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# ECONOMETRICS

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

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

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Contents

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

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

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i

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

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

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

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

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ii

8 Exercises . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . . 12. . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . 12 Univariate Time Series 12. . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . 9. . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. .12 8. . . . . . . 12. . . . . . . . . . . 11. . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Estimation . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . 9. . . . . . . . . 10 Empirical Likelihood 10. . . . . 10. . 12. . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. 9. . . . .13 One-Sided Tests . . .5 GMM: The General Case . . . . . 9. . . .3 Identiﬁcation . . . . . . . . . . . . . 11 Endogeneity 11. . 12. . . . . . . . . . . . . . . . . . . . . . 11. 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii . . . . . . . . . . . . . . . . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . .6 Over-Identiﬁcation Test . . . 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. . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . 9. . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . 11.4 Lag Operator . . . . . . . . . . . . . .11Model Selection . . .2 Reduced Form . . . . . . . . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . 11.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. .2 Fixed Eﬀects . . . . . . . . . . . . . . . . . . . . .13 Multivariate Time Series 13. . . .4 Sample Selection . . . . . . . . .7 Granger Causality . . . . . . . . . B. . . . . .4 Single Equation from a VAR . . . . . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . A. . .3 Restricted VARs . . . . . . . . . . . . . . . . . . . 13.6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . .1 Grid Search . . . . . . .4 Common Distributions .1 Kernel Density Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 16. . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . 162 A Probability A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . .1 Individual-Eﬀects Model . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Estimation . . . . . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . . . . . . . .2 Gradient Methods . . . A. . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Foundations . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . A. . .5 Multivariate Random Variables . . . . . . . . . . . . . . . . . . . .2 Random Variables . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Conditional Distributions and Expectation . . . . . . . . . B Numerical Optimization B. . . . . . . . . . . . . 14. . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . iv . . . . . . . . . . . . . . . . .1 Binary Choice . . . . . . . . . . . . . . . . . . .9 Maximum Likelihood . . . . . . 14 Limited Dependent Variables 14. A. . . .8 Cointegration . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . .3 Censored Data . . . . 13. . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . .7 Transformations . . . . . . . A. . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . 159 16 Nonparametrics 160 16. . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . . . . .3 Expectation . . . . . . . . B. . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

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

They are called the latent roots or characteristic roots or eigenvalues of A. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal.2.) If A is positive deﬁnite.. • The characteristic roots of A−1 are λ−1 . . We call B a matrix square root of 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. c0 Ac > 0. We now state some useful properties. k denote the k eigenvalues and eigenvectors of a square matrix A. has full rank k if there is no non-zero c such that Xc = 0.. and let H = [h1 · · · hk ]. then A is non-singular and A−1 exists. λ−1 . The matrix B need not be unique.. . In this case. We say that X is n × k. then A is positive semi-deﬁnite. • If A has distinct characteristic roots. If A = G0 G. 2. To see this. and then set B = HΛ1/2 . which are not necessarily distinct and may be real or complex. If A is symmetric. i = 1. 8 . c0 Ac = α0 a ≥ 0 where α = Gc. then A > 0 if and only if all its characteristic roots are positive. If A > 0 we can ﬁnd a matrix B such that A = BB 0 . We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. This is written as A ≥ 0. X 0 X is symmetric and positive deﬁnite. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. k < n. Furthermore.. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . and the characteristic roots are all real. λ−1 . there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. A−1 > 0. This is written as A > 0.6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots.. c0 Ac ≥ 0. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. (For any c 6= 0. If λi is an eigenvalue of A. We say that A is positive deﬁnite if for all non-zero c. Q • det(A) = k λi i=1 Pk • tr(A) = i=1 λi • A is non-singular if and only if all its characteristic roots are non-zero.. • If A is symmetric. Let λi and hi .5 Eigenvalues det (A − λIk ) = 0. then A = HΛH 0 and H 0 AH = Λ. A square matrix A is idempotent if AA = A. 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 .

. .8 Determinant The determinant is deﬁned for square matrices.By the uniqueness of the characteristic roots. Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . xk ) : Rk → R.. we can deﬁne the determinant as follows.. . (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. There are k! such permutations... Let π = (j1 . i Hence they must equal either 0 or 1..7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . . ... k) . xk ) be k × 1 and g(x) = g(x1 .. If A is 2 × 2. ⎠ . then its determinant is det A = a11 a22 − a12 a21 . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.. k.. . k)). Additionally.. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. and let επ = +1 if this count is even and επ = −1 if the count is odd. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.4) H0 M =H 0 0 with H 0 H = In . For a general k × k matrix A = [aij ] .. jk ) denote a permutation of (1....... . • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . 2. we deduce that Λ2 = Λ and λ2 = λi for i = 1. tr(A) = rank(A).

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

This is used when the goal is to quantify the impact of one set of variables on another variable. the conditional density of yi given xi .73. holding the other variables constant. In this context we partition the observations into the pair (yi . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. it is useful to have numerical measures of the diﬀerence. These are asymmetric (skewed) densities. The two density curves show the eﬀect of gender on the distribution of wages. When a distribution is skewed. education and experience. In the example presented in Figure 3.2) m(x) = E (yi | xi = x) = −∞ In general.1) xi = ⎜ .1 by the arrows drawn to the x-axis. the mean is not necessarily a good summary of the central tendency. . Figure 3. gender. we can focus on f (y | x) . Take a closer look at the density functions displayed in Figure 3. See Chapter 16. and exists so long as E |yi | < ∞. and that for women is $20. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. These are conditional density functions — the density of hourly wages conditional on race. the mean wage for men is $27. (3.1 displays the density1 of hourly wages for men and women.1. ⎟ . the conditioning variable. The data are from the 2004 Current Population Survey 1 11 . We call yi the dependent variable.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. ⎠ ⎝ . xi ) where yi is a scalar (real-valued) and xi is a vector.22. While it is easy to observe that the two densities are unequal. or the covariates.1. To illustrate. which is a common feature of wage distributions. xki 3. m(x) can take any form. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. These are indicated in Figure 3. We call xi alternatively the regressor. An important summary measure is the conditional mean Z ∞ yf (y | x) dy.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. You can see that the right tail of then density is much thicker than the left tail.

5.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3.1 is facilitated by the fact that the control variable (gender) is discrete. Of particular interest to graduate students may be the observation that diﬀerence between a B. Figure 3.Figure 3. the solid line displays the conditional expectation of log wages varying with education. Figure 3. implying an average 36% diﬀerence in wage levels. 2 (3. and a Ph.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. When the distribution of the control variable is continuous. 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. this yields the formula yi = m(xi ) + ei . then comparisons become more complicated. The comparison in Figure 3. 12 .36. wage regressions typically use log wages as a dependent variable rather than the level of wages.A. To illustrate. 3.2 shows the density of log hourly wages for the same population. Assuming for simplicity that this is the true joint distribution.2) evaluated at the observed value of xi : ei = yi − m(xi ).30. The conditional expectation function is close to linear. which implies a 30% average wage diﬀerence for this population. By construction.D. For this reason. The diﬀerence in the log mean wage between men and women is 0.3 is how the conditional expectation describes an important feature of the conditional distribution. the dashed line is a linear projection approximation which will be discussed in the Section 3. with mean log hourly wages drawn in with the arrows. degree in mean log hourly wages is 0.3) White non-military male wage earners with 10-15 years of potential work experience.3 displays a scatter plot2 of log wages against education levels.

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

Given the random variable xi . A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . when σ 2 (x) is a constant so that ¢ ¡ (3. 3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. To see this. in the sense of achieving the lowest mean squared error. σ 2 (x) is a non-trivial function of x.3. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic.2. the conditional variance of yi is σ 2 = σ 2 (xi ).1.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . The conditional standard deviation is its square root σ(x) = σ 2 (x). let g(x) be an arbitrary predictor of yi given xi = x. 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 . subject to the restriction p that it is non-negative. In contrast.3 Conditional Variance Generally. Thus the mean squared error is minimized by the conditional mean.Figure 3. it does not provide information about the spread of the distribution. and can take any form.

8) (3.we say that the error ei is homoskedastic. βk ⎛ (3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .5) xi = ⎜ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.1). Instead.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. and the linear assumption of the previous section is empirically unlikely to accurate. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). we assume that x1i = 1. Equivalently. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . 15 .6) (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element. ⎠ . i (3.1 and that for women is 10.5. ⎠ . The conditional standard deviation for men is 12. xki When m(x) is linear in x. they are also somewhat more dispersed. ⎝ . take the conditional wage densities displayed in Figure 3.6) as an approximation. So while men have higher average wages. it is more realistic to view the linear speciﬁcation (3. We call this the “constant” or “intercept”. its functional form is typically unknown. ⎟ .9) 3. ⎟ β=⎝ . Notationally. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.8) is called the linear regression model. where x1i is the ﬁrst element of the vector xi deﬁned in (3.4 Linear Regression An important special case of (3. As an example. Equation (3. Thus (3.1.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .7) is a k × 1 parameter vector. 3. In this case (3. which we derive in this section.

The best linear predictor is obtained by selecting β to minimize S(β). E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. 3. 2 2. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . i 16 . i (3. α0 E (xi x0 ) α = E (α0 xi )2 > 0.11) 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 . we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . i i (3. E (xi x0 ) is invertible. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. 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.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. Equivalently.1 1. i which requires that for all non-zero α. This occurs when redundant variables are included in xi . Rewriting. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.1.10) It is worth taking the time to understand the notation involved in this expression.10).5. xi contains an intercept. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . The ﬁrst-order condition for minimization (from Section 2. i (3. by “best” we mean the predictor function with lowest mean squared error. The vector (3. Given the deﬁnition of β in (3. Assumption 3. written E (xi x0 ) > 0. E (x0 xi ) < ∞. otherwise they are distinct. x0 β is the best linear predictor for yi . Therefore. It is invertible if and only if it is positive deﬁnite.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. The error is i ei = yi − x0 β. Eyi < ∞.12) This completes the derivation of the linear projection model. this situation must be excluded. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.5.which is quadratic in β. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. Observe i that for any non-zero α ∈ Rk . In order for β to be uniquely deﬁned. As before. i 4.

8)-(3.5.1 is employed to guarantee that (3. Furthermore. Let’s compare it with the linear regression model (3.5.2.11) are well deﬁned.5.11) and (3.1. Assumption 3.1.14) Proof.5.14).1 are weak.Theorem 3.9).5.5.14) holds. Equation (3.13) implies that xi and ei are uncorrelated. The ﬁnite variance Assumptions 3. ¥ (3. it follows that linear regression is a special case of the projection model. (3.10) and (3.2 and 3. For example. the orthogonality restriction (3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .1. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . (3.5.1.3 ensure that the moments in (3.13) The two equations (3.1.1.12) and (3.5.4 guarantees that the solution β exits. Since ei is mean zero by (3. Using the deﬁnitions (3.13) summarize the linear projection model.1. Since from Theorem 3.4 we know that the regression error has the property E (xi ei ) = 0.14) follows from (3. However.1. This means that the equation (3. E (xi ei ) = 0 and E (ei ) = 0. Assumption 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.3 are called regularity conditions. Figure 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.5.12) can be alternatively interpreted as a projection decomposition.1. Assumption 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.10) are deﬁned. 17 .13) and Assumption 3.4 is required to ensure that β is uniquely deﬁned. Assumption 3.1.5.2 and 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 = 0.1 Under Assumption 3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. By deﬁnition.1.5.

and under-predicts for the rest. and the straight dashed line is the linear projection. Other than the redeﬁnition of the regressor vector. In other cases the two may be quite diﬀerent. it is important to not misinterpret the generality of this statement. there are no changes in our methods or analysis.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. for any pair (yi . for those over 53 in age).3.12) with the properties listed in Theorem 3. since the resulting function is quadratic in experience. We illustrate the issue in Figure 3.5.We have shown that under mild regularity conditions. In Figure 1. In this case the linear projection is a poor approximation to the conditional mean. Figure 3.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. In contrast. However. In this example the linear projection is a close approximation to the conditional mean. In this example it is a much better approximation to the conditional mean than the linear projection. xi ) we can deﬁne a linear projection equation (3.4 we display as well this quadratic projection. In this case (3.4 displays the relationship3 between mean log hourly wages and labor market experience.5. Returning to the joint distribution displayed in Figure 3. No additional assumptions are required. 18 .10) may not hold and the implications of Theorem 3.10).1 may be false. Most importantly. The linear equation (3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.1. the dashed line is the linear projection of log wages on eduction.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. The solid line is the conditional mean. Figure 3. and are discussed in Chapter 11. It over-predicts wages for young and old workers. we can augment the regressor vector xi to include both experience and experience2 . A projection of log wages on these two variables can be called a quadratic projection. in many economic models the parameter β may be deﬁned within the model. In the example just presented. This defect in linear projection can be partially corrected through a careful selection of regressors. These structural models require alternative estimation methods.

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

2 Y =1 . . True or False. E(ei | xi ) = 0. True or False.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(ei | xi ) = 0. σ = . (x − µ)2 − σ 2 Show that Eg (X. Compute E(yi | xi = x) and V ar(yi | xi = x). then ei is independent of xi . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . Suppose that yi is discrete-valued. If yi = xi β + ei . 0 ≤ y ≤ 1. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. i 8.3 Find E(Y | X = x). 3.4 . If yi = x0 β + ei . m. If yi = xi β + ei . True or False. then ei is i i independent of xi . µ. then E(ei | xi ) = 0. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. ¡ ¢ 4.3. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . i 7. True or False. then E(x2 ei ) = 0.1 . 2. a constant. 2.. 1. µx = Exi . xi ∈ R. x 6. Let X be a random variable with µ = EX and σ 2 = V ar(X). 20 . then E(x2 ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . taking values only on the non-negative integers. Suppose that Y and X only take the values 0 and 1. xi ∈ R. Are they diﬀerent? Hint: If P (Y = j) = 5. and E(e2 | xi ) = σ 2 . s) = 0 if and only if m = µ and s = σ 2 .6 Exercises 1. and E(ei | xi ) = 0.1. Prove parts 2. E(Y 2 | X = x) and V ar(Y | X = x). and E(xi ei ) = 0. j! 0 j = 0. e−λ λj j! . 9.. σ 2 = V ar(xi ). Compute the conditional mean m(x) = E (yi | xi = x) . i 10. If yi = x0 β + ei and E(xi ei ) = 0. i 11. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . yi ). Let xi and yi have the joint density f (x. True or False. 3 and 4 of Theorem 3. and have the following joint probability distribution X=0 X=1 Y =0 .

(4.3) In Sections 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 . i n i=1 n 21 .2) (4. but for most of the chapter we retain the broader focus on the projection model.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .4) i i=1 i=1 ˆ Another way to derive β is as follows. we narrow the focus to the linear regression model. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .8. 4.2) can be written in the parametric 0 β)) = 0.1 Estimation Equation (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4. 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 . Observe that (4.1) (4.7 and 4. i It follows that the moment estimator of β replaces the population moments in (4.

ˆ This is a set of k equations which are linear in β.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. These are white male wage earners from the March 2004 Current Population Survey.95 xi yi = 42.37 µ ¶ 1. i 22 .30 + 0.14 14. 40 2.3. To illustrate.95 42.7% increase in mean wages.4).94 −2. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.83 ¶−1 µ ¶ . 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 (4.40 µ ¶µ ¶ 34. Then µ ¶ n 1X 2.170 37. with 10-15 years of potential work experience. consider the data used to generate Figure 3. ¶ 2. 0.14 205. 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.2 Least Squares There is another classic motivation for the estimator (4. 30 = .117 Educationi . An interpretation of the estimated equation is that each year of education is associated with an 11.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.117 1 14.4). 40 0. Let yi be log wages and xi be an intercept and years of education. 4.71 = −2. excluding military.14 14. This sample has 988 observations.14 205.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.

To visualize the sum-of-squared errors function. while the residual is a by-product of estimation.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.7) 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. which can cause confusion. Matrix calculus (see Appendix 2.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Figure 4. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. These two ˆ variables are frequently mislabeled. The error is unobservable.4).2 displays the contour lines of the same function — horizontal slices at equally spaced heights. the contour lines are ellipses. It is important to understand the distinction between the error ei and the residual ei . Since the function Sn (β) is a quadratic function of β. Following convention we will call β the OLS estimator of β. 23 .1: Sum-of-Squared Errors Function As a by-product of OLS estimation. i ˆ ˆ Note that yi = yi + ei . Figure 4. Figure 4.

ˆ n−k 2 i=1 (4. and hold true for all linear regression estimates.2: Sum-of-Squared Error Function Contours Equation (4.7) A justiﬁcation for the latter choice will be provided in Section 4. These are algebraic results. ˆ σ = ˆ n 2 i=1 n (4. one implication is that n 1X ei = 0. It measures the variation in the i “unexplained” part of the regression. ˆ n i=1 n Since xi contains a constant. 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.Figure 4.6) An alternative estimator uses the formula n 1 X 2 s = ei . Its method of moments estimator is the sample average 1X 2 ei .5) implies that 1X xi ei = 0. 24 . The error variance σ 2 = Ee2 is also a parameter of interest.7.

3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. An alternative estimator of ρ2 proposed by Theil called “R-bar-squared” is y R =1− where σ2 = ˜y 2 n 2 s2 σ2 ˜y 1 X (yi − y)2 . σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . and distribution theory. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. This is a parametric model. σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. maximizing the likelihood is identical to minimizing Sn (β). It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. σ 2 ). Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi . This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . 4. 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.where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. Since Ln (β. where likelihood methods can be used for estimation. The R2 is frequently mislabeled as a measure of “ﬁt”. σ 2 ). σ 2 ) is a function of β only through the sum of squared errors Sn (β). Hence the MLE for β equals the OLS estimator. testing. σ 2 ) maximize Ln (β. it should be viewed as an estimator of the population parameter ρ2 = σ2 V ar (x0 β) i =1− 2 V ar(yi ) σy where σ 2 = V ar(yi ). Instead.

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. ⎝ ⎝ . . We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. . = β+ XX 26 (4. 4. . yn ⎟ ⎟ ⎟. .Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. it is matrix notation. The linear equation (3. x0 n ⎞ ⎛ e1 e2 . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. Thus the MLE (β. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .4). yn = x0 β + en . n X i=1 Thus the estimator (4. en ⎞ Observe that Y and e are n × 1 vectors.6). ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟.8) . Sample sums can also be written in matrix notation. ⎠ .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ⎠ xi x0 = X 0 X i xi yi = X 0 Y. including computation. Due to this equivalence. one for each observation. ⎟. For example n X i=1 For many purposes. residual vector. . n or equivalently Y = Xβ + e. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. . and X is an n × k matrix. σ 2 ) = − 2 + ¡ ¢2 e2 = 0.12) is a system of n equations. and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e.

4.5

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

Regress Y on X2 . . 4.9). ⎠ ⎝ ⎠ ⎝ . In this section we derive the small sample conditional mean and variance of the OLS estimator. and X2 is the vector of observed regressors.13). Partition X = [X1 X2 ] where X1 = ι is a vector of ones. obtain OLS estimates β 2 and residuals e. ¡ ¢−1 0 ι. the FWL theorem can be used to speed computation. . In this case. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.8)(3. ˆ ˜ ˜ ˆ 3. . or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. ˆ which are “demeaned”.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. By the independence of the observations and (3. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. the primary use is theoretical. obtain residuals Y . but in most cases there is little computational advantage to using the two-step algorithm. is the demeaning formula for regression. Regress X2 on X1 .1 (Frisch-Waugh-Lovell).Theorem 4.6. . ⎟ ⎜ ⎟ ⎜ (4. obtain residuals X2 . Rather. . A common application of the FWL theorem. . .9). . . which you may have seen in an introductory econometrics course. observe that ⎞ ⎛ ⎞ ⎛ . In some contexts. In the model (4. 30 .14) or via the ˆ following algorithm: ˜ 1. ˜ 2. . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. Regress Y on X1 .

for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 .12).18). the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. and the trace operator observe that. 1 n . 0 0 ··· 0 0 . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . Then given (4. 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 . 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 = 0.20) . 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. . under the of ˆ ¢ 2 | x = σ 2 . V ar β | X = X 0 X ⎟ ⎟ ⎟.Using (4. ⎝ . . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.8).. and ³ ´ ¡ ¢−1 2 ˆ σ . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . σ 2 } = ⎜ . . From (4. ⎠ (4.. ... Next. X 0 DX = X 0 Xσ 2 . .19) ˆ and thus the OLS estimator β is unbiased for β. and (4. . .

³ ´ ˜ E β | X = A0 Xβ. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . or in the projection model. however. ˜ so β is unbiased if (and only if) A0 X = Ik . which is (3. we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense. What is the best choice of A? The Gauss-Markov theorem. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .1 Gauss-Markov. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. 32 .8)¢ ¡ (3. as it yields the smallest variance among all unbiased linear estimators. Thus since V ar (e | X) = In σ 2 under homoskedasticity. In the homoskedastic linear regression model.7) is unbiased for σ 2 by this calculation. It is important to remember. It is not unbiased in the absence of homoskedasticity. Theorem 4. As an alternative. which we now present. is a famous statement of the solution. 4.8. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. ˜ β L = A0 Y = A (Xβ + e) = β + Ae.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 . known as the Gauss-Markov theorem. the estimator ˆ 2 deﬁned (4. = σ2 n the ﬁnal equality by (4. says that the least-squares estimator is the best choice.10). Now consider the class of estimators of β which are linear functions of i the vector Y. In this case.9) plus E e2 | xi = σ 2 . that this estimator is only unbiased in the special case of the homoskedastic linear regression model. Thus σ 2 is biased towards zero. the best (minimumvariance) unbiased linear estimator is OLS.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. By a calculation similar to those of the previous section. The following result.

where 1 (·) is the indicator function. 4.21) j j=1 j=1 Thus β is a function of (π 1 .. for ﬁnite r..Proof. r. (We know the values yi and xi can take. the class of potential estimators has been restricted to linear unbiased estimators.5) as required. but we don’t know the probabilities. 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.. 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. π j is the percentage of the observations ˆ ˆ which fall in each category. Assume that the τ j and ξ j are known. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. Let A be any n×k function of X such that A0 X = Ik . j = 1. This property is called semiparametric eﬃciency. π r ) . It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. . A broader justiﬁcation is provided in Chamberlain (1987). but it is quite limited in scope. xi = ξ j = π j . . ¡ ¢ P yi = τ j . Not only has the class of models has been restricted to homoskedastic linear regressions. . xi ) is discrete. r for some constant vectors τ j . As the data are multinomial.. The MLE β mle for β is then the analog of (4.21) 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 ⎠ .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. and π j .. Set C = A − X (X 0 X)−1 . the deﬁnition (4. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . That is.. Suppose that the joint distribution of (yi . but the π j are unknown.. ˆ β mle = ⎝ j j=1 j=1 33 . We discuss the intuition behind his result in this section. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators..3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. This latter restriction is particularly unsatisfactory. ξ j . Note that X 0 C = 0. That is. and is a strong justiﬁcation for the least-squares estimator..

We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . He observes that the above argument holds for all multinomial distributions.Substituting in the expressions for π j . 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.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.5. if the data have a discrete distribution. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.1. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.22) 34 . He proves that generically the OLS estimator (4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.10 Omitted Variables xi = µ x1i x2i ¶ .10) for the class of models satisfying Assumption 3. and thus so is the OLS estimator. 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 . Chamberlain (1987) extends this argument to the case of continuously-distributed data. (4.9). the maximum likelihood estimator is identical to the OLS estimator.

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

If the i’th observation 36 . A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise.25) below. the OLS estimator based on the sample excluding the i’th observation. deﬁne the leave-one-out least-squares estimator of β. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei .12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors.−i = yi − x0 β (−i) = (1 − hi )−1 ei . To investigate the possibility of inﬂuential observations. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . What is happening is that when the regressors are highly dependent.26) As we can see. 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. that is.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . We derive expression (4.25) β (−i) = β − (1 − hi )−1 X 0 X where ¢−1 ¡ xi hi = x0 X 0 X i The i’th observation is inﬂuential on the least-squares estimate if the deletion of the observation ˆ from the sample results in a meaningful change in β. ˆ ˆ (4. We can also deﬁne the leave-one-out residual ˆ ˆ ei.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. The hi take values in [0. the precision of individual estimates are reduced.27) (4. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . ˆ i A simple comparison yields that ˆ ei − ei. 1] and sum to k. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. the worse the precision of the individual coeﬃcient estimates. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. As a consequence.−i = (1 − hi )−1 hi ei . since as ρ approaches 1 the matrix becomes singular.

ˆ We now derive equation (4.1) in Section 2. The key is equation (2. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .25). Investigations into the presence of inﬂuential observations can plot the values of (4. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .27). which is considerably more informative than plots of the uncorrected residuals ei .This implies has a large value of hi . then this observation is a leverage point and has the potential to be an inﬂuential observation.

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

tangent lines lie below it.Markov’s Inequality. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. If Xi ∈ Rk is iid and E |Xi | < ∞. So for all x. Let a + bx be the tangent line to g(x) at x = EX. (5. n→∞ lim P (|Zn − Z| > δ) = 0. Eg(X) ≥ a + bEX = g(EX).1 Weak Law of Large Numbers (WLLN). 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. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. 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 ) = + . Theorem 5.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Set Y = g(X) and let f denote the density function of Y. n i=1 42 . Then Z ∞ −1 P (Y > α) = α αf (y)dy Zα∞ ≤ α−1 yf (y)dy α Z ∞ ≤ α−1 yf (y)dy = α−1 E(Y ) −∞ the second-to-last inequality using the region of integration {y > α}. if for all δ > 0. ¥ Proof of Holder’s Inequality. Since g(x) is convex. For any strictly increasing function g(X) ≥ 0. then as n → ∞ n 1X Xn = Xi →p E(X).3). denoted Zn →p Z as n → ∞. Applying expectations. The WLLN shows that sample averages converge in probability to the population average.2.4) Proof of Jensen’s Inequality. Note EU = EV = 1. P (g(X) > α) ≤ α−1 Eg(X). Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . p p p q which is (5. ¥ 5. as stated. =E U V p q p q Proof of Markov’s Inequality.

¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. and the bound |Wi | ≤ 2C. if for all x at which F (x) is continuous.Proof: Without loss of generality.6) By Jensen’s inequality (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. where Z has distribution F (x) = P (Z ≤ x) .3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ¡¯ ¯ P ¯X n ¯ > δ ≤ η. Fix δ and η. Theorem 5.4). we can set E(X) = 0 (by recentering Xi on its expectation). by Markov’s inequality (5. 5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . the fact that the Wi are iid and mean zero. the fact that X n = W n + Z n . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.5). Jensen’s inequality (5. If Xi ∈ Rk is iid and E |Xi |2 < ∞.1) and (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. Set ε = δη/3. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞.7). the triangle inequality.1 Central Limit Theorem (CLT).1). Finally. V ) . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . We say that Zn converges in distribution to Z as n → ∞. P ¯X n ¯ > δ ≤ η. Fn (x) → F (x) as n → ∞. denoted Zn →d Z. as needed.6) and (5. 43 . We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N.3.

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

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 . we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). √ Theorem 5.1 Continuous Mapping Theorem 1 (CMT). Σ) . gθ Σgθ . µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Hence g(Zn ) →p g(c) as n → ∞. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Ik ) distribution.4.4. Recall that A ⊂ B implies P (A) ≤ P (B). we see that as n → ∞. 45 . Stacking across elements of g. Proof : By a vector Taylor series expansion.3 Delta Method: If n (θn − θ0 ) →d N (0. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. If Zn →p c as n → ∞ and g (·) is continuous at c. This is suﬃcient to establish the theorem. Theorem 5. where θ is m × 1 and Σ is m × m.4 Asymptotic Transformations Theorem 5. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0.2 Continuous Mapping Theorem 2. then g(Zn ) →p g(c) as n → ∞. and g(θ) : Rm → Rk . Proof: Since g is continuous at c.4. Σ) = N 0. Since cλλ (λn ) → cλλ (0) = −Ik . for each element of g.√ where λn → 0 lies on the line segment joining 0 and λ/ n. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. k ≤ m. If Zn →d Z as n → ∞ and g (·) is continuous. ¥ 5. then g(Zn ) →d g(Z) as n → ∞.

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.1: Sampling Density of β 2 To illustrate the possibilities in one example. since it is a function of the random data. the density function of β 2 was computed and plotted in Figure 6.1 Sampling Distribution The least-squares estimator is a random vector.1 for sample sizes of n = 25. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density. In general. 46 . Using ˆ simulation methods. and therefore has a sampling distribution.Chapter 6 Inference 6. ˆ Figure 6. n = 100 and n = 800. its distribution is a complicated function of the joint distribution of (yi . The verticle line marks the true value of the projection coeﬃcient. xi ) and the sample size n.

1. Assumption 3. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. ˆ Theorem 6.1 by the fact that the sampling densities become more concentrated as n gets larger.1 Under Assumption 3. β →p β as n → ∞.2 Consistency ˆ As discussed in Section 6. (6.1).1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.3) Ã where g(A. and the continuous mapping theorem (Theorem 5. First.3). ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1) and ˆ We now deduce the consistency of β. ˆ 47 . Ã n ! n X 1X 0 1 ˆ xi xi .1.5. Equation (4. ·) is continuous at (Q. (6. To characterize the sampling distribution more fully.1).2).2.2.4 implies that Q−1 exists and thus g(·. Hence by the continuous mapping theorem (Theorem 5. n i=1 (6.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.5. This is illustrated in Figure 6. the OLS estimator β is has a statistical distribution which is unknown. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.4.5. we can conclude ˆ that β →p β. (6. For a complete argument. 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 . Assumption 3.1.2) i i n i=1 n From (6. 6. 0).1 and the WLLN (Theorem 5. 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. using (6.1). Proof. As the sample size increases the density becomes more concentrated about the population coeﬃcient. xi ei →p g (Q. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . we will use the methods of asymptotic approximation.4.1).

1). 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 . Thus σ 2 is consistent for σ 2 . i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. (6.1). We need a strengthening of the moment conditions.1 guarantees that the elements of Ω are ﬁnite. Assumption 6. by the Cauchy-Schwarz inequality (5. (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.6) n i=1 48 .5. i i Assumption 6. By the central limit theorem (Theorem 5.3) and Theorem (6. E ¯ei ¯ E ¯e4 ¯ i i i i (6. ˆ Proof. since n/(n − k) → 1 as n → ∞.2. Ee4 < ∞ and E |xi |4 < ∞.2. n 1 X √ xi ei →d N (0. To see this. ˆ n−k 6. (6.5. Ω) .2 Under Assumption 3.1.2). (6. ˆ Finally.3.3. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.Theorem 6.3.1.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.1 In addition to Assumption 3. it follows that s2 = ¥ n σ 2 →p σ 2 .2).

3. after rescaling. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . This holds true for all joint distibutions of (yi . In´Figure 6. xi ) which satisfy the conditions of Assumption 6. |ε| ≥ 1.1 Under Assumption 6. Let yi = β 0 + β 1 xi + εi where xi is N (0.7) is true then V = V 0 . The asymptotic distribution ´ Theorem 6.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β .3. 1 X √ xi ei n i=1 n ! the N (0. Under (6. (6. there is no simple answer to this reasonable question. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.7) is true or false.9) we deﬁne V 0 = Q−1 σ 2 whether (6. The approximation may be poor when n is small. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. We call V 0 the homoskedastic covariance matrix.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.1. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.1. 1). is approximately normal when the sample size n is suﬃciently large.6). i i Condition (6. however. The expression V = Q−1 ΩQ−1 is called a sandwich form. Ω) ¡ ¢ = N 0.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. The trouble is that no matter how large is the sample size. We illustrate this problem using a simulation. Q−1 ΩQ−1 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0. but this is not a necessary condition. Theorem 6. 1) asymptotic distibution.2). setting n = 100 and varying the parameter α. V is often referred to as ˆ the asymptotic covariance matrix of β. otherwise V 6= V 0 .9) In (6.Then using (6. In Figure 6. We say that ei is a Homoskedastic Projection Error when (6. when xi and ei are independent. its variance diverges q ³ ´ ˆ to inﬁnity. As α approaches 2.3. for example.7) Cov(xi x0 . When (6.1).3.7) holds.3. How large should n be in order for the approximation to be useful? Unfortunately. V ) where V = Q−1 ΩQ−1 .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. and (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . There is a special case where Ω and V simplify. For α 49 . However. e2 ) = 0.1 states that the sampling distribution of the least-squares estimator.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.

6 and 8. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.2) and Theorem 6.2. We show the sampling distribution of n β 1 − β 1 setting n = 100.10) without changing this result.0 the density is very close to the N (0. As k increases. for k = 1.Figure 6.10) V 0 = Q−1 s2 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.2 and 6.3. concentrating most of the probability mass around zero. 6. Another example is shown in Figure 6. 1) density. 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. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 4. The lesson from Figures 6. As α diminishes the density changes signiﬁcantly.2: Density of Normalized OLS estimator α = 3.1) it is clear that V 0 →p V 0 . The estimator 2 2 in (6.11) 50 . 1). we need an estimate of Ω = E xi x0 e2 . 1) asymptotic approximation is never guaranteed to be accurate. the sampling distribution becomes highly skewed and non-normal.3 is that the N (0.

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

the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.used by an author when studying their work.35/988 = .20 −0.80 .1. p ˆ In this case the two estimates are quite similar.2.020) 6.085 p ˆ and that for β 1 is . (.80 40.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.14 6.480 . (6.30 + 0.039 and ˆ V = µ 1 14. and then the square roots.493 0.12) in turn.83 −0. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. (6.2/988 = . First. i i i i n i=1 Second.83 ¶−1 µ .14 14.83 ¶−1 = µ 7.199 2.6 ¶µ 1 14. n n i=1 52 .035 ¶ .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. just as any other estimator. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. we return to the log wage regression of Section 4.14 205.020.5 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.14 205.199 2.5) and the WLLN (Theorem 5.20 = V 14.117 Educationi . From a computational standpoint.493 −0. Using (6.085) (.14 14. from which it follows that V →p V as n → ∞.14 205.98 −0.80 2. but not under another set of assumptions. We calculate that s2 = 0. Ω 2.4) 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 . To illustrate. by Holder’s inequality (5.80 40.480 ˆ0 = 0. then take the diagonal elements. The standard errors for β 0 are 7.20 and µ ¶ ˆ = 0.

1 As n → ∞. Recall from Section 4. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.11) with the leave-one-out estimator ei.26). which. by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .25).13) of Efron (1982).13) Using formula (4.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. Using this substitution. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. these establish consistency. Andrews (1991) suggested an similar estimator based on cross-validation. n i=1 n ˆ ˆ Theorem 6.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . i=1 Third.−i = (1 − hi )−1 ei ˆ presented in (4. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. you can show that 1 Xˆ ¯ β= β (−i) . n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. Ω →p Ω and V →p V. ¯ ¯n ¯ n i=1 so Together. From equation (3. 6.5. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .

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

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

It is designed to cover θ with high probability. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution.96 and z. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. pn →d U [0. For example. regardless of the complication of the distribution of the original test statistic. Then the asymptotic p-value of the statistic tn is pn = p(tn ). and is a function of the data and hence is / random. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . from which it follows that pn →d U [0. under H0 . The p-value is more general. Otherwise the test does not reject. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. That is. 1).9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. Deﬁne the tail probability. 1].645.05 = 1. An alternative approach. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. associated with Fisher. That is. 1). The asymptotic p-value for the above statistic is constructed as follows. In a sense. s(ˆ θ) Under H0 .025 = 1. in that the reader is allowed to pick the level of signiﬁcance α. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. z. 1].The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . 1]. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. To see this fact. If the p-value pn is small (close to zero) then the evidence against H0 is strong. Let zα/2 is the upper α/2 quantile of the standard normal distribution. Either θ ∈ Cn or θ ∈ Cn . 6. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. tn →d N (0. 56 . p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . however. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). or “accepts” H0 . The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. is to report an asymptotic p-value. The coverage probability is P (θ ∈ Cn ). if Z ∼ N (0. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 .

05. = n h(β) − θ0 Hβ V Hβ 57 (6.96s(ˆ ≈ ˆ ± 2s(ˆ .17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). This corresponds to selecting the conﬁdence h i h ˆ ± 1.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. θ The interval has been constructed so that as n → ∞. 6. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. 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). 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 . ˆ + zα/2 s(ˆ . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. and it is desired to test the joint restrictions simultaneously. or α = . θ θ) (6. In this case the t-statistic approach does not work. the most common professional choice isi95%. 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. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.18) . We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .

the upper-α quantile q 2 of the χ2 distribution. The asymptotic p-value for Wn is pn = p(Wn ). Wn = n R0 β − θ0 ´ √ ³ The delta method (6. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . As before. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.1 Under H0 and Assumption 6.When h is a linear function of β. and Theorem 6. Hβ (β) →p Hβ .3.2. and there are q = k2 restrictions. a chiq square random variable with q degrees of freedom.8. Furthermore. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.19) σ2 ˆ where σ2 = ˜ 1 0 e e. the test rejects at the α% level iﬀ pn < α. Hβ (β) is a continuous function of β. 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. if rank(Hβ ) = q. Also h(β) = a selector matrix. For example. 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. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. 1] under H0 . In this case. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .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 . q and pn is asymptotically U[0. ˜˜ n ˜ e = Y − X1 β 1 . 6. χ2 (. θ = β 2 .1. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . Hence β β by Theorem A. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. then Wn →d χ2 .15) showed that n ˆ − θ →d Z ∼ N (0.5. The null hypothesis is H0 : β 2 = 0.025 . ˆ Wn = n θ θ q θ θ Theorem 6.05) = 3. h(β) = R0 β. Vθ ).10.84 = z. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).1 showed θ ˆ that V →p V.

= F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. We now derive expression (6. the residual is ˜ ˜ e = M1 Y. ˆˆ n ˆ e = Y − X β. By the FWL theorem. First. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. 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. as the sum of squared errors is a typical output from statistical packages.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . 59 .19). ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. Thus ¡ 0 ¢−1 R = X2 M1 X2 and ³ ¡ ´−1 ³ ¢−1 ´−1 ¡ 0 ¢ ˆ = σ −2 n−1 R0 X 0 X ˆ R = σ −2 n−1 X2 M1 X2 ˆ R0 V 0 R ³ ´−1 ˆ0 ˆ ˆ Wn = nβ 2 R0 V 0 R β2 = 0 ˆ ˆ0 β 2 (X2 M1 X2 ) β 2 .19) the F form of the Wald statistic. note that if we regress Y on X1 alone. still this formula often ﬁnds good use in reading applied papers. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . Because of this connection we call (6. 2 2 2 or alternatively. Now consider the residual regression of e on X2 = M1 X2 . and σ2 = ˆ 1 0 e e. Also. This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . note that partitioned matrix inversion (2.2) ¢−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 .are from OLS of Y on X1 . X2 ). The elegant feature about (6.19) is that it is directly computable from the standard output from two simple OLS regressions. 2 σ ˆ To simplify this expression further.

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

β has an exact normal distribution and t has an exact t distribution. the notable distinction is between the N (0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . n−k • ∼ tn−k ˆ In Theorem 6.10) µ h i ¶ 2 (X 0 X)−1 N 0. 0.1 If ei is independent of xi and distributed N(0.10) then ´ ³ ˆ • β ∼ N 0. We summarize these ﬁndings Theorem 6.1 shows that under the strong assumption of ˆ normality. 0.12. σ ˆ ˆ βj − βj βj − βj N (0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . In contrast. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . β 2 .1 and Theorem 6.1 we showed that in large samples. σ 2 ) discussed above. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . β 2 . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. (Unless the sample size is unreasonably small.a chi-square distribution with n − k degrees of freedom. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . so as a practical matter it does not matter which distribution is used. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . Theorem 6. σ 2 ) − Ln (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . σ2 ˆ 61 . with residual variance σ .) Now let us partition β = (β 1 .3. 0. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. β 2 . 1) and tn−k distributions.12. if standard errors are calculated using the homoskedastic formula (6. β and t are approximately normally distributed. The critical values are quite close if n − k ≥ 30. 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. Furthermore. a good testing procedure is based on the likelihood ratio statistic. As inference (conﬁdence intervals) are based on the t-ratio. σ 2 ). and standard errors are calculated using the homoskedastic formula (6. σ 2 ) = − log σ − log (2π) − .8. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.

they can work quite poorly when the restrictions are nonlinear. The increasing solid line is for the case β = 0. In the present context of the Wald statistic. setting n/σ 2 = 10. Take the model yi = β + ei ei ∼ N (0.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. the statistic Wn (s) varies with s. 62 . To demonstrate this eﬀect. 6. 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. Our ﬁrst-order asymptotic theory is not useful to help pick s. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. Through repetition. The decreasing dashed ˆ = 1. ˆ Let β and σ 2 be the sample mean and variance of yi . LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. 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. while there are other values of s for which test test statistic is insigniﬁcant.8. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . 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. features of this distribution can be calculated. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . Letting h(β) = β s .84 — the probability of a false rejection. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . This can be seen by a simple example introduced by Lafontaine and White (1986). σ 2 ) and consider the hypothesis H0 : β = 1. we have plotted in Figure 6. This is an unfortunate feature of the Wald statistic.7. and noting Hβ = sβ s−1 . 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.4 the Wald statistic Wn (s) as a function ˆ of s.

When comparing statistical procedures. Table 4. Any other choice of s leads to a test with unacceptable Type I error probabilities. In Table 4.84 | β = 1) . The value of s is varied from 1 to 10. In each case.Figure 6. Test performance deteriorates as s increases. The null hypothesis β s = 1 is true. however. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. n. remember that the ideal Type I error probability is 5% (.1 reports the simulation estimate of the Type I error probability from 50. Error rates avove 10% are considered excessive. looking for tests for which rate rejection rates are close to 5%. There is. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Rates above 20% are unexceptable.4: Wald Statistic as a function of s P (Wn (s) > 3. the Type I error probability improves towards 5% as the sample size n increases. These probabilities are calculated as the percentage of the 50. Given the simplicity of the model. this probability depends only on s. n is varied among 20.000 random samples.000 simulated Wald statistics Wn (s) which are larger than 3. For this particular example.4.1 we report the results of a Monte Carlo simulation where we vary these three parameters.84. and σ is varied among 1 and 3. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. In Table 2. 100 and 500. Typically. no magic choice of n for which all tests perform uniformly well.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . Table 4. we compare the rates row by row. the only test which meets this criterion is the conventional Wn = Wn (1) test. To interpret the table. and σ 2 .05) with deviations indicating+ distortion. and rarely fall outside of the 3%-8% range.1 you can also see the impact of variation in sample size. Type I error rates between 3% and 8% are considered reasonable. so these probabilities are Type I error.

06 .14 .06 .34 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.06 .05 .24 .22 .06 .06 .05 .08 .15 .35 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . 64 .13 .15 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. β 1 .10 . While this is clear in this particular example. Other choices are arbitrary and would not be used in practice. so the hypothesis can be stated as H0 : θ = r.20 .10 .30 .07 .05 .14 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .06 .05 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.13 .19 .31 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.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 .23 . deﬁne θ = β 1 /β 2 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.16 Rejection frequencies from 50.28 .13 .12 .33 .08 .15 .21 .25 .07 .10 . β 2 ) be the least-squares estimates of (6.06 .20 .08 .20).08 .07 .17 .22 .05 . Equivalently.25 .06 .07 .15 .12 . This point can be illustrated through another example.18 .26 .11 .08 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .05 .07 .09 .

06 . .10 . and alternatives to asymptotic critical values should be considered.00 . and are close to the ideal 5% rate for both sample sizes. 6.26 .05 . It is also prudent to consider alternative tests to the Wald statistic.06 .05 .07 .00 .7.10 . . σ 2 ) draw with σ = 3.00 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .05 .47 .06 .645) P (tn > 1.14 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.50.00 .25.00 .06 .25 . this formulation should be used. In all cases. along with sample size n. We let x1i and x2i be mutually independent N (0.09 .06 . In contrast. 65 .75 1.645) are calculated from 50.06 . while the right tail probabilities P (t1n > 1.00 .000 simulated samples. However. We vary β 2 among .06 .05 . such as the GMM distance statistic which will be presented in Section 9.645) t1n t2n t1n t2n t1n t2n t1n t2n . 1) variables. The results are presented in Table 4. If no linear formulation is feasible.05 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .2. the entries in the table should be 0.00 .00 . and 1. . The implication of Table 4. and normalize β 0 = 0 and β 1 = 1.05 . Ideally.75.645) P (tn > 1.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.15 .05 β2 .06 .10 .00 . especially for small values of β 2 .645) and P (tn > 1.0 and n among 100 and 500. This leaves β 2 as a free parameter.05. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .645) are close to zero in most cases. The left tail probabilities P (t1n < −1. Table 4.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.00 The one-sided Type I error probabilities P (tn < −1.645) greatly exceed 5%.12 . ei be an independent N (0. then the “most linear” formulation should be selected.05 .1. the rejection rates for the t1n statistic diverge greatly from this value.645) P (tn < −1.50 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.28 .05 .05 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.02 .06 .15 . if the hypothesis can be expressed as a linear restriction on the model parameters.06 . In this section we describe the method in more detail.

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

it is simple to make inferences about rejection probabilities from statistical tests. Generally. but requires more computational time. experience squared. Again our dependent variable is the natural log of wages. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. for a selection of choices of n and F. Hence the ³ ´ ˆ standard errors for B = 100. We now expand the sample all non-military wage earners. and dummy variable indicators for the following: married.05) (. immigrant. excluding military. For the dependent variable we use the natural log of wages. B b=1 (6. and therefore it is straightforward to calculate standard errors for any quantity of interest. Then qα is the N ’th number in this ordered sequence. potential work experience. It is therefore convenient to pick B so that N is an integer. and . As P is unknown. For example. then B will have to be increased. If the standard error is too large to make a reliable inference. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. hispanic.007. the performance will depend on n and F. In particular. and 90% sample quantiles of the sample {Tnb }. The α% sample quantile is a number qα such that α% of the sample are less than qα . experience squared.22/ B. B. if we set B = 999.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high.96) . We separately estimate equations for white and non-whites.21). this may ˆ be approximated by replacing P with P or with an hypothesized value. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1.022. 6. so that coeﬃcients may be interpreted as semi-elasticities.96) . female. female. In many cases. are. .95) /B ' . Often this is called the number of replications.96) is iid Bernoulli. a larger B results in more precise estimates of the features of interest of Gn . For regressors we include years of education. an estimator or test may perform wonderfully for some values. respectively. union member. and estimate a multivariate regression.15 Estimating a Wage Equation We again return to our wage equation. The average (6. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. Furthermore. potential work experience. For example. As discussed above. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. and hispanic. and poorly for others.003. such as the percentage estimate reported in (6. We us the sample of wage earners from the March 2004 Current Population Survey. immigrant. In practice. then we can set s P = (. the choice of B is often guided by the computational demands of the statistical procedure. we included a dummy 67 . Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. therefore. the researcher must select the number of experiments. The random variable 1 (Tnb ≥ 1. where N = (B +1)α.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. and dummy variable indicators for the following: married. s P = . and non-white. 1000.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. and our regressors include years of education. equalling 1 with probability P = E1 (Tnb ≥ 1. It is therefore useful to conduct a variety of experiments. and 5000. union member. Quite simply.

48772 = 515.097 −. 2β 3 68 .001 . Wn = n 1 − 2 = 18.014 .032 .101 . excluding the coeﬃcients on the state dummy variables.49452 σ ˜ Notice that the two statistics are close. Ignoring the other coeﬃcients.013 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. we ﬁnd Wn = 550. 808 1 − .00057 . The F form of the Wald statistic (6. θ ˆ 2β 3 β2 .232 .008 . Computing the Wald statistic (6.808 .033 −.variable for state of residence (including the District of Columbia. but not equal.4945. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.002 .102 −.010 .070 . this adds 50 regressors). as the 1% critical value for the χ2 distribution is 76. 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. Table 4. Alternatively.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. reestimating the model with the 50 state dummies excluded.4877 18.102 −.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.027 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.808 so the parameter estimates are quite precise and reported in Table 4.121 −.19) is ˜ µ ¶ µ ¶ σ2 ˆ . the restricted standard deviation estimate is σ = .34 ˆ s(β) .00002 .69.007 .1.18) that the state coeﬃcients are jointly zero. The available sample is 18. Using either statistic the hypothesis is easily rejected.

96.Using the Delta Method. In the previous section we discovered that such t-tests had very poor Type I error rates. 29. Since tn (θ) is a non-linear function of θ. not testing a hypothesis.5].5]. so we have to go one step further. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. 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 ). In the present context we are interested in forming a conﬁdence interval. this is a poor choice. However. This set is [27. implying a 95% conﬁdence θ) interval of [27. 69 . 29.9. but the lower end is substantially lower. Instead. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test.40.0. we can calculate a standard error of s(ˆ = . there is not a simple expression for this set. we found better Type I error rates by reformulating the hypothesis as a linear restriction. but it can be found numerically quite easily. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. This is the set of θ such that |tn (θ)| ≤ 1.

3. β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix. r ˜ is a known s × 1 vector. (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. subject to the constraint that β 1 = −β 2 . λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. β 2 ). β 2 ). 0 < s < k. 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) . ˜ (b) Verify that R0 β = r. In the model Y = X1 β 1 + X2 β 2 + e. subject to the constraint that β 1 = c (where c is some given vector) is simply the OLS regression of Y − X1 c on X2 . ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. ﬁnd the least-squares estimate of β = (β 1 . show that the least-squares estimate of β = (β 1 . (d) Under the ´ standard assumptions plus R0 β = r. In the model Y = Xβ + e. show that the least-squares estimate of β = (β 1 . 4.6. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. 2. the following deﬁnition is used. 1.16 Exercises For exercises 1-4. ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. In the model Y = X1 β 1 + X2 β 2 + e. (c) Show that if R0 β = r is true. ˜ That is. then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. In the model Y = X1 β 1 + X2 β 2 + e. and rank(R) = s. β − β = Ik − X 0 X 70 .

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

Let η i = e2 . 74 .Chapter 7 Additional Regression Topics 7. . Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . the least-squares estimator is ineﬃcient. However. σ 2 }. . Typically.. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . σ 2 } and σ 2 = σ 2 (x ) = E e2 | x ... The GLS estimator (7. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1 Generalized Least Squares In the projection model. z1i are squares (and perhaps levels) of some (or all) elements of xi . where z1i is some q × 1 function of xi . The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi ..1) XD Y β = X 0 D−1 X ¡ ¢ 2 . 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. σ1 We now discuss this estimation problem.. Often the functional form is kept simple for parsimony.. The theory of Chamberlain (1987) can be used to show that in this model the semiparametric eﬃciency bound is obtained by the Generalized Least Squares (GLS) estimator ¢−1 ¡ 0 −1 ¢ ¡ ˜ (7. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient.2) E (ξ i | xi ) = 0.1) infeasible since the matrix D is unknown.

and hence we can estimate 0 σ 2 = zi α by i ˜ (7. Vα = E zi zi (7.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Vα ) (7. or FGLS. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. and will depend on the model (and estimation method) for the skedastic regression.3) ˆ ˆ While ei is not observed. as it is estimating the conditional variance of the regression of yi on xi .Suppose ei (and thus η i ) were observed. If σ 2 < 0 for some i. if σ 2 ≈ 0 for some i. . xi ).. 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. This is the feasible GLS. 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. We may call (7... we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). which is typically undesirable. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . 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 ˜i estimator is not well deﬁned. there is no guarantee that σ 2 > 0 for all i. ˜i Suppose that σ 2 > 0 for all i. This suggests 75 . estimator of β. We have shown that α is consistently estimated by a simple procedure. then the FGLS estimator will force ˜i the regression equation through the point (yi .4) the skedastic regression. 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 . Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0.6) σ 2 = α0 zi . Furthermore.

V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. the natural estimator of the asympˆ totic variance of β is Ã n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . Why then do we not exclusively estimate regression models by FGLS? This is a good question. σ 2 ] σi i for some σ 2 > 0.2) is correctly speciﬁed. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. First.. . FGLS is asymptotically superior to OLS. It is possible to show that if the skedastic regression is correctly speciﬁed. 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 → ∞. V n n i=1 . β should perhaps be i i called a quasi-FGLS estimator of β. 1992).that there is a need to bound the estimated variances away from zero.1. We just state the result without proof.. similar to the covariance matrix of the OLS estimator. ¢¢−1 ¡ ¡ . i ˜ 0 is inconsistent for V .. e2 }. There are three reasons. then FGLS is asymptotically equivalent to GLS.1 If the skedastic regression is correctly speciﬁed. Its asymptotic variance is not that given in Theorem 7. Theorem 7.1. Instead. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. In this case we interpret α0 zi as a linear projection of e2 on zi . A trimming rule might make sense: σ 2 = max[˜ 2 . FGLS estimation depends on speciﬁcation and estimation of the skedastic regression.1. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.1. In the linear regression model. V ). but the proof of this can be tricky. ´´−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 .1. This estimator V 0 is appropriate when the skedastic regression (7. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . Since the form of the skedastic regression is unknown. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). Unless σ 2 = α0 zi . and was proposed by Cragg (Journal of Econometrics. and it may be estimated with considerable 76 V takes a sandwich form√.

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

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

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

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

These facts deﬁnitions motivate three estimators of θ.5.9) 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. however.5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . as i=1 these estimators are indeed identical. Two useful facts about the median are that (7. let Y be a continuous random variable. i n n i=1 (7. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. The second is the value which minimizes n n |yi − θ| .To recall the deﬁnition and properties of the median. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. and the substantive assumption is that the median function is linear in x. Now let’s consider the conditional median of Y given a random variable X. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) .10) The LAD estimator has the asymptotic distribution 81 . The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. These distinctions are illusory. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x.

the conditional density of the error at its median. where V = and f (e | x) is the conditional density of ei given xi = x. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . Computation of standard error for LAD estimates typically is based on equation (7. by the central limit theorem (Theorm 5. ¢¢−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) .5.11).1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. This can be done with kernel estimation techniques.5.10) is equivalent to g n (β) = 0.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . See Chapter 16. V ). Pn −1 0 β)) . When f (0 | x) is large. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .1 is advanced.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. ∂β 0 so Third.1 ´ √ ³ˆ n β − β 0 →d N (0. Let g(β) = Eg (β). by a Taylor series expansion and the fact g(β 0 ) = 0 82 . the height of the error density at its median.Theorem 7. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. (7. then there are many innovations near to the median. In the special case where the error is independent of xi .3. we provide a sketch here for completeness.5. While a complete proof of Theorem 7. First. The main diﬃculty is the estimation of f (0). then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . ˆ Proof of Theorem 7. and this improves estimation of the median.

then (7.5. For ﬁxed τ . For the random variables (yi . 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. Again. then F (Qτ (x) | x) = τ .9) for the median to all quantiles. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. 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)) . when F (y | x) is continuous and strictly monotonic in y. V ). (7.12) Qτ = argmin Eρτ (U − θ) . The following alternative representation is useful. If the random variable U has τ ’th quantile Qτ . Exi x0 ) →d i 2 = N (0. The median is the special case τ = . As functions of x. so you can think of the quantile as the inverse of the distribution function. the quantile regression functions can take any shape.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. For τ ∈ [0.13) This generalizes representation (7. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . The third line follows from an asymptotic empirical process argument. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . then F (Qτ ) = τ . ¥ 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.13). the τ ’th conditional quantile of ei is zero. 7. Vτ ).6. ˆ Given the representation (7. if the model yi = x0 β + ei has i been ﬁt by OLS. Fortunately.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . since it has discontinuous derivatives. and are widely available. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. 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 test their signiﬁcance using a Wald test. the asymptotic variance depends on the conditional density of the quantile regression error.5. Furthermore. conventional Newton-type optimization methods are inappropriate. Thus. ´ √ ³ˆ Theorem 7. The null model is yi = x0 β + εi i 84 . i By construction.1. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005).1 n β τ − β τ →d N (0. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . 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. it is useful to have a general test of the adequacy of the speciﬁcation.12). then f (0 | xi ) = f (0) . Another popular approach is the RESET test proposed by Ramsey (1969). fast linear programming methods have been developed for this problem. n numerical methods are necessary for its minimization. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. the unconditional density of ei at 0. otherwise its properties are unspeciﬁed without further restrictions. ¡ ¡ ¢¢−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. and form a Wald statistic i for γ = 0. When the error ei is independent of xi .

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

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

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

The methods extend readily to the issue of selection among multiple regressors. . . Similarly for ˆ the BIC. For example. β 3 = · · · = β K = 0 . 048. xKi }. We have discussed model selection between two models. 210 = 1024. MK : β 1 6= 0. . In the ordered case... In the unordered case. one can show that thus LRn →p ∞. there are 2K such models. and the AIC or BIC in principle can be implemented by estimating all possible subset models. In the latter case. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0.. Also under M2 . 88 . . the models are M1 : β 1 6= 0. selecting based on (7. β K 6= 0. 576. . β 2 6= 0. and then selects the model with the lowest AIC (7. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive.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. and 220 = 1.17). However. which can be a very large number. There are two leading cases: ordered regressors and unordered. β 2 6= 0. a model consists of any possible subset of the regressors {x1i . The AIC selection criteria estimates the K models by OLS. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. stores the residual variance σ 2 for each model. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . which regressors enter the regression). which are nested.15). . log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. .

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

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

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

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

Fn (y.. In general. x) is called the empirical distribution function (EDF). x). x) (1 − F (y. x∗ ≤ x) = Fn (y. by the CLT (Theorem 5. x) = P (yi ≤ y. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . Fn is by construction a step function. 50.2. note that for any (y. x))) . The EDF is a consistent estimator of the CDF. Note that while F may be either discrete or continuous. it is helpful to think of a random pair (yi . x) →p F (y. the EDF step function gets uniformly close to the true CDF. I have plotted the EDF and true CDF for three random samples of size n = 25. That is. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . ∗ P (yi ≤ y. i = 1. Notationally.2) Fn (y. x)) →d N (0. Recall that F (y. but the approximation appears to improve for the large n. The random draws are from the N (0.8.. Thus by the WLLN (Theorem 5. x) .2 The Empirical Distribution Function Fn (y. where 1(·) is the indicator function. x) = n i=1 Figure 8.1). To see the eﬀect of sample size on the EDF. n. the EDF is only a crude approximation to the CDF. x). in the Figure below. . (8. Fn is a nonparametric estimate of F. i 93 .3.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . This is a population moment. √ n (Fn (y. For n = 25. xi ). x∗ ) with the i distribution Fn . To see this. Furthermore. x) − F (y.. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. and 100.1). 1) distribution. F (y. x). as the sample size gets larger.

(When in doubt use θ. 94 The bias of ˆ is θ . A theory for the determination of the number of bootstrap replications B has been developed by Andrews and Buchinsky (2000). the parameter ˆ estimate. x) i = = the empirical sample average. x∗ .3 Nonparametric Bootstrap The nonparametric bootstrap is obtained when the bootstrap distribution (8. the t-ratio ˆ − θ /s(ˆ depends on θ.2) as the estimate Fn of F. sampling from the EDF is equivalent to random sampling a pair (yi .. ∗ ∗ ∗ The bootstrap statistic Tn = Tn (y1 . n X i=1 ∗ h (yi .. .. x∗ . yn . x∗ . When the statistic Tn³is a function of F. Since Fn is a discrete probability distribution putting probability mass 1/n at each sample point.. x∗ } will necessarily have some ties and multiple values. . xi ) randomly from the sample. . with the following points of clariﬁcation: • The sample size n used for the simulation is the same as the sample size. This is i equivalent to sampling a pair (yi . xi ) from the observed data with replacement.) at the sample estimate ˆ θ. B is known as the number of bootstrap replications. n i This is repeated B times. a bootstrap ∗ ∗ sample {y1 . However. x∗ ) are drawn randomly from the empirical distribution.1) is deﬁned using the EDF (8.4 Bootstrap Estimation of Bias and Variance θ τ n = E(ˆ − θ0 ). so long as the computational costs are reasonable. It is desireable for B to be large. x∗ ) . it is typically through dependence on a parameter. Since the EDF Fn is a multinomial (with n support points). The algorithm is identical to our discussion of Monte Carlo simulation. as there are 2n possible samples {(y1 . x∗ ) : i Z ∗ Eh (yi . n i=1 8. As the bootstrap statistic replaces F with θ θ) ˆ Fn . x∗ )) = h(y.. which is generally n 1 not a problem. the value of θ implied by Fn . n 1 such a calculation is computationally infeasible. Typically θn = θ. ∗ • The random vectors (yi . Fn ) is calculated for each bootstrap sample. x)dFn (y. xi ) . xi ) P (yi = yi . x∗ )}.. The popular alternative is to use simulation to approximate the distribution.∗ We can easily calculate the moments of functions of (yi . in principle the distribution G∗ n ∗ ∗ could be calculated by direct methods. it similarly replaces θ with θn .. ´ For example. x∗ = xi ) i n 1X h (yi . (yn . yn . 8. B = 1000 typically suﬃces. In consequence... Sampling from the EDF is particularly easy.

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

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

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

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

v 2 ). The following notation will be helpful. The derivative of an even function is odd.8.3) ´ √ 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 → ∞. θ θ θ ˆ θ ∗ ∗ Computationally. We say that a function g(x) is even if g(−x) = g(x). F ) = Φ + o (1) . it says nothing.4) v ¡ ¢ While (8. however. not ˆ − θ0 . Basically. Deﬁnition 8. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic. 99 .8.] 8. writing Tn ∼ Gn (x. Equivalently. θ [This is a typical mistake made by practitioners.3 an = o(n−r ) if nr |an | → 0 as n → ∞. Let an be a sequence. Thus here Tn (θ) = Wn (θ). where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . about the rate v of convergence. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α.8. Let Tn be a statistic such that (8. Deﬁnition 8. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . A better asymptotic approximation may be obtained through an asymptotic expansion. (8.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test.2 an = O(1) if |an | is uniformly bounded. C4 is called the symmetric percentile-t interval. or the size of the divergence for any particular sample size n. lim Gn (x. F ) then ³x´ . an = O(n−r ) if it declines to zero like n−r . The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α. The ideal test rejects if Wn ≥ qn (α). and a function h(x) is odd if h(−x) = −h(x).1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. F ) = Φ n→∞ v or ³x´ Gn (x. and vice-versa. the critical value qn (α) is found as the quantile from simulated values of W´ .8 Asymptotic Expansions Tn →d N (0. where qn (α) is the (1 − α)% quantile of the distribution of Wn . If θ is a vector.

F ) + g2 (x. the diﬀerence √ (g1 (x. To the second order. F ). and g1 is continuous with respect to F. ³x´ 1 1 + 1/2 g1 (x. F ) v which adds a symmetric non-normal component to the approximate density (for example. Fn ) − g1 (x. F ) ≈ Φ + n−1/2 g1 (x. F0 )) + O(n−1 ). where g1 is an even function of x.1 Under regularity conditions and (8. To a third order of approximation. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x.uniformly over x. F ) ≈ Φ + n−1/2 g1 (x. Fn ) + O(n−1 ). An asymptotic test is based on Φ(x). Heuristically. Theorem 8. the density function is skewed.8. F ) + O(n−3/2 ) Gn (x. which from Theorem 8. g1 (x. The diﬀerence is Φ(x) − Gn (x. F0 ) ≈ ∂ g1 (x. F0 )) converges to 0 at rate n. First. F ) = Φ v n n 8. F0 ) + O(n−1 ) 1/2 1 n 1 g (x.1. and g2 is an odd function of x. Fn ) − g1 (x. Gn (x. 1/2 1 n Because Φ(x) appears in both expansions.3).1 as follows.1 has the expansion n G∗ (x) = Gn (x. F0 ) = 1 g (x. Fn ) = Φ(x) + n 1 g (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. A bootstrap test is based on G∗ (x). Moreover. the exact distribution is P (Tn < x) = Gn (x. ³x´ Gn (x. so the order of the error is O(n−1/2 ).8. To a second order of approximation. F ) + n−1 g2 (x. √ Since Fn converges to F at rate n.9 One-Sided Tests Using the expansion of Theorem 8. adding leptokurtosis). F0 ) = Φ(x) + since v = 1.8. ³x´ Gn (x. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . Fn ) − g1 (x. F0 ) = n 1 n1/2 (g1 (x.8. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). We can interpret Theorem 8. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). 100 . v Since the derivative of g1 is odd. F ) converges to the normal limit at rate n1/2 .

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

Therefore. Twosided tests will have more accurate size (Reported Type I error). Two-sided tests have better rates of convergence than the one-sided tests. is an even function. and for the bootstrap ³x´ + O(n−1/2 ).11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. A reader might get confused between the two simultaneous eﬀects. We know that θ Tn →d N (0. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. 8. and bootstrap tests have better rates of convergence than asymptotic tests. similar to a one-sided test. Fn ) − g2 (x. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. 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. g1 . F ) = Φ v √ where v = V . n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. but one-sided tests might have more power against alternatives of interest. which is not pivotal. V ). Gn (x. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). F0 )) + O(n−3/2 ) n = O(n−3/2 ). as it depends on the unknown V. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x.Interestingly. 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 . √ the last equality because Fn converges to F0 at rate n. whose error is O(n−1 ). This is because the ﬁrst term in the asymptotic expansion. G∗ (x) = Gn (x. and g2 is continuous in F.8. This is in contrast to the use of the asymptotic distribution. F0 ) = ∗ 2 (g2 (x. Theorem 8. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. set Tn = n ˆ − θ0 . we ﬁnd Gn (x) = Gn (x. Applying (8.5) to the bootstrap distribution. 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 ). and needs to be determined on a case-by-case basis. Fn ) = Φ(x) + ∗ 2 g2 (x. meaning that the errors in the two directions exactly cancel out. Fn ) + O(n−3/2 ). Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V.

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

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

What is wrong with this procedure? Tn = θ/s(θ) n 6. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.95) denote the 5% θ) ∗ and 95% quantiles of Tn .5% quantiles of the ˆ are . with variables listed in the ﬁle hprice1.dat contains data on house prices (sales). The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. (c) With the given information. you generate bootstrap samples.75 and 1. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).5% and 97.95) denote the 95% quantile of Tn . Estimate a linear regression of price on the number of bedrooms. Let qn (. can you report the 95% Percentile-t interval for θ? 7. 105 .05) and qn (.95).95). and ˆ is calculated on each θ ∗ ∗ θ sample.pdf. (b) Report the 95% Alternative Percentile interval for θ.3. (a) Report the 95% Efron Percentile interval for θ. ˆ = 1. ∗ ∗ where s(ˆ is the standard error in the original data. θ respectively. The dataﬁle hprice1. and the colonial dummy. ˆ − s(ˆ n (. You replace c with qn (. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.2. lot size. size of house. and the 2. The ˆ are sorted.2 and s(ˆ = . Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. Using the non-parametric ∗ bootstrap. and thus reject H0 if ˆ ˆ > q ∗ (. Suppose that in an application. You do this as follows. Using the non-parametric bootstrap. ∗ ∗ ∗ Let qn (.95).Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). You want to test H0 : θ = 0 against H1 : θ > 0.05) .

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

β ˆ Note that if k = . let Jn (β) = n · g n (β)0 Wn g n (β). Proposition 9. Let and where gi = xi ei . The GMM estimator minimizes Jn (β). Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . and the GMM estimator is the MME. β GMM does not change. then g n (β) = 0.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . the dependence is only up to scale.1 β GMM = argmin Jn (β).9. if Wn = I. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. For example.2) g n (β) = (9. then. for if Wn is replaced ˆ by cWn for some c > 0. ˆ Deﬁnition 9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.2. the square of the Euclidean length. i i .2.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. but this is generally not possible when > k. ¡ ¢−1 0 ˆ Z XWn X 0 Y. This is a non-negative measure of the “length” of the vector g n (β). For some × weight matrix Wn > 0.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . β GMM = Z 0 XWn X 0 Z 9. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following.

we can set Wn = I . Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . where In general. W0 = Ω−1 is not known in practice. this is a semi-parametric problem. ˆ we still call β the eﬃcient GMM estimator. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. Ω) . the GMM estimator β is consistent yet ineﬃcient. as it has the same asymptotic distribution. ˆ Construct n 1X ˆ g n = g n (β) = gi . and this is all that is known. it turns out that the GMM estimator is semiparametrically eﬃcient. but it can be estimated consistently. 9. β). it is semiparametrically eﬃcient. a better choice is Wn = (X 0 X)−1 . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. The proof is left as an exercise.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0.3. as we are only considering alternative weight matrices Wn . n n We conclude: Theorem 9. Chamberlain showed that in this context. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. However. as shown by Gary Chamberlain (1987). Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. ˆ∗ ˆ 108 . V ) .1 ´ √ ³ˆ n β − β →d N (0. without imposing additional assumptions. This turns out to be W0 = Ω−1 . This is a weak concept of optimality. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . No estimator can do better (in this ﬁrst-order asymptotic sense). For example. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. as the distribution of the data is unknown. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. The optimal weight matrix W0 is one which minimizes V. If it is known that E (gi (β)) = 0.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. For any Wn →p W0 . ˆ n i=1 gi = gi − g n . In the linear model.2 For the eﬃcient GMM estimator. n β − β →d N 0.3. This estimator is eﬃcient only in the sense that it is the best (asymptotically) in the class of GMM estimators with this set of moment conditions. This results shows that in the linear model. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y.

when we say “GMM”. There is an important alternative to the two-step GMM estimator just described. and GMM using Wn as the weight matrix is asymptotically eﬃcient. as in (9. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. under the alternative hypothesis the moment conditions are violated. set Wn = (X 0 X)−1 . A simple solution is to use the centered moment conditions to construct the weight matrix. Instead. Since Egi = 0. ˆ and let g be the associated n × matrix. Then set gi = xi ei . we can let the weight matrix be considered as a function of β. First.5 GMM: The General Case In its most general form. 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 . and was introduced by L. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ .4) which uses the uncentered moment conditions. There is little point in using an ineﬃcient GMM estimator as it is easy to compute. (9. and construct the residual ei = yi − zi β. GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0. 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 . i. Heaton and Yaron (1996).and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . 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. Here is a simple way to compute the eﬃcient GMM estimator.e. However. ∗ gi (β) = gi (β) − g n (β) 9.4) above. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. 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. Egi 6= 0. 109 . we actually mean “eﬃcient GMM”. When constructing hypothesis tests. The estimator appears to have some better properties than traditional GMM. but can be numerically tricky to obtain in some cases. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. This is a current area of research in econometrics. so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. Hansen. J(β) = n · g n (β) n i=1 In most cases.

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

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

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

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

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

115 . subject ˆ i ˆi i=1 to the restriction h(β) = 0. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . is deﬁned as Jn (β) = ˜ β = argmin Jn (β). the distance statistic D in (9. h(β)=0 (9.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 .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 GMM estimator of β. Show how to construct an eﬃcient GMM estimator for β. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. Vn = X X i=1 ˜ and hence R0 β = r. The equation of interest is yi = g(xi . Deﬁne the Lagrangian L(β. The observed data is (yi .6) (a) Show that you can rewrite Jn (β) in (9. 6. zi ).5. VR = V − V R R0 V R (d) Show that in this setting. 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. VR ) where ¡ ¢−1 0 R V. β) + ei E (zi ei ) = 0. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . In the linear model Y = Xβ + e with E(xi ei ) = 0. zi is l × 1 and β is k × 1.6) equals the Wald statistic. l ≥ k. xi .

7. 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. 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. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . ˆ and consider the GMM estimator β of β.. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. 116 . Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix.

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

The solution (when it exists) is well deﬁned since Rn (β.1) and (10.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. µ. (see section 6. Multiplying the ﬁrst equation by pi . λ ¡ ¢ ln 1 + λ0 gi (β) . This yields the (proﬁle) empirical log-likelihood function for β. (10. but must be obtained numerically (see section 6. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .5).4) (10..5) This minimization problem is the dual of the constrained maximization problem. we also obtain the Lagrange multiplier λ = λ(β). λ) = −n ln (n) − n X i=1 For given β. summing over i. or equivalently minimizes its negative ˆ (10. the Lagrange multiplier λ(β) minimizes Rn (β. pn . p1 . The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10.. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). pi gi (β) = 0.5) ˆ ˆ As a by-product of estimation. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. λ) : λ(β) = argmin Rn (β.2) subject to the restrictions (10. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. λ).where λ and µ are Lagrange multipliers. The solution cannot be obtained explicitly.7) 118 ..3). λ) is a convex function of λ. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . p (10. probabilities 1 ³ ´´ . Ln (β) = Rn (β. . and using the second and third equations. we ﬁnd µ = n and 1 ¢. λ.

i=1 i=1 i=1i Expanding (10.1 Under regularity conditions. Thus the EL estimator is asymptotically eﬃcient. λ) = − (10.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 .13) yields n n Expanding (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . i i Theorem 10. ˆ ˆ Proof. and n β − β 0 and nλ are asymptotically independent.9) (10. in the linear model.9) and (10. Gi (.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. β) = −xi zi . G = −E (xi zi ).11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .8) and ¢ 0 0 For example.2. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .10) ¡ Ω−1 N (0.10). λ) = − (10. and Ω = E xi x0 e2 .2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (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. β λ ∂ ³ ´. 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. n (10. 0 = Rn (β. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.13) Premultiplying by G0 Ω−1 and using (10.

Vλ ) Furthermore. First.16). 120 . since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. 10. β 0 ) = 0 then LRn →d χ2−k . The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. They are asymptotically ﬁrst-order equivalent. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. 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.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. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.7) is n ³ ´´ ³ X ˆ ˆ0 (10. and (10. and it is advisable to report the statistic LRn whenever EL is the estimation method.1 If Eg(wi . ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. The same statistic can be constructed for empirical likelihood. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. The overidentiﬁcation test is a very useful by-product of EL estimation.15).14) for λ and using (10.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .15) (10. and have the same interpretation. V ) ˆ Solving (10.3 Overidentifying Restrictions In a parametric likelihood context. (10. by a Taylor expansion. LRn = i=1 Theorem 10. tests are based on the diﬀerence in the log likelihood functions. Since the EL estimator achieves this bound.3.17) 2 ln 1 + λ gi β . Ω) GΩ G →d = N (0. it is an asymptotically eﬃcient estimator for β. Proof.

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. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) and H0 : h(β) = 0. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.wisc. 10.18) Let the maintained model be where g is × 1 and β is k × 1. the simple overidentifying restrictions test (10.4. 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 (0.17) is not appropriate. h(β)=0 ˜ Fundamentally. To test the hypothesis h(β) while maintaining (10. This test statistic is a natural analog of the GMM distance statistic.edu/~bhansen/progs/elike. so there is no fundamental change in the distribution theory for β relative to β.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.1 Under (10. 10.Second.18).ssc. since ln(1 + x) ' x − x2 /2 for x small. Vλ )0 Ω−1 N (0. Theorem 10. The hypothesis of interest is h(β) = 0. LRn →d χ2 . The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). a The proof of this result is more challenging and is omitted.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). where h : Rk → Ra .4 Testing Egi (β) = 0 (10.

λ)0 0 Rn (β. λj )) Rp = Rn (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . One method uses the following quadratic approximation.19) X ∂2 ∗ ∗ gi (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β.5) for given β. λ) = − gi (β. Set δ 0 = 0. λj ) is smaller than some prespeciﬁed tolerance.19). λ) = G∗ (β. λ)0 − Rn (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. set 2 λp = λj − δ p (Rλλ (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ)0 − ∂β∂β Rn (β. λj ) . λ) G∗ (β. λj ))−1 Rλ (β. Eﬃcient convergence requires a good choice of steplength δ. λ) G∗ (β. 2.4). λp ) A quadratic function can be ﬁt exactly through these three points. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. Deﬁne ∗ gi (β. λ) . δ 1 = 1 and δ 2 = 1. For p = 0. λ) ∂λ i=1 n ∂ Rn (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. (10.19) is continued until the gradient Rλ (β. The iteration (10. λ) = i The ﬁrst derivatives of (10. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.20) . The starting value λ1 can be set to the zero vector. λj ))−1 Rλ (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β.. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next).Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) gi (β. λ) = − ∂β n X i=1 G∗ (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. 1.

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

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

That is x2i are variables which could be included in the equation for yi (in the sense 125 . In matrix notation. so should be included in xi . which does not equal either β 1 or β 2 .1. By the above deﬁnition.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.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 ¶ . In a typical set-up. Deﬁnition 11. We call z1i exogenous and z2i endogenous.1) if E (xi ei ) = 0. z1i is an instrumental variable for (11.1) where zi is k × 1. We call (11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. at least the intercept). some regressors in zi will be uncorrelated with ei (for example. (11. and x2i are the excluded exogenous variables. β →p β ∗ .2) Any solution to the problem of endogeneity requires additional information which we call instruments. So we have the partition µ ¶ z1i k1 (11. this can be written as Y = Zβ + e. 11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1). Thus we make the partition ¶ µ k1 z1i (11.1) the structural equation. This is called simultaneous equations bias.1 The × 1 random vector xi is an instrumental variable for (11. and assume that E(zi ei ) 6= 0 so there is endogeneity.

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

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

P = HΛH 0 0 0 where Λ = diag(Il . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases.14) In general this is non-zero. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. The consequences of identiﬁcation failure for inference are quite severe. 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. By the spectral decomposition of an idempotent matrix. Indeed as α → 1. the expression in (11.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . l . 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 .12) and this result. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . It is also close to zero when α = 0.13). 0). the bias in the 2SLS estimator will be large. n and (11. except when S21 = 0 (when Z is exogenous). 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 (11.14) is the probability limit of β 2SLS − β 11. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.14) approaches that in (11.Let PX = X (X 0 X)−1 X 0 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. 130 .

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

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

1. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. 6. 5. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. and Γ is l × k. Explain why this is true. where xi and β are 1 × 1. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β.) 3. show that if rank(Γ) < k then β cannot be identiﬁed. at ˆˆ If X is indeed endogeneous. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1.11. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . l ≥ k. u is n × k. (Find an expression for xi . 2. That is. Z is n × k. xi is l × 1. 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) . Find a simple expression for the IV estimator in this context. X is n × l. in the sense that e ˜ ˜ least in large samples? 4. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). Take the linear model yi = xi β + ei E (ei | xi ) = 0. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k.8 Exercises yi = zi β + ei . ˜ 0 e < e0 e. Take the linear model Y = Zβ + e. will IV “ﬁt” better than OLS. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. 133 .

Report the estimates and standard errors. and then calculate the GMM estimator from this weight matrix without further iteration. using zi as an instrument for xi . Estimate the model by 2SLS.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995).. and the remaining variables as exogenous. Report estimates and standard errors. in years. 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. (d) Re-estimate the model by eﬃcient GMM.pdf. (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). (f) Discuss your ﬁndings. In this model. Does this diﬀer from 2SLS and/or OLS? 7. Report estimates and standard errors. of the mother). There are 2215 observations with 19 variables. We want to estimate a wage equation log(W age) = β 0 + β 1 Educ + β 2 Exper + β 3 Exper2 + β 4 South + β 5 Black + e where Educ = Eduation (Years) Exper = Experience (Years). using the instrument near4. of the father) and motheduc (the education. (e) Calculate and report the J statistic for overidentiﬁcation. a dummy indicating that the observation lives near a 4-year college. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. 134 . 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. listed in card. (b) Now treat Education as endogenous. The data ﬁle card. and South and Black are regional and racial dummy variables. are the parameters identiﬁed? 8. in years.(b) Deﬁne the 2SLS estimator of β. f atheduc (the education. (a) Estimate the model by OLS.

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

ˆ 2. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . Part (1) is a direct consequence of the Ergodic theorem. and it has a ﬁnite mean by the assumption that EYt2 < ∞. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ Proof. then as T → ∞. the sequence Yt Yt−k is strictly stationary and ergodic.Theorem 12. then as T → ∞. T 1X Xt →p E(Xt ). 1. ˆ ˆ γ ¥ 136 .3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ρ(k) →p ρ(k). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).1.1.2 (Ergodic Theorem). ˆ 3. γ (0) ˆ Theorem 12. γ (k) →p γ(k). µ →p E(Yt ). T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) .1 above. If Xt is strictly stationary and ergodic and E |Xt | < ∞. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . For Part (2).1.

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

since ρ(z) = 0 when z = 1/ρ. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .1 If |ρ| < 1 then Yt is strictly stationary and ergodic.1. We say that the root of the polynomial is 1/ρ. 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). We call ρ(L) the autoregressive polynomial of Yt . Deﬁning L2 = LL.4. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . Deﬁnition 12.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.1 The lag operator L satisﬁes LYt = Yt−1 .3. ∞ X k=0 ρ2k V ar (et−k ) = 12. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . Lk Yt = Yt−k . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. the above results are unchanged. 12.3. From Theorem 12. an AR(1) is stationary iﬀ |ρ| < 1. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . 138 . In general. We call ρ(L) the autoregressive polynomial of Yt . we see that L2 Yt = LYt−1 = Yt−2 . The AR(k) model is Using the lag operator.Theorem 12.

. and is of great interest in applied time series.5. we say that ρ(L). since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. Note that ut is a MDS.. “has a unit root”. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. Proof. and hence Yt . we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. Theorem 12. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. For an AR(k). λk are the complex roots of ρ(z).1.1.1. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. it is also strictly stationary and ergodic. t T t=1 T t=1 139 . This is a special case of non-stationarity.1. β = X 0X (12. then ˆ β →p β as T → ∞.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . By Theorem 12.1) and the continuous mapping theorem. t Yt−k ¢0 ρk . so is xt x0 . it is helpful to deﬁne the process ut = xt et .6. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.1) Theorem 12. t t T t=1 ¥ Combined with (12.where the λ1 . Let |λ| denote the modulus of a complex number λ. . which satisfy ρ(λj ) = 0.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. the requirement is that all roots are larger than one. One way of stating this is that “All roots lie outside the unit circle.” If one of the roots equals 1.. The vector xt is strictly stationary and ergodic. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. and by Theorem 12. Thus t by the Ergodic Theorem.

This is identical in form to the asymptotic distribution of OLS in cross-section regression. this cannot work in a time-series application. ˆ 2.1 to see that T 1 X √ xt et →d N (0. Ω) . . eT }. xt }. T 1 X √ ut →d N (0.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. Clearly.. T t=1 Since xt et is a MDS. 140 . then as T → ∞.12. there are two popular methods to implement bootstrap resampling for time-series data. we constructed the bootstrap sample by randomly resampling from the data values {yt . the asymptotic covariance matrix is estimated just as in the cross-section case. t t Theorem 12. Y−k+2 . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .7 Asymptotic Distribution Theorem 12. T t=1 where Ω = E(xt x0 e2 ). we can apply Theorem 12. i 4..7. Ω) .. ˆ 1. Fix an initial condition (Y−k+1 .7.8 Bootstrap for Autoregressions In the non-parametric bootstrap. Divide the sample into T /m blocks of length m. Estimate β and residuals et . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. Q−1 ΩQ−1 . Y0 ). If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Method 1: Model-Based (Parametric) Bootstrap. 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∗ . Brieﬂy. In particular. Method 2: Block Resampling 1. This creates an iid bootstrap sample... . It also presumes that the AR(k) structure is the truth. t This construction imposes homoskedasticity on the errors e∗ . 12.7. which may be diﬀerent than the i properties of the actual ei .. t then as T → ∞.1 MDS CLT. The implication is that asymptotic inference is the same. as this imposes inappropriate independence. e ˆ 3.

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

) This can induce strange behavior in the AIC. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). Another is to minimize the AIC or BIC information criterion.5).. . let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . We then multiply this by θ and subtract from (12. (A simple exclusion test). and the alternative is that the error is an AR(m). AR(2).5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. The best remedy is to ﬁx a upper value k. Yt is an AR(1). e. 142 .12. and under H1 it is an AR(2). In general.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection.5) and (12. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 .5) We are interested in the question if the error ut is serially correlated. An appropriate test is the Wald test of this restriction. We want to test H0 against H1 . to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . this is the same as saying that under the alternative Yt is an AR(k+m). (12.. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. We model this as an AR(1): ut = θut−1 + et with et a MDS. Thus under H0 .6). we take (12.6) 12. you need more initial conditions. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero.. if the null hypothesis is that Yt is an AR(k).g. 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. To combine (12.. and then estimate the models AR(1). (If you increase k. AIC(k) = log σ 2 (k) + ˆ 2k .. One approach to model selection is to choose k based on a Wald tests. (12.10 Testing for Omitted Serial Correlation For simplicity.. AR(k) on this (uniﬁed) sample. and then reserve the ﬁrst k as initial conditions. Yt−k−m are jointly zero. .

(12. 143 . the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. Note that the model is stationary if α0 < 0. or ρ1 + ρ2 + · · · + ρk = 1. under H0 . Since α0 is the parameter of a linear regression. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . then ∆Yt is a stationary AR process. so conventional normal asymptotics are invalid. In this case. we say that if Yt is non-stationary but ∆d Yt is stationary. An alternative asymptotic framework has been developed to deal with non-stationary data. but simply assert the main results.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). Thus if Yt has a (single) unit root. Hence. We do not have the time to develop this theory in detail. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . As we discussed before. as the models are equivalent.7) These models are equivalent linear transformations of one another. Yt is non-stationary. To see this.7). observe that the lag polynomial for the Yt computed from (12. However. A helpful way to write the equation is the so-called Dickey-Fuller reparameterization: ∆Yt = µ + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . the natural test statistic is the t-statistic for H0 from OLS estimation of (12.12. or I(d). The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. Indeed. and test statistics are asymptotically non-normal. Because of this property. So the natural alternative is H1 : α0 < 0. Yt has a unit root when ρ(1) = 0. this is the most popular unit root test. Thus a time series with unit root is I(1). The ergodic theorem and MDS CLT do not apply. Under H0 . Yt is non-stationary. Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 .12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. then Yt is “integrated of order d”. since ρ(1) = −α0 .

GDP. Thus the Dickey-Fuller test is robust to heteroskedasticity. the ADF test rejects H0 in favor of H1 when ADF < c. where c is the critical value from the ADF table. this means that it is computed as the t-ratio for α0 from OLS estimation of (12. the test procedure is the same. a common conclusion is that the data suggests that Yt is non-stationary. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . This distribution has been extensively α tabulated. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend.1 (Dickey-Fuller Theorem). The ADF test has a diﬀerent distribution when the time trend has been included. If the series has a linear trend (e. and have negative means. this means that the evidence points to Yt being stationary. When conducting the ADF test. If a time trend is included. This is not really a correct conclusion. conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal. But the theorem does not require an assumption of homoskedasticity.Theorem 12.8). rather than the ˆ 1/2 .g. They are skewed to the left. Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. but it may be stationary around the linear time trend. In this context. If the test does not reject H0 .12. These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included. Stock Prices). T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . The natural solution is to include a time trend in the ﬁtted OLS equation. Assume α0 = 0. and may be used for testing the hypothesis H0 . All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. but does not depend on the parameters α. and a diﬀerent table should be consulted. As T → ∞. This is called a “super-consistent” rate of convergence. but diﬀerent critical values are required. Another popular setting includes as well a linear time trend. We have described the test for the setting of with an intercept. however. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal. (12. If the test rejects H0 . 144 . as the AR model cannot conceivably describe this data. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. Since the alternative hypothesis is one-sided. then the series itself is nonstationary.

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

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

direct estimation of (13. it is convenient to re-deﬁne the variables. Then the single equation takes the form (13.13. Otherwise it is invalid. which is called a common factor restriction. with time series data.2) may be estimated by iterated GLS.2) Take the equation yt = x0 β + et . and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). 147 . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . 1).1).5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13.2) is uncommon in recent applications. the model (13. general. j Often. 13. t or yt = θyt−1 + x0 β + x0 γ + ut . You may have heard of the Durbin-Watson test for omitted serial correlation. which once was very popular. We see that an appropriate. This restriction. Let et = ejt and β = aj . and is still routinely reported by conventional regression packages.1) yt = x0 β + et . and subtract oﬀ the equation once lagged multiplied by θ. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . t and xt = This is just a conventional regression. 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 . t and et is iid N (0. (13. under the restriction γ = −βθ.4 Single Equation from a VAR Yjt = a0 xt + et . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. Let yt = Yjt . and is typically rejected empirically. If valid. xt−1 ) to the regression. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s.) Since the common factor restriction appears arbitrary. we are only interested in a single equation out of a VAR system. Suppose that et is an AR(1).2) is a special case of (13.3). t t−1 (13. may be tested if desired. and Zt be the other variables. This can be done by a Wald test.3) which is a valid regression model. Another interesting fact is that (13. (A simple version of this estimator is called Cochrane-Orcutt. In this case.

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

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

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

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

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

2 Count Data exp (−λi ) λk i . Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. 14.. k! = exp(x0 β). Thus the model is that there is some latent process yi with unbounded support. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. this motivates the label Poisson “regression. i i i=1 ˆ The MLE is the value β which maximizes ln (β).) The observed data yi therefore come from a mixed continuous/discrete distribution. The conditional density is the Poisson with parameter λi .” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). any known value can substitute.1) yi = ∗ <0 . The censoring process may be explicit in data collection. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. In surveys..14. A generalization is the negative binomial. An example of a data collection censoring is top-coding of income. i If Y = {0..}. or it may be a by-product of economic constraints. .. the consumption level (purchases) in a particular period was zero. 2.1). This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . The functional form for λi has been picked to ensure that λi > 0. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. . incomes above a threshold are typically reported at the threshold. Tobin observed that for many households. σ 2 ) with the observed variable yi generated by the censoring equation (14. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . 1.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. 0 if yi (This is written for the case of the threshold being zero. 2. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. a typical approach is to employ Poisson regression. 1. This may be considered restrictive.

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

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

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

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

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

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

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

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

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 . Intuitively.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. 162 . so is estimating a smoothed version of f (x). and is larger the greater the curvature in f (x). nh (x)2 dx is called the roughness of K. ˆ the greater the bias. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . which is valid as h → 0.16. The sharper the derivative. ˆ We now examine the variance of f (x). The bias results from this smoothing. This integral (typically) is not analytically solvable. 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. so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. the estimator f (x) smooths data local to Xi = x. 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). 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 downside is that if the density is very far from normal. Their K values for the three functions introduced in the previous section are given here. We can calculate that √ R(φ00 ) = 3/ (8 π) . and R(f 00 ). 1) distribution and σ 2 is an estimate of σ 2 = V ar(X).1) is an asymptotic approximation to the MSE. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. ˆ It uses formula (16. we ﬁnd the reference rules for the three kernel functions introduced earlier. AM SEh (x) = f 00 (x)2 h4 σ 4 + K 4 nh A global measure of precision is the asymptotic mean integrated squared error (AMISE) Z h4 σ 4 R(f 00 ) R(K) K + .2) This solution takes the form h0 = cn−1/5 where c is a function of K and f.Together. This choice for h gives an optimal rule when f (x) is ˆ normal. h must tend to zero. we need h → 0 but nh → ∞. Gaussian Kernel: hrule = 1. how should the bandwidth be selected? This is a diﬃcult problem. 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) .06n−1/5 163 . Together with the above table. The asymptotically optimal choice given in (16. That is. (16. In practice.2) depends on R(K). 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 . where φ is the N (0. σ 2 . Thus for the AMISE to decline with n. and gives a nearly optimal rule when f (x) is close to normal. (16. but at a very slow rate. the rule-of-thumb h can be quite ineﬃcient. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. and there is a large and continuing literature on the subject. but not of n. We thus say that the optimal bandwidth is of order O(n−1/5 ).2) but replaces R(f 00 ) with σ −5 R(φ00 ). but at a slower rate than n−1 . 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. Equation (16. That is. Note that this h declines to zero.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . The ﬁrst two are determined by the kernel function.

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

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

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

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

m C(λ)¯ dλ λ=0 The Lp norm.4) does not hold.A. The moment generating function (MGF) of X is M (λ) = E exp (λX) . If I1 < ∞ and I2 = ∞ then we deﬁne Eg(X) = −∞. We can also write σ 2 = V ar(X). For m > 0.3 Expectation For any measurable real function g. and when E |X|m < ∞ ¯ ¯ dm ¯ = im E (X m ) . this allows the convenient expression V ar(a + bX) = b2 V ar(X). The CF always exists. Eg(X) = j=1 and if X is continuous Eg(X) = The latter is well deﬁned and ﬁnite if Z If (A. The MGF does not necessarily exist. If X is discrete. (A. p ≥ 1. For example. evaluate I1 = Z Z ∞ g(x)f (x)dx. −∞ ∞ −∞ |g(x)| f (x)dx < ∞. 168 . of the random variable X is kXkp = (E |X|p )1/p . However. More generally. r X g(τ j )π j .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) = ∞. Two special moments are the mean µ = EX and variance σ 2 = E (X − µ)2 = EX 2 − µ2 . 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. We √ call σ = σ 2 the standard deviation of X. Since E (a + bX) = a + bEX. we say that expectation is a linear operator. √ where i = −1 is the imaginary unit. If both I1 = ∞ and I2 = ∞ then Eg(X) is undeﬁned. we deﬁne the mean or expectation Eg(X) as follows. we deﬁne the m0 th moment of X as EX m and the m0 th central moment as E (X − EX)m . the characteristic function (CF) of X is C(λ) = E exp (iλX) .

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

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

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

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

y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0.6 Conditional Distributions and Expectation f (x.A k × 1 random vector X = (X1 . Letting x = (x1 . y) fX (x) f (x. y) fX (x + ε) ∂2 ∂x∂y F (x. In particular. xk )0 .. y) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε. Xk )0 is a function from S to Rk .. . y) . ∂x1 · · · ∂xk For a measurable function g : Rk → Rs ..... we have the k × 1 multivariate mean µ = EX and k × k covariance matrix ¡ ¢ Σ = E (X − µ) (X − µ)0 = EXX 0 − µµ0 If the elements of X are mutually independent. we deﬁne the expectation Z g(x)f (x)dx Eg(X) = Rk where the symbol dx denotes dx1 · · · dxk . . 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. it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x). then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A. fX (x) 173 . y) − F (x.

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

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

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

Proof of Theorem A. 1). 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 . (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .2. Thus the density of Z 2 is (A. The MGF for the density (A. 1) and Q ∼ χ2 be independent. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.8. For Z ∼ N(0. C −1 AC −10 ) = N (0. Iq ). tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. Set r Z .11) 2 with r = 1.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). q Proof of Theorem A. tr has distribution 177 .6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.Theorem A.1.3 Let Z ∼ N (0.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. C −1 CC 0 C −10 ) = N (0. which we showed in (A.3. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.13).12) E exp (tQ) = 0 Γ (A.8. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. Using the simple law of iterated expectations.8. we see that the MGF of Z 2 is (1 − 2t)−1/2 . From (A.13) is the MGF of the density (A. which can be found by applying change-of-variables to the gamma function.11).8.

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

θ) ∂θ ∂θ which holds at θ = θ0 by (A. In fact.17) is often called the information matrix equality. and the equality (A.15) Two important features of the likelihood are Theorem A. then θ V ar(˜ ≥ (nI0 )−1 . However. n n i=1 n As the MLE ˆ maximizes the left-hand-side. we can ﬁnd an explicit expression for θ as a function of the data.1 ¯ ¯ ∂ E ln f (Yi .9. More typically. θ0 ) ∂θ∂θ 0 (A. We can write this as ˆ = argmax Ln (θ). ˆ is consistent θ for this value. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. but these ˆ must be found by numerical methods. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. θ θ∈Θ ˆ In some simple cases.9.14) ¶ ∂ ∂ 0 ln f (Yi . Theorem A.17) The matrix I0 is called the information. under conventional regularity conditions. cases are rare.16). θ) The Cramer-Rao Theorem gives a lower bound for estimation. which maximizes the log-likelihood).Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .2 Cramer-Rao Lower Bound. I0 . ˆ →p θ0 as n → ∞. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. If ˜ is an unbiased estimator of θ ∈ R. 179 . θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A.9.3 Under regularity conditions.16) (A. θ) ≡ L(θ). The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . θ0 ) ln f (Yi . θ Theorem A. ∂θ ∂θ (A. θ0 ) . ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . θ) →p E ln f (Yi . we can see that it is an estimator of the maximizer θ of the right-hand-side.

18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. θ (A. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. The QMLE is consistent for the pseudo-true value. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . ˆ elements of n 0 Sometimes a parametric density function f (y. Thus in large samples the MLE has approximately the best possible variance. In this case there is not a “true” value of the parameter θ. the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. Typically. but it is not literally believed that the model f (y. θ) is used to approximate the true unknown density f (y). θ) ¶ dy Thus in large samples. V ) .14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi .9.17) does not hold. since the information matrix equality (A. but has a diﬀerent covariance matrix than in the pure MLE case. Therefore the MLE is called asymptotically eﬃcient. θ) is necessarily the true density. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. ˆ . θ) = f (y) ln 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.ˆ ˆ−1 θ We then set I0 = H −1 . θ) θ In this case. A minor adjustment to Theorem (A.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . θ). θ θ Ω= n ∂θ ∂θ n i=1 ˆ ˆ ˆˆ V = H −1 ΩH −1 Asymptotic standard errors (sometimes called qmle standard errors) are then the square roots of ˆ the diagonal elements of n−1 V . 180 .3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0. Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . ˆ ln f Yi . θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A. θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y.

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

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

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

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

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

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