ECONOMETRICS

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

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

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

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

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

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

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

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

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

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

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

A square matrix A is called orthogonal if A0 A = Ik . . . ⎥ . . . The columns of a k × r matrix A. which has ones on the diagonal. ⎦ ⎣ . . An important diagonal matrix is the identity matrix. . ⎤ ⎥ ⎥ ⎥ ⎦ 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. . 0 0 ··· 1 2.An alternative way to write the matrix product is ∙ ¸∙ A11 A12 B11 AB = A21 A22 B21 ∙ A11 B11 + A12 B21 = A21 B11 + A22 B21 and £ to use matrix partitions.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. are said to be orthogonal if A0 A = Ir . We say that two vectors a and b are orthogonal if a0 b = 0. r ≤ k. Also. . For example. for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . then AIr = A and Ik A = A. ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ .

3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A.1) . .3) The matrix A− is not necessarily unique. 7 Also. . For non-singular A and C. This matrix is called the inverse of A and is denoted by A−1 . then A−1 = A. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . The following fact about inverting partitioned matrices is sometimes useful. we can still define a generalized inverse A− as a matrix which satisfies AA− A = A. the Moore-Penrose generalized inverse A− exists and is unique. if A is an orthogonal matrix. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . In this case there exists a unique matrix B such that AB = BA = Ik . The Moore-Penrose generalized inverse A− satisfies (2. . . . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . If A − BD−1 C and D − CA−1 B are non-singular.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 . .4 Inverse A k × k matrix A has full rank. . (2. or is nonsingular. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. 2.2) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2. if there is no c 6= 0 such that Ac = 0. (2.

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

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

. an Let B be any matrix. denoted A ⊗ B. . The vec of A. • If A is orthogonal. 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. .• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. am1 B am2 B · · · amn B Some important properties are now summarized. . ⎣ ⎦ . ⎠ ⎝ . . . is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . ⎟ . The Kronecker product of A and B. • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. denoted by vec (A) . then det A = 2.9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. . . then det A = ±1 ¢ ¡ = (det D) det A − BD−1 C if det D 6= 0 Qk i=1 aii • If A is triangular (upper or lower). 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 .

and exists so long as E |yi | < ∞.1 displays the density1 of hourly wages for men and women. 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. These are indicated in Figure 3.1) xi = ⎜ . gender. holding the other variables constant. We call yi the dependent variable. it is useful to have numerical measures of the difference. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience.22. Take a closer look at the density functions displayed in Figure 3. The two density curves show the effect of gender on the distribution of wages. The data are from the 2004 Current Population Survey 1 11 . (3. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. or the covariates.1. we can focus on f (y | x) . ⎟ . m(x) can take any form.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. Figure 3. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. We call xi alternatively the regressor. the mean wage for men is $27.1 by the arrows drawn to the x-axis. This is used when the goal is to quantify the impact of one set of variables on another variable. xki 3. the conditional density of yi given xi . .1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. While it is easy to observe that the two densities are unequal. These are asymmetric (skewed) densities. the mean is not necessarily a good summary of the central tendency. xi ) where yi is a scalar (real-valued) and xi is a vector. To illustrate. In this context we partition the observations into the pair (yi . education and experience. which is a common feature of wage distributions. When a distribution is skewed. See Chapter 16.1.73. In the example presented in Figure 3.2) m(x) = E (yi | xi = x) = −∞ In general. the conditioning variable. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. and that for women is $20.

Figure 3.36. The comparison in Figure 3. degree in mean log hourly wages is 0. this yields the formula yi = m(xi ) + ei . The main point to be learned from Figure 3.2) evaluated at the observed value of xi : ei = yi − m(xi ). The difference in the log mean wage between men and women is 0.2 shows the density of log hourly wages for the same population. with mean log hourly wages drawn in with the arrows. 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. The conditional expectation function is close to linear. For this reason.3 is how the conditional expectation describes an important feature of the conditional distribution.2 Regression Equation The regression error ei is defined to be the difference between yi and its conditional mean (3. When the distribution of the control variable is continuous. Of particular interest to graduate students may be the observation that difference between a B.5. the solid line displays the conditional expectation of log wages varying with education. 2 (3. By construction.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. 12 . Assuming for simplicity that this is the true joint distribution. then comparisons become more complicated. which implies a 30% average wage difference for this population. Figure 3.1 is facilitated by the fact that the control variable (gender) is discrete.Figure 3.3) White non-military male wage earners with 10-15 years of potential work experience.3 displays a scatter plot2 of log wages against education levels.30.A. 3.D. and a Ph. the dashed line is a linear projection approximation which will be discussed in the Section 3. wage regressions typically use log wages as a dependent variable rather than the level of wages. implying an average 36% difference in wage levels.

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

In contrast. it does not provide information about the spread of the distribution. σ 2 (x) is a non-trivial function of x.3. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . Given the random variable xi .Figure 3. 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. To see this.1.2. in the sense of achieving the lowest mean squared error.3 Conditional Variance Generally. i . let g(x) be an arbitrary predictor of yi given xi = x. 3. The right-hand-side is minimized by setting g(x) = m(x). Thus the mean squared error is minimized by the conditional mean. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. The conditional standard deviation is its square root σ(x) = σ 2 (x). the conditional variance of yi is σ 2 = σ 2 (xi ). when σ 2 (x) is a constant so that ¢ ¡ (3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. subject to the restriction p that it is non-negative. and can take any form.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .

⎠ .7) is a k × 1 parameter vector. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .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 . i (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. ⎝ . xki When m(x) is linear in x. take the conditional wage densities displayed in Figure 3. ⎠ .5) xi = ⎜ . ⎟ . 3.4 Linear Regression An important special case of (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element.9) 3.1). βk ⎛ (3.6) (3. As an example.we say that the error ei is homoskedastic. Thus (3. The conditional standard deviation for men is 12.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). and the linear assumption of the previous section is empirically unlikely to accurate. This concept is less helpful than defining heteroskedasticity as the dependence of the conditional variance on the observables xi . its functional form is typically unknown. Equivalently. 15 .1. Equation (3.1) has been redefined as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. which we derive in this section.1 and that for women is 10. In this case (3. they are also somewhat more dispersed. we assume that x1i = 1. We call this the “constant” or “intercept”.8) is called the linear regression model. ⎟ β=⎝ . it is more realistic to view the linear specification (3.5.8) (3.6) as an approximation. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . Notationally. where x1i is the first element of the vector xi defined in (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. Instead. So while men have higher average wages.

there cannot i exist a non-zero vector α such that α0 xi = 0 identically.10) It is worth taking the time to understand the notation involved in this expression. Given the definition of β in (3. Rewriting. Eyi < ∞. 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. otherwise they are distinct. α0 E (xi x0 ) α = E (α0 xi )2 > 0. written E (xi x0 ) > 0. E (xi x0 ) is invertible. 3. Assumption 3. It is invertible if and only if it is positive definite.which is quadratic in β. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. 2 2. by “best” we mean the predictor function with lowest mean squared error. Observe i that for any non-zero α ∈ Rk . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.7) is 0= Solving for β we find ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . xi contains an intercept.10). this situation must be excluded. The error is i ei = yi − x0 β. In order for β to be uniquely defined. As before.5. i 16 . This occurs when redundant variables are included in xi . i (3.5. E (x0 xi ) < ∞. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-definite. x0 β is the best linear predictor for yi . Equivalently. The vector (3. β = E xi x0 i In the linear projection model the coefficient β is defined so that the function x0 β is the i best linear predictor of yi . Therefore.1 1. i (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. i 4. i which requires that for all non-zero α. i i (3. The first-order condition for minimization (from Section 2.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.1. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . The best linear predictor is obtained by selecting β to minimize S(β).

12) can be alternatively interpreted as a projection decomposition.3 ensure that the moments in (3.14) holds.12) and (3. For example. Assumption 3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . E (xi ei ) = 0 and E (ei ) = 0.5.1.14).5.1.11) are well defined. Equation (3. Furthermore. The finite variance Assumptions 3.5.10) and (3. By definition.5.1.10) are defined.13) The two equations (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.5. Using the definitions (3. Assumption 3. This means that the equation (3.5.13) summarize the linear projection model. Since ei is mean zero by (3. (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1 Under Assumption 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .1.1.14) follows from (3.14) Proof. Figure 3.13) and Assumption 3.1.1.5.2.5.1.2 and 3.1.2 and 3. (3.13) implies that xi and ei are uncorrelated.Theorem 3.5.1.4 guarantees that the solution β exits. Assumption 3.8)-(3. Since from Theorem 3.1 are weak.11) and (3.5.3 are called regularity conditions. Let’s compare it with the linear regression model (3.1.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.4 we know that the regression error has the property E (xi ei ) = 0. it follows that linear regression is a special case of the projection model.4 is required to ensure that β is uniquely defined. 17 . the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.1 is employed to guarantee that (3.5. ¥ (3. However. the orthogonality restriction (3. Assumption 3.9).4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.

and the straight dashed line is the linear projection.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.10). In the example just presented.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.We have shown that under mild regularity conditions. In this case (3. it is important to not misinterpret the generality of this statement. Other than the redefinition of the regressor vector. This defect in linear projection can be partially corrected through a careful selection of regressors. It over-predicts wages for young and old workers.5. In this case the linear projection is a poor approximation to the conditional mean. xi ) we can define a linear projection equation (3. We illustrate the issue in Figure 3. These structural models require alternative estimation methods. 18 .12) is defined by projection and the associated coefficient definition (3. The linear equation (3.12) with the properties listed in Theorem 3. In contrast. and are discussed in Chapter 11.3.5. Most importantly. Figure 3.10) may not hold and the implications of Theorem 3. since the resulting function is quadratic in experience.4 we display as well this quadratic projection. The solid line is the conditional mean.1 may be false. However. the dashed line is the linear projection of log wages on eduction. Returning to the joint distribution displayed in Figure 3. and under-predicts for the rest. in many economic models the parameter β may be defined within the model. In other cases the two may be quite different. No additional assumptions are required. for those over 53 in age). there are no changes in our methods or analysis. In this example it is a much better approximation to the conditional mean than the linear projection. Figure 3. In Figure 1. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. In this example the linear projection is a close approximation to the conditional mean.1. A projection of log wages on these two variables can be called a quadratic projection. for any pair (yi . we can augment the regressor vector xi to include both experience and experience2 .4 displays the relationship3 between mean log hourly wages and labor market experience.

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

then ei is independent of xi . σ = . Let X be a random variable with µ = EX and σ 2 = V ar(X). If yi = x0 β + ei and E(ei | xi ) = 0. (x − µ)2 − σ 2 Show that Eg (X. then E(x2 ei ) = 0. If yi = x0 β + ei . i 11.6 Exercises 1. Compute the conditional mean m(x) = E (yi | xi = x) . 9. Define µ ¶ ¢ ¡ x−µ 2 g x.1 .1. 1. Suppose that Y and X only take the values 0 and 1. µ. 0 ≤ y ≤ 1. Let xi and yi have the joint density f (x. i 10. then ei is i i independent of xi . 2. True or False. xi ∈ R. ¡ ¢ 4. True or False. then E(ei | xi ) = 0. Prove parts 2. True or False. then E(x2 ei ) = 0. s) = 0 if and only if m = µ and s = σ 2 . 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 . x 6. True or False. If yi = xi β + ei . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . and E(xi ei ) = 0. If yi = x0 β + ei and E(xi ei ) = 0. If yi = xi β + ei . 20 . σ 2 = V ar(xi ). Compute E(yi | xi = x) and V ar(yi | xi = x). i 7.3. and E(e2 | xi ) = σ 2 . E(ei | xi ) = 0. xi ∈ R. j! 0 j = 0. Suppose that yi is discrete-valued.. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. 3. Compute 2 the coefficients of the linear projection yi = β 0 + β 1 xi + ei . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. 2. taking values only on the non-negative integers. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j .2. m.2 Y =1 . e−λ λj j! . a constant. i 8. Are they different? Hint: If P (Y = j) = 5. 3 and 4 of Theorem 3. . yi ). True or False. σ 2 = V ar(yi ) and σ xy = Cov(xi . µx = Exi ..4 .3 Find E(Y | X = x). and E(ei | xi ) = 0. E(Y 2 | X = x) and V ar(Y | X = x).

Observe that (4. i n i=1 n 21 . i It follows that the moment estimator of β replaces the population moments in (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. 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 . we narrow the focus to the linear regression model.7 and 4.8.2) (4. (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.2) can be written in the parametric 0 β)) = 0.1 Estimation Equation (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i à n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 à n !−1 n X X = xi x0 xi yi . but for most of the chapter we retain the broader focus on the projection model.3) In Sections 4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .1) (4.3) writes the projection coefficient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . 4.

4).14 205.4).14 205.ˆ This is a set of k equations which are linear in β. Then µ ¶ n 1X 2.95 42. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. These are white male wage earners from the March 2004 Current Population Survey.7% increase in mean wages.3. excluding military.95 xi yi = 42. i 22 .14 14.40 µ ¶µ ¶ 34.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. 0. with 10-15 years of potential work experience.37 µ ¶ 1. 40 2.117 1 14. 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.71 = −2. An interpretation of the estimated equation is that each year of education is associated with an 11. 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 (4.30 + 0. 30 = .94 −2.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. ¶ 2. This sample has 988 observations.83 ¶−1 µ ¶ .117 Educationi . To illustrate.2 Least Squares There is another classic motivation for the estimator (4. Let yi be log wages and xi be an intercept and years of education.14 14. 40 0.170 37. 4. consider the data used to generate Figure 3.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.

Since the function Sn (β) is a quadratic function of β. These two ˆ variables are frequently mislabeled. i ˆ ˆ Note that yi = yi + ei . 23 . It is important to understand the distinction between the error ei and the residual ei .1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.4). Matrix calculus (see Appendix 2.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). while the residual is a by-product of estimation. we define the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. the contour lines are ellipses. Following convention we will call β the OLS estimator of β. The error is unobservable.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Figure 4.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Figure 4. To visualize the sum-of-squared errors function. Figure 4. which can cause confusion.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.

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

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

yn = x0 β + en . ⎟. = β+ XX 26 (4. x0 n ⎞ ⎛ e1 e2 .Maximization with respect to σ 2 yields the first-order condition n X ∂ n 1 ˆ ˆ Ln (β. . yn ⎟ ⎟ ⎟. residual vector. including computation. The linear equation (3. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . .6). Sample sums can also be written in matrix notation. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. and X is an n × k matrix.12) is a system of n equations. Thus the MLE (β. it is matrix notation. For example n X i=1 For many purposes. one for each observation. ⎠ .8) . . We define ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . 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. n X i=1 Thus the estimator (4.4). 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. Due to this equivalence. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. . ⎝ ⎝ . en ⎞ Observe that Y and e are n × 1 vectors. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. . . n or equivalently Y = Xβ + e.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . 4. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟.

4.5

Projection Matrices
¢−1 0 ¡ X P = X X 0X M ¡ ¢−1 0 = In − X X 0 X X = In − P

Define the matrices and

where In is the n × n identity matrix. They are called projection matrices due to the property that for any matrix Z which can be written as Z = XΓ for some matrix Γ, (we say that Z lies in the range space of X) then ¢−1 0 ¡ X XΓ = XΓ = Z P Z = P XΓ = X X 0 X M Z = (In − P ) Z = Z − P Z = Z − Z = 0. As an important example of this property, partition the matrix X into two matrices X1 and X2 , so that X = [X1 X2 ] . Then P X1 = X1 and M X1 = 0. It follows that M X = 0 and M P = 0, so M and P are orthogonal. The matrices P and M are symmetric and idempotent1 . To see that P is symmetric, ³ ¡ ¢−1 0 ´0 P 0 = X X 0X X ³¡ ¡ ¢0 ¢−1 ´0 X 0X = X0 (X)0 ³¡ ¢0 ´−1 0 = X X 0X X ³ ¡ ¢0 ´−1 0 = X (X)0 X 0 X = P. To establish that it is idempotent, ³ ¡ ¢−1 0 ´ ³ ¡ 0 ¢−1 0 ´ X X 0X X XX X X ¡ 0 ¢−1 0 ¡ 0 ¢−1 0 = X XX XX XX X ¡ 0 ¢−1 0 = X XX X = P, and MM = M (In − P )

and

PP

=

= M − MP = M
1

A matrix A is idempotent if AA = A.

27

since M P = 0. Another useful property is that tr P tr M where the trace operator tr A = = k = n−k
r X j=1

(4.9) (4.10)

ajj

is the sum of the diagonal elements of the matrix A. To show (4.9) and (4.10), ³ ¡ ¢−1 0 ´ X tr P = tr X X 0 X ³¡ ¢−1 0 ´ = tr X 0 X XX = tr (Ik ) = k, and tr M = tr (In − P ) = tr (In ) − tr (P ) = n − k. Given the definitions of P and M, observe that ¢−1 0 ¡ ˆ ˆ X Y = PY Y = X β = X X 0X ˆ e = Y − X β = Y − P Y = M Y. ˆ Furthermore, since Y = Xβ + e and M X = 0, then e = M (Xβ + e) = M e. ˆ Another way of writing (4.11) is ˆ ˆ Y = (P + M ) Y = P Y + M Y = Y + e. This decomposition is orthogonal, that is ˆ ˆ Y 0 e = (P Y )0 (M Y ) = Y 0 P M Y = 0. (4.12) (4.11)

and

4.6

Residual Regression
X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

Then the regression model can be rewritten as Y = X1 β 1 + X2 β 2 + e. 28 (4.13)

Observe that the OLS estimator of β = (β 0 , β 0 )0 can be obtained by regression of Y on X = [X1 1 2 X2 ]. OLS estimation can be written as ˆ ˆ Y = X1 β 1 + X2 β 2 + e. ˆ (4.14)

Suppose that we are primarily interested in β 2 , not in β 1 , so are only interested in obtaining ˆ ˆ the OLS sub-component β 2 . In this section we derive an alternative expression for β 2 which does not involve estimation of the full model. Define ¡ 0 ¢−1 0 X1 . M1 = In − X1 X1 X1
0 Recalling the definition M = I − X (X 0 X)−1 X 0 , observe that X1 M1 = 0 and thus ¡ 0 ¢−1 0 M1 M = M − X1 X1 X1 X1 M = M

It follows that

M1 e = M1 M e = M e = e. ˆ ˆ Using this result, if we premultiply (4.14) by M1 we obtain M1 Y ˆ ˆ = M1 X1 β 1 + M1 X2 β 2 + M1 e ˆ ˆ = M1 X2 β + e ˆ
2

(4.15)

0 0ˆ the second equality since M1 X1 = 0. Premultiplying by X2 and recalling that X2 e = 0, we obtain 0 0 0 0 ˆ ˆ X2 M1 Y = X2 M1 X2 β 2 + X2 e = X2 M1 X2 β 2 . ˆ

Solving, ˆ an alternative expression for β 2 . Now, define

¡ 0 ¢ ¢−1 ¡ 0 ˆ β 2 = X2 M1 X2 X2 M1 Y ˜ X2 = M1 X2 ˜ Y = M1 Y, (4.16) (4.17)

ˆ ˜ ˜ This shows that β 2 can be calculated by the OLS regression of Y on X2 . This technique is called residual regression. Furthermore, using the definitions (4.16) and (4.17), expression (4.15) can be equivalently written as ˜ ˜ ˆ ˆ Y = X2 β 2 + e. ˆ ˜ ˜ Since β 2 is precisely the OLS coefficient from a regression of Y on X2 , this shows that the residual from this regression is e, numerically the same residual as from the joint regression (4.14). We ˆ have proven the following theorem. 29

the least-squares residuals from the regression of X2 and Y, respectively, on the matrix X1 only. Since the matrix M1 is idempotent, M1 = M1 M1 and thus ¢−1 ¡ 0 ¡ 0 ¢ ˆ X2 M1 Y β 2 = X2 M1 X2 ¢ ¢−1 ¡ 0 ¡ 0 X2 M1 M1 Y = X2 M1 M1 X2 ´−1 ³ ³ ´ ˜0 ˜ ˜0 ˜ = X2 X2 X2 Y

. Regress Y on X1 . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. In some contexts. which you may have seen in an introductory econometrics course. and X2 is the vector of observed regressors. In this section we derive the small sample conditional mean and variance of the OLS estimator.13). ˜ 2. obtain residuals Y . . ˆ ˜ ˜ ˆ 3.6. but in most cases there is little computational advantage to using the two-step algorithm.8)(3. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y.14) or via the ˆ following algorithm: ˜ 1.9). ˆ which are “demeaned”. obtain OLS estimates β 2 and residuals e. is the demeaning formula for regression. ! Thus the OLS estimator for the slope coefficients is a regression with demeaned data. . .9). obtain residuals X2 . . . 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) . .Theorem 4. the primary use is theoretical. ⎠ ⎝ ⎠ ⎝ . ¡ ¢−1 0 ι. In the model (4.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. observe that ⎞ ⎛ ⎞ ⎛ . Regress Y on X2 . In this case. 4. Rather. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. . A common application of the FWL theorem. . 30 . the FWL theorem can be used to speed computation. .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.1 (Frisch-Waugh-Lovell). Regress X2 on X1 . ⎟ ⎜ ⎟ ⎜ (4. By the independence of the observations and (3.

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

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

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

the maximum likelihood estimator is identical to the OLS estimator. and thus so is the OLS estimator.10) for the class of models satisfying Assumption 3.10 Omitted Variables xi = µ x1i x2i ¶ .4) is an asymptotically efficient estimator for the parameter β defined in (3. (4. He proves that generically the OLS estimator (4.22) 34 . We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . He observes that the above argument holds for all multinomial distributions. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. Chamberlain (1987) extends this argument to the case of continuously-distributed data. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. 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 . 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. Since this is a regular parametric model the MLE is asymptotically efficient (see Appendix A.9).5. if the data have a discrete distribution.1.Substituting in the expressions for π j .

This definition is not precise. because we have not said what it means for a matrix to be “near singular”. In this case. when the columns of X are close to linearly dependent. the regression of x2i on x1i yields a set of zero coefficients (they are uncorrelated). To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . except in special cases. 4.23) where is the coefficient from a regression of x2i on x1i . and the error as ui rather than ei . Typically there are limits. This is the situation when the X 0 X matrix is near singular. or second. if X includes both the logs of two prices and the log of the relative prices. there is some α such that Xα = 0. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . For example.. This happens when the columns of X are linearly dependent. First. By construction. we regress yi on x1i only. Thus the short and long regressions have the same coefficient on x1i only under one of two conditions.23) the short regression to emphasize the distinction. It is the consequence of omission of a relevant correlated variable. which is often called “multicollinearity” for brevity. 35 . In general. this arises when sets of regressors are included which are identically related. This is one difficulty with the definition and interpretation of multicollinearity. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.Now suppose that instead of estimating equation (4.22). To see this.22) is zero.e. Goldberger (1991) calls (4. Since the error is discovered quickly.22) the long regression and (4. as many desired variables are not available in a given dataset.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. i. the coefficient on x2i in (4. The difference Γβ 2 is known as omitted variable bias. Typically. The more relevant issue is near multicollinearity. log(p2 ) and log(p1 /p2 ). When this happens.22) by least-squares. This is because the model being estimated is different than (4. This is estimation of the equation yi = x0 γ 1 + ui 1i E (x1i ui ) = 0 Notice that we have written the coefficient on x1i as γ 1 rather than β 1 . This is called strict multicollinearity. this is rarely a problem for applied econometric practice. log(p1 ). we calculate γ1 = ¡ ¡ ¢¢−1 E x1i x0 E (x1i yi ) 1i ¡ ¡ ¢¢−1 ¡ ¡ 0 ¢¢ 0 E x1i x1i β 1 + x0 β 2 + ei = E x1i x1i 2i ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 β 2 = β 1 + E x1i x0 1i 2i = β 1 + Γβ 2 ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 Γ = E x1i x0 1i 2i (4. β 1 6= γ 1 . Most commonly. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. least-squares estimation of (4. then β is not defined. the general model will be free of the omitted variables problem.

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

1) in Section 2.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . then this observation is a leverage point and has the potential to be an influential observation.25). The key is equation (2. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .27). which is considerably more informative than plots of the uncorrected residuals ei . ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .This implies has a large value of hi . ˆ We now derive equation (4. Investigations into the presence of influential observations can plot the values of (4.

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

2. Consider the OLS regression of the n × 1 vector y on the n × k matrix X. Consider an alternative set of regressors Z = XC, where C is a k × k non-singular matrix. Thus, each column of Z is a mixture of some of the columns of X. Compare the OLS estimates and residuals from the regression of Y on X to the OLS estimates from the regression of Y on Z.
0ˆ 3. Let e be the OLS residual from a regression of Y on X = [X1 X2 ]. Find X2 e. ˆ

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

as stated. Eg(X) ≥ a + bEX = g(EX). So for all x. We say that Zn converges in probability to Z as n → ∞. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . If Xi ∈ Rk is iid and E |Xi | < ∞. 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}. n i=1 42 .4) Proof of Jensen’s Inequality. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. p p p q which is (5. Set Y = g(X) and let f denote the density function of Y. denoted Zn →p Z as n → ∞.Markov’s Inequality. Since g(x) is convex. Let a + bx be the tangent line to g(x) at x = EX. The WLLN shows that sample averages converge in probability to the population average. n→∞ lim P (|Zn − Z| > δ) = 0. =E U V p q p q Proof of Markov’s Inequality. Note EU = EV = 1.3). then as n → ∞ n 1X Xn = Xi →p E(X). tangent lines lie below it. For any strictly increasing function g(X) ≥ 0.2. if for all δ > 0. ¥ Proof of Holder’s Inequality.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. P (g(X) > α) ≤ α−1 Eg(X). (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. Applying expectations. Theorem 5.1 Weak Law of Large Numbers (WLLN). 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 ) = + . ¥ 5. This is a probabilistic way of generalizing the mathematical definition of a limit. (5.

P ¯X n ¯ > δ ≤ η. denoted Zn →d Z. (5. ¡¯ ¯ P ¯X n ¯ > δ ≤ η.1) and (5. as needed. P ¯X n ¯ > δ ≤ δ δ δ the equality by the definition of ε. Define the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . the triangle inequality. and the bound |Wi | ≤ 2C. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.4). Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. 5. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.Proof: Without loss of generality. if for all x at which F (x) is continuous. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.1). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .7). the fact that X n = W n + Z n . Fn (x) → F (x) as n → ∞. V ) . where Z has distribution F (x) = P (Z ≤ x) . 43 . n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. Fix δ and η.7) the final inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . we can set E(X) = 0 (by recentering Xi on its expectation). We say that Zn converges in distribution to Z as n → ∞.3.6) By Jensen’s inequality (5. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Finally. Set ε = δη/3. by Markov’s inequality (5.5). the fact that the Wi are iid and mean zero. Theorem 5.6) and (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. If Xi ∈ Rk is iid and E |Xi |2 < ∞.1 Central Limit Theorem (CLT).5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. Jensen’s inequality (5.

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

Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.3 Delta Method: If n (θn − θ0 ) →d N (0. and g(θ) : Rm → Rk . for each element of g. ¥ 5. Proof : By a vector Taylor series expansion. we find jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.2 Continuous Mapping Theorem 2. we see that as n → ∞. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. If Zn →p c as n → ∞ and g (·) is continuous at c. Σ) . Recall that A ⊂ B implies P (A) ≤ P (B).1 Continuous Mapping Theorem 1 (CMT). Since cλλ (λn ) → cλλ (0) = −Ik . Proof: Since g is continuous at c. then g(Zn ) →d g(Z) as n → ∞. for all ε > 0 we can find a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. Ik ) distribution.4.√ where λn → 0 lies on the line segment joining 0 and λ/ n.4. Σ) = N 0.4. √ Theorem 5. where θ is m × 1 and Σ is m × m. then g(Zn ) →p g(c) as n → ∞. gθ Σgθ . 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 .4 Asymptotic Transformations Theorem 5. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. k ≤ m. Stacking across elements of g. Theorem 5. 45 . If Zn →d Z as n → ∞ and g (·) is continuous. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Hence g(Zn ) →p g(c) as n → ∞. This is sufficient to establish the theorem.

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

¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1. ·) is continuous at (Q.1 Under Assumption 3. the OLS estimator β is has a statistical distribution which is unknown. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.1).1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. (6.2 Consistency ˆ As discussed in Section 6.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1) and ˆ We now deduce the consistency of β. (6.1 by the fact that the sampling densities become more concentrated as n gets larger.4. First. Equation (4. Assumption 3. Ã n ! n X 1X 0 1 ˆ xi xi .1. This is illustrated in Figure 6. Proof.1). Hence by the continuous mapping theorem (Theorem 5.2. using (6. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 . 6. and the continuous mapping theorem (Theorem 5.2.3). we can conclude ˆ that β →p β. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.1 and the WLLN (Theorem 5.5. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1. ˆ Theorem 6.5.4.2). we will use the methods of asymptotic approximation.5. To characterize the sampling distribution more fully. Assumption 3. xi ei →p g (Q. β →p β as n → ∞.3) Ã where g(A. n i=1 (6.2) i i n i=1 n From (6.From the figure we can see that the density functions are dispersed and highly non-normal.1).1). ˆ 47 . (6.4 implies that Q−1 exists and thus g(·. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to infinity. 0). For a complete argument. As the sample size increases the density becomes more concentrated about the population coefficient.

i i Assumption 6. To see this. (6. it follows that s2 = ¥ n σ 2 →p σ 2 .2).3) and Theorem (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. Ee4 < ∞ and E |xi |4 < ∞.6) n i=1 48 . Ω) .2).Theorem 6. (6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. ˆ Proof.1 In addition to Assumption 3. i Now define ¡ ¢ Ω = E xi x0 e2 .2. ˆ n−k 6. since n/(n − k) → 1 as n → ∞.3.1.2 Under Assumption 3. n 1 X √ xi ei →d N (0.2. by the Cauchy-Schwarz inequality (5. By the central limit theorem (Theorem 5. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.3.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n à ! à 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.5.1. ˆ Finally. We need a strengthening of the moment conditions. 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 . E ¯ei ¯ E ¯e4 ¯ i i i i (6.1 guarantees that the elements of Ω are finite. Thus σ 2 is consistent for σ 2 .3. Assumption 6.1).1).5. (6. (6.

As α approaches 2.1 is commonly used to approximate the finite of √ ³ˆ sample distribution of n β − β .1. Let yi = β 0 + β 1 xi + εi where xi is N (0. ´ √ ³ ˆ n β−β = à 1X xi x0 i n i=1 n !−1 à Theorem 6. V ) where V = Q−1 ΩQ−1 . In Figure 6.9) In (6. In´Figure 6. 1) asymptotic distibution. there is no simple answer to this reasonable question. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . If α > 2 the 2 error εi has zero mean and variance α/(α − 2).6). is approximately normal when the sample size n is sufficiently large.7) is true then V = V 0 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0.2).9) we define V 0 = Q−1 σ 2 whether (6. when xi and ei are independent. This holds true for all joint distibutions of (yi .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. Under (6.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. its variance diverges q ³ ´ ˆ to infinity.2 we display the finite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . We say that ei is a Homoskedastic Projection Error when (6. Theorem 6. for any ˆ fixed n the sampling distribution of β can be arbitrarily far from the normal distribution. otherwise V 6= V 0 . We illustrate this problem using a simulation. xi ) which satisfy the conditions of Assumption 6.1. and (6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.7) is true or false.1). 1 X √ xi ei n i=1 n ! the N (0.1 Under Assumption 6. for example.3.3. There is a special case where Ω and V simplify. after rescaling.3.3. 1).7) holds. V is often referred to as ˆ the asymptotic covariance matrix of β. but this is not a necessary condition. (6. i i Condition (6. Ω) ¡ ¢ = N 0. The approximation may be poor when n is small. setting n = 100 and varying the parameter α.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. When (6.3. |ε| ≥ 1. How large should n be in order for the approximation to be useful? Unfortunately. The expression V = Q−1 ΩQ−1 is called a sandwich form. The asymptotic distribution ´ Theorem 6. The trouble is that no matter how large is the sample size. We call V 0 the homoskedastic covariance matrix.Then using (6.1 states that the sampling distribution of the least-squares estimator. Q−1 ΩQ−1 . However.7) Cov(xi x0 . e2 ) = 0. however. For α 49 .

Another example is shown in Figure 6.2) and Theorem 6. 1). 6. As α diminishes the density changes significantly.2.10) without changing this result.3 is that the N (0. The lesson from Figures 6. 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. 1) density.1) it is clear that V 0 →p V 0 . the sampling distribution becomes highly skewed and non-normal.0 the density is very close to the N (0. concentrating most of the probability mass around zero.2 and 6. We show the sampling distribution of n β 1 − β 1 setting n = 100.11) 50 . The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. 1) asymptotic approximation is never guaranteed to be accurate. for k = 1. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 4. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.3.10) V 0 = Q−1 s2 . 6 and 8.2: Density of Normalized OLS estimator α = 3.Figure 6. As k increases. we need an estimate of Ω = E xi x0 e2 .

and V is an estimator of the variance of n β − β . k. A more easily interpretable measure of spread is its square root — the standard deviation. standard errors are not unique. or that they use the “White formula”. and was still the standard choice for much empirical work done in the early 1980s. many authors will state that their “standard errors have been corrected for heteroskedasticity”. Generically. the “Huber formula”.Figure 6. as there may be more than one estimator of the variance of the estimator. β j .4. ˆ ˆ Definition 6.3: Sampling distribution where ei are the OLS residuals. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . the “Eicker-White formula”. ˆ The estimator V 0 was the dominate covariance estimator used before 1980.. these all mean the same thing. vis. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. This motivates the definition of a standard error. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . When β is a vector. we set s(β) = n−1/2 V . 1. or that they use a “heteroskedasticity-robust covariance matrix estimator”. ˆ ˆ When V is used rather than the traditional choice V 0 .. j = 0. . It is therefore important to understand what formula and method is 51 .. 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). In most cases. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. we focus on individual elements of β one-at-a-time. The methods switched during ˆ the late 1980s and early 1990s.. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. the “Huber-White formula” or the “GMM covariance matrix”. as it is not always clear which has been computed. When reading and reporting applied work.

From a computational standpoint.199 2. then take the diagonal elements. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.83 ¶−1 µ . but not under another set of assumptions.117 Educationi .20 and µ ¶ ˆ = 0. just as any other estimator.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.98 −0.4) 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 .80 .6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.14 14.085 p ˆ and that for β 1 is . Ω 2.480 .20 −0.2/988 = .80 40.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. To illustrate.035 ¶ .80 2.20 = V 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.14 205.80 40.020) 6. (6. we return to the log wage regression of Section 4.020.used by an author when studying their work. the standard method to calculate the standard errors is to ˆ first calculate n−1 V .493 0.039 and ˆ V = µ 1 14. First. (6. from which it follows that V →p V as n → ∞. The standard errors for β 0 are 7. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . p ˆ In this case the two estimates are quite similar.493 −0. (.14 14. i i i i n i=1 Second.199 2.5) and the WLLN (Theorem 5.14 205.1. n n i=1 52 . We calculate that s2 = 0.14 205. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.83 ¶−1 = µ 7.085) (.2.14 6.83 −0.35/988 = .12) in turn.30 + 0. by Holder’s inequality (5. Using (6. and then the square roots.6 ¶µ 1 14.480 ˆ0 = 0.

13) of Efron (1982). by the WLLN ¯ n ¯ à n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. is defined ˆ ˆ by replacing the OLS residual ei in (6. n i=1 n ˆ ˆ Theorem 6. which. Using this substitution.−i = (1 − hi )−1 ei ˆ presented in (4. these establish consistency. 6. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . i=1 Third.5. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . Andrews (1991) suggested an similar estimator based on cross-validation.1 As n → ∞.13) Using formula (4. ¯ ¯n ¯ n i=1 so Together.25). 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. Recall from Section 4. Ω →p Ω and V →p V.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. 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 (6.26). ¯ 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. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .14) à 1X (1 − hi )−1 xi ei ˆ n i=1 n !à 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi .12 the definition of β (−i) as the least-squares estimator with the i’th observation deleted. From equation (3. you can show that 1 Xˆ ¯ β= β (−i) .11) with the leave-one-out estimator ei.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.

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

µ I 0 ¶ ˆ the upper-left block of V . that (so θ ˆ ˆ ˆ is. Vθ ) √ Vθ = N (0. see Section X). s(ˆ = n−1/2 H 0 V Hβ . ˆ When q = 1q h(β) is real-valued). s(ˆ θ) (6. 1) →d ˆ−θ θ .8 t tests Let θ = h(β) : Rk → R be any parameter of interest. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . Since the standard normal distribution does not depend on the parameters. the statistic tn has an exact t distribution.8. the standard error for ˆ is the square root of n−1 Vθ . (For example. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-specified value. if R is a “selector matrix” R= so that if β = (β 1 .For example. and is therefore exactly free of unknowns. and θ = h(β) is some function of the parameter vector. By (6.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0.1 tn (θ) →d N (0. In special cases (such as the normal regression model. 1) Proof. θ could be a single element of β). pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. 55 . we say that tn is an exactly pivotal statistic. however. θ) β 6. we say that tn (θ) is asymptotically pivotal. In general.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. β 2 ). In this case. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. Consider the studentized statistic tn (θ) = Theorem 6.

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

θ θ) (6. = n h(β) − θ0 Hβ V Hβ 57 (6. or α = . the most common professional choice isi95%. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . 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).05. 6. θ The interval has been constructed so that as n → ∞.18) .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. 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). We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. ˆ + zα/2 s(ˆ . A good method for construction of a confidence interval is the collection of parameter values which are not rejected by a statistical test. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).16) and zα/2 is the upper α/2 quantile of the standard normal distribution. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). and it is desired to test the joint restrictions simultaneously. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value.96s(ˆ ≈ ˆ ± 2s(ˆ . In this case the t-statistic approach does not work. 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 . This corresponds to selecting the confidence h i h ˆ ± 1.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% confidence interval. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.

We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). Wn = n R0 β − θ0 ´ √ ³ The delta method (6.11 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 .3. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . 1] under H0 . h(β) = R0 β.10. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. 6.2. Hβ (β) →p Hβ . Hβ (β) is a continuous function of β. q and pn is asymptotically U[0. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. ˆ Wn = n θ θ q θ θ Theorem 6. the upper-α quantile q 2 of the χ2 distribution. θ = β 2 . 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.19) σ2 ˆ where σ2 = ˜ 1 0 e e. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . and Theorem 6. As before. then Wn →d χ2 . Vθ ). the test rejects at the α% level iff pn < α.When h is a linear function of β. The asymptotic p-value for Wn is pn = p(Wn ).1.5. a chiq square random variable with q degrees of freedom. Also h(β) = a selector matrix.05) = 3. Furthermore. if rank(Hβ ) = q.1 showed θ ˆ that V →p V.84 = z. The null hypothesis is H0 : β 2 = 0. and there are q = k2 restrictions.025 . χ2 (. For example. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . ˜˜ n ˜ e = Y − X1 β 1 . Hence β β by Theorem A.1 Under H0 and Assumption 6. In this case. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .15) showed that n ˆ − θ →d Z ∼ N (0. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).8.

2 σ ˆ To simplify this expression further. 2 2 2 or alternatively. note that if we regress Y on X1 alone. since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e.19). Also.19) is that it is directly computable from the standard output from two simple OLS regressions. 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. note that partitioned matrix inversion (2. the residual is ˜ ˜ e = M1 Y. X2 ). First. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . 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 . ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 .19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . By the FWL theorem. as the sum of squared errors is a typical output from statistical packages. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. 59 . Because of this connection we call (6.19) the F form of the Wald statistic. We now derive expression (6. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.are from OLS of Y on X1 . = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. and σ2 = ˆ 1 0 e e. This statistic is typically reported as an “F-statistic” which is defined as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . Now consider the residual regression of e on X2 = M1 X2 . The elegant feature about (6.2) ¢−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 . still this formula often finds good use in reading applied papers. ˆˆ n ˆ e = Y − X β.

there is an exact distribution theory available for the normal linear regression model. In σ 2 .4)) where H 0 H = In . In ) . when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. 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 . it follows ˆ that β is independent of any function of the OLS residuals. This special F statistic is testing the hypothesis that all slope coefficients (other than the intercept) are zero. an “F statistic” is reported. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. equivalently the residual variance from an intercept-only model. Let u = σ −1 H 0 e ∼ N (0. Since uncorrelated normal variables are independent. n−k 60 . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. 6. when an OLS regression is reported. This was a popular statistic in the early days of econometric reporting. This is rarely an issue today.where In many statistical packages. including the estimated error variance 2.3. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . introduced in Section 4. σ 2 ) can be be used to calculate a set of exact distribution results. H 0 H) ∼ N (0. this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0. as sample sizes are typically sufficiently large that this F statistic is highly “significant”. these cases are atypical. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . While there are special cases where this F statistic is useful.12 Normal Regression Model As an alternative to asymptotic distribution theory. Since linear functions of normals are also normal. In particular. The modelling assumption that the error ei is independent of xi and N (0. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi .

10) µ h i ¶ 2 (X 0 X)−1 N 0. Furthermore. 0. The critical values are quite close if n − k ≥ 30.1 and Theorem 6. β 2 . β 2 . Theorem 6.10) then ´ ³ ˆ • β ∼ N 0.a chi-square distribution with n − k degrees of freedom. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .1 If ei is independent of xi and distributed N(0. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . the notable distinction is between the N (0. σ 2 ) = − log σ − log (2π) − . σ 2 ) − Ln (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . 0.) Now let us partition β = (β 1 .12. σ 2 ).12.3. a good testing procedure is based on the likelihood ratio statistic.1 we showed that in large samples. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. In contrast. so as a practical matter it does not matter which distribution is used. β 2 . 1) and tn−k distributions. σ2 ˆ 61 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . σ 2 ) discussed above. n−k • ∼ tn−k ˆ In Theorem 6. σ ˆ ˆ βj − βj βj − βj N (0. if standard errors are calculated using the homoskedastic formula (6. β has an exact normal distribution and t has an exact t distribution. 0. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. As inference (confidence intervals) are based on the t-ratio. with residual variance σ . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . 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. 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. We summarize these findings Theorem 6. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . β and t are approximately normally distributed. (Unless the sample size is unreasonably small. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .8. and standard errors are calculated using the homoskedastic formula (6.

The increasing solid line is for the case β = 0.4 the Wald statistic Wn (s) as a function ˆ of s. The decreasing dashed ˆ = 1. ˆ Let β and σ 2 be the sample mean and variance of yi . and noting Hβ = sβ s−1 . σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaffected by the choice of s. 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. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. we have plotted in Figure 6. the statistic Wn (s) varies with s. Our first-order asymptotic theory is not useful to help pick s. setting n/σ 2 = 10. they can work quite poorly when the restrictions are nonlinear. features of this distribution can be calculated. In the present context of the Wald statistic. This produces random draws from the sampling distribution of interest. 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. This can be seen by a simple example introduced by Lafontaine and White (1986). while there are other values of s for which test test statistic is insignificant. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic.By a first-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. 6. This is an unfortunate feature of the Wald statistic. as Wn (s) →d χ2 under H0 for 1 any s.84 — the probability of a false rejection. we find that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . σ 2 ) and consider the hypothesis H0 : β = 1. To demonstrate this effect. Letting h(β) = β s . The method uses random simulation to create an artificial dataset to apply the statistical tools of interest. Through repetition. Take the model yi = β + ei ei ∼ N (0. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.8.7. 62 .

remember that the ideal Type I error probability is 5% (.4: Wald Statistic as a function of s P (Wn (s) > 3. In Table 4.000 simulated Wald statistics Wn (s) which are larger than 3. Type I error rates between 3% and 8% are considered reasonable. Error rates avove 10% are considered excessive.1 you can also see the impact of variation in sample size. and σ is varied among 1 and 3. Test performance deteriorates as s increases.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . however. this probability depends only on s. Typically. To interpret the table. Each row of the table corresponds to a different value of s — and thus corresponds to a particular choice of test statistic.05) with deviations indicating+ distortion. n is varied among 20. looking for tests for which rate rejection rates are close to 5%. When comparing statistical procedures. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Rates above 20% are unexceptable. Table 4. n. There is.Figure 6.4. The value of s is varied from 1 to 10.1 reports the simulation estimate of the Type I error probability from 50.84. The second through seventh columns contain the Type I error probabilities for different combinations of n and σ. Any other choice of s leads to a test with unacceptable Type I error probabilities.84 | β = 1) . the only test which meets this criterion is the conventional Wn = Wn (1) test. and rarely fall outside of the 3%-8% range. These probabilities are calculated as the percentage of the 50. the Type I error probability improves towards 5% as the sample size n increases. 100 and 500.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Given the simplicity of the model. In each case. so these probabilities are Type I error.000 random samples. Table 4. The null hypothesis β s = 1 is true. In Table 2. no magic choice of n for which all tests perform uniformly well. For this particular example. and σ 2 . we compare the rates row by row.

in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at first.20 .10 .07 .15 .07 . Other choices are arbitrary and would not be used in practice.33 .20).05 .19 . define θ = β 1 /β 2 .28 .22 .20 .30 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 .08 .18 .06 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .07 .08 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. This point can be illustrated through another example.13 .15 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. 64 .15 .05 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .14 . Equivalently.17 .12 .11 .35 . β 2 ) be the least-squares estimates of (6. so the hypothesis can be stated as H0 : θ = r.08 .07 .23 .08 .15 .06 .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 . Define θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .24 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.16 Rejection frequencies from 50. β 1 .06 .07 .06 .10 . While this is clear in this particular example.21 .26 .12 .10 .31 .22 .06 .25 .05 .14 .25 .06 .34 .06 .05 .13 .13 .08 .05 .05 .09 .

645) are close to zero in most cases.00 . The left tail probabilities P (t1n < −1. and are close to the ideal 5% rate for both sample sizes. along with sample size n. then the “most linear” formulation should be selected.10 .645) P (tn < −1.00 The one-sided Type I error probabilities P (tn < −1. However.05 . and alternatives to asymptotic critical values should be considered.0 and n among 100 and 500. . We let x1i and x2i be mutually independent N (0.06 . such as the GMM distance statistic which will be presented in Section 9.47 . ei be an independent N (0.10 .05 . If no linear formulation is feasible. and 1. The results are presented in Table 4.00 .02 .05 .645) P (tn > 1.15 .09 .00 .07 .05 .25. the rejection rates for the t1n statistic diverge greatly from this value.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. 6.645) and P (tn > 1. It is also prudent to consider alternative tests to the Wald statistic.645) t1n t2n t1n t2n t1n t2n t1n t2n .645) greatly exceed 5%. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .05. .05 .05 . The implication of Table 4.00 . We vary β 2 among . In all cases.2 is that the two t-ratios have dramatically different sampling behavior. .06 .06 .05 .06 .06 .06 .00 .50 . while the right tail probabilities P (t1n > 1. This leaves β 2 as a free parameter. the entries in the table should be 0.645) P (tn > 1.00 . In contrast.00 .75.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . this formulation should be used.15 .05 β2 .000 simulated samples.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. σ 2 ) draw with σ = 3. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .00 . especially for small values of β 2 . and normalize β 0 = 0 and β 1 = 1.06 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. Table 4.05 .12 .06 .00 .28 . if the hypothesis can be expressed as a linear restriction on the model parameters.2. 1) variables.06 .7.25 .75 1. In this section we describe the method in more detail.50.06 .26 . 65 .10 .05 .645) are calculated from 50. Ideally.1.

A “true” value of θ is implied by this choice. n. which implies restrictions on F . 1) random numbers. x1 . The researcher chooses F (the distribution of the data) and the sample size n. ∗ ∗ • The statistic Tn = Tn (y1 . The basic idea is that for any given F. from one observation very little can be said. (For example. θ) is calculated on this pseudo data. The above experiment creates one random draw from the distribution Gn (x.Recall. For example: Suppose we are interested in the bias. Gn (x. x∗ ) . b = 1. for example an estimator ˆ or a t-statistic (ˆ − θ)/s(ˆ The exact distribution of Tn is θ θ θ). the distribution function Gn (x. F ). From a random sample. Notationally. and calculate θ of θ \ ˆ Bias(θ) = B B 1 X 1 Xˆ Tnb = θb − θ B B b=1 b=1 B 1 X \θ) (Tnb )2 M SE(ˆ = B b=1 µ ¶2 \ = M SE(ˆ − Bias(ˆ \θ) \ ˆ V ar(θ) θ) 66 . . F ) = P (Tnb ≤ x) = P (Tn ≤ x | F ) . So the researcher repeats the experiment B times. Typically... and from these most random variables can be constructed.. Let θ be a parameter and let Tn = Tn (y1 . 1] and N (0. xn . Monte Carlo simulation uses numerical simulation to compute Gn (x. We will discuss this choice later.. The name Monte Carlo derives from the famous Mediterranean gambling resort.. Then the following experiment is conducted ∗ • n independent random pairs (yi . F ) = P (Tn ≤ x | F ) .. yn .. We then set Tn = ˆ − θ. are drawn from the distribution F using i the computer’s random number generator. B. F ) for selected choices of F. .. Clearly. our data consist of observations (yi . a chi-square can be generated by sums of squares of normals. yn . we set B = 1000 or B = 5000. The method of Monte Carlo is quite simple to describe. run the above experiment... x∗ . They constitute a random sample of size B from the distribution of Gn (x. F ) can be calculated numerically through simulation. xi ) which are random draws from a population distribution F. let the b0 th experiment result in the draw Tnb . we can estimate any feature of interest using (typically) a method of moments estimator. the exact (finite sample) distribution Gn is generally unknown.. where games of chance are played.) For step 2. it is important that the statistic be evaluated at the “true” value of θ corresponding to the choice of F. These results are stored. This is useful to investigate the performance of the statistic Tn in reasonable situations and sample sizes. mean-squared error (MSE). n n For step 1. most computer packages have built-in procedures for generating U [0.. i = 1. θ) be a statistic of interest. This is one observation from an unknown distribution. x∗ . or variance of the distribution ˆ − θ. While the asymptotic distribution of Tn might be known. where B is a large number. or equivalently the value θ is selected directly by the researcher.

We separately estimate equations for white and non-whites. then we can set s P = (. female. and poorly for others. potential work experience. then B will have to be increased. it is simple to make inferences about rejection probabilities from statistical tests. B. and our regressors include years of education. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.96) .96) is iid Bernoulli. union member. equalling 1 with probability P = E1 (Tnb ≥ 1. if we set B = 999.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. Furthermore. the choice of B is often guided by the computational demands of the statistical procedure. for a selection of choices of n and F. female. The average (6.22/ B. respectively. potential work experience. and non-white. and . and 5000. In many cases. excluding military. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. For regressors we include years of education. and hispanic. 1000. experience squared. The random variable 1 (Tnb ≥ 1.022. If the standard error is too large to make a reliable inference. such as the percentage estimate reported in (6. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. the performance will depend on n and F. therefore.007. Often this is called the number of replications. and dummy variable indicators for the following: married. Then qα is the N ’th number in this ordered sequence.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. As P is unknown. immigrant. Generally. As discussed above. so that coefficients may be interpreted as semi-elasticities.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. Hence the ³ ´ ˆ standard errors for B = 100. B b=1 (6. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. and 90% sample quantiles of the sample {Tnb }. and therefore it is straightforward to calculate standard errors for any quantity of interest.003. s P = . . and dummy variable indicators for the following: married.96) . Quite simply.95) /B ' .21). For example. It is therefore useful to conduct a variety of experiments.15 Estimating a Wage Equation We again return to our wage equation. In particular. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. are. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. we included a dummy 67 . In practice. union member. 6. It is therefore convenient to pick B so that N is an integer. For the dependent variable we use the natural log of wages. the researcher must select the number of experiments. The α% sample quantile is a number qα such that α% of the sample are less than qα . but requires more computational time. For example. where N = (B +1)α. Again our dependent variable is the natural log of wages. hispanic. a larger B results in more precise estimates of the features of interest of Gn . an estimator or test may perform wonderfully for some values. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. We now expand the sample all non-military wage earners. experience squared. immigrant. We us the sample of wage earners from the March 2004 Current Population Survey.05) (. this may ˆ be approximated by replacing P with P or with an hypothesized value. and estimate a multivariate regression.

014 . 2β 3 68 .variable for state of residence (including the District of Columbia.102 −.013 . The F form of the Wald statistic (6.808 so the parameter estimates are quite precise and reported in Table 4. Alternatively.18) that the state coefficients are jointly zero.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.102 −. the restricted standard deviation estimate is σ = . 808 1 − .007 . reestimating the model with the 50 state dummies excluded.34 ˆ s(β) .48772 = 515.00002 . Ignoring the other coefficients. excluding the coefficients on the state dummy variables.49452 σ ˜ Notice that the two statistics are close. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.008 .121 −. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.4945.032 . but not equal.232 . Using either statistic the hypothesis is easily rejected.097 −.1.00057 .010 .070 . The available sample is 18. as the 1% critical value for the χ2 distribution is 76.027 .1 we find the point estimate ˆ ˆ = − β 2 = 28. this adds 50 regressors). 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.19) is ˜ µ ¶ µ ¶ σ2 ˆ .69.010 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.808 . θ ˆ 2β 3 β2 . Table 4.002 .4877 18.033 −. Computing the Wald statistic (6. Wn = n 1 − 2 = 18.101 . we find Wn = 550.001 .

we can calculate a standard error of s(ˆ = . Since tn (θ) is a non-linear function of θ. so we have to go one step further. this is a poor choice. 29. Instead. 69 . not testing a hypothesis. but the lower end is substantially lower. In the present context we are interested in forming a confidence interval. In the previous section we discovered that such t-tests had very poor Type I error rates.40.5]. as the coverage probability of this confidence interval is one minus the Type I error of the hypothesis test based on the t-test. This set is [27. However. Notice that the upper end of the confidence interval is the same as that from the delta method.9. Our desired confidence interval will be the set of parameter values θ which are not rejected by the hypothesis test. but it can be found numerically quite easily. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ).5]. This is the set of θ such that |tn (θ)| ≤ 1. 29. we found better Type I error rates by reformulating the hypothesis as a linear restriction. there is not a simple expression for this set.96.0.Using the Delta Method. implying a 95% confidence θ) interval of [27.

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

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 à n !−1 à n ! X X 0 ˆ xi xi + λIk xi yi β=
i=1 i=1

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

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

E (xi ei ) = 0
∗ yi = yi + ui

71

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

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

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

• Qi • Di • Ci

The flow variables are annual sums for 1987. The stock variables are beginning of year. (a) Estimate a linear regression of Ii on the other variables. Calculate appropriate standard errors. (b) Calculate asymptotic confidence intervals for the coefficients. (c) This regression is related to Tobin’s q theory of investment, which suggests that investment should be predicted solely by Qi . Thus the coefficient on Qi should be positive and the others should be zero. Test the joint hypothesis that the coefficients on Ci and Di are zero. Test the hypothesis that the coefficient on Qi is zero. Are the results consistent with the predictions of the theory?
2 (d) Now try a non-linear (quadratic) specification. Regress Ii on Qi , Ci , Di , Q2 , Ci2 , Di , i Qi Ci , Qi Di , Ci Di . Test the joint hypothesis that the six interaction and quadratic coefficients are zero.

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

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

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

73

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

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

V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. In the linear regression model. σ 2 ] σi i for some σ 2 > 0. In this case we interpret α0 zi as a linear projection of e2 on zi . First. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. β should perhaps be i i called a quasi-FGLS estimator of β. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). Its asymptotic variance is not that given in Theorem 7. It is possible to show that if the skedastic regression is correctly specified. V ). then FGLS is asymptotically equivalent to GLS.1.1. i ˜ 0 is inconsistent for V . Theorem 7.. FGLS estimation depends on specification and estimation of the skedastic regression. There are three reasons.1. Instead. 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..1.1 If the skedastic regression is correctly specified. A trimming rule might make sense: σ 2 = max[˜ 2 . . This estimator V 0 is appropriate when the skedastic regression (7. and was proposed by Cragg (Journal of Econometrics. ´´−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 .. FGLS is asymptotically superior to OLS. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . V n n i=1 . and it may be estimated with considerable 76 V takes a sandwich form√. 1992).that there is a need to bound the estimated variances away from zero. e2 }. ¢¢−1 ¡ ¡ . V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . Unless σ 2 = α0 zi . This is an estimator which is robust to misspecification of the condie1 ˆn tional variance. the natural estimator of the asympˆ totic variance of β is à n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . This may be written as !−1 à n !à n !−1 à n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞.1. We just state the result without proof. but the proof of this can be tricky.2) is correctly specified. Since the form of the skedastic regression is unknown.

Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. individual estimated conditional variances may be negative. OLS is a more robust estimator of the parameter vector. We may therefore test this hypothesis by the estimation (7.4). BreuschPagan (1979) proposed what might appear to be ¡ distinct test. the two tests coincide. on the other hand. The GLS and FGLS estimators. its squares. and all cross-products. the Wald test of H0 is asymptotically χ2 . Typically. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi .3) for α simplifies to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi .error.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 .7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. but also under the assumptions of linear projection. and the cost is a reduction of robustness to misspecificatio 7. then the OLS and FGLS estimators will converge in probability to different limits. This introduces an element of arbitrariness which is unsettling to empirical researchers. The point is that the efficiency gains from FGLS are built on the stronger assumption of a correct conditional mean. If i this simplification is replaced by the standard formula (under independence of the error). and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. Vα = E zi zi (7. Second. σ 2 ). In this case. in which case ξ i is ˜ independent of xi and the asymptotic variance (7.5) and the asymptotic variance (7. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . as they will be estimating two different projections.2).3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. however. q Most tests for heteroskedasticity take this basic form. or equivalently that i H0 : α1 = 0 in the regression (7.1 Under H0 and ei independent of xi . And the FGLS probability limit will depend on the particular function selected for the skedastic regression.4) and constructing a Wald statistic. FGLS will do worse than OLS in practice. Theorem 7. In the linear regression model the conditional mean of yi given xi = x is 77 . The asymptotic distribution (7.2. 7. Third. It is consistent not only in the regression model. If the equation of interest is a linear projection. and this requires trimming to solve.7) under independence show that this test has an asymptotic chi-square distribution. and not a conditional mean. require the assumption of a correct conditional mean. the estimated conditional variances may contain more noise than information about the true conditional variances. but the only difference is that they a ¢ allowed for general choice of zi . This hypothesis does not imply that ξ i is independent of xi . The main differences between popular “tests” is which transformations of xi enter zi .

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

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

In particular. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. 1 2 The model is linear when β 2 = 0.5 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 . An alternative good measure is the conditional median. 80 . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − 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 .For θ close to the true value θ0 . Hansen (1996). θ) = β 0 zi + β 0 xi (γ). but these are not the only measures of central tendency. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out.4. θ) ' m(xi . tests of H0 do not have asymptotic normal or chi-square distributions. ¥ Based on Theorem 7. θ0 )) − m(xi . Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . 7. We have discussed projections and conditional means. m(xi . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. the parameter estimates are not asymptotically normally distributed. θ which is that stated in the theorem. Thus when the truth is that β 2 = 0. θ0 ) + m0 (θ − θ0 ) .1. under H0 . This renders the distribution theory presented in the previous section invalid. ˆ ˆ θ) ˆ θ). Suppose that m(xi . However. and this is often a useful hypothesis (sub-model) to consider. Furthermore. Thus we want to test H0 : β 2 = 0. This means that under H0 . ˆ and ei = yi − m(xi . The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. θ) ' (ei + m(xi . Identification is often tricky in nonlinear regression models. γ is not identified. θi Thus ¡ ¢ yi − m(xi . by a first-order Taylor series approximation. 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 .

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

11) This simplification is similar to the simplification of the asymptotic covariance of the OLS estimator under homoskedasticity. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . Pn −1 0 β)) . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.5. First. See Chapter 16. where V = and f (e | x) is the conditional density of ei given xi = x. then there are many innovations near to the median. Let g(β) = Eg (β). the height of the error density at its median. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . then f (0 | x) = f (0) and the asymptotic variance simplifies V = (Exi x0 )−1 i 4f (0)2 (7. Second using the law of iterated expectations and the chain rule of i differentiation. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . (7. In the special case where the error is independent of xi . ˆ Proof of Theorem 7.5.5. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.Theorem 7.1 is advanced.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . When f (0 | x) is large.3. This can be done with kernel estimation techniques. While a complete proof of Theorem 7. The main difficulty is the estimation of f (0).1 ´ √ ³ˆ n β − β 0 →d N (0. and this improves estimation of the median. Computation of standard error for LAD estimates typically is based on equation (7. we provide a sketch here for completeness.11).10) is equivalent to g n (β) = 0. by the central limit theorem (Theorm 5. ∂β 0 so Third. the conditional density of the error at its median. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . V ).

so you can think of the quantile as the inverse of the distribution function. For τ ∈ [0. The median is the special case τ = .9) for the median to all quantiles. For the random variables (yi . As functions of x. then (7. This linear specification assumes that Qτ (x) = β 0 x where the coefficients β τ τ vary across the quantiles τ . when F (y | x) is continuous and strictly monotonic in y. 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is defined as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . ¥ 7. Again.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice.13) This generalizes representation (7. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . For fixed τ .12) Qτ = argmin Eρτ (U − θ) . the quantile regression functions can take any shape. The following alternative representation is useful. V ). θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). then F (Qτ ) = τ .Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } .5. (7. Exi x0 ) →d i 2 = N (0. The third line follows from an asymptotic empirical process argument. If the random variable U has τ ’th quantile Qτ . then F (Qτ (x) | x) = τ .

the τ ’th conditional quantile of ei is zero. Thus. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). conventional Newton-type optimization methods are inappropriate.1. ˆ Given the representation (7. Furthermore. and test their significance using a Wald test. 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. Another popular approach is the RESET test proposed by Ramsey (1969).7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . ´ √ ³ˆ Theorem 7. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. and form a Wald statistic i for γ = 0. The null model is yi = x0 β + εi i 84 . the asymptotic variance depends on the conditional density of the quantile regression error. otherwise its properties are unspecified without further restrictions. fast linear programming methods have been developed for this problem.12). where and f (e | x) is the conditional density of ei given xi = x. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. i By construction. if the model yi = x0 β + ei has i been fit by OLS. n numerical methods are necessary for its minimization. When the error ei is independent of xi . the unconditional density of ei at 0.where ei is the error defined to be the difference between yi and its τ ’th conditional quantile x0 β τ . Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. Vτ ). and are widely available. ¡ ¡ ¢¢−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.6. and we have the simplification Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . since it has discontinuous derivatives. it is useful to have a general test of the adequacy of the specification. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is defined in (7.5.13).1 n β τ − β τ →d N (0. then f (0 | xi ) = f (0) . 7. Fortunately.

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

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

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

and the AIC or BIC in principle can be implemented by estimating all possible subset models. selecting based on (7.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. . which are nested. which regressors enter the regression). there are 2K such models. 048. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. Also under M2 . . The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . the models are M1 : β 1 6= 0. For example. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. However. xKi }. The AIC selection criteria estimates the K models by OLS. In the ordered case.15). There are two leading cases: ordered regressors and unordered. . stores the residual variance σ 2 for each model. one can show that thus LRn →p ∞. and 220 = 1. . . . The methods extend readily to the issue of selection among multiple regressors. which can be a very large number. Similarly for ˆ the BIC. 576. In the latter case. MK : β 1 6= 0.. β 3 = · · · = β K = 0 . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. In the unordered case. E (εi | xi ) = 0 and the question is which subset of the coefficients are non-zero (equivalently. β K 6= 0.. 210 = 1024. β 2 6= 0. a model consists of any possible subset of the regressors {x1i . β 2 6= 0. 88 . We have discussed model selection between two models.. . and then selects the model with the lowest AIC (7.17).

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

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 . Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi .. a7 ). the regression slope is a2 + a6 . at least 10 to 15) of ln Qi are both below and above a7 . For each value of a7 . (7. (ii) AIC criterion. Assess the merits of this new specification using (i) a hypothesis test. The model works best when a7 is selected so that several values (in this example. In Chapter 6. Do you agree with this modification? (b) Now try a non-linear specification.. and find the value of a7 for which the sum of squared errors is minimized. . (c) Estimate the model by non-linear least squares. Exercise 13. the variable ln Qi has a regression slope of a2 . and V is the = g(x estimate of V ar ˆ . Consider model (7. and the model imposes a smooth transition between these regimes. I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. Suppose that yi ³ ´ i .. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . For values of ln Qi much below a7 . Record the sum of squared errors. The model is non-linear because of the parameter a7 . n xi i=1 (a) Under the stated assumptions. In addition. are both estimators consistent for β? (b) Are there conditions under which either estimator is efficient? 9. This model is called a smooth threshold model. (d) Calculate standard errors for all the parameters (a1 . (iii) BIC criterion. θ) + ei with E (ei | xi ) = 0. add the variable (ln Qi )2 to the regression. 8.18) plus the extra term a6 zi .18) (a) Following Nerlove.ˆ ˆ 7. Examine the data and pick an appropriate range for a7 . you estimated a cost function on a cross-section of electric companies. calculate zi and estimate the model by OLS. θ is the NLLS estimator. Do so. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. 90 . Find an asymptotic 95% confidence interval for g(x). impose the restriction a3 + a4 + a5 = 1. For values much above a7 .

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

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

In general. i = 1. ∗ P (yi ≤ y. x). To see the effect of sample size on the EDF. x∗ ) with the i distribution Fn . x))) . (8. To see this. The random draws are from the N (0. the EDF step function gets uniformly close to the true CDF. Fn (y.3. the EDF is only a crude approximation to the CDF..8. F (y.. xi ). x) = P (yi ≤ y. n. Fn is a nonparametric estimate of F. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . Notationally. x) − F (y. x) →p F (y. 50.1). x) (1 − F (y. but the approximation appears to improve for the large n. √ n (Fn (y. x). and 100. Note that while F may be either discrete or continuous. For n = 25. Fn is by construction a step function. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . x) . That is. x∗ ≤ x) = Fn (y. . as the sample size gets larger. x) is called the empirical distribution function (EDF). The EDF is a consistent estimator of the CDF. This is a population moment.1). Furthermore.2 The Empirical Distribution Function Fn (y.2. Thus by the WLLN (Theorem 5. x)) →d N (0. x) = n i=1 Figure 8. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. by the CLT (Theorem 5. in the Figure below.. 1) distribution. I have plotted the EDF and true CDF for three random samples of size n = 25. Recall that F (y. it is helpful to think of a random pair (yi .2) Fn (y.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . note that for any (y. where 1(·) is the indicator function. i 93 . x).

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

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

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

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

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

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

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

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

Theorem 8. Another way of writing this is ∗ P (|Tn | < x) = P (|Tn | < x) + O(n−3/2 ) so the error from using the bootstrap distribution (relative to the true unknown distribution) is O(n−3/2 ). and needs to be determined on a case-by-case basis. Applying (8.8. n Thus the difference between the bootstrap and exact distributions is Gn (x) − Gn (x. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. which is not pivotal. Twosided tests will have more accurate size (Reported Type I error). we find Gn (x) = Gn (x. A reader might get confused between the two simultaneous effects. Fn ) − g2 (x. is an even function. F ) = Φ v √ where v = V .Interestingly. and for the bootstrap ³x´ + O(n−1/2 ). whose error is O(n−1 ). as it depends on the unknown V. but one-sided tests might have more power against alternatives of interest. F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . Confidence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. G∗ (x) = Gn (x. F0 )) + O(n−3/2 ) n = O(n−3/2 ). g1 . the choice between symmetric and equal-tailed confidence intervals is unclear. 8. meaning that the errors in the two directions exactly cancel out. F0 ) = ∗ 2 (g2 (x. Fn ) = Φ(x) + ∗ 2 g2 (x. √ the last equality because Fn converges to F0 at rate n. V ).5) to the bootstrap distribution.1 shows that a first-order approximation ³x´ + O(n−1/2 ). Gn (x. Two-sided tests have better rates of convergence than the one-sided tests. This is in contrast to the use of the asymptotic distribution. The analysis shows that there may be a trade-off between one-sided and two-sided tests. Therefore. This is because the first term in the asymptotic expansion. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. and g2 is continuous in F. set Tn = n ˆ − θ0 . We know that θ Tn →d N (0. The difference is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. Fn ) + O(n−3/2 ). similar to a one-sided test.11 Percentile Confidence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. and bootstrap tests have better rates of convergence than asymptotic tests. Thus a two-sided bootstrap test also achieves an asymptotic refinement.

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

13 Exercises 1. Let the statistic of interest be the sample mean Tn = y n . . yielding OLS estimates β and any other statistic of interest... . One proposal which imposes the regression condition without independence is the Wild Bootstrap. whether or not the xi are really “fixed” or random. 2. Let ∗ ∗ ∗ {y1 . Set y∗ = x∗0 β + e∗ .observed values of the regressors. and set x∗ = xi0 and e∗ = ei0 . Unfortunately this is a harder problem. e∗ ) from the pair {(xi . Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. Let Fn (x) denote the EDF of a random sample. you sample ε∗ using this two-point distribution. ˆ Draw (with replacement) n such vectors.. Let β denote the ˆ the OLS residuals. ˆi A conditional distribution with these features will preserve the main important features of the data.. Consider the following bootstrap procedure. . which is a valid statistical approach. Show that √ n (Fn (x) − F0 (x)) →d N (0. ˆ 3.. and e = Y − X β ˆ (a) Draw a random vector (x∗ ... draw a ˆ ˆ random integer i0 from [1.. The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. That is. 4... however. generate ∗ bootstrap samples. This can be achieved using a two-point distribution of the form à à √ ! ! √ 1+ 5 5−1 ∗ √ ei ˆ = P εi = 2 2 5 à à √ ! ! √ 1− 5 5+1 ∗ √ P εi = = ei ˆ 2 2 5 For each xi .. Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). 2. . yn } with µ = Eyi and σ 2 = V ar(yi ). X ∗ ). Take a random sample {y1 . 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 . i 8. Consider the following bootstrap procedure for a regression of yi on xi . Tn = (ˆ − ˆ 104 . F0 (x) (1 − F0 (x))) .. ei ) : i = 1. ˆ∗ (b) Regress Y ∗ on X ∗ . It does not really matter. creating a random bootstrap data set (Y ∗ . n]. OLS estimator from the regression of Y on X. Using the non-parametric bootstrap. Find the bootstrap moments ETn and V ar(Tn ). Find the population moments ETn and V ar(Tn ). n} . yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean.

θ θ) ∗ 1000 samples are generated from the bootstrap distribution. Calculate 95% confidence intervals for the regression coefficients using both the asymptotic normal approximation and the percentile-t bootstrap. You replace c with qn (. Using the non-parametric bootstrap.95) denote the 95% quantile of Tn . You want to test H0 : θ = 0 against H1 : θ > 0.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). and define the bootstrap confidence interval h i C = ˆ − s(ˆ n (. Suppose that in an application.95) denote the 5% θ) ∗ and 95% quantiles of Tn . What is wrong with this procedure? Tn = θ/s(θ) n 6. ∗ ∗ ∗ Let qn (. Estimate a linear regression of price on the number of bedrooms. with variables listed in the file hprice1.05) . The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.dat contains data on house prices (sales). Let qn (. The datafile hprice1. (c) With the given information. and the colonial dummy. and the 2. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).95). θ respectively.3. and thus reject H0 if ˆ ˆ > q ∗ (.05) and qn (. can you report the 95% Percentile-t interval for θ? 7. 105 . θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.5% quantiles of the ˆ are . ∗ ∗ where s(ˆ is the standard error in the original data.75 and 1. ˆ − s(ˆ n (. size of house.5% and 97. (b) Report the 95% Alternative Percentile interval for θ.pdf. You do this as follows. Using the non-parametric ∗ bootstrap. and ˆ is calculated on each θ ∗ ∗ θ sample.2 and s(ˆ = .95).2. ˆ = 1. The ˆ are sorted. you generate bootstrap samples.95). (a) Report the 95% Efron Percentile interval for θ. lot size.

This is a special case of a more general class of moment condition models. z. an asymptotically efficient estimator of β is the OLS estimator. In the statistics literature. however. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi .1) by setting g(y. while β 1 is of dimension k < . x. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. In econometrics. where the dimensions of zi and xi are k × 1 and × 1 . Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0.2) . There are − k = r more moment restrictions than free parameters.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. This model falls in the class (9.1) where β 0 is the true value of β. zi . We know that without further restrictions. β 0 ) = 0 (9. The variables zi may be components and functions of xi .Chapter 9 Generalized Method of Moments 9. x. We call r the number of overidentifying restrictions. In this case. otherwise it is overidentified. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. z. is not necessarily efficient. with ≥ k. In our previous example. β) = x(y − x0 β). Let g(y. Now suppose that we are given the information that β 2 = 0. As an important special case we will devote special attention to linear moment condition models. This situation is called overidentified. as their are restrictions in E (xi ei ) = 0. β 0 ) = x(y − z 0 β) 106 (9. 1 this class of models are called moment condition models. these are known as estimating equations. This method. If k = the model is just identified. x. g(y. xi . but this is not required.

let Jn (β) = n · g n (β)0 Wn g n (β). ¡ ¢−1 0 ˆ Z XWn X 0 Y. β GMM = Z 0 XWn X 0 Z 9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . i i . but this is generally not possible when > k. This is a non-negative measure of the “length” of the vector g n (β).2) g n (β) = (9. β ˆ Note that if k = . gi (β) = xi yi − zi β = n n n i=1 i=1 Define the sample analog of (9.2.1 β GMM = argmin Jn (β). β GMM does not change.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . 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. 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 .2. then g n (β) = 0. the dependence is only up to scale. for if Wn is replaced ˆ by cWn for some c > 0.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Proposition 9. The GMM estimator minimizes Jn (β). the square of the Euclidean length. For some × weight matrix Wn > 0. and the GMM estimator is the MME. The idea of the generalized method of moments (GMM) is to define an estimator which sets g n (β) “close” to zero. For example. then.9. ˆ Definition 9. if Wn = I.3) The method of moments estimator for β is defined as the parameter value which sets g n (β) = 0. Let and where gi = xi ei .

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

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

Identification requires l ≥ k = dim(β). this is all that is known. 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. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. For example.1 Under general regularity conditions. 1 it is possible that β 2 6= 0. and then β recomputed. and if the weight matrix is asymptotically efficient. so that the linear equation may be written as yi = β 0 x1i + ei . Under the hypothesis of correct specification. Hansen (1982). 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 .6. n β − β →d N 0. Theorem 9. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). The general theory of GMM estimation and testing was exposited by L. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. perhaps obtained by first ˆ setting Wn = I.5.6 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 . i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . 110 . ˆˆ n is a quadratic form in g n . Since the GMM estimator depends upon the first-stage estimator. This estimator can be iterated if needed. The variance of β may be estimated by G0 Ω−1 G where P ∗ ∗0 P ∂ ˆ ˆ ˆ g g and G = n−1 ˆ ˆ Ω = n−1 0 gi (β). G0 Ω−1 G .1 (Sargan-Hansen). and is thus a natural test statistic for H0 : Egi = 0.Often. Thus the model — the overidentifying restrictions — are testable. However. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = à 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. ˆ J = J(β) →d χ2−k . often the weight ˆ matrix Wn is updated. 9. Note that g n →p Egi . and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. 1 2 It is possible that β 2 = 0. β) = 0 holds.

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

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

note that the efficient instrument Ai involves the estimation of the conditional mean of zi given xi . so ˆ Since i=1 pi gi β no recentering or adjustments are needed. The efficient instrument is also inversely proportional to the conditional variance of ei .and so In the case of linear regression. so Ai = σ −2 xi . Thus according to ∗ . i ¡ ¢ σ 2 = E e2 | xi . the bootstrap applied J test will yield the wrong answer. 1 ´ Pn ˆ = 0.9 Bootstrap GMM Inference ˆ Let β be the 2SLS or GMM estimator of β. jeopardizing the theoretical justification for percentile-t methods. 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. . This has been shown by Hahn (1996). ˆ where g n (β) is from the in-sample data. i i 9. as we i discussed earlier in the course. 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. and define all statistics and tests accordingly. In the linear model. However. we need the best conditional mean model for zi given xi . Given the bootstrap sample (Y ∗ . They note that we can sample from the p observations {w³. 113 . not just an arbitrary linear projection. Using the EDF of (yi .. random variables (yi i i n ³ ³ ´´ ˆ ˆ E gi β = g n (β) 6= 0. it fails to achieve an asymptotic refinement when the model is over-identified. there are very few empirical applications of bootstrap GMM. ˆ Brown and Newey (2002) have an alternative solution. xi ... caution should be applied when interpreting such results. and construct confidence intervals for β. The bootstrap J statistic is J ∗ (β ). Z ∗ ). to get the best instrument for zi . A correction suggested by Hall and Horowitz (1996) can solve the problem. However. we can apply the ˆ bootstrap methods discussed in Chapter 8 to compute estimates of the bias and variance of β. Brown and Newey argue that this bootstrap procedure will be more efficient than the Hall-Horowitz GMM bootstrap. wn } with the empirical likelihood probabilities {ˆi } described in Chapter X. In the case of endogenous variables. as this is a very new area of research. ∗ ˆ Let β minimize J ∗ (β). X ∗ . this sampling scheme preserves the moment conditions of the model. identically as in the regression model. To date. z ∗ ) drawn from the EDF F . this implies that the bootstrap estimator is ¢−1 ¡ ∗0 ∗ ∗ ¡ ∗0 ∗ ¡ ¢¢ ˆ∗ Z X W X Y − X 0e . not from the bootstrap data. β is the “true” value and yet g n (β) 6= 0. zi ). In other words. Furthermore. This is the same as the GLS estimator. namely that improved efficiency can be obtained if the observations are weighted inversely to the conditional variance of the errors. zi = xi . Hence efficient GMM is GLS. Ai = σ −2 E (zi | xi ) . x∗ . A straightforward application of the nonparametric bootstrap works in the sense of consistently achieving the first-order asymptotic distribution. ˆ ˆ The problem is that in the sample.

114 . A = H 0 I − G G0 G (d) Show that A is positive semidefinite. i 0 0ˆ ˆ 3.9. Write out the matrix A. Show that V0 = Q0 Ω−1 Q . Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. ˆ ˆ Find the method of moments estimators (β. Take the model E (zi ηi ) = 0. we know that V − V0 is positive semi-definite if and only if V0−1 − V −1 = A is positive semi-definite. 2. (b) We want to show that for any W. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0. and therefore positive semidefinite. γ ) for (β. (c) Since Ω is positive definite. Take the model yi = zi β + ei with E (xi ei ) = 0. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . Show that Wn →p Ω i i i 4. Let ei = yi − zi β where β is consistent for ˆ β (e. Letting H = CQ and G = C 0−1 W Q. there exists a nonsingular matrix C such that C 0 C = Ω−1 . verify that A can be written as ³ ¡ ¢−1 0 ´ G H. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ).10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1.g. In the linear model estimated by GMM with general weight matrix W. a GMM estimator with arbitrary weight matrix). 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 . Define the estimate of the optimal GMM weight matrix à n !−1 1X 0 2 xi xi ei ˆ . From matrix algebra. γ). Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . V − V0 is positive semi-definite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the efficient weight matrix).

The observed data is (yi . 6.6) (a) Show that you can rewrite Jn (β) in (9. VR ) where ¡ ¢−1 0 R V. The equation of interest is yi = g(xi . h(β)=0 (9. Show how to construct an efficient GMM estimator for β. Define the Lagrangian L(β.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . Vn = X X i=1 ˜ and hence R0 β = r. Thus ˜ β = argmin Jn (β) R0 β−r à n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. 115 . l ≥ k. 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 . is defined as Jn (β) = ˜ β = argmin Jn (β). the distance statistic D in (9. the Generalized Method of Moments (GMM) criterion function for β is defined as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. In the linear model Y = Xβ + e with E(xi ei ) = 0. VR = V − V R R0 V R (d) Show that in this setting. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). The GMM estimator of β.5. β) + ei E (zi ei ) = 0. zi is l × 1 and β is k × 1.5) 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. subject ˆ i ˆi i=1 to the restriction h(β) = 0. zi ).6) equals the Wald statistic. xi .

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

. It is a non-parametric analog of likelihood estimation. xi . The n first order conditions are 0 = p−1 − µ..1) i=1 First let us consider a just-identified model.. (10.. To be a valid multinomial distribution.. The maximum likelihood estimator of the probabilities (p1 .3) i=1 117 .Chapter 10 Empirical Likelihood 10. 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 . . 2001) and has been extended to moment condition models by Qin and Lawless (1994).1).. The idea is to construct a multinomial distribution F (p1 . pn ) are those which maximize the log-likelihood subject to the constraint (10. This is equivalent to maximizing à n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier. (10.1 Non-Parametric Likelihood Since each observation is observed once in the sample. β). The idea is due to Art Owen (1988. xi . The multinomial distribution which places probability pi at each observation (yi . zi ....2) Ln (p1 . the log-likelihood function for this multinomial distribution is n X ln(pi ). . Combined with i the constraint (10. pn ) which places probability pi at each observation. pn ) = i=1 An alternative to GMM is empirical likelihood. In this case the moment condition places no additional restrictions on the multinomial distribution. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10.1) we find that the MLE is pi = n−1 yielding the log-likelihood −n log(n).. these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1.

where λ and µ are Lagrange multipliers. and using the second and third equations. we find µ = n and 1 ¢. The solution cannot be obtained explicitly.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. λ) : λ(β) = argmin Rn (β. 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 . µ. The solution (when it exists) is well defined since Rn (β. pn . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). pi gi (β) = 0. The Lagrangian for this maximization problem is à n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β.5) This minimization problem is the dual of the constrained maximization problem. or equivalently minimizes its negative ˆ (10.5). but must be obtained numerically (see section 6. λ ¡ ¢ ln 1 + λ0 gi (β) .5) ˆ ˆ As a by-product of estimation. p1 .. summing over i. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we find n Rn (β.3). (see section 6. probabilities 1 ³ ´´ .1) and (10. p (10. . Multiplying the first equation by pi .4) (10. (10.7) 118 . the Lagrange multiplier λ(β) minimizes Rn (β. This yields the (profile) empirical log-likelihood function for β. Ln (β) = Rn (β. The first-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. λ.. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . λ) is a convex function of λ. λ)..2) subject to the restrictions (10. we also obtain the Lagrange multiplier λ = λ(β).

´ √ 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 .11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . λ) = − (10. ˆ The asymptotic variance V for β is the same as for efficient GMM. Thus the EL estimator is asymptotically efficient.9) (10.2 Define Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . β) = −xi zi . and Ω = E xi x0 e2 . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. 0 = Rn (β.10) ¡ Ω−1 N (0. i=1 i=1 i=1i Expanding (10.10). G = −E (xi zi ).9) and (10. n (10. β λ ∂ ³ ´.13) Premultiplying by G0 Ω−1 and using (10.1 Under regularity conditions.10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . in the linear model. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are defined in (10. i i Theorem 10. ˆ ˆ Proof.8) and ¢ 0 0 For example.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. Gi (.2. (β. λ) = − (10.13) yields n n Expanding (10. and n β − β 0 and nλ are asymptotically independent.

and (10. LRn = i=1 Theorem 10.15) 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. β 0 ) = 0 then LRn →d χ2−k . n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . They are asymptotically first-order equivalent. The same statistic can be constructed for empirical likelihood. The EL overidentification test is similar to the GMM overidentification test. 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. it is an asymptotically efficient estimator for β. 120 . (10.16). Twice the difference between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.1 If Eg(wi .3.15) (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. Proof. and it is advisable to report the statistic LRn whenever EL is the estimation method. Since the EL estimator achieves this bound. by a Taylor expansion.7) is n ³ ´´ ³ X ˆ ˆ0 (10. 10. The overidentification test is a very useful by-product of EL estimation. Ω) GΩ G →d = N (0. First. V ) ˆ Solving (10.14) for λ and using (10.3 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 . and have the same interpretation. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.15). Vλ ) Furthermore.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. tests are based on the difference in the log likelihood functions. ¥ Chamberlain (1987) showed that V is the semiparametric efficiency bound for β in the overidentified moment condition model.17) 2 ln 1 + λ gi β .

4.18) Let the maintained model be where g is × 1 and β is k × 1.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).wisc. LRn →d χ2 . Theorem 10. 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 (0.1 Under (10. This test statistic is a natural analog of the GMM distance statistic. a The proof of this result is more challenging and is omitted.4 Testing Egi (β) = 0 (10.edu/~bhansen/progs/elike.18) and H0 : h(β) = 0. Instead we use the difference in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). since ln(1 + x) ' x − x2 /2 for x small.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. so there is no fundamental change in the distribution theory for β relative to β.ssc. By “maintained” we mean that the overidentfying restrictions contained in (10. 10. Vλ ) ¥ where the proof of the final equality is left as an exercise. h(β)=0 ˜ Fundamentally. The hypothesis of interest is h(β) = 0. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. To test the hypothesis h(β) while maintaining (10.prc 121 . Vλ )0 Ω−1 N (0.18). where h : Rk → Ra .Second. the simple overidentifying restrictions test (10.

. Efficient convergence requires a good choice of steplength δ. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) G∗ (β. The modified Newton method takes a quadratic approximation to Rn (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λj ))−1 Rλ (β. λ) G∗ (β. λj )) Rp = Rn (β. λ) .19). The iteration (10. λ) ∂λ i=1 n ∂ Rn (β. The starting value λ1 can be set to the zero vector. λ)0 0 Rn (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. One method uses the following quadratic approximation.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. λ) = − ∂β n X i=1 G∗ (β. δ 1 = 1 and δ 2 = 1. 1. λ)0 − ∂β∂β Rn (β. λp ) A quadratic function can be fit exactly through these three points.19) is continued until the gradient Rλ (β. λ) = − gi (β. λ) = G∗ (β. For p = 0. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λj ) is smaller than some prespecified tolerance. λ) gi (β. λj ))−1 Rλ (β.19) X ∂2 ∗ ∗ gi (β. 2.4).Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ)0 − Rn (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λj ) . λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. Set δ 0 = 0. set 2 λp = λj − δ p (Rλλ (β. λ) = i The first derivatives of (10. Define ∗ gi (β. (10.20) .5) for given β.

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

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

1) where zi is k × 1. and assume that E(zi ei ) 6= 0 so there is endogeneity. 11. We call (11. Definition 11.1). By the above definition. β →p β ∗ . ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. In matrix notation. z1i is an instrumental variable for (11. In a typical set-up. (11. this can be written as Y = Zβ + e. at least the intercept). So we have the partition µ ¶ z1i k1 (11. some regressors in zi will be uncorrelated with ei (for example. That is x2i are variables which could be included in the equation for yi (in the sense 125 .1) if E (xi ei ) = 0. Thus we make the partition ¶ µ k1 z1i (11. so should be included in xi . This is called simultaneous equations bias.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1 The × 1 random vector xi is an instrumental variable for (11.1) the structural equation.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. and x2i are the excluded exogenous variables.1.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.2) Any solution to the problem of endogeneity requires additional information which we call instruments. which does not equal either β 1 or β 2 . We call z1i exogenous and z2i endogenous.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 ¶ .

that they are uncorrelated with ei ) yet can be excluded, as they would have true zero coefficients in the equation. The model is just-identified if = k (i.e., if 2 = k2 ) and over-identified if > k (i.e., if 2 > k2 ). We have noted that any solution to the problem of endogeneity requires instruments. This does not mean that valid instruments actually exist.

11.2

Reduced Form

The reduced form relationship between the variables or “regressors” zi and the instruments xi is found by linear projection. Let ¡ ¢−1 ¡ 0 ¢ E xi zi Γ = E xi x0 i be the × k matrix of coefficients from a projection of zi on xi , and define ui = zi − x0 Γ i as the projection error. Then the reduced form linear relationship between zi and xi is zi = Γ0 xi + ui . In matrix notation, we can write (11.5) as Z = XΓ + u where u is n × k. By construction, E(xi u0 ) = 0, i so (11.5) is a projection and can be estimated by OLS: ˆ ˆ Z = XΓ + u ¡ 0 ¢−1 ¡ 0 ¢ ˆ XZ . Γ = XX Y = (XΓ + u) β + e = Xλ + v, where λ = Γβ and v = uβ + e. Observe that ¡ ¢ E (xi vi ) = E xi u0 β + E (xi ei ) = 0. i ˆ ˆ Y = X λ + v, ¡ 0 ¢−1 ¡ 0 ¢ ˆ λ = XX XY 126 (11.8) (11.7) (11.6) (11.5)

Substituting (11.6) into (11.2), we find

Thus (11.7) is a projection equation and may be estimated by OLS. This is

The equation (11.7) is the reduced form for Y. (11.6) and (11.7) together are the reduced form equations for the system Y = Xλ + v Z = XΓ + u. ˆ ˆ As we showed above, OLS yields the reduced-form estimates (λ, Γ)

11.3

Identification

The structural parameter β relates to (λ, Γ) through (11.8). The parameter β is identified, meaning that it can be recovered from the reduced form, if rank(Γ) = k. (11.9) Assume that (11.9) holds. If = k, then β = Γ−1 λ. If > k, then for any W > 0, β = (Γ0 W Γ)−1 Γ0 W λ. If (11.9) is not satisfied, then β cannot be recovered from (λ, Γ). Note that a necessary (although not sufficient) condition for (11.9) is ≥ k. Since X and Z have the common variables X1 , we can rewrite some of the expressions. Using (11.3) and (11.4) to make the matrix partitions X = [X1 , X2 ] and Z = [X1 , Z2 ], we can partition Γ as ∙ ¸ Γ11 Γ12 Γ = Γ21 Γ22 ∙ ¸ I Γ12 = 0 Γ22 (11.6) can be rewritten as Z1 = X1 Z2 = X1 Γ12 + X2 Γ22 + u2 . (11.10) β is identified if rank(Γ) = k, which is true if and only if rank(Γ22 ) = k2 (by the upperdiagonal structure of Γ). Thus the key to identification of the model rests on the 2 × k2 matrix Γ22 in (11.10).

11.4

Estimation
0 yi = zi β + ei

The model can be written as E (xi ei ) = 0 or Eg (wi , β) = 0 ¢ ¡ 0 g (wi , β) = xi yi − zi β .

This a moment condition model. Appropriate estimators include GMM and EL. The estimators and distribution theory developed in those Chapter 8 and 9 directly apply. Recall that the GMM estimator, for given weight matrix Wn , is ¡ ¢−1 0 ˆ β = Z 0 XWn X 0 Z Z XWn X 0 Y. 127

11.5

Special Cases: IV and 2SLS

This estimator is often called the instrumental variables estimator (IV) of β, where X is used as an instrument for Z. Observe that the weight matrix Wn has disappeared. In the just-identified case, the weight matrix places no role. This is also the MME estimator of β, and the EL estimator. Another interpretation stems from the fact that since β = Γ−1 λ, we can construct the Indirect Least Squares (ILS) estimator: ˆ ˆ ˆ β = Γ−1 λ ³¡ ¢−1 ¡ 0 ¢´−1 ³¡ 0 ¢−1 ¡ 0 ¢´ XX XZ XY = X 0X ¡ 0 ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 ¡ 0 ¢ = XZ XX XX XY ¡ 0 ¢−1 ¡ 0 ¢ = XZ XY .

If the model is just-identified, so that k = , then the formula for GMM simplifies. We find that ¡ ¢−1 0 ˆ β = Z 0 XWn X 0 Z Z XWn X 0 Y ¡ ¢−1 −1 ¡ 0 ¢−1 0 = X 0Z Wn Z X Z XWn X 0 Y ¡ ¢−1 0 = X 0Z XY

which again is the IV estimator.

¡ ¢ Recall that the optimal weight matrix is an estimate of the inverse of Ω = E xi x0 e2 . In the i i ¢ ¡ 2 special case that E ei | xi = σ 2 (homoskedasticity), then Ω = E (xi x0 ) σ 2 ∝ E (xi x0 ) suggesting i i the weight matrix Wn = (X 0 X)−1 . Using this choice, the GMM estimator equals ³ ¡ ¢−1 0 ´−1 0 ¡ 0 ¢−1 0 ˆ β 2SLS = Z 0 X X 0 X XZ ZX XX XY

then

This is called the two-stage-least squares (2SLS) estimator. It was originally proposed by Theil (1953) and Basmann (1957), and is the classic estimator for linear equations with instruments. Under the homoskedasticity assumption, the 2SLS estimator is efficient GMM, but otherwise it is inefficient. It is useful to observe that writing ¡ ¢−1 0 X, PX = X X 0 X ¡ 0 ¢−1 0 ˆ X Z, Z = PX Z = X X X ˆ β = ¢−1 0 Z PX Y Z 0 PX Z ´ ³ ˆ ˆ ˆ = Z 0 Z Z 0 Y. ¡

The source of the “two-stage” name is since it can be computed as follows ˆ ˆ ˆ • First regress Z on X, vis., Γ = (X 0 X)−1 (X 0 Z) and Z = X Γ = PX Z. ³ ´−1 ˆ ˆ ˆ ˆ ˆ • Second, regress Y on Z, vis., β = Z 0 Z Z 0 Y. 128

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

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. except when S21 = 0 (when Z is exogenous). the bias in the 2SLS estimator will be large.Let PX = X (X 0 X)−1 X 0 . The consequences of identification failure for inference are quite severe.13). indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases.14) is the probability limit of β 2SLS − β 11. 0). 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 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .12) and this result. The parameter β fails to be identified if Γ22 has deficient rank. 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. 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 . n and (11.14) In general this is non-zero. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. Indeed as α → 1. P = HΛH 0 0 0 where Λ = diag(Il . l . Let q = H 0 ξS −1/2 which satisfies Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 130 .7 Identification Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .14) approaches that in (11. By the spectral decomposition of an idempotent matrix. It is also close to zero when α = 0.

meaning that inferences about parameters of interest can be misleading. This can be handled in an asymptotic analysis by modeling it as local-to-zero. standard test statistics have non-standard asymptotic distribution of β distributions. N2 since the ratio of two normals is Cauchy. 131 . Qc + N2 ˆ As in the case of complete identification failure. Suppose that identification does not complete fail. Thus identification hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. E x2 u2 i i n n i=1 i=1 n n (11. In addition.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 . Suppose this condition fails. once again take the simple case k = l = 1.15) is unaffected.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. and was examined by Phillips (1989) and Choi and Phillips (1992). E x2 e2 i i n i=1 n (11. Then (11. but is weak. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. Here. To see the consequences. This result carries over to more general settings. viz Γ22 = n−1/2 C. as the Cauchy distribution does not have a finite mean. which occurs i when E (zi xi ) 6= 0.Take the simplest case where k = l = 1 (so there is no X1 ). so E (zi xi ) = 0. the instrument xi is weak for zi if γ = n−1/2 c. This is particularly nasty. but small. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . We see that β is identified if and only if Γ22 = γ 6= 0. where C is a full rank matrix. we find that β is inconsistent for β and the ˆ is non-normal. but (11. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. This occurs when Γ22 is full rank.

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

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

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

1. t = 1. The following two theorems are essential to the analysis of stationary time series.. Theorem 12. Yt−k ) is the autocorrelation function. . Yt−k ) = γ(k) is independent of t for all k.. Definition 12. Because of the sequential nature of time series. ..Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.1. we adopt new notation.. then Xt is strictly stationary and ergodic.1. and T to denote the number of observations. We can separate time series into two categories: univariate (yt ∈ R is scalar). and multivariate (yt ∈ Rm is vector-valued).1 Stationarity and Ergodicity Definition 12.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.2 {Yt } is strictly stationary if the joint distribution of (Yt . 135 .. The primary model for multivariate time series is vector autoregressions (VARs). γ(k) is called the autocovariance function. Yt−1 ..4 (loose).1.) is a random variable. and use the subscript t to denote the individual observation. . There proofs are rather difficult. however. A stationary time series is ergodic if γ(k) → 0 as k → ∞. Definition 12. Yt−k ) is independent of t for all k.. and Cov (Yt . so classical assumptions are not valid. To indicate the dependence on time. The primary model for univariate time series is autoregressions (ARs).3 ρ(k) = γ(k)/γ(0) = Corr(Yt . we expect that Yt and Yt−1 are not independent..1 If Yt is strictly stationary and ergodic and Xt = f (Yt .1. T . 12. Definition 12.

then as T → ∞. ˆ Proof. and it has a finite mean by the assumption that EYt2 < ∞. the sequence Yt Yt−k is strictly stationary and ergodic. ˆ ˆ γ ¥ 136 . 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) . For Part (2). ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. 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 t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). γ (0) ˆ Theorem 12. γ (k) →p γ(k).1.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ˆ 3.Theorem 12. ˆ 2. 1.1. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . Part (1) is a direct consequence of the Ergodic theorem. µ →p E(Yt ). T 1X Xt →p E(Xt ).2 (Ergodic Theorem).1 above. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). If Xt is strictly stationary and ergodic and E |Xt | < ∞.1. then as T → ∞. ρ(k) →p ρ(k).

. should be a MDS. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 ... t By back-substitution.2 Autoregressions In time-series. or consumption growth rates.12. Y2 . This occurs when |ρ| < 1.. ∞ X = ρk et−k . Definition 12.1 et is a martingale difference sequence (MDS) if E (et | It−1 ) = 0.. YT . the series {. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS.. 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. some versions of the life-cycle hypothesis imply that either changes in consumption. In fact. . 12. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. Some time-series processes may be a MDS as a consequence of optimizing behavior. E(et ) = 0 and Ee2 = σ 2 < ∞.... E(Yt−k et ) = 0. as it is difficult to derive distribution theories without this property.. Regression errors are naturally a MDS. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . this series converges if the sequence ρk et−k gets small as k → ∞..3 Stationarity of AR(1) Process Yt = ρYt−1 + et . . A mean-zero AR(1) is Assume that et is iid.. Yt−k ) . An autoregressive (AR) model specifies that only a finite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . 137 . it is even more important in the time-series context. we find Yt = et + ρet−1 + ρ2 et−2 + .. Thus for k > 0. . 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 . Yt−2 . .} is the past history of the series. Letting et = Yt − E (Yt | It−1 ) . Y1 . For example. k=0 Loosely speaking.2. The last property defines a special time-series process..} are jointly random..

the above results are unchanged. an AR(1) is stationary iff |ρ| < 1. Lk Yt = Yt−k .Theorem 12.3. Defining L2 = LL. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et .3. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. We call ρ(L) the autoregressive polynomial of Yt . and solving for EYt = EYt−1 we find EYt = α/(1 − ρ). 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.1. In general. ∞ X k=0 ρ2k V ar (et−k ) = 12. we see that L2 Yt = LYt−1 = Yt−2 .1 The lag operator L satisfies LYt = Yt−1 .4. From Theorem 12. We can compute the moments of Yt using the infinite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . We say that the root of the polynomial is 1/ρ. The AR(k) model is Using the lag operator. Note that an equivalent way to say this is that an AR(1) is stationary iff the root of the autoregressive polynomial is larger than one (in absolute value). We call ρ(L) the autoregressive polynomial of Yt . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . Definition 12.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . since ρ(z) = 0 when z = 1/ρ. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . 138 .

The vector xt is strictly stationary and ergodic. For an AR(k). ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. By Theorem 12. This is a special case of non-stationarity. t T t=1 T t=1 139 . Note that ut is a MDS. . Thus t by the Ergodic Theorem. and is of great interest in applied time series.1) Theorem 12. Let |λ| denote the modulus of a complex number λ.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞.. λk are the complex roots of ρ(z). “has a unit root”. so is xt x0 . β = X 0X (12. we see that à !−1 à ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. and hence Yt . which satisfy ρ(λj ) = 0.1. then ˆ β →p β as T → ∞. t t T t=1 ¥ Combined with (12.6. Theorem 12.5..1. and by Theorem 12. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.1. One way of stating this is that “All roots lie outside the unit circle.where the λ1 .” If one of the roots equals 1. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. it is also strictly stationary and ergodic.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . it is helpful to define the process ut = xt et .. Proof. We know that an AR(1) is stationary iff the absolute value of the root of its autoregressive polynomial is larger than one. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. we say that ρ(L). t Yt−k ¢0 ρk . the requirement is that all roots are larger than one.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.1) and the continuous mapping theorem.1. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.

Clearly. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . which may be different than the i properties of the actual ei . as this imposes inappropriate independence. This is identical in form to the asymptotic distribution of OLS in cross-section regression. there are two popular methods to implement bootstrap resampling for time-series data. 12. Method 1: Model-Based (Parametric) Bootstrap. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. In particular.7 Asymptotic Distribution Theorem 12. t This construction imposes homoskedasticity on the errors e∗ . t then as T → ∞. Fix an initial condition (Y−k+1 .1 MDS CLT.1 to see that T 1 X √ xt et →d N (0.7. .12. 140 . i 4. 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∗ . T 1 X √ ut →d N (0.8 Bootstrap for Autoregressions In the non-parametric bootstrap. Y−k+2 .2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Q−1 ΩQ−1 . this cannot work in a time-series application.. The implication is that asymptotic inference is the same. e ˆ 3. ˆ 1. It also presumes that the AR(k) structure is the truth. T t=1 where Ω = E(xt x0 e2 ).. eT }. This creates an iid bootstrap sample.. Ω) . t t Theorem 12. . ˆ 2.. Divide the sample into T /m blocks of length m.7. Ω) . Method 2: Block Resampling 1. the asymptotic covariance matrix is estimated just as in the cross-section case... Y0 ). xt }. we constructed the bootstrap sample by randomly resampling from the data values {yt . then as T → ∞.7. we can apply Theorem 12. T t=1 Since xt et is a MDS. Estimate β and residuals et . Briefly.

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

and then reserve the first k as initial conditions. AR(2).6). and under H1 it is an AR(2).. if the null hypothesis is that Yt is an AR(k). The best remedy is to fix a upper value k. Thus under H0 .5) and (12.. In general. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). you need more initial conditions.. we take (12. AIC(k) = log σ 2 (k) + ˆ 2k .6) 12. 142 . T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in defining the AIC criterion is that the sample available for estimation changes as k changes. One approach to model selection is to choose k based on a Wald tests. Yt−k−m are jointly zero.10 Testing for Omitted Serial Correlation For simplicity.. . (A simple exclusion test). Another is to minimize the AIC or BIC information criterion. An appropriate test is the Wald test of this restriction.) This can induce strange behavior in the AIC.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. to find Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .g. . let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . To combine (12. AR(k) on this (unified) sample.12. An appropriate test of H0 against H1 is therefore a Wald test that the coefficient on Yt−2 is zero. We then multiply this by θ and subtract from (12.. (12. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 .5). H0 may be expressed as the restriction that the coefficient on Yt−2 is zero. (If you increase k. Yt is an AR(1).. and the alternative is that the error is an AR(m). and this is equivalent to the restriction that the coefficients on Yt−k−1 . We model this as an AR(1): ut = θut−1 + et with et a MDS. (12. and then estimate the models AR(1).5) We are interested in the question if the error ut is serially correlated. We want to test H0 against H1 . e. this is the same as saying that under the alternative Yt is an AR(k+m).

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

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

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

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

which is called a common factor restriction. it is convenient to re-define the variables. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). j Often.2) is a special case of (13. and simple way to test for omitted serial correlation is to test the significance of extra lagged values of the dependent variable and regressors. Then the single equation takes the form (13. 147 .) Since the common factor restriction appears arbitrary. Otherwise it is invalid. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i .1). and is still routinely reported by conventional regression packages. In this case. the model (13. If valid. We see that an appropriate. and subtract off the equation once lagged multiplied by θ.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. t or yt = θyt−1 + x0 β + x0 γ + ut . This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. t and xt = This is just a conventional regression.1) yt = x0 β + et . Another interesting fact is that (13. may be tested if desired. general. 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 . under the restriction γ = −βθ. (13. Let et = ejt and β = aj .2) Take the equation yt = x0 β + et . You may have heard of the Durbin-Watson test for omitted serial correlation. Let yt = Yjt . which once was very popular. t and et is iid N (0. So testing H0 versus H1 is equivalent to testing for the significance of adding (yt−1 . This can be done by a Wald test. Suppose that et is an AR(1). direct estimation of (13.3) which is a valid regression model. (A simple version of this estimator is called Cochrane-Orcutt. with time series data.2) is uncommon in recent applications. we are only interested in a single equation out of a VAR system. 13. t t−1 (13. and is typically rejected empirically. 1).4 Single Equation from a VAR Yjt = a0 xt + et . and Zt be the other variables. This restriction. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.2) may be estimated by iterated GLS. xt−1 ) to the regression.13.3).

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

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

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

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

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

1. 2. The functional form for λi has been picked to ensure that λi > 0. the consumption level (purchases) in a particular period was zero. 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. this motivates the label Poisson “regression. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . i so the model imposes the restriction that the conditional mean and variance of Yi are the same. a typical approach is to employ Poisson regression. This model (now called the Tobit) specifies that the latent (or ideal) value of consumption may be negative (the household 153 .1). The conditional density is the Poisson with parameter λi .. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. . k! = exp(x0 β). A generalization is the negative binomial. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.1) yi = ∗ <0 . He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0..) The observed data yi therefore come from a mixed continuous/discrete distribution.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). Thus the model is that there is some latent process yi with unbounded support. 2. incomes above a threshold are typically reported at the threshold.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. . i If Y = {0.14. 0 if yi (This is written for the case of the threshold being zero.2 Count Data exp (−λi ) λk i . This model specifies that P (Yi = k | xi ) = λi k = 0. i i i=1 ˆ The MLE is the value β which maximizes ln (β). In surveys. 14. The first censored regression model was developed by Tobin (1958) to explain consumption of durable goods.. The censoring process may be explicit in data collection. σ 2 ) with the observed variable yi generated by the censoring equation (14. or it may be a by-product of economic constraints..}. 1. This may be considered restrictive. Tobin observed that for many households. An example of a data collection censoring is top-coding of income. any known value can substitute.

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

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

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

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

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

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

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

The bandwidth h controls the meaning of “near”. It follows that the variance of the density f (x) is à 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. then the weights are small and f ˆ ˆ Interestingly. f (x) ≥ 0 for all x. The second moment of the estimated density is Z ∞ n Z 1X ∞ 2 2ˆ x f (x)dx = x Kh (Xi − x) dx n −∞ i=1 −∞ n Z 1X ∞ = (Xi + uh)2 K (u) du n −∞ i=1 Z ∞ Z n n n X 2X 1X 2 ∞ 2 1 2 Xi + Xi h K(u)du + h u K (u) du = n n n −∞ −∞ = where σ2 = K 1 n i=1 n X i=1 i=1 i=1 Xi2 + h2 σ 2 K Z ∞ x2 K (x) dx ˆ is the variance of the kernel. 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 . if only a few Xi are near x. f (x) is a valid density. If a large number of the observations Xi are near ˆ x. Conversely.This estimator is the average of a set of weights. That is. where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h. 161 . ˆ(x) is small. 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. then the weights are relatively large and f (x) is larger. ˆ We can also calculate the moments of the density f (x).

the estimator f (x) smooths data local to Xi = x. ˆ the greater the bias. so is estimating a smoothed version of f (x). This integral (typically) is not analytically solvable. 162 .16.2 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. 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). The sharper the derivative. The last expression shows that the expected value is an average of f (z) locally about x. nh (x)2 dx is called the roughness of K. so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. The bias results from this smoothing. and is larger the greater the curvature in 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 . which is valid as h → 0. using first-order Taylor approximations and the fact that n−1 is of smaller order than (nh)−1 V ar (x) = = ' = ' = where R(K) = R∞ −∞ K 1 V ar (Kh (Xi − x)) n 1 1 EKh (Xi − x)2 − (EKh (Xi − x))2 n n ¶ Z ∞ µ z−x 2 1 1 K f (z)dz − f (x)2 2 nh −∞ h n Z ∞ 1 K (u)2 f (x + hu) du nh −∞ Z f (x) ∞ K (u)2 du nh −∞ f (x) R(K) . 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . Intuitively. Since it is an average of iid random variables.

(16.06n−1/5 163 . 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 . ˆ It uses formula (16. The first two are determined by the kernel function.1) is an asymptotic approximation to the MSE. we find the reference rules for the three kernel functions introduced earlier.2) depends on R(K). how should the bandwidth be selected? This is a difficult problem. Thus for the AMISE to decline with n. where φ is the N (0. 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 ). Their K values for the three functions introduced in the previous section are given here. and R(f 00 ). A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. Notice that the first term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. We can calculate that √ R(φ00 ) = 3/ (8 π) . 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. Note that this h declines to zero. We define the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. but at a very slow rate. but not of n.2) but replaces R(f 00 ) with σ −5 R(φ00 ).2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. Equation (16.Together. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). h must tend to zero. σ 2 . In practice. The downside is that if the density is very far from normal. (16. we need h → 0 but nh → ∞. and there is a large and continuing literature on the subject. The asymptotically optimal choice given in (16. This choice for h gives an optimal rule when f (x) is ˆ normal. Gaussian Kernel: hrule = 1. Together with the above table.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . That is. but at a slower rate than n−1 . and gives a nearly optimal rule when f (x) is close to normal. That is. 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 + . the rule-of-thumb h can be quite inefficient.

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

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

we say that the collection of events A1 . . If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . Furthermore. 49.1) holds. Depending on these two distinctions. there are two important distinctions. Counting may be with replacement or without replacement. For example. Rearranging the definition.. 2. the number of ¡49 if potential combinations is 6 = 13. we have four expressions for the number of objects (possible arrangements) of size r from n objects. the conditional probability function is a valid probability function where S has been replaced by B. and is with replacement if this is allowed. Ã ! \ Y P Ai = P (Ai ) .1) We say that the events A and B are statistically independent when (A. n ≥ r. These counting rules are facilitated by using the binomial coefficients which are defined for nonnegative integers n and r.. Counting may be ordered or unordered. it is useful to have simple rules to count the number of objects in a set. 816. . Ak are mutually independent when for any subset {Ai : i ∈ I}. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery. We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A).• 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.. consider a lottery where you pick six numbers from the set 1... r r! (n − r)! When counting the number of objects in a set.. as µ ¶ n n! = . i∈I i∈I 166 . we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. ¢ counting is unordered and without replacement. 983. in which case we find P (A ∩ B) = P (A) P (B) (A. This selection is without replacement if you are not allowed to select the same number twice. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. P (B) With Replacement nr ¡n+r−1¢ r For any B.

. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. .. of the sample space. The probability function for X takes the form j = 1. Instead. a These expressions only make sense if F (x) is differentiable. these cases are unusualRand are typically ignored.2 Random Variables A random variable X is a function from a sample space S into the real line. r (A.. 167 . we denote random variables by uppercase letters such as X. For a random variable X we define its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. and use lower case letters such as x for potential values and realized values. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. F (x) is nondecreasing in x 3. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. . While there are examples of continuous random variables which do not possess a PDF.. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. We say that the random variable X is continuous if F (x) is continuous in x. we represent the relative probabilities by the probability density function (PDF) f (x) = so that F (x) = and P (a ≤ X ≤ b) = Z d F (x) dx x f (u)du Z b −∞ f (x)dx. For any set B and any partition A1 .Theorem 2 (Bayes’ Rule).. This induces a new sample space — the real line — and a new probability function on the real line. A function F (x) is a CDF if and only if the following three properties hold: 1. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.3) P (X = τ j ) = π j . In the latter case.. Typically. the range of X consists of a countable set of real numbers τ 1 . 2. ... .. (A.3) is unavailable. then for each i = 1. τ r .. A2 .

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

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

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

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

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

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

then the expected value of Y is m(x). which is the same as E (g(X)Y | X) = g (X) E (Y | X) . Similarly. Z) | X) = E (Y | X) Conditioning Theorem.The conditional mean or conditional expectation is the function Z ∞ yfY |X (y | x) dy. if E (Y | X = x) = α + βx. then E (Y | X) = α + βX. Thus h(X) = g(X)m(X). The following are important facts about conditional expectations.8) (A. a transformation of X. E (g(X)Y | X) = g (X) E (Y | X) Proof : Let h(x) = E (g(X)Y | X = x) Z ∞ g(x)yfY |X (y | x) dy = −∞ Z ∞ = g(x) yfY |X (y | x) dy = g(x)m(x) −∞ (A. −∞ −∞ (A. functions of X. Simple Law of Iterated Expectations: E (E (Y | X)) = E (Y ) Proof : E (E (Y | X)) = E (m(X)) Z ∞ m(x)fX (x)dx = Z−∞ Z ∞ ∞ = yfY |X (y | x) fX (x)dydx −∞ −∞ Z ∞Z ∞ = yf (y. For example. the conditional mean m(X) and conditional variance σ 2 (x) are random variables. m(x) = E (Y | X = x) = −∞ The conditional mean m(x) is a function.7) Law of Iterated Expectations: E (E (Y | X.9) where m(x) = E (Y | X = x) . meaning that when X equals x. For any function g(x). we define the conditional variance of Y given X = x as σ 2 (x) = V ar (Y | X = x) ´ ³ = E (Y − m(x))2 | X = x ¢ ¡ = E Y 2 | X = x − m(x)2 . We write this as E(Y | X) = m(X) and V ar (Y | X) = σ 2 (X). x) dydx = E(Y ). Evaluated at x = X. 174 .

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

(A. then using the change-of-variables formula. The latter has no closed-form solution. and it is conventional to write X ∼ N (µ. Σ).11) and is known as the chi-square density with r degrees of freedom. respectively. then by the change-of-variables formula. Theorem A. we can also show that EX 2 = 1 and EX 4 = 3. −∞ < x < ∞. Theorem A. This shows that linear transformations of normals are also normal. It is conventional to write X ∼ N (0.8. If Z is standard normal and X = µ + σZ. σ 2 ). exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . 1). x ∈ Rk . the density of Y is à ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). In this case the density function can be written as j à à !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k à ¡ ¢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.8. Σ) and Y = a + BX with B an invertible matrix. then Σ = diag{σ 2 } is a diagonal matrix. and it is conventional to write X ∼ N(µ. Ir ) and set Q = X 0 X. Its mean and r variance are µ = r and σ 2 = 2r. then Z 0 A−1 Z ∼ χ2 . Since it is symmetric about zero all odd moments are zero. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. denoted χ2 . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . q 176 . X has density à ! (x − µ)2 1 exp − . then they are mutually independent. The mean and variance of the distribution are µ and σ 2 . This shows that if X is multivariate normal with uncorrelated elements. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . f (x) = √ 2σ 2 2πσ which is the univariate normal density. x ∈ Rk . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . ¢ ¡ It useful to observe ¢ that the MGF and CF of the multivariate normal are exp λ0 µ + λ0 Σλ/2 ¡ 0 and exp iλ µ − λ0 Σλ/2 . A) with A > 0. Another useful fact is that if X ∼ N (µ.This density has all moments finite. q × q. y ≥ 0.2 If Z ∼ N(0.1 Let X ∼ N (0. For x ∈ Rk . By iterated integration by parts.

6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .11).2.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). C −1 CC 0 C −10 ) = N (0. q Proof of Theorem A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.1. For Z ∼ N(0. Iq ).13) is the MGF of the density (A.11) 2 with r = 1. 1). Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Set r Z .3 Let Z ∼ N (0. Thus the density of Z 2 is (A. Proof of Theorem A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. The MGF for the density (A.13).8. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. Using the simple law of iterated expectations.Theorem A. 1) and Q ∼ χ2 be independent. which can be found by applying change-of-variables to the gamma function. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.12) E exp (tQ) = 0 Γ (A.8. we see that the MGF of Z 2 is (1 − 2t)−1/2 .3. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. From (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . C −1 AC −10 ) = N (0. which we showed in (A. tr has distribution 177 .8.8. (A.

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

14) ¶ ∂ ∂ 0 ln f (Yi .9.15) Two important features of the likelihood are Theorem A. θ0 ) ln f (Yi . ∂θ ∂θ (A. cases are rare. We can write this as ˆ = argmax Ln (θ).Define the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .16).3 Under regularity conditions. which maximizes the log-likelihood). the restriction to unbiased estimators means that the theorem has little direct relevance for finite sample efficiency. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation.9. we can see that it is an estimator of the maximizer θ of the right-hand-side. More typically. Theorem A.17) is often called the information matrix equality. θ) ≡ L(θ). The first-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . I0 . However. θ Theorem A. θ) →p E ln f (Yi . ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.2 Cramer-Rao Lower Bound. under conventional regularity conditions. θ θ∈Θ ˆ In some simple cases. 179 . then θ V ar(˜ ≥ (nI0 )−1 . but these ˆ must be found by numerical methods. ˆ is consistent θ for this value. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ0 ) ∂θ∂θ 0 (A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.17) The matrix I0 is called the information.9. If ˜ is an unbiased estimator of θ ∈ R.16) (A. θ) ∂θ ∂θ which holds at θ = θ0 by (A. n n i=1 n As the MLE ˆ maximizes the left-hand-side. In fact. and the equality (A. we can find an explicit expression for θ as a function of the data. ˆ →p θ0 as n → ∞. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.1 ¯ ¯ ∂ E ln f (Yi . θ0 ) .

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

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

Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . θn ) = ln f (Yi . θ0 ) →d N (0.3 Taking the first-order condition for maximization of Ln (θ). H −1 ΩH −1 = N 0. If it is continuous in θ.1 . ¥ 182 . the final equality using Theorem A. Ω) = N 0. θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. θ) . an application of the CLT yields 1 X ∂ √ ln f (Yi . and making a first-order Taylor series expansion. Together. θ0 ) + ' 0 ln f (Yi . H −1 . 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 ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . the specific value of θn varies by row in this expansion. θ0 ) is mean-zero with covariance matrix Ω. θ0 ) .9. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . θ n ) θ − θ 0 .Proof of Theorem A. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0.9. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . (Technically. − ln f (Yi . we find ´ ³ ˆ − θ0 = θ Since ∂ ∂θ à !−1 à n ! n X ∂2 X ∂ ln f (Yi . 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 .

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

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

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

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