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

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Contents

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

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

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i

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

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

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

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

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ii

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

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

Chapter 1 Introduction Econometrics is the study of estimation and inference for economic models using economic data. Ideally. To continue the above example. Typical examples include macroeconomic aggregates. most economic data is observational. These data sets consist surveys of a set of individuals. The diﬀerences between the groups could be attributed to the diﬀerent levels of education. Panel data combines elements of cross-section and time-series. 1.2 Observational Data A common econometric question is to quantify the impact of one set of variables on another variable. Another issue of interest is the earnings gap between men and women. They are distinguished by the dependence structure across observations. 1 . repeated over time. mandate diﬀerent levels of education to the diﬀerent groups. We can measure the joint distribution of these variables. Cross-sectional data sets are characterized by mutually independent observations. even immoral! Instead. The quality of the study will be largely determined by the data available. and panel. To measure the returns to schooling. what we observe (through data collection) is the level of a person’s education and their wage. 1. and assess the joint dependence. or corporations. we would use experimental data to answer these questions. a concern in labor economics is the returns to schooling — the change in earnings induced by increasing a worker’s education. However. This type of data is characterized by serial dependence.1 Economic Data An econometric study requires data for analysis. Time-series data is indexed by time. But we cannot infer causality. There are three major types of economic data sets: cross-sectional. Each individual (person. households. as we are not able to manipulate one variable to see the direct eﬀect on the other. prices and interest rates. an experiment might randomly divide children into groups. The individuals surveyed may be persons. and then follow the children’s wage path as they mature and enter the labor force. experiments such as this are infeasible. timeseries. household or corporation) is surveyed on multiple occasions. holding other variables constant. Applied econometrics concerns the application of these tools to economic data. Econometric theory concerns the study and development of tools and methods for applied econometric applications. For example. Surveys are a typical source for cross-sectional data.

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

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

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

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

. For example. Also. . . ⎦ ⎣ . ⎤ ⎥ ⎥ ⎥ ⎦ AB = A1 A2 · · · Ar Br = A1 B1 + A2 B2 + · · · + Ar Br r X = Ar Br j=1 ¤⎢ ⎢ ⎢ ⎣ Important properties are that if A is k × r. We say that two vectors a and b are orthogonal if a0 b = 0. are said to be orthogonal if A0 A = Ir . 0 0 ··· 1 2. The columns of a k × r matrix A. . . then AIr = A and Ik A = A. . A square matrix A is called orthogonal if A0 A = Ik .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. r ≤ k. which has ones on the diagonal. An important diagonal matrix is the identity matrix. for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ .3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. . ⎥ . . ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 .

In this case there exists a unique matrix B such that AB = BA = Ik . the Moore-Penrose generalized inverse A− exists and is unique. If A − BD−1 C and D − CA−1 B are non-singular. (2. . The following fact about inverting partitioned matrices is sometimes useful.4 Inverse A k × k matrix A has full rank. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . then A−1 = A. 7 Also. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) .The 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 A is an orthogonal matrix.3) The matrix A− is not necessarily unique. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 .2) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2. . 2. if there is no c 6= 0 such that Ac = 0. (2.1) . . The Moore-Penrose generalized inverse A− satisﬁes (2. This matrix is called the inverse of A and is denoted by A−1 . . For non-singular A and C. or is nonsingular. .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A.

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

i Hence they must equal either 0 or 1. tr(A) = rank(A)...8 Determinant The determinant is deﬁned for square matrices. then its determinant is det A = a11 a22 − a12 a21 . The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . we deduce that Λ2 = Λ and λ2 = λi for i = 1. ⎠ . k. jk ) denote a permutation of (1. ... It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2..... xk ) : Rk → R. .. . we can deﬁne the determinant as follows. Additionally.4) H0 M =H 0 0 with H 0 H = In . xk ) be k × 1 and g(x) = g(x1 . If A is 2 × 2. . There are k! such permutations. .. For a general k × k matrix A = [aij ] ... .By the uniqueness of the characteristic roots.. .. k)).7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 .. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. k) . and let επ = +1 if this count is even and επ = −1 if the count is odd. Let π = (j1 .. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . 2...

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 . ⎠ ⎝ . then det A = 2.• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. denoted A ⊗ B. . . • If A is orthogonal. The vec of A. . ⎟ . These results hold for matrices for which all matrix multiplications are conformable. denoted by vec (A) . • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. .9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. . . The Kronecker product of A and B. am1 B am2 B · · · amn B Some important properties are now summarized. is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. an Let B be any matrix. 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 are indicated in Figure 3. (3. Figure 3. In this context we partition the observations into the pair (yi .22. we can focus on f (y | x) . the mean wage for men is $27.73. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. The two density curves show the eﬀect of gender on the distribution of wages.1) xi = ⎜ .Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. and that for women is $20. the conditioning variable. holding the other variables constant. it is useful to have numerical measures of the diﬀerence. This is used when the goal is to quantify the impact of one set of variables on another variable. To illustrate. or the covariates.2) m(x) = E (yi | xi = x) = −∞ In general. When a distribution is skewed. In the example presented in Figure 3. The data are from the 2004 Current Population Survey 1 11 . ⎠ ⎝ . See Chapter 16. xi ) where yi is a scalar (real-valued) and xi is a vector. We call xi alternatively the regressor. ⎟ . m(x) can take any form. gender. .1 displays the density1 of hourly wages for men and women. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. You can see that the right tail of then density is much thicker than the left tail. the conditional density of yi given xi . These are conditional density functions — the density of hourly wages conditional on race. xki 3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. We call yi the dependent variable.1. These are asymmetric (skewed) densities. Take a closer look at the density functions displayed in Figure 3. While it is easy to observe that the two densities are unequal. and exists so long as E |yi | < ∞. which is a common feature of wage distributions.1 by the arrows drawn to the x-axis. education and experience.1. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. the mean is not necessarily a good summary of the central tendency. An important summary measure is the conditional mean Z ∞ yf (y | x) dy.

Figure 3.5. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. wage regressions typically use log wages as a dependent variable rather than the level of wages.30. 12 . For this reason. degree in mean log hourly wages is 0.36.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. implying an average 36% diﬀerence in wage levels.3) White non-military male wage earners with 10-15 years of potential work experience.2 shows the density of log hourly wages for the same population. The main point to be learned from Figure 3. with mean log hourly wages drawn in with the arrows.3 is how the conditional expectation describes an important feature of the conditional distribution. the solid line displays the conditional expectation of log wages varying with education. the dashed line is a linear projection approximation which will be discussed in the Section 3. Figure 3. Of particular interest to graduate students may be the observation that diﬀerence between a B. By construction. 3.1 is facilitated by the fact that the control variable (gender) is discrete. To illustrate. 2 (3. The comparison in Figure 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3.A. then comparisons become more complicated.3 displays a scatter plot2 of log wages against education levels.2) evaluated at the observed value of xi : ei = yi − m(xi ).Figure 3.D. The conditional expectation function is close to linear. When the distribution of the control variable is continuous. Assuming for simplicity that this is the true joint distribution. and a Ph. which implies a 30% average wage diﬀerence for this population. this yields the formula yi = m(xi ) + ei . The diﬀerence in the log mean wage between men and women is 0.

are often stated jointly as the regression framework.Figure 3. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. 3. The equations yi = m(xi ) + ei E (ei | xi ) = 0. E (ei | xi ) = 0. The remaining parts of the Theorem are left as an exercise. 2.1 Properties of the regression error ei 1.2. because no restrictions have been placed on the joint distribution of the data. It is important to understand that this is a framework. restrictions on the permissible class of regression functions m(x). To show the ﬁrst statement. most typically. E(ei ) = 0. A regression model imposes further restrictions on the joint distribution. not a model.2: Log Wage Densities Theorem 3. E(xi ei ) = 0. 13 . E (h(xi )ei ) = 0 for any function h (·) . by the deﬁnition of ei and the linearity of conditional expectations. These equations hold true by deﬁnition. 4.

A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . σ 2 (x) is a non-trivial function of x.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. let g(x) be an arbitrary predictor of yi given xi = x. when σ 2 (x) is a constant so that ¢ ¡ (3.Figure 3. The conditional standard deviation is its square root σ(x) = σ 2 (x). In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. Given the random variable xi . the conditional variance of yi is σ 2 = σ 2 (xi ). subject to the restriction p that it is non-negative. 3. i .3 Conditional Variance Generally. The right-hand-side is minimized by setting g(x) = m(x). Thus the mean squared error is minimized by the conditional mean. To see this. In contrast.3. The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. in the sense of achieving the lowest mean squared error. it does not provide information about the spread of the distribution.2.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .1. and can take any form.

This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .6) as an approximation. 3.7) is a k × 1 parameter vector. The conditional standard deviation for men is 12.5) xi = ⎜ . ⎝ . So while men have higher average wages. i (3.1. Equation (3.8) (3.5. Notationally.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). ⎟ β=⎝ .3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. In this case (3. we assume that x1i = 1. ⎟ . it is more realistic to view the linear speciﬁcation (3.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .4 Linear Regression An important special case of (3. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . Thus (3.1).6) (3. Equivalently. Instead.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element. which we derive in this section. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.we say that the error ei is homoskedastic. its functional form is typically unknown. We call this the “constant” or “intercept”.9) 3.8) is called the linear regression model. ⎠ . take the conditional wage densities displayed in Figure 3. ⎠ . they are also somewhat more dispersed. and the linear assumption of the previous section is empirically unlikely to accurate. As an example. 15 .1 and that for women is 10. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . xki When m(x) is linear in x. βk ⎛ (3. where x1i is the ﬁrst element of the vector xi deﬁned in (3.

α0 E (xi x0 ) α = E (α0 xi )2 > 0. Therefore. i 16 . Equivalently. 2 2. 3.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E 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 . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.which is quadratic in β.5. i 4. Eyi < ∞. by “best” we mean the predictor function with lowest mean squared error. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .10) It is worth taking the time to understand the notation involved in this expression. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. i which requires that for all non-zero α. The vector (3. xi contains an intercept. this situation must be excluded. 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.1 1. The error is i ei = yi − x0 β. i (3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. Observe i that for any non-zero α ∈ Rk . This occurs when redundant variables are included in xi . β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . i i (3.5. E (x0 xi ) < ∞. Rewriting. In order for β to be uniquely deﬁned. Given the deﬁnition of β in (3. E (xi x0 ) is invertible. otherwise they are distinct. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. written E (xi x0 ) > 0. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. Assumption 3. It is invertible if and only if it is positive deﬁnite. As before. i (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . The best linear predictor is obtained by selecting β to minimize S(β).12) This completes the derivation of the linear projection model.1. x0 β is the best linear predictor for yi .10). The ﬁrst-order condition for minimization (from Section 2.

14) follows from (3.4 is required to ensure that β is uniquely deﬁned.1 are weak.13) The two equations (3.1 is employed to guarantee that (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.5.1. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Assumption 3.1. However. Let’s compare it with the linear regression model (3.13) implies that xi and ei are uncorrelated. 17 .Theorem 3. This means that the equation (3. Since from Theorem 3.13) and Assumption 3. it follows that linear regression is a special case of the projection model.5. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. By deﬁnition.1. Assumption 3.5. For example. Furthermore. Assumption 3.10) are deﬁned.1. The ﬁnite variance Assumptions 3.1.5. Assumption 3.5.5.1.1.13) summarize the linear projection model. Since ei is mean zero by (3. ¥ (3.14) Proof.14).12) can be alternatively interpreted as a projection decomposition.2 and 3.12) and (3.1 Under Assumption 3.3 are called regularity conditions.5. Equation (3. E (xi ei ) = 0 and E (ei ) = 0. (3.2.11) and (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. the orthogonality restriction (3.9).4 guarantees that the solution β exits.5. (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1.14) holds.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. Figure 3.5. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .1.4 we know that the regression error has the property E (xi ei ) = 0.10) and (3.5.8)-(3.1. Using the deﬁnitions (3.3 ensure that the moments in (3.1.5.2 and 3.11) are well deﬁned.

1 may be false. for those over 53 in age).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. In contrast.We have shown that under mild regularity conditions. The linear equation (3. Other than the redeﬁnition of the regressor vector. It over-predicts wages for young and old workers. Returning to the joint distribution displayed in Figure 3. The solid line is the conditional mean. In Figure 1. and under-predicts for the rest. In this case the linear projection is a poor approximation to the conditional mean. In this case (3. it is important to not misinterpret the generality of this statement. in many economic models the parameter β may be deﬁned within the model. In the example just presented. In this example the linear projection is a close approximation to the conditional mean.5.12) with the properties listed in Theorem 3. A projection of log wages on these two variables can be called a quadratic projection. We illustrate the issue in Figure 3.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. Figure 3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. for any pair (yi .1.10). xi ) we can deﬁne a linear projection equation (3.4 we display as well this quadratic projection. In other cases the two may be quite diﬀerent. there are no changes in our methods or analysis. we can augment the regressor vector xi to include both experience and experience2 . and the straight dashed line is the linear projection. Most importantly. Figure 3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.4 displays the relationship3 between mean log hourly wages and labor market experience. the dashed line is the linear projection of log wages on eduction. 18 .5. These structural models require alternative estimation methods.10) may not hold and the implications of Theorem 3. No additional assumptions are required. 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. However.

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

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

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. 4. Observe that (4. we narrow the focus to the linear regression model. i n i=1 n 21 . Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 . but for most of the chapter we retain the broader focus on the projection model.7 and 4. i It follows that the moment estimator of β replaces the population moments in (4. (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .8.1 Estimation Equation (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .1) (4.2) can be written in the parametric 0 β)) = 0.3) In Sections 4.2) (4.4) i i=1 i=1 ˆ Another way to derive β is as follows.

40 µ ¶µ ¶ 34.14 205. with 10-15 years of potential work experience.37 µ ¶ 1.117 Educationi . 0.117 1 14.71 = −2.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. 40 0. This sample has 988 observations. 30 = . Let yi be log wages and xi be an intercept and years of education. 40 2.94 −2.4). excluding military.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.83 ¶−1 µ ¶ . ¶ 2.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.170 37. consider the data used to generate Figure 3. These are white male wage earners from the March 2004 Current Population Survey. 4. i 22 . An interpretation of the estimated equation is that each year of education is associated with an 11.95 42.95 xi yi = 42. To illustrate.7% increase in mean wages.14 14.2 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 (4.4). n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. Then µ ¶ n 1X 2.14 205.3.14 14.30 + 0. 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.ˆ This is a set of k equations which are linear in β.

while the residual is a by-product of estimation. Figure 4. To visualize the sum-of-squared errors function. Figure 4. Since the function Sn (β) is a quadratic function of β. These two ˆ variables are frequently mislabeled. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4.4). Figure 4. Matrix calculus (see Appendix 2.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. i ˆ ˆ Note that yi = yi + ei . 23 . the contour lines are ellipses. which can cause confusion.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Following convention we will call β the OLS estimator of β.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). The error is unobservable. It is important to understand the distinction between the error ei and the residual ei .

one implication is that n 1X ei = 0. Its method of moments estimator is the sample average 1X 2 ei . 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 4.2: Sum-of-Squared Error Function Contours Equation (4. The error variance σ 2 = Ee2 is also a parameter of interest. These are algebraic results. 24 . ˆ σ = ˆ n 2 i=1 n (4.7. ˆ n−k 2 i=1 (4.Figure 4.6) An alternative estimator uses the formula n 1 X 2 s = ei .5) implies that 1X xi ei = 0. and hold true for all linear regression estimates. It measures the variation in the i “unexplained” part of the regression. ˆ n i=1 n Since xi contains a constant.

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

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

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

. is the demeaning formula for regression. Regress X2 on X1 . ˆ which are “demeaned”. the primary use is theoretical. Regress Y on X1 .9).1 (Frisch-Waugh-Lovell). the FWL theorem can be used to speed computation.Theorem 4. obtain residuals X2 . In this case.9). obtain OLS estimates β 2 and residuals e. A common application of the FWL theorem. . In this section we derive the small sample conditional mean and variance of the OLS estimator. . . . obtain residuals Y . ⎟ ⎜ ⎟ ⎜ (4. . but in most cases there is little computational advantage to using the two-step algorithm. ⎠ ⎝ ⎠ ⎝ .8)(3. ¡ ¢−1 0 ι. which you may have seen in an introductory econometrics course. 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. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. By the independence of the observations and (3. . In some contexts. . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . ˜ 2. In the model (4. observe that ⎞ ⎛ ⎞ ⎛ . Rather. Regress Y on X2 . ˆ ˜ ˜ ˆ 3. 4. 30 .6. and X2 is the vector of observed regressors. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. .14) or via the ˆ following algorithm: ˜ 1. . or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.13).

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

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

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

We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . He proves that generically the OLS estimator (4. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .22) 34 . and thus so is the OLS estimator.9). the maximum likelihood estimator is identical to the OLS estimator. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. if the data have a discrete distribution.10) for the class of models satisfying Assumption 3. He observes that the above argument holds for all multinomial distributions.5.1.Substituting in the expressions for π j . Chamberlain (1987) extends this argument to the case of continuously-distributed data.10 Omitted Variables xi = µ x1i x2i ¶ . (4.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.

we calculate γ1 = ¡ ¡ ¢¢−1 E x1i x0 E (x1i yi ) 1i ¡ ¡ ¢¢−1 ¡ ¡ 0 ¢¢ 0 E x1i x1i β 1 + x0 β 2 + ei = E x1i x1i 2i ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 β 2 = β 1 + E x1i x0 1i 2i = β 1 + Γβ 2 ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 Γ = E x1i x0 1i 2i (4. the coeﬃcient on x2i in (4. which is often called “multicollinearity” for brevity. least-squares estimation of (4. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. In this case.22). Most commonly. 35 .11 Multicollinearity ˆ If rank(X 0 X) < k + 1. except in special cases. Typically. The diﬀerence Γβ 2 is known as omitted variable bias. Since the error is discovered quickly. then β is not deﬁned. we regress yi on x1i only. there is some α such that Xα = 0. For example. 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 . This happens when the columns of X are linearly dependent. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model.e. or second. First.23) the short regression to emphasize the distinction. when the columns of X are close to linearly dependent. this is rarely a problem for applied econometric practice. and the error as ui rather than ei .Now suppose that instead of estimating equation (4. Typically there are limits. This is called strict multicollinearity. i. as many desired variables are not available in a given dataset..22) the long regression and (4. This is the situation when the X 0 X matrix is near singular.23) where is the coeﬃcient from a regression of x2i on x1i . In general. 4. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). By construction. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . 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. To see this. Goldberger (1991) calls (4.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . because we have not said what it means for a matrix to be “near singular”. β 1 6= γ 1 . this arises when sets of regressors are included which are identically related. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions.22) by least-squares. The more relevant issue is near multicollinearity. When this happens. log(p2 ) and log(p1 /p2 ). This deﬁnition is not precise. the general model will be free of the omitted variables problem.22) is zero. log(p1 ). if X includes both the logs of two prices and the log of the relative prices. This is because the model being estimated is diﬀerent than (4.

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

1) in Section 2. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .This implies has a large value of hi . The key is equation (2. ¢−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 .25).27). Investigations into the presence of inﬂuential observations can plot the values of (4.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . ˆ We now derive equation (4. then this observation is a leverage point and has the potential to be an inﬂuential observation. which is considerably more informative than plots of the uncorrected residuals ei .

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

=E U V p q p q Proof of Markov’s Inequality.Markov’s Inequality. Set Y = g(X) and let f denote the density function of Y. If Xi ∈ Rk is iid and E |Xi | < ∞. P (g(X) > α) ≤ α−1 Eg(X). This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. The WLLN shows that sample averages converge in probability to the population average. denoted Zn →p Z as n → ∞. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q .3). We say that Zn converges in probability to Z as n → ∞. (5. as stated. Since g(x) is convex. Note EU = EV = 1. Let a + bx be the tangent line to g(x) at x = EX. ¥ Proof of Holder’s Inequality. Applying expectations. tangent lines lie below it. Theorem 5.1 Weak Law of Large Numbers (WLLN). For any strictly increasing function g(X) ≥ 0.2. n→∞ lim P (|Zn − Z| > δ) = 0.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. if for all δ > 0. 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 ) = + . 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}. n i=1 42 . ¥ 5. p p p q which is (5. So for all x. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. then as n → ∞ n 1X Xn = Xi →p E(X). g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX.4) Proof of Jensen’s Inequality. Eg(X) ≥ a + bEX = g(EX).

¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Theorem 5. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. Fix δ and η.4).1). and the bound |Wi | ≤ 2C.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . Set ε = δη/3. We say that Zn converges in distribution to Z as n → ∞. 43 . ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.6) and (5.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. we can set E(X) = 0 (by recentering Xi on its expectation). P ¯X n ¯ > δ ≤ η. denoted Zn →d Z. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.1 Central Limit Theorem (CLT). Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.1) and (5. V ) . If Xi ∈ Rk is iid and E |Xi |2 < ∞.6) By Jensen’s inequality (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . where Z has distribution F (x) = P (Z ≤ x) . Fn (x) → F (x) as n → ∞. Jensen’s inequality (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) .7). 5. the fact that the Wi are iid and mean zero. the fact that X n = W n + Z n .3.5).Proof: Without loss of generality. by Markov’s inequality (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . the triangle inequality. Finally. as needed. (5. if for all x at which F (x) is continuous.

∂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. By a second-order Taylor series expansion of c(λ) about λ = 0.8) where λ∗ lies on the line segment joining 0 and λ. it is suﬃcient to consider the case µ = 0 and V = Ik . 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5.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 . the independence of the Xi . the deﬁnition of c(λ) and (5. so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . 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 . ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). For ¡ ¢ λ ∈ Rk . By the properties of the exponential function.

then g(Zn ) →p g(c) as n → ∞. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. If Zn →d Z as n → ∞ and g (·) is continuous.3 Delta Method: If n (θn − θ0 ) →d N (0. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Since cλλ (λn ) → cλλ (0) = −Ik . This is suﬃcient to establish the theorem. 45 . Stacking across elements of g. Hence g(Zn ) →p g(c) as n → ∞. for each element of g.2 Continuous Mapping Theorem 2. Σ) = N 0.1 Continuous Mapping Theorem 1 (CMT). Theorem 5.√ where λn → 0 lies on the line segment joining 0 and λ/ n. and g(θ) : Rm → Rk . where θ is m × 1 and Σ is m × m. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 . gθ Σgθ . Recall that A ⊂ B implies P (A) ≤ P (B). Proof: Since g is continuous at c.4. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). k ≤ m.4 Asymptotic Transformations Theorem 5. ¥ 5. Ik ) distribution. then g(Zn ) →d g(Z) as n → ∞. Σ) . √ Theorem 5. If Zn →p c as n → ∞ and g (·) is continuous at c. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Proof : By a vector Taylor series expansion. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.4.4. we see that as n → ∞.

the density function of β 2 was computed and plotted in Figure 6. 46 . y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density.Chapter 6 Inference 6. The verticle line marks the true value of the projection coeﬃcient. Using ˆ simulation methods. let yi and xi be drawn from the joint density µ ¶ µ ¶ 1 1 1 2 2 exp − (ln y − ln x) exp − (ln x) f (x. ˆ Figure 6. since it is a function of the random data.1: Sampling Density of β 2 To illustrate the possibilities in one example.1 for sample sizes of n = 25.1 Sampling Distribution The least-squares estimator is a random vector. n = 100 and n = 800. In general. xi ) and the sample size n. its distribution is a complicated function of the joint distribution of (yi . and therefore has a sampling distribution.

Equation (4. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . 0). n i=1 (6. (6.5.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. ·) is continuous at (Q. Hence by the continuous mapping theorem (Theorem 5.5. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. Ã n ! n X 1X 0 1 ˆ xi xi .4 implies that Q−1 exists and thus g(·.5.1. ˆ 47 . (6.1). ˆ Theorem 6.1.2). To characterize the sampling distribution more fully.1).From the ﬁgure we can see that the density functions are dispersed and highly non-normal. 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.3) Ã where g(A.4.2 Consistency ˆ As discussed in Section 6.1) and ˆ We now deduce the consistency of β.1. This is illustrated in Figure 6. Assumption 3.2. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.2) i i n i=1 n From (6. 6. we can conclude ˆ that β →p β.1).1). For a complete argument. Proof.1 by the fact that the sampling densities become more concentrated as n gets larger. and the continuous mapping theorem (Theorem 5. Assumption 3. the OLS estimator β is has a statistical distribution which is unknown.1 and the WLLN (Theorem 5. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. (6.1 Under Assumption 3.3). using (6.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . xi ei →p g (Q. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. 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 .4. β →p β as n → ∞. First. we will use the methods of asymptotic approximation. As the sample size increases the density becomes more concentrated about the population coeﬃcient.2.

5. We need a strengthening of the moment conditions. ˆ n−k 6. Ω) . Thus σ 2 is consistent for σ 2 . σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. 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 .1).1 guarantees that the elements of Ω are ﬁnite.Theorem 6. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. by the Cauchy-Schwarz inequality (5. To see this. Assumption 6. ˆ Finally.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6. (6.2 Under Assumption 3.2).5. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . n 1 X √ xi ei →d N (0. it follows that s2 = ¥ n σ 2 →p σ 2 .2.1 In addition to Assumption 3. Ee4 < ∞ and E |xi |4 < ∞.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. (6. i i Assumption 6. By the central limit theorem (Theorem 5.1). ˆ Proof.2). E ¯ei ¯ E ¯e4 ¯ i i i i (6.3.6) n i=1 48 .1.2.1.3. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.3.3) and Theorem (6. since n/(n − k) → 1 as n → ∞.

We illustrate this problem using a simulation. In´Figure 6. otherwise V 6= V 0 . In Figure 6.7) is true then V = V 0 .1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . Let yi = β 0 + β 1 xi + εi where xi is N (0.3.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. How large should n be in order for the approximation to be useful? Unfortunately. and (6. its variance diverges q ³ ´ ˆ to inﬁnity. however. We say that ei is a Homoskedastic Projection Error when (6. 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. for example. There is a special case where Ω and V simplify.9) In (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . As α approaches 2. The approximation may be poor when n is small. there is no simple answer to this reasonable question. setting n = 100 and varying the parameter α. When (6.6).1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. Ω) ¡ ¢ = N 0. Theorem 6. V ) where V = Q−1 ΩQ−1 .3. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. Q−1 ΩQ−1 .1. We call V 0 the homoskedastic covariance matrix.1 Under Assumption 6. The expression V = Q−1 ΩQ−1 is called a sandwich form.1. e2 ) = 0.2). |ε| ≥ 1. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. V is often referred to as ˆ the asymptotic covariance matrix of β. i i Condition (6. after rescaling.1 states that the sampling distribution of the least-squares estimator.7) Cov(xi x0 . when xi and ei are independent. The trouble is that no matter how large is the sample size.7) holds. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. 1) asymptotic distibution. (6. The asymptotic distribution ´ Theorem 6.7) is true or false.Then using (6.3.3.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. For α 49 . If α > 2 the 2 error εi has zero mean and variance α/(α − 2).3. However. This holds true for all joint distibutions of (yi . 1). Under (6. xi ) which satisfy the conditions of Assumption 6.1). but this is not a necessary condition. 1 X √ xi ei n i=1 n ! the N (0.9) we deﬁne V 0 = Q−1 σ 2 whether (6.

Another example is shown in Figure 6. concentrating most of the probability mass around zero.3 is that the N (0.11) 50 .0 the density is very close to the N (0. for k = 1.1) it is clear that V 0 →p V 0 .2) and Theorem 6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.2: Density of Normalized OLS estimator α = 3.3. 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 . As k increases. 1) asymptotic approximation is never guaranteed to be accurate. 6 and 8. 4.Figure 6.10) V 0 = Q−1 s2 . ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. 6. we need an estimate of Ω = E xi x0 e2 . 1) density. The estimator 2 2 in (6. We show the sampling distribution of n β 1 − β 1 setting n = 100.10) without changing this result. 1).4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.2. As α diminishes the density changes signiﬁcantly. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. the sampling distribution becomes highly skewed and non-normal.2 and 6. The lesson from Figures 6.

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

by Holder’s inequality (5. we return to the log wage regression of Section 4.5) and the WLLN (Theorem 5.493 0. The standard errors for β 0 are 7. First.98 −0.80 40. To illustrate.14 205.199 2.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. n n i=1 52 .1. Ω 2.2.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. (6.117 Educationi .83 ¶−1 = µ 7. i i i i n i=1 Second.14 14.14 205.14 14.83 −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 . but not under another set of assumptions. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .020.80 2.493 −0.035 ¶ .12) in turn.039 and ˆ V = µ 1 14.480 ˆ0 = 0. then take the diagonal elements. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .480 .14 205.2/988 = . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. (. We calculate that s2 = 0.085 p ˆ and that for β 1 is .199 2.20 = V 14. just as any other estimator.35/988 = .20 and µ ¶ ˆ = 0.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.6 ¶µ 1 14.085) (. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.020) 6. p ˆ In this case the two estimates are quite similar.used by an author when studying their work.14 6. (6.30 + 0. from which it follows that V →p V as n → ∞.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. From a computational standpoint. and then the square roots.83 ¶−1 µ .80 .80 40.20 −0. Using (6.

you can show that 1 Xˆ ¯ β= β (−i) . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.25). Recall from Section 4. 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. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .11) with the leave-one-out estimator ei. Using this substitution. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .1 As n → ∞. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. i=1 Third.13) Using formula (4. which.13) of Efron (1982).6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. From equation (3.26).¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. 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. Andrews (1991) suggested an similar estimator based on cross-validation. Ω →p Ω and V →p V. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. n i=1 n − 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. these establish consistency.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 .5. ¯ ¯n ¯ n i=1 so Together.−i = (1 − hi )−1 ei ˆ presented in (4. n i=1 n ˆ ˆ Theorem 6.

so Vθ = R0 V R. ˆ θ What is an appropriate standard error for ˆ Assume that h(β) is diﬀerentiable at the true θ? value of β.. . Hβ = R and Hβ = R. For example. V ) where ∂ h(β) ∂β (k + 1) × q. then the natural estimate for the variance of ˆ is θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). (6. Andrews ˆ ˆ (1991) argues that simulation evidence indicates that V ∗∗ is an improvement on V ∗ . but omits the mean correction. Ω∗∗ = i ˆi n i=1 n 6. the function h(β) is linear: h(β) = R0 β ˆ ˆ ˆ for some k × q matrix R. By a ﬁrst-order Taylor series approximation: ³ ´ 0 ˆ ˆ h(β) ' h(β) + Hβ β − β .. Let h : Rk → Rq denote this function and let θ = h(β) denote the parameter of interest. 54 . The estimate of θ is ˆ = h(β). β k+1 ).7 Functions of Parameters Sometimes we are interested in some lower-dimensional function of the parameter vector β = (β 1 . 1X ˆ (1 − hi )−2 xi x0 e2 . Hβ = ∂β In many cases.where ˆ It is similar to the MacKinnon-White estimator V ∗ . we may be interested in a single coeﬃcient β j or a ratio β j /β l . In this case.. = N (0.15) where 0 Vθ = Hβ V Hβ . Vθ ). In these cases we can write the parameter of interest as a function of β. ˆ ˆ If V is the estimated covariance matrix for β. 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.

8. θ could be a single element of β). s(ˆ = n−1/2 H 0 V Hβ .15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. and θ = h(β) is some function of the parameter vector. In general. the statistic tn has an exact t distribution.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. µ I 0 ¶ ˆ the upper-left block of V . that (so θ ˆ ˆ ˆ is. and is therefore exactly free of unknowns. (For example. see Section X). A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . 1) Proof.For example. however. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. we say that tn is an exactly pivotal statistic. the standard error for ˆ is the square root of n−1 Vθ . Since the standard normal distribution does not depend on the parameters. we say that tn (θ) is asymptotically pivotal. Consider the studentized statistic tn (θ) = Theorem 6. 1) →d ˆ−θ θ .1 tn (θ) →d N (0.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. In this case. if R is a “selector matrix” R= so that if β = (β 1 . β 2 ). 55 . In special cases (such as the normal regression model. ˆ When q = 1q h(β) is real-valued). θ) β 6. Vθ ) √ Vθ = N (0. By (6. s(ˆ θ) (6.

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

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

θ = β 2 . Also h(β) = a selector matrix. χ2 (. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.3.19) σ2 ˆ where σ2 = ˜ 1 0 e e. For example. Vθ ). h(β) = R0 β.2. Furthermore. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.When h is a linear function of β.05) = 3. Hβ (β) is a continuous function of β.1. The asymptotic p-value for Wn is pn = p(Wn ). q and pn is asymptotically U[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 2.84 = z. Hence β β by Theorem A.1 showed θ ˆ that V →p V. if rank(Hβ ) = q. In this case. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . Hβ (β) →p Hβ . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .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 . and Theorem 6. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. 1] under H0 .15) showed that n ˆ − θ →d Z ∼ N (0. ˆ Wn = n θ θ q θ θ Theorem 6.5. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . the upper-α quantile q 2 of the χ2 distribution. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. The null hypothesis is H0 : β 2 = 0. and there are q = k2 restrictions.1 Under H0 and Assumption 6.8. 6. then Wn →d χ2 . As before. a chiq square random variable with q degrees of freedom.10. 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. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .025 . the test rejects at the α% level iﬀ pn < α. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). ˜˜ n ˜ e = Y − X1 β 1 .

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

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

Furthermore. so as a practical matter it does not matter which distribution is used. 0. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. β 2 . σ 2 ) = − log σ − log (2π) − .1 and Theorem 6. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ ˆ ˆ βj − βj βj − βj N (0.12. β has an exact normal distribution and t has an exact t distribution.1 If ei is independent of xi and distributed N(0. β and t are approximately normally distributed. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . σ2 ˆ 61 . The critical values are quite close if n − k ≥ 30. In contrast. a good testing procedure is based on the likelihood ratio statistic. 0. if standard errors are calculated using the homoskedastic formula (6. σ 2 ).) Now let us partition β = (β 1 . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .10) then ´ ³ ˆ • β ∼ N 0.8. σ 2 ) − Ln (β 1 . β 2 .3.a chi-square distribution with n − k degrees of freedom. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ 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. σ 2 ) discussed above.1 we showed that in large samples. Theorem 6. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.1 shows that under the strong assumption of ˆ normality. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . (Unless the sample size is unreasonably small. and standard errors are calculated using the homoskedastic formula (6. As inference (conﬁdence intervals) are based on the t-ratio. We summarize these ﬁndings Theorem 6. with residual variance σ . 1) and tn−k distributions.12.10) µ h i ¶ 2 (X 0 X)−1 N 0. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . β 2 . n−k • ∼ tn−k ˆ In Theorem 6. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . 0. the notable distinction is between the N (0.

In the present context of the Wald statistic. Through repetition. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. they can work quite poorly when the restrictions are nonlinear. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. The decreasing dashed ˆ = 1. features of this distribution can be calculated. Letting h(β) = β s . the statistic Wn (s) varies with s.7.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. This can be seen by a simple example introduced by Lafontaine and White (1986). LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. To demonstrate this eﬀect. The increasing solid line is for the case β = 0. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. 6. setting n/σ 2 = 10.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. This produces random draws from the sampling distribution of interest. Our ﬁrst-order asymptotic theory is not useful to help pick s. ˆ Let β and σ 2 be the sample mean and variance of yi . This is an unfortunate feature of the Wald statistic.84 — the probability of a false rejection. while there are other values of s for which test test statistic is insigniﬁcant. 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.4 the Wald statistic Wn (s) as a function ˆ of s. and noting Hβ = sβ s−1 . as Wn (s) →d χ2 under H0 for 1 any s. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . σ 2 ) and consider the hypothesis H0 : β = 1.8. 62 . Take the model yi = β + ei ei ∼ N (0. we have plotted in Figure 6.

Test performance deteriorates as s increases. The null hypothesis β s = 1 is true.000 simulated Wald statistics Wn (s) which are larger than 3. The value of s is varied from 1 to 10.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . and σ 2 . the Type I error probability improves towards 5% as the sample size n increases. we compare the rates row by row.000 random samples.84 | β = 1) .4: Wald Statistic as a function of s P (Wn (s) > 3. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. no magic choice of n for which all tests perform uniformly well. n. Any other choice of s leads to a test with unacceptable Type I error probabilities. Given the simplicity of the model. When comparing statistical procedures. Error rates avove 10% are considered excessive. remember that the ideal Type I error probability is 5% (. Rates above 20% are unexceptable. looking for tests for which rate rejection rates are close to 5%. Typically. 100 and 500.1 reports the simulation estimate of the Type I error probability from 50.84. the only test which meets this criterion is the conventional Wn = Wn (1) test.4. These probabilities are calculated as the percentage of the 50.05) with deviations indicating+ distortion. To interpret the table. In Table 4. so these probabilities are Type I error. Type I error rates between 3% and 8% are considered reasonable. and σ is varied among 1 and 3.1 we report the results of a Monte Carlo simulation where we vary these three parameters. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Table 4. Table 4. In each case. however. and rarely fall outside of the 3%-8% range. In Table 2.1 you can also see the impact of variation in sample size. For this particular example. this probability depends only on s.Figure 6. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. There is. n is varied among 20.

06 .09 .26 .13 .05 .19 .30 . This point can be illustrated through another example.06 .33 .20 .06 .15 .12 .06 .25 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.14 .20 . deﬁne θ = β 1 /β 2 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.06 .13 .07 .20). β 1 .07 . β 2 ) be the least-squares estimates of (6.05 .07 . Equivalently.21 . Other choices are arbitrary and would not be used in practice. so the hypothesis can be stated as H0 : θ = r.12 .31 .08 .06 .05 .15 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.14 .34 .25 .23 .06 .15 .22 .18 .07 .35 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .08 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .05 .15 .10 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .24 .08 .17 .22 .11 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .16 Rejection frequencies from 50.05 .10 .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 .28 . While this is clear in this particular example.08 .10 .05 .06 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. 64 .08 .07 .13 .

05 .00 .09 .05 .00 . such as the GMM distance statistic which will be presented in Section 9.645) t1n t2n t1n t2n t1n t2n t1n t2n .00 . This leaves β 2 as a free parameter.06 . . 6.645) and P (tn > 1. In all cases.645) P (tn < −1.10 . the rejection rates for the t1n statistic diverge greatly from this value.07 . It is also prudent to consider alternative tests to the Wald statistic.05 .10 .06 .06 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .645) are calculated from 50.05 .00 The one-sided Type I error probabilities P (tn < −1.06 .05 . .50.05 . We vary β 2 among . if the hypothesis can be expressed as a linear restriction on the model parameters.00 .15 . and 1. If no linear formulation is feasible. and normalize β 0 = 0 and β 1 = 1. .000 simulated samples.06 .12 .1. Ideally.00 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .06 .06 . σ 2 ) draw with σ = 3. especially for small values of β 2 .50 . Table 4. then the “most linear” formulation should be selected.06 . However.06 .47 .05 β2 . ei be an independent N (0.7. while the right tail probabilities P (t1n > 1. The left tail probabilities P (t1n < −1.645) greatly exceed 5%. The implication of Table 4. this formulation should be used.645) P (tn > 1. The results are presented in Table 4.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.15 .0 and n among 100 and 500.00 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .75 1.26 . We let x1i and x2i be mutually independent N (0.645) are close to zero in most cases.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.00 .10 .28 . along with sample size n.05 .00 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.25 . the entries in the table should be 0.06 .02 .05.75.2.645) P (tn > 1. and alternatives to asymptotic critical values should be considered. 1) variables.25. 65 .00 .05 . In this section we describe the method in more detail.05 . In contrast.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. and are close to the ideal 5% rate for both sample sizes. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.

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

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

027 .001 .48772 = 515. Table 4. 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.014 .18) that the state coeﬃcients are jointly zero.097 −. we ﬁnd Wn = 550.808 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.102 −.4945.008 .variable for state of residence (including the District of Columbia.032 .69.010 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. the restricted standard deviation estimate is σ = .033 −.34 ˆ s(β) .121 −.1. but not equal. Wn = n 1 − 2 = 18. excluding the coeﬃcients on the state dummy variables. as the 1% critical value for the χ2 distribution is 76.4877 18. Ignoring the other coeﬃcients.00057 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.010 .002 . reestimating the model with the 50 state dummies excluded. 808 1 − . 2β 3 68 . The F form of the Wald statistic (6. this adds 50 regressors).1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. θ ˆ 2β 3 β2 .007 .808 so the parameter estimates are quite precise and reported in Table 4. Alternatively.101 .070 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.00002 . Using either statistic the hypothesis is easily rejected.013 .49452 σ ˜ Notice that the two statistics are close.102 −. Computing the Wald statistic (6. The available sample is 18.232 .

this is a poor choice.9. but it can be found numerically quite easily. but the lower end is substantially lower. 29. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. Instead. 69 . we found better Type I error rates by reformulating the hypothesis as a linear restriction. In the present context we are interested in forming a conﬁdence interval. In the previous section we discovered that such t-tests had very poor Type I error rates.40. not testing a hypothesis. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. Since tn (θ) is a non-linear function of θ.Using the Delta Method. 29.5].0.96. However. we can calculate a standard error of s(ˆ = .5]. there is not a simple expression for this set. implying a 95% conﬁdence θ) interval of [27. so we have to go one step further. This set is [27. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. 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 ). This is the set of θ such that |tn (θ)| ≤ 1.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

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

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

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

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

θ) is diﬀerentiable with respect to θ. θ). In the ﬁnal two examples. 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 . V ) θ where mθi = mθ (xi . G known x2 − θ5 m(x. See Appendix E. First. Let 0 yi = ei + m0 θ0 . θ) = θ1 + θ2 xθ3 m(x. The NLLS residuals are ei = yi − m(xi . but we won’t cover that argument here. ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. which alters some of the analysis. mθ (x.8) Theorem 7. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. it is adopted as a ﬂexible approximation to an unknown regression function. ˆ must be found by numerical θ methods. ´ √ ³ n ˆ − θ0 →d N (0. m is not diﬀerentiable with respect to θ3 . In other cases.1 If the model is identiﬁed and m(x. θ) = θ1 + θ2 exp(θ3 x) m(x. ˆ ei . θ) = θ1 + θ2 m(x. θ0 ). θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples. When m(x. The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. m(x. When it exists. it must be shown that ˆ →p θ0 .4. θ))2 . let ∂ m(x. θ) = G(x0 θ). θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x.Examples of nonlinear regression functions include x 1 + θ3 x m(x. θ) is suggested by an economic model. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . θi 79 . θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. θ) is diﬀerentiable. Since ˆ →p θ0 . When the regression function is nonlinear. then the FOC for minimization are 0= n X i=1 mθ (xi . This can be done using arguments θ for optimization estimators. ˆ is close to θ θ θ0 for n large. we call this the nonlinear least squares (NLLS) θ). estimator. θ) is (generically) diﬀerentiable in the parameters θ. θ)ˆ (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. This means that under H0 . In particular.4. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. and this is often a useful hypothesis (sub-model) to consider. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ) ' (ei + m(xi . Identiﬁcation is often tricky in nonlinear regression models. This renders the distribution theory presented in the previous section invalid. ˆ and ei = yi − m(xi . γ is not identiﬁed. 7. An alternative good measure is the conditional median. θ0 ) + m0 (θ − θ0 ) .1.5 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 . under H0 . but these are not the only measures of central tendency. θ) ' m(xi . ¥ Based on Theorem 7. the parameter estimates are not asymptotically normally distributed. 80 . θ0 )) − m(xi . θ which is that stated in the theorem. θ) = β 0 zi + β 0 xi (γ). Thus we want to test H0 : β 2 = 0. tests of H0 do not have asymptotic normal or chi-square distributions. θi Thus ¡ ¢ yi − m(xi . However. Thus when the truth is that β 2 = 0. Hansen (1996). Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . m(xi . We have discussed projections and conditional means. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. 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 . Furthermore. ˆ ˆ θ) ˆ θ). Suppose that m(xi .For θ close to the true value θ0 . the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . 1 2 The model is linear when β 2 = 0.

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

ˆ Proof of Theorem 7. we provide a sketch here for completeness.Theorem 7. the height of the error density at its median.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .5. then there are many innovations near to the median. by the central limit theorem (Theorm 5. V ). The main diﬃculty is the estimation of f (0). While a complete proof of Theorem 7. When f (0 | x) is large. ¢¢−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) . then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. This can be done with kernel estimation techniques.10) is equivalent to g n (β) = 0. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. (7. the conditional density of the error at its median.5. Computation of standard error for LAD estimates typically is based on equation (7.11). See Chapter 16. and this improves estimation of the median.1 ´ √ ³ˆ n β − β 0 →d N (0. First. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. ∂β 0 so Third.3. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . where V = and f (e | x) is the conditional density of ei given xi = x. In the special case where the error is independent of xi .11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. Let g(β) = Eg (β).5. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . Pn −1 0 β)) .1 is advanced.

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.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. 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)) .9) for the median to all quantiles. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. so you can think of the quantile as the inverse of the distribution function. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } .12) Qτ = argmin Eρτ (U − θ) .13) This generalizes representation (7. For the random variables (yi . ¥ 7. Again. The third line follows from an asymptotic empirical process argument. the quantile regression functions can take any shape. then (7. For ﬁxed τ . As functions of x.5. V ). For τ ∈ [0. The median is the special case τ = . Exi x0 ) →d i 2 = N (0. If the random variable U has τ ’th quantile Qτ . The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . We then have the linear quantile regression model yi = x0 β τ + ei i 83 . when F (y | x) is continuous and strictly monotonic in y. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . then F (Qτ (x) | x) = τ . (7.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. then F (Qτ ) = τ . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). The following alternative representation is useful.

E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). n numerical methods are necessary for its minimization. and are widely available. Fortunately. 7. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. i By construction. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. otherwise its properties are unspeciﬁed without further restrictions. where and f (e | x) is the conditional density of ei given xi = x. the asymptotic variance depends on the conditional density of the quantile regression error. it is useful to have a general test of the adequacy of the speciﬁcation. Vτ ). 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. ˆ Given the representation (7.12).5. if the model yi = x0 β + ei has i been ﬁt by OLS. fast linear programming methods have been developed for this problem. 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.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Thus. conventional Newton-type optimization methods are inappropriate. then f (0 | xi ) = f (0) . Furthermore. ´ √ ³ˆ Theorem 7. Another popular approach is the RESET test proposed by Ramsey (1969). ¡ ¡ ¢¢−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. since it has discontinuous derivatives. the τ ’th conditional quantile of ei is zero.6. When the error ei is independent of xi . and test their signiﬁcance using a Wald test. The null model is yi = x0 β + εi i 84 .1. the unconditional density of ei at 0. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) .1 n β τ − β τ →d N (0. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 .13). and form a Wald statistic i for γ = 0.

It is particularly powerful at detecting single-index models of the form yi = G(x0 β) + εi i where G(·) is a smooth “link” function. To implement the test.be an (m − 1)-vector of powers of yi .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.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. β 1 = (X1 X1 )−1 (X1 Y ) . 1i 2i 2i 1i 22 . Wn →d χ2 . ⎠ . ⎟ zi = ⎝ . 3. and n→∞ say. or 4 seem to work best. 7. However. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . Another is to regress yi on x1i and x2i jointly. then 22 Q11 > Q11 − Q12 Q−1 Q21 . 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. small values such as m = 2. Q−1 σ 2 < Q11 − Q12 Q−1 Q21 11 22 85 ¡ ¡ ¢ ¢−1 2 ¡ ¢−1 2 ˆ lim nV ar(β 1 ) = Ex1i x0 − Ex1i x0 Ex2i x0 Ex2i x0 σ = Q11 − Q12 Q−1 Q21 σ . Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . β 2 ). In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . Otherwise. m must be selected in advance. Typically. yielding predicted values yi = x0 β. It is easy (although somewhat tedious) to show that under the null hypothesis. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. yielding ˆ ˜ ˆ ˆ (β 1 . The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. yi ˆm (7. and the two estimators have equal asymptotic eﬃciency. and form the Wald statistic Wn for γ = 0. they will (typically) have diﬀerence asymptotic variances. note that (7. since Q12 Q−1 Q21 > 0.14) by OLS. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. and consequently 22 ¡ ¢−1 2 σ . To see why this is the case.

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

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

. In the ordered case. Also under M2 . 210 = 1024. However. which can be a very large number. a model consists of any possible subset of the regressors {x1i .. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. MK : β 1 6= 0.15).17). and then selects the model with the lowest AIC (7. β K 6= 0. which regressors enter the regression). selecting based on (7. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. . β 2 6= 0. In the unordered case. and 220 = 1. xKi }. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . β 3 = · · · = β K = 0 . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. the models are M1 : β 1 6= 0. . .. β 2 6= 0. there are 2K such models. 576. Similarly for ˆ the BIC. . 048. For example. stores the residual variance σ 2 for each model.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. . There are two leading cases: ordered regressors and unordered. The methods extend readily to the issue of selection among multiple regressors. In the latter case. and the AIC or BIC in principle can be implemented by estimating all possible subset models. We have discussed model selection between two models. which are nested.. The AIC selection criteria estimates the K models by OLS. . 88 . one can show that thus LRn →p ∞.

and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e.. ˜ the residual vector is e = Y − X β. Thus the available information is the sample (Y. where M1 = I − X X 0 Ω−1 X ˆ ¡ 0 −1 ¢−1 0 −1 0 (c) Prove that M1 Ω−1 M1 = Ω−1 − Ω−1 X X Ω X XΩ . the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . . the residuals e. the mean absolute error (MAE) is E |yi − g(xi )| . V . σ 2 ). 5.10 Exercises 1. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. x. 4. (b) Find an estimate of the variance of this forecast. Let (yi . X). ˆ (a) Find a point forecast of y. . V ar(e | X) = σ 2 Ω with Ω known. ˆ ˆ n−k 6. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. where xji is one of the xi . E(e | X) = 0. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . In a linear model Y = Xβ + e.. Let θ satisfy Eg(Yi − θ) = 0. 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. 2.7. Show that the function g(x) which minimizes the MAE is the conditional median M (x). the estimates (β. For any predictor g(xi ) for y. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. xi ) be a random sample with E(Y | X) = Xβ. 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 .12). Verify equation (7. Is θ a quantile of the distribution of Yi ? 3. (b) Prove that e = M1 e. else equals zero). Let σ 2 be the estimate of σ 2 .. and the out-of-sample value of the regressors. wn ) and wi = x−2 . i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V .

and V is the = g(x estimate of V ar ˆ . For values of ln Qi much below a7 . I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. the variable ln Qi has a regression slope of a2 . (d) Calculate standard errors for all the parameters (a1 . 90 .18) (a) Following Nerlove. (7. This model is called a smooth threshold model. Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. the regression slope is a2 + a6 . (ii) AIC criterion. In addition. . Assess the merits of this new speciﬁcation using (i) a hypothesis test. 8. θ is the NLLS estimator. at least 10 to 15) of ln Qi are both below and above a7 . (iii) BIC criterion. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. n xi i=1 (a) Under the stated assumptions. θ) + ei with E (ei | xi ) = 0... Consider model (7. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . Record the sum of squared errors. you estimated a cost function on a cross-section of electric companies. Find an asymptotic 95% conﬁdence interval for g(x). 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 . a7 ). Examine the data and pick an appropriate range for a7 . impose the restriction a3 + a4 + a5 = 1. Exercise 13. The model is non-linear because of the parameter a7 . In Chapter 6.18) plus the extra term a6 zi . The model works best when a7 is selected so that several values (in this example. Suppose that yi ³ ´ i . and ﬁnd the value of a7 for which the sum of squared errors is minimized. are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9. and the model imposes a smooth transition between these regimes. For values much above a7 . add the variable (ln Qi )2 to the regression. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . Do so. calculate zi and estimate the model by OLS.. For each value of a7 .ˆ ˆ 7. (c) Estimate the model by non-linear least squares.

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

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

the EDF step function gets uniformly close to the true CDF. it is helpful to think of a random pair (yi . (8. I have plotted the EDF and true CDF for three random samples of size n = 25. x) − F (y. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. √ n (Fn (y. i 93 . The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x) (1 − F (y. F (y.1). x) = P (yi ≤ y. x))) . where 1(·) is the indicator function.8. Notationally.3.. ∗ P (yi ≤ y. Furthermore. x) . Fn (y.2) Fn (y. For n = 25. x). the EDF is only a crude approximation to the CDF.1). x) = n i=1 Figure 8. as the sample size gets larger. x) →p F (y. but the approximation appears to improve for the large n.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. n. 1) distribution. i = 1. x). Recall that F (y. That is. xi ). Thus by the WLLN (Theorem 5. To see the eﬀect of sample size on the EDF. x∗ ≤ x) = Fn (y. The random draws are from the N (0.2. 50. in the Figure below. x) is called the empirical distribution function (EDF). Fn is a nonparametric estimate of F. x)) →d N (0.2 The Empirical Distribution Function Fn (y. x). note that for any (y. by the CLT (Theorem 5. In general. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . . x∗ ) with the i distribution Fn . To see this.. and 100. Note that while F may be either discrete or continuous. The EDF is a consistent estimator of the CDF. Fn is by construction a step function..

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

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

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

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

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

99 .3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. The ideal test rejects if Wn ≥ qn (α).3 an = o(n−r ) if nr |an | → 0 as n → ∞. about the rate v of convergence. Let an be a sequence. (8. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α.] 8.8 Asymptotic Expansions Tn →d N (0. We say that a function g(x) is even if g(−x) = g(x). writing Tn ∼ Gn (x. the critical value qn (α) is found as the quantile from simulated values of W´ .2 an = O(1) if |an | is uniformly bounded. where qn (α) is the (1 − α)% quantile of the distribution of Wn . however.8. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic. θ θ θ ˆ θ ∗ ∗ Computationally. and vice-versa. Deﬁnition 8. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). The following notation will be helpful. Basically.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. Deﬁnition 8. Let Tn be a statistic such that (8. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α.4) v ¡ ¢ While (8. lim Gn (x. A better asymptotic approximation may be obtained through an asymptotic expansion. not ˆ − θ0 . F ) then ³x´ . where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . an = O(n−r ) if it declines to zero like n−r . θ [This is a typical mistake made by practitioners. and a function h(x) is odd if h(−x) = −h(x). it says nothing. If θ is a vector. v 2 ). C4 is called the symmetric percentile-t interval. F ) = Φ + o (1) .∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test.8.4) says that Gn converges to Φ x as n → ∞. or the size of the divergence for any particular sample size n. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . The derivative of an even function is odd. Thus here Tn (θ) = Wn (θ). Equivalently.8. F ) = Φ n→∞ v or ³x´ Gn (x.

9 One-Sided Tests Using the expansion of Theorem 8. and g1 is continuous with respect to F. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F0 ) = 1 g (x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). An asymptotic test is based on Φ(x). F ) ≈ Φ + n−1/2 g1 (x. Theorem 8.8. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). F ) + O(n−3/2 ) 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. so the order of the error is O(n−1/2 ). which from Theorem 8. To the second order.8. Fn ) + O(n−1 ). F ) v which adds a symmetric non-normal component to the approximate density (for example. ³x´ Gn (x. F ) converges to the normal limit at rate n1/2 . Moreover. Fn ) − g1 (x.uniformly over x. g1 (x. Fn ) − g1 (x. F0 )) + O(n−1 ). F ) + n−1 g2 (x. F0 )) converges to 0 at rate n.1 as follows. First. F ) ≈ Φ + n−1/2 g1 (x. Fn ) = Φ(x) + n 1 g (x. Fn ) − g1 (x. Gn (x. F0 ) = Φ(x) + since v = 1. ³x´ Gn (x. F ) = Φ v n n 8. v Since the derivative of g1 is odd.8.1 has the expansion n G∗ (x) = Gn (x. the diﬀerence √ (g1 (x. and g2 is an odd function of x. F ). adding leptokurtosis).1. Heuristically. the density function is skewed. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. F0 ) = n 1 n1/2 (g1 (x. ³x´ 1 1 + 1/2 g1 (x.1 Under regularity conditions and (8.8. F ) + g2 (x. 100 . the exact distribution is P (Tn < x) = Gn (x. The diﬀerence is Φ(x) − Gn (x.3). We can interpret Theorem 8. F0 ) ≈ ∂ g1 (x. √ Since Fn converges to F at rate n. A bootstrap test is based on G∗ (x). To a third order of approximation. 1/2 1 n Because Φ(x) appears in both expansions. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . To a second order of approximation. where g1 is an even function of x.

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

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

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

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

Estimate a linear regression of price on the number of bedrooms.5% and 97. and ˆ is calculated on each θ ∗ ∗ θ sample.95) denote the 95% quantile of Tn .75 and 1. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.dat contains data on house prices (sales).Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Let qn (.95). and the colonial dummy. ∗ ∗ ∗ Let qn (. you generate bootstrap samples.05) . and the 2. The ˆ are sorted. size of house. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).5% quantiles of the ˆ are . (c) With the given information. ˆ − s(ˆ n (. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.pdf. Using the non-parametric bootstrap. You do this as follows.3. ∗ ∗ where s(ˆ is the standard error in the original data. lot size. can you report the 95% Percentile-t interval for θ? 7. and thus reject H0 if ˆ ˆ > q ∗ (. You want to test H0 : θ = 0 against H1 : θ > 0. What is wrong with this procedure? Tn = θ/s(θ) n 6. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. The dataﬁle hprice1.95) denote the 5% θ) ∗ and 95% quantiles of Tn . (a) Report the 95% Efron Percentile interval for θ.2 and s(ˆ = .2. θ respectively. ˆ = 1. (b) Report the 95% Alternative Percentile interval for θ.95). The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. You replace c with qn (. with variables listed in the ﬁle hprice1. Using the non-parametric ∗ bootstrap. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.05) and qn (. Suppose that in an application.95). 105 .

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

For example. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi .1 β GMM = argmin Jn (β). For some × weight matrix Wn > 0.2.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following.2. Let and where gi = xi ei . The GMM estimator minimizes Jn (β). β GMM = Z 0 XWn X 0 Z 9. β ˆ Note that if k = . ¡ ¢−1 0 ˆ Z XWn X 0 Y. let Jn (β) = n · g n (β)0 Wn g n (β).9. then g n (β) = 0. the dependence is only up to scale. then. ˆ Deﬁnition 9. if Wn = I. and the GMM estimator is the MME. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . i i . β GMM does not change.2) g n (β) = (9. for if Wn is replaced ˆ by cWn for some c > 0. the square of the Euclidean length. Proposition 9. This is a non-negative measure of the “length” of the vector g n (β).3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. but this is generally not possible when > k.

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

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

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

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

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

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

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

6) (a) Show that you can rewrite Jn (β) in (9. The observed data is (yi . The equation of interest is yi = g(xi . Deﬁne the Lagrangian L(β. zi is l × 1 and β is k × 1. the distance statistic D in (9.6) equals the Wald statistic. zi ). The GMM estimator of β. 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. xi . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. 115 . h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β).5. h(β)=0 (9. 6. VR = V − V R R0 V R (d) Show that in this setting.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. In the linear model Y = Xβ + e with E(xi ei ) = 0. l ≥ k. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. VR ) where ¡ ¢−1 0 R V. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . β) + ei E (zi ei ) = 0.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . Vn = X X i=1 ˜ and hence R0 β = r. subject ˆ i ˆi i=1 to the restriction h(β) = 0. Show how to construct an eﬃcient GMM estimator for β. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). 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 .

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

these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1.3) i=1 117 . The idea is due to Art Owen (1988... xi . The multinomial distribution which places probability pi at each observation (yi . . .2) Ln (p1 . Now consider the case of an overidentiﬁed model with moment condition Egi (β 0 ) = 0 where g is × 1 and β is k × 1 and for simplicity we write gi (β) = g(yi . The n ﬁrst order conditions are 0 = p−1 − µ. Combined with i the constraint (10. The idea is to construct a multinomial distribution F (p1 ...1).1 Non-Parametric Likelihood Since each observation is observed once in the sample.1) i=1 First let us consider a just-identiﬁed model. 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. zi . It is a non-parametric analog of likelihood estimation.1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n). . (10. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. In this case the moment condition places no additional restrictions on the multinomial distribution.... xi . β).. pn ) = i=1 An alternative to GMM is empirical likelihood. pn ) are those which maximize the log-likelihood subject to the constraint (10. the log-likelihood function for this multinomial distribution is n X ln(pi ).Chapter 10 Empirical Likelihood 10. The maximum likelihood estimator of the probabilities (p1 . pn ) which places probability pi at each observation. To be a valid multinomial distribution. 2001) and has been extended to moment condition models by Qin and Lawless (1994). (10..

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

11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .13) yields n n Expanding (10.1 Under regularity conditions.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .13) Premultiplying by G0 Ω−1 and using (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . λ) = − (10.10) ¡ Ω−1 N (0. β λ ∂ ³ ´.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. n (10.9) (10. Thus the EL estimator is asymptotically eﬃcient. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.10. i i Theorem 10.10).14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . (β.2. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . i=1 i=1 i=1i Expanding (10. and Ω = E xi x0 e2 . Gi (. 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 (10.8) and ¢ 0 0 For example.9) and (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. in the linear model. β) = −xi zi . and n β − β 0 and nλ are asymptotically independent. λ) = − (10. G = −E (xi zi ). ˆ ˆ Proof. 0 = Rn (β.

(10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. LRn = i=1 Theorem 10.17) 2 ln 1 + λ gi β . β 0 ) = 0 then LRn →d χ2−k .16).15) (10. by a Taylor expansion. They are asymptotically ﬁrst-order equivalent. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. First. and have the same interpretation. 10. and it is advisable to report the statistic LRn whenever EL is the estimation method.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.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. Proof. Vλ ) Furthermore.1 If Eg(wi .3 Overidentifying Restrictions In a parametric likelihood context.15). Since the EL estimator achieves this bound. 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. The overidentiﬁcation test is a very useful by-product of EL estimation. Ω) GΩ G →d = N (0. 120 . tests are based on the diﬀerence in the log likelihood functions.7) is n ³ ´´ ³ X ˆ ˆ0 (10. The same statistic can be constructed for empirical likelihood. V ) ˆ Solving (10. it is an asymptotically eﬃcient estimator for β.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0.14) for λ and using (10. and (10. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.3. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.

1 Under (10.ssc.4 Testing Egi (β) = 0 (10.edu/~bhansen/progs/elike. 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. 10.Second. where h : Rk → Ra . since ln(1 + x) ' x − x2 /2 for x small. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.17) is not appropriate.18) Let the maintained model be where g is × 1 and β is k × 1. By “maintained” we mean that the overidentfying restrictions contained in (10. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . 10.4. Vλ )0 Ω−1 N (0.18) and H0 : h(β) = 0. The hypothesis of interest is h(β) = 0. the simple overidentifying restrictions test (10. a The proof of this result is more challenging and is omitted. This test statistic is a natural analog of the GMM distance statistic.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).18). so there is no fundamental change in the distribution theory for β relative to β. h(β)=0 ˜ Fundamentally. Theorem 10.prc 121 . To test the hypothesis h(β) while maintaining (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. LRn →d χ2 .wisc.

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

λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β.6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. 123 . the eigenvalues of Lββ should be adjusted so that all are positive. This can be done by the modiﬁed Newton method described in the previous section. λ(β)) = 0.20) fails. λ) = 0 at λ = λ(β). λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. λ(β)) + λ0 Rλ (β. where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . The gradient for (10. Outer Loop The outer loop is the minimization (10. 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 . If (10. The Hessian for (10.for all i.6). ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. and the rule is iterated until convergence. It is not guaranteed that Lββ > 0. If not.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. the stepsize δ needs to be decreased.

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

Thus we make the partition ¶ µ k1 z1i (11. This is called simultaneous equations bias. at least the intercept).1) the structural equation.1) if E (xi ei ) = 0. Deﬁnition 11. z1i is an instrumental variable for (11.1) where zi is k × 1.1. So we have the partition µ ¶ z1i k1 (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. this can be written as Y = Zβ + e. In matrix notation.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.1 The × 1 random vector xi is an instrumental variable for (11. so should be included in xi .4) xi = x2i 2 where z1i = x1i are the included exogenous variables. By the above deﬁnition. That is x2i are variables which could be included in the equation for yi (in the sense 125 . and assume that E(zi ei ) 6= 0 so there is endogeneity. β →p β ∗ . We call z1i exogenous and z2i endogenous. ¶ 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 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 ¶ . 11. and x2i are the excluded exogenous variables. In a typical set-up. some regressors in zi will be uncorrelated with ei (for example.1).2) Any solution to the problem of endogeneity requires additional information which we call instruments. We call (11. (11. which does not equal either β 1 or β 2 .

that they are uncorrelated with ei ) yet can be excluded, as they would have true zero coeﬃcients in the equation. The model is just-identiﬁed if = k (i.e., if 2 = k2 ) and over-identiﬁed if > k (i.e., if 2 > k2 ). We have noted that any solution to the problem of endogeneity requires instruments. This does not mean that valid instruments actually exist.

11.2

Reduced Form

The reduced form relationship between the variables or “regressors” zi and the instruments xi is found by linear projection. Let ¡ ¢−1 ¡ 0 ¢ E xi zi Γ = E xi x0 i be the × k matrix of coeﬃcients from a projection of zi on xi , and deﬁne ui = zi − x0 Γ i as the projection error. Then the reduced form linear relationship between zi and xi is zi = Γ0 xi + ui . In matrix notation, we can write (11.5) as Z = XΓ + u where u is n × k. By construction, E(xi u0 ) = 0, i so (11.5) is a projection and can be estimated by OLS: ˆ ˆ Z = XΓ + u ¡ 0 ¢−1 ¡ 0 ¢ ˆ XZ . Γ = XX Y = (XΓ + u) β + e = Xλ + v, where λ = Γβ and v = uβ + e. Observe that ¡ ¢ E (xi vi ) = E xi u0 β + E (xi ei ) = 0. i ˆ ˆ Y = X λ + v, ¡ 0 ¢−1 ¡ 0 ¢ ˆ λ = XX XY 126 (11.8) (11.7) (11.6) (11.5)

Substituting (11.6) into (11.2), we ﬁnd

Thus (11.7) is a projection equation and may be estimated by OLS. This is

The equation (11.7) is the reduced form for Y. (11.6) and (11.7) together are the reduced form equations for the system Y = Xλ + v Z = XΓ + u. ˆ ˆ As we showed above, OLS yields the reduced-form estimates (λ, Γ)

11.3

Identiﬁcation

The structural parameter β relates to (λ, Γ) through (11.8). The parameter β is identiﬁed, meaning that it can be recovered from the reduced form, if rank(Γ) = k. (11.9) Assume that (11.9) holds. If = k, then β = Γ−1 λ. If > k, then for any W > 0, β = (Γ0 W Γ)−1 Γ0 W λ. If (11.9) is not satisﬁed, then β cannot be recovered from (λ, Γ). Note that a necessary (although not suﬃcient) condition for (11.9) is ≥ k. Since X and Z have the common variables X1 , we can rewrite some of the expressions. Using (11.3) and (11.4) to make the matrix partitions X = [X1 , X2 ] and Z = [X1 , Z2 ], we can partition Γ as ∙ ¸ Γ11 Γ12 Γ = Γ21 Γ22 ∙ ¸ I Γ12 = 0 Γ22 (11.6) can be rewritten as Z1 = X1 Z2 = X1 Γ12 + X2 Γ22 + u2 . (11.10) β is identiﬁed if rank(Γ) = k, which is true if and only if rank(Γ22 ) = k2 (by the upperdiagonal structure of Γ). Thus the key to identiﬁcation of the model rests on the 2 × k2 matrix Γ22 in (11.10).

11.4

Estimation

0 yi = zi β + ei

The model can be written as E (xi ei ) = 0 or Eg (wi , β) = 0 ¢ ¡ 0 g (wi , β) = xi yi − zi β .

This a moment condition model. Appropriate estimators include GMM and EL. The estimators and distribution theory developed in those Chapter 8 and 9 directly apply. Recall that the GMM estimator, for given weight matrix Wn , is ¡ ¢−1 0 ˆ β = Z 0 XWn X 0 Z Z XWn X 0 Y. 127

11.5

Special Cases: IV and 2SLS

This estimator is often called the instrumental variables estimator (IV) of β, where X is used as an instrument for Z. Observe that the weight matrix Wn has disappeared. In the just-identiﬁed case, the weight matrix places no role. This is also the MME estimator of β, and the EL estimator. Another interpretation stems from the fact that since β = Γ−1 λ, we can construct the Indirect Least Squares (ILS) estimator: ˆ ˆ ˆ β = Γ−1 λ ³¡ ¢−1 ¡ 0 ¢´−1 ³¡ 0 ¢−1 ¡ 0 ¢´ XX XZ XY = X 0X ¡ 0 ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 ¡ 0 ¢ = XZ XX XX XY ¡ 0 ¢−1 ¡ 0 ¢ = XZ XY .

If the model is just-identiﬁed, so that k = , then the formula for GMM simpliﬁes. We ﬁnd that ¡ ¢−1 0 ˆ β = Z 0 XWn X 0 Z Z XWn X 0 Y ¡ ¢−1 −1 ¡ 0 ¢−1 0 = X 0Z Wn Z X Z XWn X 0 Y ¡ ¢−1 0 = X 0Z XY

which again is the IV estimator.

¡ ¢ Recall that the optimal weight matrix is an estimate of the inverse of Ω = E xi x0 e2 . In the i i ¢ ¡ 2 special case that E ei | xi = σ 2 (homoskedasticity), then Ω = E (xi x0 ) σ 2 ∝ E (xi x0 ) suggesting i i the weight matrix Wn = (X 0 X)−1 . Using this choice, the GMM estimator equals ³ ¡ ¢−1 0 ´−1 0 ¡ 0 ¢−1 0 ˆ β 2SLS = Z 0 X X 0 X XZ ZX XX XY

then

This is called the two-stage-least squares (2SLS) estimator. It was originally proposed by Theil (1953) and Basmann (1957), and is the classic estimator for linear equations with instruments. Under the homoskedasticity assumption, the 2SLS estimator is eﬃcient GMM, but otherwise it is ineﬃcient. It is useful to observe that writing ¡ ¢−1 0 X, PX = X X 0 X ¡ 0 ¢−1 0 ˆ X Z, Z = PX Z = X X X ˆ β = ¢−1 0 Z PX Y Z 0 PX Z ´ ³ ˆ ˆ ˆ = Z 0 Z Z 0 Y. ¡

The source of the “two-stage” name is since it can be computed as follows ˆ ˆ ˆ • First regress Z on X, vis., Γ = (X 0 X)−1 (X 0 Z) and Z = X Γ = PX Z. ³ ´−1 ˆ ˆ ˆ ˆ ˆ • Second, regress Y on Z, vis., β = Z 0 Z Z 0 Y. 128

11). Z2 ] and X = [Z1 . Then i h ˆ ˆ ˆ Z = Z1 . We now derive a similar result for the 2SLS estimator.11) (11.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. PX Z2 ] h i ˆ = Z1 . So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . 129 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . Using (11.12) Z = XΓ + u ξ = (e. Here we present a simpliﬁed version of one of his results.13) which is zero only when S21 = 0 (when Z is exogenous). ˆ since Z1 lies in the span of X. ¶ 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 ) . the model is Y = Zβ + e (11. Recall. First. PX Z2 ] = [Z1 . X is n × l so there are l instruments. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Z = [Z1 .ˆ It is useful to scrutinize the projection Z. Z2 . 11. we regress Y on Z1 and Z2 . X2 ].12). Z2 = [PX Z1 . let’s analyze the approximate bias of OLS applied to (11. 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. In our notation. Thus in the second stage.

14) is the probability limit of β 2SLS − β 11. 0). P = HΛH 0 0 0 where Λ = diag(Il . It is also close to zero when α = 0.12) and this result. the expression in (11. except when S21 = 0 (when Z is exogenous). n and (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .14) In general this is non-zero.14) approaches that in (11. Indeed as α → 1. l .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 .7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . 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. 130 . the bias in the 2SLS estimator will be large. The consequences of identiﬁcation failure for inference are quite severe. By the spectral decomposition of an idempotent matrix. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.13). Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 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 .

viz Γ22 = n−1/2 C. once again take the simple case k = l = 1. where C is a full rank matrix. the instrument xi is weak for zi if γ = n−1/2 c.15) is unaﬀected. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 .16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. meaning that inferences about parameters of interest can be misleading. This occurs when Γ22 is full rank. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. as the Cauchy distribution does not have a ﬁnite mean. Suppose that identiﬁcation does not complete fail. but is weak. but (11. which occurs i when E (zi xi ) 6= 0. Here. standard test statistics have non-standard asymptotic distribution of β distributions. Then (11. This result carries over to more general settings. N2 since the ratio of two normals is Cauchy. 131 . Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. Qc + N2 ˆ As in the case of complete identiﬁcation failure. E x2 e2 i i n i=1 n (11. and was examined by Phillips (1989) and Choi and Phillips (1992). but small. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. This is particularly nasty. so E (zi xi ) = 0.16) 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 . To see the consequences. E x2 u2 i i n n i=1 i=1 n n (11. In addition. Suppose this condition fails. This can be handled in an asymptotic analysis by modeling it as local-to-zero.Take the simplest case where k = l = 1 (so there is no X1 ).15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0.

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

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

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

To indicate the dependence on time. T .1.4 (loose).1. we adopt new notation.1 Stationarity and Ergodicity Deﬁnition 12. . and Cov (Yt ...1.. Deﬁnition 12. The primary model for multivariate time series is vector autoregressions (VARs). Deﬁnition 12. 135 . we expect that Yt and Yt−1 are not independent.) is a random variable.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .. 12. A stationary time series is ergodic if γ(k) → 0 as k → ∞.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. . Yt−1 . then Xt is strictly stationary and ergodic.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. and multivariate (yt ∈ Rm is vector-valued). The following two theorems are essential to the analysis of stationary time series. We can separate time series into two categories: univariate (yt ∈ R is scalar). Yt−k ) is independent of t for all k. The primary model for univariate time series is autoregressions (ARs). t = 1.1. .1. Yt−k ) is the autocorrelation function.2 {Yt } is strictly stationary if the joint distribution of (Yt . Because of the sequential nature of time series. There proofs are rather diﬃcult.. however.1 If Yt is strictly stationary and ergodic and Xt = f (Yt .. so classical assumptions are not valid.. and T to denote the number of observations. Deﬁnition 12. Theorem 12. γ(k) is called the autocovariance function. Yt−k ) = γ(k) is independent of t for all k. and use the subscript t to denote the individual observation..

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

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

Deﬁning L2 = LL. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . Lk Yt = Yt−k .Theorem 12. the above results are unchanged. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . 138 . since ρ(z) = 0 when z = 1/ρ. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . Deﬁnition 12. From Theorem 12. 12. Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value). and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).1 The lag operator L satisﬁes LYt = Yt−1 .1. We say that the root of the polynomial is 1/ρ. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .4.3. an AR(1) is stationary iﬀ |ρ| < 1. we see that L2 Yt = LYt−1 = Yt−2 .3. The AR(k) model is Using the lag operator.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. We call ρ(L) the autoregressive polynomial of Yt . We call ρ(L) the autoregressive polynomial of Yt .1 If |ρ| < 1 then Yt is strictly stationary and ergodic.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . ∞ X k=0 ρ2k V ar (et−k ) = 12. In general.

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

eT }. Divide the sample into T /m blocks of length m. Brieﬂy. Ω) .. . Y0 ). Y−k+2 ..1 to see that T 1 X √ xt et →d N (0. xt }. T 1 X √ ut →d N (0. i 4. t then as T → ∞. . as this imposes inappropriate independence. This creates an iid bootstrap sample. this cannot work in a time-series application. 140 .8 Bootstrap for Autoregressions In the non-parametric bootstrap. T t=1 where Ω = E(xt x0 e2 ).2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.7. then as T → ∞. Method 2: Block Resampling 1. Fix an initial condition (Y−k+1 . t t Theorem 12. This is identical in form to the asymptotic distribution of OLS in cross-section regression. ˆ 1.7. there are two popular methods to implement bootstrap resampling for time-series data. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . In particular. which may be diﬀerent than the i properties of the actual ei .7 Asymptotic Distribution Theorem 12. e ˆ 3. Ω) . Clearly..12. the asymptotic covariance matrix is estimated just as in the cross-section case. Estimate β and residuals et . 12.. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. ˆ 2. we can apply Theorem 12.7. t This construction imposes homoskedasticity on the errors e∗ . Method 1: Model-Based (Parametric) Bootstrap. It also presumes that the AR(k) structure is the truth.1 MDS CLT. Q−1 ΩQ−1 . we constructed the bootstrap sample by randomly resampling from the data values {yt . The implication is that asymptotic inference is the same. T t=1 Since xt et is a MDS... 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∗ .

and then perform regression (12. and for modelmisspeciﬁcation. • Use “seasonally adjusted” data. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. The results may be sensitive to the block length.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .. 5. (12.2) (12. 6. Resample complete blocks. • Include dummy variables for each season. draw T /m blocks. also alters the time-series correlations of the data. The seasonal adjustment.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . This allows for arbitrary stationary serial correlation. ﬁrst estimate (12. Paste the blocks together to create the bootstrap time-series Yt∗ . ∆s Yt = Yt − Yt−s . Seasonal Eﬀects There are three popular methods to deal with seasonal data. May not work well in small samples.. This presumes that “seasonality” does not change over the sample. however.3) sequentially by OLS.3) replacing St with St . This is a ﬂexible approach which can extract a wide range of seasonal factors. For each simulated sample. and the way that the data are partitioned into blocks. • First apply a seasonal diﬀerencing operator. • You can estimate (12. 141 . If s is the number of seasons (typically s = 4 or s = 12). The series ∆s Yt is clearly free of seasonality. (12. That is. 12. • You can estimate (12. and perhaps this was of relevance.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . heteroskedasticity. But the long-run trend is also eliminated.4) by OLS. 3. . 4. This procedure is sometimes called Detrending. get the ˆ ˆ residual St .2. ρk ).. Thus the seasonally adjusted data is a “ﬁltered” series.2).2)-(12. or the season-to-season change. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years.

142 .. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2).. if the null hypothesis is that Yt is an AR(k). . One approach to model selection is to choose k based on a Wald tests. In general.5) We are interested in the question if the error ut is serially correlated. and then reserve the ﬁrst k as initial conditions.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes.10 Testing for Omitted Serial Correlation For simplicity. AR(2). and under H1 it is an AR(2). (12.. We model this as an AR(1): ut = θut−1 + et with et a MDS. (12.5) and (12. . The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . we take (12. (If you increase k. AIC(k) = log σ 2 (k) + ˆ 2k .6) 12. and then estimate the models AR(1).. AR(k) on this (uniﬁed) sample. this is the same as saying that under the alternative Yt is an AR(k+m). The best remedy is to ﬁx a upper value k. Yt−k−m are jointly zero. Another is to minimize the AIC or BIC information criterion. Thus under H0 . let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection.6). e. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 .) This can induce strange behavior in the AIC.5).. We then multiply this by θ and subtract from (12.12. We want to test H0 against H1 . H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero.g. you need more initial conditions. (A simple exclusion test). To combine (12. Yt is an AR(1). and the alternative is that the error is an AR(m). An appropriate test is the Wald test of this restriction.

Under H0 .7). As we discussed before. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. Indeed. Because of this property. To see this. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. 143 . so conventional normal asymptotics are invalid. Yt is non-stationary. Yt is non-stationary. Thus a time series with unit root is I(1). as the models are equivalent. but simply assert the main results. or I(d). this is the most popular unit root test. (12. the natural test statistic is the t-statistic for H0 from OLS estimation of (12. An alternative asymptotic framework has been developed to deal with non-stationary data.12. Note that the model is stationary if α0 < 0. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. In this case. then Yt is “integrated of order d”. The ergodic theorem and MDS CLT do not apply. we say that if Yt is non-stationary but ∆d Yt is stationary.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . Yt has a unit root when ρ(1) = 0. observe that the lag polynomial for the Yt computed from (12. Thus if Yt has a (single) unit root. We do not have the time to develop this theory in detail. since ρ(1) = −α0 . 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. Hence. Since α0 is the parameter of a linear regression. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . However. So the natural alternative is H1 : α0 < 0. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. and test statistics are asymptotically non-normal. or ρ1 + ρ2 + · · · + ρk = 1.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L).7) These models are equivalent linear transformations of one another. under H0 .

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

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

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

general. xt−1 ) to the regression. which is called a common factor restriction. t or yt = θyt−1 + x0 β + x0 γ + ut . the model (13. 147 . In this case. which once was very popular. We see that an appropriate. If valid. and is still routinely reported by conventional regression packages. You may have heard of the Durbin-Watson test for omitted serial correlation. t and xt = This is just a conventional regression. This restriction. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. Then the single equation takes the form (13. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). This can be done by a Wald test. t and et is iid N (0.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. Otherwise it is invalid. (A simple version of this estimator is called Cochrane-Orcutt.3) which is a valid regression model. 13.2) is a special case of (13.4 Single Equation from a VAR Yjt = a0 xt + et .2) Take the equation yt = x0 β + et .2) is uncommon in recent applications. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . direct estimation of (13. and subtract oﬀ the equation once lagged multiplied by θ. Suppose that et is an AR(1). j Often.1) yt = x0 β + et .1). Another interesting fact is that (13. t t−1 (13. Let yt = Yjt . under the restriction γ = −βθ. (13.13. we are only interested in a single equation out of a VAR system. with time series data.3). and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. may be tested if desired. it is convenient to re-deﬁne the variables. Let et = ejt and β = aj .2) may be estimated by iterated GLS. and is typically rejected empirically. and Zt be the other 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 . This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. 1).) Since the common factor restriction appears arbitrary.

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

For example. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . a good method to estimate β.8.8 Cointegration The idea of cointegration is due to Granger (1981). m × r. β = (1 − 1)0 .13. yet under H1 zt is I(0). as ﬁrst shown by Stock (1987). When β is unknown. Often. The asymptotic distribution was worked out in B. 13. For 0 < r < m. the asymptotic distribution of the test is aﬀected by the presence of the time trend. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. so the ADF critical values are not appropriate. If Yt is cointegrated with a single cointegrating vector (r = 1). If r = m. and was articulated in detail by Engle and Granger (1987). then Yt is I(0). In some cases. Hansen (1992). Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . if Yt is a pair of interest rates. Then under H0 zt is I(1). Deﬁnition 13. of rank r. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . it may be necessary to include a time trend in the estimated cointegrating regression. in general. β is not consistent. Thus Yt = ˆ (Y1t . however. If Y = (log(Consumption) log(Income))0 . so zt = β 0 Yt is known. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Under H0 . but it is useful in the construction of alternative estimators and tests. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. When the data have time trends. 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 log(Consumption/Income) is stationary. If the series Yt is not cointegrated. β may not be known. This is not. then r = 0. from OLS of Y1t on Y2t .1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. such that zt = β 0 Yt is I(0). Whether or not the time trend is included. In other cases. 149 . The r vectors in β are called the cointegrating vectors.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 . Suppose that β is known. Thus H0 can be tested using a univariate ADF test on zt . then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. Yt is I(1) and cointegrated.

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

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

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

1. 2. An example of a data collection censoring is top-coding of income. or it may be a by-product of economic constraints.. the consumption level (purchases) in a particular period was zero. i so the model imposes the restriction that the conditional mean and variance of Yi are the same.) The observed data yi therefore come from a mixed continuous/discrete distribution.}. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. . Tobin observed that for many households. 2. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. In surveys. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.1) yi = ∗ <0 . i i i=1 ˆ The MLE is the value β which maximizes ln (β). 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. k! = exp(x0 β)..1). This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . this motivates the label Poisson “regression. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. 1. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. 14. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) .” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β).14. a typical approach is to employ Poisson regression. The conditional density is the Poisson with parameter λi . .2 Count Data exp (−λi ) λk i . 0 if yi (This is written for the case of the threshold being zero. The censoring process may be explicit in data collection. i If Y = {0.. This may be considered restrictive. The functional form for λi has been picked to ensure that λi > 0. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. A generalization is the negative binomial.. any known value can substitute. incomes above a threshold are typically reported at the threshold.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold.

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

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

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

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

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

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

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

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

This integral (typically) is not analytically solvable. Intuitively. and is larger the greater the curvature in f (x). so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. Since it is an average of iid random variables. The sharper the derivative. 162 . 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). which is valid as h → 0. Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K .16. the estimator f (x) smooths data local to Xi = x. The bias results from this smoothing. 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) . nh (x)2 dx is called the roughness of K.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. ˆ the greater the bias. ˆ We now examine the variance of f (x). so is estimating a smoothed version of f (x). 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . The last expression shows that the expected value is an average of f (z) locally about x.

The asymptotically optimal choice given in (16. We can calculate that √ R(φ00 ) = 3/ (8 π) . we ﬁnd the reference rules for the three kernel functions introduced earlier. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. We thus say that the optimal bandwidth is of order O(n−1/5 ). 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 . The ﬁrst two are determined by the kernel function. h must tend to zero. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). we need h → 0 but nh → ∞. σ 2 . where φ is the N (0. That is. Note that this h declines to zero. Their K values for the three functions introduced in the previous section are given here. That is. 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) .2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. Thus for the AMISE to decline with n. This choice for h gives an optimal rule when f (x) is ˆ normal. but at a very slow rate. Gaussian Kernel: hrule = 1.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . Together with the above table.1) is an asymptotic approximation to the MSE. and R(f 00 ).06n−1/5 163 . 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.2) but replaces R(f 00 ) with σ −5 R(φ00 ). Equation (16. and gives a nearly optimal rule when f (x) is close to normal. (16. ˆ It uses formula (16. but not of n. The downside is that if the density is very far from normal.2) depends on R(K). (16. In practice. and there is a large and continuing literature on the subject. the rule-of-thumb h can be quite ineﬃcient. how should the bandwidth be selected? This is a diﬃcult problem.Together. but at a slower rate than n−1 . 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 + .

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

then the collection A1 .. An event is a subset of S.. Communtatitivity: A ∪ B = B ∪ A. so we can write S = {H. we can write the four outcomes as S = {HH. Distributive Laws: A∩(B ∪ C) = (A ∩ B)∪(A ∩ C) . When S is countable. If two coins are tossed in sequence. A2 .. . HT } and {T H} are disjoint. Take the simple example of tossing a coin.. including S itself and the null set ∅. including ∅ and S. We only deﬁne probabilities for events contained in B. A∪(B ∩ C) = (A ∪ B)∩(A ∪ C) . A2 . heads and tails. are pairwise disjoint and ∪∞ Ai = S. . the event that the ﬁrst coin is heads. Continuing the two coin example. We now can give the axiomatic deﬁnition of probability. The following are useful properties of set operations. HT. B is simply the collection of all subsets of S. and if A1 . . Given S and B.Appendix A Probability A. i=1 i=1 Some important properties of the probability function include the following • P (∅) = 0 165 .. A simple example is {∅. There are two outcomes. / Complement: Ac = {x : x ∈ A}. a probability function P satisﬁes P (S) = 1.1 Foundations The set S of all possible outcomes of an experiment is called the sample space for the experiment. when S is uncountable we must be somewhat more careful. one event is A = {HH. A ∩ (B ∩ C) = (A ∩ B) ∩ C. T T }. T H. Intersection: A ∩ B = {x : x ∈ A and x ∈ B}. T }. and A1 . ∈ B implies ∪∞ Ai ∈ B. A2 . We call B the sigma algebra associated with S. P (A) ≥ 0 for all A ∈ B. if the sets A1 . A2 . A probability function assigns probabilities (numbers between 0 and 1) to events A in S. An event A is any collection of possible outcomes of an experiment. A ∩ B = B ∩ A. S} which is known as the trivial sigma i=1 algebra. the sets {HH. then P P (∪∞ Ai ) = ∞ P (Ai )..A set B is called a sigma algebra (or Borel ﬁeld) if ∅ ∈ B . ∈ B are pairwise disjoint. When S is the real line. We say that A and B are disjoint or mutually exclusive if A ∩ B = ∅.. then B is the collection of all open and closed intervals. DeMorgan’s Laws: (A ∪ B)c = Ac ∩ B c . let B be the smallest sigma algebra which contains all of the open sets in S. This is straightforward when S is countable. The following are elementary set operations: Union: A ∪ B = {x : x ∈ A or x ∈ B}. Associativity: A ∪ (B ∪ C) = (A ∪ B) ∪ C. For any sample space S. (A ∩ B)c = Ac ∪ B c . A ∈ B implies Ac ∈ B. For example. .. HT }. is called a partition i=1 of S. Furthermore.

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

A function F (x) is a CDF if and only if the following three properties hold: 1.3) P (X = τ j ) = π j . Instead. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A.Theorem 2 (Bayes’ Rule)... This induces a new sample space — the real line — and a new probability function on the real line. We say that the random variable X is continuous if F (x) is continuous in x. . 167 . The probability function for X takes the form j = 1.. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function.2 Random Variables A random variable X is a function from a sample space S into the real line. τ r . . limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.. . In the latter case. we denote random variables by uppercase letters such as X. a These expressions only make sense if F (x) is diﬀerentiable. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. of the sample space.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. these cases are unusualRand are typically ignored. F (x) is nondecreasing in x 3. Typically.. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . 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.. then for each i = 1. A2 . . In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A.3) is unavailable. 2. r (A.. While there are examples of continuous random variables which do not possess a PDF. the range of X consists of a countable set of real numbers τ 1 . For any set B and any partition A1 . and use lower case letters such as x for potential values and realized values....

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

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

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

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

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

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

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

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

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

Theorem A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Set r Z .11). Thus the density of Z 2 is (A. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. (A. which can be found by applying change-of-variables to the gamma function.12) E exp (tQ) = 0 Γ (A. which we showed in (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Proof of Theorem A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . we see that the MGF of Z 2 is (1 − 2t)−1/2 . 1).6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. From (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. tr has distribution 177 .11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .13) is the MGF of the density (A. For Z ∼ N(0.2. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. Iq ). Using the simple law of iterated expectations.1. C −1 AC −10 ) = N (0.3. q Proof of Theorem A.8.8. C −1 CC 0 C −10 ) = N (0.8.3 Let Z ∼ N (0. The MGF for the density (A. 1) and Q ∼ χ2 be independent.11) 2 with r = 1.8.13).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).

If the distribution F is continuous then the density of Yi can be written as f (y. θ) . Yn ) is n ³ ´ 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¡ ¢ . θ) = P (Y = y..θ = fn Y f (Yi . viewed as a function of θ. we say that the distribution is parametric and that θ is the parameter of the distribution F. θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector.9 Maximum Likelihood If the distribution of Yi is F (y. θ) and the joint ˜ density of a random sample Y = (Y1 . . In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ. 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 . the likelihood and log-likelihood are constructed by setting f (y. If the distribution F is discrete. θ) . 1+ √ r r rπΓ 2 ! Z P p ≤x Q/r ( r ) Q E Z≤x r !# " Ã r Q |Q E P Z≤x r Ã r ! Q EΦ x r Ã = ¥ A. θ) . i=1 The likelihood of the sample is this joint density evaluated at the observed sample values.

17) is often called the information matrix equality. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. n n i=1 n As the MLE ˆ maximizes the left-hand-side.17) The matrix I0 is called the information.1 ¯ ¯ ∂ E ln f (Yi . In fact.9. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ θ∈Θ ˆ In some simple cases. If ˜ is an unbiased estimator of θ ∈ R. cases are rare.16) (A. θ0 ) . the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . but these ˆ must be found by numerical methods. 179 . then θ V ar(˜ ≥ (nI0 )−1 . The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . θ) ≡ L(θ).2 Cramer-Rao Lower Bound. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. More typically. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. θ0 ) ∂θ∂θ 0 (A. we can see that it is an estimator of the maximizer θ of the right-hand-side. which maximizes the log-likelihood). θ) The Cramer-Rao Theorem gives a lower bound for estimation. θ0 ) ln f (Yi . I0 . θ) →p E ln f (Yi . θ Theorem A.9.15) Two important features of the likelihood are Theorem A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . and the equality (A. we can ﬁnd an explicit expression for θ as a function of the data. ˆ →p θ0 as n → ∞. under conventional regularity conditions. However. θ) ∂θ ∂θ which holds at θ = θ0 by (A.16). ∂θ ∂θ (A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.9. Theorem A. ˆ is consistent θ for this value.14) ¶ ∂ ∂ 0 ln f (Yi .3 Under regularity conditions. We can write this as ˆ = argmax Ln (θ).

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

¯ ¯ ∂ E ln f (Yi . θ0 = ln f (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜.. θ) f (y. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 ) ∂θ f (Yi .16). θ0 ) (Yi . θ0 ) ∂ ∂ − ln f (Yi .1. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . f (Yi . θ0 ) f (Yi . θ0 ) ∂ ∂θ f ∂ (Yi . (Yi . θ0 )0 f (Yi . θ0 )0 .9. θ0 ) ln f (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. ∂2 ln f (Yi . θ0 ) − f (Yi .Proof of Theorem A. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 ) d˜ = E ˜ . ∂θ ¯θ=θ0 Z ! = 0. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ) dy ¯ ∂θ f (y. Proof of Theorem A. 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 = . θ) d˜ = ˜ y ) ∂ ln f (˜. To see (A. V ar (S) nH so ¥ 181 .17). θ0 )2 (Yi . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A.. . yn ).9. Since θ Z ˜ = ˜ y)f (˜.2.1) has mean zero and variance nH.9. θ0 ) ¯ ∂ f (y. function of the data. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. we can show that E By direction computation.. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ) f (˜.

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

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

Allowing the steplength to be a free parameter allows for a line search. Another productive modiﬁcation is to add a scalar steplength λi . Then for ε small gj (θ) ' Similarly. 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). θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive deﬁnite.. θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ). Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation. numerical derivatives can be quite unstable. which are designed to converge to ˆ All require the choice of a starting value θ1 . In some cases. 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 ). ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available. Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row). a one-dimensional optimization. of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). .2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(θ) .B. they can be calculated numerically. Take the j 0 th element of g(θ). however. and all require the computation 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. ε where gi = g(θi ) and Di = H(θi )−1 for Newton’s method and Di = (H(θi ) + αi Im )−1 for quadratic hill-climbing. 2.2 Gradient Methods Gradient Methods are iterative methods which produce a sequence θi : i = 1. numerical derivatives can work well but can be computationally costly relative to analytic derivatives. θ where One problem with Newton’s method is that it will send the iterations in the wrong direction if H(θi ) is not positive deﬁnite.. To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 .

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

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