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

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

1

Contents

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

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

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i

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

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

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

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

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ii

. . . . . . . . . 12. . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . 9. . . . . . . . . . . 12. 12. . . . . . . . . . . .5 Numerical Computation . . . . . . . .8. . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . 9. . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . . . . . . . . . . . . . . . 12. . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Identiﬁcation Failure . 9. .1 Instrumental Variables . . . .13 One-Sided Tests . . . . . . 11. . . . . . . . . . . . . . . 11. . . . . . 12. . Percentile Conﬁdence Intervals . . . . . . . . . . . 11. . . . .3 Identiﬁcation . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . 10. . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . .10 8.11 8. . . .3 Overidentifying Restrictions . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . . . . . . . . . .10 Exercises . . . . . . . . . .4 Lag Operator . . . . . . . . . . iii . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . 12. . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . .2 Reduced Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . 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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . 11. . 10 Empirical Likelihood 10. . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 8. . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . .9 Bootstrap GMM Inference . . .7 Asymptotic Distribution .

. . . . . . . . . . . . . . . . . . . 162 A Probability A. . . . . . . . . . . . . . . . . . . . 160 16. . . .3 Expectation . . . . .4 Sample Selection . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . 14. . . . . . . . . . . . .7 Granger Causality . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Individual-Eﬀects Model . . . . . . . . . . . . . A. . . . . . . . .4 Single Equation from a VAR .2 Estimation . . . . . . . . . . . . .2 Count Data . . . iv . . . . . . . . . .13 Multivariate Time Series 13. . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Censored Data . . . . . . . . . . . . . . . . 14. . . . . . . B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . . A. . . . . . .3 Restricted VARs . . . . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . .2 Random Variables .1 Kernel Density Estimation . . . . .5 Multivariate Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . .2 Fixed Eﬀects . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . .1 Grid Search . . . . . . .6 Selection of Lag Length in an VAR . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . .4 Common Distributions . . . . . . . . . . . . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . . . . . . A. . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Foundations . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B Numerical Optimization B. . . . B. . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . . . . . . . 13.5 Testing for Omitted Serial Correlation 13. . . . . . .7 Transformations . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . .6 Conditional Distributions and Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Gradient Methods .1 Binary Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . .9 Maximum Likelihood . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . .

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

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

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

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

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

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

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

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

. . For a general k × k matrix A = [aij ] .. k) . i Hence they must equal either 0 or 1. There are k! such permutations.4) H0 M =H 0 0 with H 0 H = In .. jk ) denote a permutation of (1.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 .. 2. ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. 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 . Let π = (j1 .... There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2. If A is 2 × 2. then its determinant is det A = a11 a22 − a12 a21 .... xk ) be k × 1 and g(x) = g(x1 .8 Determinant The determinant is deﬁned for square matrices. xk ) : Rk → R. we can deﬁne the determinant as follows. tr(A) = rank(A). k. . and let επ = +1 if this count is even and επ = −1 if the count is odd. . .. we deduce that Λ2 = Λ and λ2 = λi for i = 1. .. ⎠ . The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ .. (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. k)).. .. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . ... Additionally.By the uniqueness of the characteristic roots..

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

Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. or the covariates. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. ⎟ . We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. holding the other variables constant. we can focus on f (y | x) .1) xi = ⎜ . (3. Take a closer look at the density functions displayed in Figure 3. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. education and experience.22. ⎠ ⎝ . the conditional density of yi given xi . it is useful to have numerical measures of the diﬀerence. Figure 3. These are conditional density functions — the density of hourly wages conditional on race. .1. While it is easy to observe that the two densities are unequal.2) m(x) = E (yi | xi = x) = −∞ In general.1 displays the density1 of hourly wages for men and women. The two density curves show the eﬀect of gender on the distribution of wages. We call yi the dependent variable. In this context we partition the observations into the pair (yi . and that for women is $20. The data are from the 2004 Current Population Survey 1 11 . m(x) can take any form. the conditioning variable. the mean wage for men is $27. When a distribution is skewed. and exists so long as E |yi | < ∞. See Chapter 16.1 by the arrows drawn to the x-axis. These are indicated in Figure 3. You can see that the right tail of then density is much thicker than the left tail. In the example presented in Figure 3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population.1. which is a common feature of wage distributions.73. xki 3. These are asymmetric (skewed) densities. xi ) where yi is a scalar (real-valued) and xi is a vector. We call xi alternatively the regressor. To illustrate. gender. the mean is not necessarily a good summary of the central tendency. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. This is used when the goal is to quantify the impact of one set of variables on another variable.

1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.30.2) evaluated at the observed value of xi : ei = yi − m(xi ). 12 . By construction.3 displays a scatter plot2 of log wages against education levels. this yields the formula yi = m(xi ) + ei . implying an average 36% diﬀerence in wage levels. degree in mean log hourly wages is 0. 3. then comparisons become more complicated.36.D. and a Ph. The conditional expectation function is close to linear. Figure 3.A. For this reason. the solid line displays the conditional expectation of log wages varying with education. The diﬀerence in the log mean wage between men and women is 0. When the distribution of the control variable is continuous. 2 (3. The comparison in Figure 3. Assuming for simplicity that this is the true joint distribution. Figure 3.2 shows the density of log hourly wages for the same population.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.Figure 3. wage regressions typically use log wages as a dependent variable rather than the level of wages. with mean log hourly wages drawn in with the arrows. Of particular interest to graduate students may be the observation that diﬀerence between a B.3) White non-military male wage earners with 10-15 years of potential work experience. the dashed line is a linear projection approximation which will be discussed in the Section 3. which implies a 30% average wage diﬀerence for this population.5. To illustrate.1 is facilitated by the fact that the control variable (gender) is discrete. The main point to be learned from 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.

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

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. The right-hand-side is minimized by setting g(x) = m(x). i . let g(x) be an arbitrary predictor of yi given xi = x. To see this. the conditional variance of yi is σ 2 = σ 2 (xi ). Given the random variable xi . The conditional standard deviation is its square root σ(x) = σ 2 (x). A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . 3. in the sense of achieving the lowest mean squared error.1. In contrast. when σ 2 (x) is a constant so that ¢ ¡ (3. σ 2 (x) is a non-trivial function of x. it does not provide information about the spread of the distribution. and can take any form. subject to the restriction p that it is non-negative. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.Figure 3.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .2.3.3 Conditional Variance Generally.

⎟ β=⎝ . which we derive in this section. ⎟ . So while men have higher average wages. Instead. The conditional standard deviation for men is 12.4 Linear Regression An important special case of (3. its functional form is typically unknown. In this case (3.we say that the error ei is homoskedastic.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. i (3.6) (3. ⎠ .5) xi = ⎜ . Notationally. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .9) 3. it is convenient to augment the regressor vector xi by listing the number “1” as an element.1 and that for women is 10. We call this the “constant” or “intercept”.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x).6) as an approximation. we assume that x1i = 1. xki When m(x) is linear in x. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .8) (3. 3. take the conditional wage densities displayed in Figure 3.1. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . and the linear assumption of the previous section is empirically unlikely to accurate. As an example. Equivalently. 15 . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. ⎠ . where x1i is the ﬁrst element of the vector xi deﬁned in (3.7) is a k × 1 parameter vector.1). they are also somewhat more dispersed. it is more realistic to view the linear speciﬁcation (3.8) is called the linear regression model.5.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (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 . Thus (3. βk ⎛ (3. Equation (3.

alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.5. E (x0 xi ) < ∞. this situation must be excluded. 2 2. Observe i that for any non-zero α ∈ Rk . α0 E (xi x0 ) α = E (α0 xi )2 > 0. This occurs when redundant variables are included in xi . As before. 3. Rewriting. i 16 . α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. x0 β is the best linear predictor for yi . For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. The ﬁrst-order condition for minimization (from Section 2. i (3. The vector (3. The best linear predictor is obtained by selecting β to minimize S(β). In order for β to be uniquely deﬁned. i (3. by “best” we mean the predictor function with lowest mean squared error. i which requires that for all non-zero α. Given the deﬁnition of β in (3.1 1. otherwise they are distinct. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) .7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. Eyi < ∞. xi contains an intercept.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 . The error is i ei = yi − x0 β. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .10).10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. E (xi x0 ) is invertible. Therefore. i 4. It is invertible if and only if it is positive deﬁnite. written E (xi x0 ) > 0.10) It is worth taking the time to understand the notation involved in this expression.which is quadratic in β.5. Assumption 3.1. i i (3.12) This completes the derivation of the linear projection model. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. Equivalently.

11) are well deﬁned.10) and (3.4 we know that the regression error has the property E (xi ei ) = 0.9). it follows that linear regression is a special case of the projection model.2. By deﬁnition.12) can be alternatively interpreted as a projection decomposition.1.1.1. This means that the equation (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.4 guarantees that the solution β exits.4 is required to ensure that β is uniquely deﬁned.1.1. The ﬁnite variance Assumptions 3.5. Let’s compare it with the linear regression model (3.1 is employed to guarantee that (3.13) The two equations (3.5.14) Proof.5. Assumption 3. Equation (3.13) and Assumption 3. However. Since ei is mean zero by (3.5.Theorem 3. For example.1. Assumption 3.14). i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1.1. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .3 are called regularity conditions.5. Assumption 3. (3. the orthogonality restriction (3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.13) implies that xi and ei are uncorrelated.10) are deﬁned. Furthermore. Since from Theorem 3. E (xi ei ) = 0 and E (ei ) = 0.1 are weak.5. Using the deﬁnitions (3.1. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.5. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.13) summarize the linear projection model. ¥ (3.5.1 Under Assumption 3.3 ensure that the moments in (3.14) follows from (3. Figure 3. (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .2 and 3.1.14) holds.12) and (3.8)-(3. 17 .5.5.5.11) and (3. Assumption 3.1.2 and 3.

Figure 3. In other cases the two may be quite diﬀerent. and the straight dashed line is the linear projection.10) may not hold and the implications of Theorem 3. A projection of log wages on these two variables can be called a quadratic projection.1. there are no changes in our methods or analysis.1 may be false.4 we display as well this quadratic projection. It over-predicts wages for young and old workers. for any pair (yi . In this case (3. The solid line is the conditional mean. In this case the linear projection is a poor approximation to the conditional mean.We have shown that under mild regularity conditions. In the example just presented. and under-predicts for the rest. in many economic models the parameter β may be deﬁned within the model. In Figure 1. In this example it is a much better approximation to the conditional mean than the linear projection. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. We illustrate the issue in Figure 3. Most importantly. The linear equation (3. In this example the linear projection is a close approximation to the conditional mean.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. Figure 3. However. 18 . Returning to the joint distribution displayed in Figure 3.5. In contrast. and are discussed in Chapter 11. we can augment the regressor vector xi to include both experience and experience2 .12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. for those over 53 in age). the dashed line is the linear projection of log wages on eduction. it is important to not misinterpret the generality of this statement. This defect in linear projection can be partially corrected through a careful selection of regressors.5.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. Other than the redeﬁnition of the regressor vector.10).4 displays the relationship3 between mean log hourly wages and labor market experience. since the resulting function is quadratic in experience.12) with the properties listed in Theorem 3.3. No additional assumptions are required. xi ) we can deﬁne a linear projection equation (3. These structural models require alternative estimation methods.

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

x 6. i 7. . σ 2 = V ar(xi ). Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . 2. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. If yi = x0 β + ei and E(xi ei ) = 0. Prove parts 2. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. and E(ei | xi ) = 0. Let xi and yi have the joint density f (x.1. True or False. then ei is i i independent of xi . and have the following joint probability distribution X=0 X=1 Y =0 . i 8. 2. and E(e2 | xi ) = σ 2 . a constant. 20 . Suppose that yi is discrete-valued. 3 and 4 of Theorem 3. xi ∈ R. i 11. True or False. Compute E(yi | xi = x) and V ar(yi | xi = x). Suppose that Y and X only take the values 0 and 1. 3. If yi = x0 β + ei . then E(ei | xi ) = 0. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . then E(x2 ei ) = 0. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. taking values only on the non-negative integers. (x − µ)2 − σ 2 Show that Eg (X. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi .2 Y =1 . If yi = x0 β + ei and E(ei | xi ) = 0.. If yi = xi β + ei . Let X be a random variable with µ = EX and σ 2 = V ar(X). σ 2 = V ar(yi ) and σ xy = Cov(xi . 1. then ei is independent of xi . ¡ ¢ 4.4 . 9. Are they diﬀerent? Hint: If P (Y = j) = 5. s) = 0 if and only if m = µ and s = σ 2 . E(Y 2 | X = x) and V ar(Y | X = x). xi ∈ R. µx = Exi .3 Find E(Y | X = x). 0 ≤ y ≤ 1.6 Exercises 1.1 . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . True or False. True or False.2.. then E(x2 ei ) = 0. E(ei | xi ) = 0. µ. σ = .3. yi ). i 10. Compute the conditional mean m(x) = E (yi | xi = x) . m. and E(xi ei ) = 0. e−λ λj j! . j! 0 j = 0. If yi = xi β + ei . True or False.

7 and 4.1) (4. i n i=1 n 21 .Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. i It follows that the moment estimator of β replaces the population moments in (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . but for most of the chapter we retain the broader focus on the projection model.2) (4. (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi . we narrow the focus to the linear regression model.8.3) In Sections 4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 . 4. Observe that (4.1 Estimation Equation (4.2) can be written in the parametric 0 β)) = 0. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .

4).117 1 14.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. excluding military.95 xi yi = 42. 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 (4.37 µ ¶ 1.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. An interpretation of the estimated equation is that each year of education is associated with an 11. 0.94 −2.170 37. with 10-15 years of potential work experience. consider the data used to generate Figure 3.14 205.3. 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.117 Educationi .4).30 + 0.2 Least Squares There is another classic motivation for the estimator (4.ˆ This is a set of k equations which are linear in β. i 22 .83 µ We often write the estimated equation using the format \ log(W agei ) = 1. This sample has 988 observations. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.14 14. To illustrate. 30 = .40 µ ¶µ ¶ 34. 40 2. Let yi be log wages and xi be an intercept and years of education.83 ¶−1 µ ¶ .95 42. ¶ 2. 4.7% increase in mean wages. These are white male wage earners from the March 2004 Current Population Survey.14 205.71 = −2. Then µ ¶ n 1X 2.14 14. 40 0.

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

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. 24 .7) A justiﬁcation for the latter choice will be provided in Section 4.2: Sum-of-Squared Error Function Contours Equation (4. and hold true for all linear regression estimates.6) An alternative estimator uses the formula n 1 X 2 s = ei . These are algebraic results.7.5) implies that 1X xi ei = 0. ˆ n i=1 n Since xi contains a constant. The error variance σ 2 = Ee2 is also a parameter of interest. It measures the variation in the i “unexplained” part of the regression.Figure 4. ˆ n−k 2 i=1 (4. one implication is that n 1X ei = 0. Its method of moments estimator is the sample average 1X 2 ei .

Hence the MLE for β equals the OLS estimator. σ 2 ). ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. This is a parametric model. 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 ). σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . maximizing the likelihood is identical to minimizing Sn (β). 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. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. 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 (0.3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. Instead. σ 2 ) maximize Ln (β. The R2 is frequently mislabeled as a measure of “ﬁt”. It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. σ 2 ) is a function of β only through the sum of squared errors Sn (β). testing. Since Ln (β.where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. where likelihood methods can be used for estimation. and distribution theory. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. An alternative estimator of ρ2 proposed by Theil called “R-bar-squared” is y R =1− where σ2 = ˜y 2 n 2 s2 σ2 ˜y 1 X (yi − y)2 . 4.

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

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

¡ ¢−1 0 ι.14) or via the ˆ following algorithm: ˜ 1.13). observe that ⎞ ⎛ ⎞ ⎛ . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . . 30 . Regress X2 on X1 .9). Regress Y on X1 . . the primary use is theoretical. ˆ which are “demeaned”. ⎠ ⎝ ⎠ ⎝ . 4.1 (Frisch-Waugh-Lovell). Regress Y on X2 . ˆ ˜ ˜ ˆ 3. obtain OLS estimates β 2 and residuals e. ˜ 2. which you may have seen in an introductory econometrics course. the FWL theorem can be used to speed computation. .Theorem 4.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. A common application of the FWL theorem. In some contexts. 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) . and X2 is the vector of observed regressors. . obtain residuals X2 . . ⎟ ⎜ ⎟ ⎜ (4. but in most cases there is little computational advantage to using the two-step algorithm. Rather. In this case. . 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. . In this section we derive the small sample conditional mean and variance of the OLS estimator. In the model (4. . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. .6. is the demeaning formula for regression.9). . By the independence of the observations and (3.8)(3. obtain residuals Y .

¡ 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 ) = 0.20) .18). 1 n .. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . Next. 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. σ 2 } = ⎜ . ⎠ (4.19) ˆ and thus the OLS estimator β is unbiased for β.12). From (4. .. and the trace operator observe that. 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. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. . . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . the properties of conditional expectations. ⎝ .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 . V ar β | X = X 0 X ⎟ ⎟ ⎟. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . X 0 DX = X 0 Xσ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ . . ..8). and (4. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . 0 0 ··· 0 0 .Using (4. . .. under the of ˆ ¢ 2 | x = σ 2 . Then given (4.

What is the best choice of A? The Gauss-Markov theorem.8)¢ ¡ (3. which we now present. known as the Gauss-Markov theorem. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . ³ ´ ˜ E β | X = A0 Xβ. Now consider the class of estimators of β which are linear functions of i the vector Y. the estimator ˆ 2 deﬁned (4. Thus σ 2 is biased towards zero. and thus can be written as ˜ β = A0 Y where A is an n × k function of X.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . It is not unbiased in the absence of homoskedasticity.8.10). The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . 32 .1 Gauss-Markov. the best (minimumvariance) unbiased linear estimator is OLS. 4. Theorem 4. It is important to remember. As an alternative.9) plus E e2 | xi = σ 2 . This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. however. says that the least-squares estimator is the best choice. = σ2 n the ﬁnal equality by (4. which is (3.7) is unbiased for σ 2 by this calculation. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. ˜ so β is unbiased if (and only if) A0 X = Ik . as it yields the smallest variance among all unbiased linear estimators. 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. In this case. In the homoskedastic linear regression model. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. The following result. Thus since V ar (e | X) = In σ 2 under homoskedasticity. is a famous statement of the solution. By a calculation similar to those of the previous section. or in the projection model.

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

Substituting in the expressions for π j .5. 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 . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 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 .9). He proves that generically the OLS estimator (4. the maximum likelihood estimator is identical to the OLS estimator. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. (4.22) 34 . if the data have a discrete distribution. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. He observes that the above argument holds for all multinomial distributions. and thus so is the OLS estimator.10) for the class of models satisfying Assumption 3.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. Chamberlain (1987) extends this argument to the case of continuously-distributed data.1.10 Omitted Variables xi = µ x1i x2i ¶ .

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

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

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

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

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

as stated. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. tangent lines lie below it. n i=1 42 . Set Y = g(X) and let f denote the density function of Y. Applying expectations.Markov’s Inequality.3). Theorem 5. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. Note EU = EV = 1. For any strictly increasing function g(X) ≥ 0. p p p q which is (5.4) Proof of Jensen’s Inequality. We say that Zn converges in probability to Z as n → ∞. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. P (g(X) > α) ≤ α−1 Eg(X). denoted Zn →p Z as n → ∞.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector.2. =E U V p q p q Proof of Markov’s Inequality. n→∞ lim P (|Zn − Z| > δ) = 0. If Xi ∈ Rk is iid and E |Xi | < ∞. The WLLN shows that sample averages converge in probability to the population average. Eg(X) ≥ a + bEX = g(EX). if for all δ > 0. 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}. (5.1 Weak Law of Large Numbers (WLLN). ¥ 5. So for all x. ¥ Proof of Holder’s Inequality. Since g(x) is convex. Let a + bx be the tangent line to g(x) at x = EX. then as n → ∞ n 1X Xn = Xi →p E(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 ) = + . Let U = |X|p /E |X|p and V = |Y |q /E |Y |q .

43 .7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . denoted Zn →d Z. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.5). as needed. Fn (x) → F (x) as n → ∞. Jensen’s inequality (5. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.6) By Jensen’s inequality (5. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. If Xi ∈ Rk is iid and E |Xi |2 < ∞. Fix δ and η. Finally. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. the fact that X n = W n + Z n .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.3.4). the fact that the Wi are iid and mean zero.7). P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. (5.6) and (5. Set ε = δη/3. We say that Zn converges in distribution to Z as n → ∞.1). we can set E(X) = 0 (by recentering Xi on its expectation). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . P ¯X n ¯ > δ ≤ η. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. ¡¯ ¯ P ¯X n ¯ > δ ≤ η.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) .1 Central Limit Theorem (CLT).Proof: Without loss of generality. the triangle inequality. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . if for all x at which F (x) is continuous.1) and (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . by Markov’s inequality (5. where Z has distribution F (x) = P (Z ≤ x) . 5. and the bound |Wi | ≤ 2C. V ) . Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. Theorem 5.

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

2 Continuous Mapping Theorem 2.4. Σ) .4. If Zn →p c as n → ∞ and g (·) is continuous at c.3 Delta Method: If n (θn − θ0 ) →d N (0. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Σ) = N 0. 45 . Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Ik ) distribution. ¥ 5. Stacking across elements of g. Recall that A ⊂ B implies P (A) ≤ P (B). for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε.1 Continuous Mapping Theorem 1 (CMT). gθ Σgθ .4. This is suﬃcient to establish the theorem. If Zn →d Z as n → ∞ and g (·) is continuous. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Proof: Since g is continuous at c. and g(θ) : Rm → Rk .4 Asymptotic Transformations Theorem 5. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.√ where λn → 0 lies on the line segment joining 0 and λ/ n. Hence g(Zn ) →p g(c) as n → ∞. Theorem 5. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. where θ is m × 1 and Σ is m × m. we see that as n → ∞. for each element of g. then g(Zn ) →p g(c) as n → ∞. then g(Zn ) →d g(Z) as n → ∞. Proof : By a vector Taylor series expansion. √ Theorem 5. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Since cλλ (λn ) → cλλ (0) = −Ik . k ≤ m. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 .

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

Ã n ! n X 1X 0 1 ˆ xi xi . the OLS estimator β is has a statistical distribution which is unknown.4. Assumption 3.4 implies that Q−1 exists and thus g(·. 6.1. As the sample size increases the density becomes more concentrated about the population coeﬃcient. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.2.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. ·) is continuous at (Q. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.2.5. 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. 0). (6. 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. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. using (6. ˆ 47 . and the continuous mapping theorem (Theorem 5. Proof. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. n i=1 (6.2) i i n i=1 n From (6.3).8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1 by the fact that the sampling densities become more concentrated as n gets larger.4.1).1) and ˆ We now deduce the consistency of β. Equation (4. (6.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. we can conclude ˆ that β →p β.2 Consistency ˆ As discussed in Section 6. we will use the methods of asymptotic approximation.1. β →p β as n → ∞.3) Ã where g(A.5.5. First.1 Under Assumption 3.2). To characterize the sampling distribution more fully. This is illustrated in Figure 6. ˆ Theorem 6.1).1). Hence by the continuous mapping theorem (Theorem 5. Assumption 3.1).1. For a complete argument.1 and the WLLN (Theorem 5. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . xi ei →p g (Q.

Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . (6. since n/(n − k) → 1 as n → ∞. To see this. (6.5. n 1 X √ xi ei →d N (0.6) n i=1 48 . E ¯ei ¯ E ¯e4 ¯ i i i i (6.1 In addition to Assumption 3. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. ˆ Proof. Ω) . (6.2).5.3.1). ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.2).2 Under Assumption 3.2.2. ˆ n−k 6. Thus σ 2 is consistent for σ 2 .3) and Theorem (6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.1). We need a strengthening of the moment conditions.1 guarantees that the elements of Ω are ﬁnite. ˆ Finally. by the Cauchy-Schwarz inequality (5. (6.1.3. Ee4 < ∞ and E |xi |4 < ∞. it follows that s2 = ¥ n σ 2 →p σ 2 . i i Assumption 6. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .3. Assumption 6.1.Theorem 6. By the central limit theorem (Theorem 5.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.

There is a special case where Ω and V simplify. However. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. The approximation may be poor when n is small. e2 ) = 0. V ) where V = Q−1 ΩQ−1 . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. The expression V = Q−1 ΩQ−1 is called a sandwich form.7) is true then V = V 0 .7) Cov(xi x0 . setting n = 100 and varying the parameter α. |ε| ≥ 1. xi ) which satisfy the conditions of Assumption 6. however.1 states that the sampling distribution of the least-squares estimator.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 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . As α approaches 2.1. there is no simple answer to this reasonable question.3. In´Figure 6.1). the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.9) In (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . Under (6.7) is true or false. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. 1). 1 X √ xi ei n i=1 n ! the N (0. but this is not a necessary condition.3. for example.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . when xi and ei are independent. otherwise V 6= V 0 . 1) asymptotic distibution.3. after rescaling.3. and (6.Then using (6. How large should n be in order for the approximation to be useful? Unfortunately. The asymptotic distribution ´ Theorem 6.7) holds.6). The trouble is that no matter how large is the sample size.1 Under Assumption 6. We illustrate this problem using a simulation. Ω) ¡ ¢ = N 0.9) we deﬁne V 0 = Q−1 σ 2 whether (6. Q−1 ΩQ−1 . In Figure 6. For α 49 . its variance diverges q ³ ´ ˆ to inﬁnity. Theorem 6. is approximately normal when the sample size n is suﬃciently large. Let yi = β 0 + β 1 xi + εi where xi is N (0.2). i i Condition (6. When (6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. We call V 0 the homoskedastic covariance matrix. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). V is often referred to as ˆ the asymptotic covariance matrix of β. (6. We say that ei is a Homoskedastic Projection Error when (6.3. This holds true for all joint distibutions of (yi .

concentrating most of the probability mass around zero. As α diminishes the density changes signiﬁcantly.3 is that the N (0.2 and 6. We show the sampling distribution of n β 1 − β 1 setting n = 100. we need an estimate of Ω = E xi x0 e2 . 6. 1) density. 4. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.10) V 0 = Q−1 s2 . ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.0 the density is very close to the N (0. The lesson from Figures 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 1).1) it is clear that V 0 →p V 0 . The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. As k increases.10) without changing this result.11) 50 . 6 and 8. 1) asymptotic approximation is never guaranteed to be accurate.2.2) and Theorem 6. the sampling distribution becomes highly skewed and non-normal. for k = 1. 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.Figure 6. Another example is shown in Figure 6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. The estimator 2 2 in (6.3.2: Density of Normalized OLS estimator α = 3.

. standard errors are not unique. A more easily interpretable measure of spread is its square root — the standard deviation. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar.. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . or that they use the “White formula”. as there may be more than one estimator of the variance of the estimator. and V is an estimator of the variance of n β − β .. these all mean the same thing. β j . as it is not always clear which has been computed. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. The estimator of V is then ˆ ˆ ˆ ˆˆ V = Q−1 ΩQ−1 This estimator was introduced to the econometrics literature by White (1980).Figure 6. vis. 1. ˆ The estimator V 0 was the dominate covariance estimator used before 1980.3: Sampling distribution where ei are the OLS residuals. The methods switched during ˆ the late 1980s and early 1990s. Generically. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . When β is a vector. or that they use a “heteroskedasticity-robust covariance matrix estimator”. In most cases.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. This motivates the deﬁnition of a standard error. j = 0. the “Eicker-White formula”. the “Huber formula”. ˆ ˆ Deﬁnition 6. ˆ ˆ When V is used rather than the traditional choice V 0 . many authors will state that their “standard errors have been corrected for heteroskedasticity”. we set s(β) = n−1/2 V . It is therefore important to understand what formula and method is 51 . and was still the standard choice for much empirical work done in the early 1980s. we focus on individual elements of β one-at-a-time.. the “Huber-White formula” or the “GMM covariance matrix”. k. When reading and reporting applied work. . so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator.4.

(. Ω 2. (6.30 + 0. and then the square roots.80 .35/988 = .480 . i i i i n i=1 Second.80 2.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.83 −0.14 6. by Holder’s inequality (5.83 ¶−1 = µ 7.020. just as any other estimator. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. We calculate that s2 = 0.085 p ˆ and that for β 1 is .6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.2.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . It is also important to understand that a particular standard error may be relevant under one set of model assumptions. To illustrate.14 14.98 −0. we return to the log wage regression of Section 4. but not under another set of assumptions.2/988 = . then take the diagonal elements.20 = V 14.used by an author when studying their work.14 14.14 205.83 ¶−1 µ . p ˆ In this case the two estimates are quite similar. from which it follows that V →p V as n → ∞. From a computational standpoint.80 40.12) in turn. First.199 2. (6.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. Using (6.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .039 and ˆ V = µ 1 14.6 ¶µ 1 14.199 2.020) 6.493 −0.085) (.20 and µ ¶ ˆ = 0.117 Educationi .480 ˆ0 = 0. n n i=1 52 . The standard errors for β 0 are 7.20 −0.035 ¶ .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 .5) and the WLLN (Theorem 5.80 40.493 0.14 205.14 205.1.

n i=1 n ˆ ˆ Theorem 6.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.25). ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .13) Using formula (4.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.1 As n → ∞.26). They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. which.13) of Efron (1982). i=1 Third. these establish consistency. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.−i = (1 − hi )−1 ei ˆ presented in (4. Using this substitution. Recall from Section 4. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. ¯ 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. 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. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. From equation (3. Andrews (1991) suggested an similar estimator based on cross-validation.11) with the leave-one-out estimator ei.5. 6. Ω →p Ω and V →p V. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6. ¯ ¯n ¯ n i=1 so Together. you can show that 1 Xˆ ¯ β= β (−i) .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 .

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

1) →d ˆ−θ θ . see Section X). In special cases (such as the normal regression model. 55 . if R is a “selector matrix” R= so that if β = (β 1 . θ could be a single element of β). Since the standard normal distribution does not depend on the parameters.8. θ) β 6. the standard error for ˆ is the square root of n−1 Vθ . In this case. and θ = h(β) is some function of the parameter vector. µ I 0 ¶ ˆ the upper-left block of V . we say that tn is an exactly pivotal statistic. that (so θ ˆ ˆ ˆ is. we say that tn (θ) is asymptotically pivotal. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . s(ˆ = n−1/2 H 0 V Hβ . and is therefore exactly free of unknowns.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. Vθ ) √ Vθ = N (0. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. Consider the studentized statistic tn (θ) = Theorem 6. (For example. 1) Proof. the statistic tn has an exact t distribution.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0.1 tn (θ) →d N (0. By (6. β 2 ). s(ˆ θ) (6.For example. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. however. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. ˆ When q = 1q h(β) is real-valued). In general.

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

17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. and it is desired to test the joint restrictions simultaneously. 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). and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. or α = . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. 6. = n h(β) − θ0 Hβ V Hβ 57 (6. 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. ˆ + zα/2 s(ˆ . In this case the t-statistic approach does not work. 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 t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. the most common professional choice isi95%. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. θ θ) (6.05.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. θ The interval has been constructed so that as n → ∞.96s(ˆ ≈ ˆ ± 2s(ˆ . This corresponds to selecting the conﬁdence h i h ˆ ± 1. 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 typically cannot calculate the exact coverage probability P (θ ∈ Cn ).18) . However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).

then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.05) = 3. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . The asymptotic p-value for Wn is pn = p(Wn ). then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. q and pn is asymptotically U[0.025 . Hβ (β) →p Hβ .8.1 Under H0 and Assumption 6.84 = z.When h is a linear function of β. then Wn →d χ2 .1 showed θ ˆ that V →p V. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. 1] under H0 .1.11 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 .19) σ2 ˆ where σ2 = ˜ 1 0 e e. a chiq square random variable with q degrees of freedom. θ = β 2 . In this case. Furthermore. Vθ ). As before.5. χ2 (. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .2. Hence β β by Theorem A. and Theorem 6. Also h(β) = a selector matrix. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Hβ (β) is a continuous function of β. and there are q = k2 restrictions. ˆ Wn = n θ θ q θ θ Theorem 6. ˜˜ n ˜ e = Y − X1 β 1 .15) showed that n ˆ − θ →d Z ∼ N (0. the test rejects at the α% level iﬀ pn < α. 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. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . 6.3.10. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). the upper-α quantile q 2 of the χ2 distribution. h(β) = R0 β. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. The null hypothesis is H0 : β 2 = 0. 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. For example. if rank(Hβ ) = q.

Now consider the residual regression of e on X2 = M1 X2 . = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.19) the F form of the Wald statistic.are from OLS of Y on X1 . Also.19). since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. note that partitioned matrix inversion (2. 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 . The elegant feature about (6. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . as the sum of squared errors is a typical output from statistical packages. ˆˆ n ˆ e = Y − X β. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . By the FWL theorem. the residual is ˜ ˜ e = M1 Y. First. 2 σ ˆ To simplify this expression further. and σ2 = ˆ 1 0 e e. 59 . X2 ). 2 2 2 or alternatively. still this formula often ﬁnds good use in reading applied papers. Thus ˜ ˆ e=X ˜ ˆ 2 ³ ´0 ³ ´ ˜ ˆ ˜ ˆ e0 e = X2 β 2 + e ˜˜ ˆ ˆ X2 β 2 + e ˆ0 ˜ 0 ˜ ˆ = β 2 X2 X2 β 2 + e0 e ˆˆ 0 0 ˆ ˆ ˆˆ = β X M1 X2 β + e0 e. Because of this connection we call (6.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. note that if we regress Y on X1 alone.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 (6.19) is that it is directly computable from the standard output from two simple OLS regressions.

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

3. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . a good testing procedure is based on the likelihood ratio statistic.12. 0. β 2 . Theorem 6. β and t are approximately normally distributed. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. β has an exact normal distribution and t has an exact t distribution.1 and Theorem 6. In contrast. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . if standard errors are calculated using the homoskedastic formula (6. σ 2 ) = − log σ − log (2π) − . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .10) µ h i ¶ 2 (X 0 X)−1 N 0.8. σ ˆ ˆ βj − βj βj − βj N (0. so as a practical matter it does not matter which distribution is used. the notable distinction is between the N (0.12. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. σ 2 ) discussed above. 0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .1 If ei is independent of xi and distributed N(0. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .) Now let us partition β = (β 1 . σ 2 ). 0. (Unless the sample size is unreasonably small.1 we showed that in large samples. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . As inference (conﬁdence intervals) are based on the t-ratio.a chi-square distribution with n − k degrees of freedom. β 2 . σ 2 ) − Ln (β 1 . with residual variance σ . 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom.1 shows that under the strong assumption of ˆ normality. The critical values are quite close if n − k ≥ 30. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .10) then ´ ³ ˆ • β ∼ N 0. We summarize these ﬁndings Theorem 6. and standard errors are calculated using the homoskedastic formula (6. β 2 . n−k • ∼ tn−k ˆ In Theorem 6. 1) and tn−k distributions. σ2 ˆ 61 . Furthermore.

and noting Hβ = sβ s−1 . This can be seen by a simple example introduced by Lafontaine and White (1986). Through repetition. The increasing solid line is for the case β = 0. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . the statistic Wn (s) varies with s.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . while there are other values of s for which test test statistic is insigniﬁcant. ˆ Let β and σ 2 be the sample mean and variance of yi .4 the Wald statistic Wn (s) as a function ˆ of s.84 — the probability of a false rejection.7. To demonstrate this eﬀect. features of this distribution can be calculated. Our ﬁrst-order asymptotic theory is not useful to help pick s.8. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. as Wn (s) →d χ2 under H0 for 1 any s. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. This produces random draws from the sampling distribution of interest. In the present context of the Wald statistic. Take the model yi = β + ei ei ∼ N (0. 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. This is an unfortunate feature of the Wald statistic. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. 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. σ 2 ) and consider the hypothesis H0 : β = 1. 6. The decreasing dashed ˆ = 1. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. we have plotted in Figure 6. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . 62 . setting n/σ 2 = 10. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. Letting h(β) = β s . they can work quite poorly when the restrictions are nonlinear.

1 reports the simulation estimate of the Type I error probability from 50. this probability depends only on s.000 simulated Wald statistics Wn (s) which are larger than 3. Given the simplicity of the model. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. In each case. Type I error rates between 3% and 8% are considered reasonable.Figure 6. the Type I error probability improves towards 5% as the sample size n increases. These probabilities are calculated as the percentage of the 50. Error rates avove 10% are considered excessive. Typically. 100 and 500. The null hypothesis β s = 1 is true. When comparing statistical procedures.05) with deviations indicating+ distortion. no magic choice of n for which all tests perform uniformly well. looking for tests for which rate rejection rates are close to 5%. n is varied among 20. Any other choice of s leads to a test with unacceptable Type I error probabilities. so these probabilities are Type I error. There is. however. To interpret the table.4. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.000 random samples. we compare the rates row by row. In Table 4.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .84 | β = 1) . Table 4. The value of s is varied from 1 to 10. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Table 4. n. the only test which meets this criterion is the conventional Wn = Wn (1) test.1 you can also see the impact of variation in sample size. and σ 2 . and rarely fall outside of the 3%-8% range. For this particular example. In Table 2.84.1 we report the results of a Monte Carlo simulation where we vary these three parameters. and σ is varied among 1 and 3.4: Wald Statistic as a function of s P (Wn (s) > 3. remember that the ideal Type I error probability is 5% (. Rates above 20% are unexceptable. Test performance deteriorates as s increases.

08 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .21 .23 .30 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.34 .09 .14 .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 .06 .13 . deﬁne θ = β 1 /β 2 .15 .06 .07 .14 . This point can be illustrated through another example.26 .06 .18 . 64 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .12 .35 .13 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.15 .15 .22 .08 .24 .06 .08 .07 .06 .05 .19 .20 .20).25 .10 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .05 .10 .07 .17 .11 .05 .15 . β 1 .06 .07 .05 .06 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.13 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . β 2 ) be the least-squares estimates of (6.08 .20 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.05 .28 .22 .06 .31 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. so the hypothesis can be stated as H0 : θ = r.05 .25 .33 .08 . Equivalently.07 .16 Rejection frequencies from 50.10 .12 . Other choices are arbitrary and would not be used in practice. While this is clear in this particular example.

06 .2.05 .15 . this formulation should be used. Ideally. We let x1i and x2i be mutually independent N (0. 6.05 .05 β2 .05 . 65 .06 .06 . ei be an independent N (0.14 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.75. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . . and 1.0 and n among 100 and 500. Table 4. along with sample size n.05 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.15 .05 . The results are presented in Table 4.00 . the rejection rates for the t1n statistic diverge greatly from this value. The left tail probabilities P (t1n < −1.75 1.07 .06 . We vary β 2 among . if the hypothesis can be expressed as a linear restriction on the model parameters. This leaves β 2 as a free parameter.00 .645) P (tn < −1.645) P (tn > 1.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.06 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.645) are close to zero in most cases. 1) variables.05 .7.00 .06 .05 .05 .10 .00 .06 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .25. the entries in the table should be 0.645) P (tn > 1.00 .26 . .02 .645) are calculated from 50.645) t1n t2n t1n t2n t1n t2n t1n t2n . In this section we describe the method in more detail.00 The one-sided Type I error probabilities P (tn < −1. σ 2 ) draw with σ = 3. In contrast.06 .645) and P (tn > 1.645) greatly exceed 5%.00 . .47 . such as the GMM distance statistic which will be presented in Section 9.00 . It is also prudent to consider alternative tests to the Wald statistic.000 simulated samples.10 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .00 .06 .05. If no linear formulation is feasible.28 . while the right tail probabilities P (t1n > 1.00 . and are close to the ideal 5% rate for both sample sizes. then the “most linear” formulation should be selected. However.25 .50.06 . and normalize β 0 = 0 and β 1 = 1.05 .09 .12 . In all cases. and alternatives to asymptotic critical values should be considered. The implication of Table 4. especially for small values of β 2 .50 .10 .1.

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

and 90% sample quantiles of the sample {Tnb }. and our regressors include years of education. Hence the ³ ´ ˆ standard errors for B = 100. excluding military. We separately estimate equations for white and non-whites. and hispanic.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. 1000.007. B b=1 (6. union member. . The α% sample quantile is a number qα such that α% of the sample are less than qα .Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. if we set B = 999. we included a dummy 67 .05) (. for a selection of choices of n and F. this may ˆ be approximated by replacing P with P or with an hypothesized value. immigrant. B. it is simple to make inferences about rejection probabilities from statistical tests. where N = (B +1)α. It is therefore convenient to pick B so that N is an integer. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. For regressors we include years of education. s P = . experience squared. immigrant. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. and estimate a multivariate regression. potential work experience. an estimator or test may perform wonderfully for some values. Often this is called the number of replications. union member. respectively. and . Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. In practice. experience squared. hispanic. 6. then B will have to be increased. therefore. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. For example.15 Estimating a Wage Equation We again return to our wage equation. If the standard error is too large to make a reliable inference. and poorly for others. Again our dependent variable is the natural log of wages. Then qα is the N ’th number in this ordered sequence. We us the sample of wage earners from the March 2004 Current Population Survey. In particular.96) . The random variable 1 (Tnb ≥ 1. the choice of B is often guided by the computational demands of the statistical procedure. female. It is therefore useful to conduct a variety of experiments. Generally. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. so that coeﬃcients may be interpreted as semi-elasticities. and non-white. and 5000. Quite simply. a larger B results in more precise estimates of the features of interest of Gn . In many cases. We now expand the sample all non-military wage earners.022.003.96) is iid Bernoulli. Furthermore.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. The average (6. As discussed above. and therefore it is straightforward to calculate standard errors for any quantity of interest. the performance will depend on n and F. For example.95) /B ' . but requires more computational time. the researcher must select the number of experiments. equalling 1 with probability P = E1 (Tnb ≥ 1.21). As P is unknown. and dummy variable indicators for the following: married. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high.96) . such as the percentage estimate reported in (6.22/ B. then we can set s P = (. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. For the dependent variable we use the natural log of wages. are. and dummy variable indicators for the following: married. female. potential work experience.

1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. Ignoring the other coeﬃcients.4945.027 .101 .00002 .010 .18) that the state coeﬃcients are jointly zero.48772 = 515.808 so the parameter estimates are quite precise and reported in Table 4.232 . Computing the Wald statistic (6. but not equal. θ ˆ 2β 3 β2 .007 .070 . Wn = n 1 − 2 = 18.121 −.002 .4877 18.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. The F form of the Wald statistic (6. this adds 50 regressors).032 .102 −.097 −.49452 σ ˜ Notice that the two statistics are close.19) is ˜ µ ¶ µ ¶ σ2 ˆ .00057 .808 . as the 1% critical value for the χ2 distribution is 76. Using either statistic the hypothesis is easily rejected.1. Alternatively.033 −. 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. the restricted standard deviation estimate is σ = . we ﬁnd Wn = 550.001 .014 . reestimating the model with the 50 state dummies excluded.69. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.102 −. Table 4. The available sample is 18.34 ˆ s(β) .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.variable for state of residence (including the District of Columbia. 808 1 − .013 . 2β 3 68 . excluding the coeﬃcients on the state dummy variables.008 .

In the previous section we discovered that such t-tests had very poor Type I error rates. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ). 29. Since tn (θ) is a non-linear function of θ. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. This set is [27.5]. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. but the lower end is substantially lower. 29. However.5]. this is a poor choice. we can calculate a standard error of s(ˆ = .0. so we have to go one step further.96. we found better Type I error rates by reformulating the hypothesis as a linear restriction. implying a 95% conﬁdence θ) interval of [27. 69 . there is not a simple expression for this set. In the present context we are interested in forming a conﬁdence interval. but it can be found numerically quite easily. Notice that the upper end of the conﬁdence interval is the same as that from the delta method.Using the Delta Method.9. Instead. not testing a hypothesis. This is the set of θ such that |tn (θ)| ≤ 1.40.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

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. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. Then set ˜i ˜ D = diag{˜ 2 . then the FGLS estimator will force ˜i the regression equation through the point (yi .5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. then the FGLS ˜i estimator is not well deﬁned. or FGLS. estimator of β. and will depend on the model (and estimation method) for the skedastic regression.3) ˆ ˆ While ei is not observed. xi ). as it is estimating the conditional variance of the regression of yi on xi . we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. If σ 2 < 0 for some i. which is typically undesirable.. if σ 2 ≈ 0 for some i. there is no guarantee that σ 2 > 0 for all i. Vα = E zi zi (7.Suppose ei (and thus η i ) were observed.6) σ 2 = α0 zi . and hence we can estimate 0 σ 2 = zi α by i ˜ (7. . This is the feasible GLS. 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 . We have shown that α is consistently estimated by a simple procedure. This suggests 75 . We may call (7.. Vα ) (7.. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . Furthermore. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. ˜i Suppose that σ 2 > 0 for all i.4) the skedastic regression.

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

3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. If i this simpliﬁcation is replaced by the standard formula (under independence of the error).5) and the asymptotic variance (7. and this requires trimming to solve. The asymptotic distribution (7. and all cross-products. individual estimated conditional variances may be negative. the estimated conditional variances may contain more noise than information about the true conditional variances. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . This introduces an element of arbitrariness which is unsettling to empirical researchers. Typically. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.4) and constructing a Wald statistic. as they will be estimating two diﬀerent projections. the two tests coincide.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . however. FGLS will do worse than OLS in practice. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. require the assumption of a correct conditional mean. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. and the cost is a reduction of robustness to misspeciﬁcatio 7. If the equation of interest is a linear projection. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . Vα = E zi zi (7.error. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. 7. or equivalently that i H0 : α1 = 0 in the regression (7.4). q Most tests for heteroskedasticity take this basic form. In the linear regression model the conditional mean of yi given xi = x is 77 . its squares. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. on the other hand.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . We may therefore test this hypothesis by the estimation (7. the Wald test of H0 is asymptotically χ2 . Theorem 7. Second. The main diﬀerences between popular “tests” is which transformations of xi enter zi . Third. OLS is a more robust estimator of the parameter vector. The GLS and FGLS estimators. and not a conditional mean. but the only diﬀerence is that they a ¢ allowed for general choice of zi .7) under independence show that this test has an asymptotic chi-square distribution. In this case. It is consistent not only in the regression model.2). σ 2 ). This hypothesis does not imply that ξ i is independent of xi .7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7.2. but also under the assumptions of linear projection.1 Under H0 and ei independent of xi .

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

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

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 . the parameter estimates are not asymptotically normally distributed.For θ close to the true value θ0 . θ) ' (ei + m(xi . This means that under H0 . θ) = β 0 zi + β 0 xi (γ). γ is not identiﬁed. θ) ' m(xi .5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi . tests of H0 do not have asymptotic normal or chi-square distributions. Hansen (1996).4. Thus when the truth is that β 2 = 0. under H0 . In particular. An alternative good measure is the conditional median. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. θ0 ) + m0 (θ − θ0 ) . 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 . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . ˆ ˆ θ) ˆ θ). the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. m(xi . Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . 80 . θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. Suppose that m(xi . and this is often a useful hypothesis (sub-model) to consider. θ which is that stated in the theorem. We have discussed projections and conditional means. Identiﬁcation is often tricky in nonlinear regression models. 7.1. Thus we want to test H0 : β 2 = 0. This renders the distribution theory presented in the previous section invalid. ¥ Based on Theorem 7. Furthermore. by a ﬁrst-order Taylor series approximation. However. 1 2 The model is linear when β 2 = 0. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θi Thus ¡ ¢ yi − m(xi . but these are not the only measures of central tendency. ˆ and ei = yi − m(xi . θ0 )) − m(xi .

as i=1 these estimators are indeed identical. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x.10) The LAD estimator has the asymptotic distribution 81 . the linear function M ed (yi | xi = x) = x0 β is the conditional median function. Two useful facts about the median are that (7. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. i n n i=1 (7. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. These distinctions are illusory. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently.9) θ0 = argmin E |Y − θ| θ and E sgn (Y − θ0 ) = 0 where sgn (u) = ½ 1 −1 if u ≥ 0 if u < 0 is the sign function. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations.To recall the deﬁnition and properties of the median.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. let Y be a continuous random variable. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0.5. The second is the value which minimizes n n |yi − θ| . and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . however. Now let’s consider the conditional median of Y given a random variable X. These facts deﬁnitions motivate three estimators of θ. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . and the substantive assumption is that the median function is linear in x. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = .

1 ´ √ ³ˆ n β − β 0 →d N (0. While a complete proof of Theorem 7. The main diﬃculty is the estimation of f (0). Computation of standard error for LAD estimates typically is based on equation (7. ∂ 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 ) .11). then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. First. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . In the special case where the error is independent of xi . where V = and f (e | x) is the conditional density of ei given xi = x.5.1 is advanced. Pn −1 0 β)) . V ). the height of the error density at its median. ¢¢−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 the central limit theorem (Theorm 5.5. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . ∂β 0 so Third. then there are many innovations near to the median. (7.Theorem 7. ˆ Proof of Theorem 7. See Chapter 16. we provide a sketch here for completeness. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.10) is equivalent to g n (β) = 0. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. This can be done with kernel estimation techniques.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. Let g(β) = Eg (β).11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .5.3. When f (0 | x) is large. and this improves estimation of the median. the conditional density of the error at its median.

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

and test their signiﬁcance using a Wald test.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. n numerical methods are necessary for its minimization. where and f (e | x) is the conditional density of ei given xi = x.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . and form a Wald statistic i for γ = 0. and are widely available. fast linear programming methods have been developed for this problem. Another popular approach is the RESET test proposed by Ramsey (1969). One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Vτ ). the asymptotic variance depends on the conditional density of the quantile regression error. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). then f (0 | xi ) = f (0) . Fortunately. since it has discontinuous derivatives. When the error ei is independent of xi . if the model yi = x0 β + ei has i been ﬁt by OLS. 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. let zi = h(xi ) denote functions of xi which are not linear functions of xi (perhaps 0˜ ˜ ˜ squares of non-binary regressors) and then ﬁt yi = x0 β +zi γ + ei by OLS.5.6. The null model is yi = x0 β + εi i 84 . Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.13). it is useful to have a general test of the adequacy of the speciﬁcation.1. conventional Newton-type optimization methods are inappropriate. the τ ’th conditional quantile of ei is zero. 7. the unconditional density of ei at 0.12). ¡ ¡ ¢¢−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. i By construction. ´ √ ³ˆ Theorem 7. Furthermore. otherwise its properties are unspeciﬁed without further restrictions. ˆ Given the representation (7. Thus.1 n β τ − β τ →d N (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. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . yielding predicted values yi = x0 β. β 2 ). lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. and the two estimators have equal asymptotic eﬃciency. β 1 = (X1 X1 )−1 (X1 Y ) . then 22 Q11 > Q11 − Q12 Q−1 Q21 . It is easy (although somewhat tedious) to show that under the null hypothesis. yi ˆm (7.be an (m − 1)-vector of powers of yi . 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 . Thus the null is rejected at the α% level if Wn m−1 exceeds the upper α% tail critical value of the χ2 m−1 distribution. However. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. and n→∞ say. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. Otherwise.14) by OLS. since Q12 Q−1 Q21 > 0.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. 1i 2i 2i 1i 22 . One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. note that (7. yielding ˆ ˜ ˆ ˆ (β 1 . and form the Wald statistic Wn for γ = 0. Typically. 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. small values such as m = 2. and consequently 22 ¡ ¢−1 2 σ . To see why this is the case. ⎠ . The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . Another is to regress yi on x1i and x2i jointly. To implement the test. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . or 4 seem to work best. Wn →d χ2 . they will (typically) have diﬀerence asymptotic variances. 3. ⎟ zi = ⎝ . m must be selected in advance.

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

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

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

. For any predictor g(xi ) for y. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. 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.10 Exercises 1. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 .. 4. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. the residuals e. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . σ 2 ). In a linear model Y = Xβ + e. Verify equation (7. Let θ satisfy Eg(Yi − θ) = 0. ˆ ˆ n−k 6. ˜ the residual vector is e = Y − X β. E(e | X) = 0. Show that the function g(x) which minimizes the MAE is the conditional median M (x). x. else equals zero). (b) Prove that e = M1 e. Thus the available information is the sample (Y. (b) Find an estimate of the variance of this forecast.. Let (yi . V ar(e | X) = σ 2 Ω with Ω known. V .12). In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . the estimates (β. Let σ 2 be the estimate of σ 2 . based on a sample of size n. xi ) be a random sample with E(Y | X) = Xβ. 2. X). and the out-of-sample value of the regressors. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition.7. the mean absolute error (MAE) is E |yi − g(xi )| . wn ) and wi = x−2 . 5. Is θ a quantile of the distribution of Yi ? 3. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y .. ˆ (a) Find a point forecast of y. where M1 = I − X X 0 Ω−1 X ˆ ¡ 0 −1 ¢−1 0 −1 0 (c) Prove that M1 Ω−1 M1 = Ω−1 − Ω−1 X X Ω X XΩ .

and ﬁnd the value of a7 for which the sum of squared errors is minimized. a7 ). (ii) AIC criterion. and the model imposes a smooth transition between these regimes.18) (a) Following Nerlove. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. the regression slope is a2 + a6 . The model works best when a7 is selected so that several values (in this example. For values of ln Qi much below a7 . Do so. The equation you estimated was ln T Ci = β 1 + β 2 ln Qi + β 3 ln P Li + β 4 ln P Ki + β 5 ln P Fi + ei . . (iii) BIC criterion. Exercise 13. In Chapter 6. This model is called a smooth threshold model. you estimated a cost function on a cross-section of electric companies. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . the variable ln Qi has a regression slope of a2 . The model is non-linear because of the parameter a7 . 90 . are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9.18) plus the extra term a6 zi . (d) Calculate standard errors for all the parameters (a1 . Consider model (7. θ) + ei with E (ei | xi ) = 0. at least 10 to 15) of ln Qi are both below and above a7 .. Find an asymptotic 95% conﬁdence interval for g(x). Record the sum of squared errors. calculate zi and estimate the model by OLS... n xi i=1 (a) Under the stated assumptions. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . and V is the = g(x estimate of V ar ˆ . In addition. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. For each value of a7 . Suppose that yi ³ ´ i . Examine the data and pick an appropriate range for a7 . Assess the merits of this new speciﬁcation using (i) a hypothesis test. θ is the NLLS estimator. impose the restriction a3 + a4 + a5 = 1.ˆ ˆ 7. For values much above a7 . 8. (7. (c) Estimate the model by non-linear least squares. add the variable (ln Qi )2 to the regression.

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

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

x) − F (y. x) = P (yi ≤ y.2) Fn (y. x) = n i=1 Figure 8.. by the CLT (Theorem 5. as the sample size gets larger. x). Recall that F (y. That is.2 The Empirical Distribution Function Fn (y. 50. .3. √ n (Fn (y. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. Fn is a nonparametric estimate of F. Note that while F may be either discrete or continuous. To see the eﬀect of sample size on the EDF. where 1(·) is the indicator function. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . Fn is by construction a step function. (8. Thus by the WLLN (Theorem 5. For n = 25. This is a population moment. Furthermore. in the Figure below. x) →p F (y. the EDF step function gets uniformly close to the true CDF. To see this.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x) is called the empirical distribution function (EDF). x). The random draws are from the N (0. x))) . The EDF is a consistent estimator of the CDF. it is helpful to think of a random pair (yi .. and 100. x∗ ≤ x) = Fn (y. In general. x)) →d N (0. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . n. I have plotted the EDF and true CDF for three random samples of size n = 25. x). 1) distribution..2. F (y. x∗ ) with the i distribution Fn .1). Notationally. x) . x) (1 − F (y. the EDF is only a crude approximation to the CDF. i 93 . Fn (y. ∗ P (yi ≤ y. i = 1.8. xi ). note that for any (y.1). but the approximation appears to improve for the large n.

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

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

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

Thus c = qn (α). 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. where c would be selected so that θ θ) P (Tn (θ0 ) < c) = α. but is not widely used in practice. the bootstrap test rejects if Tn (θ0 ) > qn (1 − α). θ sample.0 and this idealized conﬁdence interval is accurate. 8.025)].025) and q ∗ (. by the translation invariance argument presented above. Therefore. θ Let Tn (θ) = ˆ − θ. Note. it also follows that if there exists some monotonic transformation f (·) such that f (ˆ is symmetrically distributed about f (θ0 ). that the bootstrap test θ θ θ ∗ statistic is centered at the estimate ˆ and the standard error s(ˆ ) is calculated on the bootstrap θ. n Computationally.975). and the test rejects if Tn (θ0 ) < qn (α).6 Percentile-t Equal-Tailed Interval Suppose we want to test H0 : θ = θ0 against H1 : θ < θ0 at size α. θ. and this is important. The problems with the percentile method can be circumvented by an alternative method. Based on these arguments. 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) . many argue that the percentile interval should not be used unless the sampling distribution is close to unbiased and symmetric. θ However. θ This motivates a bootstrap analog ∗ θ C2 = [ˆ − qn (1 − α/2). We would set Tn (θ) = ´ ³ ˆ − θ /s(ˆ and reject H0 in favor of H1 if Tn (θ0 ) < c. these critical values can be estimated from a bootstrap simulation by sorting ³ ∗ ´ ∗ ∗ the bootstrap t-statistics Tn = ˆ − ˆ /s(ˆ ). ∗ Similarly. θ When ˆ does not have a symmetric distribution. this³interval can be estimated from a bootstrap simulation by sorting the ´ ∗ ∗ bootstrap statistics Tn = ˆ − ˆ . a bootstrap test replaces qn (α) with the bootstrap estimate ∗ ∗ qn (α). The 95% conﬁdence interval is then [θ − ˆ to yield the quantile estimates qn ˆ ˆn ∗ (. θ ˆn qn ˆ This conﬁdence interval is discussed in most theoretical treatments of the bootstrap. Computationally. if the alternative is H1 : θ > θ0 . C1 and C1 are designed for the case that ˆ has a symmetric distribution about θ0 . ∗ (. which are centered at the sample estimate ˆ These are sorted θ θ θ. θ ˆ − qn (α/2)]. These t-statistics are sorted to ﬁnd the estimated quantiles qn (α) and/or qn (1 − α). ˆ − q ∗ (.975). ˆ − q ∗ (α/2)]. C1 may perform quite poorly. ˆ∗ ˆ∗ 97 . Then so an exact (1 − α)% conﬁdence interval for θ0 would be 0 C2 = [ˆ − qn (1 − α/2). Since this is unknown. θ) then the idealized percentile bootstrap method will be accurate.

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

The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).3 an = o(n−r ) if nr |an | → 0 as n → ∞. Let an be a sequence. We say that a function g(x) is even if g(−x) = g(x).] 8. the critical value qn (α) is found as the quantile from simulated values of W´ . Let Tn be a statistic such that (8. 99 . writing Tn ∼ Gn (x. v 2 ). Deﬁnition 8. The ideal test rejects if Wn ≥ qn (α). where qn (α) is the (1 − α)% quantile of the distribution of Wn . an = O(n−r ) if it declines to zero like n−r . Deﬁnition 8.8. about the rate v of convergence. and vice-versa.2 an = O(1) if |an | is uniformly bounded. 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. 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.4) v ¡ ¢ While (8. F ) = Φ n→∞ v or ³x´ Gn (x.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. A better asymptotic approximation may be obtained through an asymptotic expansion. however. The derivative of an even function is odd. it says nothing.8. The following notation will be helpful. θ θ θ ˆ θ ∗ ∗ Computationally. Equivalently. (8. not ˆ − θ0 . Thus here Tn (θ) = Wn (θ). Basically.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.4) says that Gn converges to Φ x as n → ∞. F ) then ³x´ . If θ is a vector. and a function h(x) is odd if h(−x) = −h(x). lim Gn (x. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. C4 is called the symmetric percentile-t interval.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. θ [This is a typical mistake made by practitioners. F ) = Φ + o (1) . n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .8.8 Asymptotic Expansions Tn →d N (0. or the size of the divergence for any particular sample size n.

Moreover.8. 100 . Fn ) − g1 (x. The diﬀerence is Φ(x) − Gn (x. F ) ≈ Φ + n−1/2 g1 (x. and g2 is an odd function of x. ³x´ 1 1 + 1/2 g1 (x. F ) converges to the normal limit at rate n1/2 .1 as follows. Fn ) − g1 (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. To a third order of approximation. F ) + O(n−3/2 ) Gn (x. Fn ) + O(n−1 ). the density function is skewed. which from Theorem 8. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). F0 ) = 1 g (x. so the order of the error is O(n−1/2 ). g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. Theorem 8. A bootstrap test is based on G∗ (x). F ) + n−1 g2 (x. g1 (x. 1/2 1 n Because Φ(x) appears in both expansions. To the second order.8. F ) ≈ Φ + n−1/2 g1 (x. We can interpret Theorem 8. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). An asymptotic test is based on Φ(x). √ Since Fn converges to F at rate n.9 One-Sided Tests Using the expansion of Theorem 8. Gn (x. and g1 is continuous with respect to F.1. F0 ) = Φ(x) + since v = 1.3). F ) + g2 (x.8. where g1 is an even function of x. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . F0 ) + O(n−1 ) 1/2 1 n 1 g (x. Fn ) − g1 (x. the exact distribution is P (Tn < x) = Gn (x. F0 )) converges to 0 at rate n.1 has the expansion n G∗ (x) = Gn (x. F ). F0 ) = n 1 n1/2 (g1 (x. First.uniformly over x. Fn ) = Φ(x) + n 1 g (x. ³x´ Gn (x. v Since the derivative of g1 is odd.8. F0 ) ≈ ∂ g1 (x.1 Under regularity conditions and (8. ³x´ Gn (x. the diﬀerence √ (g1 (x. F ) = Φ v n n 8. F ) v which adds a symmetric non-normal component to the approximate density (for example. Heuristically. adding leptokurtosis). To a second order of approximation. F0 )) + O(n−1 ).

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

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

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

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

Using the non-parametric bootstrap.95) denote the 95% quantile of Tn .95).pdf. and the 2.dat contains data on house prices (sales). 105 . (b) Report the 95% Alternative Percentile interval for θ. lot size. Let qn (.5% quantiles of the ˆ are . (c) With the given information.2 and s(ˆ = . and ˆ is calculated on each θ ∗ ∗ θ sample. The ˆ are sorted. ∗ ∗ where s(ˆ is the standard error in the original data. θ respectively. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. ˆ = 1. You replace c with qn (. Using the non-parametric ∗ bootstrap.3.05) . You want to test H0 : θ = 0 against H1 : θ > 0.05) and qn (. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. size of house. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. ∗ ∗ ∗ Let qn (. can you report the 95% Percentile-t interval for θ? 7.95) denote the 5% θ) ∗ and 95% quantiles of Tn .75 and 1. The dataﬁle hprice1. and thus reject H0 if ˆ ˆ > q ∗ (. and the colonial dummy.2. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. Suppose that in an application. with variables listed in the ﬁle hprice1. you generate bootstrap samples. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. (a) Report the 95% Efron Percentile interval for θ. Estimate a linear regression of price on the number of bedrooms. What is wrong with this procedure? Tn = θ/s(θ) n 6. You do this as follows.5% and 97.95). calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).95).Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). ˆ − s(ˆ n (.

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

9. i i . ¡ ¢−1 0 ˆ Z XWn X 0 Y. let Jn (β) = n · g n (β)0 Wn g n (β).3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. and the GMM estimator is the MME. ˆ Deﬁnition 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 . gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. but this is generally not possible when > k.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .1 β GMM = argmin Jn (β).2) g n (β) = (9. Let and where gi = xi ei . the dependence is only up to scale. then. the square of the Euclidean length. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . β GMM does not change.2. The GMM estimator minimizes Jn (β). if Wn = I. For some × weight matrix Wn > 0. This is a non-negative measure of the “length” of the vector g n (β). β ˆ Note that if k = . then g n (β) = 0.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.2. for if Wn is replaced ˆ by cWn for some c > 0. 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 example. β GMM = Z 0 XWn X 0 Z 9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . Proposition 9.

1 ´ √ ³ˆ n β − β →d N (0. In the linear model. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. Ω) .3.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator.3. This turns out to be W0 = Ω−1 . β). However. n β − β →d N 0. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. ˆ we still call β the eﬃcient GMM estimator. n n We conclude: Theorem 9. This results shows that in the linear model. but it can be estimated consistently.2 For the eﬃcient GMM estimator. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. where In general. If it is known that E (gi (β)) = 0. ˆ∗ ˆ 108 . This is a weak concept of optimality. ˆ Construct n 1X ˆ g n = g n (β) = gi . β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . we can set Wn = I . and this is all that is known. as it has the same asymptotic distribution. 9. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . The optimal weight matrix W0 is one which minimizes V. 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. The proof is left as an exercise. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. Chamberlain showed that in this context.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. without imposing additional assumptions. For any Wn →p W0 . W0 = Ω−1 is not known in practice. V ) . ˆ n i=1 gi = gi − g n . as the distribution of the data is unknown. this is a semi-parametric problem. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. as shown by Gary Chamberlain (1987). a better choice is Wn = (X 0 X)−1 . it turns out that the GMM estimator is semiparametrically eﬃcient. it is semiparametrically eﬃcient. No estimator can do better (in this ﬁrst-order asymptotic sense). as we are only considering alternative weight matrices Wn . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . For example. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. the GMM estimator β is consistent yet ineﬃcient.

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

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

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

and restrictive. ei (β) = yi − x0 β. β)ei (β) which satisﬁes Egi (β) = 0 and hence deﬁnes a GMM estimator. the model implies more than an unconditional moment restriction of the form Egi (β) = 0. Given a conditional moment restriction. In practice. If xi is a valid instrument satisfying E (ei | xi ) = 0. Setting gi (β) to be this choice (which is k × 1. Another approach is to construct the optimal instrument. ei (β. It is also helpful to realize that conventional regression models also fall into this class. Which should be used? i i One solution is to construct an inﬁnite list of potent instruments. A recent study of this problem is Donald and Newey (2001). etc. i Ai = −σ −2 Ri i . The obvious problem is that the class of functions φ is inﬁnite. β). s = 1. γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2. in linear regression. β).. note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi . Then ei (β) = yi − zi β. 0 In the linear model ei (β) = yi − zi β. Which should be selected? This is equivalent to the problem of selection of the best instruments. but its form does help us think about construction of optimal instruments. It turns out that this conditional moment restriction is much more powerful.. an unconditional moment restriction can always be constructed.. then xi . x3 . For example. 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. Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β). How is k to be determined? This is an area of theory still under development. and then use the ﬁrst k instruments. The form was uncovered by Chamberlain (1987). so is just-identiﬁed) yields the best GMM estimator possible.9.8 Conditional Moment Restrictions In many contexts. than the unconditional moment restriction discussed above. we can set gi (β) = φ(xi .. 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. In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i . Ai is unknown. x2 . except that in this case zi = xi . In many cases. . Take the case s = 1. while in a nonlinear i regression model ei (β) = yi − g(xi . That is for any × 1 function φ(xi .

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

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

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

. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . Take the linear model 0 yi = zi β + ei E (xi ei ) = 0.7. ˆ and consider the GMM estimator β of β. 116 . we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. 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.

2001) and has been extended to moment condition models by Qin and Lawless (1994). β). the log-likelihood function for this multinomial distribution is n X ln(pi ).1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n). (10. pn ) which places probability pi at each observation.. 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 maximum likelihood estimator of the probabilities (p1 .1) i=1 First let us consider a just-identiﬁed model... The n ﬁrst order conditions are 0 = p−1 − µ.. In this case the moment condition places no additional restrictions on the multinomial distribution. these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. 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 .. (10. zi . pn ) are those which maximize the log-likelihood subject to the constraint (10.. The multinomial distribution which places probability pi at each observation (yi .. pn ) = i=1 An alternative to GMM is empirical likelihood. . .Chapter 10 Empirical Likelihood 10. The idea is due to Art Owen (1988. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. The idea is to construct a multinomial distribution F (p1 . xi . ...1).2) Ln (p1 . It is a non-parametric analog of likelihood estimation.1 Non-Parametric Likelihood Since each observation is observed once in the sample. Combined with i the constraint (10.3) i=1 117 . xi . To be a valid multinomial distribution.

pn . the Lagrange multiplier λ(β) minimizes Rn (β. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .5). λ) : λ(β) = argmin Rn (β. p (10. Multiplying the ﬁrst equation by pi . 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 (10.5) ˆ ˆ As a by-product of estimation. probabilities 1 ³ ´´ .4) (10. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). µ. λ.. (10. The solution (when it exists) is well deﬁned since Rn (β. Ln (β) = Rn (β. . λ). we also obtain the Lagrange multiplier λ = λ(β).2) subject to the restrictions (10. λ ¡ ¢ ln 1 + λ0 gi (β) .where λ and µ are Lagrange multipliers. 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. λ) is a convex function of λ. pi gi (β) = 0.3). but must be obtained numerically (see section 6. The solution cannot be obtained explicitly.1) and (10.7) 118 . p1 . or equivalently minimizes its negative ˆ (10.. λ) = −n ln (n) − n X i=1 For given β. and using the second and third equations.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 . we ﬁnd µ = n and 1 ¢.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. This yields the (proﬁle) empirical log-likelihood function for β. (see section 6. summing over i.

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 (10.9) and (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. i i Theorem 10.13) Premultiplying by G0 Ω−1 and using (10.9) (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . β λ ∂ ³ ´. and n β − β 0 and nλ are asymptotically independent.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .2. Gi (.1 Under regularity conditions. in the linear model.8) and ¢ 0 0 For example. 0 = Rn (β.10) ¡ Ω−1 N (0. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. G = −E (xi zi ). λ) = − (10. n (10.13) yields n n Expanding (10. (β.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.10.10). and Ω = E xi x0 e2 . β) = −xi zi . g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . ˆ ˆ Proof. i=1 i=1 i=1i Expanding (10. Thus the EL estimator is asymptotically eﬃcient. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.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 . λ) = − (10.

(10.15) (10. and (10. First.3 Overidentifying Restrictions In a parametric likelihood context.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. They are asymptotically ﬁrst-order equivalent. 120 .14) for λ and using (10. β 0 ) = 0 then LRn →d χ2−k . Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (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. and have the same interpretation. 10. Since the EL estimator achieves this bound. LRn = i=1 Theorem 10.17) 2 ln 1 + λ gi β .1 If Eg(wi .16). The overidentiﬁcation test is a very useful by-product of EL estimation. Vλ ) Furthermore.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. V ) ˆ Solving (10. by a Taylor expansion.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .3. The same statistic can be constructed for empirical likelihood. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.15). tests are based on the diﬀerence in the log likelihood functions. it is an asymptotically eﬃcient estimator for β. Ω) GΩ G →d = N (0. Proof.7) is n ³ ´´ ³ X ˆ ˆ0 (10.

Theorem 10. the simple overidentifying restrictions test (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).prc 121 . Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . By “maintained” we mean that the overidentfying restrictions contained in (10.18) Let the maintained model be where g is × 1 and β is k × 1.1 Under (10. The hypothesis of interest is h(β) = 0. To test the hypothesis h(β) while maintaining (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. LRn →d χ2 .4 Testing Egi (β) = 0 (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. a The proof of this result is more challenging and is omitted. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. 10.ssc.wisc. 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. where h : Rk → Ra . so there is no fundamental change in the distribution theory for β relative to β. h(β)=0 ˜ Fundamentally. since ln(1 + x) ' x − x2 /2 for x small. Vλ )0 Ω−1 N (0.17) is not appropriate. 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. This test statistic is a natural analog of the GMM distance statistic.Second.18) and H0 : h(β) = 0. 10.edu/~bhansen/progs/elike.18).

λ) .5) for given β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 .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. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λj ) . λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) = − gi (β.4). set 2 λp = λj − δ p (Rλλ (β. (10.20) . λp ) A quadratic function can be ﬁt exactly through these three points. For p = 0. Set δ 0 = 0. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ)0 − Rn (β. δ 1 = 1 and δ 2 = 1.19). λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λ) = G∗ (β. Eﬃcient convergence requires a good choice of steplength δ. λ)0 0 Rn (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λj ))−1 Rλ (β. The starting value λ1 can be set to the zero vector. λ) = i The ﬁrst derivatives of (10.19) X ∂2 ∗ ∗ gi (β. λ) gi (β. λj ))−1 Rλ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.. λj )) Rp = Rn (β. One method uses the following quadratic approximation. λ)0 − ∂β∂β Rn (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. 1.19) is continued until the gradient Rλ (β. The iteration (10. Deﬁne ∗ gi (β. λ) G∗ (β. 2. λ) = − ∂β n X i=1 G∗ (β. λ) ∂λ i=1 n ∂ Rn (β. λ) G∗ (β. λj ) is smaller than some prespeciﬁed tolerance.

If (10.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. and the rule is iterated until convergence. λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ . λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. If not.for all i.6). λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. The gradient for (10. the stepsize δ needs to be decreased. λ) = 0 at λ = λ(β). 123 . λ(β)) = 0. λ(β)) + λ0 Rλ (β. The Hessian for (10. It is not guaranteed that Lββ > 0.6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. the eigenvalues of Lββ should be adjusted so that all are positive. where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β.20) fails. This can be done by the modiﬁed Newton method described in the previous section. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize. Outer Loop The outer loop is the minimization (10.

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

β →p β ∗ . so should be included in xi .1. By the above deﬁnition. and x2i are the excluded exogenous variables. Thus we make the partition ¶ µ k1 z1i (11. which does not equal either β 1 or β 2 . at least the intercept).1 The × 1 random vector xi is an instrumental variable for (11. In a typical set-up. z1i is an instrumental variable for (11. this can be written as Y = Zβ + e. and assume that E(zi ei ) 6= 0 so there is endogeneity. That is x2i are variables which could be included in the equation for yi (in the sense 125 . Deﬁnition 11. 11. So we have the partition µ ¶ z1i k1 (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments.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 ¶ . ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. This is called simultaneous equations bias.1).3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. In matrix notation. We call (11. some regressors in zi will be uncorrelated with ei (for example.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.1) if E (xi ei ) = 0.1) where zi is k × 1.1) the structural equation. (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. We call z1i exogenous and z2i endogenous.

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

12) Z = XΓ + u ξ = (e.11) (11.12). X2 ]. 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. let’s analyze the approximate bias of OLS applied to (11. we regress Y on Z1 and Z2 . Z2 ] and X = [Z1 . Using (11.13) which is zero only when S21 = 0 (when Z is exogenous). ˆ since Z1 lies in the span of X. Z = [Z1 . X is n × l so there are l instruments. Thus in the second stage. Z2 . In our notation. PX Z2 ] h i ˆ = Z1 . Recall. First.ˆ It is useful to scrutinize the projection Z.11). ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . the model is Y = Zβ + e (11. Z2 = [PX Z1 .6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. Then i h ˆ ˆ ˆ Z = Z1 . We now derive a similar result for the 2SLS estimator. 129 . ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) . 11. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. PX Z2 ] = [Z1 . Here we present a simpliﬁed version of one of his results.

the bias in the 2SLS estimator will be large. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 0).7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . n and (11.12) and this result. Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11.14) In general this is non-zero. Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11. 130 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.13). It is also close to zero when α = 0.14) approaches that 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 .14) is the probability limit of β 2SLS − β 11. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.Let PX = X (X 0 X)−1 X 0 . l . Indeed as α → 1. The consequences of identiﬁcation failure for inference are quite severe. the expression in (11. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . By the spectral decomposition of an idempotent matrix. P = HΛH 0 0 0 where Λ = diag(Il . except when S21 = 0 (when Z is exogenous).

E x2 e2 i i n i=1 n (11. but (11. Then (11. the instrument xi is weak for zi if γ = n−1/2 c.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. To see the consequences. N2 since the ratio of two normals is Cauchy. where C is a full rank matrix.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 . In addition.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. but small. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. as the Cauchy distribution does not have a ﬁnite mean. Here. meaning that inferences about parameters of interest can be misleading. viz Γ22 = n−1/2 C. and was examined by Phillips (1989) and Choi and Phillips (1992). Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . but is weak. Suppose this condition fails. 131 . This is particularly nasty. once again take the simple case k = l = 1. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. Suppose that identiﬁcation does not complete fail. which occurs i when E (zi xi ) 6= 0. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0.15) is unaﬀected. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. This occurs when Γ22 is full rank. This can be handled in an asymptotic analysis by modeling it as local-to-zero.Take the simplest case where k = l = 1 (so there is no X1 ). E x2 u2 i i n n i=1 i=1 n n (11. standard test statistics have non-standard asymptotic distribution of β distributions. This result carries over to more general settings. Qc + N2 ˆ As in the case of complete identiﬁcation failure.

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

Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . 5. will IV “ﬁt” better than OLS. Find a simple expression for the IV estimator in this context. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. u is n × k. at ˆˆ If X is indeed endogeneous. 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) . xi is l × 1. in the sense that e ˜ ˜ least in large samples? 4. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. show that if rank(Γ) < k then β cannot be identiﬁed. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. and Γ is l × k. That is. Take the linear model yi = xi β + ei E (ei | xi ) = 0. Explain why this is true. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β.) 3. ˜ 0 e < e0 e.8 Exercises yi = zi β + ei . Take the linear model Y = Zβ + e. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. 1. (Find an expression for xi . Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). l ≥ k. Z is n × k. 2. X is n × l. where xi and β are 1 × 1. 133 . 6.11.

Report the estimates and standard errors. in years.pdf. Report estimates and standard errors. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. 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). (b) Now treat Education as endogenous. (d) Re-estimate the model by eﬃcient GMM. (e) Calculate and report the J statistic for overidentiﬁcation. There are 2215 observations with 19 variables.. of the mother). using zi as an instrument for xi . The data ﬁle card. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. Report estimates and standard errors. 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. In this model. Estimate the model by 2SLS. in years. Does this diﬀer from 2SLS and/or OLS? 7. f atheduc (the education.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). and the remaining variables as exogenous. of the father) and motheduc (the education. a dummy indicating that the observation lives near a 4-year college. listed in card. (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). (a) Estimate the model by OLS. are the parameters identiﬁed? 8. and South and Black are regional and racial dummy variables. and then calculate the GMM estimator from this weight matrix without further iteration. 134 .(b) Deﬁne the 2SLS estimator of β. using the instrument near4. (f) Discuss your ﬁndings.

135 .4 (loose). A stationary time series is ergodic if γ(k) → 0 as k → ∞. Yt−1 .. Deﬁnition 12.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. To indicate the dependence on time. we adopt new notation.. The primary model for univariate time series is autoregressions (ARs). T .. γ(k) is called the autocovariance function. and multivariate (yt ∈ Rm is vector-valued). ..1 If Yt is strictly stationary and ergodic and Xt = f (Yt . Deﬁnition 12. . Deﬁnition 12. The primary model for multivariate time series is vector autoregressions (VARs). we expect that Yt and Yt−1 are not independent.) is a random variable. Yt−k ) is the autocorrelation function.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. then Xt is strictly stationary and ergodic.. We can separate time series into two categories: univariate (yt ∈ R is scalar). Because of the sequential nature of time series.2 {Yt } is strictly stationary if the joint distribution of (Yt . The following two theorems are essential to the analysis of stationary time series.1. Theorem 12. There proofs are rather diﬃcult.1 Stationarity and Ergodicity Deﬁnition 12. and Cov (Yt . so classical assumptions are not valid. and use the subscript t to denote the individual observation. and T to denote the number of observations. Yt−k ) = γ(k) is independent of t for all k.1. Yt−k ) is independent of t for all k.. t = 1. ..1.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .1. 12..1. however.

then as T → ∞.1. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. γ (0) ˆ Theorem 12.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. µ →p E(Yt ). ˆ 3. 1. Part (1) is a direct consequence of the Ergodic theorem.2 (Ergodic Theorem). and it has a ﬁnite mean by the assumption that EYt2 < ∞. the sequence Yt Yt−k is strictly stationary and ergodic. 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 . ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). γ (k) →p γ(k). T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ Proof.Theorem 12. For Part (2). T 1X Xt →p E(Xt ).1 above. 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) . ρ(k) →p ρ(k). If Xt is strictly stationary and ergodic and E |Xt | < ∞. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ˆ 2.1.1. then as T → ∞. ˆ ˆ γ ¥ 136 . Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).

. Regression errors are naturally a MDS. ∞ X = ρk et−k . Some time-series processes may be a MDS as a consequence of optimizing behavior. . An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . Y1 . t By back-substitution. This occurs when |ρ| < 1. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. some versions of the life-cycle hypothesis imply that either changes in consumption. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . or consumption growth rates.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0.12.. . Deﬁnition 12.3 Stationarity of AR(1) Process Yt = ρYt−1 + et ..} is the past history of the series.. E(et ) = 0 and Ee2 = σ 2 < ∞....2 Autoregressions In time-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 .2. 12. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. Yt−2 . For example. 137 . it is even more important in the time-series context. Letting et = Yt − E (Yt | It−1 ) .. Y2 ... . the series {.. this series converges if the sequence ρk et−k gets small as k → ∞. k=0 Loosely speaking. In fact. should be a MDS.. A mean-zero AR(1) is Assume that et is iid. . as it is diﬃcult to derive distribution theories without this property.... We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression. YT .} are jointly random. Thus for k > 0. E(Yt−k et ) = 0. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . The last property deﬁnes a special time-series process. Yt−k ) .

We call ρ(L) the autoregressive polynomial of Yt . We say that the root of the polynomial is 1/ρ. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .4. Deﬁnition 12.3.Theorem 12. Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value). Lk Yt = Yt−k . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. From Theorem 12. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). an AR(1) is stationary iﬀ |ρ| < 1. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . since ρ(z) = 0 when z = 1/ρ. The AR(k) model is Using the lag operator. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . 12.3. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . we see that L2 Yt = LYt−1 = Yt−2 . 138 .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. Deﬁning L2 = LL. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . the above results are unchanged. ∞ X k=0 ρ2k V ar (et−k ) = 12.1.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. We call ρ(L) the autoregressive polynomial of Yt .1 The lag operator L satisﬁes LYt = Yt−1 . In general.

1. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.1) and the continuous mapping theorem. λk are the complex roots of ρ(z). then ˆ β →p β as T → ∞. Theorem 12.. it is helpful to deﬁne the process ut = xt et . which satisfy ρ(λj ) = 0. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. The vector xt is strictly stationary and ergodic. .. and is of great interest in applied time series. it is also strictly stationary and ergodic. This is a special case of non-stationarity. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. Note that ut is a MDS. For an AR(k).6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et .1. so is xt x0 .. Let |λ| denote the modulus of a complex number λ.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. By Theorem 12. and hence Yt . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. t t T t=1 ¥ Combined with (12.1) Theorem 12. Thus t by the Ergodic Theorem. we say that ρ(L). “has a unit root”.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. and by Theorem 12. 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 12.6. t Yt−k ¢0 ρk .where the λ1 . β = X 0X (12.1. the requirement is that all roots are larger than one.” If one of the roots equals 1.5. t T t=1 T t=1 139 . ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. Proof. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. One way of stating this is that “All roots lie outside the unit circle.1.

we can apply Theorem 12. Y−k+2 . as this imposes inappropriate independence.. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .1 MDS CLT. we constructed the bootstrap sample by randomly resampling from the data values {yt . Method 2: Block Resampling 1.7 Asymptotic Distribution Theorem 12. ˆ 2.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. Fix an initial condition (Y−k+1 . which may be diﬀerent than the i properties of the actual ei .12. there are two popular methods to implement bootstrap resampling for time-series data.8 Bootstrap for Autoregressions In the non-parametric bootstrap. xt }. t then as T → ∞. . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Method 1: Model-Based (Parametric) Bootstrap. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. Ω) . This creates an iid bootstrap sample. then as T → ∞.. Q−1 ΩQ−1 .. This is identical in form to the asymptotic distribution of OLS in cross-section regression. T t=1 where Ω = E(xt x0 e2 ). this cannot work in a time-series application. Ω) . Y0 ). . Clearly.. T t=1 Since xt et is a MDS.1 to see that T 1 X √ xt et →d N (0. T 1 X √ ut →d N (0.7. Divide the sample into T /m blocks of length m. the asymptotic covariance matrix is estimated just as in the cross-section case.7. Estimate β and residuals et . i 4.. In particular. Brieﬂy. 140 . t This construction imposes homoskedasticity on the errors e∗ . It also presumes that the AR(k) structure is the truth. e ˆ 3. 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∗ .7. eT }. t t Theorem 12. The implication is that asymptotic inference is the same.. 12. ˆ 1.

141 .2. The seasonal adjustment. also alters the time-series correlations of the data. (12. Seasonal Eﬀects There are three popular methods to deal with seasonal data.3) sequentially by OLS. Resample complete blocks.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et .4) by OLS.2)-(12...2) (12. and then perform regression (12. heteroskedasticity. ρk ). This presumes that “seasonality” does not change over the sample. If s is the number of seasons (typically s = 4 or s = 12). and for modelmisspeciﬁcation. draw T /m blocks. 6.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . For each simulated sample.2). The series ∆s Yt is clearly free of seasonality.. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . . • You can estimate (12. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. 12. • You can estimate (12. (12. May not work well in small samples. ﬁrst estimate (12. Thus the seasonally adjusted data is a “ﬁltered” series. • Use “seasonally adjusted” data. That is. and perhaps this was of relevance.3) replacing St with St . This is a ﬂexible approach which can extract a wide range of seasonal factors. 4. get the ˆ ˆ residual St . however. This allows for arbitrary stationary serial correlation. • Include dummy variables for each season. But the long-run trend is also eliminated. ∆s Yt = Yt − Yt−s . • First apply a seasonal diﬀerencing operator. The results may be sensitive to the block length. 5. and the way that the data are partitioned into blocks. or the season-to-season change. 3. Paste the blocks together to create the bootstrap time-series Yt∗ . This procedure is sometimes called Detrending.

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

Indeed. Thus a time series with unit root is I(1). as the models are equivalent. An alternative asymptotic framework has been developed to deal with non-stationary data. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. Yt is non-stationary. Note that the model is stationary if α0 < 0. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . Thus if Yt has a (single) unit root. Hence. observe that the lag polynomial for the Yt computed from (12. As we discussed before. We do not have the time to develop this theory in detail. 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 . The ergodic theorem and MDS CLT do not apply. So the natural alternative is H1 : α0 < 0. then Yt is “integrated of order d”. In this case. Yt is non-stationary. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . 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 .12. or ρ1 + ρ2 + · · · + ρk = 1.7) These models are equivalent linear transformations of one another. Yt has a unit root when ρ(1) = 0. then ∆Yt is a stationary AR process. 143 . Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . Because of this property. we say that if Yt is non-stationary but ∆d Yt is stationary. Since α0 is the parameter of a linear regression. this is the most popular unit root test. and test statistics are asymptotically non-normal. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. but simply assert the main results. However. (12. since ρ(1) = −α0 . or I(d). under H0 . Under H0 . To see this. the natural test statistic is the t-statistic for H0 from OLS estimation of (12.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L).7). so conventional normal asymptotics are invalid.

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

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

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

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

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

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

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

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

Standard errors and test statistics are computed by asymptotic approximations. i if Yi∗ > 0 . 1. Details of such calculations are left to more advanced courses. we need the conditional distribution of an individual observation. then we can write the density of Y as f (y) = py (1 − p)1−y . In the Binary choice model. Yi is conditionally Bernoulli with P (Yi = 1 | xi ) = pi = F (x0 β) . we call this the logit model. and if F is normal. If F is logistic. i i yi =0 ˆ The MLE β is the value of β which maximizes ln (β). y = 0. −1 .• Logistic: F (u) = (1 + e−u ) • Normal: F (u) = Φ(u). To construct the likelihood. we call this the probit model. otherwise Estimation is by maximum likelihood. 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 ). such that P (Y = 1) = p and P (Y = 0) = 1 − p. Thus i the conditional density is f (yi xi ) = pyi (1 − pi )1−yi i ¡ 0 ¢yi ¡ ¢ = F xi β (1 − F x0 β )1−yi . This model is identical to the latent variable model Yi∗ = x0 β + ei i ei ∼ F (·) ½ 1 Yi = 0 For then P (Yi = 1 | xi ) = P (Yi∗ > 0 | xi ) ¡ ¢ = P x0 β + ei > 0 | xi i ¢ ¡ = P ei > −x0 β | xi i ¢ ¡ = 1 − F −x0 β i ¡ ¢ = F x0 β . 152 . Recall that if Y is Bernoulli.

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

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

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

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

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

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

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

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

if only a few Xi are near 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. Conversely. ˆ We can also calculate the moments of the density f (x). The bandwidth h controls the meaning of “near”. If a large number of the observations Xi are near ˆ x. ˆ(x) is small. f (x) ≥ 0 for all x. 161 . 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 . That is. then the weights are relatively large and f (x) is larger. f (x) is a valid density.This estimator is the average of a set of weights. 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. 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. 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.

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

where φ is the N (0. The downside is that if the density is very far from normal.1) is an asymptotic approximation to the MSE. (16.2) depends on R(K). In practice.Together. Note that this h declines to zero. That is. but at a slower rate than n−1 . Together with the above table.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 . but at a very slow rate. The ﬁrst two are determined by the kernel function. The asymptotically optimal choice given in (16. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. We thus say that the optimal bandwidth is of order O(n−1/5 ). 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 need h → 0 but nh → ∞. we ﬁnd the reference rules for the three kernel functions introduced earlier. the rule-of-thumb h can be quite ineﬃcient. We can calculate that √ R(φ00 ) = 3/ (8 π) . That is. Their K values for the three functions introduced in the previous section are given here. Equation (16. 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 .2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. ˆ It uses formula (16. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. This choice for h gives an optimal rule when f (x) is ˆ normal. σ 2 . and gives a nearly optimal rule when f (x) is close to normal.2) but replaces R(f 00 ) with σ −5 R(φ00 ). and there is a large and continuing literature on the subject. and R(f 00 ).06n−1/5 163 . Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. (16. the asymptotic mean-squared error (AMSE) for ﬁxed x is the sum of the approximate squared bias and approximate variance 1 f (x) R(K) . but not of n. AM SEh (x) = f 00 (x)2 h4 σ 4 + K 4 nh A global measure of precision is the asymptotic mean integrated squared error (AMISE) Z h4 σ 4 R(f 00 ) R(K) K + . h must tend to zero. how should the bandwidth be selected? This is a diﬃcult problem. Gaussian Kernel: hrule = 1. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). Thus for the AMISE to decline with n.

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

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

. ¢ counting is unordered and without replacement. If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) .. consider a lottery where you pick six numbers from the set 1. These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r. we have four expressions for the number of objects (possible arrangements) of size r from n objects. . we say that the collection of events A1 . Depending on these two distinctions. the conditional probability function is a valid probability function where S has been replaced by B. the number of ¡49 if potential combinations is 6 = 13. Rearranging the deﬁnition.• 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. there are two important distinctions. 49. Furthermore. This selection is without replacement if you are not allowed to select the same number twice. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery.. r r! (n − r)! When counting the number of objects in a set. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. as µ ¶ n n! = . 983. it is useful to have simple rules to count the number of objects in a set..1) We say that the events A and B are statistically independent when (A. 2. n ≥ r. . Counting may be ordered or unordered. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. Ak are mutually independent when for any subset {Ai : i ∈ I}. and is with replacement if this is allowed.. 816.1) holds. We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A). P (B) With Replacement nr ¡n+r−1¢ r For any B. i∈I i∈I 166 . Counting may be with replacement or without replacement.. in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A. Ã ! \ Y P Ai = P (Ai ) . For example.

. F (x) is nondecreasing in x 3. these cases are unusualRand are typically ignored.. For any set B and any partition A1 . τ r .. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.3) P (X = τ j ) = π j .Theorem 2 (Bayes’ Rule).. . r (A.. of the sample space. This induces a new sample space — the real line — and a new probability function on the real line. we represent the relative probabilities by the probability density function (PDF) f (x) = so that F (x) = and P (a ≤ X ≤ b) = Z d F (x) dx x f (u)du Z b −∞ f (x)dx. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. and use lower case letters such as x for potential values and realized values. The probability function for X takes the form j = 1..2) Sometimes we write this as FX (x) to denote that it is the CDF of X. A function F (x) is a CDF if and only if the following three properties hold: 1. We say that the random variable X is continuous if F (x) is continuous in x. then for each i = 1.. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function.... In the latter case. While there are examples of continuous random variables which do not possess a PDF. (A. we denote random variables by uppercase letters such as X. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . Typically. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx.3) is unavailable. .2 Random Variables A random variable X is a function from a sample space S into the real line. the range of X consists of a countable set of real numbers τ 1 .. a These expressions only make sense if F (x) is diﬀerentiable. A2 . In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. . Instead. 167 . 2.

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

0≤p≤1 x = 0.. . m x1 !x2 ! · · · xm ! 1 2 = n... 2. . 0≤p≤1 V ar(X) = λ We now list some important continuous distributions. n. Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . X2 = x2 . λ>0 x = 1.4 Common Distributions For reference.. x! EX = λ x = 0.A. 1. 169 . we now list some important discrete distribution function.. . 0≤p≤1 x = 0. 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 .. 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 = V ar(X) = Poisson P (X = x) = exp (−λ) λx .. 1... 1... . Bernoulli P (X = x) = px (1 − p)1−x . 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 . 2. .. 2. x = 1..

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

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

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

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

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

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

and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). and it is conventional to write X ∼ N (µ. 1). (A. Another useful fact is that if X ∼ N (µ. The mean and variance of the distribution are µ and σ 2 . q 176 . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . Theorem A. It is conventional to write X ∼ N (0. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . By iterated integration by parts. then Z 0 A−1 Z ∼ χ2 . we can also show that EX 2 = 1 and EX 4 = 3. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. Σ) and Y = a + BX with B an invertible matrix. ¢ ¡ 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 . 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. y ≥ 0. q × q. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . X has density Ã ! (x − µ)2 1 exp − . respectively.This density has all moments ﬁnite. then Σ = diag{σ 2 } is a diagonal matrix. f (x) = √ 2σ 2 2πσ which is the univariate normal density. then using the change-of-variables formula. This shows that if X is multivariate normal with uncorrelated elements. Σ). Since it is symmetric about zero all odd moments are zero.8. A) with A > 0. Theorem A. x ∈ Rk . x ∈ Rk . denoted χ2 . Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ.2 If Z ∼ N(0.1 Let X ∼ N (0.11) and is known as the chi-square density with r degrees of freedom. σ 2 ). Its mean and r variance are µ = r and σ 2 = 2r.8. The latter has no closed-form solution. then by the change-of-variables formula. −∞ < x < ∞. then they are mutually independent. This shows that linear transformations of normals are also normal. and it is conventional to write X ∼ N(µ. If Z is standard normal and X = µ + σZ. Ir ) and set Q = X 0 X. For x ∈ Rk .

From (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.13) is the MGF of the density (A. The MGF for the density (A.13). Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.1.12) E exp (tQ) = 0 Γ (A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . C −1 CC 0 C −10 ) = N (0. which we showed in (A. which can be found by applying change-of-variables to the gamma function.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).11) 2 with r = 1. Proof of Theorem A. q Proof of Theorem A. 1).8.3 Let Z ∼ N (0. Set r Z . 1) and Q ∼ χ2 be independent.8. (A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.8. we see that the MGF of Z 2 is (1 − 2t)−1/2 . tr has distribution 177 . C −1 AC −10 ) = N (0.2. For Z ∼ N(0.11). The fact that A > 0 means that we can write A = CC 0 where C is non-singular. Iq ). Thus the density of Z 2 is (A. Using the simple law of iterated expectations.8.3.Theorem A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.

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

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

θ) θ In this case. Thus in large samples the MLE has approximately the best possible variance. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A.17) does not hold. 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 . the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. V ) . ˆ ln f Yi . ˆ elements of n 0 Sometimes a parametric density function f (y. θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y. Therefore the MLE is called asymptotically eﬃcient. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE.18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0.9. In this case there is not a “true” value of the parameter θ. ˆ . θ).18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . θ (A. θ) is used to approximate the true unknown density f (y). 180 . but it is not literally believed that the model f (y. Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi . θ) is necessarily the true density. but has a diﬀerent covariance matrix than in the pure MLE case. Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . θ) = f (y) ln f (y. A minor adjustment to Theorem (A. θ) ¶ dy Thus in large samples. since the information matrix equality (A. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A.ˆ ˆ−1 θ We then set I0 = H −1 . The QMLE is consistent for the pseudo-true value. Typically.

Since θ Z ˜ = ˜ y)f (˜. θ0 ) ¯ ∂ f (y. (Yi . θ) f (˜. ∂θ ¯θ=θ0 Z ! = 0.9. θ0 ) ∂ ∂θ f ∂ (Yi . function of the data. θ) dy ¯ ∂θ f (y.. θ0 ) f (Yi . θ0 = ln f (Yi . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. To see (A. θ) f (y..2. θ0 )2 (Yi . ∂2 ln f (Yi . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y.17). we can show that E By direction computation. θ0 ) ∂ ∂ − ln f (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜.. θ0 ) ∂θ f (Yi . ¯ ¯ ∂ E ln f (Yi . θ0 )0 f (Yi . θ0 ) d˜ = E ˜ .9. V ar (S) nH so ¥ 181 .16).1.1) has mean zero and variance nH. θ) d˜ = ˜ y ) ∂ ln f (˜. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 ) (Yi . f (Yi . θ0 ) ln f (Yi . yn ).Proof of Theorem A. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . Proof of Theorem A. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 )0 . θ0 ) − f (Yi . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.9.

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

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

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

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

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