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

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

1

Contents

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

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

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i

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

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

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

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

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ii

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 8. . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . 9.8 Conditional Moment Restrictions . . . . . . . . . .10 8.1 Overidentiﬁed Linear Model . . . . . . 11. . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . .2 Reduced Form . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . 12. . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. .2 GMM Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . .3 Identiﬁcation . . 11. . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) .3 Distribution of GMM Estimator . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . 10. . . . 9. . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . .4 Lag Operator .2 Autoregressions . iii . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 8. . . . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . .4 Estimation . . . . . . 9. . . . .6 Over-Identiﬁcation Test . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . 12. . . . . . . . . . . . . . . . . . . .10 Exercises . . 10. . . . . 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. . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . 12. . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . 12. . . . . . . . . . . . .

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

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

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

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

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

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

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

The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . or is nonsingular.4 Inverse A k × k matrix A has full rank. the Moore-Penrose generalized inverse A− exists and is unique. . if there is no c 6= 0 such that Ac = 0. (2.3) The matrix A− is not necessarily unique. . . In this case there exists a unique matrix B such that AB = BA = Ik . 2. If A − BD−1 C and D − CA−1 B are non-singular. The following fact about inverting partitioned matrices is sometimes useful. . For non-singular A and C. (2. The Moore-Penrose generalized inverse A− satisﬁes (2. . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.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 (2.1) . then A−1 = A. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . . . This matrix is called the inverse of A and is denoted by A−1 . 7 Also. if A is an orthogonal matrix.

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

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

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

the conditioning variable. While it is easy to observe that the two densities are unequal.22. . xi ) where yi is a scalar (real-valued) and xi is a vector. These are asymmetric (skewed) densities.1 displays the density1 of hourly wages for men and women. xki 3. (3. m(x) can take any form.2) m(x) = E (yi | xi = x) = −∞ In general. These are indicated in Figure 3. Figure 3. or the covariates. When a distribution is skewed. education and experience. These are conditional density functions — the density of hourly wages conditional on race.1. gender. it is useful to have numerical measures of the diﬀerence. In the example presented in Figure 3. We call yi the dependent variable. the mean wage for men is $27. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. Take a closer look at the density functions displayed in Figure 3.73. In this context we partition the observations into the pair (yi .1) xi = ⎜ . We call xi alternatively the regressor. and exists so long as E |yi | < ∞.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. ⎟ . and that for women is $20. See Chapter 16.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. the conditional density of yi given xi . which is a common feature of wage distributions. we can focus on f (y | x) . You can see that the right tail of then density is much thicker than the left tail. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. The two density curves show the eﬀect of gender on the distribution of wages. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1 by the arrows drawn to the x-axis. This is used when the goal is to quantify the impact of one set of variables on another variable.1. ⎠ ⎝ . The data are from the 2004 Current Population Survey 1 11 . In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. holding the other variables constant. To illustrate. the mean is not necessarily a good summary of the central tendency.

wage regressions typically use log wages as a dependent variable rather than the level of wages. then comparisons become more complicated. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. this yields the formula yi = m(xi ) + ei . implying an average 36% diﬀerence in wage levels. the dashed line is a linear projection approximation which will be discussed in the Section 3.36.2) evaluated at the observed value of xi : ei = yi − m(xi ).2 shows the density of log hourly wages for the same population.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. By construction. 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 main point to be learned from Figure 3. and a Ph.3 displays a scatter plot2 of log wages against education levels. The comparison in Figure 3.A.1 is facilitated by the fact that the control variable (gender) is discrete. degree in mean log hourly wages is 0.3) White non-military male wage earners with 10-15 years of potential work experience.Figure 3. Figure 3. The conditional expectation function is close to linear. Assuming for simplicity that this is the true joint distribution. For this reason. The diﬀerence in the log mean wage between men and women is 0. Figure 3.D. To illustrate. When the distribution of the control variable is continuous. which implies a 30% average wage diﬀerence for this population. 3.30. Of particular interest to graduate students may be the observation that diﬀerence between a B. 2 (3.5. the solid line displays the conditional expectation of log wages varying with education. 12 .

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

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

5) xi = ⎜ . Equivalently. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . which we derive in this section. ⎟ . ⎝ .7) is a k × 1 parameter vector.1). ⎠ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.we say that the error ei is homoskedastic. we assume that x1i = 1. take the conditional wage densities displayed in Figure 3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). In this case (3. So while men have higher average wages.6) (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element.1. 3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . Thus (3. Equation (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. they are also somewhat more dispersed. We call this the “constant” or “intercept”. ⎠ .5. 15 . As an example.4 Linear Regression An important special case of (3. where x1i is the ﬁrst element of the vector xi deﬁned in (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. The conditional standard deviation for men is 12. it is more realistic to view the linear speciﬁcation (3. Notationally.8) (3.1 and that for women is 10. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . i (3. Instead. its functional form is typically unknown. ⎟ β=⎝ .9) 3.6) as an approximation. and the linear assumption of the previous section is empirically unlikely to accurate. xki When m(x) is linear in x. βk ⎛ (3.8) is called the linear regression model.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .

In order for β to be uniquely deﬁned. E (xi x0 ) is invertible. 2 2. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.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 . Assumption 3. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. x0 β is the best linear predictor for yi . The error is i ei = yi − x0 β.which is quadratic in β. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. Therefore. 3.1.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. xi contains an intercept. i which requires that for all non-zero α. It is invertible if and only if it is positive deﬁnite.10) It is worth taking the time to understand the notation involved in this expression.1 1.12) This completes the derivation of the linear projection model. this situation must be excluded. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . i 4. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i (3.5. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. 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. i (3. This occurs when redundant variables are included in xi . by “best” we mean the predictor function with lowest mean squared error. Observe i that for any non-zero α ∈ Rk .7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. As before.10). Rewriting. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. i 16 . Eyi < ∞. The best linear predictor is obtained by selecting β to minimize S(β). written E (xi x0 ) > 0.5. Given the deﬁnition of β in (3. i i (3. otherwise they are distinct. The ﬁrst-order condition for minimization (from Section 2. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . Equivalently. E (x0 xi ) < ∞. The vector (3. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi .

Theorem 3. E (xi ei ) = 0 and E (ei ) = 0. Assumption 3.5.5.13) The two equations (3.1.5.1.5.1.10) are deﬁned.1. However.1.5.4 guarantees that the solution β exits. For example. The ﬁnite variance Assumptions 3. Figure 3.1.12) can be alternatively interpreted as a projection decomposition.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.1 Under Assumption 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. Since from Theorem 3. 17 .1. This means that the equation (3.1.5.10) and (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.14) Proof.4 we know that the regression error has the property E (xi ei ) = 0.11) are well deﬁned.8)-(3. Let’s compare it with the linear regression model (3. Assumption 3. Equation (3. (3.2 and 3. it follows that linear regression is a special case of the projection model. Using the deﬁnitions (3.13) and Assumption 3.2.1. Furthermore. (3. Assumption 3. Assumption 3.3 are called regularity conditions.13) summarize the linear projection model.1.5.5.1 are weak.1.9). By deﬁnition. Since ei is mean zero by (3. ¥ (3.14) holds.3 ensure that the moments in (3.14).5.5. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .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 = 0.1 is employed to guarantee that (3.14) follows from (3.4 is required to ensure that β is uniquely deﬁned. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. the orthogonality restriction (3.5.13) implies that xi and ei are uncorrelated.2 and 3.12) and (3.11) and (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .

and are discussed in Chapter 11.12) with the properties listed in Theorem 3.4 we display as well this quadratic projection. 18 .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. This defect in linear projection can be partially corrected through a careful selection of regressors. xi ) we can deﬁne a linear projection equation (3. The solid line is the conditional mean.1 may be false. In other cases the two may be quite diﬀerent. it is important to not misinterpret the generality of this statement.1. In this case the linear projection is a poor approximation to the conditional mean.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. Figure 3. However. Other than the redeﬁnition of the regressor vector. since the resulting function is quadratic in experience. We illustrate the issue in Figure 3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.5. Most importantly. for any pair (yi . Figure 3. In this example it is a much better approximation to the conditional mean than the linear projection. there are no changes in our methods or analysis. and under-predicts for the rest.10). in many economic models the parameter β may be deﬁned within the model. No additional assumptions are required. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.5.4 displays the relationship3 between mean log hourly wages and labor market experience. Returning to the joint distribution displayed in Figure 3. the dashed line is the linear projection of log wages on eduction. In this example the linear projection is a close approximation to the conditional mean.10) may not hold and the implications of Theorem 3. In Figure 1. we can augment the regressor vector xi to include both experience and experience2 . In the example just presented.3. and the straight dashed line is the linear projection.We have shown that under mild regularity conditions. In contrast. It over-predicts wages for young and old workers. for those over 53 in age). In this case (3. These structural models require alternative estimation methods. A projection of log wages on these two variables can be called a quadratic projection. The linear equation (3.

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

σ 2 = V ar(yi ) and σ xy = Cov(xi .6 Exercises 1. µx = Exi . then E(x2 ei ) = 0. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. 20 . If yi = x0 β + ei and E(xi ei ) = 0. Prove parts 2. 1. If yi = xi β + ei . E(ei | xi ) = 0. ¡ ¢ 4. s) = 0 if and only if m = µ and s = σ 2 .4 . and E(xi ei ) = 0. (x − µ)2 − σ 2 Show that Eg (X.2. 3 and 4 of Theorem 3.3 Find E(Y | X = x). j! 0 j = 0. xi ∈ R.2 Y =1 . then ei is independent of xi . yi ). 2. i 7. 2. If yi = x0 β + ei and E(ei | xi ) = 0. If yi = x0 β + ei . and have the following joint probability distribution X=0 X=1 Y =0 . Suppose that yi is discrete-valued. Compute the conditional mean m(x) = E (yi | xi = x) .. True or False. True or False. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . then E(ei | xi ) = 0. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . .1 . Are they diﬀerent? Hint: If P (Y = j) = 5.. E(Y 2 | X = x) and V ar(Y | X = x). then E(x2 ei ) = 0. σ = . True or False. x 6. xi ∈ R. and E(ei | xi ) = 0. True or False. i 8. Let xi and yi have the joint density f (x. 3. Compute E(yi | xi = x) and V ar(yi | xi = x). taking values only on the non-negative integers. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1.1. i 10. e−λ λj j! . m. and E(e2 | xi ) = σ 2 . then ei is i i independent of xi . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . i 11. True or False. a constant. Let X be a random variable with µ = EX and σ 2 = V ar(X). 0 ≤ y ≤ 1. 9.3. σ 2 = V ar(xi ). If yi = xi β + ei . µ. Suppose that Y and X only take the values 0 and 1.

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 .1) (4.1 Estimation Equation (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. i n i=1 n 21 . but for most of the chapter we retain the broader focus on the projection model.2) can be written in the parametric 0 β)) = 0. (4. Observe that (4.7 and 4. i It follows that the moment estimator of β replaces the population moments in (4.8. we narrow the focus to the linear regression model.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 .2) (4. 4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .3) In Sections 4.

14 14.117 1 14.83 ¶−1 µ ¶ . with 10-15 years of potential work experience.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. i 22 .14 14.4). consider the data used to generate Figure 3.7% increase in mean wages. To illustrate.14 205. 40 0.117 Educationi .4).2 Least Squares There is another classic motivation for the estimator (4.95 xi yi = 42.40 µ ¶µ ¶ 34. This sample has 988 observations.30 + 0.3. 40 2.71 = −2.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. Then µ ¶ n 1X 2.170 37.ˆ This is a set of k equations which are linear in β.94 −2.37 µ ¶ 1. 0.14 205. 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 (4.95 42. excluding military. These are white male wage earners from the March 2004 Current Population Survey. 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. 4. ¶ 2. An interpretation of the estimated equation is that each year of education is associated with an 11.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. 30 = . n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. Let yi be log wages and xi be an intercept and years of education.

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

ˆ n−k 2 i=1 (4.7. ˆ n i=1 n Since xi contains a constant.5) implies that 1X xi ei = 0.6) An alternative estimator uses the formula n 1 X 2 s = ei . Its method of moments estimator is the sample average 1X 2 ei .2: Sum-of-Squared Error Function Contours Equation (4. These are algebraic results.Figure 4. ˆ σ = ˆ n 2 i=1 n (4. one implication is that n 1X ei = 0. 24 . 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. The error variance σ 2 = Ee2 is also a parameter of interest. It measures the variation in the i “unexplained” part of the regression. and hold true for all linear regression estimates.7) A justiﬁcation for the latter choice will be provided in Section 4.

3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. σ 2 ) is a function of β only through the sum of squared errors Sn (β). Hence the MLE for β equals the OLS estimator.where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. and distribution theory. maximizing the likelihood is identical to minimizing Sn (β). testing. 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. This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi . σ ) = 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. where likelihood methods can be used for estimation. it should be viewed as an estimator of the population parameter ρ2 = σ2 V ar (x0 β) i =1− 2 V ar(yi ) σy where σ 2 = V ar(yi ). σ 2 ) maximize Ln (β. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . The R2 is frequently mislabeled as a measure of “ﬁt”. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . Instead. This is a parametric model. An alternative estimator of ρ2 proposed by Theil called “R-bar-squared” is y R =1− where σ2 = ˜y 2 n 2 s2 σ2 ˜y 1 X (yi − y)2 . 4. σ 2 ). σ 2 ). Since Ln (β.

Thus the MLE (β. Sample sums can also be written in matrix notation. . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. . . 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. . ⎟. it is matrix notation. n X i=1 Thus the estimator (4. yn = x0 β + en . Due to this equivalence. 4. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . x0 n ⎞ ⎛ e1 e2 . ⎝ ⎝ . ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. ˆ ˆˆ ˆ A useful result is obtained by inserting Y = Xβ + e into the formula for β to obtain ¢ ¡ 0 ¢−1 ¡ 0 ˆ X (Xβ + e) β = XX ¡ ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 0 Xe X Xβ + X 0 X = XX ¡ 0 ¢−1 0 X e. en ⎞ Observe that Y and e are n × 1 vectors. For example n X i=1 For many purposes.6).12) is a system of n equations. n or equivalently Y = Xβ + e. = β+ XX 26 (4. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. The linear equation (3. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. one for each observation. and X is an n × k matrix. residual vector. yn ⎟ ⎟ ⎟.4). .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . including computation. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. . We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . ⎠ . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4.8) .

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

! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. 30 . and X2 is the vector of observed regressors.9). observe that ⎞ ⎛ ⎞ ⎛ . A common application of the FWL theorem. In the model (4. .14) or via the ˆ following algorithm: ˜ 1. ¡ ¢−1 0 ι. 4. . . . . Rather. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. Regress Y on X1 . .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. By the independence of the observations and (3. the FWL theorem can be used to speed computation. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . ˆ ˜ ˜ ˆ 3. 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) . which you may have seen in an introductory econometrics course. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ˜ 2.6. In this case. obtain residuals Y . M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. the primary use is theoretical. . obtain OLS estimates β 2 and residuals e.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.8)(3.1 (Frisch-Waugh-Lovell). but in most cases there is little computational advantage to using the two-step algorithm. In this section we derive the small sample conditional mean and variance of the OLS estimator. ˆ which are “demeaned”. Regress X2 on X1 .Theorem 4. is the demeaning formula for regression.9). . ⎟ ⎜ ⎟ ⎜ (4. . Regress Y on X2 . obtain residuals X2 . ⎠ ⎝ ⎠ ⎝ .13). . In some contexts.

Next.20) . . . .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X .. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0.19) ˆ and thus the OLS estimator β is unbiased for β. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . 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. . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . . the properties of conditional expectations. and the trace operator observe that. X 0 DX = X 0 Xσ 2 . From (4. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. and ³ ´ ¡ ¢−1 2 ˆ σ . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 .8).12). . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . σ 2 } = ⎜ . Then given (4. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. . 1 n . ⎠ (4.18). and (4. under the of ˆ ¢ 2 | x = σ 2 . . ⎝ .. V ar β | X = X 0 X ⎟ ⎟ ⎟. 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.. 0 0 ··· 0 0 .

4. By a calculation similar to those of the previous section.10).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 . and thus can be written as ˜ β = A0 Y where A is an n × k function of X. As an alternative.9) plus E e2 | xi = σ 2 . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . which we now present. 32 . Now consider the class of estimators of β which are linear functions of i the vector Y.8. In the homoskedastic linear regression model. however. is a famous statement of the solution. 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. It is important to remember. the estimator ˆ 2 deﬁned (4. as it yields the smallest variance among all unbiased linear estimators.8)¢ ¡ (3. Thus since V ar (e | X) = In σ 2 under homoskedasticity. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . It is not unbiased in the absence of homoskedasticity. ³ ´ ˜ E β | X = A0 Xβ. known as the Gauss-Markov theorem. says that the least-squares estimator is the best choice. the best (minimumvariance) unbiased linear estimator is OLS. Theorem 4.1 Gauss-Markov. In this case. or in the projection model. ˜ so β is unbiased if (and only if) A0 X = Ik . What is the best choice of A? The Gauss-Markov theorem. Thus σ 2 is biased towards zero. that this estimator is only unbiased in the special case of the homoskedastic linear regression model.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. The following result. = σ2 n the ﬁnal equality by (4.7) is unbiased for σ 2 by this calculation. which is (3. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice.

r for some constant vectors τ j . where 1 (·) is the indicator function. . who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. xi = ξ j = π j . 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. 4. xi ) is discrete. Assume that the τ j and ξ j are known. but we don’t know the probabilities.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. and π j . Let A be any n×k function of X such that A0 X = Ik . A broader justiﬁcation is provided in Chamberlain (1987).. ξ j . ¡ ¢ P yi = τ j .. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1.5) as required.Proof.. r. but it is quite limited in scope... This latter restriction is particularly unsatisfactory. . It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite.. . j = 1. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . Not only has the class of models has been restricted to homoskedastic linear regressions. the deﬁnition (4. This property is called semiparametric eﬃciency. ˆ β mle = ⎝ j j=1 j=1 33 . π r ) . Suppose that the joint distribution of (yi . 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..) In this discrete setting. Set C = A − X (X 0 X)−1 . but the π j are unknown. We discuss the intuition behind his result in this section.. The MLE β mle for β is then the analog of (4. That is.21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ . for ﬁnite r.. and is a strong justiﬁcation for the least-squares estimator. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. As the data are multinomial. That is. π j is the percentage of the observations ˆ ˆ which fall in each category. (We know the values yi and xi can take.21) j j=1 j=1 Thus β is a function of (π 1 . Note that X 0 C = 0. the class of potential estimators has been restricted to linear unbiased estimators.

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 . 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. He observes that the above argument holds for all multinomial distributions.5.10 Omitted Variables xi = µ x1i x2i ¶ . He proves that generically the OLS estimator (4.1. Chamberlain (1987) extends this argument to the case of continuously-distributed data. the maximum likelihood estimator is identical to the OLS estimator.Substituting in the expressions for π j .10) for the class of models satisfying Assumption 3. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. (4.22) 34 . We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .9). and thus so is the OLS estimator.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. if the data have a discrete distribution. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.

22) by least-squares. log(p2 ) and log(p1 /p2 ). In general. The more relevant issue is near multicollinearity. First. log(p1 ).e.22). or second. β 1 6= γ 1 . the coeﬃcient on x2i in (4. least-squares estimation of (4. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . when the columns of X are close to linearly dependent.23) the short regression to emphasize the distinction. Since the error is discovered quickly. 4. In this case. i. except in special cases.. we regress yi on x1i only.22) the long regression and (4. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. This happens when the columns of X are linearly dependent. This is estimation of the equation yi = x0 γ 1 + ui 1i E (x1i ui ) = 0 Notice that we have written the coeﬃcient on x1i as γ 1 rather than β 1 . this arises when sets of regressors are included which are identically related. and the error as ui rather than ei . It is the consequence of omission of a relevant correlated variable.Now suppose that instead of estimating equation (4. To see this. which is often called “multicollinearity” for brevity. By construction. there is some α such that Xα = 0. because we have not said what it means for a matrix to be “near singular”. Typically. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. This deﬁnition is not precise. This is called strict multicollinearity. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. 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. For example. Most commonly.23) where is the coeﬃcient from a regression of x2i on x1i . Typically there are limits.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . the general model will be free of the omitted variables problem. as many desired variables are not available in a given dataset. The diﬀerence Γβ 2 is known as omitted variable bias. When this happens.22) is zero. if X includes both the logs of two prices and the log of the relative prices. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. This is because the model being estimated is diﬀerent than (4. 35 . the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). Goldberger (1991) calls (4. then β is not deﬁned. this is rarely a problem for applied econometric practice. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. This is the situation when the X 0 X matrix is near singular.

deﬁne the leave-one-out least-squares estimator of β. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (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 .27) (4. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . We can also deﬁne the leave-one-out residual ˆ ˆ ei. ˆ i A simple comparison yields that ˆ ei − ei. since as ρ approaches 1 the matrix becomes singular. 1] and sum to k. As a consequence. 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. that is. The hi take values in [0.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. the worse the precision of the individual coeﬃcient estimates. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . ˆ ˆ (4.25) below.−i = (1 − hi )−1 hi ei . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. 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. If the i’th observation 36 . the OLS estimator based on the sample excluding the i’th observation.26) As we can see.−i = yi − x0 β (−i) = (1 − hi )−1 ei . the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . To investigate the possibility of inﬂuential observations. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. We derive expression (4.25) 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.

Investigations into the presence of inﬂuential observations can plot the values of (4.25).4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .This implies has a large value of hi . which is considerably more informative than plots of the uncorrected residuals ei . then this observation is a leverage point and has the potential to be an inﬂuential observation. The key is equation (2.1) in Section 2. ˆ We now derive equation (4. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .27). ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .

4.13

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

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

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}. The WLLN shows that sample averages converge in probability to the population average. Set Y = g(X) and let f denote the density function of Y. p p p q which is (5. For any strictly increasing function g(X) ≥ 0.1 Weak Law of Large Numbers (WLLN). We say that Zn converges in probability to Z as n → ∞.3). If Xi ∈ Rk is iid and E |Xi | < ∞. Theorem 5.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Applying expectations. Note EU = EV = 1.2. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. Let a + bx be the tangent line to g(x) at x = EX. denoted Zn →p Z as n → ∞. as stated. then as n → ∞ n 1X Xn = Xi →p E(X). if for all δ > 0. (5. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . So for all x. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. P (g(X) > α) ≤ α−1 Eg(X). ¥ 5. tangent lines lie below it. n i=1 42 . =E U V p q p q Proof of Markov’s Inequality. Since g(x) is convex. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. n→∞ lim P (|Zn − Z| > δ) = 0.Markov’s Inequality.4) Proof of Jensen’s Inequality. 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 ) = + . Eg(X) ≥ a + bEX = g(EX). ¥ Proof of Holder’s Inequality.

5. 43 . We say that Zn converges in distribution to Z as n → ∞.4). ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. the fact that X n = W n + Z n . Theorem 5.1). we can set E(X) = 0 (by recentering Xi on its expectation). if for all x at which F (x) is continuous. V ) . ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. Jensen’s inequality (5. P ¯X n ¯ > δ ≤ η. by Markov’s inequality (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. denoted Zn →d Z. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Set ε = δη/3. (5.3. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Finally. If Xi ∈ Rk is iid and E |Xi |2 < ∞. and the bound |Wi | ≤ 2C.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. Fix δ and η.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞.5).6) and (5.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.7). the fact that the Wi are iid and mean zero.1) and (5.Proof: Without loss of generality. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. Fn (x) → F (x) as n → ∞.6) By Jensen’s inequality (5. as needed. the triangle inequality. where Z has distribution F (x) = P (Z ≤ x) . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.1 Central Limit Theorem (CLT). ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.

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

gθ Σgθ .4. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.4 Asymptotic Transformations Theorem 5. and g(θ) : Rm → Rk . 45 . Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. k ≤ m. Stacking across elements of g. Since cλλ (λn ) → cλλ (0) = −Ik . This is suﬃcient to establish the theorem. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0.4. Σ) . gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). where θ is m × 1 and Σ is m × m. Ik ) distribution. Proof : By a vector Taylor series expansion. then g(Zn ) →d g(Z) as n → ∞.1 Continuous Mapping Theorem 1 (CMT). Recall that A ⊂ B implies P (A) ≤ P (B). Σ) = N 0.2 Continuous Mapping Theorem 2. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Hence g(Zn ) →p g(c) as n → ∞. If Zn →p c as n → ∞ and g (·) is continuous at c. If Zn →d Z as n → ∞ and g (·) is continuous. √ Theorem 5.4. we see that as n → ∞.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.√ where λn → 0 lies on the line segment joining 0 and λ/ n. ¥ 5. 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 . then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. for each element of g. then g(Zn ) →p g(c) as n → ∞. Theorem 5. Proof: Since g is continuous at c.

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

1 by the fact that the sampling densities become more concentrated as n gets larger.5.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.3). Equation (4.1).2.1 and the WLLN (Theorem 5. (6. Assumption 3. 0). (6. ˆ 47 . As the sample size increases the density becomes more concentrated about the population coeﬃcient. Hence by the continuous mapping theorem (Theorem 5.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.5.5.1 Under Assumption 3.4 implies that Q−1 exists and thus g(·. n i=1 (6.1). A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.1. First.1. Assumption 3. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 . Ã n ! n X 1X 0 1 ˆ xi xi . xi ei →p g (Q. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. (6. ˆ Theorem 6. using (6. β →p β as n → ∞.2. 6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. we can conclude ˆ that β →p β. Proof. ·) is continuous at (Q. the OLS estimator β is has a statistical distribution which is unknown.2 Consistency ˆ As discussed in Section 6. and the continuous mapping theorem (Theorem 5.4.2) i i n i=1 n From (6. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.1).2).1). For a complete argument. This is illustrated in Figure 6.1. we will use the methods of asymptotic approximation.4.3) Ã where g(A. To characterize the sampling distribution more fully.1) and ˆ We now deduce the consistency of β.

1.3.3) and Theorem (6. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .3. (6.3.1).1. (6. ˆ Finally.6) n i=1 48 . (6.5.1 In addition to Assumption 3. since n/(n − k) → 1 as n → ∞. by the Cauchy-Schwarz inequality (5.5.2).2. ˆ Proof. i i Assumption 6. ˆ n−k 6.2). Thus σ 2 is consistent for σ 2 . ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Assumption 6. Ee4 < ∞ and E |xi |4 < ∞. 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 . To see this. Ω) .Theorem 6. it follows that s2 = ¥ n σ 2 →p σ 2 .5) Thus xi ei is iid with mean zero and has covariance matrix Ω. n 1 X √ xi ei →d N (0.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. By the central limit theorem (Theorem 5.1).2 Under Assumption 3.4) 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.1 guarantees that the elements of Ω are ﬁnite. E ¯ei ¯ E ¯e4 ¯ i i i i (6.2. (6. We need a strengthening of the moment conditions.

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. We call V 0 the homoskedastic covariance matrix.7) holds. This holds true for all joint distibutions of (yi . For α 49 . When (6. there is no simple answer to this reasonable question. and (6. its variance diverges q ³ ´ ˆ to inﬁnity.Then using (6. |ε| ≥ 1.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. In Figure 6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. 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 .3. V is often referred to as ˆ the asymptotic covariance matrix of β.2).1 Under Assumption 6. V ) where V = Q−1 ΩQ−1 . However. Theorem 6.1. otherwise V 6= V 0 .1 states that the sampling distribution of the least-squares estimator. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.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. In´Figure 6. The asymptotic distribution ´ Theorem 6. Under (6.7) is true or false. There is a special case where Ω and V simplify. setting n = 100 and varying the parameter α. for example. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .1. xi ) which satisfy the conditions of Assumption 6. We illustrate this problem using a simulation. when xi and ei are independent.3.3. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . is approximately normal when the sample size n is suﬃciently large. How large should n be in order for the approximation to be useful? Unfortunately.7) Cov(xi x0 . 1) asymptotic distibution. after rescaling.7) is true then V = V 0 . but this is not a necessary condition. (6. As α approaches 2.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. however. The trouble is that no matter how large is the sample size. The expression V = Q−1 ΩQ−1 is called a sandwich form.9) In (6. Let yi = β 0 + β 1 xi + εi where xi is N (0. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).6). We say that ei is a Homoskedastic Projection Error when (6. e2 ) = 0. The approximation may be poor when n is small. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. Q−1 ΩQ−1 .3. i i Condition (6.9) we deﬁne V 0 = Q−1 σ 2 whether (6. 1). 1 X √ xi ei n i=1 n ! the N (0.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . Ω) ¡ ¢ = N 0.

2 and 6. As α diminishes the density changes signiﬁcantly.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.11) 50 . 1) density.10) without changing this result.3 is that the N (0. As k increases.2: Density of Normalized OLS estimator α = 3. The lesson from Figures 6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . the sampling distribution becomes highly skewed and non-normal. The estimator 2 2 in (6. 1) asymptotic approximation is never guaranteed to be accurate.3.0 the density is very close to the N (0. we need an estimate of Ω = E xi x0 e2 . Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0.2) and Theorem 6.2.10) V 0 = Q−1 s2 . concentrating most of the probability mass around zero. We show the sampling distribution of n β 1 − β 1 setting n = 100. 6 and 8.1) it is clear that V 0 →p V 0 . Another example is shown in Figure 6. 6. 4. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. 1). for k = 1.Figure 6.

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

To illustrate.085 p ˆ and that for β 1 is . just as any other estimator.020.used by an author when studying their work.30 + 0.493 0. from which it follows that V →p V as n → ∞. and then the square roots. Ω 2.83 ¶−1 = µ 7. we return to the log wage regression of Section 4.6 ¶µ 1 14.80 40.12) in turn. (.5) and the WLLN (Theorem 5.14 205.2. then take the diagonal elements. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. (6. Using (6.14 14.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. but not under another set of assumptions. From a computational standpoint.035 ¶ .039 and ˆ V = µ 1 14. (6.199 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .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 .98 −0.1.493 −0.14 205.480 ˆ0 = 0.14 6.83 ¶−1 µ .80 2.020) 6. i i i i n i=1 Second.35/988 = .14 14. The standard errors for β 0 are 7. by Holder’s inequality (5. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .80 .2/988 = . p ˆ In this case the two estimates are quite similar.20 −0.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω.20 = V 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.199 2. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. First.117 Educationi .83 −0. n n i=1 52 .085) (.80 40. We calculate that s2 = 0.14 205.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.20 and µ ¶ ˆ = 0.480 .

you can show that 1 Xˆ ¯ β= β (−i) . Andrews (1991) suggested an similar estimator based on cross-validation.26).25). ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0.5. these establish consistency. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . Using this substitution. From equation (3. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.¯ ¯ ¯ ¯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. Recall from Section 4.1 As n → ∞. i=1 Third. ¯ ¯n ¯ n i=1 so Together.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. which. Ω →p Ω and V →p V.11) with the leave-one-out estimator ei. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. n i=1 n ˆ ˆ Theorem 6. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . 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. 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.−i = (1 − hi )−1 ei ˆ presented in (4.13) Using formula (4.13) of Efron (1982).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 .6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. 6.

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

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

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

96s(ˆ ≈ ˆ ± 2s(ˆ . θ θ) (6. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.18) . However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. ˆ + zα/2 s(ˆ . This corresponds to selecting the conﬁdence h i h ˆ ± 1.05. 6. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . θ The interval has been constructed so that as n → ∞. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. 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. In this case the t-statistic approach does not work.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. or α = . the most common professional choice isi95%. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . and it is desired to test the joint restrictions simultaneously.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ).16) and zα/2 is the upper α/2 quantile of the standard normal distribution. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. 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). 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). We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6.

if rank(Hβ ) = q. Hβ (β) →p Hβ . h(β) = R0 β. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.3. θ = β 2 .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 . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . Also h(β) = a selector matrix. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .1 Under H0 and Assumption 6. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. ˜˜ n ˜ e = Y − X1 β 1 .84 = z.05) = 3. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .1 showed θ ˆ that V →p V. For example. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). 6. Hβ (β) is a continuous function of β.15) showed that n ˆ − θ →d Z ∼ N (0. As before.5. ˆ Wn = n θ θ q θ θ Theorem 6. a chiq square random variable with q degrees of freedom. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2.1. In this case.025 . 1] under H0 .When h is a linear function of β. Vθ ).19) σ2 ˆ where σ2 = ˜ 1 0 e e. Furthermore.8. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. and there are q = k2 restrictions. the test rejects at the α% level iﬀ pn < α.10. Wn = n R0 β − θ0 ´ √ ³ The delta method (6.2. The asymptotic p-value for Wn is pn = p(Wn ). ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . the upper-α quantile q 2 of the χ2 distribution. and Theorem 6. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). q and pn is asymptotically U[0. Hence β β by Theorem A. 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. The null hypothesis is H0 : β 2 = 0. χ2 (. then Wn →d χ2 .

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

where In many statistical packages. including the estimated error variance 2. these cases are atypical. n−k 60 . introduced in Section 4. equivalently the residual variance from an intercept-only model. Since uncorrelated normal variables are independent. it follows ˆ that β is independent of any function of the OLS residuals. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . Since linear functions of normals are also normal. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. there is an exact distribution theory available for the normal linear regression model. H 0 H) ∼ N (0. 6. This is rarely an issue today. an “F statistic” is reported. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. In ) . This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . The modelling assumption that the error ei is independent of xi and N (0. 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. Let u = σ −1 H 0 e ∼ N (0. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2.4)) where H 0 H = In . e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . when an OLS regression is reported. 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 . While there are special cases where this F statistic is useful. This was a popular statistic in the early days of econometric reporting. In particular.12 Normal Regression Model As an alternative to asymptotic distribution theory.3. In σ 2 . σ 2 ) can be be used to calculate a set of exact distribution results.

The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .10) then ´ ³ ˆ • β ∼ N 0.a chi-square distribution with n − k degrees of freedom. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .1 If ei is independent of xi and distributed N(0. n−k • ∼ tn−k ˆ In Theorem 6. σ 2 ) = − log σ − log (2π) − .12. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. Furthermore. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . with residual variance σ . (Unless the sample size is unreasonably small. a good testing procedure is based on the likelihood ratio statistic. β 2 . σ 2 ) discussed above. the notable distinction is between the N (0. so as a practical matter it does not matter which distribution is used. We summarize these ﬁndings Theorem 6. β has an exact normal distribution and t has an exact t distribution. In contrast. β 2 . β 2 . σ 2 ) − Ln (β 1 . As inference (conﬁdence intervals) are based on the t-ratio. Theorem 6. 1) and tn−k distributions.1 shows that under the strong assumption of ˆ normality. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. and standard errors are calculated using the homoskedastic formula (6.1 and Theorem 6. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .12. σ ˆ ˆ βj − βj βj − βj N (0. β and t are approximately normally distributed. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . 0.3. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom.1 we showed that in large samples. σ2 ˆ 61 .10) µ h i ¶ 2 (X 0 X)−1 N 0. The critical values are quite close if n − k ≥ 30.) Now let us partition β = (β 1 . if standard errors are calculated using the homoskedastic formula (6. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. σ 2 ). 0. 0. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .8.

This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. setting n/σ 2 = 10.84 — the probability of a false rejection. 6. 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. The increasing solid line is for the case β = 0. To demonstrate this eﬀect. In the present context of the Wald statistic. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. we have plotted in Figure 6. This produces random draws from the sampling distribution of interest. Through repetition. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . The decreasing dashed ˆ = 1. σ 2 ) and consider the hypothesis H0 : β = 1. and noting Hβ = sβ s−1 .13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. Take the model yi = β + ei ei ∼ N (0. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 .8. 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. 62 . The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. while there are other values of s for which test test statistic is insigniﬁcant.7. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. they can work quite poorly when the restrictions are nonlinear. Our ﬁrst-order asymptotic theory is not useful to help pick s. features of this distribution can be calculated. as Wn (s) →d χ2 under H0 for 1 any s. Letting h(β) = β s .By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . This can be seen by a simple example introduced by Lafontaine and White (1986). the statistic Wn (s) varies with s.4 the Wald statistic Wn (s) as a function ˆ of s. This is an unfortunate feature of the Wald statistic. ˆ Let β and σ 2 be the sample mean and variance of yi . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.

4. In each case. Test performance deteriorates as s increases. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.84. no magic choice of n for which all tests perform uniformly well. the only test which meets this criterion is the conventional Wn = Wn (1) test. Error rates avove 10% are considered excessive. 100 and 500.000 random samples. Typically.1 you can also see the impact of variation in sample size. Type I error rates between 3% and 8% are considered reasonable. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. To interpret the table. this probability depends only on s. remember that the ideal Type I error probability is 5% (. The value of s is varied from 1 to 10. For this particular example. Any other choice of s leads to a test with unacceptable Type I error probabilities. looking for tests for which rate rejection rates are close to 5%. however.84 | β = 1) .05) with deviations indicating+ distortion. n.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . The null hypothesis β s = 1 is true. Table 4.1 reports the simulation estimate of the Type I error probability from 50. n is varied among 20.4: Wald Statistic as a function of s P (Wn (s) > 3. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.000 simulated Wald statistics Wn (s) which are larger than 3. we compare the rates row by row. and σ 2 . In Table 2. and σ is varied among 1 and 3. There is. Table 4. the Type I error probability improves towards 5% as the sample size n increases.Figure 6.1 we report the results of a Monte Carlo simulation where we vary these three parameters. so these probabilities are Type I error. Rates above 20% are unexceptable. In Table 4. Given the simplicity of the model. and rarely fall outside of the 3%-8% range. When comparing statistical procedures. These probabilities are calculated as the percentage of the 50.

35 .13 . β 1 .08 .20 .31 .24 . While this is clear in this particular example. An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.13 .26 .10 .22 .30 .34 .06 .15 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . Equivalently.13 .07 .05 . so the hypothesis can be stated as H0 : θ = r.17 .14 .14 .15 .06 .06 .20 .25 .07 .06 .05 .21 . β 2 ) be the least-squares estimates of (6.25 .06 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.18 .08 .28 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.10 .15 .33 .08 .12 .05 . This point can be illustrated through another example. 64 .12 .09 .07 .07 .06 .07 .10 .05 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .19 .05 .16 Rejection frequencies from 50. deﬁne θ = β 1 /β 2 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.20).08 .06 .11 .05 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .08 .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 . Other choices are arbitrary and would not be used in practice.06 .22 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .15 .23 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.

25.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. the entries in the table should be 0.645) P (tn > 1. In all cases.00 .06 . and are close to the ideal 5% rate for both sample sizes.06 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.07 . We let x1i and x2i be mutually independent N (0.2.05 . .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .00 The one-sided Type I error probabilities P (tn < −1. .75 1. this formulation should be used. if the hypothesis can be expressed as a linear restriction on the model parameters.645) greatly exceed 5%. It is also prudent to consider alternative tests to the Wald statistic.15 .50.1.0 and n among 100 and 500. In this section we describe the method in more detail.7.05 .28 . The implication of Table 4.06 . Ideally. However.02 .645) and P (tn > 1.00 . the rejection rates for the t1n statistic diverge greatly from this value.00 . while the right tail probabilities P (t1n > 1.06 . This leaves β 2 as a free parameter.00 .00 .05 . 65 .645) are calculated from 50.25 .12 .15 . The left tail probabilities P (t1n < −1.75.05 β2 .06 .05 .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 . We vary β 2 among .06 . then the “most linear” formulation should be selected. 6. and alternatives to asymptotic critical values should be considered. and 1. .10 . Table 4.05 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. The results are presented in Table 4.09 .645) P (tn < −1.06 . In contrast.06 .645) are close to zero in most cases. and normalize β 0 = 0 and β 1 = 1.06 . especially for small values of β 2 .05 . ei be an independent N (0. such as the GMM distance statistic which will be presented in Section 9.00 .645) t1n t2n t1n t2n t1n t2n t1n t2n .2 is that the two t-ratios have dramatically diﬀerent sampling behavior. along with sample size n.05 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .00 .645) P (tn > 1.05.10 . 1) variables.05 . σ 2 ) draw with σ = 3.47 .05 .26 .000 simulated samples.10 .06 .00 .50 . If no linear formulation is feasible.

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

The α% sample quantile is a number qα such that α% of the sample are less than qα . an estimator or test may perform wonderfully for some values.96) . if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. . and . so that coeﬃcients may be interpreted as semi-elasticities. and dummy variable indicators for the following: married. Again our dependent variable is the natural log of wages. experience squared. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. We us the sample of wage earners from the March 2004 Current Population Survey. B b=1 (6. for a selection of choices of n and F. are. such as the percentage estimate reported in (6. this may ˆ be approximated by replacing P with P or with an hypothesized value. and estimate a multivariate regression. we included a dummy 67 . it is simple to make inferences about rejection probabilities from statistical tests. In practice. immigrant. the researcher must select the number of experiments. We separately estimate equations for white and non-whites.96) is iid Bernoulli. where N = (B +1)α. union member. respectively. if we set B = 999. Generally. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. Hence the ³ ´ ˆ standard errors for B = 100. experience squared.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. and our regressors include years of education. It is therefore useful to conduct a variety of experiments. potential work experience. If the standard error is too large to make a reliable inference. Furthermore. and 5000. The random variable 1 (Tnb ≥ 1. then we can set s P = (. 1000. B. For example. potential work experience. a larger B results in more precise estimates of the features of interest of Gn . In particular. immigrant. and 90% sample quantiles of the sample {Tnb }. Quite simply. Then qα is the N ’th number in this ordered sequence. For regressors we include years of education. s P = . Often this is called the number of replications. hispanic. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. and non-white. It is therefore convenient to pick B so that N is an integer. the performance will depend on n and F. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. therefore. female. equalling 1 with probability P = E1 (Tnb ≥ 1. the choice of B is often guided by the computational demands of the statistical procedure.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. We now expand the sample all non-military wage earners. but requires more computational time. The average (6.05) (.21). and poorly for others.22/ B. In many cases.15 Estimating a Wage Equation We again return to our wage equation. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. and dummy variable indicators for the following: married.96) .95) /B ' . The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. and hispanic.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B.007. For the dependent variable we use the natural log of wages. For example. female. then B will have to be increased. 6. union member.003. excluding military.022. As P is unknown. and therefore it is straightforward to calculate standard errors for any quantity of interest. As discussed above.

69.1.001 .49452 σ ˜ Notice that the two statistics are close.101 .007 .121 −.102 −. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.48772 = 515.010 . The F form of the Wald statistic (6. but not equal.008 .032 .232 .4945.033 −.808 so the parameter estimates are quite precise and reported in Table 4.002 .4877 18.102 −. the restricted standard deviation estimate is σ = . 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.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. Table 4. Computing the Wald statistic (6.013 . we ﬁnd Wn = 550. 2β 3 68 . reestimating the model with the 50 state dummies excluded.014 . 808 1 − . excluding the coeﬃcients on the state dummy variables.18) that the state coeﬃcients are jointly zero.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant. as the 1% critical value for the χ2 distribution is 76. The available sample is 18. θ ˆ 2β 3 β2 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .097 −. Using either statistic the hypothesis is easily rejected.070 .00002 .00057 . Ignoring the other coeﬃcients.34 ˆ s(β) .027 . this adds 50 regressors). Wn = n 1 − 2 = 18. Alternatively.variable for state of residence (including the District of Columbia. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.808 .

40.9.0. However. In the previous section we discovered that such t-tests had very poor Type I error rates.5]. Since tn (θ) is a non-linear function of θ. 29. not testing a hypothesis. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.5]. 69 . These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ). 29. we found better Type I error rates by reformulating the hypothesis as a linear restriction. This set is [27. Instead. this is a poor choice. In the present context we are interested in forming a conﬁdence interval. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. there is not a simple expression for this set.Using the Delta Method. but the lower end is substantially lower. we can calculate a standard error of s(ˆ = . This is the set of θ such that |tn (θ)| ≤ 1.96. implying a 95% conﬁdence θ) interval of [27. so we have to go one step further. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. but it can be found numerically quite easily.

λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1.6. 3. then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. r ˜ is a known s × 1 vector. and rank(R) = s. 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 . ˜ That is. β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . 0 < s < k. In the model Y = X1 β 1 + X2 β 2 + e. ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. β − β = Ik − X 0 X 70 . ﬁnd the least-squares estimate of β = (β 1 . the following deﬁnition is used. (d) Under the ´ standard assumptions plus R0 β = r. In the model Y = X1 β 1 + X2 β 2 + e. β 2 ). 2. In the model Y = X1 β 1 + X2 β 2 + e. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. show that the least-squares estimate of β = (β 1 . Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. ˜ (b) Verify that R0 β = r. (c) Show that if R0 β = r is true. ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. 4. (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. 1. In the model Y = Xβ + e. 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) . β 2 ).16 Exercises For exercises 1-4. subject to the constraint that β 1 = −β 2 . show that the least-squares estimate of β = (β 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

1) infeasible since the matrix D is unknown..Chapter 7 Additional Regression Topics 7. 74 . Let η i = e2 .. we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. The theory of Chamberlain (1987) can be used to show that in this model the semiparametric eﬃciency bound is obtained by the Generalized Least Squares (GLS) estimator ¢−1 ¡ 0 −1 ¢ ¡ ˜ (7. ... The GLS estimator (7. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . However.. σ 2 }. the least-squares estimator is ineﬃcient.1 Generalized Least Squares In the projection model. Typically. z1i are squares (and perhaps levels) of some (or all) elements of xi . 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. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi .1) XD Y β = X 0 D−1 X ¡ ¢ 2 . σ1 We now discuss this estimation problem. where z1i is some q × 1 function of xi .. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . .2) E (ξ i | xi ) = 0.

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

that there is a need to bound the estimated variances away from zero. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. and it may be estimated with considerable 76 V takes a sandwich form√.1. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression.. We just state the result without proof.1. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. There are three reasons. It is possible to show that if the skedastic regression is correctly speciﬁed. similar to the covariance matrix of the OLS estimator. In this case we interpret α0 zi as a linear projection of e2 on zi ..2) is correctly speciﬁed. and was proposed by Cragg (Journal of Econometrics. V ). and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.1. Unless σ 2 = α0 zi . but the proof of this can be tricky. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). First. i ˜ 0 is inconsistent for V .. σ 2 ] σi i for some σ 2 > 0. Its asymptotic variance is not that given in Theorem 7. 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 → ∞. β should perhaps be i i called a quasi-FGLS estimator of β. ´´−1 ³ ³¡ ´´−1 ³ ³¡ ¢−1 ¢−2 2 0 ´´ ³ ³¡ 0 ¢−1 E α0 zi E α zi xi x0 σ i xi xi xi x0 . V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . A trimming rule might make sense: σ 2 = max[˜ 2 . Theorem 7. Since the form of the skedastic regression is unknown. In the linear regression model. . V n n i=1 . then FGLS is asymptotically equivalent to GLS. 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 ˜ = .1.1. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. FGLS is asymptotically superior to OLS. ¢¢−1 ¡ ¡ .1 If the skedastic regression is correctly speciﬁed. Why then do we not exclusively estimate regression models by FGLS? This is a good question. e2 }. 1992). Instead. This estimator V 0 is appropriate when the skedastic regression (7.

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

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

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

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

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

11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. The main diﬃculty is the estimation of f (0).1 ´ √ ³ˆ n β − β 0 →d N (0. When f (0 | x) is large. While a complete proof of Theorem 7. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. Computation of standard error for LAD estimates typically is based on equation (7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . V ). where V = and f (e | x) is the conditional density of ei given xi = x. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .Theorem 7. This can be done with kernel estimation techniques. by the central limit theorem (Theorm 5. First.5. Let g(β) = Eg (β). the height of the error density at its median. the conditional density of the error at its median. See Chapter 16. we provide a sketch here for completeness. ∂β 0 so Third.3.10) is equivalent to g n (β) = 0.5.11). In the special case where the error is independent of xi . ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .5. then there are many innovations near to the median.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . (7. ˆ Proof of Theorem 7. Pn −1 0 β)) . then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. and this improves estimation of the median.1 is advanced. ¢¢−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) .

9) for the median to all quantiles. The third line follows from an asymptotic empirical process argument. Exi x0 ) →d i 2 = N (0.12) Qτ = argmin Eρτ (U − θ) . ¥ 7. For ﬁxed τ . Again. then (7. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } .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. then F (Qτ ) = τ . the quantile regression functions can take any shape. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. so you can think of the quantile as the inverse of the distribution function. The median is the special case τ = . V ). θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) .13) This generalizes representation (7.5. when F (y | x) is continuous and strictly monotonic in y. 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. For the random variables (yi . If the random variable U has τ ’th quantile Qτ . As functions of x. (7. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . then F (Qτ (x) | x) = τ . The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . For τ ∈ [0. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. The following alternative representation is useful. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations).

n numerical methods are necessary for its minimization. When the error ei is independent of xi . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. The null model is yi = x0 β + εi i 84 .where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Another popular approach is the RESET test proposed by Ramsey (1969). the τ ’th conditional quantile of ei is zero. where and f (e | x) is the conditional density of ei given xi = x. otherwise its properties are unspeciﬁed without further restrictions. conventional Newton-type optimization methods are inappropriate. the unconditional density of ei at 0.12). One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. ˆ Given the representation (7. ¡ ¡ ¢¢−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.13).6. then f (0 | xi ) = f (0) . i By construction.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . 7. and test their signiﬁcance using a Wald test. fast linear programming methods have been developed for this problem. it is useful to have a general test of the adequacy of the speciﬁcation. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). the asymptotic variance depends on the conditional density of the quantile regression error. if the model yi = x0 β + ei has i been ﬁt by OLS. ´ √ ³ˆ Theorem 7. Thus.1 n β τ − β τ →d N (0. Fortunately.1. since it has discontinuous derivatives. and form a Wald statistic i for γ = 0. and are widely available. 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. 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.5. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . Furthermore.

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

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

based on Bayesian arguments.15) then where σ 2 is the variance estimate for model m. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. as the rule tends to overﬁt. and km is the number of coeﬃcients in the model. log(n) 87 . 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. k A major problem with this approach is that the critical level α is indeterminate. In contrast to the AIC. His criterion. That is. One popular choice is the Akaike Information Criterion (AIC). depending on the sample size. The rule is to select M1 if AIC1 < AIC2 . k = While many modiﬁcations of the AIC have been proposed. 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 < 1.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . AIC selection is inconsistent. The model selection rule is as follows.17) Since log(n) > 2 (if n > 8).However. M)) between the true density and the model density. Then select M1 if Wn ≤ cα . For some critical level α. since under M1 . let cα satisfy ¢ ¡ P χ22 > cα . Indeed. if α is set to be a small number. Indeed. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. as ³ ´ c P M = M1 | M1 → 1 − α < 1. etc. Another common approach to model selection is to to a selection criterion.16) holds under M1 . since (7. ¢ ¡ ˆ1 ˆ2 (7. n (7. n (7. else select M2 . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . it is more appropriate to view model selection as determining the best ﬁnite sample approximation. Another problem is that if α is held ﬁxed. then this model selection procedure is inconsistent. the most popular to be one proposed by Schwarz. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . known as the BIC. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . 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. LRn →p 0. this rule only makes sense when the true model is ﬁnite dimensional. BIC model selection is consistent. If the truth is inﬁnite dimensional. else select M2 .

β 2 6= 0. stores the residual variance σ 2 for each model. The methods extend readily to the issue of selection among multiple regressors. the models are M1 : β 1 6= 0. In the ordered case. a model consists of any possible subset of the regressors {x1i . log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. there are 2K such models. 576. which can be a very large number. xKi }. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. β 2 6= 0. The AIC selection criteria estimates the K models by OLS. 048. There are two leading cases: ordered regressors and unordered. and 220 = 1.15).17). one can show that thus LRn →p ∞. . In the unordered case. . MK : β 1 6= 0. . However. For example. We have discussed model selection between two models. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. . β 3 = · · · = β K = 0 . Also under M2 . . . which regressors enter the regression). E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi .. selecting based on (7. β K 6= 0.. and then selects the model with the lowest AIC (7.. 210 = 1024. 88 . In the latter case. and the AIC or BIC in principle can be implemented by estimating all possible subset models. Similarly for ˆ the BIC.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. which are nested. .

˜ the residual vector is e = Y − X β. V ar(e | X) = σ 2 Ω with Ω known. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. Let (yi .10 Exercises 1. Let θ satisfy Eg(Yi − θ) = 0. V . 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 . 5. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . Let σ 2 be the estimate of σ 2 . . and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. wn ) and wi = x−2 . 4. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. σ 2 ).. Verify equation (7. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . the residuals e. ˆ ˆ n−k 6. E(e | X) = 0. (b) Find an estimate of the variance of this forecast. where xji is one of the xi . Thus the available information is the sample (Y. the mean absolute error (MAE) is E |yi − g(xi )| . X). Is θ a quantile of the distribution of Yi ? 3.12). 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 . and the out-of-sample value of the regressors. Show that the function g(x) which minimizes the MAE is the conditional median M (x). x. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . xi ) be a random sample with E(Y | X) = Xβ.. the estimates (β. else equals zero). For any predictor g(xi ) for y. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . (b) Prove that e = M1 e. based on a sample of size n. ˆ (a) Find a point forecast of y. In a linear model Y = Xβ + e. . 2.. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition.7.

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

Interpret. 91 . (a) Start by an OLS regression of LNWAGE on the other variables. if desired. (f) Construct a model for the conditional variance. Estimate your selected model and report the results.dat contains 550 observations on 20 variables taken from the May 1978 current population survey. Variables are listed in the 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.pdf.10. (g) Using this model for the conditional variance. Note any interesting diﬀerences. (e) Test whether the error variance is diﬀerent for whites and nonwhites. (d) Test whether the error variance is diﬀerent for men and women. Report coeﬃcient estimates and standard errors. test for general heteroskedasticity and report the results. re-estimate the model from part (c) using FGLS. (b) Consider augmenting the model by squares and/or cross-products of the conditioning variables. The goal of the exercise is to estimate a model for the log of earnings (variable LNWAGE) as a function of the conditioning variables. (h) Do the OLS and FGLS estimates diﬀer greatly? Note any interesting diﬀerences. Estimate such a model. The data ﬁle cps78. Report the results. Interpret. (i) Compare the estimated standard errors.

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

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

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

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

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

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

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

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

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

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

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

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

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

with variables listed in the ﬁle hprice1. and the colonial dummy. Using the non-parametric ∗ bootstrap. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. What is wrong with this procedure? Tn = θ/s(θ) n 6.95). ∗ ∗ ∗ Let qn (. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. ˆ = 1.95).3. Using the non-parametric bootstrap.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). and thus reject H0 if ˆ ˆ > q ∗ (. θ respectively. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. The ˆ are sorted.05) and qn (. Estimate a linear regression of price on the number of bedrooms. (b) Report the 95% Alternative Percentile interval for θ. (c) With the given information. Let qn (.75 and 1.2.95) denote the 5% θ) ∗ and 95% quantiles of Tn . θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. The dataﬁle hprice1. Suppose that in an application. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.dat contains data on house prices (sales). size of house.5% quantiles of the ˆ are . You replace c with qn (.95) denote the 95% quantile of Tn . can you report the 95% Percentile-t interval for θ? 7. and ˆ is calculated on each θ ∗ ∗ θ sample. (a) Report the 95% Efron Percentile interval for θ.pdf.05) .5% and 97. you generate bootstrap samples. lot size. 105 . You want to test H0 : θ = 0 against H1 : θ > 0. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and the 2. ˆ − s(ˆ n (. ∗ ∗ where s(ˆ is the standard error in the original data.95). You do this as follows.2 and s(ˆ = .

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

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

V ) . ˆ Construct n 1X ˆ g n = g n (β) = gi . this is a semi-parametric problem. In the linear model. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . a better choice is Wn = (X 0 X)−1 . W0 = Ω−1 is not known in practice. The optimal weight matrix W0 is one which minimizes V. it turns out that the GMM estimator is semiparametrically eﬃcient. However.2 For the eﬃcient GMM estimator. 9.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . Ω) . Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. If it is known that E (gi (β)) = 0.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. β). This is a weak concept of optimality. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. it is semiparametrically eﬃcient. For any Wn →p W0 . the GMM estimator β is consistent yet ineﬃcient. as we are only considering alternative weight matrices Wn . n β − β →d N 0. ˆ n i=1 gi = gi − g n .3.3. as shown by Gary Chamberlain (1987). This turns out to be W0 = Ω−1 . and this is all that is known. The proof is left as an exercise. without imposing additional assumptions. as it has the same asymptotic distribution. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . Chamberlain showed that in this context. where In general. but it can be estimated consistently. 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. No estimator can do better (in this ﬁrst-order asymptotic sense). we can set Wn = I . n n We conclude: Theorem 9. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. This results shows that in the linear model. as the distribution of the data is unknown. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. ˆ∗ ˆ 108 . For example.1 ´ √ ³ˆ n β − β →d N (0. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. ˆ we still call β the eﬃcient GMM estimator. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator.

as in (9. Since Egi = 0. However. Egi 6= 0. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. There is an important alternative to the two-step GMM estimator just described. and construct the residual ei = yi − zi β. 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. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β).and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. β = Z 0 X g 0 g − ng n g 0 n n ˆ Asymptotic standard errors are given by the square roots of the diagonal elements of V . these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. when we say “GMM”. Heaton and Yaron (1996). There is little point in using an ineﬃcient GMM estimator as it is easy to compute. ∗ gi (β) = gi (β) − g n (β) 9. i. Instead. under the alternative hypothesis the moment conditions are violated. A simple solution is to use the centered moment conditions to construct the weight matrix. Here is a simple way to compute the eﬃcient GMM estimator. The estimator appears to have some better properties than traditional GMM. Hansen. First. This is a current area of research in econometrics.4) above. ˆ and let g be the associated n × matrix. we can let the weight matrix be considered as a function of β. (9. and GMM using Wn as the weight matrix is asymptotically eﬃcient. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. 109 . Then set gi = xi ei . GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0.4) which uses the uncentered moment conditions. and was introduced by L. set Wn = (X 0 X)−1 . we actually mean “eﬃcient GMM”. J(β) = n · g n (β) n i=1 In most cases. Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ .5 GMM: The General Case In its most general form.e. When constructing hypothesis tests. 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 . 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. but can be numerically tricky to obtain in some cases.

n β − β →d N 0. β) = 0 holds. and is thus a natural test statistic for H0 : Egi = 0. 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. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. 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 . G0 Ω−1 G . However. For example. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. ˆ J = J(β) →d χ2−k . This estimator can be iterated if needed. 1 it is possible that β 2 6= 0. 1 2 It is possible that β 2 = 0. this is all that is known. The variance of β may be estimated by G0 Ω−1 G where P ∗ ∗0 P ∂ ˆ ˆ ˆ g g and G = n−1 ˆ ˆ Ω = n−1 0 gi (β). Thus the model — the overidentifying restrictions — are testable. so that the linear equation may be written as yi = β 0 x1i + ei . take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. Theorem 9. and if the weight matrix is asymptotically eﬃcient. The general theory of GMM estimation and testing was exposited by L. and then β recomputed. Note that g n →p Egi .Often. Under the hypothesis of correct speciﬁcation. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . Since the GMM estimator depends upon the ﬁrst-stage estimator. 110 .6. often the weight ˆ matrix Wn is updated. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Hansen (1982). perhaps obtained by ﬁrst ˆ setting Wn = I. 9. ˆˆ n is a quadratic form in g n .6 Over-Identiﬁcation Test Overidentiﬁed models ( > k) are special in the sense that there may not be a parameter value β such that the moment condition Eg(wi . In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. Identiﬁcation requires l ≥ k = dim(β).5.1 (Sargan-Hansen). 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 Under general regularity conditions.

1 If the same weight matrix Wn is used for both null and alternative. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). the hypothesis is H0 : h(β) = 0.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. Hansen (1982) for the general case. but it is typically cause for concern. The idea was ﬁrst put forward by Newey and West (1987). This is sometimes called the GMM Distance statistic. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). This reasoning is not compelling. 111 .The proof of the theorem is left as an exercise. it is unclear what is wrong. Proposition 9. and it is advisable to report the statistic J whenever GMM is the estimation method. These may be used to construct Wald tests of statistical hypotheses. If h is linear in β. and some current research suggests that this restriction is not necessary for good performance of the test. 9. D →d χ2 r 3. we can reject the model. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). then D equals the Wald statistic. it is customary to report the J statistic as a general test of model adequacy. Based on this information alone. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. a better approach is to directly use the GMM criterion function. D ≥ 0 2. and by L. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). For a given weight matrix Wn . The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. If h is non-linear. In contrast. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . as this ensures that D ≥ 0. If the statistic J exceeds the chi-square critical value. however. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. 1. When over-identiﬁed models are estimated by GMM. and is the preferred test statistic. If the hypothesis is non-linear. This result was established by Sargan (1958) for a specialized case.7. the Wald statistic can work quite poorly. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. current evidence suggests that the D statistic appears to have quite good sampling properties.

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

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

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

β) + ei E (zi ei ) = 0. subject ˆ i ˆi i=1 to the restriction h(β) = 0. the distance statistic D in (9. Deﬁne the Lagrangian L(β. 6. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). Vn = X X i=1 ˜ and hence R0 β = r. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.6) equals the Wald statistic.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . The equation of interest is yi = g(xi . 115 . xi .6) (a) Show that you can rewrite Jn (β) in (9. 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. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . In the linear model Y = Xβ + e with E(xi ei ) = 0. 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 . Show how to construct an eﬃcient GMM estimator for β. The observed data is (yi . zi ). h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). h(β)=0 (9. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. VR ) where ¡ ¢−1 0 R V. VR = V − V R R0 V R (d) Show that in this setting. zi is l × 1 and β is k × 1. l ≥ k.5.5) 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.

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

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

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

´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.10) ¡ Ω−1 N (0. Thus the EL estimator is asymptotically eﬃcient. n (10.13) Premultiplying by G0 Ω−1 and using (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.13) yields n n Expanding (10.8) and ¢ 0 0 For example. β λ ∂ ³ ´.10. β) = −xi zi . i i Theorem 10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. λ) = − (10. 0 = Rn (β.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .9) (10. λ) = − (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.1 Under regularity conditions. G = −E (xi zi ). (β. and n β − β 0 and nλ are asymptotically independent.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . in the linear model. and Ω = E xi x0 e2 .9) and (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . i=1 i=1 i=1i Expanding (10.14) 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 . 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. ˆ ˆ Proof.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.10). Gi (. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.2.

16). it is an asymptotically eﬃcient estimator for β. LRn = i=1 Theorem 10. The same statistic can be constructed for empirical likelihood. They are asymptotically ﬁrst-order equivalent.7) is n ³ ´´ ³ X ˆ ˆ0 (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. by a Taylor expansion.17) 2 ln 1 + λ gi β .14) for λ and using (10. and (10. and have the same interpretation. The overidentiﬁcation test is a very useful by-product of EL estimation.15) (10.3. Vλ ) Furthermore. First. and it is advisable to report the statistic LRn whenever EL is the estimation method.15). Since the EL estimator achieves this bound. V ) ˆ Solving (10. β 0 ) = 0 then LRn →d χ2−k .3 Overidentifying Restrictions In a parametric likelihood context. 120 . n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.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. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .1 If Eg(wi .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. 10. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. tests are based on the diﬀerence in the log likelihood functions. (10. Ω) GΩ G →d = N (0. Proof.

Theorem 10.Second. This test statistic is a natural analog of the GMM distance statistic.edu/~bhansen/progs/elike. Vλ )0 Ω−1 N (0.1 Under (10. h(β)=0 ˜ Fundamentally. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. By “maintained” we mean that the overidentfying restrictions contained in (10.ssc. so there is no fundamental change in the distribution theory for β relative to β.18) and H0 : h(β) = 0. 10. a The proof of this result is more challenging and is omitted.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). To test the hypothesis h(β) while maintaining (10.18).18) Let the maintained model be where g is × 1 and β is k × 1. since ln(1 + x) ' x − x2 /2 for x small. the simple overidentifying restrictions test (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.17) is not appropriate. where h : Rk → Ra . 10.wisc. The hypothesis of interest is h(β) = 0. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). LRn →d χ2 .4 Testing Egi (β) = 0 (10.4.prc 121 . 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. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.

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

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

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

1 The × 1 random vector xi is an instrumental variable for (11. This is called simultaneous equations bias. So we have the partition µ ¶ z1i k1 (11. at least the intercept). which does not equal either β 1 or β 2 . That is x2i are variables which could be included in the equation for yi (in the sense 125 .2) Any solution to the problem of endogeneity requires additional information which we call instruments.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.1) if E (xi ei ) = 0.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1. and x2i are the excluded exogenous variables. Deﬁnition 11.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ . z1i is an instrumental variable for (11. In a typical set-up. (11. some regressors in zi will be uncorrelated with ei (for example. In matrix notation. Thus we make the partition ¶ µ k1 z1i (11. We call z1i exogenous and z2i endogenous. 11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. By the above deﬁnition.1) where zi is k × 1.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1). so should be included in xi .1) the structural equation. We call (11. and assume that E(zi ei ) 6= 0 so there is endogeneity. this can be written as Y = Zβ + e. β →p β ∗ .

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

14) is the probability limit of β 2SLS − β 11. P = HΛH 0 0 0 where Λ = diag(Il . Indeed as α → 1. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. the bias in the 2SLS estimator will be large. The consequences of identiﬁcation failure for inference are quite severe.12) and this result. l . 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. 0).14) approaches that in (11. 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 . the expression in (11. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. By the spectral decomposition of an idempotent matrix.Let PX = X (X 0 X)−1 X 0 .7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . except when S21 = 0 (when Z is exogenous). n and (11. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 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 (11.13). indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 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 . 130 .14) In general this is non-zero. It is also close to zero when α = 0.

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

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

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

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

...3 ρ(k) = γ(k)/γ(0) = Corr(Yt . T .1. Deﬁnition 12. then Xt is strictly stationary and ergodic. The primary model for multivariate time series is vector autoregressions (VARs). . and Cov (Yt . The following two theorems are essential to the analysis of stationary time series. There proofs are rather diﬃcult. and multivariate (yt ∈ Rm is vector-valued).1..) is a random variable. so classical assumptions are not valid.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. and use the subscript t to denote the individual observation. 12.1.1.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. Yt−k ) is the autocorrelation function.. Yt−k ) = γ(k) is independent of t for all k. Deﬁnition 12. γ(k) is called the autocovariance function. Theorem 12. Yt−1 . t = 1. 135 . To indicate the dependence on time. however. Yt−k ) is independent of t for all k. ..2 {Yt } is strictly stationary if the joint distribution of (Yt ... we expect that Yt and Yt−1 are not independent.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . Because of the sequential nature of time series. . we adopt new notation.1 Stationarity and Ergodicity Deﬁnition 12.4 (loose).1. Deﬁnition 12. We can separate time series into two categories: univariate (yt ∈ R is scalar). A stationary time series is ergodic if γ(k) → 0 as k → ∞. and T to denote the number of observations. The primary model for univariate time series is autoregressions (ARs).

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

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

138 . From Theorem 12. We call ρ(L) the autoregressive polynomial of Yt . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .1. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . We call ρ(L) the autoregressive polynomial of Yt .3.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. The AR(k) model is Using the lag operator. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . Deﬁning L2 = LL. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. Lk Yt = Yt−k .3. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .1 The lag operator L satisﬁes LYt = Yt−1 . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). since ρ(z) = 0 when z = 1/ρ. 12. We say that the root of the polynomial is 1/ρ. an AR(1) is stationary iﬀ |ρ| < 1. we see that L2 Yt = LYt−1 = Yt−2 .4.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. the above results are unchanged.Theorem 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). The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . Deﬁnition 12. In general.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . ∞ X k=0 ρ2k V ar (et−k ) = 12.

One way of stating this is that “All roots lie outside the unit circle.where the λ1 .6. it is also strictly stationary and ergodic.” If one of the roots equals 1.1..1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. This is a special case of non-stationarity. Let |λ| denote the modulus of a complex number λ.1. . since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. which satisfy ρ(λj ) = 0. Proof..1) Theorem 12. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.1. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. then ˆ β →p β as T → ∞. t Yt−k ¢0 ρk .1. Note that ut is a MDS. The vector xt is strictly stationary and ergodic. so is xt x0 .. By Theorem 12. β = X 0X (12. and hence Yt . the requirement is that all roots are larger than one. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. “has a unit root”. it is helpful to deﬁne the process ut = xt et . T ¢ ¡ 1X xt x0 →p E xt x0 = Q. 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. we say that ρ(L).1) and the continuous mapping theorem. t t T t=1 ¥ Combined with (12. and by Theorem 12. t T t=1 T t=1 139 . and is of great interest in applied time series.5.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. λk are the complex roots of ρ(z). Theorem 12. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. For an AR(k). Thus t by the Ergodic Theorem.

7. Fix an initial condition (Y−k+1 . ˆ 2. t t Theorem 12. . we constructed the bootstrap sample by randomly resampling from the data values {yt . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Clearly. T 1 X √ ut →d N (0.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. In particular. Y−k+2 .7 Asymptotic Distribution Theorem 12. The implication is that asymptotic inference is the same.. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. Divide the sample into T /m blocks of length m. t then as T → ∞. ˆ 1. there are two popular methods to implement bootstrap resampling for time-series data.7. T t=1 where Ω = E(xt x0 e2 ). eT }.. Y0 ). If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Ω) . t This construction imposes homoskedasticity on the errors e∗ . e ˆ 3. T t=1 Since xt et is a MDS. the asymptotic covariance matrix is estimated just as in the cross-section case... as this imposes inappropriate independence. Method 1: Model-Based (Parametric) Bootstrap. which may be diﬀerent than the i properties of the actual ei .8 Bootstrap for Autoregressions In the non-parametric bootstrap.12. Ω) . Method 2: Block Resampling 1. xt }. Estimate β and residuals et . i 4. we can apply Theorem 12.7. This creates an iid bootstrap sample. 140 . It also presumes that the AR(k) structure is the truth. Q−1 ΩQ−1 . then as T → ∞. This is identical in form to the asymptotic distribution of OLS in cross-section regression. this cannot work in a time-series application.1 to see that T 1 X √ xt et →d N (0. Brieﬂy. .. 12.1 MDS CLT. 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∗ ..

. The results may be sensitive to the block length.. For each simulated sample.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . and perhaps this was of relevance.3) replacing St with St .2) (12. But the long-run trend is also eliminated. or the season-to-season change. This is a ﬂexible approach which can extract a wide range of seasonal factors. 5.2. If s is the number of seasons (typically s = 4 or s = 12). also alters the time-series correlations of the data. Paste the blocks together to create the bootstrap time-series Yt∗ . • First apply a seasonal diﬀerencing operator. May not work well in small samples. heteroskedasticity. ρk ).4) by OLS. Thus the seasonally adjusted data is a “ﬁltered” series.2). This allows for arbitrary stationary serial correlation. This procedure is sometimes called Detrending. draw T /m blocks. (12. Seasonal Eﬀects There are three popular methods to deal with seasonal data. 141 .3) sequentially by OLS. ﬁrst estimate (12.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . and the way that the data are partitioned into blocks. 4.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . The series ∆s Yt is clearly free of seasonality. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. and for modelmisspeciﬁcation. however. 6.2)-(12. get the ˆ ˆ residual St . Resample complete blocks. This presumes that “seasonality” does not change over the sample.. The seasonal adjustment. • You can estimate (12. • Use “seasonally adjusted” data. 12. That is. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. . (12. and then perform regression (12. 3. • You can estimate (12. ∆s Yt = Yt − Yt−s . • Include dummy variables for each season.

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

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

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

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

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

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

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

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

Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. it is simple to test for cointegration by testing the rank of Π. 1991. When r > 1. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . this is the MLE of the restricted parameters under the assumption that et is iid N (0. we typically just normalize one element to equal unity. 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 . If β is unknown. and are similar to the Dickey-Fuller distributions.Theorem 13. 150 . If β is known. As they were discovered by Johansen (1988. they are typically called the “Johansen Max and Trace” tests. rank(α) = r. When r = 1.9. which is least-squares subject to the stated restriction. These tests are constructed as likelihood ratio (LR) tests. Their asymptotic distributions are non-standard. Equivalently. this does not work. 1995).1 (Granger Representation Theorem). One diﬃculty is that β is not identiﬁed without normalization. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. then estimation is done by “reduced rank regression”. Thus cointegration imposes a restriction upon the parameters of a VAR. In the context of a cointegrated VAR estimated by reduced rank regression. Ω).

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

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

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

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

The naive estimator of β is OLS regression of yi on xi for those observations for which yi is available. ρ from OLS of yi on xi and λ(z 0 γ ). The problem is that this is equivalent to conditioning on the event {Ti = 1}. The binary dependent variable is Ti . zi . Ti } for all observations. E (e0i | e0i > −x) = λ(x) = Φ(x) and the function λ(x) is called the inverse Mills ratio. Under the normality assumption. The dependent variable yi is observed if (and only if) Ti = 1.A simple sample selection model can be written as the latent model yi = x0 β + e1i i ¡ 0 ¢ Ti = 1 zi γ + e0i > 0 where 1 (·) is the indicator function. 1). ¡ ¢ 0 E (e1i | Ti = 1. Heckman (1979) observed that we could consistently estimate β and ρ from this equation. i • The OLS standard errors will be incorrect. Thus E (ui | Ti = 1. which can be observed only if a person is employed. A useful fact about the standard normal distribution is that φ(x) . Zi + E vi | {e0i > −zi γ}. by viewing the Probit/OLS estimation equations as a large joint GMM problem. where Hence ¡ 0 ¢ e1i = ρλ zi γ + ui . ˆ ³ ´ ˆ ˆ ˆ • Estimate β. Zi ) = 0. The equation for Ti is an equation specifying the probability that the person is employed. e1i ρ σ2 It is presumed that we observe {xi . alternatively. where vi is independent of e0i ∼ N (0. using regressors zi . The model is often completed by specifying that the errors are jointly normal ¶ µ µ ¶¶ µ 1 ρ e0i ∼ N 0.2) is a valid regression equation for the observations for which Ti = 1. Zi ¡ 0 ¢ = ρλ zi γ . Or. They can be corrected using a more complicated formula. but also can be consistently estimated by a Probit model for selection. . e1i = ρe0i + vi . For example. Zi ) = E e1i | {e0i > −zi γ}. yi could be a wage. as this is a two-step estimator. Zi ¢ ¡ ¢ ¡ 0 0 = ρE e0i | {e0i > −zi γ}. However. 155 . if γ were known. It is unknown. The “Heckit” estimator is thus calculated as follows • Estimate γ from a Probit. Else it is unobserved. ¡ 0 ¢ yi = x0 β + ρλ zi γ + ui i (14. which is non-zero.

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

. 15.. OLS can be improved upon via a GLS technique. . An observation is the pair {yit . It is a strong assumption.. i = 1. xit } : For i = 1.. xit } : t = 1.1) is true. A panel may be balanced : {yit . Condition (15. n. then OLS is inconsistent. The motivation is to allow ui to be arbitrary..Chapter 15 Panel Data A panel is a set of observations on individuals. however. It is consistent if E (xit ui ) = 0 (15.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. The goal is to eliminate ui from the estimator. . or unbalanced : {yit . If (15. and the t subscript denotes time. OLS of yit on xit is called pooled estimation. 157 . . that eit is iid across individuals and time. and most applied researchers try to avoid its use. In either event.. that ui and eit are independent. (15. There are several derivations of the estimator.. xit }. and that eit is uncorrelated with xit . OLS appears a poor estimation choice. t = ti .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 .. where the i subscript denotes the individual.1) is called the random eﬀects hypothesis.. T .. n. and have arbitrary correlated with xi ... . ti . it The typical maintained assumptions are that the individuals i are mutually independent. This is often believed to be plausible if ui is an omitted variable. collected over time.1) If this condition fails. and thus achieve invariance. 15.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit .

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

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

Kh (u) = K h h be the kernel K rescaled by the bandwidth h. Deﬁnition 1 K(u) is a second-order kernel function if it is a symmetric zero-mean density function. |x| ≤ 1 0 |x| > 1 ¡ ¢2 1 − x2 . The kernel functions are used to smooth the data. we cannot deﬁne d F (x) since F (x) is a step function. we can simply focus on the problem where x is a speciﬁc ﬁxed number. n i=1 n 160 .. The ˆ ˆ EDF F i=1 dx standard nonparametric method to estimate f (x) is based on smoothing using a kernel. the choice between these three rarely makes a meaningful diﬀerence in the estimates. The amount of smoothing is controlled by the bandwidth h > 0. . The kernel density estimator of f (x) is 1X ˆ f (x) = Kh (Xi − x) . |x| ≤ 1 0 |x| > 1 In practice.1 Kernel Density Estimation d Let X be a random variable with continuous distribution F (x) and density f (x) = dx F (x). and then see how the method generalizes to estimating the entire function. The goal is to estimateP(x) from a random sample (X1 .. Let 1 ³u´ . Xn } While F (x) can be estimated by the f ˆ (x) = n−1 n 1 (Xi ≤ x) .Chapter 16 Nonparametrics 16. 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 .. While we are typically interested in estimating the entire function f (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. f (x) is a valid density. then the weights are small and f ˆ ˆ Interestingly. where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h. f (x) ≥ 0 for all x. That is. and Z ∞ ˆ f (x)dx = −∞ Z ∞ −∞ 1X 1X Kh (Xi − x) dx = n n i=1 i=1 n n Z ∞ −∞ Kh (Xi − x) dx = 1X n i=1 n Z ∞ K (u) du = 1 −∞ where the second-to-last equality makes the change-of-variables u = (Xi − x)/h. The mean is Z ∞ ˆ xf (x)dx = = = = −∞ 1X n 1 n 1 n 1 n n i=1 −∞ n XZ ∞ Z ∞ xKh (Xi − x) dx (Xi + uh) K (u) du n i=1 −∞ n X Z ∞ Xi Xi i=1 n X i=1 1X K (u) du + h n −∞ i=1 Z ∞ uK (u) du −∞ the sample mean of the Xi . Conversely. If a large number of the observations Xi are near ˆ x. The bandwidth h controls the meaning of “near”. 161 . then the weights are relatively large and f (x) is larger.This estimator is the average of a set of weights. ˆ We can also calculate the moments of the density f (x). if only a few Xi are near x. ˆ(x) is small. 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.

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

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

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

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

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

τ r . 2. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1...3) P (X = τ j ) = π j .. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2. A function F (x) is a CDF if and only if the following three properties hold: 1. Instead. 167 .Theorem 2 (Bayes’ Rule).. then for each i = 1. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) 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 . . F (x) is nondecreasing in x 3.. these cases are unusualRand are typically ignored. This induces a new sample space — the real line — and a new probability function on the real line. we represent the relative probabilities by the probability density function (PDF) f (x) = so that F (x) = and P (a ≤ X ≤ b) = Z d F (x) dx x f (u)du Z b −∞ f (x)dx. .. and use lower case letters such as x for potential values and realized values. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. Typically. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. In the latter case. The probability function for X takes the form j = 1. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . a These expressions only make sense if F (x) is diﬀerentiable.3) is unavailable. r (A. of the sample space. (A. we denote random variables by uppercase letters such as X.2) Sometimes we write this as FX (x) to denote that it is the CDF of X.2 Random Variables A random variable X is a function from a sample space S into the real line.. A2 . .. We say that the random variable X is continuous if F (x) is continuous in x... For any set B and any partition A1 .

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

x! EX = λ x = 0. . 0≤p≤1 x = 0... Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . 1.. 0≤p≤1 V ar(X) = λ We now list some important continuous distributions. . . 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . λ>0 x = 1..A... X2 = x2 . 169 . 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 .. we now list some important discrete distribution function. 2. 2.4 Common Distributions For reference... 2. .... 0≤p≤1 x = 0.. 1... . x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 . 1. x = 1. x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx . EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x . m x1 !x2 ! · · · xm ! 1 2 = n. Bernoulli P (X = x) = px (1 − p)1−x . n.

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

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

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

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

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

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

Ir ) and set Q = X 0 X. x ∈ Rk . x ∈ Rk . If Z is standard normal and X = µ + σZ. denoted χ2 .1 Let X ∼ N (0. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . The latter has no closed-form solution. Σ) and Y = a + BX with B an invertible matrix. we can also show that EX 2 = 1 and EX 4 = 3. Theorem A. then Σ = diag{σ 2 } is a diagonal matrix. A) with A > 0. 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. respectively. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). and it is conventional to write X ∼ N (µ. q 176 . f (x) = √ 2σ 2 2πσ which is the univariate normal density. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . 1).8.This density has all moments ﬁnite. ¢ ¡ 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 . This shows that if X is multivariate normal with uncorrelated elements. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . Another useful fact is that if X ∼ N (µ.11) and is known as the chi-square density with r degrees of freedom. then using the change-of-variables formula. (A. σ 2 ). Theorem A. By iterated integration by parts. For x ∈ Rk . Its mean and r variance are µ = r and σ 2 = 2r. It is conventional to write X ∼ N (0.2 If Z ∼ N(0. Σ). X has density Ã ! (x − µ)2 1 exp − . then by the change-of-variables formula. −∞ < x < ∞. q × q. This shows that linear transformations of normals are also normal. The mean and variance of the distribution are µ and σ 2 . and it is conventional to write X ∼ N(µ. then Z 0 A−1 Z ∼ χ2 . y ≥ 0.8. Since it is symmetric about zero all odd moments are zero. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. then they are mutually independent.

8. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .3. For Z ∼ N(0. Set r Z . Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. From (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . Using the simple law of iterated expectations. Iq ).11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.8.8.1.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). q Proof of Theorem A.13) is the MGF of the density (A. 1). we see that the MGF of Z 2 is (1 − 2t)−1/2 .12) E exp (tQ) = 0 Γ (A. which can be found by applying change-of-variables to the gamma function. Thus the density of Z 2 is (A. tr has distribution 177 . which we showed in (A. 1) and Q ∼ χ2 be independent.13).11) 2 with r = 1. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Proof of Theorem A. C −1 AC −10 ) = N (0.8. C −1 CC 0 C −10 ) = N (0. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.11).Theorem A.3 Let Z ∼ N (0. The MGF for the density (A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. (A.2.

The log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi .. θ) . If the distribution F is continuous then the density of Yi can be written as f (y. Yn ) is n ³ ´ Y ˜.. 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. .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¡ ¢ . 178 . θ) = P (Y = y. θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector. The space Θ is the set of permissible value for θ.. i=1 The likelihood of the sample is this joint density evaluated at the observed sample values. viewed as a function of θ.θ = fn Y f (Yi . θ) . If the distribution F is discrete. In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ.9 Maximum Likelihood If the distribution of Yi is F (y. we say that the distribution is parametric and that θ is the parameter of the distribution F. θ) . θ) and the joint ˜ density of a random sample Y = (Y1 . the likelihood and log-likelihood are constructed by setting f (y.

17) The matrix I0 is called the information. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. θ) ∂θ ∂θ which holds at θ = θ0 by (A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .14) ¶ ∂ ∂ 0 ln f (Yi . The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. but these ˆ must be found by numerical methods. If ˜ is an unbiased estimator of θ ∈ R. ∂θ ∂θ (A. we can ﬁnd an explicit expression for θ as a function of the data. cases are rare.17) is often called the information matrix equality. Theorem A.9.9.15) Two important features of the likelihood are Theorem A.9. θ Theorem A.16). the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. θ) The Cramer-Rao Theorem gives a lower bound for estimation. More typically. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ) ≡ L(θ). θ0 ) .2 Cramer-Rao Lower Bound. 179 . θ0 ) ∂θ∂θ 0 (A. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . under conventional regularity conditions. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi .3 Under regularity conditions. n n i=1 n As the MLE ˆ maximizes the left-hand-side. ˆ →p θ0 as n → ∞. then θ V ar(˜ ≥ (nI0 )−1 .16) (A. which maximizes the log-likelihood). θ θ∈Θ ˆ In some simple cases. and the equality (A. However. θ) →p E ln f (Yi . θ0 ) ln f (Yi . In fact. we can see that it is an estimator of the maximizer θ of the right-hand-side. ˆ is consistent θ for this value. I0 .1 ¯ ¯ ∂ E ln f (Yi . θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. We can write this as ˆ = argmax Ln (θ).

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

S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 ) ∂ ∂θ f ∂ (Yi . θ0 ) f (Yi . θ0 )2 (Yi .1) has mean zero and variance nH. θ0 ) ¯ ∂ f (y.Proof of Theorem A. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ0 ) (Yi . θ0 = ln f (Yi . To see (A.2. Since θ Z ˜ = ˜ y)f (˜. θ) f (y. (Yi . .9. θ) dy ¯ ∂θ f (y. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . V ar (S) nH so ¥ 181 .. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 ) ln f (Yi .. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ) f (˜. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 ) d˜ = E ˜ . θ) d˜ = ˜ y ) ∂ ln f (˜. f (Yi . θ0 )0 . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. Proof of Theorem A. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. ∂2 ln f (Yi . ∂θ ¯θ=θ0 Z ! = 0.16). θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.9.. yn ). θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. function of the data. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 ) ∂ ∂ − ln f (Yi .9. we can show that E By direction computation. θ0 )0 f (Yi . ¯ ¯ ∂ E ln f (Yi .1. θ0 ) ∂θ f (Yi . θ0 ) − f (Yi .17).

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

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

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

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

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