This action might not be possible to undo. Are you sure you want to continue?

# ECONOMETRICS

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

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

1

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

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

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 . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

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

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

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

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

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 . . . . . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

ii

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

8 Cointegration . . . . . . . . 14. . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . B. . . . . . 160 16. . .4 Sample Selection . A. . . . . . . . . . . . . . . 13. . . . . .9 Maximum Likelihood . . . . . . . . . . . 13.3 Restricted VARs . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . A. . . 13. . . .1 Binary Choice . . . . . . . . . . . .5 Multivariate Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . .3 Expectation . .6 Selection of Lag Length in an VAR . . . . . . . . . iv . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Transformations . .2 Fixed Eﬀects . . . . . . .13 Multivariate Time Series 13. . . . . . . . . . . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Kernel Density Estimation . . . . . . . . .9 Cointegrated VARs . . . 13. . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . 13. . . . . . . . . . . B Numerical Optimization B. . . . . . . . . . . . . . .4 Common Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Estimation . . . . . . . . . . . . A. . . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . . . . . . B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . .6 Conditional Distributions and Expectation . . . . . . . .7 Granger Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 A Probability A. . . . . . . . . . . . . . . .3 Censored Data . . . . . . . . . . .8 Normal and Related Distributions . 14. .1 Foundations . . . . 159 16 Nonparametrics 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . .2 Random Variables . . . . . . . . . . . . . . . . . . . . . . . .4 Single Equation from a VAR . . . . . . . . . . . . . . . . . . . . . . . 157 15. 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . .1 Grid Search . . . . .2 Gradient Methods . . . . . . . .1 Individual-Eﬀects Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . . A. . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

A vector a is a k × 1 list of numbers. ⎠ . ⎟ ⎝ . We write this as ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ a=⎜ . . ak . ⎦ ⎣ .Chapter 2 Matrix Algebra This chapter reviews the essential components of matrix algebra. A matrix A is a k × r rectangular array of numbers. a vector a is an element of Euclidean k space. ⎦ . . ⎡ 0 ⎤ α1 ⎢ α0 ⎥ ¤ ⎢ 2 ⎥ £ A = a1 a2 · · · ar = ⎢ . ⎥ = [aij ] . If r = k = 1.1 Terminology Equivalently. hence a ∈ Rk . . . typically arranged in a column. A matrix can be written as a set of column vectors or as a set of row vectors. ⎥ ⎣ . . . . If k = 1 then a is a scalar. ak1 ak2 · · · akr By convention aij refers to the i0 th row and j 0 th column of A. That is. 2. written as ⎤ ⎡ a11 a12 · · · a1r ⎢ a21 a22 · · · a2r ⎥ ⎥ ⎢ A=⎢ . then A is a scalar. . α0 k where ⎢ ⎢ ai = ⎢ ⎣ 4 ⎡ a1i a2i . If r = 1 or k = 1 then A is a vector. aki ⎤ ⎥ ⎥ ⎥ ⎦ A scalar a is a single number.

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

. ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . . . . 0 0 ··· 1 2. which has ones on the diagonal. A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . . . The columns of a k × r matrix A.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. . A square matrix A is called orthogonal if A0 A = Ik . . ⎤ ⎥ ⎥ ⎥ ⎦ 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. Also. 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. ⎦ ⎣ . We say that two vectors a and b are orthogonal if a0 b = 0. then AIr = A and Ik A = A. An important diagonal matrix is the identity matrix. are said to be orthogonal if A0 A = Ir . For example. r ≤ k.

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

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

i Hence they must equal either 0 or 1. ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.4) H0 M =H 0 0 with H 0 H = In .... k)). . jk ) denote a permutation of (1.8 Determinant The determinant is deﬁned for square matrices. For a general k × k matrix A = [aij ] . .. and let επ = +1 if this count is even and επ = −1 if the count is odd.. . tr(A) = rank(A). • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ ..By the uniqueness of the characteristic roots.. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ .. Additionally. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. Let π = (j1 . we can deﬁne the determinant as follows. 2.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . . (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. If A is 2 × 2... Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . There are k! such permutations.. we deduce that Λ2 = Λ and λ2 = λi for i = 1.... It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.. ... ⎠ . xk ) : Rk → R. . xk ) be k × 1 and g(x) = g(x1 . then its determinant is det A = a11 a22 − a12 a21 .. k. k) . .

. is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. The vec of A. The Kronecker product of A and B. . . denoted A ⊗ B. ⎟ . an Let B be any matrix.9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. det(A ⊗ B) = (det (A))n (det (B))m • (A ⊗ B)−1 = A−1 ⊗ B −1 • If A > 0 and B > 0 then A ⊗ B > 0 • vec (ABC) = (C 0 ⊗ A) vec (B) • tr (ABCD) = vec (D0 )0 (C 0 ⊗ A) vec (B) 10 . . • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. . • If A is orthogonal. then det A = 2. . ⎣ ⎦ .• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. denoted by vec (A) . . . . am1 B am2 B · · · amn B Some important properties are now summarized. is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . then det A = ±1 ¢ ¡ = (det D) det A − BD−1 C if det D 6= 0 Qk i=1 aii • If A is triangular (upper or lower). ⎠ ⎝ . These results hold for matrices for which all matrix multiplications are conformable.

1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. ⎠ ⎝ .1. xki 3. the mean wage for men is $27. When a distribution is skewed. the mean is not necessarily a good summary of the central tendency.22.2) m(x) = E (yi | xi = x) = −∞ In general. (3. education and experience. In this context we partition the observations into the pair (yi . These are conditional density functions — the density of hourly wages conditional on race.1) xi = ⎜ . m(x) can take any form. Take a closer look at the density functions displayed in Figure 3. An important summary measure is the conditional mean Z ∞ yf (y | x) dy.1 displays the density1 of hourly wages for men and women. we can focus on f (y | x) . ⎟ . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. This is used when the goal is to quantify the impact of one set of variables on another variable. We call yi the dependent variable. Figure 3. The two density curves show the eﬀect of gender on the distribution of wages. These are indicated in Figure 3. See Chapter 16. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. In the example presented in Figure 3. holding the other variables constant. gender. . We call xi alternatively the regressor. These are asymmetric (skewed) densities. and exists so long as E |yi | < ∞. To illustrate. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. or the covariates. the conditional density of yi given xi . xi ) where yi is a scalar (real-valued) and xi is a vector.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. The data are from the 2004 Current Population Survey 1 11 . You can see that the right tail of then density is much thicker than the left tail. and that for women is $20.1.73. the conditioning variable. While it is easy to observe that the two densities are unequal.1 by the arrows drawn to the x-axis. which is a common feature of wage distributions. it is useful to have numerical measures of the diﬀerence.

A. 12 . Figure 3.3) White non-military male wage earners with 10-15 years of potential work experience.36.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. the solid line displays the conditional expectation of log wages varying with education.2 shows the density of log hourly wages for the same population. with mean log hourly wages drawn in with the arrows.Figure 3. Assuming for simplicity that this is the true joint distribution. When the distribution of the control variable is continuous. Of particular interest to graduate students may be the observation that diﬀerence between a B.3 displays a scatter plot2 of log wages against education levels.3 is how the conditional expectation describes an important feature of the conditional distribution. this yields the formula yi = m(xi ) + ei . The comparison in Figure 3. and a Ph. then comparisons become more complicated. which implies a 30% average wage diﬀerence for this population.1 is facilitated by the fact that the control variable (gender) is discrete.2) evaluated at the observed value of xi : ei = yi − m(xi ). 3. By construction.5. degree in mean log hourly wages is 0. implying an average 36% diﬀerence in wage levels. The conditional expectation function is close to linear. For this reason. Figure 3. 2 (3.30. To illustrate. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. The main point to be learned from Figure 3. the dashed line is a linear projection approximation which will be discussed in the Section 3. wage regressions typically use log wages as a dependent variable rather than the level of wages.D. The diﬀerence in the log mean wage between men and women is 0.

are often stated jointly as the regression framework. It is important to understand that this is a framework. These equations hold true by deﬁnition. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. 13 . most typically. E(ei ) = 0. E(xi ei ) = 0. The remaining parts of the Theorem are left as an exercise. The equations yi = m(xi ) + ei E (ei | xi ) = 0.Figure 3.1 Properties of the regression error ei 1. because no restrictions have been placed on the joint distribution of the data. E (h(xi )ei ) = 0 for any function h (·) . A regression model imposes further restrictions on the joint distribution. restrictions on the permissible class of regression functions m(x). 2. To show the ﬁrst statement. E (ei | xi ) = 0. not a model. 4. by the deﬁnition of ei and the linearity of conditional expectations.2.2: Log Wage Densities Theorem 3. 3.

3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. In contrast.2.3 Conditional Variance Generally.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . the conditional variance of yi is σ 2 = σ 2 (xi ).Figure 3. The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. The conditional standard deviation is its square root σ(x) = σ 2 (x).1. The right-hand-side is minimized by setting g(x) = m(x). Thus the mean squared error is minimized by the conditional mean. when σ 2 (x) is a constant so that ¢ ¡ (3. subject to the restriction p that it is non-negative. and can take any form. it does not provide information about the spread of the distribution. i . σ 2 (x) is a non-trivial function of x. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. let g(x) be an arbitrary predictor of yi given xi = x. To see this. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x .3. in the sense of achieving the lowest mean squared error. Given the random variable xi .

xki When m(x) is linear in x.6) (3. Notationally. they are also somewhat more dispersed.5. we assume that x1i = 1.1 and that for women is 10. The conditional standard deviation for men is 12. ⎝ . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . So while men have higher average wages. As an example.8) is called the linear regression model.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 . ⎟ . We call this the “constant” or “intercept”.1). it is convenient to augment the regressor vector xi by listing the number “1” as an element. In this case (3. Equivalently.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x).4 Linear Regression An important special case of (3. Instead. it is more realistic to view the linear speciﬁcation (3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.6) as an approximation. where x1i is the ﬁrst element of the vector xi deﬁned in (3. take the conditional wage densities displayed in Figure 3. i (3. its functional form is typically unknown. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . Equation (3. ⎠ .5) xi = ⎜ . Thus (3. ⎠ . which we derive in this section. βk ⎛ (3.we say that the error ei is homoskedastic.9) 3. and the linear assumption of the previous section is empirically unlikely to accurate. 3.7) is a k × 1 parameter vector.1.8) (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. 15 . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . ⎟ β=⎝ .

The error is i ei = yi − x0 β. As before. α0 E (xi x0 ) α = E (α0 xi )2 > 0. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. xi contains an intercept.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. i i (3. This occurs when redundant variables are included in xi .1 1.which is quadratic in β. 3. Rewriting. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . 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 .5. 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 16 . E (xi x0 ) is invertible.5. Equivalently. written E (xi x0 ) > 0. It is invertible if and only if it is positive deﬁnite. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.10) It is worth taking the time to understand the notation involved in this expression. x0 β is the best linear predictor for yi .12) This completes the derivation of the linear projection model. The ﬁrst-order condition for minimization (from Section 2. i which requires that for all non-zero α. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.1. The best linear predictor is obtained by selecting β to minimize S(β). In order for β to be uniquely deﬁned. i (3. Eyi < ∞. i (3. Therefore. E (x0 xi ) < ∞. 2 2. otherwise they are distinct. Assumption 3. Observe i that for any non-zero α ∈ Rk . this situation must be excluded. by “best” we mean the predictor function with lowest mean squared error. i 4.10). 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.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. Given the deﬁnition of β in (3. The vector (3. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.

Using the deﬁnitions (3.10) and (3.1.13) summarize the linear projection model.2 and 3.5.1 Under Assumption 3.1. the orthogonality restriction (3.12) can be alternatively interpreted as a projection decomposition.4 guarantees that the solution β exits. However.9). The ﬁnite variance Assumptions 3. Assumption 3.5.1. Assumption 3.Theorem 3.1 is employed to guarantee that (3. Since from Theorem 3.5.1. Furthermore. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.11) and (3.14) holds.5. Assumption 3.12) and (3. Figure 3. ¥ (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.5.14) Proof. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.14).1.4 is required to ensure that β is uniquely deﬁned. Let’s compare it with the linear regression model (3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0. By deﬁnition.5.14) follows from (3.1. Since ei is mean zero by (3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .5.3 ensure that the moments in (3. For example. Assumption 3.5.4 we know that the regression error has the property E (xi ei ) = 0. (3.8)-(3.13) implies that xi and ei are uncorrelated.1.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.5.11) are well deﬁned. (3.13) The two equations (3.2 and 3. it follows that linear regression is a special case of the projection model. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .3 are called regularity conditions.1 are weak.2. 17 . E (xi ei ) = 0 and E (ei ) = 0.1.10) are deﬁned.5.1. This means that the equation (3.13) and Assumption 3.1.1.5. Equation (3.

Other than the redeﬁnition of the regressor vector. In this case the linear projection is a poor approximation to the conditional mean. for those over 53 in age). it is important to not misinterpret the generality of this statement. Figure 3. No additional assumptions are required.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. and under-predicts for the rest.3. Figure 3. and are discussed in Chapter 11. since the resulting function is quadratic in experience. In this example it is a much better approximation to the conditional mean than the linear projection. there are no changes in our methods or analysis.1.5.1 may be false. xi ) we can deﬁne a linear projection equation (3. and the straight dashed line is the linear projection. The linear equation (3.10).5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.12) with the properties listed in Theorem 3.10) may not hold and the implications of Theorem 3. These structural models require alternative estimation methods. Most importantly. the dashed line is the linear projection of log wages on eduction. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. This defect in linear projection can be partially corrected through a careful selection of regressors.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. 18 . However. we can augment the regressor vector xi to include both experience and experience2 . in many economic models the parameter β may be deﬁned within the model. The solid line is the conditional mean. In other cases the two may be quite diﬀerent. In the example just presented. In this case (3. In this example the linear projection is a close approximation to the conditional mean. It over-predicts wages for young and old workers.4 we display as well this quadratic projection. Returning to the joint distribution displayed in Figure 3. In contrast.5. A projection of log wages on these two variables can be called a quadratic projection.4 displays the relationship3 between mean log hourly wages and labor market experience.We have shown that under mild regularity conditions. In Figure 1. for any pair (yi . We illustrate the issue in Figure 3.

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

i 11. σ = . True or False. σ 2 = V ar(xi ). y) = 3 x2 + y 2 on 0 ≤ x ≤ 1.6 Exercises 1. If yi = x0 β + ei and E(xi ei ) = 0. 1. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . E(ei | xi ) = 0. then E(x2 ei ) = 0. If yi = xi β + ei . µ. and E(e2 | xi ) = σ 2 . σ 2 = V ar(yi ) and σ xy = Cov(xi . If yi = xi β + ei .3. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . x 6.4 . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . e−λ λj j! . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. then E(x2 ei ) = 0. xi ∈ R.1 . i 8. 0 ≤ y ≤ 1. xi ∈ R. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi .1. Let X be a random variable with µ = EX and σ 2 = V ar(X). and E(xi ei ) = 0. j! 0 j = 0. 2. s) = 0 if and only if m = µ and s = σ 2 . True or False. True or False.2. m. and have the following joint probability distribution X=0 X=1 Y =0 . Compute E(yi | xi = x) and V ar(yi | xi = x). If yi = x0 β + ei . a constant. then ei is i i independent of xi .. 2. 20 .3 Find E(Y | X = x). Let xi and yi have the joint density f (x. then ei is independent of xi .. Suppose that yi is discrete-valued. ¡ ¢ 4. µx = Exi . . then E(ei | xi ) = 0. E(Y 2 | X = x) and V ar(Y | X = x). If yi = x0 β + ei and E(ei | xi ) = 0. i 7. True or False. taking values only on the non-negative integers. 3. Prove parts 2. Are they diﬀerent? Hint: If P (Y = j) = 5. i 10. Suppose that Y and X only take the values 0 and 1.2 Y =1 . (x − µ)2 − σ 2 Show that Eg (X. and E(ei | xi ) = 0. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. 3 and 4 of Theorem 3. yi ). Compute the conditional mean m(x) = E (yi | xi = x) . True or False. 9.

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 . Observe that (4.1) (4. but for most of the chapter we retain the broader focus on the projection model.4) i i=1 i=1 ˆ Another way to derive β is as follows.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.1 Estimation Equation (4. 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 . (4.2) (4. we narrow the focus to the linear regression model.8.7 and 4. i n i=1 n 21 .3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . 4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . i It follows that the moment estimator of β replaces the population moments in (4.2) can be written in the parametric 0 β)) = 0.3) In Sections 4.

40 µ ¶µ ¶ 34.30 + 0. excluding military.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.4).2 Least Squares There is another classic motivation for the estimator (4. 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 (4.71 = −2.117 Educationi . 40 0. This sample has 988 observations. 30 = . These are white male wage earners from the March 2004 Current Population Survey.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.7% increase in mean wages.4). 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. consider the data used to generate Figure 3. with 10-15 years of potential work experience.14 205. Then µ ¶ n 1X 2. 40 2. An interpretation of the estimated equation is that each year of education is associated with an 11.37 µ ¶ 1. i 22 .170 37. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.14 14. 4.14 205.117 1 14.14 14.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. 0. ¶ 2.94 −2.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.3. To illustrate.95 42.95 xi yi = 42.83 ¶−1 µ ¶ .

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

ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero.7) A justiﬁcation for the latter choice will be provided in Section 4. 24 . The error variance σ 2 = Ee2 is also a parameter of interest. ˆ n i=1 n Since xi contains a constant.Figure 4.6) An alternative estimator uses the formula n 1 X 2 s = ei . ˆ n−k 2 i=1 (4. one implication is that n 1X ei = 0. and hold true for all linear regression estimates. Its method of moments estimator is the sample average 1X 2 ei . It measures the variation in the i “unexplained” part of the regression.5) implies that 1X xi ei = 0. ˆ σ = ˆ n 2 i=1 n (4. These are algebraic results.7.2: Sum-of-Squared Error Function Contours Equation (4.

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

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

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

ˆ which are “demeaned”. 4.13). . 30 . .1 (Frisch-Waugh-Lovell). 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) . In this case. .9). . and X2 is the vector of observed regressors. . the FWL theorem can be used to speed computation. but in most cases there is little computational advantage to using the two-step algorithm. .9). . ⎠ ⎝ ⎠ ⎝ . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. ˆ ˜ ˜ ˆ 3. is the demeaning formula for regression.14) or via the ˆ following algorithm: ˜ 1. ¡ ¢−1 0 ι. the primary use is theoretical. Rather. which you may have seen in an introductory econometrics course. observe that ⎞ ⎛ ⎞ ⎛ . In this section we derive the small sample conditional mean and variance of the OLS estimator. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 .Theorem 4. obtain residuals Y . By the independence of the observations and (3. . ˜ 2. .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. . A common application of the FWL theorem. Regress X2 on X1 . Partition X = [X1 X2 ] where X1 = ι is a vector of ones.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. Regress Y on X1 . In some contexts. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. obtain residuals X2 .6. In the model (4. obtain OLS estimates β 2 and residuals e. Regress Y on X2 . 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. ⎟ ⎜ ⎟ ⎜ (4.8)(3.

. . . . V ar β | X = X 0 X ⎟ ⎟ ⎟. 1 n . and the trace operator observe that.20) .8). the properties of conditional expectations. σ 2 } = ⎜ . . . ⎠ (4. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for 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.. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . . ⎝ . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 .12). . under the of ˆ ¢ 2 | x = σ 2 . 0 0 ··· 0 0 ..Using (4. . Next. we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0.. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ . Then given (4. and (4.18). X 0 DX = X 0 Xσ 2 . From (4. ¡ 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 ) = 0.19) 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 .19) ˆ and thus the OLS estimator β is unbiased for β.

In the homoskedastic linear regression model. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . however. In this case. which we now present. the estimator ˆ 2 deﬁned (4. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. 32 . or in the projection model. The following result. the best (minimumvariance) unbiased linear estimator is OLS. Now consider the class of estimators of β which are linear functions of i the vector Y. says that the least-squares estimator is the best choice. that this estimator is only unbiased in the special case of the homoskedastic linear regression model.8)¢ ¡ (3.8.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. It is important to remember.7) is unbiased for σ 2 by this calculation. known as the Gauss-Markov theorem.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . ˜ so β is unbiased if (and only if) A0 X = Ik .10). = σ2 n the ﬁnal equality by (4. It is not unbiased in the absence of homoskedasticity. is a famous statement of the solution. ³ ´ ˜ E β | X = A0 Xβ. as it yields the smallest variance among all unbiased linear estimators. Thus since V ar (e | X) = In σ 2 under homoskedasticity. which is (3. As an alternative. 4. By a calculation similar to those of the previous section. Thus σ 2 is biased towards zero. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 .9) plus E e2 | xi = σ 2 .1 Gauss-Markov. 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. What is the best choice of A? The Gauss-Markov theorem. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. Theorem 4.

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

9).5. (4. Chamberlain (1987) extends this argument to the case of continuously-distributed data.10) for the class of models satisfying Assumption 3. the maximum likelihood estimator is identical to the OLS estimator. He proves that generically the OLS estimator (4. 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 . Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. and thus so is the OLS estimator. 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 observes that the above argument holds for all multinomial distributions.22) 34 . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. if the data have a discrete distribution. 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 .10 Omitted Variables xi = µ x1i x2i ¶ .1.Substituting in the expressions for π j .

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

As a consequence. ˆ i A simple comparison yields that ˆ ei − ei.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . To investigate the possibility of inﬂuential observations. that is.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. We can also deﬁne the leave-one-out residual ˆ ˆ ei. 1] and sum to k. What is happening is that when the regressors are highly dependent. deﬁne the leave-one-out least-squares estimator of β. ˆ ˆ (4. the OLS estimator based on the sample excluding the i’th observation.25) below. We derive expression (4. 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. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. 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.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. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.−i = yi − x0 β (−i) = (1 − hi )−1 ei . the precision of individual estimates are reduced.−i = (1 − hi )−1 hi ei . the worse the precision of the individual coeﬃcient estimates. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4.27) (4. If the i’th observation 36 .One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced.26) As we can see. The hi take values in [0.

Investigations into the presence of inﬂuential observations can plot the values of (4. The key is equation (2. ˆ We now derive equation (4. ¢−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 .25).1) in Section 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 .27). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

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

¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.1 Central Limit Theorem (CLT). (5. denoted Zn →d Z. If Xi ∈ Rk is iid and E |Xi |2 < ∞. as needed. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.7). ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. Set ε = δη/3.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ¡¯ ¯ P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ η.4). the fact that X n = W n + Z n . V ) .1). Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.5). we can set E(X) = 0 (by recentering Xi on its expectation). We say that Zn converges in distribution to Z as n → ∞. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. and the bound |Wi | ≤ 2C. Fn (x) → F (x) as n → ∞.6) By Jensen’s inequality (5.6) and (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . 5.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .3. where Z has distribution F (x) = P (Z ≤ x) . Theorem 5. Finally. 43 . if for all x at which F (x) is continuous.1) and (5. the triangle inequality. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . Jensen’s inequality (5.Proof: Without loss of generality. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. the fact that the Wi are iid and mean zero.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. by Markov’s inequality (5. Fix δ and η.

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

Stacking across elements of g. ¥ 5. √ Theorem 5. This is suﬃcient to establish the theorem. and g(θ) : Rm → Rk . gθ Σgθ . Hence g(Zn ) →p g(c) as n → ∞. then g(Zn ) →d g(Z) as n → ∞.2 Continuous Mapping Theorem 2.4. Ik ) distribution. Since cλλ (λn ) → cλλ (0) = −Ik . k ≤ m. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). If Zn →p c as n → ∞ and g (·) is continuous at c. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Recall that A ⊂ B implies P (A) ≤ P (B). Σ) . Proof: Since g is continuous at c. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. then g(Zn ) →p g(c) as n → ∞. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. 45 . Theorem 5. for each element of g. If Zn →d Z as n → ∞ and g (·) is continuous. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 . Σ) = N 0. we see that as n → ∞. where θ is m × 1 and Σ is m × m.4. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.√ where λn → 0 lies on the line segment joining 0 and λ/ n. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. Proof : By a vector Taylor series expansion.1 Continuous Mapping Theorem 1 (CMT).4 Asymptotic Transformations Theorem 5.3 Delta Method: If n (θn − θ0 ) →d N (0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.4.

The verticle line marks the true value of the projection coeﬃcient. In general. the density function of β 2 was computed and plotted in Figure 6. since it is a function of the random data. ˆ Figure 6. 46 .1 for sample sizes of n = 25. and therefore has a sampling distribution. Using ˆ simulation methods. xi ) and the sample size n. n = 100 and n = 800.1 Sampling Distribution The least-squares estimator is a random vector. its distribution is a complicated function of the joint distribution of (yi . 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.Chapter 6 Inference 6. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density.1: Sampling Density of β 2 To illustrate the possibilities in one example.

1).1 and the WLLN (Theorem 5. 6.1 Under Assumption 3. This is illustrated in Figure 6.2).2 Consistency ˆ As discussed in Section 6. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. As the sample size increases the density becomes more concentrated about the population coeﬃcient. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. xi ei →p g (Q. n i=1 (6.4 implies that Q−1 exists and thus g(·. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .3) Ã where g(A. we can conclude ˆ that β →p β.1). 0). (6. Hence by the continuous mapping theorem (Theorem 5.1).1 by the fact that the sampling densities become more concentrated as n gets larger.2.1) and ˆ We now deduce the consistency of β. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.1.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1.5.5.2) i i n i=1 n From (6. β →p β as n → ∞.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.1).8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . First. Assumption 3.3). Assumption 3. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 . (6.4. Ã n ! n X 1X 0 1 ˆ xi xi . Equation (4. (6. ˆ 47 . ·) is continuous at (Q.4.2. using (6. For a complete argument. To characterize the sampling distribution more fully.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. ˆ Theorem 6. and the continuous mapping theorem (Theorem 5.5. we will use the methods of asymptotic approximation. Proof. the OLS estimator β is has a statistical distribution which is unknown.

6) n i=1 48 .3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . i i Assumption 6.Theorem 6. n 1 X √ xi ei →d N (0.1 In addition to Assumption 3.3.2. Ω) . Ee4 < ∞ and E |xi |4 < ∞.3.1).1. (6. We need a strengthening of the moment conditions. (6.1 guarantees that the elements of Ω are ﬁnite. By the central limit theorem (Theorem 5. E ¯ei ¯ E ¯e4 ¯ i i i i (6.3) and Theorem (6. ˆ Finally.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 .3. (6. ˆ n−k 6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. To see this. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. Assumption 6. it follows that s2 = ¥ n σ 2 →p σ 2 .2).2. ˆ Proof.5.5.2 Under Assumption 3. (6.1. by the Cauchy-Schwarz inequality (5.1).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. Thus σ 2 is consistent for σ 2 . since n/(n − k) → 1 as n → ∞.

3. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.7) Cov(xi x0 . however.7) holds.9) In (6. Ω) ¡ ¢ = N 0.9) we deﬁne V 0 = Q−1 σ 2 whether (6.1. 1) asymptotic distibution.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . V ) where V = Q−1 ΩQ−1 . In Figure 6. We call V 0 the homoskedastic covariance matrix. xi ) which satisfy the conditions of Assumption 6. In´Figure 6. e2 ) = 0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.2). but this is not a necessary condition. its variance diverges q ³ ´ ˆ to inﬁnity.3. 1 X √ xi ei n i=1 n ! the N (0. How large should n be in order for the approximation to be useful? Unfortunately. i i Condition (6. otherwise V 6= V 0 .3.1).3.7) is true then V = V 0 . is approximately normal when the sample size n is suﬃciently large. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.1 Under Assumption 6. 1).1. V is often referred to as ˆ the asymptotic covariance matrix of β. For α 49 . Let yi = β 0 + β 1 xi + εi where xi is N (0. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). The expression V = Q−1 ΩQ−1 is called a sandwich form.Then using (6. |ε| ≥ 1. We illustrate this problem using a simulation.6).2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . When (6.3. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. for example. Theorem 6. The trouble is that no matter how large is the sample size. As α approaches 2. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . However. There is a special case where Ω and V simplify.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.7) is true or false. there is no simple answer to this reasonable question. Q−1 ΩQ−1 . for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. Under (6.1 states that the sampling distribution of the least-squares estimator. and (6. The asymptotic distribution ´ Theorem 6. setting n = 100 and varying the parameter α. (6. when xi and ei are independent. This holds true for all joint distibutions of (yi . We say that ei is a Homoskedastic Projection Error when (6. after rescaling.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. The approximation may be poor when n is small.

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. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .Figure 6. As α diminishes the density changes signiﬁcantly.11) 50 . 1). concentrating most of the probability mass around zero. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.3. We show the sampling distribution of n β 1 − β 1 setting n = 100. 1) asymptotic approximation is never guaranteed to be accurate. 6 and 8.2 and 6. The estimator 2 2 in (6.1) it is clear that V 0 →p V 0 .2) and Theorem 6. 1) density. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. Another example is shown in Figure 6. the sampling distribution becomes highly skewed and non-normal.0 the density is very close to the N (0.2: Density of Normalized OLS estimator α = 3.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. As k increases. 4.10) V 0 = Q−1 s2 . we need an estimate of Ω = E xi x0 e2 .3 is that the N (0.10) without changing this result. for k = 1. 6. The lesson from Figures 6.2.

3: Sampling distribution where ei are the OLS residuals. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β.Figure 6. the “Eicker-White formula”. . as it is not always clear which has been computed. The methods switched during ˆ the late 1980s and early 1990s. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. we focus on individual elements of β one-at-a-time. we set s(β) = n−1/2 V . When β is a vector. many authors will state that their “standard errors have been corrected for heteroskedasticity”. the “Huber formula”. and V is an estimator of the variance of n β − β . ˆ ˆ When V is used rather than the traditional choice V 0 . In most cases. the “Huber-White formula” or the “GMM covariance matrix”.. When reading and reporting applied work. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . A more easily interpretable measure of spread is its square root — the standard deviation. and was still the standard choice for much empirical work done in the early 1980s. as there may be more than one estimator of the variance of the estimator. vis. It is therefore important to understand what formula and method is 51 . or that they use the “White formula”. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. ˆ ˆ Deﬁnition 6.. it is important to pay ˆ ˆ attention to the distinction between V 0 and V .. β j . 1.4. these all mean the same thing. 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). k. or that they use a “heteroskedasticity-robust covariance matrix estimator”. Generically.. j = 0. This motivates the deﬁnition of a standard error. standard errors are not unique.

14 205. The standard errors for β 0 are 7.20 −0. First. n n i=1 52 .12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. Using (6.used by an author when studying their work.480 ˆ0 = 0.14 205. then take the diagonal elements. p ˆ In this case the two estimates are quite similar.14 205.6 ¶µ 1 14. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.480 . i i i i n i=1 Second. from which it follows that V →p V as n → ∞.117 Educationi .20 = V 14.14 14.085 p ˆ and that for β 1 is .493 −0. Ω 2.30 + 0.039 and ˆ V = µ 1 14. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . To illustrate.14 6.035 ¶ .80 2.2/988 = .35/988 = . (6. (6.80 40.1. but not under another set of assumptions. (.5) and the WLLN (Theorem 5.80 40.5 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.20 and µ ¶ ˆ = 0. and then the square roots.020.83 ¶−1 = µ 7.020) 6.085) (. by Holder’s inequality (5. We calculate that s2 = 0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.80 . just as any other estimator.14 14. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.83 −0.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. we return to the log wage regression of Section 4.199 2. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .199 2.98 −0.4) 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 . From a computational standpoint.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.83 ¶−1 µ .12) in turn.493 0.2.

you can show that 1 Xˆ ¯ β= β (−i) . n i=1 n ˆ ˆ Theorem 6. which.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.13) Using formula (4. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . i=1 Third.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . From equation (3. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. ¯ ¯n ¯ n i=1 so Together. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .5.11) with the leave-one-out estimator ei. these establish consistency.25). ¯ 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 0.1 As n → ∞. Using this substitution. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. Andrews (1991) suggested an similar estimator based on cross-validation. 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. Ω →p Ω and V →p V. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6. 6.−i = (1 − hi )−1 ei ˆ presented in (4.13) of Efron (1982). Recall from Section 4.26). 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.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.14) 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 .

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

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

or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . 1). 56 . however. associated with Fisher. pn →d U [0. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. In a sense. Otherwise the test does not reject. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. 1).The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . regardless of the complication of the distribution of the original test statistic. from which it follows that pn →d U [0. If the p-value pn is small (close to zero) then the evidence against H0 is strong. The coverage probability is P (θ ∈ Cn ). 1]. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. 6. Let zα/2 is the upper α/2 quantile of the standard normal distribution. in that the reader is allowed to pick the level of signiﬁcance α. It is designed to cover θ with high probability. if Z ∼ N (0. z.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α.645. That is. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0.96 and z.025 = 1. Deﬁne the tail probability. Then the asymptotic p-value of the statistic tn is pn = p(tn ). This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. and is a function of the data and hence is / random. The p-value is more general. is to report an asymptotic p-value. For example.05 = 1. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . s(ˆ θ) Under H0 . An alternative approach. 1]. That is. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. tn →d N (0. 1]. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. or “accepts” H0 . To see this fact. under H0 . note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). The asymptotic p-value for the above statistic is constructed as follows. Either θ ∈ Cn or θ ∈ Cn .

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

where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. 1] under H0 .1 showed θ ˆ that V →p V.10.84 = z. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. The asymptotic p-value for Wn is pn = p(Wn ). then Wn →d χ2 . 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. and Theorem 6. As before.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 .15) showed that n ˆ − θ →d Z ∼ N (0. Vθ ).When h is a linear function of β. Hβ (β) →p Hβ . For example. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . 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. θ = β 2 . The null hypothesis is H0 : β 2 = 0.2. and there are q = k2 restrictions.19) σ2 ˆ where σ2 = ˜ 1 0 e e. Hβ (β) is a continuous function of β.8. the test rejects at the α% level iﬀ pn < α. ˜˜ n ˜ e = Y − X1 β 1 . the upper-α quantile q 2 of the χ2 distribution. q and pn is asymptotically U[0. ˆ Wn = n θ θ q θ θ Theorem 6. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).05) = 3.1 Under H0 and Assumption 6. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .1. Furthermore.5. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . h(β) = R0 β. χ2 (.025 . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). a chiq square random variable with q degrees of freedom. if rank(Hβ ) = q. Also h(β) = a selector matrix. In this case. 6. Hence β β by Theorem A.3.

and σ2 = ˆ 1 0 e e. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . 59 . Also.19) the F form of the Wald statistic. Because of this connection we call (6. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. as the sum of squared errors is a typical output from statistical packages. Now consider the residual regression of e on X2 = M1 X2 . the residual is ˜ ˜ e = M1 Y. X2 ). note that if we regress Y on X1 alone. By the FWL theorem. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. 2 σ ˆ To simplify this expression further. We now derive expression (6. 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 ¶ . still this formula often ﬁnds good use in reading applied papers.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. First.are from OLS of Y on X1 . Thus ˜ ˆ e=X ˜ ˆ 2 ³ ´0 ³ ´ ˜ ˆ ˜ ˆ e0 e = X2 β 2 + e ˜˜ ˆ ˆ X2 β 2 + e ˆ0 ˜ 0 ˜ ˆ = β 2 X2 X2 β 2 + e0 e ˆˆ 0 0 ˆ ˆ ˆˆ = β X M1 X2 β + e0 e.19).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 . The elegant feature about (6.19) is that it is directly computable from the standard output from two simple OLS regressions. 2 2 2 or alternatively. Thus ¡ 0 ¢−1 R = X2 M1 X2 and ³ ¡ ´−1 ³ ¢−1 ´−1 ¡ 0 ¢ ˆ = σ −2 n−1 R0 X 0 X ˆ R = σ −2 n−1 X2 M1 X2 ˆ R0 V 0 R ³ ´−1 ˆ0 ˆ ˆ Wn = nβ 2 R0 V 0 R β2 = 0 ˆ ˆ0 β 2 (X2 M1 X2 ) β 2 . note that partitioned matrix inversion (2. ˆˆ n ˆ e = Y − X β.

This is rarely an issue today. In ) . an “F statistic” is reported. including the estimated error variance 2. 6. there is an exact distribution theory available for the normal linear regression model. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression.3. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. In σ 2 . H 0 H) ∼ N (0.4)) where H 0 H = In . n−k 60 . e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . introduced in Section 4. Let u = σ −1 H 0 e ∼ N (0. The modelling assumption that the error ei is independent of xi and N (0. it follows ˆ that β is independent of any function of the OLS residuals. equivalently the residual variance from an intercept-only model. Since uncorrelated normal variables are independent. these cases are atypical. This was a popular statistic in the early days of econometric reporting. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . when an OLS regression is reported.12 Normal Regression Model As an alternative to asymptotic distribution theory. In particular. While there are special cases where this F statistic is useful. Since linear functions of normals are also normal.where In many statistical packages. this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. σ 2 ) can be be used to calculate a set of exact distribution results.

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

By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . Our ﬁrst-order asymptotic theory is not useful to help pick s. they can work quite poorly when the restrictions are nonlinear. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. 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. 6. This can be seen by a simple example introduced by Lafontaine and White (1986). the statistic Wn (s) varies with s. In the present context of the Wald statistic. we have plotted in Figure 6. while there are other values of s for which test test statistic is insigniﬁcant. 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. The decreasing dashed ˆ = 1.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . setting n/σ 2 = 10. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. features of this distribution can be calculated. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. The increasing solid line is for the case β = 0. as Wn (s) →d χ2 under H0 for 1 any s. To demonstrate this eﬀect.4 the Wald statistic Wn (s) as a function ˆ of s.7. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.8. This produces random draws from the sampling distribution of interest. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Through repetition. σ 2 ) and consider the hypothesis H0 : β = 1.84 — the probability of a false rejection. 62 . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. ˆ Let β and σ 2 be the sample mean and variance of yi . Take the model yi = β + ei ei ∼ N (0. Letting h(β) = β s . and noting Hβ = sβ s−1 . This is an unfortunate feature of the Wald statistic.

and rarely fall outside of the 3%-8% range.1 reports the simulation estimate of the Type I error probability from 50. remember that the ideal Type I error probability is 5% (.000 simulated Wald statistics Wn (s) which are larger than 3. The null hypothesis β s = 1 is true.Figure 6. In each case.4: Wald Statistic as a function of s P (Wn (s) > 3. and σ is varied among 1 and 3. so these probabilities are Type I error.4.000 random samples. Error rates avove 10% are considered excessive.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .05) with deviations indicating+ distortion.84.1 we report the results of a Monte Carlo simulation where we vary these three parameters. These probabilities are calculated as the percentage of the 50. To interpret the table.84 | β = 1) . the Type I error probability improves towards 5% as the sample size n increases. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. Table 4. the only test which meets this criterion is the conventional Wn = Wn (1) test. Type I error rates between 3% and 8% are considered reasonable. In Table 2. Any other choice of s leads to a test with unacceptable Type I error probabilities. Rates above 20% are unexceptable. this probability depends only on s. Table 4. we compare the rates row by row. n. When comparing statistical procedures. The value of s is varied from 1 to 10. n is varied among 20. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. no magic choice of n for which all tests perform uniformly well.1 you can also see the impact of variation in sample size. Given the simplicity of the model. Typically. looking for tests for which rate rejection rates are close to 5%. For this particular example. In Table 4. There is. however. and σ 2 . 100 and 500. Test performance deteriorates as s increases.

20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .20 . Other choices are arbitrary and would not be used in practice.15 .08 .06 .10 .33 . so the hypothesis can be stated as H0 : θ = r.22 . deﬁne θ = β 1 /β 2 .22 .06 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.15 .06 .05 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.05 .18 . β 1 .13 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.06 .08 .13 .07 .31 .07 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 .17 .26 .21 .25 .34 .16 Rejection frequencies from 50.30 . 64 .11 .12 .10 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .05 .20).15 .28 .20 .10 . β 2 ) be the least-squares estimates of (6.35 .06 .s 1 2 3 4 5 6 7 8 9 10 Note: σ=1 σ=3 n = 20 n = 100 n = 500 n = 20 n = 100 n = 500 .05 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .25 .15 .08 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.06 .19 .07 .06 .08 .09 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.13 .23 . Equivalently.12 .14 . While this is clear in this particular example.07 .24 .07 .08 .05 .05 . This point can be illustrated through another example.14 .

05 . Table 4. The implication of Table 4.000 simulated samples. 6.06 .10 .06 . . However.05 .05.09 .00 .05 . In contrast. . We vary β 2 among .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.26 . If no linear formulation is feasible.15 .28 . In this section we describe the method in more detail.75 1. ei be an independent N (0.00 . the entries in the table should be 0.645) and P (tn > 1. while the right tail probabilities P (t1n > 1. and alternatives to asymptotic critical values should be considered.05 . especially for small values of β 2 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .12 .06 .00 .645) are close to zero in most cases. 65 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.645) P (tn < −1. if the hypothesis can be expressed as a linear restriction on the model parameters.06 .05 . This leaves β 2 as a free parameter.7. . In all cases.05 .06 .0 and n among 100 and 500.07 .00 . Ideally. The results are presented in Table 4.645) P (tn > 1.05 .06 . We let x1i and x2i be mutually independent N (0. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .15 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.00 .645) P (tn > 1.75. and are close to the ideal 5% rate for both sample sizes.00 . and 1. such as the GMM distance statistic which will be presented in Section 9.06 .10 .2.50.10 .1. then the “most linear” formulation should be selected.06 .645) are calculated from 50. The left tail probabilities P (t1n < −1.645) greatly exceed 5%.05 .645) t1n t2n t1n t2n t1n t2n t1n t2n . It is also prudent to consider alternative tests to the Wald statistic. the rejection rates for the t1n statistic diverge greatly from this value.06 .05 β2 . this formulation should be used. and normalize β 0 = 0 and β 1 = 1. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.00 The one-sided Type I error probabilities P (tn < −1. along with sample size n.00 .25 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .06 .00 .00 . 1) variables.02 .05 .47 . σ 2 ) draw with σ = 3.50 .25.

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

6. The average (6. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. Often this is called the number of replications. hispanic. Hence the ³ ´ ˆ standard errors for B = 100. B b=1 (6. union member. therefore. For example.96) is iid Bernoulli. and non-white. In particular. and estimate a multivariate regression. immigrant. 1000. potential work experience. an estimator or test may perform wonderfully for some values. In practice. we included a dummy 67 . For the dependent variable we use the natural log of wages. then B will have to be increased. if we set B = 999. The random variable 1 (Tnb ≥ 1. so that coeﬃcients may be interpreted as semi-elasticities. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. If the standard error is too large to make a reliable inference. It is therefore convenient to pick B so that N is an integer. potential work experience. As P is unknown. . B. experience squared. but requires more computational time. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. female. the researcher must select the number of experiments. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. immigrant. Generally. the performance will depend on n and F. are.022. s P = .22/ B. As discussed above. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. experience squared. respectively. and poorly for others. equalling 1 with probability P = E1 (Tnb ≥ 1. and 5000. and our regressors include years of education. for a selection of choices of n and F. and 90% sample quantiles of the sample {Tnb }. For example. excluding military. a larger B results in more precise estimates of the features of interest of Gn .21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. then we can set s P = (.003. In many cases. Furthermore.96) . Quite simply.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. We now expand the sample all non-military wage earners.96) . and dummy variable indicators for the following: married. union member. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. the choice of B is often guided by the computational demands of the statistical procedure. It is therefore useful to conduct a variety of experiments.95) /B ' . and dummy variable indicators for the following: married. such as the percentage estimate reported in (6.21). The α% sample quantile is a number qα such that α% of the sample are less than qα . female. it is simple to make inferences about rejection probabilities from statistical tests. Again our dependent variable is the natural log of wages.05) (. We us the sample of wage earners from the March 2004 Current Population Survey.15 Estimating a Wage Equation We again return to our wage equation. and therefore it is straightforward to calculate standard errors for any quantity of interest. and hispanic. and . We separately estimate equations for white and non-whites.007. Then qα is the N ’th number in this ordered sequence. For regressors we include years of education. where N = (B +1)α. this may ˆ be approximated by replacing P with P or with an hypothesized value.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test.

Ignoring the other coeﬃcients.033 −. The available sample is 18. θ ˆ 2β 3 β2 . Table 4.808 so the parameter estimates are quite precise and reported in Table 4.variable for state of residence (including the District of Columbia. Computing the Wald statistic (6.010 . Alternatively.1.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.34 ˆ s(β) .001 .027 .00002 .070 . reestimating the model with the 50 state dummies excluded. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.4945. 808 1 − .808 .48772 = 515. Wn = n 1 − 2 = 18.097 −. Using either statistic the hypothesis is easily rejected. The F form of the Wald statistic (6. we can write this eﬀect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model.49452 σ ˜ Notice that the two statistics are close.18) that the state coeﬃcients are jointly zero.102 −.008 .002 . we ﬁnd Wn = 550.007 .101 .032 .102 −.00057 .69. the restricted standard deviation estimate is σ = .4877 18. 2β 3 68 .121 −.19) is ˜ µ ¶ µ ¶ σ2 ˆ .013 . excluding the coeﬃcients on the state dummy variables.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.014 .232 . this adds 50 regressors).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. as the 1% critical value for the χ2 distribution is 76. but not equal.

implying a 95% conﬁdence θ) interval of [27.9. This set is [27.5].96. 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.Using the Delta Method. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. we can calculate a standard error of s(ˆ = . so we have to go one step further. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. we found better Type I error rates by reformulating the hypothesis as a linear restriction. Instead.5].40. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. 29. there is not a simple expression for this set. but the lower end is substantially lower. 69 . This is the set of θ such that |tn (θ)| ≤ 1. However. Since tn (θ) is a non-linear function of θ. not testing a hypothesis. this is a poor choice.0. In the present context we are interested in forming a conﬁdence interval. 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 ). 29.

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

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

Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi .2) E (ξ i | xi ) = 0.. Typically..1 Generalized Least Squares In the projection model. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi .1) infeasible since the matrix D is unknown.. the least-squares estimator is ineﬃcient. 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. However. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1) XD Y β = X 0 D−1 X ¡ ¢ 2 . z1i are squares (and perhaps levels) of some (or all) elements of xi . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . The GLS estimator (7. 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.. σ 2 }. Often the functional form is kept simple for parsimony. we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. . The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. Let η i = e2 . 74 . . σ1 We now discuss this estimation problem.. where z1i is some q × 1 function of xi . σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .Chapter 7 Additional Regression Topics 7..

˜i Suppose that σ 2 > 0 for all i. 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 .Suppose ei (and thus η i ) were observed. or FGLS. then the FGLS ˜i estimator is not well deﬁned.. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0. We may call (7. Vα ) (7. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. if σ 2 ≈ 0 for some i. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. If σ 2 < 0 for some i.3) ˆ ˆ While ei is not observed. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi .4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0.6) σ 2 = α0 zi . One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. there is no guarantee that σ 2 > 0 for all i. then the FGLS estimator will force ˜i the regression equation through the point (yi .. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi .. This suggests 75 . We have shown that α is consistently estimated by a simple procedure. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. as it is estimating the conditional variance of the regression of yi on xi . 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). estimator of β. which is typically undesirable. xi ). Then set ˜i ˜ D = diag{˜ 2 . Vα = E zi zi (7. This is the feasible GLS. .5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant.4) the skedastic regression. Furthermore.

that there is a need to bound the estimated variances away from zero.1.1 If the skedastic regression is correctly speciﬁed. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). Since the form of the skedastic regression is unknown. V n n i=1 . Instead. Theorem 7. the natural estimator of the asympˆ totic variance of β is Ã n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. e2 }.2) is correctly speciﬁed. This estimator V 0 is appropriate when the skedastic regression (7. First. then FGLS is asymptotically equivalent to GLS. Its asymptotic variance is not that given in Theorem 7.. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. In this case we interpret α0 zi as a linear projection of e2 on zi . There are three reasons. V )..1. FGLS is asymptotically superior to OLS. and it may be estimated with considerable 76 V takes a sandwich form√. 1992). A trimming rule might make sense: σ 2 = max[˜ 2 . This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞.1. . σ 2 ] σi i for some σ 2 > 0. ¢¢−1 ¡ ¡ . In the linear regression model.1. We just state the result without proof. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 .. i ˜ 0 is inconsistent for V .1. ´´−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 . similar to the covariance matrix of the OLS estimator. and was proposed by Cragg (Journal of Econometrics. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. It is possible to show that if the skedastic regression is correctly speciﬁed. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . β should perhaps be i i called a quasi-FGLS estimator of β. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. Unless σ 2 = α0 zi . but the proof of this can be tricky. Why then do we not exclusively estimate regression models by FGLS? This is a good question.

Third. In this case. Vα = E zi zi (7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. This hypothesis does not imply that ξ i is independent of xi . and the cost is a reduction of robustness to misspeciﬁcatio 7. on the other hand. 7. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. as they will be estimating two diﬀerent projections. or equivalently that i H0 : α1 = 0 in the regression (7. If the equation of interest is a linear projection. but also under the assumptions of linear projection. The GLS and FGLS estimators.7) under independence show that this test has an asymptotic chi-square distribution. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. however. require the assumption of a correct conditional mean. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . but the only diﬀerence is that they a ¢ allowed for general choice of zi . In the linear regression model the conditional mean of yi given xi = x is 77 . and all cross-products.5) and the asymptotic variance (7. σ 2 ).3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . This introduces an element of arbitrariness which is unsettling to empirical researchers. Theorem 7.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. FGLS will do worse than OLS in practice. The main diﬀerences between popular “tests” is which transformations of xi enter zi . and this requires trimming to solve. We may therefore test this hypothesis by the estimation (7.4) and constructing a Wald statistic. the estimated conditional variances may contain more noise than information about the true conditional variances. individual estimated conditional variances may be negative. the two tests coincide. and not a conditional mean. The asymptotic distribution (7. its squares.2. Second. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.1 Under H0 and ei independent of xi . the Wald test of H0 is asymptotically χ2 .error. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0.2). White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . If i this simpliﬁcation is replaced by the standard formula (under independence of the error). q Most tests for heteroskedasticity take this basic form. Typically. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . OLS is a more robust estimator of the parameter vector. It is consistent not only in the regression model.4).

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

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

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

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

5.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. Pn −1 0 β)) .5. ∂β 0 so Third. Computation of standard error for LAD estimates typically is based on equation (7. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . First.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .5. the conditional density of the error at its 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 ) . Second using the law of iterated expectations and the chain rule of i diﬀerentiation. This can be done with kernel estimation techniques. by the central limit theorem (Theorm 5. In the special case where the error is independent of xi . the height of the error density at its median. See Chapter 16. and this improves estimation of the median. where V = and f (e | x) is the conditional density of ei given xi = x.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.3. we provide a sketch here for completeness. (7. ¢¢−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) .1 is advanced. then there are many innovations near to the median.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. When f (0 | x) is large.Theorem 7.10) is equivalent to g n (β) = 0. While a complete proof of Theorem 7. Let g(β) = Eg (β). ˆ Proof of Theorem 7. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . V ).11). then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . The main diﬃculty is the estimation of f (0).

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

it is useful to have a general test of the adequacy of the speciﬁcation.1 n β τ − β τ →d N (0. and form a Wald statistic i for γ = 0. 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. When the error ei is independent of xi . ¡ ¡ ¢¢−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.5. i By construction.6.1. the asymptotic variance depends on the conditional density of the quantile regression error. and test their signiﬁcance using a Wald test. ˆ Given the representation (7.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Vτ ). Furthermore. where and f (e | x) is the conditional density of ei given xi = x. The null model is yi = x0 β + εi i 84 . fast linear programming methods have been developed for this problem.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . and are widely available. otherwise its properties are unspeciﬁed without further restrictions. 7. the unconditional density of ei at 0.12). Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. n numerical methods are necessary for its minimization. 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. conventional Newton-type optimization methods are inappropriate. ´ √ ³ˆ Theorem 7. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). Another popular approach is the RESET test proposed by Ramsey (1969). and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 .13). Fortunately. then f (0 | xi ) = f (0) . since it has discontinuous derivatives. the τ ’th conditional quantile of ei is zero. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. if the model yi = x0 β + ei has i been ﬁt by OLS. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. Thus.

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

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

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

β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. For example. which regressors enter the regression). MK : β 1 6= 0.15). .. However. and then selects the model with the lowest AIC (7. β 3 = · · · = β K = 0 . In the unordered case. . The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . . the models are M1 : β 1 6= 0. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. β K 6= 0. which can be a very large number. xKi }. In the latter case. β 2 6= 0. The AIC selection criteria estimates the K models by OLS. Also under M2 . selecting based on (7. stores the residual variance σ 2 for each model. The methods extend readily to the issue of selection among multiple regressors. 210 = 1024. 576. there are 2K such models. β 2 6= 0. a model consists of any possible subset of the regressors {x1i .. 88 . 048.. We have discussed model selection between two models. . In the ordered case. . one can show that thus LRn →p ∞. and 220 = 1. . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently.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. . There are two leading cases: ordered regressors and unordered. Similarly for ˆ the BIC. which are nested. and the AIC or BIC in principle can be implemented by estimating all possible subset models. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive.17).

In a linear model Y = Xβ + e. the mean absolute error (MAE) is E |yi − g(xi )| . where xji is one of the xi . 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 . Show that the function g(x) which minimizes the MAE is the conditional median M (x). E(e | X) = 0. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. σ 2 ). Is θ a quantile of the distribution of Yi ? 3. 2.. . and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. Thus the available information is the sample (Y. ˜ the residual vector is e = Y − X β. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. 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 . x. Let (yi . ˆ (a) Find a point forecast of y. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . the estimates (β. 4. and the out-of-sample value of the regressors. V ar(e | X) = σ 2 Ω with Ω known. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. 5. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 .. based on a sample of size n. wn ) and wi = x−2 . . Let σ 2 be the estimate of σ 2 .10 Exercises 1. Let θ satisfy Eg(Yi − θ) = 0. (b) Find an estimate of the variance of this forecast. X). (b) Prove that e = M1 e. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . ˆ ˆ n−k 6.12).. V . xi ) be a random sample with E(Y | X) = Xβ. else equals zero). For any predictor g(xi ) for y.7. the residuals e. Verify equation (7.

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

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

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

To see this. and 100. i 93 .1). 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. it is helpful to think of a random pair (yi . x) . Note that while F may be either discrete or continuous. but the approximation appears to improve for the large n. the EDF step function gets uniformly close to the true CDF. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x) →p F (y. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . x)) →d N (0. x). That is.. x). 50. x) = n i=1 Figure 8. (8. xi ). F (y. x) (1 − F (y.. in the Figure below. Thus by the WLLN (Theorem 5. as the sample size gets larger. The random draws are from the N (0.. x) − F (y. Fn is a nonparametric estimate of F. by the CLT (Theorem 5. Notationally.8. In general.2 The Empirical Distribution Function Fn (y. note that for any (y.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . This is a population moment. ∗ P (yi ≤ y. x) is called the empirical distribution function (EDF).1). Recall that F (y.2) Fn (y. where 1(·) is the indicator function. x) = P (yi ≤ y. Fn (y. For n = 25. . √ n (Fn (y. 1) distribution. x∗ ) with the i distribution Fn . To see the eﬀect of sample size on the EDF. the EDF is only a crude approximation to the CDF. Furthermore. I have plotted the EDF and true CDF for three random samples of size n = 25. The EDF is a consistent estimator of the CDF.2.3. x))) . Fn is by construction a step function. i = 1. x). n. x∗ ≤ x) = Fn (y.

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

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

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

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

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

C4 is called the symmetric percentile-t interval. θ [This is a typical mistake made by practitioners. Basically.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. F ) = Φ + o (1) . and a function h(x) is odd if h(−x) = −h(x).8 Asymptotic Expansions Tn →d N (0.4) v ¡ ¢ While (8. Deﬁnition 8.3 an = o(n−r ) if nr |an | → 0 as n → ∞. v 2 ). an = O(n−r ) if it declines to zero like n−r . however. 99 . writing Tn ∼ Gn (x. Let an be a sequence.8. The ideal test rejects if Wn ≥ qn (α). Thus here Tn (θ) = Wn (θ). where qn (α) is the (1 − α)% quantile of the distribution of Wn . We say that a function g(x) is even if g(−x) = g(x).8. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . F ) then ³x´ . If θ is a vector. F ) = Φ n→∞ v or ³x´ Gn (x.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. about the rate v of convergence. The following notation will be helpful. Deﬁnition 8.2 an = O(1) if |an | is uniformly bounded. θ θ θ ˆ θ ∗ ∗ Computationally.] 8. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ .∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. A better asymptotic approximation may be obtained through an asymptotic expansion. 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. lim Gn (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. The derivative of an even function is odd. Let Tn be a statistic such that (8. not ˆ − θ0 .8.4) says that Gn converges to Φ x as n → ∞. it says nothing. Equivalently. and vice-versa. the critical value qn (α) is found as the quantile from simulated values of W´ . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. (8. or the size of the divergence for any particular sample size n.

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

1). F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ).8. F ). Since Tn →d Z. Similarly. n . then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. then |Tn | →d |Z| ∼ Φ. 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. F0 ) distribution. Thus asymptotic critical values are taken from the Φ distribution. F0 ) = O(n−1 ). F ) = Gn (x. if Tn has exact distribution Gn (x. F ) − Gn (−x.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x).1. We conclude that G∗ (x) − Gn (x. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. as F is a function. n (8.5) where the simpliﬁcations are because g1 is even and g2 is odd. F0 ) = The order of the error is O(n−1 ). then |Tn | has the distribution function Gn (x. A two-sided hypothesis test rejects H0 for large values of |Tn | . F ) + O(n−3/2 ). F ) + g2 (x. F ). From Theorem 8. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )).The “derivative” ∂ ∂F g1 (x. F ) + g2 (−x. 8. = P (X ≤ x) − P (X ≤ −x) For example. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. if Z ∼ N (0. F ) is only heuristic. F0 ) + O(n−3/2 ) = O(n−1 ). F ) = Gn (x. and exact critical values are taken from the Gn (x. we can calculate that Gn (x. F ) − Gn (−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). 101 2 g2 (x.

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

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

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

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

β 0 ) = x(y − z 0 β) 106 (9. xi . We know that without further restrictions. We call r the number of overidentifying restrictions. however. If k = the model is just identiﬁed. x. x. otherwise it is overidentiﬁed.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. g(y. Now suppose that we are given the information that β 2 = 0. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . This is a special case of a more general class of moment condition models. In the statistics literature.1) by setting g(y. but this is not required. is not necessarily eﬃcient. zi . while β 1 is of dimension k < . as their are restrictions in E (xi ei ) = 0. In this case. In our previous example. This method. In econometrics.1) where β 0 is the true value of β. these are known as estimating equations. This situation is called overidentiﬁed. 1 this class of models are called moment condition models. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0.2) . The variables zi may be components and functions of xi . z. z. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. with ≥ k. where the dimensions of zi and xi are k × 1 and × 1 . β) = x(y − x0 β).Chapter 9 Generalized Method of Moments 9. β 0 ) = 0 (9. Let g(y. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. This model falls in the class (9. x. As an important special case we will devote special attention to linear moment condition models. There are − k = r more moment restrictions than free parameters. an asymptotically eﬃcient estimator of β is the OLS estimator.

but this is generally not possible when > k.9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. then. 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.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . the dependence is only up to scale. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . the square of the Euclidean length. ¡ ¢−1 0 ˆ Z XWn X 0 Y.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. and the GMM estimator is the MME.2. β GMM does not change. For example. 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 . Proposition 9. ˆ Deﬁnition 9. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .1 β GMM = argmin Jn (β). β ˆ Note that if k = . let Jn (β) = n · g n (β)0 Wn g n (β).2) g n (β) = (9.2. The GMM estimator minimizes Jn (β). This is a non-negative measure of the “length” of the vector g n (β). β GMM = Z 0 XWn X 0 Z 9. Let and where gi = xi ei . then g n (β) = 0. For some × weight matrix Wn > 0. for if Wn is replaced ˆ by cWn for some c > 0. if Wn = I. i i .

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

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

and then β recomputed. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . β) = 0 holds. Note that g n →p Egi . Hansen (1982). 1 it is possible that β 2 6= 0. often the weight ˆ matrix Wn is updated.6.1 Under general regularity conditions. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not.1 (Sargan-Hansen). 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. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. 1 2 It is possible that β 2 = 0.5. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9.Often. However. G0 Ω−1 G . The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. perhaps obtained by ﬁrst ˆ setting Wn = I. 9. and is thus a natural test statistic for H0 : Egi = 0. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Thus the model — the overidentifying restrictions — are testable.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 . so that the linear equation may be written as yi = β 0 x1i + ei . this is all that is known. Since the GMM estimator depends upon the ﬁrst-stage estimator. This estimator can be iterated if needed. The general theory of GMM estimation and testing was exposited by L. ˆˆ n is a quadratic form in g n . The criterion function at the parameter estimates is J = n g 0 Wn g n n ¡ ¢−1 2 0 = n g n g 0 g − ng n g 0 gn . Theorem 9. Under the hypothesis of correct speciﬁcation. and if the weight matrix is asymptotically eﬃcient. Identiﬁcation requires l ≥ k = dim(β). n β − β →d N 0. 110 . 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). For example. ˆ J = J(β) →d χ2−k .

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

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

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

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

β) + ei E (zi ei ) = 0. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. 6.6) equals the Wald statistic. VR = V − V R R0 V R (d) Show that in this setting. h(β)=0 (9. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β).5. l ≥ k. Vn = X X i=1 ˜ and hence R0 β = r. The observed data is (yi . the distance statistic D in (9. 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 . VR ) where ¡ ¢−1 0 R V. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. Show how to construct an eﬃcient GMM estimator for β.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . The equation of interest is yi = g(xi .6) (a) Show that you can rewrite Jn (β) in (9. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. xi .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. Deﬁne the Lagrangian L(β. zi ). subject ˆ i ˆi i=1 to the restriction h(β) = 0. zi is l × 1 and β is k × 1. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . is deﬁned as Jn (β) = ˜ β = argmin Jn (β). In the linear model Y = Xβ + e with E(xi ei ) = 0. 115 . The GMM estimator of β.

116 . Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 .7. ˆ and consider the GMM estimator β of β. we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0.. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. Deﬁne ¶µ ¶−1 µ 1 0 ˆ −1 1 0 1 0 ˆ −1 0−1 0 1 0 XZ Z XΩ XZ Z XΩ C Dn = Il − C n n n n 1 0 Xe g n (β 0 ) = n ¡ ¢ 0 R = C 0 E xi zi Show that Jn →d χ2 as n → ∞ by demonstrating each of the following: l−k (a) Since Ω > 0. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0.

. pn ) are those which maximize the log-likelihood subject to the constraint (10. (10. β).1). To be a valid multinomial distribution.1) i=1 First let us consider a just-identiﬁed model. these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1.1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n).. Now consider the case of an overidentiﬁed model with moment condition Egi (β 0 ) = 0 where g is × 1 and β is k × 1 and for simplicity we write gi (β) = g(yi .. zi . zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10.1 Non-Parametric Likelihood Since each observation is observed once in the sample.. xi .3) i=1 117 .2) Ln (p1 . .. Combined with i the constraint (10.. The idea is to construct a multinomial distribution F (p1 . xi . . 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. pn ) which places probability pi at each observation. In this case the moment condition places no additional restrictions on the multinomial distribution. The n ﬁrst order conditions are 0 = p−1 − µ. (10. It is a non-parametric analog of likelihood estimation. 2001) and has been extended to moment condition models by Qin and Lawless (1994). The multinomial distribution which places probability pi at each observation (yi . pn ) = i=1 An alternative to GMM is empirical likelihood. The maximum likelihood estimator of the probabilities (p1 . the log-likelihood function for this multinomial distribution is n X ln(pi ). . The idea is due to Art Owen (1988....Chapter 10 Empirical Likelihood 10.

7) 118 . λ) = −n ln (n) − n X i=1 For given β.4) (10.2) subject to the restrictions (10. or equivalently minimizes its negative ˆ (10. λ. probabilities 1 ³ ´´ . Ln (β) = Rn (β. λ). λ) : λ(β) = argmin Rn (β. . pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. pn . 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.5) This minimization problem is the dual of the constrained maximization problem. λ ¡ ¢ ln 1 + λ0 gi (β) . summing over i.5) ˆ ˆ As a by-product of estimation. (10. and using the second and third equations. pi gi (β) = 0. This yields the (proﬁle) empirical log-likelihood function for β.1) and (10.where λ and µ are Lagrange multipliers. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . p (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. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .3).. The solution (when it exists) is well deﬁned since Rn (β. but must be obtained numerically (see section 6. Multiplying the ﬁrst equation by pi . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). λ) is a convex function of λ. (see section 6.5). The solution cannot be obtained explicitly. we ﬁnd µ = n and 1 ¢.. µ. we also obtain the Lagrange multiplier λ = λ(β).. p1 . the Lagrange multiplier λ(β) minimizes 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. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .13) yields n n Expanding (10. and Ω = E xi x0 e2 . λ) = − (10. Gi (. λ) = − (10.10) ¡ Ω−1 N (0.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .9) (10. n (10. Thus the EL estimator is asymptotically eﬃcient. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. ˆ ˆ Proof. and n β − β 0 and nλ are asymptotically independent.13) Premultiplying by G0 Ω−1 and using (10. i i Theorem 10.1 Under regularity conditions. 0 = Rn (β.2.9) and (10. β) = −xi zi . in the linear model. G = −E (xi zi ).10). β λ ∂ ³ ´. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. (β.8) and ¢ 0 0 For example.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 . i=1 i=1 i=1i Expanding (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10.

and it is advisable to report the statistic LRn whenever EL is the estimation method. The same statistic can be constructed for empirical likelihood. First.3. 120 .15) (10. V ) ˆ Solving (10. and have the same interpretation.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.1 If Eg(wi . (10. 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. Since the EL estimator achieves this bound. Proof. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .3 Overidentifying Restrictions In a parametric likelihood context. tests are based on the diﬀerence in the log likelihood functions. LRn = i=1 Theorem 10. Ω) GΩ G →d = N (0. β 0 ) = 0 then LRn →d χ2−k . They are asymptotically ﬁrst-order equivalent.14) for λ and using (10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Vλ ) Furthermore. The overidentiﬁcation test is a very useful by-product of EL estimation. it is an asymptotically eﬃcient estimator for β.7) is n ³ ´´ ³ X ˆ ˆ0 (10.15) 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. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.17) 2 ln 1 + λ gi β . by a Taylor expansion.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. and (10. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.16).15). 10.

4 Testing Egi (β) = 0 (10.wisc.ssc. To test the hypothesis h(β) while maintaining (10. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. where h : Rk → Ra . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. The hypothesis of interest is h(β) = 0.Second. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. This test statistic is a natural analog of the GMM distance statistic. 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) are assumed to hold and are not being challenged (at least for the test discussed in this section).18) Let the maintained model be where g is × 1 and β is k × 1. since ln(1 + x) ' x − x2 /2 for x small. h(β)=0 ˜ Fundamentally. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).prc 121 .1 Under (10. the simple overidentifying restrictions test (10. Vλ )0 Ω−1 N (0.18) and H0 : h(β) = 0.4. a The proof of this result is more challenging and is omitted. 10. Theorem 10.17) is not appropriate.edu/~bhansen/progs/elike. LRn →d χ2 . By “maintained” we mean that the overidentfying restrictions contained in (10. 10. so there is no fundamental change in the distribution theory for β relative to β.18).

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

123 .6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize. λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ .for all i. The gradient for (10.20) fails. It is not guaranteed that Lββ > 0. This can be done by the modiﬁed Newton method described in the previous section. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. and the rule is iterated until convergence. If (10. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. If not. Outer Loop The outer loop is the minimization (10.6).6) is Lβ = ∂ ∂ Ln (β) = Rn (β. where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . the eigenvalues of Lββ should be adjusted so that all are positive. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. λ) = 0 at λ = λ(β). The Hessian for (10. the stepsize δ needs to be decreased. λ(β)) + λ0 Rλ (β. λ(β)) = 0.

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

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 ¶ . and assume that E(zi ei ) 6= 0 so there is endogeneity. In a typical set-up. and x2i are the excluded exogenous variables.1) the structural equation.2) Any solution to the problem of endogeneity requires additional information which we call instruments. In matrix notation. Deﬁnition 11. so should be included in xi . By the above deﬁnition.1) if E (xi ei ) = 0.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. this can be written as Y = Zβ + e. (11.1) where zi is k × 1. β →p β ∗ .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. z1i is an instrumental variable for (11.1. Thus we make the partition ¶ µ k1 z1i (11. 11. We call (11. which does not equal either β 1 or β 2 . That is x2i are variables which could be included in the equation for yi (in the sense 125 . We call z1i exogenous and z2i endogenous.1 The × 1 random vector xi is an instrumental variable for (11.1). some regressors in zi will be uncorrelated with ei (for example. ¶ 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 we have the partition µ ¶ z1i k1 (11. at least the intercept). This is called simultaneous equations bias.

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

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

¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . n and (11. the expression in (11. 0). the bias in the 2SLS estimator will be large.13).7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .Let PX = X (X 0 X)−1 X 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 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.12) and this result. The consequences of identiﬁcation failure for inference are quite severe.14) is the probability limit of β 2SLS − β 11. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. P = HΛH 0 0 0 where Λ = diag(Il .14) approaches that in (11. It is also close to zero when α = 0. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 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 (11.14) In general this is non-zero. except when S21 = 0 (when Z is exogenous). By the spectral decomposition of an idempotent matrix. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . l . 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. 130 . Indeed as α → 1.

In addition.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. This is particularly nasty. This can be handled in an asymptotic analysis by modeling it as local-to-zero. but is weak.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. but small. so E (zi xi ) = 0. Here. This occurs when Γ22 is full rank. but (11.15) is unaﬀected. Suppose this condition fails. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. To see the consequences. Then (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 . The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. E x2 u2 i i n n i=1 i=1 n n (11. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . the instrument xi is weak for zi if γ = n−1/2 c. E x2 e2 i i n i=1 n (11. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. which occurs i when E (zi xi ) 6= 0. N2 since the ratio of two normals is Cauchy. viz Γ22 = n−1/2 C. 131 .Take the simplest case where k = l = 1 (so there is no X1 ). Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. This result carries over to more general settings. Suppose that identiﬁcation does not complete fail. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. and was examined by Phillips (1989) and Choi and Phillips (1992). once again take the simple case k = l = 1. where C is a full rank matrix. standard test statistics have non-standard asymptotic distribution of β distributions. as the Cauchy distribution does not have a ﬁnite mean. meaning that inferences about parameters of interest can be misleading. Qc + N2 ˆ As in the case of complete identiﬁcation failure.

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

ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. Explain why this is true. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . and Γ is l × k. X is n × l. 6. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). That is. Take the linear model yi = xi β + ei E (ei | xi ) = 0. xi is l × 1. Z is n × k. 2. at ˆˆ If X is indeed endogeneous. u is n × k. 1. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. Take the linear model Y = Zβ + e.) 3. ˜ 0 e < e0 e. 5. will IV “ﬁt” better than OLS. 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. in the sense that e ˜ ˜ least in large samples? 4. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). (Find an expression for xi . l ≥ k. Find a simple expression for the IV estimator in this context. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . 133 .8 Exercises yi = zi β + ei . show that if rank(Γ) < k then β cannot be identiﬁed. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β.11. where xi and β are 1 × 1.

(e) Calculate and report the J statistic for overidentiﬁcation. There are 2215 observations with 19 variables. The data ﬁle card. are the parameters identiﬁed? 8. a dummy indicating that the observation lives near a 4-year college. (b) Now treat Education as endogenous. and South and Black are regional and racial dummy variables. and the remaining variables as exogenous. We want to estimate a wage equation log(W age) = β 0 + β 1 Educ + β 2 Exper + β 3 Exper2 + β 4 South + β 5 Black + e where Educ = Eduation (Years) Exper = Experience (Years).pdf. and then calculate the GMM estimator from this weight matrix without further iteration. f atheduc (the education. Suppose that price and quantity are determined by the intersection of the linear demand and supply curves Demand : Supply : Q = a0 + a1 P + a2 Y + e1 Q = b0 + b1 P + b2 W + e2 ¡ ¢ (a) Show that E (xi ei ) = 0 and E x2 ei = 0. Report estimates and standard errors. (a) Estimate the model by OLS. 134 .. in years. of the father) and motheduc (the education.(b) Deﬁne the 2SLS estimator of β. using zi as an instrument for xi . of the mother). listed in card. Estimate the model by 2SLS. In this model. (f) Discuss your ﬁndings. in years.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). (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). I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. Report estimates and standard errors. (d) Re-estimate the model by eﬃcient GMM. using the instrument near4. Report the estimates and standard errors. Does this diﬀer from 2SLS and/or OLS? 7. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market. 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.

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

then as T → ∞.Theorem 12. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k).2 (Ergodic Theorem). 1.1.1 above. ρ(k) →p ρ(k). ˆ ˆ γ ¥ 136 . ˆ Proof. µ →p E(Yt ). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). the sequence Yt Yt−k is strictly stationary and ergodic. then as T → ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . T 1X Xt →p E(Xt ). ˆ 2. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 .1. For Part (2). γ (k) →p γ(k). 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) . Part (1) is a direct consequence of the Ergodic theorem. and it has a ﬁnite mean by the assumption that EYt2 < ∞.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. γ (0) ˆ Theorem 12. If Xt is strictly stationary and ergodic and E |Xt | < ∞.1. ˆ 3.

.} are jointly random. A linear AR model (the most common type used in practice) speciﬁes linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k . Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. some versions of the life-cycle hypothesis imply that either changes in consumption. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . the series {.. E(Yt−k et ) = 0.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. E(et ) = 0 and Ee2 = σ 2 < ∞..3 Stationarity of AR(1) Process Yt = ρYt−1 + et . Thus for k > 0. . A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 .} is the past history of the series. k=0 Loosely speaking. t By back-substitution.2.. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . Some time-series processes may be a MDS as a consequence of optimizing behavior. it is even more important in the time-series context. Y2 . .. Letting et = Yt − E (Yt | It−1 ) . 137 . Yt−k ) . The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression. as it is diﬃcult to derive distribution theories without this property... In fact. For example..... then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. Yt−2 . . Y1 . ∞ X = ρk et−k . Regression errors are naturally a MDS. should be a MDS.12. The last property deﬁnes a special time-series process.. YT . A mean-zero AR(1) is Assume that et is iid.. This occurs when |ρ| < 1. this series converges if the sequence ρk et−k gets small as k → ∞. Deﬁnition 12. or consumption growth rates.. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . .. 12.2 Autoregressions In time-series.

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

1. Thus t by the Ergodic Theorem.. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.” If one of the roots equals 1. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. and by Theorem 12. the requirement is that all roots are larger than one. so is xt x0 . Proof. and is of great interest in applied time series. By Theorem 12. Theorem 12. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.1) Theorem 12. t t T t=1 ¥ Combined with (12. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. which satisfy ρ(λj ) = 0. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.6.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. t Yt−k ¢0 ρk . it is helpful to deﬁne the process ut = xt et . it is also strictly stationary and ergodic. we say that ρ(L). For an AR(k). ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. This is a special case of non-stationarity.. β = X 0X (12. One way of stating this is that “All roots lie outside the unit circle. Note that ut is a MDS. “has a unit root”.1.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et ..5. 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. The vector xt is strictly stationary and ergodic. λk are the complex roots of ρ(z). .where the λ1 .1) and the continuous mapping theorem. then ˆ β →p β as T → ∞.1. t T t=1 T t=1 139 . and hence Yt . Let |λ| denote the modulus of a complex number λ.

which may be diﬀerent than the i properties of the actual ei .1 to see that T 1 X √ xt et →d N (0. then as T → ∞. xt }.. T 1 X √ ut →d N (0. there are two popular methods to implement bootstrap resampling for time-series data....7.12. Method 1: Model-Based (Parametric) Bootstrap. Fix an initial condition (Y−k+1 . ˆ 1. Brieﬂy.7.7 Asymptotic Distribution Theorem 12. Method 2: Block Resampling 1. It also presumes that the AR(k) structure is the truth. T t=1 where Ω = E(xt x0 e2 ). If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Divide the sample into T /m blocks of length m. we can apply Theorem 12. as this imposes inappropriate independence. i 4. we constructed the bootstrap sample by randomly resampling from the data values {yt .8 Bootstrap for Autoregressions In the non-parametric bootstrap. Ω) . . Ω) . The implication is that asymptotic inference is the same. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . t t Theorem 12.. e ˆ 3. This creates an iid bootstrap sample. This is identical in form to the asymptotic distribution of OLS in cross-section regression. 12. t then as T → ∞. Q−1 ΩQ−1 . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. Y0 ). 140 .7.1 MDS CLT. eT }. Clearly.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. t This construction imposes homoskedasticity on the errors e∗ . Estimate β and residuals et . In particular. the asymptotic covariance matrix is estimated just as in the cross-section case. . Y−k+2 . Create the bootstrap series Yt∗ by the recursive formula ˆ ˆ ∗ ˆ ∗ ˆ ∗ Yt∗ = α + ρ1 Yt−1 + ρ2 Yt−2 + · · · + ρk Yt−k + e∗ .. this cannot work in a time-series application. ˆ 2. T t=1 Since xt et is a MDS.

and perhaps this was of relevance. ∆s Yt = Yt − Yt−s . 141 . • First apply a seasonal diﬀerencing operator. • You can estimate (12. • Include dummy variables for each season. (12.4) by OLS. Resample complete blocks.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . and then perform regression (12. and the way that the data are partitioned into blocks. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. get the ˆ ˆ residual St . also alters the time-series correlations of the data. 6. May not work well in small samples. This presumes that “seasonality” does not change over the sample. 12. The results may be sensitive to the block length. This is a ﬂexible approach which can extract a wide range of seasonal factors. This allows for arbitrary stationary serial correlation. 4.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . That is. The seasonal adjustment. For each simulated sample. • Use “seasonally adjusted” data. (12.2. ρk ).3) sequentially by OLS. 3. This procedure is sometimes called Detrending. or the season-to-season change.2)-(12. ﬁrst estimate (12. Thus the seasonally adjusted data is a “ﬁltered” series.3) replacing St with St . . Seasonal Eﬀects There are three popular methods to deal with seasonal data. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.2) (12. 5... Paste the blocks together to create the bootstrap time-series Yt∗ .3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .. however. If s is the number of seasons (typically s = 4 or s = 12). But the long-run trend is also eliminated. The series ∆s Yt is clearly free of seasonality. heteroskedasticity.2). and for modelmisspeciﬁcation. • You can estimate (12. draw T /m blocks.

12. AIC(k) = log σ 2 (k) + ˆ 2k .5) We are interested in the question if the error ut is serially correlated. We want to test H0 against H1 . to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . and then reserve the ﬁrst k as initial conditions. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes. (A simple exclusion test). e.. We then multiply this by θ and subtract from (12.. Yt is an AR(1).5). One approach to model selection is to choose k based on a Wald tests. . Yt−k−m are jointly zero. and under H1 it is an AR(2). and the alternative is that the error is an AR(m). AR(2). H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. Thus under H0 .5) and (12.. The best remedy is to ﬁx a upper value k.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . (12. We model this as an AR(1): ut = θut−1 + et with et a MDS. In general. (12. 142 .6).. we take (12.6) 12.) This can induce strange behavior in the AIC. (If you increase k. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. An appropriate test is the Wald test of this restriction. you need more initial conditions. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . and then estimate the models AR(1). Another is to minimize the AIC or BIC information criterion.. .10 Testing for Omitted Serial Correlation For simplicity. this is the same as saying that under the alternative Yt is an AR(k+m). if the null hypothesis is that Yt is an AR(k).. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 .g. To combine (12. AR(k) on this (uniﬁed) sample.

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

Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal. then the series itself is nonstationary. This is called a “super-consistent” rate of convergence.g. 144 . rather than the ˆ 1/2 .8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. as the AR model cannot conceivably describe this data.8).Theorem 12.1 (Dickey-Fuller Theorem). Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. If the series has a linear trend (e. but it may be stationary around the linear time trend. this means that the evidence points to Yt being stationary. and have negative means. When conducting the ADF test. This is not really a correct conclusion. All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. The ADF test has a diﬀerent distribution when the time trend has been included. where c is the critical value from the ADF table. (12. Since the alternative hypothesis is one-sided. Another popular setting includes as well a linear time trend. and a diﬀerent table should be consulted. Thus the Dickey-Fuller test is robust to heteroskedasticity. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. As T → ∞. however. But the theorem does not require an assumption of homoskedasticity. but diﬀerent critical values are required. and may be used for testing the hypothesis H0 . If a time trend is included. The natural solution is to include a time trend in the ﬁtted OLS equation. These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included. the ADF test rejects H0 in favor of H1 when ADF < c. They are skewed to the left. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal. This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . We have described the test for the setting of with an intercept. If the test does not reject H0 . it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. a common conclusion is that the data suggests that Yt is non-stationary. this means that it is computed as the t-ratio for α0 from OLS estimation of (12. If the test rejects H0 . Stock Prices). Assume α0 = 0. In this context. GDP. the test procedure is the same. but does not depend on the parameters α. This distribution has been extensively α tabulated.12.

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

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

h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . Then the single equation takes the form (13. This restriction.4 Single Equation from a VAR Yjt = a0 xt + et . Let et = ejt and β = aj .3) which is a valid regression model. may be tested if desired.2) is a special case of (13. t or yt = θyt−1 + x0 β + x0 γ + ut . Another interesting fact is that (13.2) may be estimated by iterated GLS. general. which is called a common factor restriction. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. under the restriction γ = −βθ. xt−1 ) to the regression. Otherwise it is invalid. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. j Often.) Since the common factor restriction appears arbitrary. Let yt = Yjt . So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 .1) yt = x0 β + et .1). Suppose that et is an AR(1). We see that an appropriate. t t−1 (13.3). and is typically rejected empirically.13. which once was very popular. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. 147 . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). (A simple version of this estimator is called Cochrane-Orcutt. and Zt be the other variables.2) is uncommon in recent applications. In this case. This can be done by a Wald test. If valid. and subtract oﬀ the equation once lagged multiplied by θ. direct estimation of (13. it is convenient to re-deﬁne the variables. 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 . (13. 13.2) Take the equation yt = x0 β + et . t and xt = This is just a conventional regression. t and et is iid N (0. 1). Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. with time series data. You may have heard of the Durbin-Watson test for omitted serial correlation. we are only interested in a single equation out of a VAR system. the model (13. and is still routinely reported by conventional regression packages.

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

Deﬁnition 13. In other cases.9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . β = (1 − 1)0 . if Yt is a pair of interest rates.8. of rank r. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. from OLS of Y1t on Y2t . Often. as ﬁrst shown by Stock (1987). 13. so zt = β 0 Yt is known. the asymptotic distribution of the test is aﬀected by the presence of the time trend. 149 . Hansen (1992). Under H0 .1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. The asymptotic distribution was worked out in B. If r = m. so the ADF critical values are not appropriate. such that zt = β 0 Yt is I(0). then Yt is I(0). When β is unknown. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. then r = 0. and was articulated in detail by Engle and Granger (1987). β may not be known. it may be believed that β is known a priori. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. it may be necessary to include a time trend in the estimated cointegrating regression. m × r. a good method to estimate β. but it is useful in the construction of alternative estimators and tests. Yt is I(1) and cointegrated.13. If Y = (log(Consumption) log(Income))0 . Then under H0 zt is I(1). Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . If the series Yt is not cointegrated. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. When the data have time trends. If Yt is cointegrated with a single cointegrating vector (r = 1). Whether or not the time trend is included. yet under H1 zt is I(0). however. β is not consistent. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. In some cases. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . For 0 < r < m. For example. Thus H0 can be tested using a univariate ADF test on zt . Thus Yt = ˆ (Y1t . in general.8 Cointegration The idea of cointegration is due to Granger (1981). This is not. The r vectors in β are called the cointegrating vectors. Suppose that β is known.

then estimation is done by “reduced rank regression”. Ω). this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . which is least-squares subject to the stated restriction. As they were discovered by Johansen (1988. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. this is the MLE of the restricted parameters under the assumption that et is iid N (0. Equivalently. In the context of a cointegrated VAR estimated by reduced rank regression.9.1 (Granger Representation Theorem). 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 . they are typically called the “Johansen Max and Trace” tests. rank(α) = r. 150 . and are similar to the Dickey-Fuller distributions. it is simple to test for cointegration by testing the rank of Π. When r = 1. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. we typically just normalize one element to equal unity.Theorem 13. this does not work. If β is unknown. One diﬃculty is that β is not identiﬁed without normalization. 1991. 1995). Their asymptotic distributions are non-standard. If β is known. Thus cointegration imposes a restriction upon the parameters of a VAR. These tests are constructed as likelihood ratio (LR) tests. When r > 1.

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

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

i i i=1 ˆ The MLE is the value β which maximizes ln (β).1) yi = ∗ <0 . This model speciﬁes that P (Yi = k | xi ) = λi k = 0. The censoring process may be explicit in data collection.) The observed data yi therefore come from a mixed continuous/discrete distribution.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. The conditional density is the Poisson with parameter λi . i so the model imposes the restriction that the conditional mean and variance of Yi are the same.1). this motivates the label Poisson “regression. . 1. k! = exp(x0 β). 2. a typical approach is to employ Poisson regression. the consumption level (purchases) in a particular period was zero. Thus the model is that there is some latent process yi with unbounded support. σ 2 ) with the observed variable yi generated by the censoring equation (14. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. 0 if yi (This is written for the case of the threshold being zero. any known value can substitute. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). 1. i If Y = {0. .. 2. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. or it may be a by-product of economic constraints. The functional form for λi has been picked to ensure that λi > 0. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . In surveys. Tobin observed that for many households. A generalization is the negative binomial..14..}. An example of a data collection censoring is top-coding of income. 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 !) .. incomes above a threshold are typically reported at the threshold.2 Count Data exp (−λi ) λk i . This may be considered restrictive. 14.

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

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

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

. . . xit } : For i = 1. xit } : t = 1. A panel may be balanced : {yit . and have arbitrary correlated with xi . OLS of yit on xit is called pooled estimation.. then OLS is inconsistent. xit }. n. . This is often believed to be plausible if ui is an omitted variable. There are several derivations of the estimator.. Condition (15. The motivation is to allow ui to be arbitrary...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 . OLS appears a poor estimation choice. OLS can be improved upon via a GLS technique. and the t subscript denotes time..Chapter 15 Panel Data A panel is a set of observations on individuals. If (15. and thus achieve invariance. where the i subscript denotes the individual.1) is true.. In either event. collected over time. . it The typical maintained assumptions are that the individuals i are mutually independent. that ui and eit are independent. The goal is to eliminate ui from the estimator.. 15. t = ti .. n. An observation is the pair {yit . It is a strong assumption. i = 1.1) If this condition fails. and most applied researchers try to avoid its use..2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions.. (15.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . 157 . and that eit is uncorrelated with xit . that eit is iid across individuals and time. however. ti . 15. It is consistent if E (xit ui ) = 0 (15. or unbalanced : {yit .1) is called the random eﬀects hypothesis. T ..

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

15. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. are valid instruments. it (15. A more sophisticated GMM estimator recognizes that for time-periods later in the sample. This is because the sample mean of yit−1 is correlated with that of eit . Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . the predicted value from these regressions is the individual speciﬁc mean y i . the dependent variable and regressors in deviationit from-mean form. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed.4) will be inconsistent. two periods back. Alternatively. but loses a time-series observation). there are more instruments available.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. 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.4) . we use lags of the dependent variable. But if there are valid instruments. at least if T is held ﬁnite as n → ∞.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . so the instrument list should be diﬀerent for each equation. Thus values of yit−k . e So OLS on (15. i ∗ yit = x∗0 β + e∗ . then IV or GMM can be used to estimate the equation. Typically.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . we ﬁnd y i = x0 β + ui + ei . it However. Taking ﬁrst-diﬀerences of (15. A simple application of GMM yields the parameter estimates and standard errors. if eit is iid. as yt−2 is uncorrelated with ∆eit . the ﬁxed eﬀects estimator is inconsistent.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. Unfortunately. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . it it which is free of the individual-eﬀect ui . 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 . This is conveniently organized by the GMM principle. k ≥ 2.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. Hence a valid estimator of α and β is to estimate (15. 159 (15. and the residual is the demean value ∗ yit = yit − yi .

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

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

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

(16. Together with the above table. Equation (16. where φ is the N (0. The asymptotically optimal choice given in (16. We can calculate that √ R(φ00 ) = 3/ (8 π) .1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . The downside is that if the density is very far from normal.Together. Their K values for the three functions introduced in the previous section are given here. but not of n. That is. 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 + . We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. we need h → 0 but nh → ∞. we ﬁnd the reference rules for the three kernel functions introduced earlier. R∞ R∞ K σ 2 = −∞ x2 K (x) dx R(K) = −∞ K (x)2 dx K √ Gaussian 1 1/(2 π) Epanechnikov 1/5 1/5 Biweight 1/7 5/7 An obvious diﬃculty is that R(f 00 ) is unknown. but at a very slow rate.2) depends on R(K). Gaussian Kernel: hrule = 1.06n−1/5 163 . 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) . Thus for the AMISE to decline with n. We thus say that the optimal bandwidth is of order O(n−1/5 ). Note that this h declines to zero. h must tend to zero. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). how should the bandwidth be selected? This is a diﬃcult problem.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. The ﬁrst two are determined by the kernel function. ˆ It uses formula (16. and R(f 00 ). Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. (16. σ 2 . and gives a nearly optimal rule when f (x) is close to normal. and there is a large and continuing literature on the subject. the rule-of-thumb h can be quite ineﬃcient.1) is an asymptotic approximation to the MSE. This choice for h gives an optimal rule when f (x) is ˆ normal. That is.2) but replaces R(f 00 ) with σ −5 R(φ00 ). A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. 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 . but at a slower rate than n−1 .

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

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

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

2. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. a These expressions only make sense if F (x) is diﬀerentiable... 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. . A function F (x) is a CDF if and only if the following three properties hold: 1.. and use lower case letters such as x for potential values and realized values. 167 . . Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) .. For any set B and any partition A1 . of the sample space. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. r (A. Instead..2) Sometimes we write this as FX (x) to denote that it is the CDF of X. . While there are examples of continuous random variables which do not possess a PDF. This induces a new sample space — the real line — and a new probability function on the real line.. Typically. (A.2 Random Variables A random variable X is a function from a sample space S into the real line. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. the range of X consists of a countable set of real numbers τ 1 . In the latter case. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2. τ r .Theorem 2 (Bayes’ Rule)... then for each i = 1... . A2 . The probability function for X takes the form j = 1. these cases are unusualRand are typically ignored. we denote random variables by uppercase letters such as X.3) is unavailable. F (x) is nondecreasing in x 3.3) P (X = τ j ) = π j . We say that the random variable X is continuous if F (x) is continuous in x.

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

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

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

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

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

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

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

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

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

8.8. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.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). From (A. which we showed in (A. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. (A.8.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .3. q Proof of Theorem A.11).12) E exp (tQ) = 0 Γ (A.11) 2 with r = 1.8. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.Theorem A.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.13) is the MGF of the density (A. Set r Z . The MGF for the density (A. 1) and Q ∼ χ2 be independent. For Z ∼ N(0. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Using the simple law of iterated expectations.2. 1). Proof of Theorem A.3 Let Z ∼ N (0. C −1 CC 0 C −10 ) = N (0. Iq ). we see that the MGF of Z 2 is (1 − 2t)−1/2 .1.13). Thus the density of Z 2 is (A. C −1 AC −10 ) = N (0. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . which can be found by applying change-of-variables to the gamma function. tr has distribution 177 .

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

θ) ∂θ ∂θ which holds at θ = θ0 by (A.2 Cramer-Rao Lower Bound. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. n n i=1 n As the MLE ˆ maximizes the left-hand-side. we can see that it is an estimator of the maximizer θ of the right-hand-side.15) Two important features of the likelihood are Theorem A. but these ˆ must be found by numerical methods. under conventional regularity conditions. If ˜ is an unbiased estimator of θ ∈ R. I0 . The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.9. ∂θ ∂θ (A.1 ¯ ¯ ∂ E ln f (Yi . The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . In fact. 179 . the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency.14) ¶ ∂ ∂ 0 ln f (Yi . ˆ →p θ0 as n → ∞.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .9. θ) The Cramer-Rao Theorem gives a lower bound for estimation. Theorem A. and the equality (A. θ) ≡ L(θ). θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. However. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . θ0 ) ln f (Yi .3 Under regularity conditions. We can write this as ˆ = argmax Ln (θ). θ Theorem A. θ) →p E ln f (Yi . cases are rare.9.16) (A. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.16).17) is often called the information matrix equality.17) The matrix I0 is called the information. θ0 ) ∂θ∂θ 0 (A. More typically. then θ V ar(˜ ≥ (nI0 )−1 . θ θ∈Θ ˆ In some simple cases. ˆ is consistent θ for this value. θ0 ) . which maximizes the log-likelihood). we can ﬁnd an explicit expression for θ as a function of the data.

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

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

If it is continuous in θ. ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . Together. θn ) = ln f (Yi . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. H −1 ΩH −1 = N 0. the speciﬁc value of θn varies by row in this expansion. (Technically. θ0 ) + ' 0 ln f (Yi .1 . θ0 ) . and making a ﬁrst-order Taylor series expansion. the ﬁnal equality using Theorem A. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . Ω) = N 0. then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi .Proof of Theorem A. θ n ) θ − θ 0 . θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . H −1 .) Rewriting this equation. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. θ0 ) is mean-zero with covariance matrix Ω. θ0 ) →d N (0. ¥ 182 .9.9. θ) . Ω) . an application of the CLT yields 1 X ∂ √ ln f (Yi . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi .3 Taking the ﬁrst-order condition for maximization of Ln (θ). we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . − ln f (Yi . ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 .

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

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

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

“Tests for parameter instability and structural change with unknown change point. T.K. [15] Brown. [14] Breusch. [13] Bose.” Proceedings of the Royal Statistical Society. D. H. 59. Petroc and F. eﬃcient bootstrapping.K. L. (1988): “Laws of large numbers for dependent non-identically distributed random variables.S.W.W. 307-345. D. (1973): “Information theory and an extension of the maximum likelihood principle. and W. Second International Symposium on Information Theory. and improved inference .” Econometrica.” Econometrica. 1709-1722.” Journal of Business and Economic Statistics.K. [12] Billingsley. (1957): “A generalized classical method of linear estimation of coeﬃcients in a structural equation. [10] Bekker. (1991). 42-48. A. P. New York: Wiley. New York: Wiley.” Review of Economic Studies.K. D.W. 62. [8] Andrews. eds.’ Econometric Theory. Buchinsky: (2000): “A three-step method for choosing the number of bootstrap replications. 16.Bibliography [1] Aitken. R. [11] Billingsley.” Econometrica. 77-83. [4] Andrews.” Annals of Statistics.K. Csake. A. 62. P. 68.W. 20. (1935): “On least squares and linear combinations of observations. D. 821-8516. B. 47. (1968): Convergence of Probability Measures. 657-681. P.” In B. 4. and W. 61.W. [3] Anderson. [2] Akaike. Econometrica. and H. [5] Andrews.R.. 25.A. (1988): “Edgeworth correction by bootstrap in autoregressions. [9] Basmann.W. Pagan (1979): “The Lagrange multiplier test and its application to model speciﬁcation in econometrics. 239-253.” The Annals of Mathematical Statistics. 1383-1414.K. and M. [6] Andrews. [7] Andrews.W.C. 186 . and A. D. 55.” Econometrica. (1993). 23-51. “Asymptotic normality of series estimators for nonparameric and semiparametric regression models. (1979): Probability and Measure.” Econometrica. 458-467. 46-63. (1994): “Alternative approximations to the distributions of instrumental variable estimators. Newey (2002): “GMM. Ploberger (1994): “Optimal tests when a nuisance parameter is present only under the alternative. Rubin (1949): “Estimation of the parameters of a single equation in a complete system of stochastic equations. T.

427-431. [31] Gallant.” Journal of Econometrics. 187 . (1994): Stochastic Limit Theory: An Introduction for Econometricians. [27] Efron. G.A. Fuller (1979): “Distribution of the estimators for autoregressive time series with a unit root. R.W. Society for Industrial and Applied Mathematics. 447-456. [33] Goldberger.V.” Econometrica. and Other Resampling Plans. 387-401. [17] Chamberlain. 14.[16] Carlstein. 305-334. the Bootstrap. A. (1991): A Course in Econometrics.” Annals of Statistics. Nychka (1987): “Seminonparametric maximum likelihood estimation. (1960): “Tests of equality between sets of coeﬃcients in two linear regressions. Newey (2001): “Choosing the number of instruments. Waugh (1933): “Partial time regressions as compared with individual trends. (1963): “Asymptotic normality and consistency of the least squares estimators for families of linear regressions. 591-603. 1161-1191. and W. 251-276.” Econometrica. (1986): “The use of subseries methods for estimating the variance of a general statistic from a stationary time series. D. 34. J.” Journal of Econometrics. Granger (1987): “Co-integration and error correction: Representation. 55. and C. White (1988): A Uniﬁed Theory of Estimation and Inference for Nonlinear Dynamic Models.F.J.W.” Journal of the American Statistical Association.J. [32] Gallant. 363-390. (1987): “Asymptotic eﬃciency in estimation with conditional moment restrictions. and D. estimation and testing.F. Tibshirani (1993): An Introduction to the Bootstrap. 1365-1387. New York: Basil Blackwell.” Econometrica.R. [23] Donald S.C.K. Oxford: Oxford University Press. [19] Chow. 113-150. 69. [30] Frisch. 28. 1.A. Arthur S. and P. [28] Eicker. 1-26. [24] Dufour. [21] Davison. Hinkley (1997): Bootstrap Methods and their Application. Cambridge: Harvard University Press. 55.” Econometrica. Bradley (1982): The Jackknife. [22] Dickey. [29] Engle. J. [25] Efron. and W. and F. [20] Davidson. 1171-1179.C. New York: Chapman-Hall. and H. 7. F. 65. 34.” Econometrica. A.M.” Annals of Mathematical Statistics. and D. A.C. R. G. Phillips (1992): “Asymptotic and ﬁnite sample distribution theory for IV estimators and tests in partially identiﬁed structural equations. E. 74.” Econometrica.B.G. Bradley (1979): “Bootstrap methods: Another look at the jackknife. I. [18] Choi. [26] Efron. Cambridge University Press. Bradley and R.” Annals of Statistics. 51. (1997): “Some impossibility theorems in econometrics with applications to structural and dynamic models.

W. [41] Hall. (1996): “Inference when a nuisance parameter is not identiﬁed under the null hypothesis. IV.” Econometrica.D. W. McFadden. 891-916. Horowitz (1996): “Bootstrap critical values for tests based on GeneralizedMethod-of-Moments estimation. G.L. R. and A.” Econometrica. Oxford University Press. Teräsvirta (1993): Modelling Nonlinear Economic Relationships.. J. R. 16.” Journal of Econometrics. 1517-1527.” Journal of Econometrics. L. Spady and P.E. J. 37. P. K.E. B. New York: Springer-Verlag. [44] Hansen. C.J. (1978): “Speciﬁcation tests in econometrics.” Econometrica.F. 262-280. C. 12. (2000): “Covariance matrix estimation and the power of the overidentifying restrictions test.P. B. A. 46. 359-383. 50. P. [47] Hansen. 255-259. Rogers (1994): “Global optimization of statistical functions with simulated annealing. Vol.K. (1982): “Large sample properties of generalized method of moments estimators. 333-357. 60. and A. Yaron (1996): “Finite sample properties of some alternative GMM estimators. Engle and D. 188 . (1996): “A note on bootstrapping generalized method of moments estimators. 87-121.W. L. eds. [52] Jarque. VII. G. 1029-1054. Econometrica.[34] Goﬀe. 64. 68.M.W. C.” Econometrica.J. 1251-1271. 65-99. [48] Hausman.” Handbook of Econometrics. Heaton.W. Economic Letters. [43] Hahn. 64.F. homoskedasticity and serial independence of regression residuals. (1994): “Methodology and theory for the bootstrap. (1981): “Some properties of time series data and their use in econometric speciﬁcation. 424-438. G. 153161. R. [39] Hall. [46] Hansen. [40] Hall.” Review of Economic Studies.” in Werke. (1992): The Bootstrap and Edgeworth Expansion. Ferrier and J.” Journal of Econometrics. Bera (1980): “Eﬃcient tests for normality.L. [37] Granger. Johnson (1998): “Information theoretic approaches to inference in moment condition models. 66. 6.A. (1969): “Investigating causal relations by econometric models and crossspectral methods.” Econometrica.” Econometrica. 47. 64.J. (1997): “One step estimators for over-identiﬁed generalized method of moments models. [51] Imbens...” Journal of Business and Economic Statistics. [49] Heckman. 187-197. [36] Granger. (1992): “Eﬃcient estimation and testing of cointegrating vectors in the presence of deterministic trends. 121-130. (1979): “Sample selection bias as a speciﬁcation error. and J. 14. Oxford. [42] Hall. J. C. 53.W. [35] Gauss. and T.” Econometrica. 240-254. New York: Elsevier Science. P.H. [38] Granger. (1809): “Theoria motus corporum coelestium. 413-430. J. [50] Imbens. [45] Hansen.” Econometric Theory.L.P. Vol.

White (1985): “Some heteroskedasticity-consistent covariance matrix estimators with improved ﬁnite sample properties. J. J. White (1986): “Obtaining any Wald statistic you want. 7. Roger (2005): Quantile Regression. 53. S. W. Stutzer (1997): “An information-theoretic alternative to generalized method of moments. [55] Johansen. M. New York: John Wiley and Sons. 21. 75. [66] Magnus.R. (1990): “Critical values for cointegration. [63] Lovell. 993-1010.K.W. J. and R. [58] Kitamura. [67] Muirhead. 308-313. Oxford University Press. [60] Kunsch. Juselius (1992): “Testing structural hypotheses in a multivariate cointegration analysis of the PPP and the UIP for the UK. Cambridge University Press. P. [69] Newey.” Biometrika. and H. Shin (1992): “Testing the null hypothesis of stationarity against the alternative of a unit root: How sure are we that economic time series have a unit root?” Journal of Econometrics. Schmidt. S. R. Mead (1965): “A simplex method for function minimization. 211-244. 1551-1580.[53] Johansen. Y. [61] Kwiatkowski. (1963): “Seasonal adjustment of economic time series... 861-874.” Annals of Statistics. Oxford University Press. [68] Nelder. F. New York: Wiley.” Journal of Econometrics. 35-40. Oxford. and K.” Journal of Economic Dynamics and Control. 159-178. [62] Lafontaine.C. (1982): Aspects of Multivariate Statistical Theory. 29. [59] Koenker. and M. 189 . 54. 777-787. S.” Econometrica. (1988): “Statistical analysis of cointegrating vectors. (1988): “Empirical likelihood ratio conﬁdence intervals for a single functional. 17.” in Engle. Granger (eds.C.” Computer Journal. 59. 58.B. 237-249.D. and C.” Economics Letters. [70] Owen. R. [65] MacKinnon.” Econometrica. D. R.. Y. 1217-1241. Art B.” Econometrica. H.J. [64] MacKinnon. 28.F.” International Economic Review. West (1987): “Hypothesis testing with eﬃcient method of moments estimation. [56] Johansen. (1989): “The jackknife and the bootstrap for general stationary observations.G. (1991): “Estimation and hypothesis testing of cointegration vectors in the presence of linear trend. 1661-1672. 65.J. and K. 305-325. (2001): “Asymptotic optimality and empirical likelihood for testing moment restrictions. P. S. and K. 231-254. [54] Johansen. and Y.G.” Journal of the American Statistical Association. Neudecker (1988): Matrix Diﬀerential Calculus with Applications in Statistics and Econometrics. (1995): Likelihood-Based Inference in Cointegrated Vector Auto-Regressive Models. and H.” Journal of Econometrics. J. [57] Kitamura. 12. 69. Phillips.) Long-Run Economic Relationships: Readings in Cointegration.

Art B. [88] Stock. (1994): “A residual-based test of the null of cointegration against the alternative of no cointegration. 1-48. 3rd edition.” Econometrica. (1989): “Partially identiﬁed econometric models. 1055-1096.” Journal of Monetary Economics. 540-552. 435-460. [80] Shao. Jones (1991): “A reliable data-based bandwidth selection method for kernel density estimation.” American Economic Review. Dickey (1984): “Testing for unit roots in autoregressive-moving average models of unknown order. 599-608. 55. Tu (1995): The Jackknife and Bootstrap.H. B. [79] Said.” Biometrika.[71] Owen. (1972): “Money. 1303-1313. 7.” Journal of the American Statistical Association. P.B. P. J. Wright (2000): “GMM with weak identiﬁcation. 91-115. 557-586. [76] Qin. [87] Staiger.” Econometrica. Series B. 71. 1035-1056. Y.D. (1987): Real and Complex Analysis.A.J.” The Annals of Statistics. [72] Phillips. D.H. (1987): “Asymptotic properties of least squares estimators of cointegrating vectors. [75] Potscher. and D.H. D. (1980): “Macroeconomics and reality. (2001): Empirical Likelihood.M. [90] Stock. [86] Sims.” Econometric Theory.N. 22. 393-415. 163-185. and D. 62. [74] Politis. B. [89] Stock.H. (1991): “Conﬁdence intervals for the largest autoregressive root in U. (1991): “Eﬀects of model selection on inference. 350-371. [82] Sheather. [81] Sargan. 10. Journal of the Royal Statistical Society. J.B.C. 58. [83] Shin. macroeconomic time series. and J. C. and J.” Econometric Theory. income and causality.A.” Econometric Theory. 190 . (1969): “Tests for speciﬁcation errors in classical linear least-squares regression analysis.P.” Econometrica. 300-325. 2 6. 68. J.” Econometrica.C. 48. [85] Sims. (1986): Density Estimation for Statistics and Data Analysis. 28.S. New York: Chapman & Hall. Ouliaris (1990): “Asymptotic properties of residual based tests for cointegration. C. J. S. 31. 165-193. NY: Springer.” Econometrica. S. 181-240.H. (1958): “The estimation of economic relationships using instrumental variables. 65. and S. London: Chapman and Hall.C. [73] Phillips.” Econometrica. B. New York: McGraw-Hill. [78] Rudin.” Journal of the Royal Statistical Society. Romano (1996): “The stationary bootstrap. J.W. W. Stock (1997): “Instrumental variables regression with weak instruments. [77] Ramsey. and J. J. 89.A. [84] Silverman. 5. Series B. and M. 683-690. and J. J. 53.E. Lawless (1994): “Empirical likelihood and general estimating equations.

and E. (1943): “Tests of statistical hypotheses concerning several parameters when the number of observations is large. Academic Press. H. H. [97] Zellner. Zivot (1998): “Inference on structural parameters in instrumental variables regression with weak instruments. 1389-1404. H.” Transactions of the American Mathematical Society. 426-482. mimeo. Central Planning Bureau. 54. [95] White. A. (1958): “Estimation of relationships for limited dependent variables.[91] Theil.” The Hague.” Journal of the American Statistical Association. [96] White. [94] Wang. (1980): “A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity. 2 6. 817-838.” Econometrica. 348-368.” Econometrica. (1962): “An eﬃcient method of estimating seemingly unrelated regressions. 57. (1984): Asymptotic Theory for Econometricians. [92] Tobin. and tests for aggregation bias. J. J. 24-36. 191 . (1953): “Repeated least squares applied to complete equation systems. 66. [93] Wald. 48. A.” Econometrica.