0. From (A. Using the simple law of iterated expectations.Theorem A. 1). Set r Z .12) E exp (tQ) = 0 Γ (A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. 1) and Q ∼ χ2 be independent.8.8.11). Thus the density of Z 2 is (A. For Z ∼ N(0.13) is the MGF of the density (A. which can be found by applying change-of-variables to the gamma function.8. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. tr has distribution 177 . we see that the MGF of Z 2 is (1 − 2t)−1/2 .

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

n n i=1 n As the MLE ˆ maximizes the left-hand-side. then θ V ar(˜ ≥ (nI0 )−1 . the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . If ˜ is an unbiased estimator of θ ∈ R. θ θ∈Θ ˆ In some simple cases. θ0 ) ln f (Yi . However.9.9.3 Under regularity conditions. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. and the equality (A.15) Two important features of the likelihood are Theorem A. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ) ∂θ ∂θ which holds at θ = θ0 by (A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .16) (A. I0 . In fact. under conventional regularity conditions.1 ¯ ¯ ∂ E ln f (Yi .17) is often called the information matrix equality.17) The matrix I0 is called the information. Theorem A. cases are rare. ˆ is consistent θ for this value. θ Theorem A. ˆ →p θ0 as n → ∞. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. 179 .2 Cramer-Rao Lower Bound.16).9. We can write this as ˆ = argmax Ln (θ). θ0 ) ∂θ∂θ 0 (A.14) ¶ ∂ ∂ 0 ln f (Yi . ∂θ ∂θ (A. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ) ≡ L(θ). θ0 ) . θ) →p E ln f (Yi . we can see that it is an estimator of the maximizer θ of the right-hand-side. θ) The Cramer-Rao Theorem gives a lower bound for estimation. but these ˆ must be found by numerical methods. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. More typically. which maximizes the log-likelihood). we can ﬁnd an explicit expression for θ as a function of the data. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .

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

θ0 ) ln f (Yi . θ0 )2 (Yi . θ) d˜ = ˜ y ) ∂ ln f (˜. To see (A.. θ0 ) ¯ ∂ f (y. we can show that E By direction computation. θ0 )0 . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ0 )0 f (Yi . θ0 ) − f (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ) dy ¯ ∂θ f (y. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ) f (˜. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y .9.2. θ0 ) (Yi . ¯ ¯ ∂ E ln f (Yi . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. (Yi . θ0 = ln f (Yi . Since θ Z ˜ = ˜ y)f (˜. f (Yi . θ0 ) ∂ ∂ − ln f (Yi .17). V ar (S) nH so ¥ 181 ..1) has mean zero and variance nH. θ0 ) d˜ = E ˜ . θ0 ) ∂ ∂θ f ∂ (Yi . .16). θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y.Proof of Theorem A.9. Proof of Theorem A. 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 = . ∂2 ln f (Yi .9. ∂θ ¯θ=θ0 Z ! = 0. function of the data. yn ). θ0 ) ∂θ f (Yi .1.. θ) f (y. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ.

an application of the CLT yields 1 X ∂ √ ln f (Yi . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . If it is continuous in θ.9. θn ) = ln f (Yi . θ0 ) + ' 0 ln f (Yi . then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi .1 . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . θ n ) θ − θ 0 .9. Ω) = N 0. the speciﬁc value of θn varies by row in this expansion. H −1 .) Rewriting this equation. Together. ¥ 182 . ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . H −1 ΩH −1 = N 0. (Technically. θ0 ) is mean-zero with covariance matrix Ω. θ0 ) . and making a ﬁrst-order Taylor series expansion.Proof of Theorem A. θ0 ) →d N (0.3 Taking the ﬁrst-order condition for maximization of Ln (θ). − ln f (Yi . Ω) . θ) . the ﬁnal equality using Theorem A.

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

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

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

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