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

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Contents

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

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

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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

. . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . 9. . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . .8 Bootstrap for Autoregressions . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 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. . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . 12.3 Distribution of GMM Estimator . . . . . . . . .5 Numerical Computation . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . 12 Univariate Time Series 12. . 12. . . . .11 8. . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . .2 GMM Estimator . . . . . 12. . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . .6 Over-Identiﬁcation Test . . .5 Special Cases: IV and 2SLS 11. . 10. 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . iii . . . . 12. . . . . . . . . .9 8. . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . . . . 11. . . . . . . . .11Model Selection . . . . . . . . . . . . 10. . .2 Reduced Form . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 8. . . . . . . . . . . . . . . . . . . .10 Exercises . . .1 Instrumental Variables . . . . . . . . . .4 Testing . . . . . .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . .3 Overidentifying Restrictions . . . . .10Testing for Omitted Serial Correlation 12. . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . 9. . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . . . . 9. . . . . .2 Autoregressions . . . 12. .1 Overidentiﬁed Linear Model . . . . . . . . . . . . . . . . . . . . . . 12. .

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

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

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

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

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

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

. . A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . 0 0 ··· 1 2.3 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. which has ones on the diagonal. . . A square matrix A is called orthogonal if A0 A = Ik . 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. For example. are said to be orthogonal if A0 A = Ir . . r ≤ k. then AIr = A and Ik A = A. Also. ⎤ ⎥ ⎥ ⎥ ⎦ AB = A1 A2 · · · Ar Br = A1 B1 + A2 B2 + · · · + Ar Br r X = Ar Br j=1 ¤⎢ ⎢ ⎢ ⎣ Important properties are that if A is k × r. An important diagonal matrix is the identity matrix. ⎥ . We say that two vectors a and b are orthogonal if a0 b = 0. The columns of a k × r matrix A. . .

if A is an orthogonal matrix.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. . . If A − BD−1 C and D − CA−1 B are non-singular. (2. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. The Moore-Penrose generalized inverse A− satisﬁes (2. For non-singular A and C. or is nonsingular. . This matrix is called the inverse of A and is denoted by A−1 . the Moore-Penrose generalized inverse A− exists and is unique. . . The following fact about inverting partitioned matrices is sometimes useful. then A−1 = A. In this case there exists a unique matrix B such that AB = BA = Ik .3) The matrix A− is not necessarily unique. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 .1) . . 7 Also. (2. .2) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. 2.4 Inverse A k × k matrix A has full rank. if there is no c 6= 0 such that Ac = 0.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 .

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

. Let π = (j1 ... jk ) denote a permutation of (1. ⎠ ... we deduce that Λ2 = Λ and λ2 = λi for i = 1.4) H0 M =H 0 0 with H 0 H = In .. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . There are k! such permutations. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1... .By the uniqueness of the characteristic roots. 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 . k)). . .. Additionally. For a general k × k matrix A = [aij ] . 2. . The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ .7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . . It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2. k.8 Determinant The determinant is deﬁned for square matrices. xk ) be k × 1 and g(x) = g(x1 . .. If A is 2 × 2. k) . tr(A) = rank(A). we can deﬁne the determinant as follows.. and let επ = +1 if this count is even and επ = −1 if the count is odd. (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2... xk ) : Rk → R..... then its determinant is det A = a11 a22 − a12 a21 . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.. i Hence they must equal either 0 or 1..

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

1.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. it is useful to have numerical measures of the diﬀerence. m(x) can take any form.2) m(x) = E (yi | xi = x) = −∞ In general. we can focus on f (y | x) . 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. .1 by the arrows drawn to the x-axis. the conditioning variable. These are indicated in Figure 3.22. gender. and exists so long as E |yi | < ∞. To illustrate. The two density curves show the eﬀect of gender on the distribution of wages. We call xi alternatively the regressor. (3. xi ) where yi is a scalar (real-valued) and xi is a vector. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience.1 displays the density1 of hourly wages for men and women. and that for women is $20. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. the conditional density of yi given xi . or the covariates. These are conditional density functions — the density of hourly wages conditional on race. While it is easy to observe that the two densities are unequal. When a distribution is skewed. xki 3. Figure 3. See Chapter 16. the mean is not necessarily a good summary of the central tendency. ⎠ ⎝ . In the example presented in Figure 3. which is a common feature of wage distributions. This is used when the goal is to quantify the impact of one set of variables on another variable. We call yi the dependent variable. holding the other variables constant. An important summary measure is the conditional mean Z ∞ yf (y | x) dy.1.73.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. Take a closer look at the density functions displayed in Figure 3. education and experience. These are asymmetric (skewed) densities. ⎟ . In this context we partition the observations into the pair (yi . You can see that the right tail of then density is much thicker than the left tail. the mean wage for men is $27.1) xi = ⎜ .

D. 2 (3. degree in mean log hourly wages is 0. Figure 3.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. 12 .2) evaluated at the observed value of xi : ei = yi − m(xi ). For this reason. the dashed line is a linear projection approximation which will be discussed in the Section 3. and a Ph. the solid line displays the conditional expectation of log wages varying with education. Assuming for simplicity that this is the true joint distribution. with mean log hourly wages drawn in with the arrows. When the distribution of the control variable is continuous.3) White non-military male wage earners with 10-15 years of potential work experience. wage regressions typically use log wages as a dependent variable rather than the level of wages. The main point to be learned from Figure 3.3 displays a scatter plot2 of log wages against education levels. this yields the formula yi = m(xi ) + ei . Figure 3.Figure 3. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. The conditional expectation function is close to linear.2 shows the density of log hourly wages for the same population. To illustrate. 3.1 is facilitated by the fact that the control variable (gender) is discrete. The diﬀerence in the log mean wage between men and women is 0.A. which implies a 30% average wage diﬀerence for this population.36. Of particular interest to graduate students may be the observation that diﬀerence between a B.5. then comparisons become more complicated.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3.3 is how the conditional expectation describes an important feature of the conditional distribution. The comparison in Figure 3.30. By construction. implying an average 36% diﬀerence in wage levels.

It is important to understand that this is a framework. These equations hold true by deﬁnition. A regression model imposes further restrictions on the joint distribution. 3. 2. most typically. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.1 Properties of the regression error ei 1. 4. restrictions on the permissible class of regression functions m(x). by the deﬁnition of ei and the linearity of conditional expectations. To show the ﬁrst statement. The equations yi = m(xi ) + ei E (ei | xi ) = 0. because no restrictions have been placed on the joint distribution of the data. The remaining parts of the Theorem are left as an exercise. E (h(xi )ei ) = 0 for any function h (·) . E(ei ) = 0. 13 .2. E(xi ei ) = 0. E (ei | xi ) = 0.2: Log Wage Densities Theorem 3. not a model. are often stated jointly as the regression framework.Figure 3.

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

⎠ . So while men have higher average wages.6) as an approximation. we assume that x1i = 1. where x1i is the ﬁrst element of the vector xi deﬁned in (3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. The conditional standard deviation for men is 12.we say that the error ei is homoskedastic.7) is a k × 1 parameter vector. Equation (3. Equivalently. ⎟ β=⎝ .8) is called the linear regression model. In this case (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . they are also somewhat more dispersed. take the conditional wage densities displayed in Figure 3. Thus (3.1.9) 3.6) (3. it is more realistic to view the linear speciﬁcation (3. its functional form is typically unknown. which we derive in this section. Instead.5.5) xi = ⎜ .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). 3.8) (3. Notationally. As an example.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.4 Linear Regression An important special case of (3. i (3.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.1 and that for women is 10. βk ⎛ (3. We call this the “constant” or “intercept”. ⎟ . xki When m(x) is linear in x. 15 . ⎠ .1). and the linear assumption of the previous section is empirically unlikely to accurate. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . ⎝ .

i 4. by “best” we mean the predictor function with lowest mean squared error.5.1 1. E (x0 xi ) < ∞.1. otherwise they are distinct. i i (3. The ﬁrst-order condition for minimization (from Section 2.5. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.which is quadratic in β. Given the deﬁnition of β in (3. The best linear predictor is obtained by selecting β to minimize S(β).11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . 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 . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. i 16 .10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.10) It is worth taking the time to understand the notation involved in this expression. As before. x0 β is the best linear predictor for yi .10).12) This completes the derivation of the linear projection model. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. 2 2. The error is i ei = yi − x0 β. written E (xi x0 ) > 0. i which requires that for all non-zero α. 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. In order for β to be uniquely deﬁned. Assumption 3. The vector (3. 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. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . 3. α0 E (xi x0 ) α = E (α0 xi )2 > 0. It is invertible if and only if it is positive deﬁnite. Equivalently. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. i (3. E (xi x0 ) is invertible. This occurs when redundant variables are included in xi . Therefore. this situation must be excluded. Rewriting. Eyi < ∞. xi contains an intercept.

2 and 3.1 Under Assumption 3.2 and 3.11) and (3.5. Furthermore.12) and (3.1. Assumption 3.1. Assumption 3.14) follows from (3. E (xi ei ) = 0 and E (ei ) = 0.1.12) can be alternatively interpreted as a projection decomposition. This means that the equation (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.1. Equation (3.13) The two equations (3.3 are called regularity conditions.9).1.1. the orthogonality restriction (3.5. ¥ (3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .1.5. Let’s compare it with the linear regression model (3. Since from Theorem 3. The ﬁnite variance Assumptions 3.5.8)-(3.1.13) and Assumption 3.1. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Since ei is mean zero by (3.5.1 is employed to guarantee that (3.5.4 we know that the regression error has the property E (xi ei ) = 0. Using the deﬁnitions (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.4 guarantees that the solution β exits.3 ensure that the moments in (3.Theorem 3. However.4 is required to ensure that β is uniquely deﬁned. 17 .1 are weak. it follows that linear regression is a special case of the projection model.5. Assumption 3. (3. For example.14) holds.13) implies that xi and ei are uncorrelated.5. By deﬁnition.2.14).1.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.14) Proof.5.11) are well deﬁned. (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.1.10) and (3.5.5.10) are deﬁned.13) summarize the linear projection model. Assumption 3. Figure 3.

12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. The linear equation (3. Figure 3.10) may not hold and the implications of Theorem 3. we can augment the regressor vector xi to include both experience and experience2 . Most importantly. it is important to not misinterpret the generality of this statement. in many economic models the parameter β may be deﬁned within the model.5. In the example just presented. Returning to the joint distribution displayed in Figure 3. there are no changes in our methods or analysis. In this example the linear projection is a close approximation to the conditional mean. Other than the redeﬁnition of the regressor vector.4 displays the relationship3 between mean log hourly wages and labor market experience. This defect in linear projection can be partially corrected through a careful selection of regressors. 18 . A projection of log wages on these two variables can be called a quadratic projection. We illustrate the issue in Figure 3.12) with the properties listed in Theorem 3.3. for any pair (yi . In this example it is a much better approximation to the conditional mean than the linear projection.4 we display as well this quadratic projection. However. since the resulting function is quadratic in experience. In contrast.1. the dashed line is the linear projection of log wages on eduction. In other cases the two may be quite diﬀerent. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. xi ) we can deﬁne a linear projection equation (3. In this case the linear projection is a poor approximation to the conditional mean. No additional assumptions are required. In this case (3. Figure 3. and the straight dashed line is the linear projection.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.We have shown that under mild regularity conditions.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.5. The solid line is the conditional mean.1 may be false. for those over 53 in age).10). It over-predicts wages for young and old workers. These structural models require alternative estimation methods. In Figure 1. and are discussed in Chapter 11. and under-predicts for the rest.

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

and E(ei | xi ) = 0. 20 . xi ∈ R. 9. Suppose that Y and X only take the values 0 and 1. ¡ ¢ 4. xi ∈ R. E(Y 2 | X = x) and V ar(Y | X = x).. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. 1. µ. m. i 10. If yi = x0 β + ei and E(xi ei ) = 0. and E(xi ei ) = 0.3 Find E(Y | X = x). Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . Suppose that yi is discrete-valued. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. E(ei | xi ) = 0. Compute E(yi | xi = x) and V ar(yi | xi = x). then E(ei | xi ) = 0. then E(x2 ei ) = 0. True or False.3. 3. 0 ≤ y ≤ 1. 2. i 8.. If yi = x0 β + ei and E(ei | xi ) = 0. i 11.2 Y =1 . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . and have the following joint probability distribution X=0 X=1 Y =0 . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . then ei is independent of xi . e−λ λj j! . If yi = x0 β + ei . then E(x2 ei ) = 0. σ = . Are they diﬀerent? Hint: If P (Y = j) = 5. If yi = xi β + ei . 3 and 4 of Theorem 3. yi ). If yi = xi β + ei . .2.1. i 7. s) = 0 if and only if m = µ and s = σ 2 . µx = Exi . (x − µ)2 − σ 2 Show that Eg (X. a constant. j! 0 j = 0. True or False. True or False. then ei is i i independent of xi . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. True or False.1 . x 6. 2.6 Exercises 1. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . and E(e2 | xi ) = σ 2 . True or False. Prove parts 2. Let X be a random variable with µ = EX and σ 2 = V ar(X). Let xi and yi have the joint density f (x. σ 2 = V ar(xi ). Compute the conditional mean m(x) = E (yi | xi = x) . σ 2 = V ar(yi ) and σ xy = Cov(xi .4 . taking values only on the non-negative integers.

2) (4. 4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .2) can be written in the parametric 0 β)) = 0.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .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 .8. i n i=1 n 21 . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .1) (4. i It follows that the moment estimator of β replaces the population moments in (4. but for most of the chapter we retain the broader focus on the projection model.3) In Sections 4.1 Estimation Equation (4.7 and 4.4) i i=1 i=1 ˆ Another way to derive β is as follows. Observe that (4. (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. we narrow the focus to the linear regression model.

i 22 .ˆ This is a set of k equations which are linear in β. An interpretation of the estimated equation is that each year of education is associated with an 11.4). 30 = . consider the data used to generate Figure 3.71 = −2. ¶ 2.14 14.7% increase in mean wages. This sample has 988 observations.170 37. Let yi be log wages and xi be an intercept and years of education. 0.3. 40 0. 40 2. Then µ ¶ n 1X 2.14 205.40 µ ¶µ ¶ 34. with 10-15 years of potential work experience.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. 4.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.37 µ ¶ 1.83 ¶−1 µ ¶ .117 Educationi . To illustrate.14 205. These are white male wage earners from the March 2004 Current Population Survey. excluding military. 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 42.117 1 14. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. 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.95 xi yi = 42.94 −2.14 14.2 Least Squares There is another classic motivation for the estimator (4.30 + 0.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.4).

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. To visualize the sum-of-squared errors function.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Following convention we will call β the OLS estimator of β. 23 .1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.4). we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. The error is unobservable. which can cause confusion. It is important to understand the distinction between the error ei and the residual ei .The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Figure 4. Figure 4. the contour lines are ellipses. i ˆ ˆ Note that yi = yi + ei . Matrix calculus (see Appendix 2.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Figure 4. while the residual is a by-product of estimation. These two ˆ variables are frequently mislabeled. Since the function Sn (β) is a quadratic function of β.

The error variance σ 2 = Ee2 is also a parameter of interest. one implication is that n 1X ei = 0. ˆ n−k 2 i=1 (4. ˆ σ = ˆ n 2 i=1 n (4. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. and hold true for all linear regression estimates.5) implies that 1X xi ei = 0.6) An alternative estimator uses the formula n 1 X 2 s = ei . 24 . ˆ n i=1 n Since xi contains a constant.7) A justiﬁcation for the latter choice will be provided in Section 4.2: Sum-of-Squared Error Function Contours Equation (4. Its method of moments estimator is the sample average 1X 2 ei . These are algebraic results.Figure 4.7. It measures the variation in the i “unexplained” part of the regression.

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

= β+ XX 26 (4. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. Due to this equivalence. . yn ⎟ ⎟ ⎟. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. ⎟.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . 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. The linear equation (3.6). n X i=1 Thus the estimator (4. x0 n ⎞ ⎛ e1 e2 . ⎝ ⎝ . n or equivalently Y = Xβ + e. and X is an n × k matrix. Sample sums can also be written in matrix notation.4). residual vector. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. 4. ⎠ . one for each observation. . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. . including computation. it is matrix notation.8) . . . en ⎞ Observe that Y and e are n × 1 vectors.12) is a system of n equations. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . For example n X i=1 For many purposes. Thus the MLE (β. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. yn = x0 β + en . 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. .

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. obtain residuals X2 . .14) or via the ˆ following algorithm: ˜ 1.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.Theorem 4. . In this case. is the demeaning formula for regression.9). Rather. . ˜ 2.8)(3. and X2 is the vector of observed regressors. the primary use is theoretical. . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. . ⎠ ⎝ ⎠ ⎝ . . but in most cases there is little computational advantage to using the two-step algorithm. ˆ which are “demeaned”. observe that ⎞ ⎛ ⎞ ⎛ . In some contexts. In the model (4. 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) . 30 .1 (Frisch-Waugh-Lovell).13). the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. 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. which you may have seen in an introductory econometrics course. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . ˆ ˜ ˜ ˆ 3. . . In this section we derive the small sample conditional mean and variance of the OLS estimator.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. ⎟ ⎜ ⎟ ⎜ (4.9). ¡ ¢−1 0 ι. the FWL theorem can be used to speed computation. By the independence of the observations and (3. . obtain OLS estimates β 2 and residuals e. Regress X2 on X1 . obtain residuals Y . 4. Regress Y on X1 . Regress Y on X2 .6. A common application of the FWL theorem.

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

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

¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. and is a strong justiﬁcation for the least-squares estimator.Proof. r. Suppose that the joint distribution of (yi ... That is.. We discuss the intuition behind his result in this section. where 1 (·) is the indicator function. ¡ ¢ P yi = τ j . for ﬁnite r. the class of potential estimators has been restricted to linear unbiased estimators.5) as required. Note that X 0 C = 0. ξ j . r for some constant vectors τ j ... As the data are multinomial. Let A be any n×k function of X such that A0 X = Ik . It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. This property is called semiparametric eﬃciency. A broader justiﬁcation is provided in Chamberlain (1987). π r ) . j = 1.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. ˆ β mle = ⎝ j j=1 j=1 33 .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 ⎠ .. (We know the values yi and xi can take. but the π j are unknown. . 4.. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. xi ) is discrete.21) j j=1 j=1 Thus β is a function of (π 1 . Set C = A − X (X 0 X)−1 . This latter restriction is particularly unsatisfactory. π j is the percentage of the observations ˆ ˆ which fall in each category. xi = ξ j = π j . and π j . as the theorem leaves open the possibility that a non-linear or biased estimator could have lower mean squared error than the least-squares estimator. The MLE β mle for β is then the analog of (4. Then we calculate that ³ ¡ ¡ ¢−1 ¡ ¢−1 ´0 ³ ¢−1∗ ´ ¡ 0 ¢−1 C + X X 0X − XX = C + X X 0X A0 A − X 0 X ¡ 0 ¢−1 ¡ 0 ¢−1 0 ¡ ¢−1 0 ¡ 0 ¢−1 ¡ 0 ¢−1 = C 0C + C 0X X X + XX X C + X 0X XX XX − XX = C 0C The matrix C 0 C is positive semi-deﬁnite (see Appendix 2. .. but it is quite limited in scope. . the deﬁnition (4. Assume that the τ j and ξ j are known. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. Not only has the class of models has been restricted to homoskedastic linear regressions..) In this discrete setting.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . but we don’t know the probabilities. That is.

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 . Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. the maximum likelihood estimator is identical to the OLS estimator.1. He observes that the above argument holds for all multinomial distributions. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.10 Omitted Variables xi = µ x1i x2i ¶ .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. (4. He proves that generically the OLS estimator (4. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.Substituting in the expressions for π j .22) 34 . 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. Chamberlain (1987) extends this argument to the case of continuously-distributed data. and thus so is the OLS estimator.9).5.10) for the class of models satisfying Assumption 3. if the data have a discrete distribution.

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

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

ˆ We now derive equation (4.1) in Section 2. Investigations into the presence of inﬂuential observations can plot the values of (4. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . 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.27).25). The key is equation (2. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .This implies has a large value of hi .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .

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

ij i=1 j=1 (5.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. then g(E(X)) ≤ E(g(X)). Jensen’s Inequality. The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 . We list here some of the most critical deﬁnitions and inequalities. Cauchy-Schwarz Inequality. If g(·) : R → R is convex. Triangle inequality |X + Y | ≤ |X| + |Y | .1) (5.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . 41 .2) + 1 q = 1.1 Inequalities Asymptotic theory is based on a set of approximations. then (5. 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. 5. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . |a| = a a i i=1 If A is a m × n matrix. ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality.

n→∞ lim P (|Zn − Z| > δ) = 0. 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. For any strictly increasing function g(X) ≥ 0. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. p p p q which is (5.1 Weak Law of Large Numbers (WLLN).Markov’s Inequality. ¥ 5.2. Eg(X) ≥ a + bEX = g(EX). then as n → ∞ n 1X Xn = Xi →p E(X).3). P (g(X) > α) ≤ α−1 Eg(X). 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 ) = + . if for all δ > 0. Let a + bx be the tangent line to g(x) at x = EX. =E U V p q p q Proof of Markov’s Inequality. Theorem 5. tangent lines lie below it. (5. Applying expectations. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. We say that Zn converges in probability to Z as n → ∞. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. ¥ Proof of Holder’s Inequality.4) Proof of Jensen’s Inequality. Since g(x) is convex. denoted Zn →p Z as n → ∞. as stated. Note EU = EV = 1. So for all x. Then Z ∞ −1 P (Y > α) = α αf (y)dy Zα∞ ≤ α−1 yf (y)dy α Z ∞ ≤ α−1 yf (y)dy = α−1 E(Y ) −∞ the second-to-last inequality using the region of integration {y > α}. If Xi ∈ Rk is iid and E |Xi | < ∞. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . n i=1 42 .2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector.

We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. if for all x at which F (x) is continuous. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .5).7).6) By Jensen’s inequality (5.4). and the bound |Wi | ≤ 2C. P ¯X n ¯ > δ ≤ η.Proof: Without loss of generality.1). the fact that X n = W n + Z n . by Markov’s inequality (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . 5.3. Finally. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . Fix δ and η. we can set E(X) = 0 (by recentering Xi on its expectation). the fact that the Wi are iid and mean zero. Theorem 5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. where Z has distribution F (x) = P (Z ≤ x) . We say that Zn converges in distribution to Z as n → ∞. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. Jensen’s inequality (5. Fn (x) → F (x) as n → ∞. (5. as needed. 43 . the triangle inequality.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. If Xi ∈ Rk is iid and E |Xi |2 < ∞. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. ¡¯ ¯ P ¯X n ¯ > δ ≤ η.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) .1) and (5. V ) . Set ε = δη/3. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η.6) and (5.1 Central Limit Theorem (CLT). then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. denoted Zn →d Z.

8) where λ∗ lies on the line segment joining 0 and λ. ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . the independence of the Xi .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 . Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . the deﬁnition of c(λ) and (5.Proof: Without loss of generality. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. For ¡ ¢ λ ∈ Rk . 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 . By a second-order Taylor series expansion of c(λ) about λ = 0. By the properties of the exponential function. let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). ∂λ∂λ cλ (λ) = cλλ (λ) = ∂ ∂ c(λ) = C(λ)−1 C(λ) ∂λ ∂λ ∂ ∂2 ∂2 −2 ∂ C(λ) 0 C(λ) c(λ) = C(λ)−1 0 0 C(λ) − C(λ) ∂λ ∂λ∂λ ∂λ∂λ ∂λ so when evaluated at λ = 0 Furthermore.

Proof: Since g is continuous at c. Σ) . then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. ¥ 5. Stacking across elements of g. for each element of g. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. and g(θ) : Rm → Rk . Σ) = N 0. Theorem 5.4. gθ Σgθ . we see that as n → ∞. Recall that A ⊂ B implies P (A) ≤ P (B). 45 .√ where λn → 0 lies on the line segment joining 0 and λ/ n. √ Theorem 5.3 Delta Method: If n (θn − θ0 ) →d N (0.2 Continuous Mapping Theorem 2. Proof : By a vector Taylor series expansion.4. Hence g(Zn ) →p g(c) as n → ∞.4. Ik ) distribution. then g(Zn ) →p g(c) as n → ∞. This is suﬃcient to establish the theorem. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. If Zn →p c as n → ∞ and g (·) is continuous at c. where θ is m × 1 and Σ is m × m.1 Continuous Mapping Theorem 1 (CMT). k ≤ m. If Zn →d Z as n → ∞ and g (·) is continuous. then g(Zn ) →d g(Z) as n → ∞. Since cλλ (λn ) → cλλ (0) = −Ik . gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.4 Asymptotic Transformations Theorem 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 .

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

4 implies that Q−1 exists and thus g(·.1 and the WLLN (Theorem 5. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.2. n i=1 (6.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.2. we can conclude ˆ that β →p β. ·) is continuous at (Q.1. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. we will use the methods of asymptotic approximation. Assumption 3. 0). For a complete argument.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. xi ei →p g (Q. ˆ 47 .1. and the continuous mapping theorem (Theorem 5.2) i i n i=1 n From (6. using (6. To characterize the sampling distribution more fully.5. the OLS estimator β is has a statistical distribution which is unknown. β →p β as n → ∞. ˆ Theorem 6. As the sample size increases the density becomes more concentrated about the population coeﬃcient.5.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .4.5. Proof. First.2 Consistency ˆ As discussed in Section 6. 6.1) and ˆ We now deduce the consistency of β.1 by the fact that the sampling densities become more concentrated as n gets larger. (6. Hence by the continuous mapping theorem (Theorem 5.1). Equation (4.3). (6.1).1).2).1 Under Assumption 3. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 . (6.1. Ã n ! n X 1X 0 1 ˆ xi xi . ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1). This is illustrated in Figure 6. Assumption 3. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.4.3) Ã where g(A.

2).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. Thus σ 2 is consistent for σ 2 .2. (6.6) n i=1 48 . ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. it follows that s2 = ¥ n σ 2 →p σ 2 . n 1 X √ xi ei →d N (0. since n/(n − k) → 1 as n → ∞.1). E ¯ei ¯ E ¯e4 ¯ i i i i (6. (6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . To see this. ˆ Proof.1. i i Assumption 6.5.1.3. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.2. Ω) . ˆ n−k 6. (6.Theorem 6. We need a strengthening of the moment conditions.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.2). ˆ Finally.5.3. by the Cauchy-Schwarz inequality (5. By the central limit theorem (Theorem 5.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.3) and Theorem (6. (6. Ee4 < ∞ and E |xi |4 < ∞.1). Assumption 6.3.2 Under Assumption 3. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .1 In addition to Assumption 3.

1). is approximately normal when the sample size n is suﬃciently large. In´Figure 6. its variance diverges q ³ ´ ˆ to inﬁnity.2). i i Condition (6.1 states that the sampling distribution of the least-squares estimator. (6. e2 ) = 0.7) holds. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. V is often referred to as ˆ the asymptotic covariance matrix of β. This holds true for all joint distibutions of (yi . How large should n be in order for the approximation to be useful? Unfortunately. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.3. As α approaches 2. xi ) which satisfy the conditions of Assumption 6. We call V 0 the homoskedastic covariance matrix. setting n = 100 and varying the parameter α. When (6. when xi and ei are independent. The approximation may be poor when n is small. Theorem 6.1.1). but this is not a necessary condition.3.6). for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.1. and (6. There is a special case where Ω and V simplify. however.7) is true or false. The trouble is that no matter how large is the sample size. We say that ei is a Homoskedastic Projection Error when (6. after rescaling. 1 X √ xi ei n i=1 n ! the N (0.7) is true then V = V 0 . there is no simple answer to this reasonable question. However.Then using (6.3. otherwise V 6= V 0 .7) Cov(xi x0 . for example.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. Let yi = β 0 + β 1 xi + εi where xi is N (0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. Under (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. Ω) ¡ ¢ = N 0. The asymptotic distribution ´ Theorem 6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).1 Under Assumption 6. In Figure 6. For α 49 .9) In (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . Q−1 ΩQ−1 .2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .3. The expression V = Q−1 ΩQ−1 is called a sandwich form. V ) where V = Q−1 ΩQ−1 . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. 1) asymptotic distibution.3. |ε| ≥ 1.9) we deﬁne V 0 = Q−1 σ 2 whether (6.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . We illustrate this problem using a simulation.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.

2: Density of Normalized OLS estimator α = 3. The lesson from Figures 6. 1) density. 4. 6 and 8.0 the density is very close to the N (0. 1).3 is that the N (0. The estimator 2 2 in (6. We show the sampling distribution of n β 1 − β 1 setting n = 100.10) without changing this result. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .Figure 6. concentrating most of the probability mass around zero.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 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. the sampling distribution becomes highly skewed and non-normal.2 and 6. we need an estimate of Ω = E xi x0 e2 . 1) asymptotic approximation is never guaranteed to be accurate. for k = 1. Another example is shown in Figure 6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.11) 50 . As α diminishes the density changes signiﬁcantly.2) and Theorem 6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.3. As k increases.1) it is clear that V 0 →p V 0 .10) V 0 = Q−1 s2 . 6.2.

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

493 0.80 .085 p ˆ and that for β 1 is .039 and ˆ V = µ 1 14. Ω 2. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.480 ˆ0 = 0.83 ¶−1 = µ 7. we return to the log wage regression of Section 4.80 40.used by an author when studying their work.30 + 0.83 −0.117 Educationi . but not under another set of assumptions. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .20 −0. and then the square roots. from which it follows that V →p V as n → ∞.14 205.98 −0.14 205.493 −0. To illustrate. (. Using (6.199 2. p ˆ In this case the two estimates are quite similar.020) 6.480 .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 .14 6. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .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. then take the diagonal elements.80 40.035 ¶ . We calculate that s2 = 0. by Holder’s inequality (5.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. The standard errors for β 0 are 7. i i i i n i=1 Second. (6.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.199 2.2/988 = .35/988 = .14 205.14 14.12) in turn.80 2.5) and the WLLN (Theorem 5.020. From a computational standpoint. n n i=1 52 .14 14.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.6 ¶µ 1 14. just as any other estimator.1. First.20 and µ ¶ ˆ = 0.83 ¶−1 µ . (6.20 = V 14.085) (.2.

i=1 Third. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.13) Using formula (4.−i = (1 − hi )−1 ei ˆ presented in (4. ¯ 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. which. Using this substitution. 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 (6.14) 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 . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . ¯ ¯n ¯ n i=1 so Together.13) of Efron (1982). is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.5.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. Ω →p Ω and V →p V. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . n i=1 n ˆ ˆ Theorem 6.25).11) with the leave-one-out estimator ei. 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. 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. 6. these establish consistency.26). From equation (3. Recall from Section 4. Andrews (1991) suggested an similar estimator based on cross-validation.1 As n → ∞.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. you can show that 1 Xˆ ¯ β= β (−i) .

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

ˆ When q = 1q h(β) is real-valued). A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. θ) β 6.For example. the standard error for ˆ is the square root of n−1 Vθ . Vθ ) √ Vθ = N (0. 1) Proof. Consider the studentized statistic tn (θ) = Theorem 6. that (so θ ˆ ˆ ˆ is. however.1 tn (θ) →d N (0. we say that tn is an exactly pivotal statistic. In this case. and θ = h(β) is some function of the parameter vector.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0.8. µ I 0 ¶ ˆ the upper-left block of V .16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. 1) →d ˆ−θ θ . In general. 55 . β 2 ). then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . In special cases (such as the normal regression model. (For example. and is therefore exactly free of unknowns. By (6. the statistic tn has an exact t distribution. s(ˆ θ) (6. θ could be a single element of β). Since the standard normal distribution does not depend on the parameters. if R is a “selector matrix” R= so that if β = (β 1 . see Section X). s(ˆ = n−1/2 H 0 V Hβ .8 t tests Let θ = h(β) : Rk → R be any parameter of interest. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. we say that tn (θ) is asymptotically pivotal.

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

We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. 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. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. θ θ) (6. and it is desired to test the joint restrictions simultaneously.18) . 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 . We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. ˆ + zα/2 s(ˆ . θ The interval has been constructed so that as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6. or α = .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.96s(ˆ ≈ ˆ ± 2s(ˆ . ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). the most common professional choice isi95%. 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. A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ).10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. This corresponds to selecting the conﬁdence h i h ˆ ± 1. In this case the t-statistic approach does not work. 6. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.05.

= nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .2. The asymptotic p-value for Wn is pn = p(Wn ). if rank(Hβ ) = q.19) σ2 ˆ where σ2 = ˜ 1 0 e e.10. ˆ Wn = n θ θ q θ θ Theorem 6.3.5.1. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2.8. θ = β 2 .15) showed that n ˆ − θ →d Z ∼ N (0. Hβ (β) →p Hβ . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . and Theorem 6.When h is a linear function of β. ˜˜ n ˜ e = Y − X1 β 1 . Hence β β by Theorem A. then Wn →d χ2 .84 = z.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . the upper-α quantile q 2 of the χ2 distribution. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .025 . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.1 Under H0 and Assumption 6. Furthermore. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). As before. q and pn is asymptotically U[0. Hβ (β) is a continuous function of β. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). a chiq square random variable with q degrees of freedom. 6. χ2 (. The null hypothesis is H0 : β 2 = 0. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. In this case.05) = 3. Vθ ). Also h(β) = a selector matrix. h(β) = R0 β. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . 1] under H0 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. and there are q = k2 restrictions.1 showed θ ˆ that V →p V. 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 test rejects at the α% level iﬀ pn < α. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. For example.

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

H 0 H) ∼ N (0. σ 2 ) can be be used to calculate a set of exact distribution results. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. 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. an “F statistic” is reported. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. 6. This is rarely an issue today. Since linear functions of normals are also normal. including the estimated error variance 2. there is an exact distribution theory available for the normal linear regression model. equivalently the residual variance from an intercept-only model. it follows ˆ that β is independent of any function of the OLS residuals. This was a popular statistic in the early days of econometric reporting. these cases are atypical. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. Let u = σ −1 H 0 e ∼ N (0. In σ 2 . σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . In ) . when an OLS regression is reported. introduced in Section 4.4)) where H 0 H = In . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. The modelling assumption that the error ei is independent of xi and N (0. In particular. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = .where In many statistical packages. Since uncorrelated normal variables are independent. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . While there are special cases where this F statistic is useful. 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 .12 Normal Regression Model As an alternative to asymptotic distribution theory. n−k 60 .3. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression.

β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. Theorem 6. 0. if standard errors are calculated using the homoskedastic formula (6.) Now let us partition β = (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 .1 shows that under the strong assumption of ˆ normality.1 If ei is independent of xi and distributed N(0. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. The critical values are quite close if n − k ≥ 30. σ 2 ). β 2 .12. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .1 we showed that in large samples. In contrast. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.10) µ h i ¶ 2 (X 0 X)−1 N 0. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . β 2 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 .a chi-square distribution with n − k degrees of freedom.10) then ´ ³ ˆ • β ∼ N 0. As inference (conﬁdence intervals) are based on the t-ratio. the notable distinction is between the N (0. a good testing procedure is based on the likelihood ratio statistic. β has an exact normal distribution and t has an exact t distribution. β 2 . with residual variance σ . 1) and tn−k distributions. σ2 ˆ 61 . so as a practical matter it does not matter which distribution is used. Furthermore. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ) = − log σ − log (2π) − .12. β and t are approximately normally distributed. n−k • ∼ tn−k ˆ In Theorem 6. σ 2 ) discussed above. 0.8. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. 0.1 and Theorem 6. σ 2 ) − Ln (β 1 .3. We summarize these ﬁndings Theorem 6. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . (Unless the sample size is unreasonably small. and standard errors are calculated using the homoskedastic formula (6. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ ˆ ˆ βj − βj βj − βj N (0. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .

σ 2 ) and consider the hypothesis H0 : β = 1.84 — the probability of a false rejection. and noting Hβ = sβ s−1 . Our ﬁrst-order asymptotic theory is not useful to help pick s. ˆ Let β and σ 2 be the sample mean and variance of yi . The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. 62 . the statistic Wn (s) varies with s. we have plotted in Figure 6. while there are other values of s for which test test statistic is insigniﬁcant. 6.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .7. The decreasing dashed ˆ = 1. This can be seen by a simple example introduced by Lafontaine and White (1986). This is an unfortunate feature of the Wald statistic. Letting h(β) = β s . Through repetition. 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. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Take the model yi = β + ei ei ∼ N (0. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. features of this distribution can be calculated. To demonstrate this eﬀect. The increasing solid line is for the case β = 0. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. setting n/σ 2 = 10.8. they can work quite poorly when the restrictions are nonlinear. 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. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. In the present context of the Wald statistic.4 the Wald statistic Wn (s) as a function ˆ of s. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. This produces random draws from the sampling distribution of interest. as Wn (s) →d χ2 under H0 for 1 any s. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n .

the Type I error probability improves towards 5% as the sample size n increases.05) with deviations indicating+ distortion. the only test which meets this criterion is the conventional Wn = Wn (1) test. remember that the ideal Type I error probability is 5% (.000 random samples. For this particular example.000 simulated Wald statistics Wn (s) which are larger than 3. n. we compare the rates row by row. Given the simplicity of the model. The value of s is varied from 1 to 10. Table 4. n is varied among 20.4: Wald Statistic as a function of s P (Wn (s) > 3. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. looking for tests for which rate rejection rates are close to 5%.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . no magic choice of n for which all tests perform uniformly well. In Table 2. so these probabilities are Type I error. To interpret the table. Test performance deteriorates as s increases. These probabilities are calculated as the percentage of the 50. Type I error rates between 3% and 8% are considered reasonable. this probability depends only on s. Error rates avove 10% are considered excessive. 100 and 500. and σ is varied among 1 and 3.1 we report the results of a Monte Carlo simulation where we vary these three parameters. and rarely fall outside of the 3%-8% range.84 | β = 1) . In Table 4. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.Figure 6. and σ 2 . Rates above 20% are unexceptable. The null hypothesis β s = 1 is true. When comparing statistical procedures.1 reports the simulation estimate of the Type I error probability from 50. Typically.1 you can also see the impact of variation in sample size.4. however. Any other choice of s leads to a test with unacceptable Type I error probabilities. In each case. There is. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. Table 4.84.

05 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.06 .05 .07 .12 .15 .34 .33 .20 .15 .10 .13 .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 .15 . Other choices are arbitrary and would not be used in practice.13 .08 .12 .08 . While this is clear in this particular example. Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.05 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. Equivalently.14 .06 .23 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.10 .15 .25 .20).05 .16 Rejection frequencies from 50.20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . β 1 .28 .08 .07 .07 .10 .06 .07 .07 . β 2 ) be the least-squares estimates of (6. so the hypothesis can be stated as H0 : θ = r.21 .31 .17 .06 .24 .06 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.35 .05 .09 . deﬁne θ = β 1 /β 2 .14 .06 .05 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .19 .11 .25 .13 .26 .06 . 64 .08 .22 .22 .06 . This point can be illustrated through another example.08 .30 .18 .20 .

This leaves β 2 as a free parameter.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.05. It is also prudent to consider alternative tests to the Wald statistic. In contrast.02 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.10 .645) greatly exceed 5%.00 .10 .10 .00 . σ 2 ) draw with σ = 3.0 and n among 100 and 500. this formulation should be used. .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .28 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .50 .06 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.25. the rejection rates for the t1n statistic diverge greatly from this value.7.00 . Ideally.00 . Table 4. such as the GMM distance statistic which will be presented in Section 9. along with sample size n. In this section we describe the method in more detail.05 .75 1. if the hypothesis can be expressed as a linear restriction on the model parameters.25 .06 .06 . We let x1i and x2i be mutually independent N (0.05 . ei be an independent N (0.000 simulated samples. 65 .05 .05 .00 .645) P (tn > 1.15 .75.07 .47 . We vary β 2 among . and are close to the ideal 5% rate for both sample sizes.00 . while the right tail probabilities P (t1n > 1.645) t1n t2n t1n t2n t1n t2n t1n t2n .05 .00 .645) are close to zero in most cases.645) P (tn > 1.05 . The left tail probabilities P (t1n < −1.15 .05 .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.645) are calculated from 50.06 . and alternatives to asymptotic critical values should be considered.06 .00 .1. then the “most linear” formulation should be selected. 6.12 .06 . In all cases.00 The one-sided Type I error probabilities P (tn < −1.26 . If no linear formulation is feasible. The results are presented in Table 4. especially for small values of β 2 . .05 . The implication of Table 4.06 . However. 1) variables.645) and P (tn > 1. the entries in the table should be 0.09 . and normalize β 0 = 0 and β 1 = 1.2.06 .645) P (tn < −1.00 . .06 .05 β2 . and 1.06 .50.

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

the researcher must select the number of experiments. and our regressors include years of education. 6. and 5000. It is therefore useful to conduct a variety of experiments.003. Again our dependent variable is the natural log of wages. Generally. For the dependent variable we use the natural log of wages. Quite simply. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. are. B. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. We separately estimate equations for white and non-whites. and .96) is iid Bernoulli. Then qα is the N ’th number in this ordered sequence. The average (6. For example. therefore. We now expand the sample all non-military wage earners. s P = . The α% sample quantile is a number qα such that α% of the sample are less than qα . respectively.95) /B ' . Furthermore.96) . for a selection of choices of n and F.96) . and hispanic. . potential work experience. For example. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. so that coeﬃcients may be interpreted as semi-elasticities. experience squared. it is simple to make inferences about rejection probabilities from statistical tests.15 Estimating a Wage Equation We again return to our wage equation.007. female. The random variable 1 (Tnb ≥ 1. and dummy variable indicators for the following: married. potential work experience. where N = (B +1)α. then B will have to be increased. this may ˆ be approximated by replacing P with P or with an hypothesized value. immigrant. and 90% sample quantiles of the sample {Tnb }. Often this is called the number of replications. a larger B results in more precise estimates of the features of interest of Gn . We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. hispanic. It is therefore convenient to pick B so that N is an integer. immigrant. In practice. equalling 1 with probability P = E1 (Tnb ≥ 1.22/ B. we included a dummy 67 . experience squared. and poorly for others. We us the sample of wage earners from the March 2004 Current Population Survey. then we can set s P = (.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. if we set B = 999. union member. In particular. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. female. and therefore it is straightforward to calculate standard errors for any quantity of interest. the performance will depend on n and F.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. an estimator or test may perform wonderfully for some values. As discussed above.05) (. For regressors we include years of education. union member. but requires more computational time. and dummy variable indicators for the following: married. such as the percentage estimate reported in (6. If the standard error is too large to make a reliable inference. As P is unknown. B b=1 (6. In many cases. Hence the ³ ´ ˆ standard errors for B = 100. and non-white. and estimate a multivariate regression. excluding military.21). the choice of B is often guided by the computational demands of the statistical procedure. 1000.022.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B.

101 .013 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.002 .102 −.808 so the parameter estimates are quite precise and reported in Table 4. The F form of the Wald statistic (6.4945.4877 18. but not equal. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. excluding the coeﬃcients on the state dummy variables.001 .00057 .121 −.34 ˆ s(β) .19) is ˜ µ ¶ µ ¶ σ2 ˆ . as the 1% critical value for the χ2 distribution is 76. The available sample is 18.014 .variable for state of residence (including the District of Columbia. θ ˆ 2β 3 β2 .808 . 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.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.070 . 808 1 − .232 .007 .027 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. Table 4.49452 σ ˜ Notice that the two statistics are close. we ﬁnd Wn = 550.097 −.102 −.48772 = 515. this adds 50 regressors). Ignoring the other coeﬃcients. 2β 3 68 . Using either statistic the hypothesis is easily rejected.008 . Alternatively.032 . the restricted standard deviation estimate is σ = .033 −.69. Wn = n 1 − 2 = 18.1.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. reestimating the model with the 50 state dummies excluded.010 .00002 .18) that the state coeﬃcients are jointly zero. Computing the Wald statistic (6.

Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.5]. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. 29. not testing a hypothesis. This set is [27. so we have to go one step further.5].9. This is the set of θ such that |tn (θ)| ≤ 1.96. but the lower end is substantially lower. there is not a simple expression for this set. In the previous section we discovered that such t-tests had very poor Type I error rates. 29. we can calculate a standard error of s(ˆ = .Using the Delta Method. Since tn (θ) is a non-linear function of θ. Instead. In the present context we are interested in forming a conﬁdence interval.0. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. However. this is a poor choice. 69 .40. but it can be found numerically quite easily. 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 ). implying a 95% conﬁdence θ) interval of [27. we found better Type I error rates by reformulating the hypothesis as a linear restriction.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

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

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

This introduces an element of arbitrariness which is unsettling to empirical researchers.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. The GLS and FGLS estimators. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. If the equation of interest is a linear projection. individual estimated conditional variances may be negative.7) under independence show that this test has an asymptotic chi-square distribution. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . We may therefore test this hypothesis by the estimation (7. It is consistent not only in the regression model.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. its squares. Typically. Third.2.4) and constructing a Wald statistic. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. FGLS will do worse than OLS in practice. 7. The asymptotic distribution (7. In the linear regression model the conditional mean of yi given xi = x is 77 .1 Under H0 and ei independent of xi . the Wald test of H0 is asymptotically χ2 . σ 2 ). and all cross-products. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. If i this simpliﬁcation is replaced by the standard formula (under independence of the error).error. on the other hand. and the cost is a reduction of robustness to misspeciﬁcatio 7. the estimated conditional variances may contain more noise than information about the true conditional variances. require the assumption of a correct conditional mean. Vα = E zi zi (7. q Most tests for heteroskedasticity take this basic form. however. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. Second. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . In this case. The main diﬀerences between popular “tests” is which transformations of xi enter zi . OLS is a more robust estimator of the parameter vector. and this requires trimming to solve.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. Theorem 7. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi .2). and not a conditional mean. as they will be estimating two diﬀerent projections. but also under the assumptions of linear projection. the two tests coincide. This hypothesis does not imply that ξ i is independent of xi .4). but the only diﬀerence is that they a ¢ allowed for general choice of zi . or equivalently that i H0 : α1 = 0 in the regression (7.5) and the asymptotic variance (7.

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

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

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

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

5. then there are many innovations near to the median. where V = and f (e | x) is the conditional density of ei given xi = x. the conditional density of the error at its median. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. In the special case where the error is independent of xi . First. ˆ Proof of Theorem 7. Computation of standard error for LAD estimates typically is based on equation (7. by the central limit theorem (Theorm 5.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . When f (0 | x) is large.5. ∂β 0 so Third.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. Pn −1 0 β)) . ∂ 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 ) . ¢¢−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) . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . the height of the error density at its median.1 is advanced. The main diﬃculty is the estimation of f (0). Second using the law of iterated expectations and the chain rule of i diﬀerentiation. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.5. V ). we provide a sketch here for completeness.11).1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.1 ´ √ ³ˆ n β − β 0 →d N (0.3. While a complete proof of Theorem 7. (7. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .10) is equivalent to g n (β) = 0. See Chapter 16.Theorem 7. This can be done with kernel estimation techniques. and this improves estimation of the median. Let g(β) = Eg (β).

the quantile regression functions can take any shape. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . For ﬁxed τ . For τ ∈ [0.Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. Exi x0 ) →d i 2 = N (0. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . For the random variables (yi . 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)) . The following alternative representation is useful. then F (Qτ ) = τ .12) Qτ = argmin Eρτ (U − θ) .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. ¥ 7. V ). 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . then F (Qτ (x) | x) = τ . then (7. when F (y | x) is continuous and strictly monotonic in y. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). (7. The third line follows from an asymptotic empirical process argument. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors.9) for the median to all quantiles. so you can think of the quantile as the inverse of the distribution function. Again. As functions of x. The median is the special case τ = .5. If the random variable U has τ ’th quantile Qτ .13) This generalizes representation (7.

´ √ ³ˆ Theorem 7.1. let zi = h(xi ) denote functions of xi which are not linear functions of xi (perhaps 0˜ ˜ ˜ squares of non-binary regressors) and then ﬁt yi = x0 β +zi γ + ei by OLS. conventional Newton-type optimization methods are inappropriate.12). Another popular approach is the RESET test proposed by Ramsey (1969).7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . Vτ ).where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . 7. if the model yi = x0 β + ei has i been ﬁt by OLS. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Furthermore. Thus.5. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). it is useful to have a general test of the adequacy of the speciﬁcation. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7. and are widely available. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . Fortunately.6. where and f (e | x) is the conditional density of ei given xi = x. otherwise its properties are unspeciﬁed without further restrictions. then f (0 | xi ) = f (0) . ¡ ¡ ¢¢−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. the unconditional density of ei at 0. fast linear programming methods have been developed for this problem. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. since it has discontinuous derivatives. the asymptotic variance depends on the conditional density of the quantile regression error. the τ ’th conditional quantile of ei is zero.13). and form a Wald statistic i for γ = 0. The null model is yi = x0 β + εi i 84 . i By construction. 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 7.1 n β τ − β τ →d N (0. and test their signiﬁcance using a Wald test. n numerical methods are necessary for its minimization. ˆ Given the representation (7.

and n→∞ say. Q−1 σ 2 < Q11 − Q12 Q−1 Q21 11 22 85 ¡ ¡ ¢ ¢−1 2 ¡ ¢−1 2 ˆ lim nV ar(β 1 ) = Ex1i x0 − Ex1i x0 Ex2i x0 Ex2i x0 σ = Q11 − Q12 Q−1 Q21 σ . In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . note that (7. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . Typically. ⎠ . Wn →d χ2 . yielding predicted values yi = x0 β. To see why this is the case. and the two estimators have equal asymptotic eﬃciency. m must be selected in advance. However. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. 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. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. It is easy (although somewhat tedious) to show that under the null hypothesis.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. and consequently 22 ¡ ¢−1 2 σ . Another is to regress yi on x1i and x2i jointly. ⎟ zi = ⎝ . yi ˆm (7. To implement the test.be an (m − 1)-vector of powers of yi . small values such as m = 2. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . 3. β 2 ). Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. and form the Wald statistic Wn for γ = 0. 1i 2i 2i 1i 22 . yielding ˆ ˜ ˆ ˆ (β 1 . or 4 seem to work best. since Q12 Q−1 Q21 > 0. 7.14) 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. they will (typically) have diﬀerence asymptotic variances.14) by OLS. then 22 Q11 > Q11 − Q12 Q−1 Q21 . 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. β 1 = (X1 X1 )−1 (X1 Y ) .

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

A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . known as the BIC. let cα satisfy ¢ ¡ P χ22 > cα . k = While many modiﬁcations of the AIC have been proposed. then this model selection procedure is inconsistent. If the truth is inﬁnite dimensional. since under M1 . as ³ ´ c P M = M1 | M1 → 1 − α < 1. since (7. The rule is to select M1 if AIC1 < AIC2 . if α is set to be a small number. Indeed. this rule only makes sense when the true model is ﬁnite dimensional. In contrast to the AIC. based on Bayesian arguments. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. LRn →p 0. AIC selection is inconsistent. That is. k ´ ³ c P M = M1 | M1 P (AIC1 < AIC2 | M1 ) µ ¶ k1 k1 + k2 2 2 σ | M1 = P log(ˆ 1 ) + 2 < log(ˆ 2 ) + 2 σ n n = P (LRn < 2k2 | M1 ) ¡ ¢ → P χ22 < 2k2 < 1. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . One popular choice is the Akaike Information Criterion (AIC). M)) between the true density and the model density.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . ¢ ¡ ˆ1 ˆ2 (7.17) Since log(n) > 2 (if n > 8). the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. The model selection rule is as follows. For some critical level α. and km is the number of coeﬃcients in the model. Another problem is that if α is held ﬁxed. His criterion. Another common approach to model selection is to to a selection criterion. n (7. the most popular to be one proposed by Schwarz. else select M2 . n (7. k A major problem with this approach is that the critical level α is indeterminate. as the rule tends to overﬁt. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. depending on the sample size.However. etc.16) holds under M1 . ˆm The AIC can be derived as an estimate of the KullbackLeibler information distance K(M) = E (log f (Y | X) − log f (Y | X. The 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. log(n) 87 .15) then where σ 2 is the variance estimate for model m. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . else select M2 . Then select M1 if Wn ≤ cα . Indeed. BIC model selection is consistent.

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

. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . based on a sample of size n. Let θ satisfy Eg(Yi − θ) = 0. ˆ (a) Find a point forecast of y. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . Thus the available information is the sample (Y. Let (yi . and the out-of-sample value of the regressors. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . For any predictor g(xi ) for y. the estimates (β. where xji is one of the xi . Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. Verify equation (7. 5.12). the mean absolute error (MAE) is E |yi − g(xi )| . ˜ the residual vector is e = Y − X β. Show that the function g(x) which minimizes the MAE is the conditional median M (x). . 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 .7.10 Exercises 1. V . You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. In a linear model Y = Xβ + e. ˆ ˆ n−k 6. σ 2 ). (b) Find an estimate of the variance of this forecast. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. 4. V ar(e | X) = σ 2 Ω with Ω known. xi ) be a random sample with E(Y | X) = Xβ. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. Is θ a quantile of the distribution of Yi ? 3... wn ) and wi = x−2 . the residuals e. x.. (b) Prove that e = M1 e. else equals zero). 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 . 2. E(e | X) = 0. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . X). Let σ 2 be the estimate of σ 2 .

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

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

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

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

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

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

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

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

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

about the rate v of convergence. 99 . Let Tn be a statistic such that (8. The ideal test rejects if Wn ≥ qn (α). A better asymptotic approximation may be obtained through an asymptotic expansion. it says nothing. and a function h(x) is odd if h(−x) = −h(x). F ) = Φ + o (1) . 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. θ θ θ ˆ θ ∗ ∗ Computationally. lim Gn (x. (8. Thus here Tn (θ) = Wn (θ). Let an be a sequence. Equivalently.] 8. Deﬁnition 8. an = O(n−r ) if it declines to zero like n−r . If θ is a vector. Basically.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. where qn (α) is the (1 − α)% quantile of the distribution of Wn .2 an = O(1) if |an | is uniformly bounded.8.8 Asymptotic Expansions Tn →d N (0.8. and vice-versa. We say that a function g(x) is even if g(−x) = g(x). θ [This is a typical mistake made by practitioners. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ .4) says that Gn converges to Φ x as n → ∞. C4 is called the symmetric percentile-t interval. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. The derivative of an even function is odd. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).8. or the size of the divergence for any particular sample size n.4) v ¡ ¢ While (8. v 2 ). The following notation will be helpful. Deﬁnition 8. F ) then ³x´ . writing Tn ∼ Gn (x. F ) = Φ n→∞ v or ³x´ Gn (x.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test.3 an = o(n−r ) if nr |an | → 0 as n → ∞. not ˆ − θ0 . 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.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. the critical value qn (α) is found as the quantile from simulated values of W´ . however.

8. F ) = Φ v n n 8. We can interpret Theorem 8.1 as follows. To the second order. ³x´ 1 1 + 1/2 g1 (x. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . Fn ) + O(n−1 ). which from Theorem 8. and g2 is an odd function of x. F0 ) = 1 g (x. so the order of the error is O(n−1/2 ).8. Fn ) − g1 (x.1 Under regularity conditions and (8. ³x´ Gn (x. An asymptotic test is based on Φ(x). F0 ) ≈ ∂ g1 (x. √ Since Fn converges to F at rate n. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. Moreover. the density function is skewed.9 One-Sided Tests Using the expansion of Theorem 8.3). and g1 is continuous with respect to F. A bootstrap test is based on G∗ (x). To a third order of approximation. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. v Since the derivative of g1 is odd. F ) ≈ Φ + n−1/2 g1 (x. 100 . g1 (x. To a second order of approximation. F0 ) = n 1 n1/2 (g1 (x. Fn ) − g1 (x.8. where g1 is an even function of x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ).1. Fn ) = Φ(x) + n 1 g (x. Heuristically. ³x´ Gn (x. the diﬀerence √ (g1 (x. First.uniformly over x. the exact distribution is P (Tn < x) = Gn (x. Fn ) − g1 (x. F ) converges to the normal limit at rate n1/2 . F0 )) + O(n−1 ). 1/2 1 n Because Φ(x) appears in both expansions. F ) + O(n−3/2 ) Gn (x. F ) + g2 (x. F ) ≈ Φ + n−1/2 g1 (x. F0 ) = Φ(x) + since v = 1. The diﬀerence is Φ(x) − Gn (x. F ).8. Gn (x. F0 )) converges to 0 at rate n. 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 ).1 has the expansion n G∗ (x) = Gn (x. F ) v which adds a symmetric non-normal component to the approximate density (for example. adding leptokurtosis). F ) + n−1 g2 (x. Theorem 8.

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

We know that θ Tn →d N (0.5) to the bootstrap distribution. Therefore. and needs to be determined on a case-by-case basis. which is not pivotal. but one-sided tests might have more power against alternatives of interest. This is in contrast to the use of the asymptotic distribution. This is because the ﬁrst term in the asymptotic expansion. G∗ (x) = Gn (x. Two-sided tests have better rates of convergence than the one-sided tests. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. F0 )) + O(n−3/2 ) n = O(n−3/2 ). The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. Theorem 8. Fn ) + O(n−3/2 ). as it depends on the unknown V. and bootstrap tests have better rates of convergence than asymptotic tests.8. Gn (x. Twosided tests will have more accurate size (Reported Type I error). meaning that the errors in the two directions exactly cancel out. we ﬁnd Gn (x) = Gn (x. Fn ) − g2 (x. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. Applying (8. whose error is O(n−1 ). The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . Conﬁdence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. √ the last equality because Fn converges to F0 at rate n. F0 ) = ∗ 2 (g2 (x.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. F ) = Φ v √ where v = V .Interestingly. similar to a one-sided test. 8.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). g1 . and g2 is continuous in F. A reader might get confused between the two simultaneous eﬀects. and for the bootstrap ³x´ + O(n−1/2 ). Fn ) = Φ(x) + ∗ 2 g2 (x. set Tn = n ˆ − θ0 . 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 ). V ).

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

That is. Find the population moments ETn and V ar(Tn ). Unfortunately this is a harder problem. which is a valid statistical approach.. creating a random bootstrap data set (Y ∗ . draw a ˆ ˆ random integer i0 from [1. ei ) : i = 1. Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0.. . 2. Let β denote the ˆ the OLS residuals.. ˆ 3. however.. Using the non-parametric bootstrap.. . ˆ Draw (with replacement) n such vectors. One proposal which imposes the regression condition without independence is the Wild Bootstrap. Show that √ n (Fn (x) − F0 (x)) →d N (0. 4. n} . Find the bootstrap moments ETn and V ar(Tn ). you sample ε∗ using this two-point distribution. yn } with µ = Eyi and σ 2 = V ar(yi ).observed values of the regressors.. . . 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 . 2.13 Exercises 1. It does not really matter. 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 . Let the statistic of interest be the sample mean Tn = y n . The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. Let Fn (x) denote the EDF of a random sample... yielding OLS estimates β and any other statistic of interest.. Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). F0 (x) (1 − F0 (x))) . and set x∗ = xi0 and e∗ = ei0 .. Consider the following bootstrap procedure for a regression of yi on xi . and e = Y − X β ˆ (a) Draw a random vector (x∗ . ˆ∗ (b) Regress Y ∗ on X ∗ . generate ∗ bootstrap samples. X ∗ ). Consider the following bootstrap procedure. ˆi A conditional distribution with these features will preserve the main important features of the data.. Let ∗ ∗ ∗ {y1 . yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean.. OLS estimator from the regression of Y on X. whether or not the xi are really “ﬁxed” or random. Take a random sample {y1 . n]. Tn = (ˆ − ˆ 104 . Set y∗ = x∗0 β + e∗ . i 8. e∗ ) from the pair {(xi .

The ˆ are sorted. can you report the 95% Percentile-t interval for θ? 7. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. ˆ − s(ˆ n (. (a) Report the 95% Efron Percentile interval for θ.pdf. size of house. and the 2.75 and 1. and thus reject H0 if ˆ ˆ > q ∗ (. You replace c with qn (. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (.3.05) . θ respectively. (c) With the given information. Suppose that in an application. ∗ ∗ where s(ˆ is the standard error in the original data.95).05) and qn (. with variables listed in the ﬁle hprice1.2 and s(ˆ = .5% and 97.95) denote the 5% θ) ∗ and 95% quantiles of Tn . ˆ = 1. you generate bootstrap samples.5% quantiles of the ˆ are . Estimate a linear regression of price on the number of bedrooms. The dataﬁle hprice1. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). You do this as follows. You want to test H0 : θ = 0 against H1 : θ > 0. Using the non-parametric bootstrap. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.dat contains data on house prices (sales).95).95) denote the 95% quantile of Tn . What is wrong with this procedure? Tn = θ/s(θ) n 6. and the colonial dummy. lot size. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. and ˆ is calculated on each θ ∗ ∗ θ sample.2. Using the non-parametric ∗ bootstrap. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. (b) Report the 95% Alternative Percentile interval for θ. 105 .Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). ∗ ∗ ∗ Let qn (.95). Let qn (.

Let g(y. as their are restrictions in E (xi ei ) = 0. x. Now suppose that we are given the information that β 2 = 0. This situation is called overidentiﬁed. This method. is not necessarily eﬃcient. but this is not required. In econometrics. with ≥ k. an asymptotically eﬃcient estimator of β is the OLS estimator. where the dimensions of zi and xi are k × 1 and × 1 . z. z. these are known as estimating equations. There are − k = r more moment restrictions than free parameters. This is a special case of a more general class of moment condition models. g(y. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . β) = x(y − x0 β). Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. The variables zi may be components and functions of xi . This model falls in the class (9. We call r the number of overidentifying restrictions. x.1) by setting g(y. while β 1 is of dimension k < .Chapter 9 Generalized Method of Moments 9. As an important special case we will devote special attention to linear moment condition models. We know that without further restrictions. β 0 ) = 0 (9. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. zi . otherwise it is overidentiﬁed. 1 this class of models are called moment condition models. β 0 ) = x(y − z 0 β) 106 (9.1) where β 0 is the true value of β.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. In our previous example. however. In this case. In the statistics literature. If k = the model is just identiﬁed.2) . xi . x.

then g n (β) = 0. β GMM = Z 0 XWn X 0 Z 9. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . ¡ ¢−1 0 ˆ Z XWn X 0 Y. i i . ˆ Deﬁnition 9. For some × weight matrix Wn > 0.2. β GMM does not change. 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. β ˆ Note that if k = . and the GMM estimator is the MME. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.9.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. This is a non-negative measure of the “length” of the vector g n (β). the dependence is only up to scale. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . the square of the Euclidean length. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. but this is generally not possible when > k.2) g n (β) = (9. Let and where gi = xi ei .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . then.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . The GMM estimator minimizes Jn (β). Proposition 9.1 β GMM = argmin Jn (β). if Wn = I. For example. let Jn (β) = n · g n (β)0 Wn g n (β).2.

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

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

9. 1 it is possible that β 2 6= 0. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Theorem 9. ˆˆ n is a quadratic form in g n . 110 . Note that g n →p Egi . and if the weight matrix is asymptotically eﬃcient. The general theory of GMM estimation and testing was exposited by L. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0.Often. However. This estimator can be iterated if needed. so that the linear equation may be written as yi = β 0 x1i + ei . 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). often the weight ˆ matrix Wn is updated. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. and is thus a natural test statistic for H0 : Egi = 0. this is all that is known.5. For example. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . β) = 0 holds. Since the GMM estimator depends upon the ﬁrst-stage estimator. n β − β →d N 0. G0 Ω−1 G . and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. 1 2 It is possible that β 2 = 0. Identiﬁcation requires l ≥ k = dim(β). and in this case it would be impossible to ﬁnd a value of β 1 so that both E (x1i (yi − x0 β 1 )) = 0 and E (x2i (yi − x0 β 1 )) = 0 hold simultaneously.1 Under general regularity conditions.6. ˆ J = J(β) →d χ2−k .1 (Sargan-Hansen). Hansen (1982). and then β recomputed.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 . ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. Thus the model — the overidentifying restrictions — are testable. 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 . Under the hypothesis of correct speciﬁcation. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. perhaps obtained by ﬁrst ˆ setting Wn = I.

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

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

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

and therefore positive semideﬁnite. (b) We want to show that for any W. γ ) for (β. 114 . there exists a nonsingular matrix C such that C 0 C = Ω−1 . Show that Wn →p Ω i i i 4. Show that V0 = Q0 Ω−1 Q . V − V0 is positive semi-deﬁnite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the eﬃcient weight matrix). verify that A can be written as ³ ¡ ¢−1 0 ´ G H. Take the model yi = zi β + ei with E (xi ei ) = 0. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 .g. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 .10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. Take the model E (zi ηi ) = 0. Let ei = yi − zi β where β is consistent for ˆ β (e. γ). In the linear model estimated by GMM with general weight matrix W. ˆ ˆ Find the method of moments estimators (β. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0.9. 2. Write out the matrix A. i 0 0ˆ ˆ 3. Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. Letting H = CQ and G = C 0−1 W Q. the asymptotic variˆ ance of β GMM is ¡ ¢−1 0 ¡ ¢−1 V = Q0 W Q Q W ΩW Q Q0 W Q ¡ ¢−1 (a) Let V0 be this matrix when W = Ω−1 . Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). From matrix algebra. (c) Since Ω is positive deﬁnite. a GMM estimator with arbitrary weight matrix).

Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . The equation of interest is yi = g(xi . In the linear model Y = Xβ + e with E(xi ei ) = 0. h(β)=0 (9. zi ). 6. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . zi is l × 1 and β is k × 1. VR = V − V R R0 V R (d) Show that in this setting. β) + ei E (zi ei ) = 0. the distance statistic D in (9. Show how to construct an eﬃcient GMM estimator for β. Deﬁne the Lagrangian L(β. 115 . l ≥ k. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (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) (9.5) 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. xi . The GMM estimator of β. The observed data is (yi . λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. subject ˆ i ˆi i=1 to the restriction h(β) = 0. Vn = X X i=1 ˜ and hence R0 β = r.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 .5. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). VR ) where ¡ ¢−1 0 R V.6) equals the Wald statistic.6) (a) Show that you can rewrite Jn (β) in (9.

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

these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1.3) i=1 117 .. (10. 2001) and has been extended to moment condition models by Qin and Lawless (1994). β). The maximum likelihood estimator of the probabilities (p1 . The multinomial distribution which places probability pi at each observation (yi ..Chapter 10 Empirical Likelihood 10. Combined with i the constraint (10.1) i=1 First let us consider a just-identiﬁed model. 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 . ..2) Ln (p1 . In this case the moment condition places no additional restrictions on the multinomial distribution. pn ) = i=1 An alternative to GMM is empirical likelihood. To be a valid multinomial distribution.. It is a non-parametric analog of likelihood estimation.. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10.. pn ) which places probability pi at each observation.1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n). The n ﬁrst order conditions are 0 = p−1 − µ. xi . . (10.. xi . zi . pn ) are those which maximize the log-likelihood subject to the constraint (10.1 Non-Parametric Likelihood Since each observation is observed once in the sample. 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.. The idea is due to Art Owen (1988. the log-likelihood function for this multinomial distribution is n X ln(pi ). .1). The idea is to construct a multinomial distribution F (p1 ..

3).1) and (10. or equivalently minimizes its negative ˆ (10. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . pi gi (β) = 0. we also obtain the Lagrange multiplier λ = λ(β). The solution cannot be obtained explicitly.4) (10. Multiplying the ﬁrst equation by pi . probabilities 1 ³ ´´ . The solution (when it exists) is well deﬁned since Rn (β. (see section 6.5) ˆ ˆ As a by-product of estimation.7) 118 . The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. λ) : λ(β) = argmin Rn (β. λ). the Lagrange multiplier λ(β) minimizes Rn (β.. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β.2) subject to the restrictions (10. µ. p1 .5). we ﬁnd µ = n and 1 ¢. Ln (β) = Rn (β.. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). λ) is a convex function of λ. λ) = −n ln (n) − n X i=1 For given β.5) This minimization problem is the dual of the constrained maximization problem. . µ) = n i=1 i=1 i=1 L∗ n with respect to pi .. and using the second and third equations. but must be obtained numerically (see section 6.where λ and µ are Lagrange multipliers. p (10.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. pn . λ ¡ ¢ ln 1 + λ0 gi (β) . This yields the (proﬁle) empirical log-likelihood function for β. λ. summing over i. (10.

11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . β λ ∂ ³ ´. and Ω = E xi x0 e2 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. Gi (.9) (10.8) and ¢ 0 0 For example.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . λ) = − (10. β) = −xi zi . Thus the EL estimator is asymptotically eﬃcient.1 Under regularity conditions. 0 = Rn (β.10. and n β − β 0 and nλ are asymptotically independent. i i Theorem 10. λ) = − (10.13) yields n n Expanding (10.10). n (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.9) and (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. (β. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. ˆ ˆ Proof. in the linear model.10) ¡ Ω−1 N (0.13) Premultiplying by G0 Ω−1 and using (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 . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. i=1 i=1 i=1i Expanding (10.2. G = −E (xi zi ).

Since the EL estimator achieves this bound.3. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.15). The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. by a Taylor expansion.14) for λ and using (10. it is an asymptotically eﬃcient estimator for β. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Vλ ) Furthermore. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .3 Overidentifying Restrictions In a parametric likelihood context.7) is n ³ ´´ ³ X ˆ ˆ0 (10. V ) ˆ Solving (10. Ω) GΩ G →d = N (0. and have the same interpretation.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. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. tests are based on the diﬀerence in the log likelihood functions.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. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.16). and (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. LRn = i=1 Theorem 10.17) 2 ln 1 + λ gi β . They are asymptotically ﬁrst-order equivalent. β 0 ) = 0 then LRn →d χ2−k . (10. The overidentiﬁcation test is a very useful by-product of EL estimation. 120 .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. and it is advisable to report the statistic LRn whenever EL is the estimation method.15) (10. First. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. Proof. The same statistic can be constructed for empirical likelihood. 10.1 If Eg(wi .

Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.17) is not appropriate. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .edu/~bhansen/progs/elike.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).18). LRn →d χ2 . The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).4 Testing Egi (β) = 0 (10.prc 121 . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.wisc. 10.ssc. since ln(1 + x) ' x − x2 /2 for x small. so there is no fundamental change in the distribution theory for β relative to β. By “maintained” we mean that the overidentfying restrictions contained in (10.1 Under (10.Second. h(β)=0 ˜ Fundamentally. Vλ )0 Ω−1 N (0. This test statistic is a natural analog of the GMM distance statistic. where h : Rk → Ra .5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.4. Theorem 10.18) and H0 : h(β) = 0. The hypothesis of interest is h(β) = 0. 10. To test the hypothesis h(β) while maintaining (10.18) Let the maintained model be where g is × 1 and β is k × 1. a The proof of this result is more challenging and is omitted. LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. the simple overidentifying restrictions test (10.

λj )) Rp = Rn (β. λ)0 − Rn (β. λj ) . δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λ) = i The ﬁrst derivatives of (10. The starting value λ1 can be set to the zero vector. The iteration (10. 1. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). set 2 λp = λj − δ p (Rλλ (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10.5) for given β. Set δ 0 = 0. One method uses the following quadratic approximation. Deﬁne ∗ gi (β. λj ) is smaller than some prespeciﬁed tolerance. (10.4). λ) gi (β.19) X ∂2 ∗ ∗ gi (β. For p = 0.19) is continued until the gradient Rλ (β. Eﬃcient convergence requires a good choice of steplength δ. λ) . λj ))−1 Rλ (β.20) . δ 1 = 1 and δ 2 = 1. λ) = G∗ (β. λ) = − gi (β. λ)0 − ∂β∂β Rn (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β.19). λ) ∂λ i=1 n ∂ Rn (β. λ) G∗ (β. λp ) A quadratic function can be ﬁt exactly through these three points. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λj ))−1 Rλ (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. 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)0 0 Rn (β. λ) G∗ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. 2. λ) = − ∂β n X i=1 G∗ (β.. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 .

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

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

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

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). we regress Y on Z1 and Z2 . 11. the model is Y = Zβ + e (11. First. X is n × l so there are l instruments. let’s analyze the approximate bias of OLS applied to (11. Using (11. We now derive a similar result for the 2SLS estimator. Recall. In our notation. Z = [Z1 . So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 .ˆ It is useful to scrutinize the projection Z. Z2 = [PX Z1 . ˆ since Z1 lies in the span of X.12) Z = XΓ + u ξ = (e.13) which is zero only when S21 = 0 (when Z is exogenous).6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. Z2 ] and X = [Z1 . PX Z2 ] = [Z1 . Here we present a simpliﬁed version of one of his results. Hence by a ﬁrst-order approximation i µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ OLS − β E β ZZ Ze ≈ E E n n ¡ ¢−1 = Γ0 QΓ + S22 S21 (11.12). ¶ 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 ) . X2 ]. Then i h ˆ ˆ ˆ Z = Z1 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y .11) (11. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Thus in the second stage. PX Z2 ] h i ˆ = Z1 . 129 . Z2 .

0).14) approaches that in (11.13). 130 .14) In general this is non-zero. 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) pointed out that it also has the reverse implication — that when α = l/n is large. By the spectral decomposition of an idempotent matrix. P = HΛH 0 0 0 where Λ = diag(Il . l . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.Let PX = X (X 0 X)−1 X 0 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . the expression in (11.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11. n 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 . Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11. except when S21 = 0 (when Z is exogenous). the bias in the 2SLS estimator will be large. Indeed as α → 1. It is also close to zero when α = 0. The consequences of identiﬁcation failure for inference are quite severe.12) and this result.14) is the probability limit of β 2SLS − β 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 .

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

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

Explain why this is true. u is n × k. Take the linear model Y = Zβ + e. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. That is. (Find an expression for xi .8 Exercises yi = zi β + ei . in the sense that e ˜ ˜ least in large samples? 4. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . show that if rank(Γ) < k then β cannot be identiﬁed. 6.) 3. X is n × l. and Γ is l × k.11. will IV “ﬁt” better than OLS. Z is n × k. at ˆˆ If X is indeed endogeneous. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). Find a simple expression for the IV estimator in this context. where xi and β are 1 × 1. 5. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. 2. 1. 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). Take the linear model yi = xi β + ei E (ei | xi ) = 0. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. ˜ 0 e < e0 e. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . 133 . The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. xi is l × 1.

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

and multivariate (yt ∈ Rm is vector-valued). and use the subscript t to denote the individual observation. To indicate the dependence on time. 135 . γ(k) is called the autocovariance function. t = 1. Yt−k ) is the autocorrelation function.1.4 (loose).1 Stationarity and Ergodicity Deﬁnition 12. and T to denote the number of observations. however. A stationary time series is ergodic if γ(k) → 0 as k → ∞.. There proofs are rather diﬃcult. .. The primary model for multivariate time series is vector autoregressions (VARs). we expect that Yt and Yt−1 are not independent. The following two theorems are essential to the analysis of stationary time series..2 {Yt } is strictly stationary if the joint distribution of (Yt . 12.. Yt−k ) = γ(k) is independent of t for all k.1. .. then Xt is strictly stationary and ergodic. Deﬁnition 12.1. .) is a random variable. We can separate time series into two categories: univariate (yt ∈ R is scalar).1.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.. we adopt new notation. The primary model for univariate time series is autoregressions (ARs).3 ρ(k) = γ(k)/γ(0) = Corr(Yt .. Deﬁnition 12.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . Deﬁnition 12. Theorem 12. T . Yt−1 .. Because of the sequential nature of time series. Yt−k ) is independent of t for all k.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. and Cov (Yt . so classical assumptions are not valid.1.

γ (k) →p γ(k). 1. T 1X Xt →p E(Xt ). For Part (2). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . and it has a ﬁnite mean by the assumption that EYt2 < ∞. Part (1) is a direct consequence of the Ergodic theorem. If Xt is strictly stationary and ergodic and E |Xt | < ∞. then as T → ∞. ρ(k) →p ρ(k). note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 .1. µ →p E(Yt ).Theorem 12.1. T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) . then as T → ∞. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ 2. ˆ 3. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).1.1 above. ˆ Proof.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).2 (Ergodic Theorem). the sequence Yt Yt−k is strictly stationary and ergodic. γ (0) ˆ Theorem 12. ˆ ˆ γ ¥ 136 .

Y2 .} are jointly random. 12. The last property deﬁnes a special time-series process. Y1 . A mean-zero AR(1) is Assume that et is iid. Some time-series processes may be a MDS as a consequence of optimizing behavior... Yt−k ) . this series converges if the sequence ρk et−k gets small as k → ∞.. For example.. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0..} is the past history of the series. 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 . 137 . we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + ...1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. k=0 Loosely speaking. as it is diﬃcult to derive distribution theories without this property.2. E(Yt−k et ) = 0. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . . .. YT . This occurs when |ρ| < 1.12. 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. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. Regression errors are naturally a MDS. should be a MDS.. Yt−2 .... ∞ X = ρk et−k . We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . Letting et = Yt − E (Yt | It−1 ) . Thus for k > 0. or consumption growth rates.2 Autoregressions In time-series. it is even more important in the time-series context.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . . some versions of the life-cycle hypothesis imply that either changes in consumption. E(et ) = 0 and Ee2 = σ 2 < ∞. Deﬁnition 12. t By back-substitution.. . An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . In fact. the series {...

Lk Yt = Yt−k . we see that L2 Yt = LYt−1 = Yt−2 . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. Deﬁning L2 = LL. 138 . since ρ(z) = 0 when z = 1/ρ. From Theorem 12. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .3. In general. Deﬁnition 12.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . The AR(k) model is Using the lag operator. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L.Theorem 12.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. 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).1 If |ρ| < 1 then Yt is strictly stationary and ergodic.3. We say that the root of the polynomial is 1/ρ.1. We call ρ(L) the autoregressive polynomial of Yt . the above results are unchanged. We call ρ(L) the autoregressive polynomial of Yt . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . 12. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . an AR(1) is stationary iﬀ |ρ| < 1.1 The lag operator L satisﬁes LYt = Yt−1 . ∞ X k=0 ρ2k V ar (et−k ) = 12. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et .4.

” If one of the roots equals 1.1. For an AR(k). T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. t T t=1 T t=1 139 .1. “has a unit root”. β = X 0X (12.. This is a special case of non-stationarity. One way of stating this is that “All roots lie outside the unit circle.. t t T t=1 ¥ Combined with (12. The vector xt is strictly stationary and ergodic. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. Theorem 12. By Theorem 12.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. Proof. t Yt−k ¢0 ρk . we say that ρ(L). . Thus t by the Ergodic Theorem. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . λk are the complex roots of ρ(z). and by Theorem 12. so is xt x0 . it is also strictly stationary and ergodic.1. which satisfy ρ(λj ) = 0.1) Theorem 12. and hence Yt . since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.6. the requirement is that all roots are larger than one.1. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.where the λ1 . we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. then ˆ β →p β as T → ∞.. Note that ut is a MDS. it is helpful to deﬁne the process ut = xt et . We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.5.1) and the continuous mapping theorem. Let |λ| denote the modulus of a complex number λ. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. and is of great interest in applied time series.

This creates an iid bootstrap sample. t then as T → ∞. xt }. Q−1 ΩQ−1 .. In particular. 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∗ . Clearly. we constructed the bootstrap sample by randomly resampling from the data values {yt . the asymptotic covariance matrix is estimated just as in the cross-section case.7.. . T t=1 where Ω = E(xt x0 e2 )..2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.7.8 Bootstrap for Autoregressions In the non-parametric bootstrap. 12. T t=1 Since xt et is a MDS.7 Asymptotic Distribution Theorem 12. It also presumes that the AR(k) structure is the truth. The implication is that asymptotic inference is the same. Ω) . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . we can apply Theorem 12. Method 2: Block Resampling 1.. Y−k+2 . Divide the sample into T /m blocks of length m. there are two popular methods to implement bootstrap resampling for time-series data. then as T → ∞. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. eT }. Ω) . Estimate β and residuals et . Fix an initial condition (Y−k+1 . Y0 ).7. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. This is identical in form to the asymptotic distribution of OLS in cross-section regression.12. which may be diﬀerent than the i properties of the actual ei . as this imposes inappropriate independence. ˆ 2.. t t Theorem 12. i 4..1 to see that T 1 X √ xt et →d N (0. ˆ 1. this cannot work in a time-series application. Brieﬂy.1 MDS CLT. t This construction imposes homoskedasticity on the errors e∗ . e ˆ 3. T 1 X √ ut →d N (0. . 140 . Method 1: Model-Based (Parametric) Bootstrap.

Seasonal Eﬀects There are three popular methods to deal with seasonal data. 3. 12.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . This presumes that “seasonality” does not change over the sample. That is.. draw T /m blocks. Paste the blocks together to create the bootstrap time-series Yt∗ . also alters the time-series correlations of the data. 5.2). (12. The seasonal adjustment.4) by OLS.2. and then perform regression (12. Thus the seasonally adjusted data is a “ﬁltered” series. and perhaps this was of relevance. But the long-run trend is also eliminated. The series ∆s Yt is clearly free of seasonality. • You can estimate (12. May not work well in small samples. For each simulated sample.3) replacing St with St . • First apply a seasonal diﬀerencing operator. heteroskedasticity.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . The results may be sensitive to the block length. 4.. • Use “seasonally adjusted” data. This allows for arbitrary stationary serial correlation. (12. however. If s is the number of seasons (typically s = 4 or s = 12). 6.3) sequentially by OLS. • You can estimate (12. This is a ﬂexible approach which can extract a wide range of seasonal factors. or the season-to-season change. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. ﬁrst estimate (12. • Include dummy variables for each season.2)-(12. . This procedure is sometimes called Detrending. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. and for modelmisspeciﬁcation.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . get the ˆ ˆ residual St . ρk ). Resample complete blocks..2) (12. 141 . and the way that the data are partitioned into blocks. ∆s Yt = Yt − Yt−s .

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

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

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

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

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

and Zt be the other variables. 147 . Otherwise it is invalid.2) Take the equation yt = x0 β + et . Let yt = Yjt . we are only interested in a single equation out of a VAR system. 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 . direct estimation of (13. with time series data. You may have heard of the Durbin-Watson test for omitted serial correlation. the model (13.2) may be estimated by iterated GLS. j Often. t or yt = θyt−1 + x0 β + x0 γ + ut . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).3) which is a valid regression model. (13. under the restriction γ = −βθ. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.2) is uncommon in recent applications. t and et is iid N (0. This restriction. This can be done by a Wald test. general. it is convenient to re-deﬁne the variables. Another interesting fact is that (13.1) yt = x0 β + et . Then the single equation takes the form (13. 13. and is still routinely reported by conventional regression packages. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . Let et = ejt and β = aj . In this case.1). and is typically rejected empirically. Suppose that et is an AR(1). (A simple version of this estimator is called Cochrane-Orcutt.13. and subtract oﬀ the equation once lagged multiplied by θ. 1). This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s.2) is a special case of (13. t and xt = This is just a conventional regression. If valid. xt−1 ) to the regression. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0.4 Single Equation from a VAR Yjt = a0 xt + et . We see that an appropriate.3). may be tested if desired.) Since the common factor restriction appears arbitrary. which once was very popular. which is called a common factor restriction. t t−1 (13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors.

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

In some cases. however. so the ADF critical values are not appropriate.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. 13. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . β = (1 − 1)0 . then r = 0. The asymptotic distribution was worked out in B. If the series Yt is not cointegrated. then Yt is I(0).13.9 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 . yet under H1 zt is I(0). β may not be known. If Y = (log(Consumption) log(Income))0 . Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Often. it may be necessary to include a time trend in the estimated cointegrating regression. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. If Yt is cointegrated with a single cointegrating vector (r = 1). In other cases. The r vectors in β are called the cointegrating vectors. Deﬁnition 13. in general. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). a good method to estimate β. When the data have time trends. Yt is I(1) and cointegrated. When β is unknown. Thus H0 can be tested using a univariate ADF test on zt . Then under H0 zt is I(1).8 Cointegration The idea of cointegration is due to Granger (1981). For 0 < r < m. m × r. Thus Yt = ˆ (Y1t . β is not consistent. as ﬁrst shown by Stock (1987). If r = m. Hansen (1992). Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. from OLS of Y1t on Y2t . of rank r. and was articulated in detail by Engle and Granger (1987). if Yt is a pair of interest rates. the asymptotic distribution of the test is aﬀected by the presence of the time trend. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . Suppose that β is known. but it is useful in the construction of alternative estimators and tests.8. 149 . then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. For example. such that zt = β 0 Yt is I(0). it may be believed that β is known a priori. This is not. Whether or not the time trend is included. so zt = β 0 Yt is known. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. Under H0 . Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 .

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

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

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

This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . 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.}. i i i=1 ˆ The MLE is the value β which maximizes ln (β). A generalization is the negative binomial. Tobin observed that for many households. the consumption level (purchases) in a particular period was zero. 2. 1.1) yi = ∗ <0 .. . The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.. any known value can substitute. i If Y = {0. Thus the model is that there is some latent process yi with unbounded support. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. 0 if yi (This is written for the case of the threshold being zero. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. 14. k! = exp(x0 β). An example of a data collection censoring is top-coding of income. In surveys. incomes above a threshold are typically reported at the threshold. The censoring process may be explicit in data collection. this motivates the label Poisson “regression. The functional form for λi has been picked to ensure that λi > 0.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . i so the model imposes the restriction that the conditional mean and variance of Yi are the same. or it may be a by-product of economic constraints. a typical approach is to employ Poisson regression.14. .1).) The observed data yi therefore come from a mixed continuous/discrete distribution. σ 2 ) with the observed variable yi generated by the censoring equation (14. 2. This may be considered restrictive.2 Count Data exp (−λi ) λk i . The conditional density is the Poisson with parameter λi .. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.. 1.

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

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

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

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

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

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

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

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

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

but not of n. That is.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. and there is a large and continuing literature on the subject. the rule-of-thumb h can be quite ineﬃcient. The ﬁrst two are determined by the kernel function.06n−1/5 163 .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 . This choice for h gives an optimal rule when f (x) is ˆ normal. how should the bandwidth be selected? This is a diﬃcult problem. (16. and R(f 00 ). The downside is that if the density is very far from normal. The asymptotically optimal choice given in (16. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. Gaussian Kernel: hrule = 1. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. where φ is the N (0. We can calculate that √ R(φ00 ) = 3/ (8 π) . ˆ It uses formula (16. but at a very slow rate. Together with the above table. (16. we ﬁnd the reference rules for the three kernel functions introduced earlier. 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 + . That is. and gives a nearly optimal rule when f (x) is close to normal. Their K values for the three functions introduced in the previous section are given here.Together. Thus for the AMISE to decline with n. Equation (16. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. σ 2 . R∞ R∞ K σ 2 = −∞ x2 K (x) dx R(K) = −∞ K (x)2 dx K √ Gaussian 1 1/(2 π) Epanechnikov 1/5 1/5 Biweight 1/7 5/7 An obvious diﬃculty is that R(f 00 ) is unknown. We thus say that the optimal bandwidth is of order O(n−1/5 ). h0 = argmin AM ISEh h It can be found by solving the ﬁrst order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 . Note that this h declines to zero. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). but at a slower rate than n−1 .2) but replaces R(f 00 ) with σ −5 R(φ00 ). In practice.2) depends on R(K). h must tend to zero.1) is an asymptotic approximation to the MSE. we need h → 0 but nh → ∞. 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) .

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

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

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

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

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

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

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

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

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

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

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

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

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

1).8. q Proof of Theorem A.11).6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. From (A. Thus the density of Z 2 is (A. which we showed in (A. The MGF for the density (A.13) is the MGF of the density (A. For Z ∼ N(0.12) E exp (tQ) = 0 Γ (A.8. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. 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 . Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Set r Z . The fact that A > 0 means that we can write A = CC 0 where C is non-singular.3 Let Z ∼ N (0. C −1 CC 0 C −10 ) = N (0. (A.8. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Proof of Theorem A. tr has distribution 177 .3.11) 2 with r = 1. we see that the MGF of Z 2 is (1 − 2t)−1/2 .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).8.2. 1) and Q ∼ χ2 be independent. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.1.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Using the simple law of iterated expectations. which can be found by applying change-of-variables to the gamma function. Iq ). C −1 AC −10 ) = N (0. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .13).Theorem A.

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

cases are rare.2 Cramer-Rao Lower Bound. θ) ≡ L(θ).16) (A. θ θ∈Θ ˆ In some simple cases.9.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .3 Under regularity conditions. ˆ is consistent θ for this value. and the equality (A.9.1 ¯ ¯ ∂ E ln f (Yi . 179 . More typically. ˆ →p θ0 as n → ∞. θ) →p E ln f (Yi . θ0 ) .14) ¶ ∂ ∂ 0 ln f (Yi .16).17) The matrix I0 is called the information. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. In fact. Theorem A. n n i=1 n As the MLE ˆ maximizes the left-hand-side.15) Two important features of the likelihood are Theorem A. then θ V ar(˜ ≥ (nI0 )−1 . I0 . we can ﬁnd an explicit expression for θ as a function of the data. θ0 ) ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. under conventional regularity conditions. θ) ∂θ ∂θ which holds at θ = θ0 by (A. which maximizes the log-likelihood). we can see that it is an estimator of the maximizer θ of the right-hand-side. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. We can write this as ˆ = argmax Ln (θ). θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .9. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . If ˜ is an unbiased estimator of θ ∈ R.17) is often called the information matrix equality. ∂θ ∂θ (A. but these ˆ must be found by numerical methods. However. θ0 ) ∂θ∂θ 0 (A. θ Theorem A. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.

θ) = f (y) ln f (y. ˆ ln f Yi . 180 . Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . but has a diﬀerent covariance matrix than in the pure MLE case. Typically.9.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi .18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . θ) is necessarily the true density. θ).18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. The QMLE is consistent for the pseudo-true value. the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. ˆ . θ (A. Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0. Therefore the MLE is called asymptotically eﬃcient. Thus in large samples the MLE has approximately the best possible variance. but it is not literally believed that the model f (y. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . since the information matrix equality (A.17) does not hold.ˆ ˆ−1 θ We then set I0 = H −1 . θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y. ˆ elements of n 0 Sometimes a parametric density function f (y. V ) . θ) θ In this case. θ) is used to approximate the true unknown density f (y). θ) ¶ dy Thus in large samples. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. In this case there is not a “true” value of the parameter θ. A minor adjustment to Theorem (A. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A. θ θ Ω= n ∂θ ∂θ n i=1 ˆ ˆ ˆˆ V = H −1 ΩH −1 Asymptotic standard errors (sometimes called qmle standard errors) are then the square roots of ˆ the diagonal elements of n−1 V .

θ0 = ln f (Yi .. θ0 ) f (Yi . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ0 ) ∂ ∂θ f ∂ (Yi .9. θ) f (y. θ0 ) ¯ ∂ f (y. θ0 ) ln f (Yi . yn ). θ0 ) (Yi .1.. θ0 )0 .16).9. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . . function of the data. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ0 )0 f (Yi . ∂θ ¯θ=θ0 Z ! = 0. Proof of Theorem A. θ0 ) ∂θ f (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. Since θ Z ˜ = ˜ y)f (˜.. we can show that E By direction computation. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. ∂2 ln f (Yi . V ar (S) nH so ¥ 181 . θ0 ) d˜ = E ˜ .Proof of Theorem A. (Yi . θ) f (˜. ¯ ¯ ∂ E ln f (Yi . θ0 )2 (Yi .2. f (Yi . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ0 ) ∂ ∂ − ln f (Yi . To see (A. θ0 ) − f (Yi . θ) dy ¯ ∂θ f (y. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.1) has mean zero and variance nH.9.17). θ) d˜ = ˜ y ) ∂ ln f (˜. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y.

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

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

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

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

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