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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. . . . . . . . . . . . . . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . 9. . 9. Percentile Confidence Intervals . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10.11 8. 11. . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . .3 Identification . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identification Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . .10 8. . . . . .9 Trend Stationarity . . . . . .12 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . 9. . . . . . .9 Bootstrap GMM Inference .8. . . 11. . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . iii . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . .7 Identification Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 Exercises . 9. . . . . . . . . . . . . . . . . . . . . . . . . . .8 Exercises . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. . . .5 GMM: The General Case . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . .5 Numerical Computation . . . . . . . . . . . . . . . . 12. . . . . . . . .12Autoregressive Unit Roots . . . . . . . . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . . . . . 11. . . .1 Stationarity and Ergodicity . . . 12. . . 9. . . . . . . . . . . . . . . . . 12. . . . .2 Reduced Form . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . 11. . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . . . 9. .4 Estimation of the Efficient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . .9 8. . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . .1 Overidentified Linear Model . . .

. . . . . . 13. . .4 Single Equation from a VAR . . . . . . . . . . . . . . . . . A. . . 159 16 Nonparametrics 160 16. .2 Fixed Effects . . .8 Cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Expectation . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Multivariate Random Variables . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Estimation . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . 162 A Probability A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Transformations . . . . . . . . . . . . . . .13 Multivariate Time Series 13. . . . . . . . 13. . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . 13. . . . . . . . . . . . . . . . . . 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . . . 157 15. . .2 Gradient Methods . . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . . . . . . . A. . . . . . 13. . . . . . .3 Censored Data . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Binary Choice . . B Numerical Optimization B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . . . . . . . . . . . B. . . . . . . . . . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Restricted VARs . . . . . . . . . . . 14. . . .7 Granger Causality . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . .1 Foundations . . .1 Kernel Density Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . .6 Conditional Distributions and Expectation . . . . . . . . . . . . . . . . . .1 Individual-Effects Model . .2 Asymptotic MSE for Kernel Estimates . . B. .2 Random Variables . . . . . .1 Grid Search . . . . . . . . . . . . . . . . . . . . . . A. A. . . . . . . . . 14.9 Maximum Likelihood . . . .4 Common Distributions . A. .4 Sample Selection . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . 14. . . iv . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

7 Also. In this case there exists a unique matrix B such that AB = BA = Ik . if there is no c 6= 0 such that Ac = 0. . (2.2) 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. For non-singular A and C. we can still define a generalized inverse A− as a matrix which satisfies AA− A = A. . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . the Moore-Penrose generalized inverse A− exists and is unique. The Moore-Penrose generalized inverse A− satisfies (2.3) The matrix A− is not necessarily unique. (2. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. .1) .4 Inverse A k × k matrix A has full rank. . . 2. . then A−1 = A. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . This matrix is called the inverse of A and is denoted by A−1 .The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . The following fact about inverting partitioned matrices is sometimes useful.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. or is nonsingular. if A is an orthogonal matrix. If A − BD−1 C and D − CA−1 B are non-singular. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . .

This is written as A ≥ 0.. . which are not necessarily distinct and may be real or complex. λ−1 . then A > 0 if and only if all its characteristic roots are positive. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. The matrix B need not be unique. 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. To see this. 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 . One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal. We say that A is positive definite if for all non-zero c. c0 Ac = α0 a ≥ 0 where α = Gc. We call B a matrix square root of A.. This is written as A > 0. and the characteristic roots are all real. and then set B = HΛ1/2 . 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. They are called the latent roots or characteristic roots or eigenvalues of A. then A is positive semi-definite.2.. • The characteristic roots of A−1 are λ−1 . 2.5 Eigenvalues det (A − λIk ) = 0. then A = HΛH 0 and H 0 AH = Λ. c0 Ac ≥ 0.. If A is symmetric. and let H = [h1 · · · hk ]. In this case. i = 1. If A = G0 G. .. We now state some useful properties. We say that a square matrix A is positive semi-definite if for all non-zero c.) If A is positive 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. k denote the k eigenvalues and eigenvectors of a square matrix A. A−1 > 0.. has full rank k if there is no non-zero c such that Xc = 0. • If A is symmetric. If A > 0 we can find a matrix B such that A = BB 0 . then A is non-singular and A−1 exists. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. Let λi and hi . • If A has distinct characteristic roots. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. Furthermore.6 Rank and Positive Definiteness The rank of a square matrix is the number of its non-zero characteristic roots. k < n. 8 . Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . 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. X 0 X is symmetric and positive definite. (For any c 6= 0. λ−1 . c0 Ac > 0. A square matrix A is idempotent if AA = A. If λi is an eigenvalue of A.

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

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

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

30. the dashed line is a linear projection approximation which will be discussed in the Section 3. which implies a 30% average wage difference for this population. Figure 3. the solid line displays the conditional expectation of log wages varying with education.2) evaluated at the observed value of xi : ei = yi − m(xi ). The comparison in Figure 3.1 is facilitated by the fact that the control variable (gender) is discrete. By construction.36. The difference in the log mean wage between men and women is 0.A. Figure 3. The conditional expectation function is close to linear. This is a more robust measure of the typical wage gap between men and women than the difference in the untransformed wage means. and a Ph.5. 3. Of particular interest to graduate students may be the observation that difference between a B. The main point to be learned from Figure 3.3 displays a scatter plot2 of log wages against education levels. 12 . with mean log hourly wages drawn in with the arrows.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.3) White non-military male wage earners with 10-15 years of potential work experience. 2 (3. implying an average 36% difference in wage levels. then comparisons become more complicated.3 is how the conditional expectation describes an important feature of the conditional distribution.2 Regression Equation The regression error ei is defined to be the difference between yi and its conditional mean (3. To illustrate. degree in mean log hourly wages is 0.D.Figure 3. this yields the formula yi = m(xi ) + ei . Assuming for simplicity that this is the true joint distribution. For this reason. When the distribution of the control variable is continuous.2 shows the density of log hourly wages for the same population. wage regressions typically use log wages as a dependent variable rather than the level of wages.

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

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

we say that the error ei is homoskedastic. we assume that x1i = 1. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .1). where x1i is the first element of the vector xi defined in (3. 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). Notationally.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. take the conditional wage densities displayed in Figure 3. Equation (3. and the linear assumption of the previous section is empirically unlikely to accurate.5. We call this the “constant” or “intercept”. xki When m(x) is linear in x.8) (3. it is more realistic to view the linear specification (3. The conditional standard deviation for men is 12. Thus (3.1.1) has been redefined as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.9) 3. 3.8) is called the linear regression model. This concept is less helpful than defining heteroskedasticity as the dependence of the conditional variance on the observables xi .6) as an approximation. ⎝ . they are also somewhat more dispersed. βk ⎛ (3. ⎠ . So while men have higher average wages. its functional form is typically unknown. it is convenient to augment the regressor vector xi by listing the number “1” as an element. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . i (3. As an example.1 and that for women is 10. 15 .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 .7) is a k × 1 parameter vector.4 Linear Regression An important special case of (3.6) (3. ⎟ .5) xi = ⎜ . Instead. ⎟ β=⎝ . In this case (3. Equivalently.

Rewriting.5. otherwise they are distinct. xi contains an intercept. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . i i (3. 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 . i which requires that for all non-zero α.10) It is worth taking the time to understand the notation involved in this expression. i (3. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. The error is i ei = yi − x0 β. The first-order condition for minimization (from Section 2. It is invertible if and only if it is positive definite. Equivalently. this situation must be excluded. The vector (3. This occurs when redundant variables are included in xi . by “best” we mean the predictor function with lowest mean squared error. i 16 . Observe i that for any non-zero α ∈ Rk .1 1.12) This completes the derivation of the linear projection model.1. As before. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-definite.7) is 0= Solving for β we find ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. 3. Eyi < ∞.which is quadratic in β.10). written E (xi x0 ) > 0. Given the definition of β in (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 . i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . x0 β is the best linear predictor for yi . Therefore. i 4. i (3. 2 2. E (xi x0 ) is invertible.5. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. α0 E (xi x0 ) α = E (α0 xi )2 > 0. E (x0 xi ) < ∞. The best linear predictor is obtained by selecting β to minimize S(β). Assumption 3. In order for β to be uniquely defined. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.

14). the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. Figure 3. Let’s compare it with the linear regression model (3.14) follows from (3. For example. it follows that linear regression is a special case of the projection model. By definition.1. Since ei is mean zero by (3.1.4 we know that the regression error has the property E (xi ei ) = 0.2 and 3. E (xi ei ) = 0 and E (ei ) = 0.10) and (3.5.5. (3.Theorem 3. Since from Theorem 3.1. (3.5.5. Assumption 3.9).14) Proof. Using the definitions (3.8)-(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 = 0.5.1.1.5.11) and (3.1.1. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.10) are defined. ¥ (3.13) and Assumption 3.1 Under Assumption 3. Equation (3. However.5.5. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .1.3 ensure that the moments in (3.1.5.14) holds.3 are called regularity conditions.1 are weak. Furthermore. the orthogonality restriction (3.13) The two equations (3.11) are well defined.13) summarize the linear projection model.12) can be alternatively interpreted as a projection decomposition.5.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. 17 .1 is employed to guarantee that (3.2.1. The finite variance Assumptions 3.2 and 3.12) and (3.13) implies that xi and ei are uncorrelated.1. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .5. Assumption 3. Assumption 3.4 guarantees that the solution β exits. This means that the equation (3.4 is required to ensure that β is uniquely defined. Assumption 3.

3. Figure 3.1 may be false. In this case the linear projection is a poor approximation to the conditional mean. In the example just presented. In Figure 1. This defect in linear projection can be partially corrected through a careful selection of regressors. In this example the linear projection is a close approximation to the conditional mean.1. 18 . No additional assumptions are required. and under-predicts for the rest. 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. Most importantly. for those over 53 in age). Figure 3. and are discussed in Chapter 11. In contrast. since the resulting function is quadratic in experience. We illustrate the issue in Figure 3. and the straight dashed line is the linear projection. xi ) we can define a linear projection equation (3.10).10) may not hold and the implications of Theorem 3. there are no changes in our methods or analysis. we can augment the regressor vector xi to include both experience and experience2 . In other cases the two may be quite different. A projection of log wages on these two variables can be called a quadratic projection.4 displays the relationship3 between mean log hourly wages and labor market experience. These structural models require alternative estimation methods. the dashed line is the linear projection of log wages on eduction. Other than the redefinition of the regressor vector. The solid line is the conditional mean. However.5.12) with the properties listed in Theorem 3.5. The linear equation (3. Returning to the joint distribution displayed in Figure 3.4 we display as well this quadratic projection.We have shown that under mild regularity conditions. for any pair (yi .12) is defined by projection and the associated coefficient definition (3. It over-predicts wages for young and old workers. In this case (3.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. In this example it is a much better approximation to the conditional mean than the linear projection. in many economic models the parameter β may be defined within the model. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.

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

and E(e2 | xi ) = σ 2 . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. xi ∈ R. i 7.1 . 20 . then E(ei | xi ) = 0. then ei is i i independent of xi .6 Exercises 1. Suppose that yi is discrete-valued. Compute the conditional mean m(x) = E (yi | xi = x) . m. E(ei | xi ) = 0. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. 2. taking values only on the non-negative integers. If yi = x0 β + ei and E(xi ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi .1.2. Compute 2 the coefficients of the linear projection yi = β 0 + β 1 xi + ei .4 . 3 and 4 of Theorem 3.. i 8. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . σ 2 = V ar(xi ). i 11. True or False. Are they different? Hint: If P (Y = j) = 5. xi ∈ R. e−λ λj j! . . Define µ ¶ ¢ ¡ x−µ 2 g x. True or False. If yi = x0 β + ei and E(ei | xi ) = 0. a constant. True or False. Suppose that Y and X only take the values 0 and 1. σ = . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Define µy = Eyi . E(Y 2 | X = x) and V ar(Y | X = x). µ.. 9. Prove parts 2. If yi = xi β + ei . Let X be a random variable with µ = EX and σ 2 = V ar(X). 3. 1. j! 0 j = 0. µx = Exi . then E(x2 ei ) = 0. and E(xi ei ) = 0. True or False. If yi = x0 β + ei . yi ). s) = 0 if and only if m = µ and s = σ 2 . x 6. and E(ei | xi ) = 0.2 Y =1 . then ei is independent of xi . i 10.3. Compute E(yi | xi = x) and V ar(yi | xi = x). 0 ≤ y ≤ 1. Let xi and yi have the joint density f (x. ¡ ¢ 4.3 Find E(Y | X = x). and have the following joint probability distribution X=0 X=1 Y =0 . then E(x2 ei ) = 0. If yi = xi β + ei . 2. (x − µ)2 − σ 2 Show that Eg (X. True or False.

we narrow the focus to the linear regression model. 4.3) writes the projection coefficient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 . but for most of the chapter we retain the broader focus on the projection model.2) (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i à n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 à n !−1 n X X = xi x0 xi yi .1 Estimation Equation (4.7 and 4.1) (4.3) In Sections 4. i It follows that the moment estimator of β replaces the population moments in (4. Observe that (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .8.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. i n i=1 n 21 .2) can be written in the parametric 0 β)) = 0. (4.4) i i=1 i=1 ˆ Another way to derive β is as follows.

These are white male wage earners from the March 2004 Current Population Survey. 0.71 = −2. To illustrate.117 Educationi .95 42.14 205. This sample has 988 observations. i 22 . with 10-15 years of potential work experience. 4.14 14. An interpretation of the estimated equation is that each year of education is associated with an 11.117 1 14. 40 2. Define the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. 30 = .ˆ This is a set of k equations which are linear in β.94 −2. consider the data used to generate Figure 3.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.40 µ ¶µ ¶ 34.95 xi yi = 42. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.83 ¶−1 µ ¶ .37 µ ¶ 1.4).30 + 0. 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. excluding military.170 37. Then µ ¶ n 1X 2. ¶ 2. 40 0.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.2 Least Squares There is another classic motivation for the estimator (4. Let yi be log wages and xi be an intercept and years of education.14 205.14 14.7% increase in mean wages.3.4).

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

5) implies that 1X xi ei = 0. one implication is that n 1X ei = 0.7. ˆ σ = ˆ n 2 i=1 n (4. ˆ n i=1 n Since xi contains a constant. Its method of moments estimator is the sample average 1X 2 ei .Figure 4.2: Sum-of-Squared Error Function Contours Equation (4. These are algebraic results.7) A justification for the latter choice will be provided in Section 4. and hold true for all linear regression estimates. The error variance σ 2 = Ee2 is also a parameter of interest.6) An alternative estimator uses the formula n 1 X 2 s = ei . 24 . ˆ n−k 2 i=1 (4. It measures the variation in the i “unexplained” part of the regression. 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 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 ). Hence the MLE for β equals the OLS estimator. 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 . 4. The log-likelihood function for the normal regression model is à ¶! µ n X ¢2 1 1 ¡ 2 0 log exp − 2 yi − xi β Ln (β. This is a parametric model.where A measure of the explained variation relative to the total variation is the coefficient of determination or R-squared. This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. Instead. 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 . and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . testing.3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. Since Ln (β. where likelihood methods can be used for estimation. and distribution theory. 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 ). maximizing the likelihood is identical to minimizing Sn (β). It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. σ 2 ) maximize Ln (β. The R2 is frequently mislabeled as a measure of “fit”. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. σ 2 ).

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

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

ˆ ˜ ˜ ˆ 3.Theorem 4. .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.9). the primary use is theoretical. the FWL theorem can be used to speed computation. A common application of the FWL theorem. ⎟ ⎜ ⎟ ⎜ (4. and X2 is the vector of observed regressors. . In this case. ¡ ¢−1 0 ι. . observe that ⎞ ⎛ ⎞ ⎛ . which you may have seen in an introductory econometrics course. ⎠ ⎝ ⎠ ⎝ . Regress Y on X2 . ˜ 2. Rather. 30 . ˆ which are “demeaned”. . In this section we derive the small sample conditional mean and variance of the OLS estimator. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.14) or via the ˆ following algorithm: ˜ 1. obtain OLS estimates β 2 and residuals e. obtain residuals Y . Regress X2 on X1 .13).9). is the demeaning formula for regression. but in most cases there is little computational advantage to using the two-step algorithm. obtain residuals X2 . Regress Y on X1 . . 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) . ! Thus the OLS estimator for the slope coefficients is a regression with demeaned data.6. . By the independence of the observations and (3.8)(3. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. . In the model (4. .1 (Frisch-Waugh-Lovell). The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . In some contexts. 4. .

⎠ (4. 0 0 ··· 0 0 . .. X 0 DX = X 0 Xσ 2 . .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 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th off-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.12). the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.18).20) . and ³ ´ ¡ ¢−1 2 ˆ σ . Next. σ2 n ⎞ We now calculate the finite sample bias of the method ¡ moments estimator σ 2 for σ 2 . From (4. . 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. σ 2 } = ⎜ . for any random vector Z define the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . under the of ˆ ¢ 2 | x = σ 2 . ⎝ . σ 2 = σ 2 and we have the simplii fications D = In σ 2 .. and (4. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model.. and the trace operator observe that. Then given (4.. .19) ˆ and thus the OLS estimator β is unbiased for β. 1 n .Using (4.8). . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . V ar β | X = X 0 X ⎟ ⎟ ⎟. . . the properties of conditional expectations.

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. In the homoskedastic linear regression model. It is not unbiased in the absence of homoskedasticity. This is the justification for the common s ˆ preference of s2 over σ 2 in empirical practice. is a famous statement of the solution. Theorem 4. 4. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .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 .7) is unbiased for σ 2 by this calculation. Now consider the class of estimators of β which are linear functions of i the vector Y. Thus σ 2 is biased towards zero. By a calculation similar to those of the previous section.8.8)¢ ¡ (3. or in the projection model. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. however. known as the Gauss-Markov theorem. = σ2 n the final equality by (4. As an alternative. 32 .9) plus E e2 | xi = σ 2 . the estimator ˆ 2 defined (4. What is the best choice of A? The Gauss-Markov theorem. ³ ´ ˜ E β | X = A0 Xβ. ˜ so β is unbiased if (and only if) A0 X = Ik . The following result. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. says that the least-squares estimator is the best choice.10). The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . It is important to remember. the best (minimumvariance) unbiased linear estimator is OLS. In this case. which is (3.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. which we now present.1 Gauss-Markov. as it yields the smallest variance among all unbiased linear estimators. Thus since V ar (e | X) = In σ 2 under homoskedasticity.

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

if the data have a discrete distribution. Since this is a regular parametric model the MLE is asymptotically efficient (see Appendix A.5. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .10) for the class of models satisfying Assumption 3. and thus so is the OLS estimator. He observes that the above argument holds for all multinomial distributions.22) 34 .1. Let the regressors be partitioned as Suppose we are interested in the coefficient on x1i alone in the regression of yi on the full set xi . He proves that generically the OLS estimator (4.Substituting in the expressions for π j .9). Chamberlain (1987) extends this argument to the case of continuously-distributed data. 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. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. (4. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.10 Omitted Variables xi = µ x1i x2i ¶ .4) is an asymptotically efficient estimator for the parameter β defined in (3. the maximum likelihood estimator is identical to the OLS estimator.

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

27) (4.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.12 Influential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.25) 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.−i = (1 − hi )−1 hi ei . A more relevant implication of near multicollinearity is that individual coefficient estimates will be imprecise. What is happening is that when the regressors are highly dependent. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. 1] and sum to k. The hi take values in [0. ˆ ˆ (4. To investigate the possibility of influential observations. the worse the precision of the individual coefficient estimates. since as ρ approaches 1 the matrix becomes singular. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. it is statistically difficult to disentangle the impact of β 1 from that of β 2 . the precision of individual estimates are reduced. the OLS estimator based on the sample excluding the i’th observation. If the i’th observation 36 . Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. As a consequence. We can also define the leave-one-out residual ˆ ˆ ei. In extreme cases it is possible that the reported calculations will be in error due to floating-point calculation difficulties. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . the change in the coefficient estimate by deletion of the i’th observation depends critically on the magnitude of hi .26) As we can see. ˆ i A simple comparison yields that ˆ ei − ei. that is.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. We derive expression (4. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .25) below. 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. define the leave-one-out least-squares estimator of β.−i = yi − x0 β (−i) = (1 − hi )−1 ei .

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 . Investigations into the presence of influential observations can plot the values of (4. The key is equation (2.This implies has a large value of hi .27).4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .25). then this observation is a leverage point and has the potential to be an influential observation.1) in Section 2. ˆ We now derive equation (4. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

2. Consider the OLS regression of the n × 1 vector y on the n × k matrix X. Consider an alternative set of regressors Z = XC, where C is a k × k non-singular matrix. Thus, each column of Z is a mixture of some of the columns of X. Compare the OLS estimates and residuals from the regression of Y on X to the OLS estimates from the regression of Y on Z.
0ˆ 3. Let e be the OLS residual from a regression of Y on X = [X1 X2 ]. Find X2 e. ˆ

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

p p p q which is (5. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. =E U V p q p q Proof of Markov’s Inequality. n→∞ lim P (|Zn − Z| > δ) = 0. So for all x. Theorem 5. tangent lines lie below it. denoted Zn →p Z as n → ∞. For any strictly increasing function g(X) ≥ 0. then as n → ∞ n 1X Xn = Xi →p E(X). (5. if for all δ > 0.4) Proof of Jensen’s Inequality.1 Weak Law of Large Numbers (WLLN). We say that Zn converges in probability to Z as n → ∞. ¥ 5. Since g(x) is convex.3). If Xi ∈ Rk is iid and E |Xi | < ∞. Let a + bx be the tangent line to g(x) at x = EX. n i=1 42 . 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 ) = + .2. ¥ Proof of Holder’s Inequality. as stated. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Set Y = g(X) and let f denote the density function of Y. Note EU = EV = 1. This is a probabilistic way of generalizing the mathematical definition of a limit. The WLLN shows that sample averages converge in probability to the population average.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Applying expectations.Markov’s Inequality. 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}. P (g(X) > α) ≤ α−1 Eg(X). Eg(X) ≥ a + bEX = g(EX).

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

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

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

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

·) is continuous at (Q. using (6.2. (6.1). Assumption 3.2). (6.1).4 implies that Q−1 exists and thus g(·.5. (6. β →p β as n → ∞. This is illustrated in Figure 6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. we will use the methods of asymptotic approximation.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. Hence by the continuous mapping theorem (Theorem 5. the OLS estimator β is has a statistical distribution which is unknown.1. First.1.2) i i n i=1 n From (6.2 Consistency ˆ As discussed in Section 6.2.5.4.1 Under Assumption 3. Ã n ! n X 1X 0 1 ˆ xi xi . To characterize the sampling distribution more fully.1). 6. and the continuous mapping theorem (Theorem 5. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. As the sample size increases the density becomes more concentrated about the population coefficient. Assumption 3. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. Proof.3). n i=1 (6. ˆ 47 .4.1 by the fact that the sampling densities become more concentrated as n gets larger.1).8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . 0).3) Ã where g(A. For a complete argument.From the figure we can see that the density functions are dispersed and highly non-normal. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. Equation (4.1 and the WLLN (Theorem 5. xi ei →p g (Q.1. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to infinity.1) and ˆ We now deduce the consistency of β.5. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . we can conclude ˆ that β →p β. 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 . ˆ Theorem 6.

2. E ¯ei ¯ E ¯e4 ¯ i i i i (6. Ω) . Assumption 6. i i Assumption 6. i Now define ¡ ¢ Ω = E xi x0 e2 . ˆ Proof.5.1 In addition to Assumption 3. by the Cauchy-Schwarz inequality (5.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.6) n i=1 48 .5.Theorem 6.1).3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.2). To see this. Ee4 < ∞ and E |xi |4 < ∞.3) and Theorem (6. (6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. (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 à ! à n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. ˆ n−k 6.1 guarantees that the elements of Ω are finite.1. (6.1.2.1).3. it follows that s2 = ¥ n σ 2 →p σ 2 .3. ˆ Finally. By the central limit theorem (Theorem 5.3. since n/(n − k) → 1 as n → ∞. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. We need a strengthening of the moment conditions.2 Under Assumption 3. n 1 X √ xi ei →d N (0. Thus σ 2 is consistent for σ 2 . (6.2).

How large should n be in order for the approximation to be useful? Unfortunately. Q−1 ΩQ−1 . ´ √ ³ ˆ n β−β = à 1X xi x0 i n i=1 n !−1 à Theorem 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. after rescaling. There is a special case where Ω and V simplify. for any ˆ fixed n the sampling distribution of β can be arbitrarily far from the normal distribution. but this is not a necessary condition.7) Cov(xi x0 . and (6.Then using (6.2). In´Figure 6.3. is approximately normal when the sample size n is sufficiently large. We say that ei is a Homoskedastic Projection Error when (6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. For α 49 . The trouble is that no matter how large is the sample size.6). i i Condition (6.7) is true or false.1 Under Assumption 6. As α approaches 2. 1). If α > 2 the 2 error εi has zero mean and variance α/(α − 2).7) holds. Let yi = β 0 + β 1 xi + εi where xi is N (0. Ω) ¡ ¢ = N 0. xi ) which satisfy the conditions of Assumption 6. V is often referred to as ˆ the asymptotic covariance matrix of β. We call V 0 the homoskedastic covariance matrix. Theorem 6. otherwise V 6= V 0 . We illustrate this problem using a simulation.3. Under (6. The asymptotic distribution ´ Theorem 6. there is no simple answer to this reasonable question. |ε| ≥ 1.3. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.9) we define V 0 = Q−1 σ 2 whether (6.1. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.1. The approximation may be poor when n is small. its variance diverges q ³ ´ ˆ to infinity. when xi and ei are independent. (6.1 states that the sampling distribution of the least-squares estimator.9) In (6. 1 X √ xi ei n i=1 n ! the N (0.3. V ) where V = Q−1 ΩQ−1 .1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes.1).8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. However. The expression V = Q−1 ΩQ−1 is called a sandwich form.7) is true then V = V 0 .3. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .2 we display the finite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . however. for example.1 is commonly used to approximate the finite of √ ³ˆ sample distribution of n β − β . 1) asymptotic distibution. When (6. This holds true for all joint distibutions of (yi . In Figure 6. e2 ) = 0. setting n = 100 and varying the parameter α.

the sampling distribution becomes highly skewed and non-normal.10) without changing this result. 4. As k increases.3. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. 6. The lesson from Figures 6.2) and Theorem 6.1) it is clear that V 0 →p V 0 . concentrating most of the probability mass around zero.0 the density is very close to the N (0.10) V 0 = Q−1 s2 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2. We show the sampling distribution of n β 1 − β 1 setting n = 100.2 and 6.11) 50 . ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. 1). 1) density. As α diminishes the density changes significantly.Figure 6. for k = 1.3 is that the N (0. The estimator 2 2 in (6. 1) asymptotic approximation is never guaranteed to be accurate. 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 (0.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. Another example is shown in Figure 6. 6 and 8. we need an estimate of Ω = E xi x0 e2 .2: Density of Normalized OLS estimator α = 3.

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

493 −0. and then the square roots.14 205. We calculate that s2 = 0.83 ¶−1 µ .30 + 0. From a computational standpoint. the standard method to calculate the standard errors is to ˆ first calculate n−1 V . then take the diagonal elements.117 Educationi .020) 6. The standard errors for β 0 are 7.14 14.20 and µ ¶ ˆ = 0.480 ˆ0 = 0.14 205.2/988 = . i i i i n i=1 Second.80 2.83 −0.493 0. we return to the log wage regression of Section 4. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. by Holder’s inequality (5. from which it follows that V →p V as n → ∞. p ˆ In this case the two estimates are quite similar. just as any other estimator.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. (6.80 .020.80 40.14 14.2.039 and ˆ V = µ 1 14.14 6. but not under another set of assumptions.480 .035 ¶ .085 p ˆ and that for β 1 is . E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . To illustrate. (.1. n n i=1 52 .35/988 = .085) (.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.14 205.5) and the WLLN (Theorem 5.98 −0.6 ¶µ 1 14.199 2.used by an author when studying their work.12) in turn.20 −0.199 2. Using (6. Ω 2.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. (6.83 ¶−1 = µ 7.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.80 40.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.4) 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 . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. First.20 = V 14.

12 the definition of β (−i) as the least-squares estimator with the i’th observation deleted. Andrews (1991) suggested an similar estimator based on cross-validation. From equation (3. Ω →p Ω and V →p V.25). ¯ ¯n ¯ n i=1 so Together. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . Recall from Section 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 (6.5. which.13) Using formula (4.13) of Efron (1982).¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. 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. 6. ¯ 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. these establish consistency.14) à 1X (1 − hi )−1 xi ei ˆ n i=1 n !à 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . n i=1 n ˆ ˆ Theorem 6.11) with the leave-one-out estimator ei.−i = (1 − hi )−1 ei ˆ presented in (4. Using this substitution.1 As n → ∞. is defined ˆ ˆ by replacing the OLS residual ei in (6. you can show that 1 Xˆ ¯ β= β (−i) . by the WLLN ¯ n ¯ à n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. i=1 Third. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .26).6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.

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

8 t tests Let θ = h(β) : Rk → R be any parameter of interest. In this case. β 2 ). the statistic tn has an exact t distribution.8. Consider the studentized statistic tn (θ) = Theorem 6. we say that tn (θ) is asymptotically pivotal. however. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. θ could be a single element of β). 55 . s(ˆ θ) (6.1 tn (θ) →d N (0. and is therefore exactly free of unknowns. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . the standard error for ˆ is the square root of n−1 Vθ . we say that tn is an exactly pivotal statistic. and θ = h(β) is some function of the parameter vector. 1) Proof.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. In special cases (such as the normal regression model. 1) →d ˆ−θ θ . θ) β 6. s(ˆ = n−1/2 H 0 V Hβ . By (6. see Section X). Vθ ) √ Vθ = N (0.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0.For example. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. µ I 0 ¶ ˆ the upper-left block of V . ˆ When q = 1q h(β) is real-valued). A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-specified value. Since the standard normal distribution does not depend on the parameters. if R is a “selector matrix” R= so that if β = (β 1 . In general. that (so θ ˆ ˆ ˆ is. (For example.

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

A good method for construction of a confidence interval is the collection of parameter values which are not rejected by a statistical test. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.05. and it is desired to test the joint restrictions simultaneously. θ θ) (6.18) . 6. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .16) and zα/2 is the upper α/2 quantile of the standard normal distribution. = n h(β) − θ0 Hβ V Hβ 57 (6. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. ˆ + zα/2 s(ˆ .We typically cannot calculate the exact coverage probability P (θ ∈ Cn ).10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. 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). θ The interval has been constructed so that as n → ∞. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . In this case the t-statistic approach does not work. or α = . This corresponds to selecting the confidence h i h ˆ ± 1.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% confidence interval. the most common professional choice isi95%.96s(ˆ ≈ ˆ ± 2s(ˆ . 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. ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β).

The null hypothesis is H0 : β 2 = 0.1.84 = z. Also h(β) = a selector matrix.1 Under H0 and Assumption 6. and there are q = k2 restrictions. the upper-α quantile q 2 of the χ2 distribution. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . The asymptotic p-value for Wn is pn = p(Wn ). θ = β 2 . if rank(Hβ ) = q. Hβ (β) →p Hβ .10. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).3. Vθ ).2. h(β) = R0 β. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. Furthermore. For example. the test rejects at the α% level iff pn < 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. a chiq square random variable with q degrees of freedom.1 showed θ ˆ that V →p V. In this case. ˆ Wn = n θ θ q θ θ Theorem 6. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .When h is a linear function of β. and Theorem 6.025 . 6.19) σ2 ˆ where σ2 = ˜ 1 0 e e.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 .5.8. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. Hβ (β) is a continuous function of β. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. Hence β β by Theorem A. then Wn →d χ2 . 1] under H0 . the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity. ˜˜ n ˜ e = Y − X1 β 1 .15) showed that n ˆ − θ →d Z ∼ N (0. χ2 (. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). As before. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. q and pn is asymptotically U[0.05) = 3.

2 2 2 or alternatively. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. X2 ). ˆˆ n ˆ e = Y − X β. note that if we regress Y on X1 alone. Now consider the residual regression of e on X2 = M1 X2 . ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . the residual is ˜ ˜ e = M1 Y. We now derive expression (6.19) the F form of the Wald statistic. 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 .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 . = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. 59 . Because of this connection we call (6. This statistic is typically reported as an “F-statistic” which is defined as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed.are from OLS of Y on X1 . note that partitioned matrix inversion (2. and σ2 = ˆ 1 0 e e. Thus ˜ ˆ e=X ˜ ˆ 2 ³ ´0 ³ ´ ˜ ˆ ˜ ˆ e0 e = X2 β 2 + e ˜˜ ˆ ˆ X2 β 2 + e ˆ0 ˜ 0 ˜ ˆ = β 2 X2 X2 β 2 + e0 e ˆˆ 0 0 ˆ ˆ ˆˆ = β X M1 X2 β + e0 e.19) is that it is directly computable from the standard output from two simple OLS regressions.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. as the sum of squared errors is a typical output from statistical packages. The elegant feature about (6. By the FWL theorem. still this formula often finds good use in reading applied papers. First.19). Also. 2 σ ˆ To simplify this expression further.

when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. 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. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . In ) . In particular. Let u = σ −1 H 0 e ∼ N (0. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . This special F statistic is testing the hypothesis that all slope coefficients (other than the intercept) are zero. While there are special cases where this F statistic is useful. n−k 60 . σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. introduced in Section 4. an “F statistic” is reported.4)) where H 0 H = In . This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . Since linear functions of normals are also normal. This is rarely an issue today. there is an exact distribution theory available for the normal linear regression model.12 Normal Regression Model As an alternative to asymptotic distribution theory. 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. Since uncorrelated normal variables are independent. In σ 2 .where In many statistical packages. H 0 H) ∼ N (0. including the estimated error variance 2. 6. these cases are atypical. equivalently the residual variance from an intercept-only model. σ 2 ) can be be used to calculate a set of exact distribution results. when an OLS regression is reported.3. as sample sizes are typically sufficiently large that this F statistic is highly “significant”. it follows ˆ that β is independent of any function of the OLS residuals.

1) and tn−k distributions. if standard errors are calculated using the homoskedastic formula (6. We summarize these findings Theorem 6. σ 2 ). 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 we showed that in large samples.12. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . β and t are approximately normally distributed.8.a chi-square distribution with n − k degrees of freedom. the notable distinction is between the N (0. and standard errors are calculated using the homoskedastic formula (6. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . 0.1 shows that under the strong assumption of ˆ normality. β 2 . σ 2 ) discussed above. 0. a good testing procedure is based on the likelihood ratio statistic. β 2 .10) then ´ ³ ˆ • β ∼ N 0.3. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. which is twice the difference in the log-likelihood function evaluated under the null and alternative hypotheses. 0. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . In contrast. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.10) µ h i ¶ 2 (X 0 X)−1 N 0. As inference (confidence intervals) are based on the t-ratio. σ2 ˆ 61 . β has an exact normal distribution and t has an exact t distribution. Furthermore.1 If ei is independent of xi and distributed N(0. σ 2 ) = − log σ − log (2π) − .) Now let us partition β = (β 1 . The critical values are quite close if n − k ≥ 30. n−k • ∼ tn−k ˆ In Theorem 6. σ ˆ ˆ βj − βj βj − βj N (0.12. so as a practical matter it does not matter which distribution is used. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . β 2 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .1 and Theorem 6. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . Theorem 6. (Unless the sample size is unreasonably small. σ 2 ) − Ln (β 1 . with residual variance σ .

The decreasing dashed ˆ = 1.4 the Wald statistic Wn (s) as a function ˆ of s. features of this distribution can be calculated. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. To demonstrate this effect. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is significant relative to asymptotic critical values. This produces random draws from the sampling distribution of interest. we find that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Letting h(β) = β s . Our first-order asymptotic theory is not useful to help pick s. ˆ Let β and σ 2 be the sample mean and variance of yi . Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n .13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. setting n/σ 2 = 10. σ 2 ) and consider the hypothesis H0 : β = 1. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. the statistic Wn (s) varies with s. we have plotted in Figure 6. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. This can be seen by a simple example introduced by Lafontaine and White (1986). while there are other values of s for which test test statistic is insignificant. Take the model yi = β + ei ei ∼ N (0. 62 . 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. and noting Hβ = sβ s−1 . This is an unfortunate feature of the Wald statistic. Through repetition.By a first-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .8. as Wn (s) →d χ2 under H0 for 1 any s. In the present context of the Wald statistic. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaffected by the choice of s. they can work quite poorly when the restrictions are nonlinear. 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.84 — the probability of a false rejection.7. 6.

looking for tests for which rate rejection rates are close to 5%. 100 and 500. Error rates avove 10% are considered excessive.1 you can also see the impact of variation in sample size. The null hypothesis β s = 1 is true. this probability depends only on s. The value of s is varied from 1 to 10. Table 4. so these probabilities are Type I error.000 simulated Wald statistics Wn (s) which are larger than 3.84 | β = 1) . In each case. These probabilities are calculated as the percentage of the 50. In Table 2. Any other choice of s leads to a test with unacceptable Type I error probabilities. Type I error rates between 3% and 8% are considered reasonable. and σ 2 .1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .1 reports the simulation estimate of the Type I error probability from 50. To interpret the table. Rates above 20% are unexceptable.Figure 6. Given the simplicity of the model. no magic choice of n for which all tests perform uniformly well. There is. Each row of the table corresponds to a different value of s — and thus corresponds to a particular choice of test statistic.84.05) with deviations indicating+ distortion. however. and σ is varied among 1 and 3.4: Wald Statistic as a function of s P (Wn (s) > 3. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.4. When comparing statistical procedures. remember that the ideal Type I error probability is 5% (. we compare the rates row by row. n is varied among 20. Table 4. the Type I error probability improves towards 5% as the sample size n increases. For this particular example. The second through seventh columns contain the Type I error probabilities for different combinations of n and σ.1 we report the results of a Monte Carlo simulation where we vary these three parameters. the only test which meets this criterion is the conventional Wn = Wn (1) test. n. In Table 4.000 random samples. Test performance deteriorates as s increases. Typically. and rarely fall outside of the 3%-8% range.

07 .07 .18 .24 .08 .10 .05 .08 . This point can be illustrated through another example.13 .06 . While this is clear in this particular example. 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. β 2 ) be the least-squares estimates of (6.15 .15 .10 .19 .12 .14 .06 . define θ = β 1 /β 2 .11 .25 .10 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.05 .05 . so the hypothesis can be stated as H0 : θ = r.22 .05 .06 . 64 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .07 .20).17 .13 .25 .12 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.31 .07 .06 .08 .14 .07 . Other choices are arbitrary and would not be used in practice.06 .08 .22 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .06 .05 .20 .s 1 2 3 4 5 6 7 8 9 10 Note: σ=1 σ=3 n = 20 n = 100 n = 500 n = 20 n = 100 n = 500 .20 .08 . β 1 .06 .30 .13 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. Equivalently.26 .23 .05 . Define θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .16 Rejection frequencies from 50.15 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at first.33 .21 .09 .06 .28 .34 .35 .15 .

2. along with sample size n.05 .50 . then the “most linear” formulation should be selected.75.06 . and alternatives to asymptotic critical values should be considered.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. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. . 6. The left tail probabilities P (t1n < −1.50.06 .645) P (tn < −1. In contrast.645) P (tn > 1.000 simulated samples. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.645) are calculated from 50.645) are close to zero in most cases.00 The one-sided Type I error probabilities P (tn < −1. This leaves β 2 as a free parameter. .26 .06 .05 . We let x1i and x2i be mutually independent N (0. In all cases.10 . If no linear formulation is feasible. while the right tail probabilities P (t1n > 1. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .00 .06 .05 .02 .06 .00 . and are close to the ideal 5% rate for both sample sizes.05 .0 and n among 100 and 500.25.00 .645) P (tn > 1.12 .7.15 . the rejection rates for the t1n statistic diverge greatly from this value. this formulation should be used.05. Ideally.00 . The implication of Table 4. σ 2 ) draw with σ = 3.10 . if the hypothesis can be expressed as a linear restriction on the model parameters. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .645) t1n t2n t1n t2n t1n t2n t1n t2n .05 β2 .06 .00 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . We vary β 2 among .00 . The results are presented in Table 4.06 . the entries in the table should be 0.06 . Table 4. 1) variables.05 .05 . It is also prudent to consider alternative tests to the Wald statistic. such as the GMM distance statistic which will be presented in Section 9.1.00 .25 . .09 .15 . ei be an independent N (0. 65 .06 . However.07 .2 is that the two t-ratios have dramatically different sampling behavior.00 .28 .06 .47 . and 1.645) and P (tn > 1.75 1. and normalize β 0 = 0 and β 1 = 1. In this section we describe the method in more detail. especially for small values of β 2 .645) greatly exceed 5%.00 .05 .05 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.10 .05 .

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

immigrant.22/ B. the researcher must select the number of experiments. then we can set s P = (. For example. Quite simply.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. and hispanic. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. As discussed above. for a selection of choices of n and F. the choice of B is often guided by the computational demands of the statistical procedure. respectively. but requires more computational time. In practice. and 90% sample quantiles of the sample {Tnb }. and dummy variable indicators for the following: married. For the dependent variable we use the natural log of wages. hispanic. a larger B results in more precise estimates of the features of interest of Gn . In many cases. The average (6. It is therefore convenient to pick B so that N is an integer. We us the sample of wage earners from the March 2004 Current Population Survey. immigrant. are. If the standard error is too large to make a reliable inference. Generally. female. We now expand the sample all non-military wage earners. s P = .05) (. . then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. and our regressors include years of education. union member.003.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. female. we included a dummy 67 . potential work experience. It is therefore useful to conduct a variety of experiments. and therefore it is straightforward to calculate standard errors for any quantity of interest. 1000. such as the percentage estimate reported in (6.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. As P is unknown. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. In particular.95) /B ' .96) . equalling 1 with probability P = E1 (Tnb ≥ 1. Again our dependent variable is the natural log of wages. an estimator or test may perform wonderfully for some values. B. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. For example. potential work experience. 6. and poorly for others. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. The random variable 1 (Tnb ≥ 1. experience squared.15 Estimating a Wage Equation We again return to our wage equation. this may ˆ be approximated by replacing P with P or with an hypothesized value. The α% sample quantile is a number qα such that α% of the sample are less than qα .96) . it is simple to make inferences about rejection probabilities from statistical tests. Then qα is the N ’th number in this ordered sequence. Hence the ³ ´ ˆ standard errors for B = 100.022. For regressors we include years of education. the performance will depend on n and F. so that coefficients may be interpreted as semi-elasticities. then B will have to be increased. and . where N = (B +1)α. excluding military. therefore. if we set B = 999. and estimate a multivariate regression. Furthermore. and dummy variable indicators for the following: married. Often this is called the number of replications.007. B b=1 (6. and 5000. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. union member. experience squared. We separately estimate equations for white and non-whites. and non-white.96) is iid Bernoulli.21).

808 . the restricted standard deviation estimate is σ = . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.19) is ˜ µ ¶ µ ¶ σ2 ˆ . The available sample is 18. Wn = n 1 − 2 = 18.1.808 so the parameter estimates are quite precise and reported in Table 4.070 .00002 .013 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. Ignoring the other coefficients. θ ˆ 2β 3 β2 . as the 1% critical value for the χ2 distribution is 76.010 . excluding the coefficients on the state dummy variables. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.101 . Alternatively. 808 1 − . reestimating the model with the 50 state dummies excluded.49452 σ ˜ Notice that the two statistics are close. The F form of the Wald statistic (6.121 −.1 we find the point estimate ˆ ˆ = − β 2 = 28.4877 18.002 . 2β 3 68 . but not equal.00057 . we find Wn = 550. 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.007 .008 . this adds 50 regressors).4945.34 ˆ s(β) .69.033 −. Computing the Wald statistic (6. Using either statistic the hypothesis is easily rejected.001 .097 −.032 .102 −.variable for state of residence (including the District of Columbia. Table 4.102 −.232 .48772 = 515.014 .027 .18) that the state coefficients are jointly zero.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.

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 ).40.5]. Instead. 69 . this is a poor choice. However. not testing a hypothesis. there is not a simple expression for this set.96. but it can be found numerically quite easily. This set is [27.Using the Delta Method.9.0.5]. This is the set of θ such that |tn (θ)| ≤ 1. we found better Type I error rates by reformulating the hypothesis as a linear restriction. Since tn (θ) is a non-linear function of θ. Notice that the upper end of the confidence interval is the same as that from the delta method. In the present context we are interested in forming a confidence interval. 29. In the previous section we discovered that such t-tests had very poor Type I error rates. we can calculate a standard error of s(ˆ = . implying a 95% confidence θ) interval of [27. but the lower end is substantially lower. Our desired confidence interval will be the set of parameter values θ which are not rejected by the hypothesis test. as the coverage probability of this confidence interval is one minus the Type I error of the hypothesis test based on the t-test. 29. so we have to go one step further.

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

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

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

is the homoskedasticity-formula standard error.

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

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

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

E (xi ei ) = 0
∗ yi = yi + ui

71

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

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

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

• Qi • Di • Ci

The flow variables are annual sums for 1987. The stock variables are beginning of year. (a) Estimate a linear regression of Ii on the other variables. Calculate appropriate standard errors. (b) Calculate asymptotic confidence intervals for the coefficients. (c) This regression is related to Tobin’s q theory of investment, which suggests that investment should be predicted solely by Qi . Thus the coefficient on Qi should be positive and the others should be zero. Test the joint hypothesis that the coefficients on Ci and Di are zero. Test the hypothesis that the coefficient on Qi is zero. Are the results consistent with the predictions of the theory?
2 (d) Now try a non-linear (quadratic) specification. Regress Ii on Qi , Ci , Di , Q2 , Ci2 , Di , i Qi Ci , Qi Di , Ci Di . Test the joint hypothesis that the six interaction and quadratic coefficients are zero.

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

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

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

73

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

then the FGLS estimator will force ˜i the regression equation through the point (yi . σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. estimator of β.. This is the feasible GLS.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. Furthermore. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. then the FGLS ˜i estimator is not well defined. there is no guarantee that σ 2 > 0 for all i. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i specification. 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. If σ 2 < 0 for some i. Since there is not a unique specification for the conditional variance the FGLS estimator is not unique. Vα ) (7. This suggests 75 .Suppose ei (and thus η i ) were observed. if σ 2 ≈ 0 for some i. Vα = E zi zi (7. We may call (7.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. xi ). Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . ˜i Suppose 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. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β).. which is typically undesirable.3) ˆ ˆ While ei is not observed.. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . and will depend on the model (and estimation method) for the skedastic regression. or FGLS. as it is estimating the conditional variance of the regression of yi on xi .6) σ 2 = α0 zi . Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. .4) the skedastic regression. We have shown that α is consistently estimated by a simple procedure.

FGLS is asymptotically superior to OLS. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.2) 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 ). We just state the result without proof. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . Since the form of the skedastic regression is unknown. This estimator V 0 is appropriate when the skedastic regression (7. i ˜ 0 is inconsistent for V . Instead. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . then FGLS is asymptotically equivalent to GLS.that there is a need to bound the estimated variances away from zero. Its asymptotic variance is not that given in Theorem 7. This is an estimator which is robust to misspecification of the condie1 ˆn tional variance. In the linear regression model.1 If the skedastic regression is correctly specified.. FGLS estimation depends on specification and estimation of the skedastic regression.1. and it may be estimated with considerable 76 V takes a sandwich form√. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. Why then do we not exclusively estimate regression models by FGLS? This is a good question. Unless σ 2 = α0 zi . β should perhaps be i i called a quasi-FGLS estimator of β. This may be written as !−1 à n !à n !−1 à n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞..1. In this case we interpret α0 zi as a linear projection of e2 on zi . σ 2 ] σi i for some σ 2 > 0.1.. V n n i=1 . e2 }. A trimming rule might make sense: σ 2 = max[˜ 2 .1. There are three reasons. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7.1. 1992). but the proof of this can be tricky. similar to the covariance matrix of the OLS estimator. ¢¢−1 ¡ ¡ . Theorem 7. First. the natural estimator of the asympˆ totic variance of β is à n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . It is possible to show that if the skedastic regression is correctly specified. . V ). and was proposed by Cragg (Journal of Econometrics.

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

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

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

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

Now let’s consider the conditional median of Y given a random variable X. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. let Y be a continuous random variable. 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 least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. These distinctions are illusory. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0.5. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations.5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. The first definition is the 50th empirical 1 P quantile. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . These facts definitions motivate three estimators of 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 second is the value which minimizes n n |yi − θ| . i n n i=1 (7. as i=1 these estimators are indeed identical. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = .To recall the definition and properties of the median. Two useful facts about the median are that (7. however.10) The LAD estimator has the asymptotic distribution 81 . the linear function M ed (yi | xi = x) = x0 β is the conditional median function. and the third definition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . and let M ed (Y | X) = m(X) be this function evaluated at the random variable X.

∂ 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 ) .5. where V = and f (e | x) is the conditional density of ei given xi = x. Second using the law of iterated expectations and the chain rule of i differentiation. See Chapter 16. When f (0 | x) is large. Pn −1 0 β)) . V ).10) is equivalent to g n (β) = 0. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . First. The main difficulty is the estimation of f (0). (7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . then f (0 | x) = f (0) and the asymptotic variance simplifies V = (Exi x0 )−1 i 4f (0)2 (7. we provide a sketch here for completeness.11) This simplification is similar to the simplification of the asymptotic covariance of the OLS estimator under homoskedasticity.Theorem 7. This can be done with kernel estimation techniques. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . and this improves estimation of the median.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.1 ´ √ ³ˆ n β − β 0 →d N (0. the height of the error density at its median.11). Computation of standard error for LAD estimates typically is based on equation (7.5. ¢¢−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) . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. then there are many innovations near to the median.3. In the special case where the error is independent of xi . Let g(β) = Eg (β).1 is advanced. ˆ Proof of Theorem 7.5. ∂β 0 so Third. While a complete proof of Theorem 7. the conditional density of the error at its median. by the central limit theorem (Theorm 5.

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

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

since Q12 Q−1 Q21 > 0. 3. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . yi ˆm (7.14) by OLS. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. 7. Another is to regress yi on x1i and x2i jointly. and consequently 22 ¡ ¢−1 2 σ . One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. Typically.be an (m − 1)-vector of powers of yi . and the two estimators have equal asymptotic efficiency. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . 1i 2i 2i 1i 22 . then 22 Q11 > Q11 − Q12 Q−1 Q21 . lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. they will (typically) have difference asymptotic variances. or 4 seem to work best. 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. However. To implement the test. Thus the null is rejected at the α% level if Wn m−1 exceeds the upper α% tail critical value of the χ2 m−1 distribution. yielding predicted values yi = x0 β. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. ⎟ zi = ⎝ .8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. Wn →d χ2 . Q−1 σ 2 < Q11 − Q12 Q−1 Q21 11 22 85 ¡ ¡ ¢ ¢−1 2 ¡ ¢−1 2 ˆ lim nV ar(β 1 ) = Ex1i x0 − Ex1i x0 Ex2i x0 Ex2i x0 σ = Q11 − Q12 Q−1 Q21 σ . Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 .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. and form the Wald statistic Wn for γ = 0. yielding ˆ ˜ ˆ ˆ (β 1 . The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. ⎠ . In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. Otherwise. and n→∞ say. To see why this is the case. small values such as m = 2. β 1 = (X1 X1 )−1 (X1 Y ) . β 2 ). m must be selected in advance. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . note that (7. It is easy (although somewhat tedious) to show that under the null hypothesis.

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

n (7. then this model selection procedure is inconsistent. if α is set to be a small number. since (7. The reasoning which helps guide the choice of α in hypothesis testing (controlling Type I error) is ´ not ³ c = M1 | M1 ≈ relevant for model selection. known as the BIC. it is more appropriate to view model selection as determining the best finite sample approximation. this rule only makes sense when the true model is finite dimensional. 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. The model selection rule is as follows. depending on the sample size. Another common approach to model selection is to to a selection criterion. based on Bayesian arguments. etc. One popular choice is the Akaike Information Criterion (AIC). The rule is to select M1 if AIC1 < AIC2 . else select M2 .16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . For some critical level α. That is. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. LRn →p 0. 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. n (7. and km is the number of coefficients in the model.17) Since log(n) > 2 (if n > 8).16) holds under M1 . as the rule tends to overfit. k = While many modifications of the AIC have been proposed. as ³ ´ c P M = M1 | M1 → 1 − α < 1. M)) between the true density and the model density. log(n) 87 . If the truth is infinite dimensional. let cα satisfy ¢ ¡ P χ22 > cα .15) then where σ 2 is the variance estimate for model m. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . Then select M1 if Wn ≤ cα . the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. In contrast to the AIC. AIC selection is inconsistent.However. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . His criterion. since under M1 . Indeed. the most popular to be one proposed by Schwarz. ¢ ¡ ˆ1 ˆ2 (7. BIC model selection is consistent. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . else select M2 . k A major problem with this approach is that the critical level α is indeterminate. Another problem is that if α is held fixed. Indeed.

β 3 = · · · = β K = 0 . In the latter case. and then selects the model with the lowest AIC (7. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. and 220 = 1. The AIC selection criteria estimates the K models by OLS. β 2 6= 0.. 576. 048. which can be a very large number.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. Also under M2 . In the ordered case. 210 = 1024. . a model consists of any possible subset of the regressors {x1i . the models are M1 : β 1 6= 0. there are 2K such models. selecting based on (7. one can show that thus LRn →p ∞. Similarly for ˆ the BIC. E (εi | xi ) = 0 and the question is which subset of the coefficients are non-zero (equivalently. . However. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. β K 6= 0. . 88 . β 2 6= 0. We have discussed model selection between two models. .17).. and the AIC or BIC in principle can be implemented by estimating all possible subset models. . which regressors enter the regression). For example. xKi }. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. .15). The methods extend readily to the issue of selection among multiple regressors. In the unordered case. stores the residual variance σ 2 for each model. There are two leading cases: ordered regressors and unordered. which are nested. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi .. . MK : β 1 6= 0.

Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. Is θ a quantile of the distribution of Yi ? 3. Let θ satisfy Eg(Yi − θ) = 0. Verify equation (7. V . Let σ 2 be the estimate of σ 2 . the estimates (β. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . X). else equals zero). 5. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . 2.7.. the residuals e. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . Define g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. V ar(e | X) = σ 2 Ω with Ω known. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. (b) Prove that e = M1 e. In a linear model Y = Xβ + e.. ˜ the residual vector is e = Y − X β. and the out-of-sample value of the regressors. ˆ ˆ n−k 6. . xi ) be a random sample with E(Y | X) = Xβ.. 4. based on a sample of size n.12). For any predictor g(xi ) for y. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . σ 2 ). . E(e | X) = 0. where xji is one of the xi . x. the mean absolute error (MAE) is E |yi − g(xi )| . Show that the function g(x) which minimizes the MAE is the conditional median M (x). Thus the available information is the sample (Y.10 Exercises 1. wn ) and wi = x−2 . ˆ (a) Find a point forecast of y. 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 . Let (yi . (b) Find an estimate of the variance of this forecast.

(d) Calculate standard errors for all the parameters (a1 . the regression slope is a2 + a6 . . (iii) BIC criterion. are both estimators consistent for β? (b) Are there conditions under which either estimator is efficient? 9. θ) + ei with E (ei | xi ) = 0.18) plus the extra term a6 zi . This model is called a smooth threshold model. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . The model is non-linear because of the parameter a7 . I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. Do so. at least 10 to 15) of ln Qi are both below and above a7 . (7. n xi i=1 (a) Under the stated assumptions. Assess the merits of this new specification using (i) a hypothesis test. and the model imposes a smooth transition between these regimes. θ is the NLLS estimator. 8. and V is the = g(x estimate of V ar ˆ . 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. impose the restriction a3 + a4 + a5 = 1. a7 ). (ii) AIC criterion. you estimated a cost function on a cross-section of electric companies. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. Exercise 13. the variable ln Qi has a regression slope of a2 . (c) Estimate the model by non-linear least squares.ˆ ˆ 7. For values of ln Qi much below a7 . Suppose that yi ³ ´ i .18) (a) Following Nerlove.. For values much above a7 . 90 . calculate zi and estimate the model by OLS.. In addition. Consider model (7. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. Find an asymptotic 95% confidence interval for g(x). add the variable (ln Qi )2 to the regression.. Record the sum of squared errors. and find the value of a7 for which the sum of squared errors is minimized. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . The model works best when a7 is selected so that several values (in this example. In Chapter 6. Examine the data and pick an appropriate range for a7 . For each value of a7 .

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

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

but the approximation appears to improve for the large n. in the Figure below.1). 50. x). x∗ ≤ x) = Fn (y. and 100. x). x)) →d N (0. Fn is a nonparametric estimate of F. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) .1).. Note that while F may be either discrete or continuous. x))) . 1) distribution. This is a population moment. note that for any (y. For n = 25.. Fn is by construction a step function. by the CLT (Theorem 5. it is helpful to think of a random pair (yi . In general. the EDF step function gets uniformly close to the true CDF. x) = n i=1 Figure 8. x) is called the empirical distribution function (EDF).3. F (y. x) . i 93 . Notationally.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . Recall that F (y. i = 1. xi ). The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . The EDF is a consistent estimator of the CDF. the EDF is only a crude approximation to the CDF. x∗ ) with the i distribution Fn .8.2. Furthermore. I have plotted the EDF and true CDF for three random samples of size n = 25.2) Fn (y. That is. √ n (Fn (y. x) →p F (y. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y.. (8. To see this. Thus by the WLLN (Theorem 5. The random draws are from the N (0. x) = P (yi ≤ y. x). where 1(·) is the indicator function. . To see the effect of sample size on the EDF. x) (1 − F (y. ∗ P (yi ≤ y. as the sample size gets larger. n. x) − F (y.2 The Empirical Distribution Function Fn (y. Fn (y.

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

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

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

θ ˆn qn ˆ This confidence interval is discussed in most theoretical treatments of the bootstrap.025)]. Thus c = qn (α). it also follows that if there exists some monotonic transformation f (·) such that f (ˆ is symmetrically distributed about f (θ0 ). These t-statistics are sorted to find the estimated quantiles qn (α) and/or qn (1 − α). The problems with the percentile method can be circumvented by an alternative method. Then so an exact (1 − α)% confidence interval for θ0 would be 0 C2 = [ˆ − qn (1 − α/2).0 and this idealized confidence interval is accurate. θ. the bootstrap test rejects if Tn (θ0 ) > qn (1 − α). θ ˆ − qn (α/2)]. θ This motivates a bootstrap analog ∗ θ C2 = [ˆ − qn (1 − α/2). these critical values can be estimated from a bootstrap simulation by sorting ³ ∗ ´ ∗ ∗ the bootstrap t-statistics Tn = ˆ − ˆ /s(ˆ ). Therefore. by the translation invariance argument presented above. this³interval can be estimated from a bootstrap simulation by sorting the ´ ∗ ∗ bootstrap statistics Tn = ˆ − ˆ . and the test rejects if Tn (θ0 ) < qn (α). θ sample. We would set Tn (θ) = ´ ³ ˆ − θ /s(ˆ and reject H0 in favor of H1 if Tn (θ0 ) < c. θ) then the idealized percentile bootstrap method will be accurate. ˆ∗ ˆ∗ 97 . θ When ˆ does not have a symmetric distribution. ∗ Similarly. 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. Based on these arguments. C1 and C1 are designed for the case that ˆ has a symmetric distribution about θ0 . Computationally.975). 8.975).6 Percentile-t Equal-Tailed Interval Suppose we want to test H0 : θ = θ0 against H1 : θ < θ0 at size α. ˆ − q ∗ (. ˆ − q ∗ (α/2)]. Since this is unknown. C1 may perform quite poorly. 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. The 95% confidence interval is then [θ − ˆ to yield the quantile estimates qn ˆ ˆn ∗ (. many argue that the percentile interval should not be used unless the sampling distribution is close to unbiased and symmetric. but is not widely used in practice. θ 1 − α = P (qn (α/2) ≤ Tn (θ0 ) ≤ qn (1 − α/2)) ´ ³ θ = P ˆ − qn (1 − α/2) ≤ θ0 ≤ ˆ − qn (α/2) . and this is important. θ However. n Computationally. θ Let Tn (θ) = ˆ − θ. where c would be selected so that θ θ) P (Tn (θ0 ) < c) = α. ∗ (. Note. a bootstrap test replaces qn (α) with the bootstrap estimate ∗ ∗ qn (α).025) and q ∗ (. if the alternative is H1 : θ > θ0 . which are centered at the sample estimate ˆ These are sorted θ θ θ.

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

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

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

which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). 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). A two-sided hypothesis test rejects H0 for large values of |Tn | . F ) − Gn (−x. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). F0 ) = The order of the error is O(n−1 ). F ) + O(n−3/2 ). Since Tn →d Z.The “derivative” ∂ ∂F g1 (x.8. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. if Tn has exact distribution Gn (x. if Z ∼ N (0. F ) = Gn (x. then |Tn | has the distribution function Gn (x. F ) + g2 (x. n (8. we can calculate that Gn (x. then |Tn | →d |Z| ∼ Φ. and exact critical values are taken from the Gn (x. F ) is only heuristic. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). Similarly.1. = P (X ≤ x) − P (X ≤ −x) For example. Thus asymptotic critical values are taken from the Φ distribution. F ) = Gn (x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1.5) where the simplifications are because g1 is even and g2 is odd. Hence the difference between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. We conclude that G∗ (x) − Gn (x. 101 2 g2 (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. 8. F0 ) + O(n−3/2 ) = O(n−1 ). F ). F ). 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. as F is a function. F ) − Gn (−x. F ) + g2 (−x. 1). From Theorem 8. F0 ) = O(n−1 ). n . F0 ) distribution.

and needs to be determined on a case-by-case basis. We know that θ Tn →d N (0. g1 . Theorem 8. meaning that the errors in the two directions exactly cancel out. Fn ) − g2 (x. The difference is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. The analysis shows that there may be a trade-off between one-sided and two-sided tests. F0 ) = ∗ 2 (g2 (x. Two-sided tests have better rates of convergence than the one-sided tests. as it depends on the unknown V. and for the bootstrap ³x´ + O(n−1/2 ). A reader might get confused between the two simultaneous effects. Thus a two-sided bootstrap test also achieves an asymptotic refinement. Therefore. similar to a one-sided test. Fn ) = Φ(x) + ∗ 2 g2 (x. F0 )) + O(n−3/2 ) n = O(n−3/2 ). Twosided tests will have more accurate size (Reported Type I error). and bootstrap tests have better rates of convergence than asymptotic tests. n Thus the difference between the bootstrap and exact distributions is Gn (x) − Gn (x. whose error is O(n−1 ). 8.11 Percentile Confidence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval.1 shows that a first-order approximation ³x´ + O(n−1/2 ). Gn (x. which is not pivotal. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. This is in contrast to the use of the asymptotic distribution.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 ). Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. we find Gn (x) = Gn (x. is an even function. F ) = Φ v √ where v = V . √ the last equality because Fn converges to F0 at rate n.Interestingly. and g2 is continuous in F. set Tn = n ˆ − θ0 . Fn ) + O(n−3/2 ). G∗ (x) = Gn (x. the choice between symmetric and equal-tailed confidence intervals is unclear. Applying (8. This is because the first term in the asymptotic expansion. V ). F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . but one-sided tests might have more power against alternatives of interest. 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.5) to the bootstrap distribution.

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

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

95) denote the 5% θ) ∗ and 95% quantiles of Tn . and ˆ is calculated on each θ ∗ ∗ θ sample. (a) Report the 95% Efron Percentile interval for θ.2 and s(ˆ = . (c) With the given information.75 and 1.3.pdf. Estimate a linear regression of price on the number of bedrooms.95). You do this as follows. Suppose that in an application. 105 . θ respectively.dat contains data on house prices (sales). You want to test H0 : θ = 0 against H1 : θ > 0.5% and 97. can you report the 95% Percentile-t interval for θ? 7. and define the bootstrap confidence interval h i C = ˆ − s(ˆ n (. lot size. ∗ ∗ where s(ˆ is the standard error in the original data.05) . θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.95). You replace c with qn (. and the colonial dummy.2. The ˆ are sorted. The datafile hprice1.95). θ θ) ∗ 1000 samples are generated from the bootstrap distribution. Using the non-parametric bootstrap. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Let qn (.5% quantiles of the ˆ are . with variables listed in the file hprice1. 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 .05) and qn (. Calculate 95% confidence intervals for the regression coefficients using both the asymptotic normal approximation and the percentile-t bootstrap. size of house. What is wrong with this procedure? Tn = θ/s(θ) n 6. ˆ = 1. and the 2. and thus reject H0 if ˆ ˆ > q ∗ (. ˆ − s(ˆ n (. (b) Report the 95% Alternative Percentile interval for θ. Using the non-parametric ∗ bootstrap. you generate bootstrap samples. ∗ ∗ ∗ Let qn (.

otherwise it is overidentified. zi . as their are restrictions in E (xi ei ) = 0.1) by setting g(y. The variables zi may be components and functions of xi . β 0 ) = 0 (9. This method. z. z. We know that without further restrictions. β 0 ) = x(y − z 0 β) 106 (9.2) .1 Overidentified Linear Model yi = x0 β + ei i = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where x1i is k × 1 and x2 is r × 1 with = k + r. x. with ≥ k. 1 this class of models are called moment condition models. There are − k = r more moment restrictions than free parameters. x. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . As an important special case we will devote special attention to linear moment condition models. Let g(y. This is a special case of a more general class of moment condition models. where the dimensions of zi and xi are k × 1 and × 1 .Chapter 9 Generalized Method of Moments 9. while β 1 is of dimension k < . xi . If k = the model is just identified. an asymptotically efficient estimator of β is the OLS estimator. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. Now suppose that we are given the information that β 2 = 0. g(y. but this is not required. these are known as estimating equations. x. This situation is called overidentified. is not necessarily efficient. however. In our previous example.1) where β 0 is the true value of β. β) = x(y − x0 β). This model falls in the class (9. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. In econometrics. We call r the number of overidentifying restrictions. In this case. In the statistics literature.

3) The method of moments estimator for β is defined as the parameter value which sets g n (β) = 0.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . This is a non-negative measure of the “length” of the vector g n (β). β GMM does not change. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Let and where gi = xi ei .1 β GMM = argmin Jn (β).9. For example. 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. and the GMM estimator is the MME. The idea of the generalized method of moments (GMM) is to define an estimator which sets g n (β) “close” to zero. for if Wn is replaced ˆ by cWn for some c > 0. β ˆ Note that if k = . β GMM = Z 0 XWn X 0 Z 9. then. let Jn (β) = n · g n (β)0 Wn g n (β). Proposition 9.2) g n (β) = (9. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi .3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. then g n (β) = 0. ¡ ¢−1 0 ˆ Z XWn X 0 Y.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . For some × weight matrix Wn > 0.2. but this is generally not possible when > k. if Wn = I.2. The GMM estimator minimizes Jn (β). gi (β) = xi yi − zi β = n n n i=1 i=1 Define the sample analog of (9. the square of the Euclidean length. i i . the dependence is only up to scale. ˆ Definition 9.

where In general. as it has the same asymptotic distribution. n β − β →d N 0. In the linear model. ˆ n i=1 gi = gi − g n . However. W0 = Ω−1 is not known in practice. the GMM estimator β is consistent yet inefficient. Chamberlain showed that in this context. The proof is left as an exercise. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . 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. we can define the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . but it can be estimated consistently. This results shows that in the linear model.3. this is a semi-parametric problem. without imposing additional assumptions. as the distribution of the data is unknown. ˆ Construct n 1X ˆ g n = g n (β) = gi . as we are only considering alternative weight matrices Wn . This turns out to be W0 = Ω−1 . This is a weak concept of optimality. and this is all that is known. This yields the efficient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. If it is known that E (gi (β)) = 0. ˆ We have described the estimator β as “efficient GMM” if the optimal (variance minimizing) weight matrix is selected. it turns out that the GMM estimator is semiparametrically efficient. no estimator has greater asymptotic efficiency than the efficient linear GMM estimator. No estimator can do better (in this first-order asymptotic sense).1 ´ √ ³ˆ n β − β →d N (0. as shown by Gary Chamberlain (1987). For any Wn →p W0 . The optimal weight matrix W0 is one which minimizes V. Given any such first0ˆ ˆ ˆ ˆ step estimator. we can set Wn = I . Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . 9. a better choice is Wn = (X 0 X)−1 . β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . For example. ˆ we still call β the efficient GMM estimator. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. 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. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. V ) . ˆ∗ ˆ 108 .and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. Ω) .2 For the efficient GMM estimator. it is semiparametrically efficient.4 Estimation of the Efficient Weight Matrix ˆ Given any weight matrix Wn > 0.3. β).

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

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

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

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

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

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

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

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

these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1.. The idea is due to Art Owen (1988.. pn ) = i=1 An alternative to GMM is empirical likelihood. pn ) which places probability pi at each observation.. The multinomial distribution which places probability pi at each observation (yi .3) i=1 117 .. The idea is to construct a multinomial distribution F (p1 . This is equivalent to maximizing à n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier.. The maximum likelihood estimator of the probabilities (p1 . β). the log-likelihood function for this multinomial distribution is n X ln(pi ). xi . Combined with i the constraint (10.1).2) Ln (p1 .Chapter 10 Empirical Likelihood 10. (10.1) i=1 First let us consider a just-identified model. 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. The n first order conditions are 0 = p−1 − µ. . (10. Now consider the case of an overidentified model with moment condition Egi (β 0 ) = 0 where g is × 1 and β is k × 1 and for simplicity we write gi (β) = g(yi . zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. . It is a non-parametric analog of likelihood estimation. xi . . pn ) are those which maximize the log-likelihood subject to the constraint (10. To be a valid multinomial distribution... zi . In this case the moment condition places no additional restrictions on the multinomial distribution.1) we find that the MLE is pi = n−1 yielding the log-likelihood −n log(n)..

we find µ = n and 1 ¢. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). λ ¡ ¢ ln 1 + λ0 gi (β) . the Lagrange multiplier λ(β) minimizes Rn (β. (see section 6. p1 . and using the second and third equations. Ln (β) = Rn (β. p (10.3). or equivalently minimizes its negative ˆ (10.2) subject to the restrictions (10.5) This minimization problem is the dual of the constrained maximization problem. probabilities 1 ³ ´´ . µ) = n i=1 i=1 i=1 L∗ n with respect to pi . λ). The Lagrangian for this maximization problem is à n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β.5) ˆ ˆ As a by-product of estimation.. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . µ. pi gi (β) = 0. λ) = −n ln (n) − n X i=1 For given β.1) and (10.. (10. The solution cannot be obtained explicitly. 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. we also obtain the Lagrange multiplier λ = λ(β). pn . summing over i. λ) is a convex function of λ. The solution (when it exists) is well defined since Rn (β. Multiplying the first equation by pi .4) (10. . pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we find n Rn (β.5).6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. λ. This yields the (profile) empirical log-likelihood function for β. λ) : λ(β) = argmin Rn (β.. but must be obtained numerically (see section 6.where λ and µ are Lagrange multipliers.7) 118 .

(β.13) Premultiplying by G0 Ω−1 and using (10. 0 = Rn (β.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. ˆ ˆ Proof. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. in the linear model.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . and n β − β 0 and nλ are asymptotically independent. λ) = − (10. i i Theorem 10. G = −E (xi zi ).1 Under regularity conditions.10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .10) ¡ Ω−1 N (0.8) and ¢ 0 0 For example.2 Define Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Thus the EL estimator is asymptotically efficient. β) = −xi zi . g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .2. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10. λ) = − (10.9) and (10.10). Gi (.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 .9) (10. i=1 i=1 i=1i Expanding (10. and Ω = E xi x0 e2 . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are defined in (10. ˆ The asymptotic variance V for β is the same as for efficient GMM. n (10.13) yields n n Expanding (10. β λ ∂ ³ ´.

This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .17) 2 ln 1 + λ gi β . Since the EL estimator achieves this bound. and it is advisable to report the statistic LRn whenever EL is the estimation method. 10. Ω) GΩ G →d = N (0.14) for λ and using (10. 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. The same statistic can be constructed for empirical likelihood. Proof. First.16). and have the same interpretation. 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. Vλ ) Furthermore.7) is n ³ ´´ ³ X ˆ ˆ0 (10. The EL overidentification test is similar to the GMM overidentification test. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.1 If Eg(wi . and (10. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .15). 120 . by a Taylor expansion.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 (0.15) 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. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.3. tests are based on the difference in the log likelihood functions. They are asymptotically first-order equivalent. β 0 ) = 0 then LRn →d χ2−k . V ) ˆ Solving (10. ¥ Chamberlain (1987) showed that V is the semiparametric efficiency bound for β in the overidentified moment condition model. (10. LRn = i=1 Theorem 10. The overidentification test is a very useful by-product of EL estimation.15) (10. it is an asymptotically efficient estimator for β.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.

10. 10. h(β)=0 ˜ Fundamentally. Instead we use the difference in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . the simple overidentifying restrictions test (10. LRn →d χ2 .1 Under (10. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). Vλ )0 Ω−1 N (0.edu/~bhansen/progs/elike.Second.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. Theorem 10. since ln(1 + x) ' x − x2 /2 for x small. so there is no fundamental change in the distribution theory for β relative to β. a The proof of this result is more challenging and is omitted.wisc.ssc.17) is not appropriate. This test statistic is a natural analog of the GMM distance statistic. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. Vλ ) ¥ where the proof of the final equality is left as an exercise. To test the hypothesis h(β) while maintaining (10.18) Let the maintained model be where g is × 1 and β is k × 1. By “maintained” we mean that the overidentfying restrictions contained in (10.18).4 Testing Egi (β) = 0 (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). where h : Rk → Ra . The hypothesis of interest is h(β) = 0.18) and H0 : h(β) = 0.4.prc 121 .

Define ∗ gi (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β.19) is continued until the gradient Rλ (β. λ) = i The first derivatives of (10.. set 2 λp = λj − δ p (Rλλ (β.4). λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) . λ) = − ∂β n X i=1 G∗ (β. λj ) is smaller than some prespecified tolerance. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. One method uses the following quadratic approximation. For p = 0.5) for given β. λj ))−1 Rλ (β. The modified Newton method takes a quadratic approximation to Rn (β.19) X ∂2 ∗ ∗ gi (β. Efficient convergence requires a good choice of steplength δ. The iteration (10. λj ) . λ) gi (β.19). δ 1 = 1 and δ 2 = 1. λ) = G∗ (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. The starting value λ1 can be set to the zero vector. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λ) ∂λ i=1 n ∂ Rn (β. λ)0 − Rn (β. (10. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λj )) Rp = Rn (β.20) .Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) G∗ (β. 2. Set δ 0 = 0. λ) G∗ (β. 1. λj ))−1 Rλ (β. λp ) A quadratic function can be fit exactly through these three points. λ) = − gi (β. λ)0 − ∂β∂β Rn (β. λ)0 0 Rn (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β.

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

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

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

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

X is n × l so there are l instruments.12) Z = XΓ + u ξ = (e. X2 ].11) (11. Z2 .ˆ It is useful to scrutinize the projection Z. ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) .11).12). Z2 = [PX Z1 . Thus in the second stage. Z2 ] and X = [Z1 . Here we present a simplified version of one of his results. 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. 129 . the model is Y = Zβ + e (11.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the finite-sample bias in the 2SLS estimator. Recall. In our notation. Then i h ˆ ˆ ˆ Z = Z1 .13) which is zero only when S21 = 0 (when Z is exogenous). let’s analyze the approximate bias of OLS applied to (11. 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 . PX Z2 ] = [Z1 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. First. we regress Y on Z1 and Z2 . Using (11. 11. Z = [Z1 . ˆ since Z1 lies in the span of X. PX Z2 ] h i ˆ = Z1 .

n and (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . By the spectral decomposition of an idempotent matrix. The parameter β fails to be identified if Γ22 has deficient rank. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.14) approaches that in (11.14) is the probability limit of β 2SLS − β 11. Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11. the bias in the 2SLS estimator will be large. except when S21 = 0 (when Z is exogenous). Let q = H 0 ξS −1/2 which satisfies Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. The consequences of identification failure for inference are quite severe. 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 .14) In general this is non-zero. 0). indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. Indeed as α → 1. It is also close to zero when α = 0. 130 .13). l .7 Identification Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . P = HΛH 0 0 0 where Λ = diag(Il . 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.Let PX = X (X 0 X)−1 X 0 .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 . the expression in (11.

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

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

Take the linear model yi = xi β + ei E (ei | xi ) = 0. Z is n × k. That is. 5. in the sense that e ˜ ˜ least in large samples? 4. X is n × l. l ≥ k.) 3. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. u is n × k. where xi and β are 1 × 1.11. 1. we claim that β is identified (can be recovered from the reduced form) if rank(Γ) = k. ˜ 0 e < e0 e. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1).8 Exercises yi = zi β + ei . Take the linear model Y = Zβ + e. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. (Find an expression for xi . Find a simple expression for the IV estimator in this context. xi is l × 1. Explain why this is true. and Γ is l × k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . at ˆˆ If X is indeed endogeneous. 2. will IV “fit” better than OLS. 6. The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. show that if rank(Γ) < k then β cannot be identified. 133 . 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) .

using the instrument near4. are the parameters identified? 8. and South and Black are regional and racial dummy variables. (f) Discuss your findings. in years. 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. using zi as an instrument for xi .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). 134 . (a) Estimate the model by OLS. and the remaining variables as exogenous. (b) Now treat Education as endogenous. Estimate the model by 2SLS. of the mother).pdf. Report the estimates and standard errors. and then calculate the GMM estimator from this weight matrix without further iteration.. I suggest that you use the 2SLS estimates as the first-step to get the weight matrix. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market. Report estimates and standard errors. in years. (d) Re-estimate the model by efficient GMM. (e) Calculate and report the J statistic for overidentification. 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. Does this differ from 2SLS and/or OLS? 7. The data file card. listed in card. f atheduc (the education. a dummy indicating that the observation lives near a 4-year college. of the father) and motheduc (the education. 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).(b) Define the 2SLS estimator of β. In this model. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). Report estimates and standard errors. There are 2215 observations with 19 variables.

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

1 above. T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) .1. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).Theorem 12. ˆ Proof. ρ(k) →p ρ(k). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . T 1X Xt →p E(Xt ).1.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. and it has a finite mean by the assumption that EYt2 < ∞.2 (Ergodic Theorem). then as T → ∞. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . γ (k) →p γ(k). ˆ 2. If Xt is strictly stationary and ergodic and E |Xt | < ∞. Part (1) is a direct consequence of the Ergodic theorem. then as T → ∞. ˆ ˆ γ ¥ 136 . For Part (2). γ (0) ˆ Theorem 12.1. ˆ 3. the sequence Yt Yt−k is strictly stationary and ergodic. 1. µ →p E(Yt ).

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

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

t Yt−k ¢0 ρk . One way of stating this is that “All roots lie outside the unit circle. we see that à !−1 à ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.1.5. which satisfy ρ(λj ) = 0. λk are the complex roots of ρ(z).1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. For an AR(k). Thus T T 1X 1X xt et = ut →p E (ut ) = 0. and is of great interest in applied time series. it is also strictly stationary and ergodic.where the λ1 . This is a special case of non-stationarity.1) Theorem 12. Theorem 12. it is helpful to define the process ut = xt et . T ¢ ¡ 1X xt x0 →p E xt x0 = Q.” If one of the roots equals 1. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. By Theorem 12. The vector xt is strictly stationary and ergodic. Note that ut is a MDS. .. t T t=1 T t=1 139 . the requirement is that all roots are larger than one. and hence Yt . we say that ρ(L). β = X 0X (12. so is xt x0 .6.1) and the continuous mapping theorem. t t T t=1 ¥ Combined with (12..6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12.1. We know that an AR(1) is stationary iff the absolute value of the root of its autoregressive polynomial is larger than one. and by Theorem 12. then ˆ β →p β as T → ∞. Thus t by the Ergodic Theorem. Proof.1. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. “has a unit root”. Let |λ| denote the modulus of a complex number λ.1.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞.

ˆ 2... eT }. Divide the sample into T /m blocks of length m. there are two popular methods to implement bootstrap resampling for time-series data.. this cannot work in a time-series application. we constructed the bootstrap sample by randomly resampling from the data values {yt . e ˆ 3. Q−1 ΩQ−1 . t This construction imposes homoskedasticity on the errors e∗ .7. t t Theorem 12.7. Y−k+2 . The implication is that asymptotic inference is the same.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 . Briefly.1 to see that T 1 X √ xt et →d N (0. as this imposes inappropriate independence. we can apply Theorem 12. i 4. t then as T → ∞.8 Bootstrap for Autoregressions In the non-parametric bootstrap. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. Fix an initial condition (Y−k+1 . T t=1 Since xt et is a MDS. T 1 X √ ut →d N (0.. . 140 . Method 2: Block Resampling 1. ˆ 1.12. Ω) . xt }..1 MDS CLT. then as T → ∞. Method 1: Model-Based (Parametric) Bootstrap. which may be different than the i properties of the actual ei . 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∗ . This creates an iid bootstrap sample. In particular..7. the asymptotic covariance matrix is estimated just as in the cross-section case. Estimate β and residuals et . Ω) . It also presumes that the AR(k) structure is the truth. T t=1 where Ω = E(xt x0 e2 ). . This is identical in form to the asymptotic distribution of OLS in cross-section regression. Clearly. 12. Y0 ).7 Asymptotic Distribution Theorem 12. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.

or the season-to-season change. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. ρk ). The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. • Include dummy variables for each season. Thus the seasonally adjusted data is a “filtered” series.2. Paste the blocks together to create the bootstrap time-series Yt∗ . This is a flexible approach which can extract a wide range of seasonal factors.. The series ∆s Yt is clearly free of seasonality. • Use “seasonally adjusted” data. draw T /m blocks. But the long-run trend is also eliminated. get the ˆ ˆ residual St . This presumes that “seasonality” does not change over the sample.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . however. The results may be sensitive to the block length. 3. If s is the number of seasons (typically s = 4 or s = 12). (12... That is.2)-(12. 4. 5.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . The seasonal adjustment. also alters the time-series correlations of the data. This procedure is sometimes called Detrending. • You can estimate (12. For each simulated sample.2) (12. 6. and the way that the data are partitioned into blocks. and then perform regression (12. and perhaps this was of relevance. . Seasonal Effects There are three popular methods to deal with seasonal data.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et .3) sequentially by OLS. 141 . May not work well in small samples. • You can estimate (12.4) by OLS. (12. first estimate (12. This allows for arbitrary stationary serial correlation.2). Resample complete blocks.3) replacing St with St . 12. ∆s Yt = Yt − Yt−s . • First apply a seasonal differencing operator. and for modelmisspecification. heteroskedasticity.

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

this is the most popular unit root test. Yt is non-stationary. or I(d). Because of this property. the natural test statistic is the t-statistic for H0 from OLS estimation of (12. but simply assert the main results. To see this. so conventional normal asymptotics are invalid. Since α0 is the parameter of a linear regression. Under H0 . Thus a time series with unit root is I(1). the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. we say that if Yt is non-stationary but ∆d Yt is stationary. In this case. as the models are equivalent. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . and test statistics are asymptotically non-normal. Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . As we discussed before. (12. under H0 . Indeed. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . since ρ(1) = −α0 .12. An alternative asymptotic framework has been developed to deal with non-stationary data. It would seem natural to assess the significance of the ADF statistic using the normal table. So the natural alternative is H1 : α0 < 0. Yt has a unit root when ρ(1) = 0.7) These models are equivalent linear transformations of one another. Yt is non-stationary. observe that the lag polynomial for the Yt computed from (12.7). 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 . which is an AR(k-1) in the first-difference ∆Yt .7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). 143 . However. or ρ1 + ρ2 + · · · + ρk = 1. The ergodic theorem and MDS CLT do not apply. then ∆Yt is a stationary AR process. Hence. Thus if Yt has a (single) unit root. We do not have the time to develop this theory in detail. Note that the model is stationary if α0 < 0. then Yt is “integrated of order d”.

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

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

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

and Zt be the other variables. 13.2) is uncommon in recent applications. 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 . t t−1 (13. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. the model (13.2) is a special case of (13. Let et = ejt and β = aj . with time series data. general.2) Take the equation yt = x0 β + et . 1).5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. 147 .) Since the common factor restriction appears arbitrary. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . under the restriction γ = −βθ. t and xt = This is just a conventional regression.3) which is a valid regression model. Suppose that et is an AR(1). direct estimation of (13. Then the single equation takes the form (13. t and et is iid N (0. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0.2) may be estimated by iterated GLS. it is convenient to re-define the variables. (13. and is still routinely reported by conventional regression packages. If valid.13. t or yt = θyt−1 + x0 β + x0 γ + ut . So testing H0 versus H1 is equivalent to testing for the significance of adding (yt−1 . and is typically rejected empirically. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). xt−1 ) to the regression. j Often. Another interesting fact is that (13. and subtract off the equation once lagged multiplied by θ.3). Otherwise it is invalid.1). You may have heard of the Durbin-Watson test for omitted serial correlation. which once was very popular. and simple way to test for omitted serial correlation is to test the significance of extra lagged values of the dependent variable and regressors. This restriction.1) yt = x0 β + et . which is called a common factor restriction. (A simple version of this estimator is called Cochrane-Orcutt.4 Single Equation from a VAR Yjt = a0 xt + et . may be tested if desired. This can be done by a Wald test. We see that an appropriate. In this case. we are only interested in a single equation out of a VAR system. Let yt = Yjt .

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

Their justification was Stock’s result that β is superˆ ˆ consistent under H1 . it may be believed that β is known a priori. then β = (1 − 1)0 specifies that the spread (the difference in returns) is stationary. but it is useful in the construction of alternative estimators and tests.8.9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. as first shown by Stock (1987). and was articulated in detail by Engle and Granger (1987). Thus Yt = ˆ (Y1t . in general. When the data have time trends. then β = (1 − 1)0 specifies that log(Consumption/Income) is stationary.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. For 0 < r < m. If r = m. Thus H0 can be tested using a univariate ADF test on zt .8 Cointegration The idea of cointegration is due to Granger (1981). such that zt = β 0 Yt is I(0). Yt is I(1) and cointegrated. then Yt is I(0). We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0.13. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . from OLS of Y1t on Y2t . For example. then r = 0. When β is unknown. if Yt is a pair of interest rates. The asymptotic distribution was worked out in B. If Y = (log(Consumption) log(Income))0 . m × r. β may not be known. If the series Yt is not cointegrated. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). the asymptotic distribution of the test is affected by the presence of the time trend. In other cases. however. In some cases. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. 149 . The r vectors in β are called the cointegrating vectors. Suppose that β is known. Then under H0 zt is I(1). Often. of rank r. so the ADF critical values are not appropriate. 13. Under H0 . Whether or not the time trend is included. This is not. yet under H1 zt is I(0). a good method to estimate β. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . If Yt is cointegrated with a single cointegrating vector (r = 1). Hansen (1992). Definition 13. β is not consistent. it may be necessary to include a time trend in the estimated cointegrating regression. so zt = β 0 Yt is known. β = (1 − 1)0 .

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

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

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

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

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

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

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

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

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

Alternatively. Typically. as yt−2 is uncorrelated with ∆eit . if eit is iid. 159 (15.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit .4) will be inconsistent. Unfortunately. it However. ∗ ˆ The fixed effects estimator β is OLS of yit on x∗ . Taking first-differences of (15. as this enables the moments from the different timeperiods to be stacked together to create a list of all the moment conditions. i ∗ yit = x∗0 β + e∗ . the fixed effects estimator is inconsistent. it and then take individual-specific means by taking the average for the i0 th individual: ti ti ti 1 X 1 X 0 1 X yit = x β + ui + eit Ti t=t Ti t=t it Ti t=t i i i or Subtracting. we find y i = x0 β + ui + ei . The standard approach to estimate a dynamic panel is to combine first-differencing with IV or GMM. the dependent variable and regressors in deviationit from-mean form. there are more instruments available. e So OLS on (15. Hence a valid estimator of α and β is to estimate (15. and the residual is the demean value ∗ yit = yit − yi . it (15.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. we use lags of the dependent variable.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identified). but loses a time-series observation). are valid instruments. two periods back.3) eliminates the individual-specific effect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . But if there are valid instruments. This is because the sample mean of yit−1 is correlated with that of eit . Thus values of yit−k . so the instrument list should be different for each equation. the predicted value from these regressions is the individual specific mean y i . A simple application of GMM yields the parameter estimates and standard errors. then IV or GMM can be used to estimate the equation. at least if T is held finite as n → ∞. it it which is free of the individual-effect ui .Since the regression of yit on di is a regression onto individual-specific dummies. A more sophisticated GMM estimator recognizes that for time-periods later in the sample. k ≥ 2.4) . This is conveniently organized by the GMM principle. 15. GMM using yt−2 and yt−3 as instruments (which is overidentified. 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 .

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

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

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

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

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

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

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

r (A. (A. We say that the random variable X is continuous if F (x) is continuous in x.. . For any set B and any partition A1 . A function F (x) is a CDF if and only if the following three properties hold: 1. F (x) is nondecreasing in x 3. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. This induces a new sample space — the real line — and a new probability function on the real line. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx.... . F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. In the latter case. and use lower case letters such as x for potential values and realized values. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A.3) P (X = τ j ) = π j . these cases are unusualRand are typically ignored.3) is unavailable. of the sample space. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2. For a random variable X we define its cumulative distribution function (CDF) as F (x) = P (X ≤ x) ..Theorem 2 (Bayes’ Rule). The probability function for X takes the form j = 1. we denote random variables by uppercase letters such as X. a These expressions only make sense if F (x) is differentiable.. 2..2 Random Variables A random variable X is a function from a sample space S into the real line. While there are examples of continuous random variables which do not possess a PDF. the range of X consists of a countable set of real numbers τ 1 . 167 .. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. . Typically. A2 . Instead.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. then for each i = 1... τ r . . 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 MGF does not necessarily exist. However. For example. the characteristic function (CF) of X is C(λ) = E exp (iλX) . For m > 0. 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.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) = ∞. 168 . We can also write σ 2 = V ar(X). (A. If I1 < ∞ and I2 = ∞ then we define Eg(X) = −∞.A. −∞ ∞ −∞ |g(x)| f (x)dx < ∞.3 Expectation For any measurable real function g. p ≥ 1. We √ call σ = σ 2 the standard deviation of X. The CF always exists. m C(λ)¯ dλ λ=0 The Lp norm. r X g(τ j )π j . More generally. evaluate I1 = Z Z ∞ g(x)f (x)dx. this allows the convenient expression V ar(a + bX) = b2 V ar(X). The moment generating function (MGF) of X is M (λ) = E exp (λX) . Two special moments are the mean µ = EX and variance σ 2 = E (X − µ)2 = EX 2 − µ2 . we say that expectation is a linear operator. If both I1 = ∞ and I2 = ∞ then Eg(X) is undefined. √ where i = −1 is the imaginary unit. Since E (a + bX) = a + bEX. If X is discrete. we define the mean or expectation Eg(X) as follows. and when E |X|m < ∞ ¯ ¯ dm ¯ = im E (X m ) . Eg(X) = j=1 and if X is continuous Eg(X) = The latter is well defined and finite if Z If (A. of the random variable X is kXkp = (E |X|p )1/p .4) does not hold. we define the m0 th moment of X as EX m and the m0 th central moment as E (X − EX)m .

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

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

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

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). Another implication of (A.Similarly. If X and Y are independent. Y ) = ρXY = σ XY . If X and Y are independent. Furthermore. 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 ) . For example. X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x. The reverse. X 2 ) = 0. The covariance between X and Y is Cov(X. y) = fX (x)fY (y).5) if the expectations exist. then V ar (X + Y ) = V ar(X) + V ar(Y ). if EX = 0 and EX 3 = 0.5) is that if X and Y are independent and Z = X + Y. is not true. y)dx. 172 . A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X. σxσY (A. (A. Y ). y) = g(x)h(y). free of units of measurement. An implication is that if X and Y are independent. The correlation between X and Y is Corr(X.6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1. the marginal density of Y is fY (y) = Z ∞ f (x. then Cov(X. if X and Y are independent then E(XY ) = EXEY. the variance of the sum is the sum of the variances. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y. −∞ The random variables X and Y are defined to be independent if f (x. then σ XY = 0 and ρXY = 0. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. however.The correlation is a measure of linear dependence. For example.

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

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

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

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

11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.3 Let Z ∼ N (0.1.13) is the MGF of the density (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.8.2.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.11) 2 with r = 1. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. C −1 AC −10 ) = N (0.11). For Z ∼ N(0. Using the simple law of iterated expectations. 1). tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.8.8.12) E exp (tQ) = 0 Γ (A. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. we see that the MGF of Z 2 is (1 − 2t)−1/2 .8. (A.13). which can be found by applying change-of-variables to the gamma function. Iq ). Set r Z . From (A. tr has distribution 177 . 1) and Q ∼ χ2 be independent.Theorem A. Thus the density of Z 2 is (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . which we showed in (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. C −1 CC 0 C −10 ) = N (0. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . Proof of Theorem A. The MGF for the density (A.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). q Proof of Theorem A.3.

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

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

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

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

∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi .3 Taking the first-order condition for maximization of Ln (θ). θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. Ω) . θ0 ) is mean-zero with covariance matrix Ω. Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi .) Rewriting this equation. θ0 ) →d N (0. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn .9. θ0 ) + ' 0 ln f (Yi . H −1 ΩH −1 = N 0. then since θn →p θ0 we find H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . θ n ) θ − θ 0 . θ0 ) . θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . If it is continuous in θ. θn ) = ln f (Yi . ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. − ln f (Yi . θ) . ¥ 182 . H −1 .9.1 .Proof of Theorem A. the final equality using Theorem A. Together. Ω) = N 0. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . and making a first-order Taylor series expansion. (Technically. an application of the CLT yields 1 X ∂ √ ln f (Yi . we find ´ ³ ˆ − θ0 = θ Since ∂ ∂θ à !−1 à n ! n X ∂2 X ∂ ln f (Yi . the specific value of θn varies by row in this expansion.

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

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

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

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