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

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Contents

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

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

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

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

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

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

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ii

. . .2 GMM Estimator . . . . . 12. . . . . . 10. . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . . . .1 Stationarity and Ergodicity . . . . .5 Special Cases: IV and 2SLS 11. 9. . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . 12 Univariate Time Series 12. . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . . . . . . 11. .4 Testing . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . 12. . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . 10. 9. . . . . .8 Bootstrap for Autoregressions . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Estimation . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . .10 8. . . . . . . . .10Testing for Omitted Serial Correlation 12.11 8. . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . .13 One-Sided Tests .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . 9. . . . . . . .12 8. . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . .2 Reduced Form . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . 11. . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . 12. . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . .3 Stationarity of AR(1) Process . . .4 Lag Operator . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . iii . 12. . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . 12.

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

and assess the joint dependence. we would use experimental data to answer these questions. They are distinguished by the dependence structure across observations. The quality of the study will be largely determined by the data available. However. But we cannot infer causality. repeated over time. experiments such as this are infeasible. households. 1.1 Economic Data An econometric study requires data for analysis. This type of data is characterized by serial dependence. most economic data is observational. To continue the above example. Econometric theory concerns the study and development of tools and methods for applied econometric applications. even immoral! Instead. mandate diﬀerent levels of education to the diﬀerent groups. an experiment might randomly divide children into groups. timeseries. Another issue of interest is the earnings gap between men and women.2 Observational Data A common econometric question is to quantify the impact of one set of variables on another variable. Ideally. and panel. what we observe (through data collection) is the level of a person’s education and their wage. Typical examples include macroeconomic aggregates. a concern in labor economics is the returns to schooling — the change in earnings induced by increasing a worker’s education. prices and interest rates. Time-series data is indexed by time. Cross-sectional data sets are characterized by mutually independent observations. holding other variables constant. as we are not able to manipulate one variable to see the direct eﬀect on the other. There are three major types of economic data sets: cross-sectional. We can measure the joint distribution of these variables. and then follow the children’s wage path as they mature and enter the labor force. Panel data combines elements of cross-section and time-series. Each individual (person. Applied econometrics concerns the application of these tools to economic data. For example. These data sets consist surveys of a set of individuals. The individuals surveyed may be persons. Surveys are a typical source for cross-sectional data. To measure the returns to schooling. household or corporation) is surveyed on multiple occasions. 1 . or corporations. The diﬀerences between the groups could be attributed to the diﬀerent levels of education. 1.Chapter 1 Introduction Econometrics is the study of estimation and inference for economic models using economic data.

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

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

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

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

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

4 Inverse A k × k matrix A has full rank. if there is no c 6= 0 such that Ac = 0.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. (2. if A is an orthogonal matrix.1) . .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 . (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) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2. . 2. 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 = . The Moore-Penrose generalized inverse A− satisﬁes (2. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. In this case there exists a unique matrix B such that AB = BA = Ik . . For non-singular A and C. If A − BD−1 C and D − CA−1 B are non-singular. or is nonsingular. This matrix is called the inverse of A and is denoted by A−1 .3) The matrix A− is not necessarily unique. then A−1 = A. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . . . . 7 Also. . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 .

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

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

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

1 displays the density1 of hourly wages for men and women. and that for women is $20. holding the other variables constant. ⎟ . the conditional density of yi given xi . The two density curves show the eﬀect of gender on the distribution of wages.73. the mean wage for men is $27. Figure 3. Take a closer look at the density functions displayed in Figure 3. In the example presented in Figure 3.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression.1.1 by the arrows drawn to the x-axis. which is a common feature of wage distributions. we can focus on f (y | x) .1) xi = ⎜ . While it is easy to observe that the two densities are unequal. m(x) can take any form.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. We call xi alternatively the regressor. These are asymmetric (skewed) densities. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. education and experience. When a distribution is skewed.1. See Chapter 16. . In this context we partition the observations into the pair (yi .2) m(x) = E (yi | xi = x) = −∞ In general. You can see that the right tail of then density is much thicker than the left tail. These are conditional density functions — the density of hourly wages conditional on race. We call yi the dependent variable.22. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. the mean is not necessarily a good summary of the central tendency. the conditioning variable. To illustrate. (3. and exists so long as E |yi | < ∞. it is useful to have numerical measures of the diﬀerence. These are indicated in Figure 3. The data are from the 2004 Current Population Survey 1 11 . An important summary measure is the conditional mean Z ∞ yf (y | x) dy. xki 3. This is used when the goal is to quantify the impact of one set of variables on another variable. gender. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. ⎠ ⎝ . xi ) where yi is a scalar (real-valued) and xi is a vector. or the covariates.

with mean log hourly wages drawn in with the arrows.2 shows the density of log hourly wages for the same population. Figure 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. which implies a 30% average wage diﬀerence for this population. wage regressions typically use log wages as a dependent variable rather than the level of wages.3 displays a scatter plot2 of log wages against education levels.3) White non-military male wage earners with 10-15 years of potential work experience.D. For this reason. Assuming for simplicity that this is the true joint distribution.3 is how the conditional expectation describes an important feature of the conditional distribution. degree in mean log hourly wages is 0. then comparisons become more complicated. By construction.2) evaluated at the observed value of xi : ei = yi − m(xi ).5. 3. 2 (3. implying an average 36% diﬀerence in wage levels.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. the dashed line is a linear projection approximation which will be discussed in the Section 3. Of particular interest to graduate students may be the observation that diﬀerence between a B. When the distribution of the control variable is continuous. The conditional expectation function is close to linear. 12 . The main point to be learned from Figure 3. the solid line displays the conditional expectation of log wages varying with education. this yields the formula yi = m(xi ) + ei . To illustrate. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.36. Figure 3. The diﬀerence in the log mean wage between men and women is 0. The comparison in Figure 3.A.Figure 3.30.1 is facilitated by the fact that the control variable (gender) is discrete.

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

subject to the restriction p that it is non-negative. The conditional standard deviation is its square root σ(x) = σ 2 (x). To see this. and can take any form. let g(x) be an arbitrary predictor of yi given xi = x. it does not provide information about the spread of the distribution. when σ 2 (x) is a constant so that ¢ ¡ (3.3. σ 2 (x) is a non-trivial function of x. Thus the mean squared error is minimized by the conditional mean.Figure 3. The right-hand-side is minimized by setting g(x) = m(x). the conditional variance of yi is σ 2 = σ 2 (xi ). in the sense of achieving the lowest mean squared error. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x .4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.3 Conditional Variance Generally. 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 3.1. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. i . Given the random variable xi . 3.2. In contrast.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .

An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . So while men have higher average wages. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . Instead.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.we say that the error ei is homoskedastic. We call this the “constant” or “intercept”. xki When m(x) is linear in x. Equivalently.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). ⎟ .5) xi = ⎜ .8) is called the linear regression model. i (3. As an example.1 and that for women is 10. Notationally. ⎠ .7) is a k × 1 parameter vector. we assume that x1i = 1. it is more realistic to view the linear speciﬁcation (3. ⎟ β=⎝ .6) (3. and the linear assumption of the previous section is empirically unlikely to accurate. ⎠ . βk ⎛ (3. they are also somewhat more dispersed. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . The conditional standard deviation for men is 12.9) 3.5. take the conditional wage densities displayed in Figure 3.6) as an approximation. it is convenient to augment the regressor vector xi by listing the number “1” as an element. 3.1). In this case (3.8) (3. ⎝ . Equation (3.4 Linear Regression An important special case of (3. which we derive in this section. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.1.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. where x1i is the ﬁrst element of the vector xi deﬁned in (3. its functional form is typically unknown.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . Thus (3. 15 .

E (xi x0 ) is invertible. i (3. otherwise they are distinct.1 1.11) 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 .10) It is worth taking the time to understand the notation involved in this expression. Given the deﬁnition of β in (3. i 4. 3. written E (xi x0 ) > 0. this situation must be excluded. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . Eyi < ∞. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. The ﬁrst-order condition for minimization (from Section 2. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. xi contains an intercept. Equivalently.5. The vector (3. It is invertible if and only if it is positive deﬁnite.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . Assumption 3. i 16 . α0 E (xi x0 ) α = E (α0 xi )2 > 0. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. i which requires that for all non-zero α. E (x0 xi ) < ∞.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. 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 .which is quadratic in β. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. i (3. Therefore. i i (3. 2 2.5. This occurs when redundant variables are included in xi . As before. The best linear predictor is obtained by selecting β to minimize S(β). x0 β is the best linear predictor for yi . The error is i ei = yi − x0 β.10). 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.12) This completes the derivation of the linear projection model.1. Observe i that for any non-zero α ∈ Rk . In order for β to be uniquely deﬁned. Rewriting. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. by “best” we mean the predictor function with lowest mean squared error.

2.5.10) ¡ ¡ ¢¢ 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. 17 .13) implies that xi and ei are uncorrelated.1. E (xi ei ) = 0 and E (ei ) = 0.5.Theorem 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.5. the orthogonality restriction (3. However.1 is employed to guarantee that (3. This means that the equation (3.14) holds.1.1. (3.1.10) are deﬁned. Furthermore. Assumption 3.13) The two equations (3. ¥ (3.4 is required to ensure that β is uniquely deﬁned. By deﬁnition.14).5. Assumption 3.1.5. it follows that linear regression is a special case of the projection model.14) follows from (3.4 we know that the regression error has the property E (xi ei ) = 0.5.5.5. Figure 3.4 guarantees that the solution β exits. Assumption 3.13) and Assumption 3.1 Under Assumption 3. Using the deﬁnitions (3.2 and 3.3 are called regularity conditions.11) and (3.8)-(3. Since ei is mean zero by (3. The ﬁnite variance Assumptions 3.9).1.5.1 are weak. For example. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .10) and (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.11) are well deﬁned.1. Let’s compare it with the linear regression model (3.1.13) summarize the linear projection model.5.1.3 ensure that the moments in (3. Equation (3.5. Assumption 3.14) Proof. (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.12) can be alternatively interpreted as a projection decomposition.1.2 and 3. Since from Theorem 3.12) and (3.

In this case the linear projection is a poor approximation to the conditional mean.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. The linear equation (3. In this case (3. These structural models require alternative estimation methods. and are discussed in Chapter 11.We have shown that under mild regularity conditions. However. In Figure 1.12) with the properties listed in Theorem 3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. The solid line is the conditional mean.4 we display as well this quadratic projection. Figure 3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. for any pair (yi .5. since the resulting function is quadratic in experience. A projection of log wages on these two variables can be called a quadratic projection. for those over 53 in age). the dashed line is the linear projection of log wages on eduction. We illustrate the issue in Figure 3.10) may not hold and the implications of Theorem 3.4 displays the relationship3 between mean log hourly wages and labor market experience. Other than the redeﬁnition of the regressor vector. there are no changes in our methods or analysis. It over-predicts wages for young and old workers. 18 .1 may be false. and the straight dashed line is the linear projection.10). In contrast.5. we can augment the regressor vector xi to include both experience and experience2 . In the example just presented. 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. in many economic models the parameter β may be deﬁned within the model. Figure 3. In other cases the two may be quite diﬀerent.3. Returning to the joint distribution displayed in Figure 3. This defect in linear projection can be partially corrected through a careful selection of regressors. it is important to not misinterpret the generality of this statement.1. Most importantly.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. and under-predicts for the rest. No additional assumptions are required.

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

True or False. 1. Suppose that Y and X only take the values 0 and 1. 3 and 4 of Theorem 3. ¡ ¢ 4. 20 . True or False. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . E(ei | xi ) = 0. 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 = xi β + ei .3 Find E(Y | X = x). Suppose that yi is discrete-valued.2. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. a constant.3. True or False. (x − µ)2 − σ 2 Show that Eg (X. Compute E(yi | xi = x) and V ar(yi | xi = x). 3. Compute the conditional mean m(x) = E (yi | xi = x) .. then E(ei | xi ) = 0. 0 ≤ y ≤ 1. µ. xi ∈ R. σ = . then ei is i i independent of xi . µx = Exi . Are they diﬀerent? Hint: If P (Y = j) = 5. Let X be a random variable with µ = EX and σ 2 = V ar(X). and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . i 10. s) = 0 if and only if m = µ and s = σ 2 . x 6. 9. 2. yi ). 2. Prove parts 2. E(Y 2 | X = x) and V ar(Y | X = x). and E(xi ei ) = 0. True or False. then ei is independent of xi . σ 2 = V ar(xi ). True or False. i 7. then E(x2 ei ) = 0. Let xi and yi have the joint density f (x. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei .1. σ 2 = V ar(yi ) and σ xy = Cov(xi . If yi = x0 β + ei and E(ei | xi ) = 0. i 8.2 Y =1 . and have the following joint probability distribution X=0 X=1 Y =0 . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . . If yi = x0 β + ei and E(xi ei ) = 0. If yi = x0 β + ei .1 . i 11. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. j! 0 j = 0. If yi = xi β + ei .4 ..6 Exercises 1. and E(ei | xi ) = 0. then E(x2 ei ) = 0. xi ∈ R. e−λ λj j! . m. and E(e2 | xi ) = σ 2 . taking values only on the non-negative integers.

7 and 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 .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 .4) i i=1 i=1 ˆ Another way to derive β is as follows. 4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .1) (4.2) can be written in the parametric 0 β)) = 0. we narrow the focus to the linear regression model.3) In Sections 4.8. i n i=1 n 21 . (4. i It follows that the moment estimator of β replaces the population moments in (4. Observe that (4.2) (4.1 Estimation Equation (4. but for most of the chapter we retain the broader focus on the projection model. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .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.

71 = −2. An interpretation of the estimated equation is that each year of education is associated with an 11.4). 40 0.2 Least Squares There is another classic motivation for the estimator (4.170 37. ¶ 2. excluding military. 4. 0. 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 ¶ 34.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.4). To illustrate.83 ¶−1 µ ¶ . 40 2.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. 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.14 14.14 205.14 205.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. consider the data used to generate Figure 3. with 10-15 years of potential work experience.117 Educationi . Then µ ¶ n 1X 2.95 xi yi = 42.3.95 42. Let yi be log wages and xi be an intercept and years of education. This sample has 988 observations.7% increase in mean wages.94 −2.117 1 14.30 + 0. i 22 .37 µ ¶ 1. 30 = .14 14.ˆ This is a set of k equations which are linear in β. These are white male wage earners from the March 2004 Current Population Survey.

These two ˆ variables are frequently mislabeled. Matrix calculus (see Appendix 2. The error is unobservable. i ˆ ˆ Note that yi = yi + ei . Following convention we will call β the OLS estimator of β. which can cause confusion. Figure 4.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Since the function Sn (β) is a quadratic function of β. the contour lines are ellipses.4). we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β.2 displays the contour lines of the same function — horizontal slices at equally spaced heights.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. while the residual is a by-product of estimation. 23 . It is important to understand the distinction between the error ei and the residual ei . Figure 4. Figure 4. To visualize the sum-of-squared errors function.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 (4.1: Sum-of-Squared Errors Function As a by-product of OLS estimation.

It measures the variation in the i “unexplained” part of the regression.2: Sum-of-Squared Error Function Contours Equation (4.7. These are algebraic results. ˆ n i=1 n Since xi contains a constant.7) A justiﬁcation for the latter choice will be provided in Section 4. 24 . ˆ n−k 2 i=1 (4.5) implies that 1X xi ei = 0. ˆ σ = ˆ n 2 i=1 n (4. one implication is that n 1X ei = 0. 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.6) An alternative estimator uses the formula n 1 X 2 s = ei .Figure 4. and hold true for all linear regression estimates. The error variance σ 2 = Ee2 is also a parameter of interest. Its method of moments estimator is the sample average 1X 2 ei .

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

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

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 X2 on X1 . In the model (4.9). 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) . . ˜ 2. .8)(3. ¡ ¢−1 0 ι. and X2 is the vector of observed regressors. obtain OLS estimates β 2 and residuals e. . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. A common application of the FWL theorem. 4. obtain residuals Y . observe that ⎞ ⎛ ⎞ ⎛ .13). Rather.1 (Frisch-Waugh-Lovell). the FWL theorem can be used to speed computation. 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.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. . . ⎟ ⎜ ⎟ ⎜ (4. . ⎠ ⎝ ⎠ ⎝ . . By the independence of the observations and (3. Regress Y on X1 . In this section we derive the small sample conditional mean and variance of the OLS estimator.6. ˆ which are “demeaned”. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. ˆ ˜ ˜ ˆ 3. Regress Y on X2 . but in most cases there is little computational advantage to using the two-step algorithm. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 .9).14) or via the ˆ following algorithm: ˜ 1. In some contexts. obtain residuals X2 . . . the primary use is theoretical. 30 . is the demeaning formula for regression. In this case.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. Partition X = [X1 X2 ] where X1 = ι is a vector of ones.Theorem 4. which you may have seen in an introductory econometrics course. .

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

Now consider the class of estimators of β which are linear functions of i the vector Y. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. as it yields the smallest variance among all unbiased linear estimators. It is important to remember. known as the Gauss-Markov theorem.8. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. In this case. the estimator ˆ 2 deﬁned (4. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . Thus since V ar (e | X) = In σ 2 under homoskedasticity. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . or in the projection model.7) is unbiased for σ 2 by this calculation. says that the least-squares estimator is the best choice.10). however.1 Gauss-Markov. ³ ´ ˜ E β | X = A0 Xβ.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. = σ2 n the ﬁnal equality by (4. 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. Thus σ 2 is biased towards zero. In the homoskedastic linear regression model.8)¢ ¡ (3. What is the best choice of A? The Gauss-Markov theorem.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . It is not unbiased in the absence of homoskedasticity. The following result. which we now present. ˜ so β is unbiased if (and only if) A0 X = Ik . the best (minimumvariance) unbiased linear estimator is OLS. which is (3. 32 . As an alternative.9) plus E e2 | xi = σ 2 . is a famous statement of the solution. Theorem 4. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. By a calculation similar to those of the previous section. 4. that this estimator is only unbiased in the special case of the homoskedastic linear regression model.

the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. Suppose that the joint distribution of (yi .. That is.21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ . As the data are multinomial. It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. but the π j are unknown.. j = 1. The MLE β mle for β is then the analog of (4. (We know the values yi and xi can take. Not only has the class of models has been restricted to homoskedastic linear regressions. xi = ξ j = π j . Note that X 0 C = 0. .. and π j .21) j j=1 j=1 Thus β is a function of (π 1 . We discuss the intuition behind his result in this section. π r ) .3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. ¡ ¢ P yi = τ j . This property is called semiparametric eﬃciency. ˆ β mle = ⎝ j j=1 j=1 33 . 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. for ﬁnite r. Let A be any n×k function of X such that A0 X = Ik . ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. . That is. where 1 (·) is the indicator function. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. 4. A broader justiﬁcation is provided in Chamberlain (1987). Assume that the τ j and ξ j are known.. the deﬁnition (4.5) as required.. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . and is a strong justiﬁcation for the least-squares estimator. but it is quite limited in scope.Proof.. Set C = A − X (X 0 X)−1 . xi ) is discrete. .. This latter restriction is particularly unsatisfactory. r for some constant vectors τ j ... Then we calculate that ³ ¡ ¡ ¢−1 ¡ ¢−1 ´0 ³ ¢−1∗ ´ ¡ 0 ¢−1 C + X X 0X − XX = C + X X 0X A0 A − X 0 X ¡ 0 ¢−1 ¡ 0 ¢−1 0 ¡ ¢−1 0 ¡ 0 ¢−1 ¡ 0 ¢−1 = C 0C + C 0X X X + XX X C + X 0X XX XX − XX = C 0C The matrix C 0 C is positive semi-deﬁnite (see Appendix 2. π j is the percentage of the observations ˆ ˆ which fall in each category. ξ j . r.) In this discrete setting. but we don’t know the probabilities. the class of potential estimators has been restricted to linear unbiased estimators.

5. He observes that the above argument holds for all multinomial distributions. (4.10 Omitted Variables xi = µ x1i x2i ¶ . 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 . the maximum likelihood estimator is identical to the OLS estimator. 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.1.22) 34 .10) for the class of models satisfying Assumption 3. Chamberlain (1987) extends this argument to the case of continuously-distributed data.9). 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. 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 . if the data have a discrete distribution. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.Substituting in the expressions for π j . and thus so is the OLS estimator. He proves that generically the OLS estimator (4.

Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.Now suppose that instead of estimating equation (4. then β is not deﬁned. as many desired variables are not available in a given dataset. When this happens. This happens when the columns of X are linearly dependent.e. least-squares estimation of (4. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated).22) the long regression and (4. this arises when sets of regressors are included which are identically related. Most commonly. log(p2 ) and log(p1 /p2 ). This is called strict multicollinearity. i.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . we regress yi on x1i only. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. This is because the model being estimated is diﬀerent than (4. Typically. and the error as ui rather than ei . 4. The more relevant issue is near multicollinearity. if X includes both the logs of two prices and the log of the relative prices. Typically there are limits. This deﬁnition is not precise. In general. The diﬀerence Γβ 2 is known as omitted variable bias. there is some α such that Xα = 0. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation.. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity.22). For example. Goldberger (1991) calls (4. we calculate γ1 = ¡ ¡ ¢¢−1 E x1i x0 E (x1i yi ) 1i ¡ ¡ ¢¢−1 ¡ ¡ 0 ¢¢ 0 E x1i x1i β 1 + x0 β 2 + ei = E x1i x1i 2i ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 β 2 = β 1 + E x1i x0 1i 2i = β 1 + Γβ 2 ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 Γ = E x1i x0 1i 2i (4. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. log(p1 ). In this case. Since the error is discovered quickly.22) is zero. or second.23) the short regression to emphasize the distinction. because we have not said what it means for a matrix to be “near singular”. β 1 6= γ 1 . which is often called “multicollinearity” for brevity. except in special cases. This is the situation when the X 0 X matrix is near singular. It is the consequence of omission of a relevant correlated variable.22) by least-squares. this is rarely a problem for applied econometric practice. By construction. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . the coeﬃcient on x2i in (4. the general model will be free of the omitted variables problem. First. 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 . when the columns of X are close to linearly dependent.11 Multicollinearity ˆ If rank(X 0 X) < k + 1.23) where is the coeﬃcient from a regression of x2i on x1i . To see this. 35 .

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

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

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. These approximations are bounded through the use of mathematical inequalities.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q .1) (5.1 Inequalities Asymptotic theory is based on a set of approximations. 41 . Cauchy-Schwarz Inequality. Triangle inequality |X + Y | ≤ |X| + |Y | . then (5. Jensen’s Inequality. 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 ⎠ .2) + 1 q = 1. We list here some of the most critical deﬁnitions and inequalities. |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 . ij i=1 j=1 (5. If g(·) : R → R is convex. 5.

The WLLN shows that sample averages converge in probability to the population average. tangent lines lie below it. if for all δ > 0.2. P (g(X) > α) ≤ α−1 Eg(X). n→∞ lim P (|Zn − Z| > δ) = 0. as stated. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Note EU = EV = 1.3). ¥ Proof of Holder’s Inequality. 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}. Applying expectations.4) Proof of Jensen’s Inequality. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. We say that Zn converges in probability to Z as n → ∞. So for all x.1 Weak Law of Large Numbers (WLLN).Markov’s Inequality. denoted Zn →p Z as n → ∞. =E U V p q p q Proof of Markov’s Inequality. Since 1 + 1 = 1 an application of Jensen’s inequality shows that p q U Then 1/p V 1/q 1 1 ln U + ln V = exp p q E |XY | ∙ ¸ ≤ 1 1 U V exp (ln U ) + exp (ln V ) = + . Set Y = g(X) and let f denote the density function of Y. For any strictly increasing function g(X) ≥ 0. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. Eg(X) ≥ a + bEX = g(EX). n i=1 42 . Let a + bx be the tangent line to g(x) at x = EX. ¥ 5.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. (5. p p p q which is (5. Since g(x) is convex. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. Theorem 5. If Xi ∈ Rk is iid and E |Xi | < ∞. then as n → ∞ n 1X Xn = Xi →p E(X).

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

For ¡ ¢ λ ∈ Rk . 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 . so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. By a second-order Taylor series expansion of c(λ) about λ = 0. ∂λ∂λ cλ (λ) = cλλ (λ) = ∂ ∂ c(λ) = C(λ)−1 C(λ) ∂λ ∂λ ∂ ∂2 ∂2 −2 ∂ C(λ) 0 C(λ) c(λ) = C(λ)−1 0 0 C(λ) − C(λ) ∂λ ∂λ∂λ ∂λ∂λ ∂λ so when evaluated at λ = 0 Furthermore. Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik .Proof: Without loss of generality. let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . it is suﬃcient to consider the case µ = 0 and V = Ik . By the properties of the exponential function. the deﬁnition of c(λ) and (5.8) where λ∗ lies on the line segment joining 0 and λ.

for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε.2 Continuous Mapping Theorem 2. we see that as n → ∞. where θ is m × 1 and Σ is m × m. Σ) . It follows that ajn = gjθ (θ∗ ) − gjθ →p 0.4. This is suﬃcient to establish the theorem. and g(θ) : Rm → Rk . Recall that A ⊂ B implies P (A) ≤ P (B). ¥ 5. Ik ) distribution. then g(Zn ) →p g(c) as n → ∞. gθ Σgθ .√ where λn → 0 lies on the line segment joining 0 and λ/ n. If Zn →d Z as n → ∞ and g (·) is continuous. then g(Zn ) →d g(Z) as n → ∞. Hence g(Zn ) →p g(c) as n → ∞. 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 . Proof: Since g is continuous at c. for each element of g. k ≤ m. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Theorem 5.4 Asymptotic Transformations Theorem 5. 45 . If Zn →p c as n → ∞ and g (·) is continuous at c.4. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).3 Delta Method: If n (θn − θ0 ) →d N (0.4. Stacking across elements of g. Proof : By a vector Taylor series expansion. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. √ Theorem 5. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Σ) = N 0. Since cλλ (λn ) → cλλ (0) = −Ik .1 Continuous Mapping Theorem 1 (CMT). then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0.

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

Assumption 3.1).1. 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 .2). Assumption 3. For a complete argument.1). 6.5. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . This is illustrated in Figure 6. using (6.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.2 Consistency ˆ As discussed in Section 6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.5.2. (6. Hence by the continuous mapping theorem (Theorem 5. ˆ Theorem 6. we can conclude ˆ that β →p β.1.2) i i n i=1 n From (6.1) and ˆ We now deduce the consistency of β.3). Ã n ! n X 1X 0 1 ˆ xi xi . n i=1 (6.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. As the sample size increases the density becomes more concentrated about the population coeﬃcient. 0).1 Under Assumption 3. 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.4. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. Equation (4. ˆ 47 .1). and the continuous mapping theorem (Theorem 5. (6. xi ei →p g (Q.1 and the WLLN (Theorem 5. the OLS estimator β is has a statistical distribution which is unknown. β →p β as n → ∞.4 implies that Q−1 exists and thus g(·. we will use the methods of asymptotic approximation.5. Proof.1. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1). To characterize the sampling distribution more fully.2. (6.4. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. ·) is continuous at (Q. First.1 by the fact that the sampling densities become more concentrated as n gets larger.3) Ã where g(A.

by the Cauchy-Schwarz inequality (5.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.6) n i=1 48 .2. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. n 1 X √ xi ei →d N (0.1 guarantees that the elements of Ω are ﬁnite.3.1. 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 . (6.2. Ω) . ˆ n−k 6.5.3. (6. E ¯ei ¯ E ¯e4 ¯ i i i i (6.1 In addition to Assumption 3. ˆ Finally. We need a strengthening of the moment conditions. (6. it follows that s2 = ¥ n σ 2 →p σ 2 .Theorem 6. ˆ Proof. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Thus σ 2 is consistent for σ 2 . Assumption 6.3) and Theorem (6.3.2 Under Assumption 3. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .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. Ee4 < ∞ and E |xi |4 < ∞. (6. To see this.1). By the central limit theorem (Theorem 5.1.2).5) Thus xi ei is iid with mean zero and has covariance matrix Ω.1). i i Assumption 6.5. since n/(n − k) → 1 as n → ∞.2).

As α approaches 2.3.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. for example. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. Theorem 6. The expression V = Q−1 ΩQ−1 is called a sandwich form.1. (6.2). when xi and ei are independent. |ε| ≥ 1. but this is not a necessary condition. e2 ) = 0. Under (6.1 Under Assumption 6. The approximation may be poor when n is small. 1). We call V 0 the homoskedastic covariance matrix. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . Ω) ¡ ¢ = N 0.7) is true then V = V 0 .1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . When (6.3. however. In Figure 6. We say that ei is a Homoskedastic Projection Error when (6.7) Cov(xi x0 .1). We illustrate this problem using a simulation. How large should n be in order for the approximation to be useful? Unfortunately. The trouble is that no matter how large is the sample size.7) is true or false. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. 1) asymptotic distibution. xi ) which satisfy the conditions of Assumption 6.9) In (6. Q−1 ΩQ−1 . V ) where V = Q−1 ΩQ−1 . for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. V is often referred to as ˆ the asymptotic covariance matrix of β. The asymptotic distribution ´ Theorem 6. Let yi = β 0 + β 1 xi + εi where xi is N (0. setting n = 100 and varying the parameter α. However. is approximately normal when the sample size n is suﬃciently large. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. There is a special case where Ω and V simplify.3.6). after rescaling. This holds true for all joint distibutions of (yi . there is no simple answer to this reasonable question. and (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .1.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. i i Condition (6.3. 1 X √ xi ei n i=1 n ! the N (0. For α 49 . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.3.9) we deﬁne V 0 = Q−1 σ 2 whether (6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.Then using (6. its variance diverges q ³ ´ ˆ to inﬁnity.7) holds.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . otherwise V 6= V 0 . In´Figure 6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).1 states that the sampling distribution of the least-squares estimator.

1) density. We show the sampling distribution of n β 1 − β 1 setting n = 100.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 1). 1) asymptotic approximation is never guaranteed to be accurate. The estimator 2 2 in (6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.3. concentrating most of the probability mass around zero.3 is that the N (0. 6 and 8. 4.2 and 6. As k increases. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 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 (0.10) V 0 = Q−1 s2 . for k = 1. 6.11) 50 .10) without changing this result.2.2: Density of Normalized OLS estimator α = 3. the sampling distribution becomes highly skewed and non-normal.Figure 6.0 the density is very close to the N (0. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. The lesson from Figures 6.1) it is clear that V 0 →p V 0 . we need an estimate of Ω = E xi x0 e2 .2) and Theorem 6. Another example is shown in Figure 6. As α diminishes the density changes signiﬁcantly.

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

we return to the log wage regression of Section 4. (6.14 205.5) and the WLLN (Theorem 5.14 14.14 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. (.480 .20 −0.98 −0.80 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . First.6 ¶µ 1 14.020. Ω 2. We calculate that s2 = 0. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. and then the square roots.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 . (6.085 p ˆ and that for β 1 is .80 40.12) in turn.2/988 = . i i i i n i=1 Second.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. To illustrate.117 Educationi .493 −0.35/988 = .80 .480 ˆ0 = 0. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.83 ¶−1 µ . the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .83 −0. n n i=1 52 .20 = V 14. p ˆ In this case the two estimates are quite similar.020) 6.493 0.14 205. by Holder’s inequality (5.30 + 0. just as any other estimator. but not under another set of assumptions.1. Using (6.085) (. From a computational standpoint.14 205.20 and µ ¶ ˆ = 0.199 2. from which it follows that V →p V as n → ∞.199 2.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.83 ¶−1 = µ 7.039 and ˆ V = µ 1 14. then take the diagonal elements.80 40.14 6. The standard errors for β 0 are 7.5 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.2.used by an author when studying their work.035 ¶ .

26). From equation (3.1 As n → ∞.11) with the leave-one-out estimator ei. these establish consistency.13) Using formula (4. Andrews (1991) suggested an similar estimator based on cross-validation. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .5. Ω →p Ω and V →p V. which. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. 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. ¯ 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. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.25). i=1 Third.13) of Efron (1982).14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . 6. ¯ ¯n ¯ n i=1 so Together. n i=1 n ˆ ˆ Theorem 6. 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. you can show that 1 Xˆ ¯ β= β (−i) . Recall from Section 4. 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.−i = (1 − hi )−1 ei ˆ presented in (4.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. Using this substitution.

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

then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . θ) β 6. 55 . ˆ When q = 1q h(β) is real-valued). In general. if R is a “selector matrix” R= so that if β = (β 1 .For example.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. that (so θ ˆ ˆ ˆ is. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. s(ˆ θ) (6.1 tn (θ) →d N (0. s(ˆ = n−1/2 H 0 V Hβ . see Section X). the statistic tn has an exact t distribution. however. we say that tn is an exactly pivotal statistic. Consider the studentized statistic tn (θ) = Theorem 6.8. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. (For example.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. and is therefore exactly free of unknowns. By (6. In this case. Vθ ) √ Vθ = N (0. β 2 ). µ I 0 ¶ ˆ the upper-left block of V . Since the standard normal distribution does not depend on the parameters. and θ = h(β) is some function of the parameter vector. 1) Proof. we say that tn (θ) is asymptotically pivotal. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. 1) →d ˆ−θ θ . In special cases (such as the normal regression model. the standard error for ˆ is the square root of n−1 Vθ . θ could be a single element of β).16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal.

For example.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. and is a function of the data and hence is / random. or “accepts” H0 . The asymptotic p-value for the above statistic is constructed as follows. To see this fact. from which it follows that pn →d U [0. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. regardless of the complication of the distribution of the original test statistic. 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. however. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . In a sense.025 = 1. associated with Fisher. 1]. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. It is designed to cover θ with high probability. tn →d N (0.96 and z. is to report an asymptotic p-value. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. Let zα/2 is the upper α/2 quantile of the standard normal distribution. 1]. pn →d U [0. Then the asymptotic p-value of the statistic tn is pn = p(tn ). z.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . Either θ ∈ Cn or θ ∈ Cn . Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. Deﬁne the tail probability. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. 1). or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . Otherwise the test does not reject. The coverage probability is P (θ ∈ Cn ). That is. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. 56 . That is. if Z ∼ N (0. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. s(ˆ θ) Under H0 . 1]. An alternative approach. The p-value is more general. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α.645. If the p-value pn is small (close to zero) then the evidence against H0 is strong. 1). 6.05 = 1. under H0 . p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 .

A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. or α = . We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. This corresponds to selecting the conﬁdence h i h ˆ ± 1. = n h(β) − θ0 Hβ V Hβ 57 (6.18) .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. and it is desired to test the joint restrictions simultaneously.96s(ˆ ≈ ˆ ± 2s(ˆ . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. 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). Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. θ The interval has been constructed so that as n → ∞. In this case the t-statistic approach does not work. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. 6.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.05. ˆ + zα/2 s(ˆ .16) and zα/2 is the upper α/2 quantile of the standard normal distribution. 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). θ θ) (6. 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 → ∞.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval.

and Theorem 6. if rank(Hβ ) = q. Vθ ).025 . and there are q = k2 restrictions. For example.15) showed that n ˆ − θ →d Z ∼ N (0. The null hypothesis is H0 : β 2 = 0. ˜˜ n ˜ e = Y − X1 β 1 . The asymptotic p-value for Wn is pn = p(Wn ). the test rejects at the α% level iﬀ pn < α. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).8. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .10.05) = 3. Also h(β) = a selector matrix.1 Under H0 and Assumption 6. θ = β 2 . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). χ2 (. In this case.19) σ2 ˆ where σ2 = ˜ 1 0 e e. 6. 1] under H0 . q and pn is asymptotically U[0.3. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. ˆ Wn = n θ θ q θ θ Theorem 6.1. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity. Hβ (β) →p Hβ . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.84 = z. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.When h is a linear function of β. Furthermore.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 .2. 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. Hence β β by Theorem A. As before. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . the upper-α quantile q 2 of the χ2 distribution. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . h(β) = R0 β.5. Hβ (β) is a continuous function of β.1 showed θ ˆ that V →p V. then Wn →d χ2 . a chiq square random variable with q degrees of freedom.

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

it follows ˆ that β is independent of any function of the OLS residuals. introduced in Section 4.3. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . While there are special cases where this F statistic is useful. when an OLS regression is reported. Since uncorrelated normal variables are independent. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. The modelling assumption that the error ei is independent of xi and N (0. equivalently the residual variance from an intercept-only model. an “F statistic” is reported. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. n−k 60 . e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero.where In many statistical packages. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . In particular. these cases are atypical. 6. 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 0.4)) where H 0 H = In .12 Normal Regression Model As an alternative to asymptotic distribution theory. 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 . H 0 H) ∼ N (0. In ) . This is rarely an issue today. σ 2 ) can be be used to calculate a set of exact distribution results. including the estimated error variance 2. This was a popular statistic in the early days of econometric reporting. there is an exact distribution theory available for the normal linear regression model. In σ 2 . Since linear functions of normals are also normal. Let u = σ −1 H 0 e ∼ N (0.

σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. Theorem 6. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses.1 shows that under the strong assumption of ˆ normality. β has an exact normal distribution and t has an exact t distribution. β 2 . σ 2 ) discussed above. σ 2 ) − Ln (β 1 . σ2 ˆ 61 .1 and Theorem 6.) Now let us partition β = (β 1 . In contrast.12.8. β and t are approximately normally distributed. σ ˆ ˆ βj − βj βj − βj N (0. The critical values are quite close if n − k ≥ 30. n−k • ∼ tn−k ˆ In Theorem 6. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .10) µ h i ¶ 2 (X 0 X)−1 N 0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . 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. We summarize these ﬁndings Theorem 6. σ 2 ) = − log σ − log (2π) − .12. 1) and tn−k distributions. so as a practical matter it does not matter which distribution is used. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .1 If ei is independent of xi and distributed N(0.a chi-square distribution with n − k degrees of freedom. Furthermore. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .1 we showed that in large samples. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . the notable distinction is between the N (0. 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. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ). 0. and standard errors are calculated using the homoskedastic formula (6. 0.10) then ´ ³ ˆ • β ∼ N 0. with residual variance σ . β 2 .3. a good testing procedure is based on the likelihood ratio statistic. (Unless the sample size is unreasonably small. β 2 . As inference (conﬁdence intervals) are based on the t-ratio. if standard errors are calculated using the homoskedastic formula (6.

The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. In the present context of the Wald statistic. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. This can be seen by a simple example introduced by Lafontaine and White (1986).84 — the probability of a false rejection. The increasing solid line is for the case β = 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.7. Through repetition. and noting Hβ = sβ s−1 . This produces random draws from the sampling distribution of interest. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . To demonstrate this eﬀect. 6.8. the statistic Wn (s) varies with s. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. Take the model yi = β + ei ei ∼ N (0. This is an unfortunate feature of the Wald statistic. 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. we have plotted in Figure 6. Letting h(β) = β s . σ 2 ) and consider the hypothesis H0 : β = 1.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . as Wn (s) →d χ2 under H0 for 1 any s. setting n/σ 2 = 10. Our ﬁrst-order asymptotic theory is not useful to help pick s. while there are other values of s for which test test statistic is insigniﬁcant. The decreasing dashed ˆ = 1. they can work quite poorly when the restrictions are nonlinear. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. features of this distribution can be calculated. 62 . we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . ˆ Let β and σ 2 be the sample mean and variance of yi . This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples.4 the Wald statistic Wn (s) as a function ˆ of s.

05) with deviations indicating+ distortion. The null hypothesis β s = 1 is true. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.Figure 6. In Table 4. remember that the ideal Type I error probability is 5% (. The value of s is varied from 1 to 10. When comparing statistical procedures. looking for tests for which rate rejection rates are close to 5%. In each case. the only test which meets this criterion is the conventional Wn = Wn (1) test. These probabilities are calculated as the percentage of the 50. and σ is varied among 1 and 3. Typically. To interpret the table. so these probabilities are Type I error. Rates above 20% are unexceptable.84 | β = 1) . Table 4. 100 and 500. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.4.1 we report the results of a Monte Carlo simulation where we vary these three parameters. the Type I error probability improves towards 5% as the sample size n increases.000 random samples. and σ 2 . n.000 simulated Wald statistics Wn (s) which are larger than 3.84. and rarely fall outside of the 3%-8% range.1 you can also see the impact of variation in sample size. this probability depends only on s. For this particular example. no magic choice of n for which all tests perform uniformly well. Any other choice of s leads to a test with unacceptable Type I error probabilities. Given the simplicity of the model. In Table 2. n is varied among 20. Table 4. we compare the rates row by row. Type I error rates between 3% and 8% are considered reasonable.1 reports the simulation estimate of the Type I error probability from 50. however.4: Wald Statistic as a function of s P (Wn (s) > 3. Error rates avove 10% are considered excessive. Test performance deteriorates as s increases. There is.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .

deﬁne θ = β 1 /β 2 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .05 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .15 . 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. β 2 ) be the least-squares estimates of (6.06 .20 .08 .07 .25 .07 .08 .24 . 64 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.05 .12 .13 .35 .23 .34 .06 .20 .06 .19 .26 .22 .22 .21 .28 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.07 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.05 .05 .17 .06 .33 .06 .08 .07 . Equivalently.13 .13 .11 .10 .09 .08 .31 .06 .15 .08 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .05 .06 .07 .25 .14 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.06 .10 . This point can be illustrated through another example. While this is clear in this particular example.12 .14 .20).30 .16 Rejection frequencies from 50.15 .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 .05 . so the hypothesis can be stated as H0 : θ = r.10 .18 . Other choices are arbitrary and would not be used in practice.15 . β 1 .

−r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.06 . and alternatives to asymptotic critical values should be considered. If no linear formulation is feasible.0 and n among 100 and 500. and 1. 65 . ei be an independent N (0. along with sample size n.15 .645) P (tn > 1.00 .05 .50.06 . . The left tail probabilities P (t1n < −1.00 . This leaves β 2 as a free parameter. and normalize β 0 = 0 and β 1 = 1.00 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .10 .00 . .10 . σ 2 ) draw with σ = 3.06 .12 . The results are presented in Table 4.09 .05 . and are close to the ideal 5% rate for both sample sizes.47 .05 β2 . Ideally.000 simulated samples.06 .06 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.50 .00 The one-sided Type I error probabilities P (tn < −1. In this section we describe the method in more detail. 1) variables. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .00 .05.06 .05 . In all cases.28 .02 .25 .645) P (tn < −1. We let x1i and x2i be mutually independent N (0. 6. The implication of Table 4. However.06 .00 .7.1.06 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .10 .75. Table 4.05 .645) t1n t2n t1n t2n t1n t2n t1n t2n . while the right tail probabilities P (t1n > 1.05 .07 .00 .05 .26 . We vary β 2 among . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.05 .06 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.05 . It is also prudent to consider alternative tests to the Wald statistic. such as the GMM distance statistic which will be presented in Section 9.25.2.645) P (tn > 1. if the hypothesis can be expressed as a linear restriction on the model parameters.00 . the entries in the table should be 0.75 1. the rejection rates for the t1n statistic diverge greatly from this value.645) are close to zero in most cases.15 .00 .645) greatly exceed 5%.645) and P (tn > 1.05 . In contrast.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. then the “most linear” formulation should be selected. this formulation should be used.06 .645) are calculated from 50. . especially for small values of β 2 .

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

and our regressors include years of education.022. .007. Quite simply.003. a larger B results in more precise estimates of the features of interest of Gn . and estimate a multivariate regression. It is therefore useful to conduct a variety of experiments. As discussed above. but requires more computational time. the choice of B is often guided by the computational demands of the statistical procedure. if we set B = 999. If the standard error is too large to make a reliable inference.96) . the performance will depend on n and F. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. excluding military. The random variable 1 (Tnb ≥ 1. experience squared.22/ B. The average (6. immigrant. and poorly for others. the researcher must select the number of experiments. For example. female. union member. and therefore it is straightforward to calculate standard errors for any quantity of interest. 1000. and 5000. and hispanic. For the dependent variable we use the natural log of wages. and dummy variable indicators for the following: married. For regressors we include years of education.15 Estimating a Wage Equation We again return to our wage equation. potential work experience. it is simple to make inferences about rejection probabilities from statistical tests.96) is iid Bernoulli. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. For example. female. As P is unknown.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. therefore. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. and . hispanic. We separately estimate equations for white and non-whites. are. B b=1 (6.96) . Then qα is the N ’th number in this ordered sequence. It is therefore convenient to pick B so that N is an integer. In practice. this may ˆ be approximated by replacing P with P or with an hypothesized value. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. Hence the ³ ´ ˆ standard errors for B = 100. We us the sample of wage earners from the March 2004 Current Population Survey. experience squared. We now expand the sample all non-military wage earners. then we can set s P = (. Often this is called the number of replications. so that coeﬃcients may be interpreted as semi-elasticities. respectively. for a selection of choices of n and F. equalling 1 with probability P = E1 (Tnb ≥ 1.21). Generally. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. s P = . potential work experience. an estimator or test may perform wonderfully for some values.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. B. In many cases. Again our dependent variable is the natural log of wages. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. we included a dummy 67 . Furthermore. union member. The α% sample quantile is a number qα such that α% of the sample are less than qα .05) (. immigrant. and dummy variable indicators for the following: married. and 90% sample quantiles of the sample {Tnb }. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. and non-white. In particular. 6. then B will have to be increased. where N = (B +1)α. such as the percentage estimate reported in (6.95) /B ' .

Alternatively.48772 = 515. 808 1 − .070 .variable for state of residence (including the District of Columbia. as the 1% critical value for the χ2 distribution is 76.013 . The available sample is 18. Ignoring the other coeﬃcients.008 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. 2β 3 68 .4945.033 −. this adds 50 regressors).001 . Wn = n 1 − 2 = 18. reestimating the model with the 50 state dummies excluded.097 −.102 −.34 ˆ s(β) .00002 . The F form of the Wald statistic (6. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.027 .002 .49452 σ ˜ Notice that the two statistics are close. the restricted standard deviation estimate is σ = .808 .010 .232 .1.121 −. excluding the coeﬃcients on the state dummy variables.69. Using either statistic the hypothesis is easily rejected. we ﬁnd Wn = 550. θ ˆ 2β 3 β2 . but not equal.808 so the parameter estimates are quite precise and reported in Table 4. Computing the Wald statistic (6.19) is ˜ µ ¶ µ ¶ σ2 ˆ .102 −.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.032 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.101 .4877 18. 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.18) that the state coeﬃcients are jointly zero.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.014 .00057 .007 . Table 4.

Using the Delta Method. we found better Type I error rates by reformulating the hypothesis as a linear restriction.40. Since tn (θ) is a non-linear function of θ. This set is [27. This is the set of θ such that |tn (θ)| ≤ 1. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. not testing a hypothesis. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. but it can be found numerically quite easily. 29. 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. However.0. there is not a simple expression for this set. we can calculate a standard error of s(ˆ = . 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 previous section we discovered that such t-tests had very poor Type I error rates. implying a 95% conﬁdence θ) interval of [27. 29. 69 . In the present context we are interested in forming a conﬁdence interval.5]. Instead.5]. this is a poor choice.9.96. but the lower end is substantially lower.

˜ That is. (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. In the model Y = X1 β 1 + X2 β 2 + e. then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. the least-squares estimate of β subject to the restriction h(β) = 0 is ˜ β = argmin Sn (β) h(β)=0 Sn (β) = (Y − Xβ)0 (Y − Xβ) . Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. 3.6. ﬁnd the least-squares estimate of β = (β 1 . ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix. β 2 ). β 2 ). ˜ (b) Verify that R0 β = r.16 Exercises For exercises 1-4. 1. r ˜ is a known s × 1 vector. 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 . ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. 4. (c) Show that if R0 β = r is true. β − β = Ik − X 0 X 70 . subject to the constraint that β 1 = −β 2 . In the model Y = X1 β 1 + X2 β 2 + e. 2. show that the least-squares estimate of β = (β 1 . the following deﬁnition is used. 0 < s < k. β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . and rank(R) = s. In the model Y = Xβ + e. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. (d) Under the ´ standard assumptions plus R0 β = r. λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. In the model Y = X1 β 1 + X2 β 2 + e. show that the least-squares estimate of β = (β 1 .

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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. σ 2 }. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi .. However. Let η i = e2 . the least-squares estimator is ineﬃcient. where z1i is some q × 1 function of xi . Typically. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 .1) XD Y β = X 0 D−1 X ¡ ¢ 2 .. The GLS estimator (7.. we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. σ1 We now discuss this estimation problem. Often the functional form is kept simple for parsimony. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1) infeasible since the matrix D is unknown. z1i are squares (and perhaps levels) of some (or all) elements of xi . Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7.2) E (ξ i | xi ) = 0.. . Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi .1 Generalized Least Squares In the projection model... 74 . . σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .Chapter 7 Additional Regression Topics 7.

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

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

Third. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. This hypothesis does not imply that ξ i is independent of xi . In this case. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. and all cross-products. Typically. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi .3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β.error. OLS is a more robust estimator of the parameter vector. individual estimated conditional variances may be negative. 7. require the assumption of a correct conditional mean. The main diﬀerences between popular “tests” is which transformations of xi enter zi . q Most tests for heteroskedasticity take this basic form. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . its squares.4) and constructing a Wald statistic. If the equation of interest is a linear projection. This introduces an element of arbitrariness which is unsettling to empirical researchers. on the other hand. and the cost is a reduction of robustness to misspeciﬁcatio 7. It is consistent not only in the regression model.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . but the only diﬀerence is that they a ¢ allowed for general choice of zi .7) under independence show that this test has an asymptotic chi-square distribution. In the linear regression model the conditional mean of yi given xi = x is 77 .7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). the two tests coincide. and this requires trimming to solve. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.5) and the asymptotic variance (7. the estimated conditional variances may contain more noise than information about the true conditional variances. Second. then the OLS and FGLS estimators will converge in probability to diﬀerent limits.4). but also under the assumptions of linear projection. FGLS will do worse than OLS in practice. We may therefore test this hypothesis by the estimation (7. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. σ 2 ). Theorem 7.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . as they will be estimating two diﬀerent projections. or equivalently that i H0 : α1 = 0 in the regression (7. and not a conditional mean.2). the Wald test of H0 is asymptotically χ2 .1 Under H0 and ei independent of xi . The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. The GLS and FGLS estimators. The asymptotic distribution (7.2. however. Vα = E zi zi (7.

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

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

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

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

V ). See Chapter 16. 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. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .10) is equivalent to g n (β) = 0.5.3. and this improves estimation of the median. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. ˆ Proof of Theorem 7. by a Taylor series expansion and the fact g(β 0 ) = 0 82 .1 ´ √ ³ˆ n β − β 0 →d N (0. The main diﬃculty is the estimation of f (0). we provide a sketch here for completeness.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . Let g(β) = Eg (β). This can be done with kernel estimation techniques.Theorem 7.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . ∂ 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 ) . the conditional density of the error at its median. ∂β 0 so Third.5. then there are many innovations near to the median. While a complete proof of Theorem 7. (7. where V = and f (e | x) is the conditional density of ei given xi = x. When f (0 | x) is large. the height of the error density at its median. First.11). Computation of standard error for LAD estimates typically is based on equation (7.1 is advanced. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . by the central limit theorem (Theorm 5.5. Pn −1 0 β)) . In the special case where the error is independent of xi .

(7. 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)) . For ﬁxed τ . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations).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. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . V ). so you can think of the quantile as the inverse of the distribution function.12) Qτ = argmin Eρτ (U − θ) .9) for the median to all quantiles. Exi x0 ) →d i 2 = N (0. Again. the quantile regression functions can take any shape. when F (y | x) is continuous and strictly monotonic in y. then F (Qτ (x) | x) = τ . The third line follows from an asymptotic empirical process argument. For τ ∈ [0. The following alternative representation is useful. then (7. ¥ 7.13) This generalizes representation (7. then F (Qτ ) = τ . 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. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . The median is the special case 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 . As functions of x. If the random variable U has τ ’th quantile Qτ .5. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . For the random variables (yi .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice.

ˆ Given the representation (7. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.5. the unconditional density of ei at 0.13). Furthermore. ¡ ¡ ¢¢−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. 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. 7. and are widely available. it is useful to have a general test of the adequacy of the speciﬁcation. n numerical methods are necessary for its minimization. if the model yi = x0 β + ei has i been ﬁt by OLS. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . Vτ ). i By construction. Thus. then f (0 | xi ) = f (0) . 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. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . conventional Newton-type optimization methods are inappropriate.6. and test their signiﬁcance using a Wald test. since it has discontinuous derivatives.12).1. and form a Wald statistic i for γ = 0. the τ ’th conditional quantile of ei is zero. otherwise its properties are unspeciﬁed without further restrictions. 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. Fortunately. Another popular approach is the RESET test proposed by Ramsey (1969). ´ √ ³ˆ Theorem 7. The null model is yi = x0 β + εi i 84 . where and f (e | x) is the conditional density of ei given xi = x. the asymptotic variance depends on the conditional density of the quantile regression error. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. When the error ei is independent of xi .where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . fast linear programming methods have been developed for this problem.

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

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

BIC model selection is consistent. this rule only makes sense when the true model is ﬁnite dimensional. known as the BIC. The rule is to select M1 if AIC1 < AIC2 . the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. let cα satisfy ¢ ¡ P χ22 > cα . as the rule tends to overﬁt. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically.However. AIC selection is inconsistent. n (7. etc. Then select M1 if Wn ≤ cα . since (7. as ³ ´ c P M = M1 | M1 → 1 − α < 1. based on Bayesian arguments. the most popular to be one proposed by Schwarz. Indeed. Indeed. 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. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . His criterion. log(n) 87 .15) then where σ 2 is the variance estimate for model m. The model selection rule is as follows. depending on the sample size. If the truth is inﬁnite dimensional. else select M2 . else select M2 . n (7. Another problem is that if α is held ﬁxed. That is. k = While many modiﬁcations of the AIC have been proposed. k ´ ³ c P M = M1 | M1 P (AIC1 < AIC2 | M1 ) µ ¶ k1 k1 + k2 2 2 σ | M1 = P log(ˆ 1 ) + 2 < log(ˆ 2 ) + 2 σ n n = P (LRn < 2k2 | M1 ) ¡ ¢ → P χ22 < 2k2 < 1. and km is the number of coeﬃcients in the model.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 .16) holds under M1 . it is more appropriate to view model selection as determining the best ﬁnite sample approximation. 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. M)) between the true density and the model density. Another common approach to model selection is to to a selection criterion. One popular choice is the Akaike Information Criterion (AIC). since under M1 . if α is set to be a small number.17) Since log(n) > 2 (if n > 8). For some critical level α. In contrast to the AIC. LRn →p 0. then this model selection procedure is inconsistent. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . k A major problem with this approach is that the critical level α is indeterminate. ¢ ¡ ˆ1 ˆ2 (7.

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

i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . . Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . V .7.10 Exercises 1. 4. (b) Find an estimate of the variance of this forecast. For any predictor g(xi ) for y. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. where M1 = I − X X 0 Ω−1 X ˆ ¡ 0 −1 ¢−1 0 −1 0 (c) Prove that M1 Ω−1 M1 = Ω−1 − Ω−1 X X Ω X XΩ . and the out-of-sample value of the regressors. the residuals e. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. 5. the mean absolute error (MAE) is E |yi − g(xi )| . . Thus the available information is the sample (Y. ˆ ˆ n−k 6. In a linear model Y = Xβ + e. Show that the function g(x) which minimizes the MAE is the conditional median M (x). Let σ 2 be the estimate of σ 2 . ˆ (a) Find a point forecast of y. E(e | X) = 0. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. Is θ a quantile of the distribution of Yi ? 3. based on a sample of size n. where xji is one of the xi . Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . X). 2. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . xi ) be a random sample with E(Y | X) = Xβ. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ .12). else equals zero).. x. (b) Prove that e = M1 e. Verify equation (7. wn ) and wi = x−2 . ˜ the residual vector is e = Y − X β. Let (yi . V ar(e | X) = σ 2 Ω with Ω known. σ 2 ). Let θ satisfy Eg(Yi − θ) = 0.. the estimates (β..

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

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

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

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

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

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

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

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

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

and vice-versa.2 an = O(1) if |an | is uniformly bounded. Let an be a sequence.4) says that Gn converges to Φ x as n → ∞. 99 . the critical value qn (α) is found as the quantile from simulated values of W´ . (8. lim Gn (x. The derivative of an even function is odd. an = O(n−r ) if it declines to zero like n−r .3 an = o(n−r ) if nr |an | → 0 as n → ∞. Basically.8. F ) then ³x´ .4) v ¡ ¢ While (8.] 8.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. not ˆ − θ0 . where qn (α) is the (1 − α)% quantile of the distribution of Wn . θ [This is a typical mistake made by practitioners. The ideal test rejects if Wn ≥ qn (α). Thus here Tn (θ) = Wn (θ). Deﬁnition 8. v 2 ). F ) = Φ + o (1) .3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.8 Asymptotic Expansions Tn →d N (0. Equivalently.8. We say that a function g(x) is even if g(−x) = g(x). writing Tn ∼ Gn (x. F ) = Φ n→∞ v or ³x´ Gn (x. or the size of the divergence for any particular sample size n.8. however.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. about the rate v of convergence. If θ is a vector. and a function h(x) is odd if h(−x) = −h(x). n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). C4 is called the symmetric percentile-t interval. 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 following notation will be helpful. it says nothing. θ θ θ ˆ θ ∗ ∗ Computationally. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . Let Tn be a statistic such that (8. A better asymptotic approximation may be obtained through an asymptotic expansion. 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. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. Deﬁnition 8.

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

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

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

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

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

Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. and ˆ is calculated on each θ ∗ ∗ θ sample. ∗ ∗ ∗ Let qn (. (a) Report the 95% Efron Percentile interval for θ. ˆ − s(ˆ n (. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. ˆ = 1. Estimate a linear regression of price on the number of bedrooms. size of house.95).05) and qn (.3. and the colonial dummy. 105 . θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. Suppose that in an application.95).pdf. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. You do this as follows. and the 2. you generate bootstrap samples. with variables listed in the ﬁle hprice1. The ˆ are sorted. can you report the 95% Percentile-t interval for θ? 7.2 and s(ˆ = .95) denote the 5% θ) ∗ and 95% quantiles of Tn .95). Let qn (. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. Using the non-parametric ∗ bootstrap.5% and 97.05) . θ respectively. The dataﬁle hprice1. and thus reject H0 if ˆ ˆ > q ∗ (.95) denote the 95% quantile of Tn .dat contains data on house prices (sales).75 and 1. You replace c with qn (. Using the non-parametric bootstrap. (c) With the given information.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).5% quantiles of the ˆ are . You want to test H0 : θ = 0 against H1 : θ > 0. ∗ ∗ where s(ˆ is the standard error in the original data. What is wrong with this procedure? Tn = θ/s(θ) n 6. (b) Report the 95% Alternative Percentile interval for θ.2. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). lot size.

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

i i . Proposition 9. the square of the Euclidean length.9. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . and the GMM estimator is the MME. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi .1 β GMM = argmin Jn (β).2. if Wn = I.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. β ˆ Note that if k = . For example. 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. ˆ Deﬁnition 9.2. β GMM = Z 0 XWn X 0 Z 9. β GMM does not change. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. but this is generally not possible when > k. For some × weight matrix Wn > 0.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . for if Wn is replaced ˆ by cWn for some c > 0. let Jn (β) = n · g n (β)0 Wn g n (β). This is a non-negative measure of the “length” of the vector g n (β). ¡ ¢−1 0 ˆ Z XWn X 0 Y.2) g n (β) = (9. Let and where gi = xi ei . then.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. the dependence is only up to scale. then g n (β) = 0. The GMM estimator minimizes Jn (β).2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .

no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . Ω) .1 ´ √ ³ˆ n β − β →d N (0. 9.3. The proof is left as an exercise. as we are only considering alternative weight matrices Wn .2 For the eﬃcient GMM estimator. This is a weak concept of optimality. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . it turns out that the GMM estimator is semiparametrically eﬃcient.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. For any Wn →p W0 . n n We conclude: Theorem 9. ˆ∗ ˆ 108 .3. ˆ n i=1 gi = gi − g n . 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. and this is all that is known. it is semiparametrically eﬃcient. No estimator can do better (in this ﬁrst-order asymptotic sense). we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . ˆ we still call β the eﬃcient GMM estimator. Chamberlain showed that in this context. without imposing additional assumptions. a better choice is Wn = (X 0 X)−1 . n β − β →d N 0. For example. as shown by Gary Chamberlain (1987). This results shows that in the linear model. This turns out to be W0 = Ω−1 . this is a semi-parametric problem. as it has the same asymptotic distribution. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . In the linear model. W0 = Ω−1 is not known in practice. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. 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. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. where In general. β). If it is known that E (gi (β)) = 0. the GMM estimator β is consistent yet ineﬃcient. V ) . but it can be estimated consistently. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. However. The optimal weight matrix W0 is one which minimizes V. ˆ Construct n 1X ˆ g n = g n (β) = gi . we can set Wn = I . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances.

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

For example. The variance of β may be estimated by G0 Ω−1 G where P ∗ ∗0 P ∂ ˆ ˆ ˆ g g and G = n−1 ˆ ˆ Ω = n−1 0 gi (β). take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. 9.1 (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. Under the hypothesis of correct speciﬁcation. This estimator can be iterated if needed. 1 it is possible that β 2 6= 0. The general theory of GMM estimation and testing was exposited by L. 1 2 It is possible that β 2 = 0. ˆ J = J(β) →d χ2−k . i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . 110 . Thus the model — the overidentifying restrictions — are testable. 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. However. 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 . Theorem 9. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). perhaps obtained by ﬁrst ˆ setting Wn = I. and if the weight matrix is asymptotically eﬃcient. n β − β →d N 0. so that the linear equation may be written as yi = β 0 x1i + ei . ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9.Often. ˆˆ n is a quadratic form in g n . G0 Ω−1 G . Identiﬁcation requires l ≥ k = dim(β).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 .1 Under general regularity conditions.6. Hansen (1982). this is all that is known. and then β recomputed. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction.5. often the weight ˆ matrix Wn is updated. Since the GMM estimator depends upon the ﬁrst-stage estimator. Note that g n →p Egi . and is thus a natural test statistic for H0 : Egi = 0. β) = 0 holds. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not.

and it is advisable to report the statistic J whenever GMM is the estimation method. current evidence suggests that the D statistic appears to have quite good sampling properties. we can reject the model. Based on this information alone. as this ensures that D ≥ 0.The proof of the theorem is left as an exercise. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). D →d χ2 r 3.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. If the statistic J exceeds the chi-square critical value. the Wald statistic can work quite poorly. the hypothesis is H0 : h(β) = 0. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . it is unclear what is wrong. however. This reasoning is not compelling. This is sometimes called the GMM Distance statistic. This result was established by Sargan (1958) for a specialized case. These may be used to construct Wald tests of statistical hypotheses. 111 . The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. but it is typically cause for concern. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). Hansen (1982) for the general case. D ≥ 0 2. 9. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. and some current research suggests that this restriction is not necessary for good performance of the test. and is the preferred test statistic. a better approach is to directly use the GMM criterion function.1 If the same weight matrix Wn is used for both null and alternative. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). then D equals the Wald statistic.7. it is customary to report the J statistic as a general test of model adequacy. In contrast. If the hypothesis is non-linear. The idea was ﬁrst put forward by Newey and West (1987). 1. When over-identiﬁed models are estimated by GMM. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). If h is linear in β. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. Proposition 9. For a given weight matrix Wn . and by L. If h is non-linear.

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

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

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

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

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

these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1.. the log-likelihood function for this multinomial distribution is n X ln(pi ). . pn ) which places probability pi at each observation. In this case the moment condition places no additional restrictions on the multinomial distribution. The n ﬁrst order conditions are 0 = p−1 − µ. 2001) and has been extended to moment condition models by Qin and Lawless (1994). .1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n). 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 .Chapter 10 Empirical Likelihood 10. The multinomial distribution which places probability pi at each observation (yi . The idea is to construct a multinomial distribution F (p1 . (10. β)... xi . pn ) are those which maximize the log-likelihood subject to the constraint (10.2) Ln (p1 . It is a non-parametric analog of likelihood estimation.. This is equivalent to maximizing Ã n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier.. The idea is due to Art Owen (1988. . xi .. To be a valid multinomial distribution.1). zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. (10... The maximum likelihood estimator of the probabilities (p1 . pn ) = i=1 An alternative to GMM is empirical likelihood. zi .3) i=1 117 . Combined with i the constraint (10.1) i=1 First let us consider a just-identiﬁed model..1 Non-Parametric Likelihood Since each observation is observed once in the sample.

3).4) (10. p (10. the Lagrange multiplier λ(β) minimizes Rn (β. (see section 6. The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. λ) : λ(β) = argmin Rn (β.5) ˆ ˆ As a by-product of estimation.5). or equivalently minimizes its negative ˆ (10.2) subject to the restrictions (10. 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. µ. but must be obtained numerically (see section 6.7) 118 . This yields the (proﬁle) empirical log-likelihood function for β.1) and (10. Ln (β) = Rn (β. probabilities 1 ³ ´´ . Multiplying the ﬁrst equation by pi . p1 .5) This minimization problem is the dual of the constrained maximization problem. we also obtain the Lagrange multiplier λ = λ(β). pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . pn . The solution cannot be obtained explicitly.. λ) = −n ln (n) − n X i=1 For given β... µ) = n i=1 i=1 i=1 L∗ n with respect to pi . The solution (when it exists) is well deﬁned since Rn (β. λ). λ. λ ¡ ¢ ln 1 + λ0 gi (β) .where λ and µ are Lagrange multipliers. λ) is a convex function of λ. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). . we ﬁnd µ = n and 1 ¢. and using the second and third equations. (10. summing over i.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. pi gi (β) = 0.

2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.14) 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 .9) and (10. λ) = − (10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. (β. and n β − β 0 and nλ are asymptotically independent. 0 = Rn (β. G = −E (xi zi ). i=1 i=1 i=1i Expanding (10.2. λ) = − (10.1 Under regularity conditions. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. in the linear model. and Ω = E xi x0 e2 .10).10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . 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. β) = −xi zi . i i Theorem 10.13) Premultiplying by G0 Ω−1 and using (10. Thus the EL estimator is asymptotically eﬃcient. Gi (.10) ¡ Ω−1 N (0. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . β λ ∂ ³ ´.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. n (10.13) yields n n Expanding (10. ˆ ˆ Proof.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .8) and ¢ 0 0 For example.9) (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.

Vλ ) Furthermore. and have the same interpretation.15) (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.15) 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 (0.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.1 If Eg(wi .14) for λ and using (10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. V ) ˆ Solving (10. by a Taylor expansion. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. 120 .3 Overidentifying Restrictions In a parametric likelihood context. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .17) 2 ln 1 + λ gi β . and it is advisable to report the statistic LRn whenever EL is the estimation method. Since the EL estimator achieves this bound. and (10. The overidentiﬁcation test is a very useful by-product of EL estimation.3. Proof. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . First. (10.15). Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. They are asymptotically ﬁrst-order equivalent. tests are based on the diﬀerence in the log likelihood functions.7) is n ³ ´´ ³ X ˆ ˆ0 (10. it is an asymptotically eﬃcient estimator for β.16). β 0 ) = 0 then LRn →d χ2−k . 10. LRn = i=1 Theorem 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. The same statistic can be constructed for empirical likelihood. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.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. Ω) GΩ G →d = N (0.

The hypothesis of interest is h(β) = 0. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. 10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.ssc.4 Testing Egi (β) = 0 (10. By “maintained” we mean that the overidentfying restrictions contained in (10.Second.18). Theorem 10.17) is not appropriate. LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. 10.1 Under (10. This test statistic is a natural analog of the GMM distance statistic. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). h(β)=0 ˜ Fundamentally. LRn →d χ2 .prc 121 . the simple overidentifying restrictions test (10.wisc. so there is no fundamental change in the distribution theory for β relative to β.18) and H0 : h(β) = 0. Vλ )0 Ω−1 N (0. a The proof of this result is more challenging and is omitted.18) Let the maintained model be where g is × 1 and β is k × 1.edu/~bhansen/progs/elike. since ln(1 + x) ' x − x2 /2 for x small.4. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . To test the hypothesis h(β) while maintaining (10. where h : Rk → Ra .

λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. For p = 0. Set δ 0 = 0. λ) = − ∂β n X i=1 G∗ (β.5) for given β. λ)0 − ∂β∂β Rn (β. λ) ∂λ i=1 n ∂ Rn (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next).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. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) = − gi (β. (10. Eﬃcient convergence requires a good choice of steplength δ. λj ))−1 Rλ (β. λ) gi (β. set 2 λp = λj − δ p (Rλλ (β. 1. λ) G∗ (β. λ)0 0 Rn (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β.20) . The iteration (10.19) is continued until the gradient Rλ (β.19) X ∂2 ∗ ∗ gi (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λj ) is smaller than some prespeciﬁed tolerance. λ)0 − Rn (β. Deﬁne ∗ gi (β.19). δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) = i The ﬁrst derivatives of (10. 2. λj ) . λ) G∗ (β. The starting value λ1 can be set to the zero vector. λj )) Rp = Rn (β. λp ) A quadratic function can be ﬁt exactly through these three points.4). λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λj ))−1 Rλ (β. λ) . λ) = G∗ (β. δ 1 = 1 and δ 2 = 1.. One method uses the following quadratic approximation.

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

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

and assume that E(zi ei ) 6= 0 so there is endogeneity. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. By the above deﬁnition. some regressors in zi will be uncorrelated with ei (for example.1. and x2i are the excluded exogenous variables. z1i is an instrumental variable for (11. In a typical set-up.1) if E (xi ei ) = 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 ¶ . which does not equal either β 1 or β 2 . So we have the partition µ ¶ z1i k1 (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. 11. Thus we make the partition ¶ µ k1 z1i (11.1) where zi is k × 1. this can be written as Y = Zβ + e.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. We call (11. so should be included in xi .1 The × 1 random vector xi is an instrumental variable for (11. In matrix notation.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. That is x2i are variables which could be included in the equation for yi (in the sense 125 . Deﬁnition 11.1). (11. β →p β ∗ . We call z1i exogenous and z2i endogenous.1) the structural equation. This is called simultaneous equations bias.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. at least the intercept).

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

PX Z2 ] = [Z1 . X2 ].11) (11. PX Z2 ] h i ˆ = Z1 . Z2 ] and X = [Z1 . X is n × l so there are l instruments. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. let’s analyze the approximate bias of OLS applied to (11. In our notation.ˆ It is useful to scrutinize the projection Z. 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. ˆ since Z1 lies in the span of X. Z = [Z1 . Using (11. Z2 . Here we present a simpliﬁed version of one of his results. Z2 = [PX Z1 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . Recall.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. ¶ 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 ) . we regress Y on Z1 and Z2 . First. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . 11.13) which is zero only when S21 = 0 (when Z is exogenous). 129 . Then i h ˆ ˆ ˆ Z = Z1 . We now derive a similar result for the 2SLS estimator.12).12) Z = XΓ + u ξ = (e. the model is Y = Zβ + e (11.11). Thus in the second stage.

12) and this result. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.13). the bias in the 2SLS estimator will be large. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .Let PX = X (X 0 X)−1 X 0 . 130 . n and (11. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. By the spectral decomposition of an idempotent matrix. 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 . except when S21 = 0 (when Z is exogenous). Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. P = HΛH 0 0 0 where Λ = diag(Il . 0). The consequences of identiﬁcation failure for inference are quite severe. 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 (11.14) In general this is non-zero.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . It is also close to zero when α = 0. Indeed as α → 1. 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. the expression in (11. 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 . l .

To see the consequences. E x2 u2 i i n n i=1 i=1 n n (11. which occurs i when E (zi xi ) 6= 0. but is weak.15) is unaﬀected. once again take the simple case k = l = 1. so E (zi xi ) = 0. Then (11. E x2 e2 i i n i=1 n (11.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. This is particularly nasty. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. Suppose that identiﬁcation does not complete fail.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 . but (11. and was examined by Phillips (1989) and Choi and Phillips (1992). as the Cauchy distribution does not have a ﬁnite mean. meaning that inferences about parameters of interest can be misleading. This occurs when Γ22 is full rank. 131 . viz Γ22 = n−1/2 C. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. where C is a full rank matrix.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. the instrument xi is weak for zi if γ = n−1/2 c.Take the simplest case where k = l = 1 (so there is no X1 ). N2 since the ratio of two normals is Cauchy. This result carries over to more general settings. standard test statistics have non-standard asymptotic distribution of β distributions. This can be handled in an asymptotic analysis by modeling it as local-to-zero. Suppose this condition fails. but small. Here. In addition. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. Qc + N2 ˆ As in the case of complete identiﬁcation failure.

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

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

Estimate the model by 2SLS. (b) Now treat Education as endogenous. using zi as an instrument for xi . Report estimates and standard errors. Suppose that price and quantity are determined by the intersection of the linear demand and supply curves Demand : Supply : Q = a0 + a1 P + a2 Y + e1 Q = b0 + b1 P + b2 W + e2 ¡ ¢ (a) Show that E (xi ei ) = 0 and E x2 ei = 0.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). f atheduc (the education. (a) Estimate the model by OLS. using the instrument near4. In this model. We want to estimate a wage equation log(W age) = β 0 + β 1 Educ + β 2 Exper + β 3 Exper2 + β 4 South + β 5 Black + e where Educ = Eduation (Years) Exper = Experience (Years). of the mother). 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. are the parameters identiﬁed? 8. (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). and the remaining variables as exogenous. and South and Black are regional and racial dummy variables. (e) Calculate and report the J statistic for overidentiﬁcation. Report estimates and standard errors.. Report the estimates and standard errors. The data ﬁle card. There are 2215 observations with 19 variables. 134 . of the father) and motheduc (the education. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix.pdf. Does this diﬀer from 2SLS and/or OLS? 7.(b) Deﬁne the 2SLS estimator of β. a dummy indicating that the observation lives near a 4-year college. and then calculate the GMM estimator from this weight matrix without further iteration. (d) Re-estimate the model by eﬃcient GMM. (f) Discuss your ﬁndings. in years. in years. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. listed in card.

and multivariate (yt ∈ Rm is vector-valued).. however. The primary model for univariate time series is autoregressions (ARs).1. Yt−k ) = γ(k) is independent of t for all k. then Xt is strictly stationary and ergodic.4 (loose). and use the subscript t to denote the individual observation. we adopt new notation. T .2 {Yt } is strictly stationary if the joint distribution of (Yt .. and Cov (Yt . we expect that Yt and Yt−1 are not independent. so classical assumptions are not valid.1. . .) is a random variable.. Because of the sequential nature of time series. 12. There proofs are rather diﬃcult. To indicate the dependence on time. Yt−k ) is independent of t for all k.1 Stationarity and Ergodicity Deﬁnition 12. We can separate time series into two categories: univariate (yt ∈ R is scalar)..1. t = 1. Yt−k ) is the autocorrelation function. Deﬁnition 12. The following two theorems are essential to the analysis of stationary time series. 135 . Theorem 12. and T to denote the number of observations. γ(k) is called the autocovariance function.1.1.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . . Deﬁnition 12..Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.. A stationary time series is ergodic if γ(k) → 0 as k → ∞.. The primary model for multivariate time series is vector autoregressions (VARs). Yt−1 . Deﬁnition 12..

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

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

the above results are unchanged.1. Deﬁning L2 = LL.3.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. Lk Yt = Yt−k . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . The AR(k) model is Using the lag operator.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.Theorem 12. an AR(1) is stationary iﬀ |ρ| < 1. From Theorem 12. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. since ρ(z) = 0 when z = 1/ρ. We call ρ(L) the autoregressive polynomial of Yt . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L.1 The lag operator L satisﬁes LYt = Yt−1 .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . In general. 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). ∞ X k=0 ρ2k V ar (et−k ) = 12. 12. we see that L2 Yt = LYt−1 = Yt−2 . We call ρ(L) the autoregressive polynomial of Yt . We say that the root of the polynomial is 1/ρ. 138 . We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .4.3. Deﬁnition 12. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .

The vector xt is strictly stationary and ergodic. For an AR(k).1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. then ˆ β →p β as T → ∞.. Note that ut is a MDS.5. so is xt x0 . Thus t by the Ergodic Theorem. the requirement is that all roots are larger than one. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. and by Theorem 12. it is also strictly stationary and ergodic. and hence Yt .1.1. which satisfy ρ(λj ) = 0. β = X 0X (12. Theorem 12..1) and the continuous mapping theorem.. . Proof. t t T t=1 ¥ Combined with (12.6.1) Theorem 12. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.1. “has a unit root”. One way of stating this is that “All roots lie outside the unit circle.1.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . λk are the complex roots of ρ(z). Let |λ| denote the modulus of a complex number λ. and is of great interest in applied time series. By Theorem 12. This is a special case of non-stationarity. we say that ρ(L). it is helpful to deﬁne the process ut = xt et .” If one of the roots equals 1. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. t T t=1 T t=1 139 . T ¢ ¡ 1X xt x0 →p E xt x0 = Q.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. t Yt−k ¢0 ρk .where the λ1 .

eT }.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. Y0 ). Fix an initial condition (Y−k+1 . e ˆ 3. 12. xt }.. . ˆ 2. Method 1: Model-Based (Parametric) Bootstrap. which may be diﬀerent than the i properties of the actual ei . This is identical in form to the asymptotic distribution of OLS in cross-section regression.. Y−k+2 . Ω) . Divide the sample into T /m blocks of length m. Ω) . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.7 Asymptotic Distribution Theorem 12. T t=1 Since xt et is a MDS. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .. Clearly. ˆ 1. Estimate β and residuals et .7. the asymptotic covariance matrix is estimated just as in the cross-section case. Brieﬂy. there are two popular methods to implement bootstrap resampling for time-series data.1 MDS CLT. we can apply Theorem 12. . t t Theorem 12. Q−1 ΩQ−1 .1 to see that T 1 X √ xt et →d N (0. The implication is that asymptotic inference is the same. In particular. T t=1 where Ω = E(xt x0 e2 ). 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∗ . then as T → ∞. t This construction imposes homoskedasticity on the errors e∗ .8 Bootstrap for Autoregressions In the non-parametric bootstrap.7. This creates an iid bootstrap sample.. T 1 X √ ut →d N (0. we constructed the bootstrap sample by randomly resampling from the data values {yt . this cannot work in a time-series application. Method 2: Block Resampling 1.12. as this imposes inappropriate independence. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.7. t then as T → ∞.. i 4.. It also presumes that the AR(k) structure is the truth. 140 .

• You can estimate (12. That is. This presumes that “seasonality” does not change over the sample.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 6.2). heteroskedasticity. Paste the blocks together to create the bootstrap time-series Yt∗ . This allows for arbitrary stationary serial correlation. But the long-run trend is also eliminated.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . This is a ﬂexible approach which can extract a wide range of seasonal factors. and then perform regression (12. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.2)-(12. ∆s Yt = Yt − Yt−s .. This procedure is sometimes called Detrending. get the ˆ ˆ residual St . The seasonal adjustment. Resample complete blocks. 4. and for modelmisspeciﬁcation. • Use “seasonally adjusted” data. or the season-to-season change. ﬁrst estimate (12. also alters the time-series correlations of the data.. If s is the number of seasons (typically s = 4 or s = 12).2) (12. • You can estimate (12. Thus the seasonally adjusted data is a “ﬁltered” series. ρk ). The results may be sensitive to the block length. The series ∆s Yt is clearly free of seasonality.. Seasonal Eﬀects There are three popular methods to deal with seasonal data. (12.2. May not work well in small samples. • Include dummy variables for each season. • First apply a seasonal diﬀerencing operator. draw T /m blocks.3) replacing St with St .3) sequentially by OLS.4) by OLS. and perhaps this was of relevance. For each simulated sample.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . 12. 141 . and the way that the data are partitioned into blocks. however. . 5. 3. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. (12.

10 Testing for Omitted Serial Correlation For simplicity. An appropriate test is the Wald test of this restriction. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .. To combine (12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. (If you increase k.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . The best remedy is to ﬁx a upper value k. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero.5) and (12. Another is to minimize the AIC or BIC information criterion.. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. we take (12. T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes.12. We want to test H0 against H1 . Yt is an AR(1). and then estimate the models AR(1).. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . (A simple exclusion test). . AR(2). you need more initial conditions.g. AR(k) on this (uniﬁed) sample.) This can induce strange behavior in the AIC. We then multiply this by θ and subtract from (12.5) We are interested in the question if the error ut is serially correlated. One approach to model selection is to choose k based on a Wald tests. In general.6). and the alternative is that the error is an AR(m)..6) 12. and then reserve the ﬁrst k as initial conditions. (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. (12. and under H1 it is an AR(2)... this is the same as saying that under the alternative Yt is an AR(k+m). Thus under H0 . if the null hypothesis is that Yt is an AR(k).5). Yt−k−m are jointly zero. AIC(k) = log σ 2 (k) + ˆ 2k . 142 . e.

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

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

... . Yt−k ) .. . 13. Let It−1 = (Yt−1 . Yt−k A= ¡ ⎛ 1 ⎞ ⎟ ⎟ ⎟ ⎟ ⎟ ⎠ Ak ¢ . and the m × (mk + 1) matrix A0 A1 A2 · · · 145 .. The typical goal is to ﬁnd the conditional expectation E (Yt | It−1 ) . Yt−2 . Deﬁning the m × 1 regression error et = Yt − E (Yt | It−1 ) . deﬁning the mk + 1 vector ⎜ Yt−1 ⎜ ⎜ xt = ⎜ Yt−2 ⎜ .. Alternatively. Note that since Yt is a vector. .. this conditional expectation is also a vector.and each of A1 through Ak are m × m matrices.Chapter 13 Multivariate Time Series A multivariate time series Yt is a vector process m × 1. we have the VAR model Yt = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k + et E (et | It−1 ) = 0.1 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 . ⎝ .. .) be all lagged information at time t. Yt−k ) = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k . A linear VAR speciﬁes that this conditional mean is linear in the arguments: E (Yt | Yt−1 . Observe that A0 is m × 1.

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

t and et is iid N (0. 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 .2) is uncommon in recent applications.4 Single Equation from a VAR Yjt = a0 xt + et . it is convenient to re-deﬁne the variables. Another interesting fact is that (13. which once was very popular. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. In this case. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. 147 . Then the single equation takes the form (13. (A simple version of this estimator is called Cochrane-Orcutt.2) may be estimated by iterated GLS. general. If valid.3). You may have heard of the Durbin-Watson test for omitted serial correlation. t t−1 (13.13.2) Take the equation yt = x0 β + et . Otherwise it is invalid. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . 1). This restriction. 13. and Zt be the other variables. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . and is still routinely reported by conventional regression packages. Let yt = Yjt . (13. j Often.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13.1). This can be done by a Wald test. t and xt = This is just a conventional regression. with time series data.2) is a special case of (13. may be tested if desired. We see that an appropriate. and subtract oﬀ the equation once lagged multiplied by θ. t or yt = θyt−1 + x0 β + x0 γ + ut . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). Suppose that et is an AR(1). direct estimation of (13. which is called a common factor restriction. under the restriction γ = −βθ. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. we are only interested in a single equation out of a VAR system. Let et = ejt and β = aj . the model (13. xt−1 ) to the regression.) Since the common factor restriction appears arbitrary.1) yt = x0 β + et .3) which is a valid regression model. and is typically rejected empirically.

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

Yt is I(1) and cointegrated. the asymptotic distribution of the test is aﬀected by the presence of the time trend. For 0 < r < m. In some cases.8. 13. and was articulated in detail by Engle and Granger (1987). If the series Yt is not cointegrated.13. from OLS of Y1t on Y2t . This is not. When β is unknown. If Yt is cointegrated with a single cointegrating vector (r = 1). Suppose that β is known. In other cases. Thus Yt = ˆ (Y1t . such that zt = β 0 Yt is I(0). it may be necessary to include a time trend in the estimated cointegrating regression. in general. however.8 Cointegration The idea of cointegration is due to Granger (1981). it may be believed that β is known a priori. 149 . Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1.9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . The asymptotic distribution was worked out by Phillips and Ouliaris (1990). Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . but it is useful in the construction of alternative estimators and tests. then r = 0. When the data have time trends. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. If Y = (log(Consumption) log(Income))0 .1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. then Yt is I(0). so the ADF critical values are not appropriate. β = (1 − 1)0 . of rank r. Hansen (1992). β may not be known. as ﬁrst shown by Stock (1987). Then under H0 zt is I(1). Deﬁnition 13. Thus H0 can be tested using a univariate ADF test on zt . a good method to estimate β. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Whether or not the time trend is included. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . β is not consistent. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. Often. so zt = β 0 Yt is known. yet under H1 zt is I(0). If r = m. m × r. The asymptotic distribution was worked out in B. Under H0 . then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. For example. The r vectors in β are called the cointegrating vectors. if Yt is a pair of interest rates.

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

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

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

0 if yi (This is written for the case of the threshold being zero. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. An example of a data collection censoring is top-coding of income. i If Y = {0. any known value can substitute... This model speciﬁes that P (Yi = k | xi ) = λi k = 0. The censoring process may be explicit in data collection. . k! = exp(x0 β). The conditional density is the Poisson with parameter λi . 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.. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. 2.}. 1. Thus the model is that there is some latent process yi with unbounded support.1) yi = ∗ <0 .2 Count Data exp (−λi ) λk i .. A generalization is the negative binomial.14. 1.1). In surveys. This may be considered restrictive. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. σ 2 ) with the observed variable yi generated by the censoring equation (14. or it may be a by-product of economic constraints. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . i i i=1 ˆ The MLE is the value β which maximizes ln (β). Tobin observed that for many households. The functional form for λi has been picked to ensure that λi > 0. this motivates the label Poisson “regression.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). . 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 !) . the consumption level (purchases) in a particular period was zero.) The observed data yi therefore come from a mixed continuous/discrete distribution.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. incomes above a threshold are typically reported at the threshold. 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. 2.

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

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

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

1 Individual-Eﬀects Model The standard panel data speciﬁcation is that there is an individual-speciﬁc eﬀect which enters linearly in the regression yit = x0 β + ui + eit ... OLS of yit on xit is called pooled estimation.. i = 1. OLS appears a poor estimation choice.. Condition (15. collected over time...1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . If (15. It is a strong assumption. 15. or unbalanced : {yit . . t = ti . T . that eit is iid across individuals and time.. An observation is the pair {yit . that ui and eit are independent. and the t subscript denotes time. and that eit is uncorrelated with xit . 157 . . . This is often believed to be plausible if ui is an omitted variable.. xit } : For i = 1. It is consistent if E (xit ui ) = 0 (15.. The motivation is to allow ui to be arbitrary. OLS can be improved upon via a GLS technique. ti . .. n. then OLS is inconsistent.. xit }. n.Chapter 15 Panel Data A panel is a set of observations on individuals. however.1) is called the random eﬀects hypothesis.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. The goal is to eliminate ui from the estimator. There are several derivations of the estimator.1) If this condition fails. In either event. and most applied researchers try to avoid its use.1) is true.. it The typical maintained assumptions are that the individuals i are mutually independent. 15. A panel may be balanced : {yit . and have arbitrary correlated with xi . where the i subscript denotes the individual. xit } : t = 1. and thus achieve invariance. (15.

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

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

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

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

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

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

perhaps adjusted by visual inspection of the resulting estimate ˆ f (x). but they are also known to converge very slowly to the optimal values.Epanechnikov Kernel: hrule = 2. I now discuss some of these choices. There are some desirable properties of cross-validation bandwidths. They are also quite ill-behaved when the data has some discretization (as is common in economics). there are modern versions of this estimator work well. 164 . in particular the iterative method of Sheather and Jones (1991). However.34n−1/5 Biweight (Quartic) Kernel: hrule = 2.78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice.2). Fortunately there are remedies. This works by constructing an estimate of the MISE using leave-one-out estimators. as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x). but implementation can be delicate. and then plug this estimate into the formula (16. Another popular choice for selection of h is cross-validation. which are known as smoothed cross-validation which is a close cousin of the bootstrap. in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates. The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. There are other approaches. This is more treacherous than may ﬁrst appear.

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

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

. This induces a new sample space — the real line — and a new probability function on the real line.. A2 . Instead. τ r . 2.3) is unavailable. a These expressions only make sense if F (x) is diﬀerentiable... In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. . . . (A. and use lower case letters such as x for potential values and realized values. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . Typically. In the latter case.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. these cases are unusualRand are typically ignored.. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function.Theorem 2 (Bayes’ Rule). P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. 167 . F (x) is nondecreasing in x 3.2 Random Variables A random variable X is a function from a sample space S into the real line. we denote random variables by uppercase letters such as X. r (A.. .. then for each i = 1. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. The probability function for X takes the form j = 1. 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.3) P (X = τ j ) = π j .. For any set B and any partition A1 . of the sample space. While there are examples of continuous random variables which do not possess a PDF.. the range of X consists of a countable set of real numbers τ 1 . A function F (x) is a CDF if and only if the following three properties hold: 1. We say that the random variable X is continuous if F (x) is continuous in x..

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

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

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

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

then σ XY = 0 and ρXY = 0. −∞ The random variables X and Y are deﬁned to be independent if f (x. The correlation between X and Y is Corr(X. If X and Y are independent. then MZ (λ) = E exp (λ (X + Y )) = E (exp (λX) exp (λY )) ¡ ¢ ¡ ¢ = E exp λ0 X E exp λ0 Y = MX (λ)MY (λ). An implication is that if X and Y are independent. For example. then Cov(X.The correlation is a measure of linear dependence.Similarly. y) = fX (x)fY (y). Y ).5) is that if X and Y are independent and Z = X + Y. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y. If X and Y are independent. if X and Y are independent then E(XY ) = EXEY. free of units of measurement. The covariance between X and Y is Cov(X. Another implication of (A. The reverse. x)dydx Z Z = g(x)h(y)fY (y)fX (x)dydx Z Z = g(x)fX (x)dx h(y)fY (y)dy = Eg (X) Eh (Y ) . X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x. 172 . σxσY (A. however. Y ) = ρXY = σ XY . y)dx. then V ar (X + Y ) = V ar(X) + V ar(Y ). is not true. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. X 2 ) = 0. A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X.6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1. For example. y) = g(x)h(y). the marginal density of Y is fY (y) = Z ∞ f (x. the variance of the sum is the sum of the variances. if EX = 0 and EX 3 = 0.5) if the expectations exist. Furthermore. (A.

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

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

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

2 If Z ∼ N(0. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . then using the change-of-variables formula. X has density Ã ! (x − µ)2 1 exp − . then Σ = diag{σ 2 } is a diagonal matrix. we can also show that EX 2 = 1 and EX 4 = 3. y ≥ 0. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . then Z 0 A−1 Z ∼ χ2 . If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. then they are mutually independent. A) with A > 0.11) and is known as the chi-square density with r degrees of freedom. q 176 . (A.8. Theorem A. The latter has no closed-form solution. Theorem A. Σ) and Y = a + BX with B an invertible matrix. By iterated integration by parts. and it is conventional to write X ∼ N (µ. The mean and variance of the distribution are µ and σ 2 . and it is conventional to write X ∼ N(µ. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . If Z is standard normal and X = µ + σZ.1 Let X ∼ N (0. respectively. σ 2 ). In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. For x ∈ Rk . x ∈ Rk . Since it is symmetric about zero all odd moments are zero. Σ).8. f (x) = √ 2σ 2 2πσ which is the univariate normal density. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Ir ) and set Q = X 0 X. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . It is conventional to write X ∼ N (0.This density has all moments ﬁnite. 1). x ∈ Rk . Another useful fact is that if X ∼ N (µ. ¢ ¡ It useful to observe ¢ that the MGF and CF of the multivariate normal are exp λ0 µ + λ0 Σλ/2 ¡ 0 and exp iλ µ − λ0 Σλ/2 . This shows that linear transformations of normals are also normal. then by the change-of-variables formula. This shows that if X is multivariate normal with uncorrelated elements. q × q. −∞ < x < ∞. denoted χ2 . Its mean and r variance are µ = r and σ 2 = 2r. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = .

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 . Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Iq ).13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).8. q Proof of Theorem A. (A. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. C −1 CC 0 C −10 ) = N (0.13) is the MGF of the density (A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. For Z ∼ N(0.3 Let Z ∼ N (0.11).8. C −1 AC −10 ) = N (0. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .8. The MGF for the density (A.8.11) 2 with r = 1.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.2.12) E exp (tQ) = 0 Γ (A.13). 1) and Q ∼ χ2 be independent. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. Proof of Theorem A. which can be found by applying change-of-variables to the gamma function. Set r Z . Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. 1).3. tr has distribution 177 . we see that the MGF of Z 2 is (1 − 2t)−1/2 . which we showed in (A. Thus the density of Z 2 is (A.Theorem A. Using the simple law of iterated expectations. From (A.1.

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

In fact.16).Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. we can ﬁnd an explicit expression for θ as a function of the data. which maximizes the log-likelihood). ∂θ ∂θ (A. 179 . the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. If ˜ is an unbiased estimator of θ ∈ R. then θ V ar(˜ ≥ (nI0 )−1 . but these ˆ must be found by numerical methods. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. we can see that it is an estimator of the maximizer θ of the right-hand-side. θ θ∈Θ ˆ In some simple cases. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . Theorem A. n n i=1 n As the MLE ˆ maximizes the left-hand-side. θ) ≡ L(θ).15) Two important features of the likelihood are Theorem A. More typically.2 Cramer-Rao Lower Bound.9. I0 . θ) The Cramer-Rao Theorem gives a lower bound for estimation. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.1 ¯ ¯ ∂ E ln f (Yi . ˆ →p θ0 as n → ∞.3 Under regularity conditions. θ) ∂θ ∂θ which holds at θ = θ0 by (A. θ0 ) ∂θ∂θ 0 (A. cases are rare.17) is often called the information matrix equality. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. under conventional regularity conditions. We can write this as ˆ = argmax Ln (θ). θ) →p E ln f (Yi . θ0 ) . and the equality (A. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .9.16) (A.17) The matrix I0 is called the information. ˆ is consistent θ for this value. θ Theorem A.9. θ0 ) ln f (Yi .14) ¶ ∂ ∂ 0 ln f (Yi . However.

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

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

Ω) = N 0. Together. H −1 . If it is continuous in θ. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . the ﬁnal equality using Theorem A. Ω) . an application of the CLT yields 1 X ∂ √ ln f (Yi . θ0 ) →d N (0. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 .9. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi .) Rewriting this equation. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θ n ) θ − θ 0 . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . and making a ﬁrst-order Taylor series expansion. H −1 ΩH −1 = N 0.9. (Technically.3 Taking the ﬁrst-order condition for maximization of Ln (θ). − ln f (Yi . 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. ¥ 182 . θ0 ) + ' 0 ln f (Yi . we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ 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 . θ0 ) .Proof of Theorem A. θn ) = ln f (Yi . θ) .1 .

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

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

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

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