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

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Contents

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

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

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i

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

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

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

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

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ii

. . . . . . . . .1 Instrumental Variables . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . 9. . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . 9. . . . . . 9. . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . .8. . . . . . . . . . . . . . . 12. . . 10. . . . . . . . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . .3 Overidentifying Restrictions . . . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Reduced Form . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Lag Operator . . . iii . 12. 12. . .7 Asymptotic Distribution . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . 11. . . . . 12. . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . 9. . .12 8. . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . 9.9 Bootstrap GMM Inference . . . 9. . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . . . . . .10 Exercises .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . 9. . . . . 12 Univariate Time Series 12. .1 Non-Parametric Likelihood . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . 11. .1 Overidentiﬁed Linear Model . . . . . . .10 8. . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . Percentile Conﬁdence Intervals . . . . . . . . . . . .8 Exercises .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

We say that two vectors a and b are orthogonal if a0 b = 0. for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . . .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. Also. ⎤ ⎥ ⎥ ⎥ ⎦ AB = A1 A2 · · · Ar Br = A1 B1 + A2 B2 + · · · + Ar Br r X = Ar Br j=1 ¤⎢ ⎢ ⎢ ⎣ Important properties are that if A is k × r. which has ones on the diagonal. r ≤ k. An important diagonal matrix is the identity matrix. The columns of a k × r matrix A. 0 0 ··· 1 2. . are said to be orthogonal if A0 A = Ir . . ⎦ ⎣ . ⎥ . A square matrix A is called orthogonal if A0 A = Ik .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 . . . . For example. then AIr = A and Ik A = A.

If A − BD−1 C and D − CA−1 B are non-singular. . . For non-singular A and C. if there is no c 6= 0 such that Ac = 0. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = .1) . The Moore-Penrose generalized inverse A− satisﬁes (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 (2.4 Inverse A k × k matrix A has full rank. In this case there exists a unique matrix B such that AB = BA = Ik . . 7 Also. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . . then A−1 = A.The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . (2. (2. . if A is an orthogonal matrix. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. . the Moore-Penrose generalized inverse A− exists and is unique. 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. This matrix is called the inverse of A and is denoted by A−1 . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.3) The matrix A− is not necessarily unique. 2.

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

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

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

⎠ ⎝ . (3. See Chapter 16.73. gender. These are asymmetric (skewed) densities. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. The two density curves show the eﬀect of gender on the distribution of wages. The data are from the 2004 Current Population Survey 1 11 . which is a common feature of wage distributions. In this context we partition the observations into the pair (yi . These are indicated in Figure 3. holding the other variables constant. When a distribution is skewed. In the example presented in Figure 3. This is used when the goal is to quantify the impact of one set of variables on another variable. These are conditional density functions — the density of hourly wages conditional on race.22. 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. the conditional density of yi given xi . m(x) can take any form. xi ) where yi is a scalar (real-valued) and xi is a vector. Figure 3. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. the mean is not necessarily a good summary of the central tendency.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. ⎟ .1. or the covariates. the mean wage for men is $27.2) m(x) = E (yi | xi = x) = −∞ In general. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. and exists so long as E |yi | < ∞.1 displays the density1 of hourly wages for men and women. education and experience.1. Take a closer look at the density functions displayed in Figure 3. . we can focus on f (y | x) . xki 3. and that for women is $20. We call yi the dependent variable. We call xi alternatively the regressor.1) xi = ⎜ . To illustrate.1 by the arrows drawn to the x-axis. the conditioning variable. While it is easy to observe that the two densities are unequal.

1 is facilitated by the fact that the control variable (gender) is discrete. The comparison in Figure 3.36.3 is how the conditional expectation describes an important feature of the conditional distribution. 12 . 2 (3.3) White non-military male wage earners with 10-15 years of potential work experience. Figure 3.2) evaluated at the observed value of xi : ei = yi − m(xi ). To illustrate.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. wage regressions typically use log wages as a dependent variable rather than the level of wages. By construction.D. and a Ph. Figure 3. Assuming for simplicity that this is the true joint distribution. with mean log hourly wages drawn in with the arrows. Of particular interest to graduate students may be the observation that diﬀerence between a B. this yields the formula yi = m(xi ) + ei . then comparisons become more complicated.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. The conditional expectation function is close to linear.3 displays a scatter plot2 of log wages against education levels. When the distribution of the control variable is continuous. For this reason. The main point to be learned from Figure 3. degree in mean log hourly wages is 0. the solid line displays the conditional expectation of log wages varying with education. the dashed line is a linear projection approximation which will be discussed in the Section 3. 3.5.Figure 3. The diﬀerence in the log mean wage between men and women is 0. implying an average 36% diﬀerence in wage levels.2 shows the density of log hourly wages for the same population.30. which implies a 30% average wage diﬀerence for this population. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.A.

1 Properties of the regression error ei 1.2: Log Wage Densities Theorem 3. It is important to understand that this is a framework. because no restrictions have been placed on the joint distribution of the data. E (h(xi )ei ) = 0 for any function h (·) . The equations yi = m(xi ) + ei E (ei | xi ) = 0.Figure 3. To show the ﬁrst statement. 2. 13 . not a model. by the deﬁnition of ei and the linearity of conditional expectations. A regression model imposes further restrictions on the joint distribution. most typically.2. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. E (ei | xi ) = 0. 3. restrictions on the permissible class of regression functions m(x). E(ei ) = 0. are often stated jointly as the regression framework. These equations hold true by deﬁnition. E(xi ei ) = 0. The remaining parts of the Theorem are left as an exercise. 4.

3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . in the sense of achieving the lowest mean squared error. The conditional standard deviation is its square root σ(x) = σ 2 (x). The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3.3. Thus the mean squared error is minimized by the conditional mean. and can take any form. The right-hand-side is minimized by setting g(x) = m(x). it does not provide information about the spread of the distribution. To see this. when σ 2 (x) is a constant so that ¢ ¡ (3. let g(x) be an arbitrary predictor of yi given xi = x. the conditional variance of yi is σ 2 = σ 2 (xi ).Figure 3. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x .2. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. 3.3 Conditional Variance Generally.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. Given the random variable xi .1. σ 2 (x) is a non-trivial function of x. subject to the restriction p that it is non-negative. i . In contrast.

and the linear assumption of the previous section is empirically unlikely to accurate. In this case (3.we say that the error ei is homoskedastic.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.1). i (3. they are also somewhat more dispersed. its functional form is typically unknown.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 . ⎟ . xki When m(x) is linear in x. Notationally.6) as an approximation. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . it is convenient to augment the regressor vector xi by listing the number “1” as an element. Equivalently. which we derive in this section.6) (3.5. So while men have higher average wages.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. Equation (3. Thus (3. where x1i is the ﬁrst element of the vector xi deﬁned in (3.8) is called the linear regression model. The conditional standard deviation for men is 12.7) is a k × 1 parameter vector. ⎟ β=⎝ .4 Linear Regression An important special case of (3. take the conditional wage densities displayed in Figure 3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). ⎠ . ⎠ . it is more realistic to view the linear speciﬁcation (3. 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 . βk ⎛ (3.1 and that for women is 10. 3.1. We call this the “constant” or “intercept”.5) xi = ⎜ .9) 3. Instead. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . As an example. ⎝ .8) (3. 15 .

alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. In order for β to be uniquely deﬁned. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . i which requires that for all non-zero α. otherwise they are distinct.5.1 1. This occurs when redundant variables are included in xi . As before. Equivalently. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. i (3. this situation must be excluded. i 4. i 16 . We now summarize the assumptions necessary for its derivation and list the implications in Theorem 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 .7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.10) It is worth taking the time to understand the notation involved in this expression. The ﬁrst-order condition for minimization (from Section 2.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.5. 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 . The error is i ei = yi − x0 β. Rewriting. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. Observe i that for any non-zero α ∈ Rk . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. It is invertible if and only if it is positive deﬁnite. by “best” we mean the predictor function with lowest mean squared error. The best linear predictor is obtained by selecting β to minimize S(β). written E (xi x0 ) > 0. Assumption 3.10). E (x0 xi ) < ∞. x0 β is the best linear predictor for yi . 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. xi contains an intercept.12) This completes the derivation of the linear projection model. Therefore. α0 E (xi x0 ) α = E (α0 xi )2 > 0. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . Given the deﬁnition of β in (3.1. i (3. E (xi x0 ) is invertible. i i (3. Eyi < ∞. 3. 2 2. The vector (3.which is quadratic in β.

(3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. 17 . Equation (3.9).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 = 0.4 is required to ensure that β is uniquely deﬁned.14) follows from (3.1.3 are called regularity conditions. Let’s compare it with the linear regression model (3. E (xi ei ) = 0 and E (ei ) = 0.13) and Assumption 3.8)-(3.5.2. it follows that linear regression is a special case of the projection model.14).1 are weak.5.5.4 guarantees that the solution β exits.Theorem 3.5.3 ensure that the moments in (3. Assumption 3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . For example. Furthermore.1 Under Assumption 3.1.1. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.5.11) and (3. However. This means that the equation (3.5.13) implies that xi and ei are uncorrelated. Since ei is mean zero by (3.2 and 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. ¥ (3. (3.5. The ﬁnite variance Assumptions 3.5.11) are well deﬁned. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Figure 3.5. By deﬁnition.1.1. Using the deﬁnitions (3.14) Proof. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1 is employed to guarantee that (3.5.10) are deﬁned.5.13) summarize the linear projection model.1. the orthogonality restriction (3.4 we know that the regression error has the property E (xi ei ) = 0.1. Assumption 3. Assumption 3. Since from Theorem 3.2 and 3. Assumption 3.12) and (3.1.13) The two equations (3.12) can be alternatively interpreted as a projection decomposition.1.1.1.14) holds.10) and (3.

In this case (3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. 18 . xi ) we can deﬁne a linear projection equation (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.4 we display as well this quadratic projection. the dashed line is the linear projection of log wages on eduction. In other cases the two may be quite diﬀerent. In this example it is a much better approximation to the conditional mean than the linear projection.10). In Figure 1. No additional assumptions are required. for any pair (yi . These structural models require alternative estimation methods.4 displays the relationship3 between mean log hourly wages and labor market experience. and under-predicts for the rest. In contrast.10) may not hold and the implications of Theorem 3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. However. we can augment the regressor vector xi to include both experience and experience2 . Figure 3. In this case the linear projection is a poor approximation to the conditional mean. and are discussed in Chapter 11. In the example just presented. A projection of log wages on these two variables can be called a quadratic projection. for those over 53 in age). Most importantly. We illustrate the issue in Figure 3.5.3. The linear equation (3. It over-predicts wages for young and old workers.5. there are no changes in our methods or analysis. it is important to not misinterpret the generality of this statement. This defect in linear projection can be partially corrected through a careful selection of regressors.1 may be false. in many economic models the parameter β may be deﬁned within the model.We have shown that under mild regularity conditions. Figure 3.1. In this example the linear projection is a close approximation to the conditional mean. Other than the redeﬁnition of the regressor vector. Returning to the joint distribution displayed in Figure 3. since the resulting function is quadratic in experience.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. and the straight dashed line is the linear projection. The solid line is the conditional mean.12) with the properties listed in Theorem 3.

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

(x − µ)2 − σ 2 Show that Eg (X. 20 . ¡ ¢ 4. and E(xi ei ) = 0. then E(ei | xi ) = 0.1 . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . Prove parts 2. σ 2 = V ar(yi ) and σ xy = Cov(xi . Let X be a random variable with µ = EX and σ 2 = V ar(X). If yi = x0 β + ei . Are they diﬀerent? Hint: If P (Y = j) = 5. If yi = x0 β + ei and E(ei | xi ) = 0. True or False. x 6. 9. . a constant.2. True or False. and E(e2 | xi ) = σ 2 . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . 2. i 11. i 10. s) = 0 if and only if m = µ and s = σ 2 . E(Y 2 | X = x) and V ar(Y | X = x). If yi = x0 β + ei and E(xi ei ) = 0. σ = . σ 2 = V ar(xi ). and have the following joint probability distribution X=0 X=1 Y =0 . True or False. True or False. xi ∈ R. then E(x2 ei ) = 0. Let xi and yi have the joint density f (x. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. 3.4 . µ. e−λ λj j! .. Compute E(yi | xi = x) and V ar(yi | xi = x). then ei is independent of xi .1. 0 ≤ y ≤ 1.6 Exercises 1. Compute the conditional mean m(x) = E (yi | xi = x) . If yi = xi β + ei . xi ∈ R.2 Y =1 . 1.3 Find E(Y | X = x). i 8. then E(x2 ei ) = 0.. i 7. True or False. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. yi ). Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. 3 and 4 of Theorem 3. µx = Exi . 2. If yi = xi β + ei .3. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . j! 0 j = 0. m. Suppose that Y and X only take the values 0 and 1. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . E(ei | xi ) = 0. taking values only on the non-negative integers. and E(ei | xi ) = 0. then ei is i i independent of xi . Suppose that yi is discrete-valued.

2) (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .1) (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.8. but for most of the chapter we retain the broader focus on the projection model. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . we narrow the focus to the linear regression model. Observe that (4. i It follows that the moment estimator of β replaces the population moments in (4.1 Estimation Equation (4. i n i=1 n 21 . (4.7 and 4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .4) i i=1 i=1 ˆ Another way to derive β is as follows.3) In Sections 4. 4.2) can be written in the parametric 0 β)) = 0.

40 2. To illustrate.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.30 + 0. consider the data used to generate Figure 3.94 −2.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.117 Educationi .2 Least Squares There is another classic motivation for the estimator (4.40 µ ¶µ ¶ 34. with 10-15 years of potential work experience. 0.3.14 14.4).95 42.95 xi yi = 42.37 µ ¶ 1. 4. An interpretation of the estimated equation is that each year of education is associated with an 11.170 37.14 14.4).83 ¶−1 µ ¶ . excluding military. These are white male wage earners from the March 2004 Current Population Survey. 30 = .ˆ This is a set of k equations which are linear in β. Let yi be log wages and xi be an intercept and years of education. i 22 .117 1 14.7% increase in mean wages.14 205. Then µ ¶ n 1X 2. 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. ¶ 2. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.71 = −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.14 205. This sample has 988 observations. 40 0.

The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β).4). Since the function Sn (β) is a quadratic function of β. The error is unobservable. It is important to understand the distinction between the error ei and the residual ei .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. the contour lines are ellipses.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Figure 4. i ˆ ˆ Note that yi = yi + ei . Matrix calculus (see Appendix 2. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. Figure 4. which can cause confusion. while the residual is a by-product of estimation. These two ˆ variables are frequently mislabeled. To visualize the sum-of-squared errors function. 23 .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. Figure 4.

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

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

yn = x0 β + en . . en ⎞ Observe that Y and e are n × 1 vectors. 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. ⎠ . Sample sums can also be written in matrix notation. it is matrix notation. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. σ 2 ) = − 2 + ¡ ¢2 e2 = 0.4). For example n X i=1 For many purposes. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. . residual vector. = β+ XX 26 (4. . and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e. Thus the MLE (β. . Due to this equivalence. The linear equation (3. yn ⎟ ⎟ ⎟. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. x0 n ⎞ ⎛ e1 e2 . including computation.8) . n X i=1 Thus the estimator (4. .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 .Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . 4. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . and X is an n × k matrix. ⎝ ⎝ . . ˆ ˆˆ ˆ A useful result is obtained by inserting Y = Xβ + e into the formula for β to obtain ¢ ¡ 0 ¢−1 ¡ 0 ˆ X (Xβ + e) β = XX ¡ ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 0 Xe X Xβ + X 0 X = XX ¡ 0 ¢−1 0 X e.6). one for each observation. ⎟.12) is a system of n equations.

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

. In this section we derive the small sample conditional mean and variance of the OLS estimator. By the independence of the observations and (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.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. obtain residuals Y . 30 . . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . observe that ⎞ ⎛ ⎞ ⎛ . Regress X2 on X1 . . ˆ which are “demeaned”.6. . 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) . but in most cases there is little computational advantage to using the two-step algorithm. the FWL theorem can be used to speed computation.14) or via the ˆ following algorithm: ˜ 1. obtain OLS estimates β 2 and residuals e. Regress Y on X1 . obtain residuals X2 . Rather.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. and X2 is the vector of observed regressors. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. . . ⎟ ⎜ ⎟ ⎜ (4. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. In the model (4. which you may have seen in an introductory econometrics course. . ¡ ¢−1 0 ι.13). Regress Y on X2 .1 (Frisch-Waugh-Lovell). is the demeaning formula for regression.9). A common application of the FWL theorem. . ˜ 2. In this case.Theorem 4.9). ˆ ˜ ˜ ˆ 3.8)(3. In some contexts. 4. the primary use is theoretical. . .

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

˜ so β is unbiased if (and only if) A0 X = Ik . is a famous statement of the solution.10). In this case. says that the least-squares estimator is the best choice. ³ ´ ˜ E β | X = A0 Xβ. the best (minimumvariance) unbiased linear estimator is OLS. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. 32 .8)¢ ¡ (3.7) is unbiased for σ 2 by this calculation. Thus σ 2 is biased towards zero. In the homoskedastic linear regression model. which we now present. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. 4. As an alternative. = σ2 n the ﬁnal equality by (4. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. as it yields the smallest variance among all unbiased linear estimators. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . Now consider the class of estimators of β which are linear functions of i the vector Y. It is important to remember. The following result.9) plus E e2 | xi = σ 2 . we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. which is (3. or in the projection model.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 . known as the Gauss-Markov theorem.8. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. Thus since V ar (e | X) = In σ 2 under homoskedasticity. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .1 Gauss-Markov. What is the best choice of A? The Gauss-Markov theorem. By a calculation similar to those of the previous section. It is not unbiased in the absence of homoskedasticity. Theorem 4. the estimator ˆ 2 deﬁned (4. however.

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

Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. He observes that the above argument holds for all multinomial distributions. 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. He proves that generically the OLS estimator (4. and thus so is the OLS estimator.22) 34 .9).5.Substituting in the expressions for π j . We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .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 . the maximum likelihood estimator is identical to the OLS estimator. (4.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.10) for the class of models satisfying Assumption 3. if the data have a discrete distribution.10 Omitted Variables xi = µ x1i x2i ¶ . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.

or second. i. This deﬁnition is not precise. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. and the error as ui rather than ei .e. if X includes both the logs of two prices and the log of the relative prices. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. 35 .23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . the coeﬃcient on x2i in (4. Goldberger (1991) calls (4.23) the short regression to emphasize the distinction. log(p1 ). as many desired variables are not available in a given dataset. the general model will be free of the omitted variables problem. By construction. when the columns of X are close to linearly dependent. Most commonly. which is often called “multicollinearity” for brevity. For example. First.23) where is the coeﬃcient from a regression of x2i on x1i . This is the situation when the X 0 X matrix is near singular. This happens when the columns of X are linearly dependent. This is because the model being estimated is diﬀerent than (4.22) by least-squares. To see this.22) is zero. This is estimation of the equation yi = x0 γ 1 + ui 1i E (x1i ui ) = 0 Notice that we have written the coeﬃcient on x1i as γ 1 rather than β 1 . except in special cases. then β is not deﬁned. The diﬀerence Γβ 2 is known as omitted variable bias.22).Now suppose that instead of estimating equation (4. there is some α such that Xα = 0. Since the error is discovered quickly. this arises when sets of regressors are included which are identically related. Typically there are limits. When this happens. This is called strict multicollinearity. 4. least-squares estimation of (4.. because we have not said what it means for a matrix to be “near singular”. Typically. In general. 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. β 1 6= γ 1 . It is the consequence of omission of a relevant correlated variable. log(p2 ) and log(p1 /p2 ). Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. The more relevant issue is near multicollinearity. we regress yi on x1i only.11 Multicollinearity ˆ If rank(X 0 X) < k + 1.22) the long regression and (4. In this case. this is rarely a problem for applied econometric practice. 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. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation.

the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi .27) (4. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. deﬁne the leave-one-out least-squares estimator of β. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. ˆ i A simple comparison yields that ˆ ei − ei. that is.−i = (1 − hi )−1 hi ei . We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . 1] and sum to k. The hi take values in [0. As a consequence. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors.−i = yi − x0 β (−i) = (1 − hi )−1 ei .26) As we can see.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 .One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. the OLS estimator based on the sample excluding the i’th observation. the precision of individual estimates are reduced. ˆ ˆ (4.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.25) below. since as ρ approaches 1 the matrix becomes singular. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . What is happening is that when the regressors are highly dependent. If the i’th observation 36 . This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . We can also deﬁne the leave-one-out residual ˆ ˆ ei. We derive expression (4. To investigate the possibility of inﬂuential observations. the worse the precision of the individual coeﬃcient estimates. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.25) β (−i) = β − (1 − hi )−1 X 0 X where ¢−1 ¡ xi hi = x0 X 0 X i The i’th observation is inﬂuential on the least-squares estimate if the deletion of the observation ˆ from the sample results in a meaningful change in β.

ˆ We now derive equation (4. Investigations into the presence of inﬂuential observations can plot the values of (4.27). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . The key is equation (2. which is considerably more informative than plots of the uncorrected residuals ei . then this observation is a leverage point and has the potential to be an inﬂuential observation.This implies has a large value of hi .25).1) in Section 2.

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

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

Theorem 5.3). We say that Zn converges in probability to Z as n → ∞. Since 1 + 1 = 1 an application of Jensen’s inequality shows that p q U Then 1/p V 1/q 1 1 ln U + ln V = exp p q E |XY | ∙ ¸ ≤ 1 1 U V exp (ln U ) + exp (ln V ) = + .2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. then as n → ∞ n 1X Xn = Xi →p E(X).2. (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 . n i=1 42 .4) Proof of Jensen’s Inequality. For any strictly increasing function g(X) ≥ 0. Let a + bx be the tangent line to g(x) at x = EX. Note EU = EV = 1. =E U V p q p q Proof of Markov’s Inequality. Applying expectations. p p p q which is (5. The WLLN shows that sample averages converge in probability to the population average. (5. So for all x. Eg(X) ≥ a + bEX = g(EX). 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}. If Xi ∈ Rk is iid and E |Xi | < ∞. P (g(X) > α) ≤ α−1 Eg(X). ¥ Proof of Holder’s Inequality. denoted Zn →p Z as n → ∞.1 Weak Law of Large Numbers (WLLN). Set Y = g(X) and let f denote the density function of Y. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. as stated. if for all δ > 0. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. tangent lines lie below it. Since g(x) is convex.Markov’s Inequality. n→∞ lim P (|Zn − Z| > δ) = 0. ¥ 5.

the fact that the Wi are iid and mean zero.4). We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. we can set E(X) = 0 (by recentering Xi on its expectation). We say that Zn converges in distribution to Z as n → ∞. Theorem 5. Finally. 43 . and the bound |Wi | ≤ 2C. Fix δ and η. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. the fact that X n = W n + Z n . ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . 5.6) and (5. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . Set ε = δη/3. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. where Z has distribution F (x) = P (Z ≤ x) .Proof: Without loss of generality. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. P ¯X n ¯ > δ ≤ η. ¡¯ ¯ P ¯X n ¯ > δ ≤ η.7).5). denoted Zn →d Z. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. the triangle inequality.1). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . by Markov’s inequality (5. If Xi ∈ Rk is iid and E |Xi |2 < ∞.1) and (5. as needed. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. if for all x at which F (x) is continuous. Jensen’s inequality (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . (5.3. V ) . Fn (x) → F (x) as n → ∞.1 Central Limit Theorem (CLT).6) By Jensen’s inequality (5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.

8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 . let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). By a second-order Taylor series expansion of c(λ) about λ = 0.8) where λ∗ lies on the line segment joining 0 and λ. the deﬁnition of c(λ) and (5. ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . the independence of the Xi . ∂λ∂λ cλ (λ) = cλλ (λ) = ∂ ∂ c(λ) = C(λ)−1 C(λ) ∂λ ∂λ ∂ ∂2 ∂2 −2 ∂ C(λ) 0 C(λ) c(λ) = C(λ)−1 0 0 C(λ) − C(λ) ∂λ ∂λ∂λ ∂λ∂λ ∂λ so when evaluated at λ = 0 Furthermore.Proof: Without loss of generality. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . By the properties of the exponential function. it is suﬃcient to consider the case µ = 0 and V = Ik . For ¡ ¢ λ ∈ Rk .

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

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

2. the OLS estimator β is has a statistical distribution which is unknown.1. n i=1 (6. To characterize the sampling distribution more fully.2) i i n i=1 n From (6. Ã n ! n X 1X 0 1 ˆ xi xi .1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. using (6. Hence by the continuous mapping theorem (Theorem 5. 0).1). 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.5. 6. This is illustrated in Figure 6. ˆ 47 . xi ei →p g (Q. β →p β as n → ∞. and the continuous mapping theorem (Theorem 5.4 implies that Q−1 exists and thus g(·. For a complete argument. ·) is continuous at (Q. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . Assumption 3. we can conclude ˆ that β →p β.1.1) and ˆ We now deduce the consistency of β. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1).8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1). (6.1).2 Consistency ˆ As discussed in Section 6. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 .2.1. (6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.3) Ã where g(A.2). (6. we will use the methods of asymptotic approximation.5.4.5. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.4. Equation (4.3).1 Under Assumption 3.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. First. ˆ Theorem 6. As the sample size increases the density becomes more concentrated about the population coeﬃcient. Assumption 3. Proof.1 and the WLLN (Theorem 5.1 by the fact that the sampling densities become more concentrated as n gets larger.

3. ˆ Proof.2). (6.2 Under Assumption 3. ˆ n−k 6.1 guarantees that the elements of Ω are ﬁnite. n 1 X √ xi ei →d N (0.5. ˆ Finally. Ee4 < ∞ and E |xi |4 < ∞. To see this.2. We need a strengthening of the moment conditions. Thus σ 2 is consistent for σ 2 . Ω) . i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .3) and Theorem (6.5. By the central limit theorem (Theorem 5.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.1). by the Cauchy-Schwarz inequality (5. E ¯ei ¯ E ¯e4 ¯ i i i i (6.1). it follows that s2 = ¥ n σ 2 →p σ 2 .3.2. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . (6. i i Assumption 6. 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 Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.3. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.2).6) n i=1 48 . Assumption 6.1 In addition to Assumption 3.1. (6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.Theorem 6. since n/(n − k) → 1 as n → ∞.1.

2).1 states that the sampling distribution of the least-squares estimator. As α approaches 2.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . i i Condition (6. The expression V = Q−1 ΩQ−1 is called a sandwich form.9) we deﬁne V 0 = Q−1 σ 2 whether (6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. |ε| ≥ 1.3. 1).6). The trouble is that no matter how large is the sample size. 1 X √ xi ei n i=1 n ! the N (0. Ω) ¡ ¢ = N 0. (6.3. e2 ) = 0. Q−1 ΩQ−1 . V ) where V = Q−1 ΩQ−1 . xi ) which satisfy the conditions of Assumption 6.7) is true then V = V 0 . We call V 0 the homoskedastic covariance matrix. for example. when xi and ei are independent. however. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . There is a special case where Ω and V simplify. otherwise V 6= V 0 . for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. there is no simple answer to this reasonable question.Then using (6. Let yi = β 0 + β 1 xi + εi where xi is N (0. For α 49 .1). If α > 2 the 2 error εi has zero mean and variance α/(α − 2). This holds true for all joint distibutions of (yi . The asymptotic distribution ´ Theorem 6. In´Figure 6.3. Theorem 6. However. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. and (6.1. V is often referred to as ˆ the asymptotic covariance matrix of β. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.1 Under Assumption 6. How large should n be in order for the approximation to be useful? Unfortunately. is approximately normal when the sample size n is suﬃciently large. after rescaling.3. but this is not a necessary condition. When (6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. In Figure 6. We illustrate this problem using a simulation.9) In (6. 1) asymptotic distibution. Under (6.7) Cov(xi x0 .3. We say that ei is a Homoskedastic Projection Error when (6.7) is true or false.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. its variance diverges q ³ ´ ˆ to inﬁnity. setting n = 100 and varying the parameter α.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .7) holds. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1. The approximation may be poor when n is small.

6. the sampling distribution becomes highly skewed and non-normal. The estimator 2 2 in (6.Figure 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2: Density of Normalized OLS estimator α = 3. concentrating most of the probability mass around zero.10) V 0 = Q−1 s2 .11) 50 .2.2 and 6. we need an estimate of Ω = E xi x0 e2 . 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 (0.3. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.10) without changing this result. 6 and 8.2) and Theorem 6. 4. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. As α diminishes the density changes signiﬁcantly. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. 1) asymptotic approximation is never guaranteed to be accurate. 1) density. 1). As k increases. Another example is shown in Figure 6. We show the sampling distribution of n β 1 − β 1 setting n = 100.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.0 the density is very close to the N (0. for k = 1.1) it is clear that V 0 →p V 0 .3 is that the N (0. The lesson from Figures 6.

k. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. β j . and was still the standard choice for much empirical work done in the early 1980s. It is therefore important to understand what formula and method is 51 . A more easily interpretable measure of spread is its square root — the standard deviation. Generically. the “Eicker-White formula”. When reading and reporting applied work. j = 0.. 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). ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . 1. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β.. we set s(β) = n−1/2 V .3: Sampling distribution where ei are the OLS residuals. many authors will state that their “standard errors have been corrected for heteroskedasticity”. standard errors are not unique. or that they use the “White formula”.. the “Huber formula”. vis. This motivates the deﬁnition of a standard error. . Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator.4.. ˆ ˆ Deﬁnition 6.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. ˆ ˆ When V is used rather than the traditional choice V 0 . we focus on individual elements of β one-at-a-time.Figure 6. When β is a vector. or that they use a “heteroskedasticity-robust covariance matrix estimator”. the “Huber-White formula” or the “GMM covariance matrix”. as it is not always clear which has been computed. In most cases. as there may be more than one estimator of the variance of the estimator. and V is an estimator of the variance of n β − β . these all mean the same thing. The methods switched during ˆ the late 1980s and early 1990s.

12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.14 205.83 ¶−1 = µ 7. From a computational standpoint. First.80 40. and then the square roots.2/988 = .20 −0.20 = V 14.039 and ˆ V = µ 1 14.80 . from which it follows that V →p V as n → ∞.493 −0. (. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .199 2.80 40. by Holder’s inequality (5. p ˆ In this case the two estimates are quite similar.83 ¶−1 µ .14 14. Using (6. just as any other estimator.199 2.14 205. n n i=1 52 .14 6.6 ¶µ 1 14.480 .used by an author when studying their work.14 14.085 p ˆ and that for β 1 is .14 205. To illustrate.30 + 0. but not under another set of assumptions. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .1.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.2.085) (.12) in turn. then take the diagonal elements.35/988 = .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.117 Educationi . The standard errors for β 0 are 7.83 −0.493 0.5) and the WLLN (Theorem 5.80 2. (6. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. we return to the log wage regression of Section 4.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.20 and µ ¶ ˆ = 0.020. Ω 2.020) 6. (6. i i i i n i=1 Second.035 ¶ . We calculate that s2 = 0.98 −0. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.4) 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 .480 ˆ0 = 0.

13) Using formula (4.1 As n → ∞.25). Andrews (1991) suggested an similar estimator based on cross-validation.13) of Efron (1982). 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. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.11) with the leave-one-out estimator ei. these establish consistency.5. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. n i=1 n ˆ ˆ Theorem 6. by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. Using this substitution.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . Recall from Section 4.−i = (1 − hi )−1 ei ˆ presented in (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. 6. i=1 Third. which. From equation (3. Ω →p Ω and V →p V.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .26). you can show that 1 Xˆ ¯ β= β (−i) . ¯ ¯n ¯ n i=1 so Together.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. ¯ 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. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .

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

Since the standard normal distribution does not depend on the parameters.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. θ could be a single element of β). s(ˆ = n−1/2 H 0 V Hβ . 55 . µ I 0 ¶ ˆ the upper-left block of V . the standard error for ˆ is the square root of n−1 Vθ . the statistic tn has an exact t distribution. see Section X). θ) β 6. s(ˆ θ) (6. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error.8.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . 1) →d ˆ−θ θ . In this case. β 2 ). Consider the studentized statistic tn (θ) = Theorem 6.1 tn (θ) →d N (0. ˆ When q = 1q h(β) is real-valued).15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. Vθ ) √ Vθ = N (0. In special cases (such as the normal regression model. and θ = h(β) is some function of the parameter vector. that (so θ ˆ ˆ ˆ is.For example. however. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. we say that tn (θ) is asymptotically pivotal. (For example. we say that tn is an exactly pivotal statistic. if R is a “selector matrix” R= so that if β = (β 1 . and is therefore exactly free of unknowns. 1) Proof. In general. By (6.

The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. or “accepts” H0 . The p-value is more general. For example. Deﬁne the tail probability. Otherwise the test does not reject. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. 56 . 1]. regardless of the complication of the distribution of the original test statistic. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. pn →d U [0. In a sense. If the p-value pn is small (close to zero) then the evidence against H0 is strong. An alternative approach.025 = 1. s(ˆ θ) Under H0 . however. Either θ ∈ Cn or θ ∈ Cn . P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. 1). from which it follows that pn →d U [0. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . z. associated with Fisher. and is a function of the data and hence is / random. under H0 . if Z ∼ N (0. in that the reader is allowed to pick the level of signiﬁcance α. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 .05 = 1. Then the asymptotic p-value of the statistic tn is pn = p(tn ). 6. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) .9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. To see this fact. 1). This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. 1]. 1]. Let zα/2 is the upper α/2 quantile of the standard normal distribution. It is designed to cover θ with high probability.645.96 and z. That is. tn →d N (0. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. is to report an asymptotic p-value. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. The coverage probability is P (θ ∈ Cn ). That is. The asymptotic p-value for the above statistic is constructed as follows.

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

1 Under H0 and Assumption 6. In this case. ˆ Wn = n θ θ q θ θ Theorem 6.2. 6.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . The asymptotic p-value for Wn is pn = p(Wn ). if rank(Hβ ) = q. Also h(β) = a selector matrix. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .10.1. Vθ ). As before. a chiq square random variable with q degrees of freedom.19) σ2 ˆ where σ2 = ˜ 1 0 e e. For example.5. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.8. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. and there are q = k2 restrictions. h(β) = R0 β. Furthermore. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . then Wn →d χ2 . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . the test rejects at the α% level iﬀ pn < α. χ2 (. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Hβ (β) →p Hβ .025 . the upper-α quantile q 2 of the χ2 distribution.3. ˜˜ n ˜ e = Y − X1 β 1 .15) showed that n ˆ − θ →d Z ∼ N (0. q and pn is asymptotically U[0.05) = 3. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . Hβ (β) is a continuous function of β.1 showed θ ˆ that V →p V. 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.When h is a linear function of β. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). The null hypothesis is H0 : β 2 = 0. and Theorem 6. θ = β 2 . Hence β β by Theorem A.84 = z. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. 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.

By the FWL theorem. still this formula often ﬁnds good use in reading applied papers. Thus ˜ ˆ e=X ˜ ˆ 2 ³ ´0 ³ ´ ˜ ˆ ˜ ˆ e0 e = X2 β 2 + e ˜˜ ˆ ˆ X2 β 2 + e ˆ0 ˜ 0 ˜ ˆ = β 2 X2 X2 β 2 + e0 e ˆˆ 0 0 ˆ ˆ ˆˆ = β X M1 X2 β + e0 e. ˆˆ n ˆ e = Y − X β. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 .19) the F form of the Wald statistic. 2 σ ˆ To simplify this expression further. This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . Because of this connection we call (6. Also. note that partitioned matrix inversion (2. First. as the sum of squared errors is a typical output from statistical packages. We now derive expression (6.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ .19). The elegant feature about (6. Now consider the residual regression of e on X2 = M1 X2 . and σ2 = ˆ 1 0 e e.2) ¢−1 ¡ R = R0 R X 0X 0 µ 0 0 X1 X1 X1 X2 0X 0 X2 1 X2 X2 ¶−1 0 0 where M1 = I − X1 (X1 X1 )−1 X1 . ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. X2 ). = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. the residual is ˜ ˜ e = M1 Y. note that if we regress Y on X1 alone.are from OLS of Y on X1 .19) is that it is directly computable from the standard output from two simple OLS regressions. 59 . ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. 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 2 2 or alternatively.

This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. 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 .4)) where H 0 H = In . as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2.12 Normal Regression Model As an alternative to asymptotic distribution theory.3. introduced in Section 4. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0.where In many statistical packages. equivalently the residual variance from an intercept-only model. it follows ˆ that β is independent of any function of the OLS residuals. an “F statistic” is reported. 6. including the estimated error variance 2. 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 is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . 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. While there are special cases where this F statistic is useful. there is an exact distribution theory available for the normal linear regression model. Since uncorrelated normal variables are independent. H 0 H) ∼ N (0. This is rarely an issue today. In ) . σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . Since linear functions of normals are also normal. The modelling assumption that the error ei is independent of xi and N (0. these cases are atypical. In particular. n−k 60 . when an OLS regression is reported. In σ 2 . when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. σ 2 ) can be be used to calculate a set of exact distribution results. This was a popular statistic in the early days of econometric reporting.

The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . Furthermore. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. σ 2 ) = − log σ − log (2π) − .1 we showed that in large samples. the notable distinction is between the N (0. if standard errors are calculated using the homoskedastic formula (6. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . β 2 .10) then ´ ³ ˆ • β ∼ N 0. σ ˆ ˆ βj − βj βj − βj N (0. (Unless the sample size is unreasonably small. 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. We summarize these ﬁndings Theorem 6. 0. β 2 . a good testing procedure is based on the likelihood ratio statistic. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .1 and Theorem 6. σ2 ˆ 61 . 0.8. with residual variance σ . In contrast. 1) and tn−k distributions.12. The critical values are quite close if n − k ≥ 30. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .a chi-square distribution with n − k degrees of freedom. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. 0. β has an exact normal distribution and t has an exact t distribution. so as a practical matter it does not matter which distribution is used. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .12. σ 2 ). and standard errors are calculated using the homoskedastic formula (6. β and t are approximately normally distributed. Theorem 6. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . As inference (conﬁdence intervals) are based on the t-ratio.1 shows that under the strong assumption of ˆ normality. σ 2 ) − Ln (β 1 .) Now let us partition β = (β 1 . n−k • ∼ tn−k ˆ In Theorem 6. σ 2 ) discussed above. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models.10) µ h i ¶ 2 (X 0 X)−1 N 0.3. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .1 If ei is independent of xi and distributed N(0. β 2 .

LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. while there are other values of s for which test test statistic is insigniﬁcant. σ 2 ) and consider the hypothesis H0 : β = 1. Our ﬁrst-order asymptotic theory is not useful to help pick s. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. To demonstrate this eﬀect. The decreasing dashed ˆ = 1. ˆ Let β and σ 2 be the sample mean and variance of yi . The increasing solid line is for the case β = 0. they can work quite poorly when the restrictions are nonlinear. 62 . 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.7. Take the model yi = β + ei ei ∼ N (0. and noting Hβ = sβ s−1 . The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. This can be seen by a simple example introduced by Lafontaine and White (1986). Letting h(β) = β s . 6.4 the Wald statistic Wn (s) as a function ˆ of s. we have plotted in Figure 6. Through repetition. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.84 — the probability of a false rejection. setting n/σ 2 = 10.8. as Wn (s) →d χ2 under H0 for 1 any s.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . This produces random draws from the sampling distribution of interest. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. features of this distribution can be calculated. the statistic Wn (s) varies with s. In the present context of the Wald statistic. This is an unfortunate feature of the Wald statistic. 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.

4. Any other choice of s leads to a test with unacceptable Type I error probabilities. looking for tests for which rate rejection rates are close to 5%. this probability depends only on s. Type I error rates between 3% and 8% are considered reasonable. 100 and 500.84. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.4: Wald Statistic as a function of s P (Wn (s) > 3. Test performance deteriorates as s increases. To interpret the table.000 random samples. remember that the ideal Type I error probability is 5% (.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . Rates above 20% are unexceptable. n is varied among 20. Given the simplicity of the model. the only test which meets this criterion is the conventional Wn = Wn (1) test. the Type I error probability improves towards 5% as the sample size n increases. no magic choice of n for which all tests perform uniformly well. In each case. and σ 2 . In Table 2. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. There is.Figure 6. When comparing statistical procedures.000 simulated Wald statistics Wn (s) which are larger than 3. n. however.84 | β = 1) .1 you can also see the impact of variation in sample size. For this particular example.05) with deviations indicating+ distortion. The null hypothesis β s = 1 is true. and σ is varied among 1 and 3. The value of s is varied from 1 to 10. Table 4. In Table 4. Table 4. we compare the rates row by row. These probabilities are calculated as the percentage of the 50. and rarely fall outside of the 3%-8% range. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.1 reports the simulation estimate of the Type I error probability from 50. Error rates avove 10% are considered excessive. so these probabilities are Type I error. Typically.1 we report the results of a Monte Carlo simulation where we vary these three parameters.

06 .07 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. This point can be illustrated through another example.13 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .12 .10 .17 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .12 .13 .21 .10 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.13 .05 .06 .14 .06 .33 .05 .11 . While this is clear in this particular example.14 .05 .26 . β 1 .25 .15 . 64 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.08 .07 .23 . Equivalently.35 .08 .10 .06 .20 .16 Rejection frequencies from 50.15 . Other choices are arbitrary and would not be used in practice.06 .22 .09 .20 .07 .08 . so the hypothesis can be stated as H0 : θ = r.22 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .18 .15 .30 .28 .19 .25 .05 .34 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.31 .05 .06 .06 .08 . β 2 ) be the least-squares estimates of (6.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 .05 .20). An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.07 . deﬁne θ = β 1 /β 2 .08 .07 .24 .15 .

25 . and are close to the ideal 5% rate for both sample sizes.645) are close to zero in most cases.15 .10 . This leaves β 2 as a free parameter.10 .50. 1) variables.05 . In contrast.06 .00 .50 .10 .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. Ideally.06 .00 The one-sided Type I error probabilities P (tn < −1.09 .05. while the right tail probabilities P (t1n > 1.00 .06 .645) P (tn < −1. In all cases. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. However. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . if the hypothesis can be expressed as a linear restriction on the model parameters. The implication of Table 4.06 .05 .05 . ei be an independent N (0.645) P (tn > 1. The results are presented in Table 4.06 .75 1.05 . If no linear formulation is feasible.05 .06 .05 . along with sample size n. σ 2 ) draw with σ = 3. 65 .07 . .05 .02 .26 .645) and P (tn > 1. and 1.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. the rejection rates for the t1n statistic diverge greatly from this value.06 . Table 4.645) P (tn > 1.15 . 6. such as the GMM distance statistic which will be presented in Section 9. We let x1i and x2i be mutually independent N (0.75. The left tail probabilities P (t1n < −1.12 . this formulation should be used. It is also prudent to consider alternative tests to the Wald statistic.1. and alternatives to asymptotic critical values should be considered. the entries in the table should be 0.0 and n among 100 and 500.645) greatly exceed 5%.645) are calculated from 50.05 . and normalize β 0 = 0 and β 1 = 1.25.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.28 .645) t1n t2n t1n t2n t1n t2n t1n t2n .7. .00 .00 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.00 .00 . We vary β 2 among .2.06 .00 .000 simulated samples. then the “most linear” formulation should be selected.00 . .06 .00 . In this section we describe the method in more detail.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .06 .05 β2 . especially for small values of β 2 .05 .47 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .

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

21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. 6. Furthermore. and dummy variable indicators for the following: married. the researcher must select the number of experiments. In practice. therefore. an estimator or test may perform wonderfully for some values. For example. a larger B results in more precise estimates of the features of interest of Gn . It is therefore useful to conduct a variety of experiments. Quite simply. We now expand the sample all non-military wage earners. this may ˆ be approximated by replacing P with P or with an hypothesized value. 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. the performance will depend on n and F. female. union member.96) . the choice of B is often guided by the computational demands of the statistical procedure. If the standard error is too large to make a reliable inference. immigrant. The α% sample quantile is a number qα such that α% of the sample are less than qα . Hence the ³ ´ ˆ standard errors for B = 100.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. we included a dummy 67 . The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. equalling 1 with probability P = E1 (Tnb ≥ 1. potential work experience. Then qα is the N ’th number in this ordered sequence. experience squared. for a selection of choices of n and F. union member. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. The random variable 1 (Tnb ≥ 1. then we can set s P = (. and estimate a multivariate regression. respectively.95) /B ' . For the dependent variable we use the natural log of wages. where N = (B +1)α. are. Often this is called the number of replications. In particular. and poorly for others.21). The average (6. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.007. B. experience squared. and our regressors include years of education. It is therefore convenient to pick B so that N is an integer.05) (. female. B b=1 (6. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. s P = . We separately estimate equations for white and non-whites. if we set B = 999. . it is simple to make inferences about rejection probabilities from statistical tests. hispanic. Generally. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.15 Estimating a Wage Equation We again return to our wage equation. and non-white. For regressors we include years of education. 1000. As discussed above. excluding military. and hispanic.022.96) is iid Bernoulli.003. and 90% sample quantiles of the sample {Tnb }. potential work experience. so that coeﬃcients may be interpreted as semi-elasticities. In many cases. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. but requires more computational time. immigrant. and dummy variable indicators for the following: married. As P is unknown. and 5000. For example. and .96) . then B will have to be increased. We us the sample of wage earners from the March 2004 Current Population Survey. and therefore it is straightforward to calculate standard errors for any quantity of interest.22/ B. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. Again our dependent variable is the natural log of wages.

if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.027 . Wn = n 1 − 2 = 18.010 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.808 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .001 .007 .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.34 ˆ s(β) . as the 1% critical value for the χ2 distribution is 76.002 . Computing the Wald statistic (6.101 . The available sample is 18.008 . excluding the coeﬃcients on the state dummy variables. Ignoring the other coeﬃcients. reestimating the model with the 50 state dummies excluded.014 .1.4877 18.49452 σ ˜ Notice that the two statistics are close.variable for state of residence (including the District of Columbia.010 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.033 −.00057 .4945. this adds 50 regressors).032 .121 −. but not equal.102 −. 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.69. Table 4. we ﬁnd Wn = 550. Using either statistic the hypothesis is easily rejected.808 so the parameter estimates are quite precise and reported in Table 4.48772 = 515. Alternatively.18) that the state coeﬃcients are jointly zero. 808 1 − . θ ˆ 2β 3 β2 .013 . 2β 3 68 . The F form of the Wald statistic (6.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.097 −. the restricted standard deviation estimate is σ = .102 −.232 .070 .00002 .

This set is [27. there is not a simple expression for this set. Instead. we found better Type I error rates by reformulating the hypothesis as a linear restriction.5].96. 29. 29. Since tn (θ) is a non-linear function of θ. not testing a hypothesis. so we have to go one step further. we can calculate a standard error of s(ˆ = . However. implying a 95% conﬁdence θ) interval of [27.40. 69 . These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ).Using the Delta Method. this is a poor choice.9.5]. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. This is the set of θ such that |tn (θ)| ≤ 1. In the previous section we discovered that such t-tests had very poor Type I error rates. but it can be found numerically quite easily. but the lower end is substantially lower.0. In the present context we are interested in forming a conﬁdence interval.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

Let η i = e2 . The theory of Chamberlain (1987) can be used to show that in this model the semiparametric eﬃciency bound is obtained by the Generalized Least Squares (GLS) estimator ¢−1 ¡ 0 −1 ¢ ¡ ˜ (7. The GLS estimator (7.2) E (ξ i | xi ) = 0.. we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7..1 Generalized Least Squares In the projection model.1) XD Y β = X 0 D−1 X ¡ ¢ 2 . 74 .1) infeasible since the matrix D is unknown. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . . where z1i is some q × 1 function of xi . σ1 We now discuss this estimation problem. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . Typically. 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 ..Chapter 7 Additional Regression Topics 7. . The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. σ 2 }. the least-squares estimator is ineﬃcient.. However.. z1i are squares (and perhaps levels) of some (or all) elements of xi . Often the functional form is kept simple for parsimony.

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

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

The GLS and FGLS estimators.1 Under H0 and ei independent of xi . If i this simpliﬁcation is replaced by the standard formula (under independence of the error). σ 2 ). OLS is a more robust estimator of the parameter vector. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. Typically.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. then the OLS and FGLS estimators will converge in probability to diﬀerent limits.2). FGLS will do worse than OLS in practice. or equivalently that i H0 : α1 = 0 in the regression (7. the two tests coincide. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. In the linear regression model the conditional mean of yi given xi = x is 77 . and the cost is a reduction of robustness to misspeciﬁcatio 7. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . Third.7) under independence show that this test has an asymptotic chi-square distribution.4) and constructing a Wald statistic. require the assumption of a correct conditional mean. The main diﬀerences between popular “tests” is which transformations of xi enter zi . and not a conditional mean. individual estimated conditional variances may be negative.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . the estimated conditional variances may contain more noise than information about the true conditional variances. This hypothesis does not imply that ξ i is independent of xi . but also under the assumptions of linear projection. its squares. and this requires trimming to solve. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . but the only diﬀerence is that they a ¢ allowed for general choice of zi . Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. q Most tests for heteroskedasticity take this basic form.error. however. It is consistent not only in the regression model. on the other hand. 7. Theorem 7. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. In this case. and all cross-products. the Wald test of H0 is asymptotically χ2 . This introduces an element of arbitrariness which is unsettling to empirical researchers. If the equation of interest is a linear projection. The asymptotic distribution (7. We may therefore test this hypothesis by the estimation (7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. as they will be estimating two diﬀerent projections. Second.5) and the asymptotic variance (7.2. Vα = E zi zi (7. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0.4).

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

V ) θ where mθi = mθ (xi . θ).Examples of nonlinear regression functions include x 1 + θ3 x m(x. See Appendix E. In the ﬁnal two examples. θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. but we won’t cover that argument here. it must be shown that ˆ →p θ0 . Let 0 yi = ei + m0 θ0 . The NLLS residuals are ei = yi − m(xi . When it exists. In other cases. θ) is suggested by an economic model. which alters some of the analysis. θ) is diﬀerentiable with respect to θ. estimator. The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . θ)ˆ (7.1 If the model is identiﬁed and m(x. G known x2 − θ5 m(x. ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. ˆ must be found by numerical θ methods. θ) = θ1 + θ2 xθ3 m(x. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . ´ √ ³ n ˆ − θ0 →d N (0.8) Theorem 7. θ) = G(x0 θ). θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. ˆ is close to θ θ θ0 for n large. θ))2 . This can be done using arguments θ for optimization estimators. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. θ) is diﬀerentiable. θ) = θ1 + θ2 exp(θ3 x) m(x. θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples. m(x. ˆ ei . Since ˆ →p θ0 . let ∂ m(x. then the FOC for minimization are 0= n X i=1 mθ (xi . mθ (x. ˆ ˆ One motivation for the choice of NLLS as the estimation method is that the parameter θ is the solution to the population problem minθ E (yi − m(xi . we call this the nonlinear least squares (NLLS) θ). θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. θi 79 . it is adopted as a ﬂexible approximation to an unknown regression function. θ) = θ1 + θ2 m(x. m is not diﬀerentiable with respect to θ3 . First.4. When the regression function is nonlinear. θ0 ). θ) is (generically) diﬀerentiable in the parameters θ. When m(x.

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

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

11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. Pn −1 0 β)) .1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. While a complete proof of Theorem 7. When f (0 | x) is large. ∂β 0 so Third. and this improves estimation of the median. The main diﬃculty is the estimation of f (0). V ).5.10) is equivalent to g n (β) = 0. the height of the error density at its median.11). ˆ Proof of Theorem 7. the conditional density of the error at its median. by the central limit theorem (Theorm 5. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . ¢¢−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) . ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . In the special case where the error is independent of xi . by a Taylor series expansion and the fact g(β 0 ) = 0 82 .1 ´ √ ³ˆ n β − β 0 →d N (0. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. See Chapter 16.5. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. First.3.5. (7. Computation of standard error for LAD estimates typically is based on equation (7.1 is advanced. This can be done with kernel estimation techniques.Theorem 7. where V = and f (e | x) is the conditional density of ei given xi = x. then there are many innovations near to the median. ∂ 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 ) . Let g(β) = Eg (β). we provide a sketch here for completeness.

V ). The median is the special case τ = . the quantile regression functions can take any shape. The following alternative representation is useful. Again. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. The third line follows from an asymptotic empirical process argument. We then have the linear quantile regression model yi = x0 β τ + ei i 83 .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. so you can think of the quantile as the inverse of the distribution function. If the random variable U has τ ’th quantile Qτ .9) for the median to all quantiles.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. For ﬁxed τ . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). then F (Qτ (x) | x) = τ . when F (y | x) is continuous and strictly monotonic in y.13) This generalizes representation (7. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . (7. 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. ¥ 7. Exi x0 ) →d i 2 = N (0. then (7.5. For the random variables (yi . The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . As functions of x. then F (Qτ ) = τ . For τ ∈ [0. 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)) .12) Qτ = argmin Eρτ (U − θ) .

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

However. ⎟ zi = ⎝ . yielding predicted values yi = x0 β. β 1 = (X1 X1 )−1 (X1 Y ) . In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. It is easy (although somewhat tedious) to show that under the null hypothesis. β 2 ).14) by OLS. note that (7.be an (m − 1)-vector of powers of yi . Another is to regress yi on x1i and x2i jointly. 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 . In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . 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. 3.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. yielding ˆ ˜ ˆ ˆ (β 1 . m must be selected in advance. then 22 Q11 > Q11 − Q12 Q−1 Q21 . yi ˆm (7. since Q12 Q−1 Q21 > 0. and the two estimators have equal asymptotic eﬃciency. 7. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. To implement the test. 1i 2i 2i 1i 22 . Typically. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. small values such as m = 2. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. ⎠ . Otherwise. they will (typically) have diﬀerence asymptotic variances. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . or 4 seem to work best. and n→∞ say. and consequently 22 ¡ ¢−1 2 σ . To see why this is the case. It is particularly powerful at detecting single-index models of the form yi = G(x0 β) + εi i where G(·) is a smooth “link” function. and form the Wald statistic Wn for γ = 0. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 .14) may be written as ³ ´3 ³ ´m ³ ´2 ˜ ˆ ˜ ˆ ˜ ˆ yi = x0 β + x0 β γ 1 + x0 β γ 2 + · · · x0 β γ m−1 + ei ˜ ˜ i i i i which has essentially approximated G(·) by a m’th order polynomial. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone.

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

as the rule tends to overﬁt. LRn →p 0. 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. AIC selection is inconsistent. n (7.16) holds under M1 . A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . since (7.15) then where σ 2 is the variance estimate for model m. His criterion. For some critical level α. n (7. since under M1 . is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . In contrast to the AIC. BIC model selection is consistent. this rule only makes sense when the true model is ﬁnite dimensional. if α is set to be a small number. depending on the sample size. known as the BIC. else select M2 . let cα satisfy ¢ ¡ P χ22 > cα . Indeed. k A major problem with this approach is that the critical level α is indeterminate. The rule is to select M1 if AIC1 < AIC2 . as ³ ´ c P M = M1 | M1 → 1 − α < 1. Indeed. 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. M)) between the true density and the model density. Another common approach to model selection is to to a selection criterion. the most popular to be one proposed by Schwarz.However. Then select M1 if Wn ≤ cα . Another problem is that if α is held ﬁxed. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . 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. That is. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. and km is the number of coeﬃcients in the model. If the truth is inﬁnite dimensional. log(n) 87 . One popular choice is the Akaike Information Criterion (AIC).17) Since log(n) > 2 (if n > 8).16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. ¢ ¡ ˆ1 ˆ2 (7. k = While many modiﬁcations of the AIC have been proposed. The model selection rule is as follows. else select M2 . etc. based on Bayesian arguments. then this model selection procedure is inconsistent.

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

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

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

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

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

8. x) (1 − F (y. Note that while F may be either discrete or continuous. Furthermore.2) Fn (y. Recall that F (y. x) = n i=1 Figure 8. For n = 25.. n. x). i = 1. To see the eﬀect of sample size on the EDF. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . I have plotted the EDF and true CDF for three random samples of size n = 25.1). the EDF is only a crude approximation to the CDF. This is a population moment. in the Figure below. and 100. Fn (y. Fn is a nonparametric estimate of F. 50. That is. x)) →d N (0. xi ). as the sample size gets larger.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x))) . In general. (8. x) . x) − F (y..2. x).. 1) distribution. i 93 . x∗ ≤ x) = Fn (y. √ n (Fn (y. Notationally.2 The Empirical Distribution Function Fn (y. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. Thus by the WLLN (Theorem 5. by the CLT (Theorem 5. To see this. x). x∗ ) with the i distribution Fn .3. x) →p F (y. Fn is by construction a step function. it is helpful to think of a random pair (yi . The EDF is a consistent estimator of the CDF.1). x) = P (yi ≤ y. The random draws are from the N (0. ∗ P (yi ≤ y. the EDF step function gets uniformly close to the true CDF. F (y. x) is called the empirical distribution function (EDF). but the approximation appears to improve for the large n. where 1(·) is the indicator function. note that for any (y. . The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) .

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

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

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

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

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

then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. Deﬁnition 8. and vice-versa. The following notation will be helpful. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). (8. F ) = Φ n→∞ v or ³x´ Gn (x. Let an be a sequence.8. C4 is called the symmetric percentile-t interval. 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.3 an = o(n−r ) if nr |an | → 0 as n → ∞. Equivalently.8.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. however. v 2 ).∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. If θ is a vector. 99 .8. where qn (α) is the (1 − α)% quantile of the distribution of Wn . F ) = Φ + o (1) . Thus here Tn (θ) = Wn (θ).3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.8 Asymptotic Expansions Tn →d N (0. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . We say that a function g(x) is even if g(−x) = g(x). 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. Let Tn be a statistic such that (8. The derivative of an even function is odd. lim Gn (x. and a function h(x) is odd if h(−x) = −h(x). F ) then ³x´ .2 an = O(1) if |an | is uniformly bounded. not ˆ − θ0 . about the rate v of convergence. or the size of the divergence for any particular sample size n. Deﬁnition 8. it says nothing. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . the critical value qn (α) is found as the quantile from simulated values of W´ . Basically. θ θ θ ˆ θ ∗ ∗ Computationally.4) says that Gn converges to Φ x as n → ∞. The ideal test rejects if Wn ≥ qn (α). writing Tn ∼ Gn (x.4) v ¡ ¢ While (8. an = O(n−r ) if it declines to zero like n−r .] 8. A better asymptotic approximation may be obtained through an asymptotic expansion. θ [This is a typical mistake made by practitioners.

F0 )) converges to 0 at rate n. F0 )) + O(n−1 ).1 has the expansion n G∗ (x) = Gn (x. F0 ) = n 1 n1/2 (g1 (x. F ) + n−1 g2 (x.1 as follows.1 Under regularity conditions and (8. F ) + O(n−3/2 ) Gn (x. Fn ) = Φ(x) + n 1 g (x. F ) + g2 (x. F ) ≈ Φ + n−1/2 g1 (x. √ Since Fn converges to F at rate n. and g2 is an odd function of x. the exact distribution is P (Tn < x) = Gn (x. First. ³x´ Gn (x. Gn (x. so the order of the error is O(n−1/2 ). the diﬀerence √ (g1 (x.8. F ) = Φ v n n 8. Theorem 8. F0 ) = 1 g (x. F0 ) = Φ(x) + since v = 1. where g1 is an even function of x. F ) ≈ Φ + n−1/2 g1 (x.3). 100 . F0 ) + O(n−1 ) 1/2 1 n 1 g (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. An asymptotic test is based on Φ(x). F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). To a third order of approximation. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . the density function is skewed. F ) converges to the normal limit at rate n1/2 . F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. adding leptokurtosis). A bootstrap test is based on G∗ (x). which from Theorem 8. and g1 is continuous with respect to F. Fn ) − g1 (x. Fn ) − g1 (x. Fn ) + O(n−1 ). v Since the derivative of g1 is odd. F ) v which adds a symmetric non-normal component to the approximate density (for example.1.9 One-Sided Tests Using the expansion of Theorem 8.8. To the second order. 1/2 1 n Because Φ(x) appears in both expansions. ³x´ 1 1 + 1/2 g1 (x.uniformly over x. ³x´ Gn (x. g1 (x. The diﬀerence is Φ(x) − Gn (x.8. To a second order of approximation. Heuristically. Moreover. We can interpret Theorem 8.8. Fn ) − g1 (x. F0 ) ≈ ∂ g1 (x. F ).

n (8. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. F ) − Gn (−x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. Since Tn →d Z. 101 2 g2 (x. We conclude that G∗ (x) − Gn (x. if Z ∼ N (0.8. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). From Theorem 8. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F ). F ) + g2 (−x. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )).1. Thus asymptotic critical values are taken from the Φ distribution. then |Tn | →d |Z| ∼ Φ. = P (X ≤ x) − P (X ≤ −x) For example. we can calculate that Gn (x. 1). F ). A two-sided hypothesis test rejects H0 for large values of |Tn | . then |Tn | has the distribution function Gn (x. and exact critical values are taken from the Gn (x. F ) = Gn (x. F0 ) = The order of the error is O(n−1 ). F ) − Gn (−x.The “derivative” ∂ ∂F g1 (x. This rate can be used to show that one-tailed bootstrap inference based on the tratio achieves a so-called asymptotic reﬁnement — the Type I error of the test converges at a faster rate than an analogous asymptotic test. F ) is only heuristic. F0 ) distribution. F0 ) = O(n−1 ). F ) + O(n−3/2 ). F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F ) = Gn (x. n .10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). as F is a function. if Tn has exact distribution Gn (x. Similarly. F0 ) + O(n−3/2 ) = O(n−1 ).5) where the simpliﬁcations are because g1 is even and g2 is odd. 8. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. 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). F ) + g2 (x.

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

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

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

ˆ = 1. and thus reject H0 if ˆ ˆ > q ∗ (.95). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. 105 .05) . The dataﬁle hprice1. You want to test H0 : θ = 0 against H1 : θ > 0.75 and 1. Estimate a linear regression of price on the number of bedrooms. Using the non-parametric ∗ bootstrap. and the 2.3. The ˆ are sorted. with variables listed in the ﬁle hprice1.5% and 97. You replace c with qn (. size of house.95) denote the 95% quantile of Tn . The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. lot size.05) and qn (. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). can you report the 95% Percentile-t interval for θ? 7. ∗ ∗ where s(ˆ is the standard error in the original data. and the colonial dummy.95). θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. What is wrong with this procedure? Tn = θ/s(θ) n 6.pdf. Let qn (.2. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.95). (c) With the given information. θ respectively.dat contains data on house prices (sales).2 and s(ˆ = . and ˆ is calculated on each θ ∗ ∗ θ sample. you generate bootstrap samples.95) denote the 5% θ) ∗ and 95% quantiles of Tn .Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). (b) Report the 95% Alternative Percentile interval for θ.5% quantiles of the ˆ are . ˆ − s(ˆ n (. You do this as follows. Using the non-parametric bootstrap. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. ∗ ∗ ∗ Let qn (. Suppose that in an application. (a) Report the 95% Efron Percentile interval for θ.

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

3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. then g n (β) = 0. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . For example.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. for if Wn is replaced ˆ by cWn for some c > 0. but this is generally not possible when > k. β GMM does not change. ¡ ¢−1 0 ˆ Z XWn X 0 Y. if Wn = I. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. i i .9. Proposition 9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . This is a non-negative measure of the “length” of the vector g n (β). β ˆ Note that if k = . Let and where gi = xi ei . then.2) g n (β) = (9.1 β GMM = argmin Jn (β).2. The GMM estimator minimizes Jn (β). and the GMM estimator is the MME. the dependence is only up to scale. the square of the Euclidean length. For some × weight matrix Wn > 0.2. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. let Jn (β) = n · g n (β)0 Wn g n (β). β GMM = Z 0 XWn X 0 Z 9. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. ˆ Deﬁnition 9.

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

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

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

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

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

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

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

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

Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0. 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.. 116 .7. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. ˆ and consider the GMM estimator β of β. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix.

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

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. Ln (β) = Rn (β.5) This minimization problem is the dual of the constrained maximization problem. or equivalently minimizes its negative ˆ (10.5). probabilities 1 ³ ´´ . the Lagrange multiplier λ(β) minimizes Rn (β. λ).. λ ¡ ¢ ln 1 + λ0 gi (β) . . summing over i. (see section 6. and using the second and third equations. 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. Multiplying the ﬁrst equation by pi . The solution (when it exists) is well deﬁned since Rn (β. but must be obtained numerically (see section 6. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . This yields the (proﬁle) empirical log-likelihood function for β. µ. we ﬁnd µ = n and 1 ¢. p1 . pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. λ. p (10. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . λ) : λ(β) = argmin Rn (β.2) subject to the restrictions (10. (10.4) (10.where λ and µ are Lagrange multipliers. λ) is a convex function of λ. pn . The solution cannot be obtained explicitly.. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. we also obtain the Lagrange multiplier λ = λ(β).7) 118 .1) and (10. pi gi (β) = 0. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). λ) = −n ln (n) − n X i=1 For given β..5) ˆ ˆ As a by-product of estimation.3).

8) and ¢ 0 0 For example. (β. 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 (10.10). g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.1 Under regularity conditions. Thus the EL estimator is asymptotically eﬃcient. λ) = − (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . i=1 i=1 i=1i Expanding (10. i i Theorem 10. Gi (. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. G = −E (xi zi ). n (10.13) yields n n Expanding (10.9) (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. β) = −xi zi . λ) = − (10. 0 = Rn (β.10.9) and (10.13) Premultiplying by G0 Ω−1 and using (10. in the linear model.10) ¡ Ω−1 N (0.2.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . and n β − β 0 and nλ are asymptotically independent. and Ω = E xi x0 e2 . ˆ ˆ Proof.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 . β λ ∂ ³ ´.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .

15).17) 2 ln 1 + λ gi β . β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ.15) (10. Vλ ) Furthermore. 10. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. The overidentiﬁcation test is a very useful by-product of EL estimation. Since the EL estimator achieves this bound.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. and (10. and have the same interpretation. LRn = i=1 Theorem 10.3. First. Proof. and it is advisable to report the statistic LRn whenever EL is the estimation method. β 0 ) = 0 then LRn →d χ2−k . This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . V ) ˆ Solving (10. 120 . since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. it is an asymptotically eﬃcient estimator for β. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. They are asymptotically ﬁrst-order equivalent.16). n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .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. (10. The same statistic can be constructed for empirical likelihood.3 Overidentifying Restrictions In a parametric likelihood context.1 If Eg(wi . by a Taylor expansion. tests are based on the diﬀerence in the log likelihood functions. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. Ω) GΩ G →d = N (0. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.7) is n ³ ´´ ³ X ˆ ˆ0 (10.14) for λ and using (10.

1 Under (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.prc 121 .18) and H0 : h(β) = 0. The hypothesis of interest is h(β) = 0. Vλ )0 Ω−1 N (0.Second.4.17) is not appropriate.ssc. where h : Rk → Ra . a The proof of this result is more challenging and is omitted. 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 (0.18) 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) are assumed to hold and are not being challenged (at least for the test discussed in this section). Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . the simple overidentifying restrictions test (10. This test statistic is a natural analog of the GMM distance statistic. h(β)=0 ˜ Fundamentally.18).wisc. To test the hypothesis h(β) while maintaining (10. Theorem 10.4 Testing Egi (β) = 0 (10.edu/~bhansen/progs/elike. 10. since ln(1 + x) ' x − x2 /2 for x small. 10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). LRn →d χ2 . so there is no fundamental change in the distribution theory for β relative to β.

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

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

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

1.1) if E (xi ei ) = 0.2) Any solution to the problem of endogeneity requires additional information which we call instruments. This is called simultaneous equations bias.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. (11.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ . That is x2i are variables which could be included in the equation for yi (in the sense 125 . In matrix notation.1 The × 1 random vector xi is an instrumental variable for (11. β →p β ∗ . and assume that E(zi ei ) 6= 0 so there is endogeneity. We call z1i exogenous and z2i endogenous. which does not equal either β 1 or β 2 .1) where zi is k × 1. In a typical set-up. So we have the partition µ ¶ z1i k1 (11. this can be written as Y = Zβ + e. We call (11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. Thus we make the partition ¶ µ k1 z1i (11. 11. Deﬁnition 11.1) the structural equation. By the above deﬁnition. and x2i are the excluded exogenous variables. at least the intercept). some regressors in zi will be uncorrelated with ei (for example.1). z1i is an instrumental variable for (11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. so should be included in xi .4) xi = x2i 2 where z1i = x1i are the included exogenous variables.

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

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

The consequences of identiﬁcation failure for inference are quite severe. Indeed as α → 1. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. the bias in the 2SLS estimator will be large.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . the expression in (11.14) approaches that in (11. By the spectral decomposition of an idempotent matrix.Let PX = X (X 0 X)−1 X 0 . 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. n and (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . P = HΛH 0 0 0 where Λ = diag(Il .14) is the probability limit of β 2SLS − β 11. It is also close to zero when α = 0. n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. 130 . 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 . 0). 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. except when S21 = 0 (when Z is exogenous).12) and this result. l . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases.14) In general this is non-zero.13).

16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. This can be handled in an asymptotic analysis by modeling it as local-to-zero. Here. Suppose that identiﬁcation does not complete fail. Qc + N2 ˆ As in the case of complete identiﬁcation failure. but small. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. once again take the simple case k = l = 1. viz Γ22 = n−1/2 C. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 .15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. standard test statistics have non-standard asymptotic distribution of β distributions. and was examined by Phillips (1989) and Choi and Phillips (1992). Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. but (11.16) 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 . E x2 u2 i i n n i=1 i=1 n n (11. This result carries over to more general settings. where C is a full rank matrix. as the Cauchy distribution does not have a ﬁnite mean. the instrument xi is weak for zi if γ = n−1/2 c. This occurs when Γ22 is full rank.15) is unaﬀected. N2 since the ratio of two normals is Cauchy. 131 . meaning that inferences about parameters of interest can be misleading. To see the consequences. E x2 e2 i i n i=1 n (11. Suppose this condition fails. which occurs i when E (zi xi ) 6= 0. This is particularly nasty. In addition. Then (11. but is weak.Take the simplest case where k = l = 1 (so there is no X1 ). so E (zi xi ) = 0.

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

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

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

. and Cov (Yt ..) is a random variable.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . t = 1. and T to denote the number of observations. The following two theorems are essential to the analysis of stationary time series.1. Deﬁnition 12.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. we adopt new notation. Yt−k ) is independent of t for all k...1. .2 {Yt } is strictly stationary if the joint distribution of (Yt . Yt−k ) is the autocorrelation function..1. Yt−k ) = γ(k) is independent of t for all k.1. Theorem 12.. γ(k) is called the autocovariance function. however. T . The primary model for multivariate time series is vector autoregressions (VARs). A stationary time series is ergodic if γ(k) → 0 as k → ∞. To indicate the dependence on time.. Deﬁnition 12. . 135 . Yt−1 .4 (loose). and use the subscript t to denote the individual observation. then Xt is strictly stationary and ergodic. and multivariate (yt ∈ Rm is vector-valued).3 ρ(k) = γ(k)/γ(0) = Corr(Yt . we expect that Yt and Yt−1 are not independent. Deﬁnition 12.1.1 Stationarity and Ergodicity Deﬁnition 12. We can separate time series into two categories: univariate (yt ∈ R is scalar). The primary model for univariate time series is autoregressions (ARs). so classical assumptions are not valid.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.. There proofs are rather diﬃcult.. 12. Because of the sequential nature of time series.

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

should be a MDS.. . . this series converges if the sequence ρk et−k gets small as k → ∞. as it is diﬃcult to derive distribution theories without this property. k=0 Loosely speaking. Regression errors are naturally a MDS.} are jointly random. the series {. For example. Deﬁnition 12.3 Stationarity of AR(1) Process Yt = ρYt−1 + et .2. Yt−2 .. In fact. 12. A mean-zero AR(1) is Assume that et is iid.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .. The last property deﬁnes a special time-series process.12. . some versions of the life-cycle hypothesis imply that either changes in consumption. or consumption growth rates. YT . .. Y1 . A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . E(et ) = 0 and Ee2 = σ 2 < ∞. Thus for k > 0... we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + .. ∞ X = ρk et−k . 137 .2 Autoregressions In time-series.} is the past history of the series. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. t By back-substitution. it is even more important in the time-series context.. Yt−k ) . Some time-series processes may be a MDS as a consequence of optimizing behavior. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . E(Yt−k et ) = 0. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. This occurs when |ρ| < 1. The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression... A 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 .. Letting et = Yt − E (Yt | It−1 ) . Y2 .....

5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .4. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L.3. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . we see that L2 Yt = LYt−1 = Yt−2 . since ρ(z) = 0 when z = 1/ρ. 138 . the above results are unchanged. Deﬁning L2 = LL. We call ρ(L) the autoregressive polynomial of Yt . We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . Lk Yt = Yt−k .1. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). ∞ X k=0 ρ2k V ar (et−k ) = 12. From Theorem 12. The AR(k) model is Using the lag operator.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. In general. 12. Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value).Theorem 12. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. We say that the root of the polynomial is 1/ρ. an AR(1) is stationary iﬀ |ρ| < 1.1 The lag operator L satisﬁes LYt = Yt−1 .3. We call ρ(L) the autoregressive polynomial of Yt . Deﬁnition 12.

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

there are two popular methods to implement bootstrap resampling for time-series data. .8 Bootstrap for Autoregressions In the non-parametric bootstrap. t t Theorem 12. Method 1: Model-Based (Parametric) Bootstrap. 140 . t This construction imposes homoskedasticity on the errors e∗ ..7. The implication is that asymptotic inference is the same. ˆ 1.. It also presumes that the AR(k) structure is the truth. . Ω) . Ω) . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.7 Asymptotic Distribution Theorem 12. i 4. Estimate β and residuals et .12.1 to see that T 1 X √ xt et →d N (0. Brieﬂy. eT }. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. t then as T → ∞. the asymptotic covariance matrix is estimated just as in the cross-section case. 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∗ . then as T → ∞. Clearly. This is identical in form to the asymptotic distribution of OLS in cross-section regression. Fix an initial condition (Y−k+1 .. T t=1 Since xt et is a MDS. e ˆ 3. 12. T 1 X √ ut →d N (0. we can apply Theorem 12. which may be diﬀerent than the i properties of the actual ei . Y0 ). Q−1 ΩQ−1 .. T t=1 where Ω = E(xt x0 e2 ). Divide the sample into T /m blocks of length m. Method 2: Block Resampling 1.1 MDS CLT.. this cannot work in a time-series application. This creates an iid bootstrap sample. we constructed the bootstrap sample by randomly resampling from the data values {yt . In particular. xt }.7. as this imposes inappropriate independence. ˆ 2. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Y−k+2 .7..

2). Seasonal Eﬀects There are three popular methods to deal with seasonal data. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. This presumes that “seasonality” does not change over the sample.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .2) (12. 12. ρk ). • You can estimate (12. and for modelmisspeciﬁcation. Resample complete blocks. This allows for arbitrary stationary serial correlation.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et .4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .2. draw T /m blocks. .. Thus the seasonally adjusted data is a “ﬁltered” series.2)-(12. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.4) by OLS. • You can estimate (12. and the way that the data are partitioned into blocks. This is a ﬂexible approach which can extract a wide range of seasonal factors. ∆s Yt = Yt − Yt−s . • First apply a seasonal diﬀerencing operator. The results may be sensitive to the block length. If s is the number of seasons (typically s = 4 or s = 12). 6. 141 . The seasonal adjustment. 5. and perhaps this was of relevance. 4. (12. also alters the time-series correlations of the data. That is.3) replacing St with St . heteroskedasticity. Paste the blocks together to create the bootstrap time-series Yt∗ . or the season-to-season change. • Use “seasonally adjusted” data. May not work well in small samples. For each simulated sample. and then perform regression (12.3) sequentially by OLS. This procedure is sometimes called Detrending.. • Include dummy variables for each season. 3.. get the ˆ ˆ residual St . The series ∆s Yt is clearly free of seasonality. ﬁrst estimate (12. But the long-run trend is also eliminated. however. (12.

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

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

Stock Prices). where c is the critical value from the ADF table. Another popular setting includes as well a linear time trend. (12. This is not really a correct conclusion. The ADF test has a diﬀerent distribution when the time trend has been included. As T → ∞.1 (Dickey-Fuller Theorem). The natural solution is to include a time trend in the ﬁtted OLS equation. Assume α0 = 0. We have described the test for the setting of with an intercept. When conducting the ADF test. If the series has a linear trend (e. as the AR model cannot conceivably describe this data. Thus the Dickey-Fuller test is robust to heteroskedasticity. In this context. and have negative means.12. If the test rejects H0 . Since the alternative hypothesis is one-sided. conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal. But the theorem does not require an assumption of homoskedasticity. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. They are skewed to the left.g. a common conclusion is that the data suggests that Yt is non-stationary. and may be used for testing the hypothesis H0 . but diﬀerent critical values are required. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. If the test does not reject H0 .8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. the test procedure is the same. 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. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal. If a time trend is included. rather than the ˆ 1/2 . This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error. All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . and a diﬀerent table should be consulted. 144 . the ADF test rejects H0 in favor of H1 when ADF < c. This distribution has been extensively α tabulated. this means that it is computed as the t-ratio for α0 from OLS estimation of (12. GDP. however. then the series itself is nonstationary. but it may be stationary around the linear time trend. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model.8). but does not depend on the parameters α.Theorem 12. This is called a “super-consistent” rate of convergence.

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

¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt . 13. Then the VAR system can be written as the equations Yjt = a0 xt + ejt .2 Estimation E (xt ejt ) = 0. One way to write this is to let a0 be the jth row j of A. either as a regression. 146 . This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator. The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj . some regressors may be excluded from some of the equations.. For example. or as a linear projection.3 Restricted VARs The unrestricted VAR is a system of m equations. ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 . each with the same set of regressors. The GMM framework gives a convenient method to impose such restrictions on estimation. A restricted VAR imposes restrictions on the system. ˆj ˆ And if we stack these to create the estimate A. . The VAR model is a system of m equations. ˆ An alternative way to compute this is as follows. or across equations.then Yt = Axt + et . Restrictions may be imposed on individual equations. ⎟ ⎝ . m. we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ . Note that a0 = Yj0 X(X 0 X)−1 .. Consider the moment conditions j = 1. These are implied by the VAR model. and was originally derived by Zellner (1962) ¢ 13.2 ⎟ X(X 0 X)−1 A ⎜ .. j Unrestricted VARs were introduced to econometrics by Sims (1980).

1). This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. If valid. Otherwise it is invalid. the model (13. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . direct estimation of (13. t t−1 (13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. j Often.2) Take the equation yt = x0 β + et .) Since the common factor restriction appears arbitrary. we are only interested in a single equation out of a VAR system.13. xt−1 ) to the regression. Then the single equation takes the form (13. with time series data. may be tested if desired. and subtract oﬀ the equation once lagged multiplied by θ.1).4 Single Equation from a VAR Yjt = a0 xt + et . (A simple version of this estimator is called Cochrane-Orcutt. Let yt = Yjt . under the restriction γ = −βθ. t and xt = This is just a conventional regression. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . We see that an appropriate. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. Another interesting fact is that (13.2) is uncommon in recent applications. Let et = ejt and β = aj . t or yt = θyt−1 + x0 β + x0 γ + ut .3).2) may be estimated by iterated GLS. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). In this case. t and et is iid N (0.2) is a special case of (13. You may have heard of the Durbin-Watson test for omitted serial correlation. 13. Suppose that et is an AR(1). which once was very popular. (13. This restriction. 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 . general. which is called a common factor restriction. This can be done by a Wald test. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. and is typically rejected empirically. it is convenient to re-deﬁne the variables. and is still routinely reported by conventional regression packages.1) yt = x0 β + et . and Zt be the other variables. 147 . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.3) which is a valid regression model.

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

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

One diﬃculty is that β is not identiﬁed without normalization. These tests are constructed as likelihood ratio (LR) tests. Ω). 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 . this is the MLE of the restricted parameters under the assumption that et is iid N (0. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . Thus cointegration imposes a restriction upon the parameters of a VAR. In the context of a cointegrated VAR estimated by reduced rank regression. Their asymptotic distributions are non-standard. If β is unknown. we typically just normalize one element to equal unity. they are typically called the “Johansen Max and Trace” tests. 150 . If β is known. and are similar to the Dickey-Fuller distributions. it is simple to test for cointegration by testing the rank of Π. 1995). which is least-squares subject to the stated restriction.Theorem 13. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. 1991.9. When r = 1. Equivalently. this does not work. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. then estimation is done by “reduced rank regression”. When r > 1. rank(α) = r. As they were discovered by Johansen (1988.1 (Granger Representation Theorem).

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

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

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

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

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

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

t = ti .. it The typical maintained assumptions are that the individuals i are mutually independent. . and most applied researchers try to avoid its use. (15. 15. In either event.. 15..Chapter 15 Panel Data A panel is a set of observations on individuals. There are several derivations of the estimator....1) is called the random eﬀects hypothesis. i = 1.. n. however. T . The motivation is to allow ui to be arbitrary.1) If this condition fails. xit } : For i = 1. and the t subscript denotes time. OLS of yit on xit is called pooled estimation. It is consistent if E (xit ui ) = 0 (15. .. xit }.1) is true. that eit is iid across individuals and time.. A panel may be balanced : {yit . that ui and eit are independent. OLS appears a poor estimation choice. The goal is to eliminate ui from the estimator.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . or unbalanced : {yit . Condition (15. where the i subscript denotes the individual. and have arbitrary correlated with xi . and thus achieve invariance. then OLS is inconsistent. and that eit is uncorrelated with xit . .2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions.1 Individual-Eﬀects Model The standard panel data speciﬁcation is that there is an individual-speciﬁc eﬀect which enters linearly in the regression yit = x0 β + ui + eit .. n. An observation is the pair {yit . 157 . OLS can be improved upon via a GLS technique. collected over time.. It is a strong assumption. ti . xit } : t = 1. If (15. This is often believed to be plausible if ui is an omitted variable. ..

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

Taking ﬁrst-diﬀerences of (15. 159 (15. 15. A simple application of GMM yields the parameter estimates and standard errors. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed).3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. This is because the sample mean of yit−1 is correlated with that of eit . Typically. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . it and then take individual-speciﬁc means by taking the average for the i0 th individual: ti ti ti 1 X 1 X 0 1 X yit = x β + ui + eit Ti t=t Ti t=t it Ti t=t i i i or Subtracting. Hence a valid estimator of α and β is to estimate (15. 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 .3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . are valid instruments. it it which is free of the individual-eﬀect ui . if eit is iid. Thus values of yit−k . the dependent variable and regressors in deviationit from-mean form. the predicted value from these regressions is the individual speciﬁc mean y i . Alternatively. as yt−2 is uncorrelated with ∆eit . and the residual is the demean value ∗ yit = yit − yi . But if there are valid instruments. we use lags of the dependent variable. e So OLS on (15.4) . ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . we ﬁnd y i = x0 β + ui + ei . it However. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . A more sophisticated GMM estimator recognizes that for time-periods later in the sample.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. at least if T is held ﬁnite as n → ∞. there are more instruments available. two periods back. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. Unfortunately. then IV or GMM can be used to estimate the equation.4) will be inconsistent. i ∗ yit = x∗0 β + e∗ . it (15. so the instrument list should be diﬀerent for each equation. This is conveniently organized by the GMM principle. but loses a time-series observation). the ﬁxed eﬀects estimator is inconsistent. k ≥ 2.

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

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

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

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

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

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

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 have four expressions for the number of objects (possible arrangements) of size r from n objects. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. Furthermore.. Rearranging the deﬁnition. the conditional probability function is a valid probability function where S has been replaced by B. 983.. If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . there are two important distinctions. Counting may be ordered or unordered..1) We say that the events A and B are statistically independent when (A. Counting may be with replacement or without replacement. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery. . we say that the collection of events A1 . consider a lottery where you pick six numbers from the set 1. n ≥ r.1) holds. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. r r! (n − r)! When counting the number of objects in a set. 816. ¢ counting is unordered and without replacement. as µ ¶ n n! = . 49. Ã ! \ Y P Ai = P (Ai ) .• 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. Depending on these two distinctions. . P (B) With Replacement nr ¡n+r−1¢ r For any B. it is useful to have simple rules to count the number of objects in a set. Ak are mutually independent when for any subset {Ai : i ∈ I}.. in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A. 2. i∈I i∈I 166 . For example. 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. These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r.

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

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

.. 2. x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 ... x = 1. 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . we now list some important discrete distribution function.. Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm .. 1.A.. 2.. 1. λ>0 x = 1.. n. . . . 0≤p≤1 V ar(X) = λ We now list some important continuous distributions.. 169 . 1. 2... 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 . m x1 !x2 ! · · · xm ! 1 2 = n. X2 = x2 ... Bernoulli P (X = x) = px (1 − p)1−x . 0≤p≤1 x = 0.4 Common Distributions For reference. 0≤p≤1 x = 0. . x! EX = λ x = 0. EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x . x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx . ..

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

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

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

y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0.6 Conditional Distributions and Expectation f (x. fX (x) 173 .... then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A. y) − F (x. ∂x1 · · · ∂xk For a measurable function g : Rk → Rs . . 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. 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) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε. .. Letting x = (x1 . In particular. xk )0 . it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x).. y) fX (x) f (x. we deﬁne the expectation Z g(x)f (x)dx Eg(X) = Rk where the symbol dx denotes dx1 · · · dxk . y) .A k × 1 random vector X = (X1 . Xk )0 is a function from S to Rk . y) fX (x + ε) ∂2 ∂x∂y F (x..

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

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

then by the change-of-variables formula. X has density Ã ! (x − µ)2 1 exp − . f (x) = √ 2σ 2 2πσ which is the univariate normal density. (A. Σ).11) and is known as the chi-square density with r degrees of freedom. y ≥ 0.This density has all moments ﬁnite. By iterated integration by parts.8. Theorem A. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . σ 2 ). we can also show that EX 2 = 1 and EX 4 = 3. q 176 . then Σ = diag{σ 2 } is a diagonal matrix. The latter has no closed-form solution. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . and it is conventional to write X ∼ N(µ. x ∈ Rk . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. This shows that if X is multivariate normal with uncorrelated elements. If Z is standard normal and X = µ + σZ. Since it is symmetric about zero all odd moments are zero. Its mean and r variance are µ = r and σ 2 = 2r. then Z 0 A−1 Z ∼ χ2 . It is conventional to write X ∼ N (0. then they are mutually independent. −∞ < x < ∞. A) with A > 0.2 If Z ∼ N(0.1 Let X ∼ N (0. For x ∈ Rk . x ∈ Rk . Σ) and Y = a + BX with B an invertible matrix. The mean and variance of the distribution are µ and σ 2 .8. and it is conventional to write X ∼ N (µ. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). Theorem A. q × q. then using the change-of-variables formula. Ir ) and set Q = X 0 X. respectively. 1). denoted χ2 . the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. ¢ ¡ 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 . Another useful fact is that if X ∼ N (µ. This shows that linear transformations of normals are also normal. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 .

11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. which can be found by applying change-of-variables to the gamma function. The MGF for the density (A.13) is the MGF of the density (A. C −1 CC 0 C −10 ) = N (0. Thus the density of Z 2 is (A. C −1 AC −10 ) = N (0.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.8. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. Set r Z . 1) and Q ∼ χ2 be independent. From (A. Using the simple law of iterated expectations.13).11) 2 with r = 1.8. Proof of Theorem A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .12) E exp (tQ) = 0 Γ (A.3 Let Z ∼ N (0.11). we see that the MGF of Z 2 is (1 − 2t)−1/2 . q Proof of Theorem A.8. tr has distribution 177 . For Z ∼ N(0.1. (A.Theorem A. which we showed in (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). tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. 1). Iq ). ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.3.2.8. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.

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

17) is often called the information matrix equality. θ Theorem A. θ) ≡ L(θ).1 ¯ ¯ ∂ E ln f (Yi .15) Two important features of the likelihood are Theorem A. θ) ∂θ ∂θ which holds at θ = θ0 by (A. ˆ →p θ0 as n → ∞.9. which maximizes the log-likelihood). cases are rare. Theorem A. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ0 ) .9. In fact. θ θ∈Θ ˆ In some simple cases.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . 179 .17) The matrix I0 is called the information.9. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . θ0 ) ln f (Yi . under conventional regularity conditions. we can see that it is an estimator of the maximizer θ of the right-hand-side.3 Under regularity conditions.16). θ) The Cramer-Rao Theorem gives a lower bound for estimation. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.14) ¶ ∂ ∂ 0 ln f (Yi . but these ˆ must be found by numerical methods. θ) →p E ln f (Yi . θ0 ) ∂θ∂θ 0 (A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. More typically. n n i=1 n As the MLE ˆ maximizes the left-hand-side. ∂θ ∂θ (A. then θ V ar(˜ ≥ (nI0 )−1 . θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. We can write this as ˆ = argmax Ln (θ).16) (A. and the equality (A. ˆ is consistent θ for this value. If ˜ is an unbiased estimator of θ ∈ R. I0 . the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.2 Cramer-Rao Lower Bound. However. we can ﬁnd an explicit expression for θ as a function of the data. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi .

ˆ . 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.18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. ˆ elements of n 0 Sometimes a parametric density function f (y. Typically. θ) θ In this case.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0. 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 . ˆ ln f Yi . Thus in large samples the MLE has approximately the best possible variance. θ) is necessarily the true density. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A. Therefore the MLE is called asymptotically eﬃcient. In this case there is not a “true” value of the parameter θ.17) does not hold.ˆ ˆ−1 θ We then set I0 = H −1 . Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance.9.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi . θ) is used to approximate the true unknown density f (y). θ). we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. but it is not literally believed that the model f (y. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y. A minor adjustment to Theorem (A.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . 180 . V ) . Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . since the information matrix equality (A. θ) = f (y) ln f (y. θ) ¶ dy Thus in large samples. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . θ (A. The QMLE is consistent for the pseudo-true value.

θ0 ) (Yi . . θ0 ) d˜ = E ˜ . 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 = . yn ). θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. ¯ ¯ ∂ E ln f (Yi . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ) f (˜. Since θ Z ˜ = ˜ y)f (˜. ∂θ ¯θ=θ0 Z ! = 0. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . we can show that E By direction computation. f (Yi . θ0 ) ∂ ∂θ f ∂ (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A.2.9. θ0 ) ln f (Yi . θ0 ) f (Yi . ∂2 ln f (Yi .Proof of Theorem A. θ0 )0 f (Yi . θ0 ) − f (Yi . To see (A. (Yi .17). θ0 ) ¯ ∂ f (y. θ0 ) ∂θ f (Yi . V ar (S) nH so ¥ 181 .16).. θ) d˜ = ˜ y ) ∂ ln f (˜. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 .1.. θ0 = ln f (Yi . θ) f (y. function of the data.9. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. Proof of Theorem A.9.1) has mean zero and variance nH.. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ) dy ¯ ∂θ f (y. θ0 )0 . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 )2 (Yi . θ0 ) ∂ ∂ − ln f (Yi .

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

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

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

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

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