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

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

1

Contents

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

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

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i

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

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

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

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

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ii

. .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation . 9. . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . 9. . . .1 Instrumental Variables . . . . . . . . . . . 10.3 Distribution of GMM Estimator . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . . . . . iii . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . 11. . . . . . . . . . .11Model Selection . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Lag Operator . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . .12 8. . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . 10. . . . . . . . 9. . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . 11. . . . . . . . . . . . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . 11.8 Conditional Moment Restrictions . . . . . . . . . . . . . 12. . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . .13 One-Sided Tests . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. 9. . . . . . . . . . .1 Overidentiﬁed Linear Model . .2 Reduced Form . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 8.6 Over-Identiﬁcation Test . Percentile Conﬁdence Intervals . 12. . . . . . 9. . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . . .10 8. . . . . . .6 Estimation . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . 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 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . .

. . . . . . . A.1 Binary Choice . . . . . . . . . . . . . . . .2 Estimation . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . 13. . . . . . . . . . . A. . . . . . . . . . . . . 13. . . .2 Gradient Methods . . . . . . . . .3 Censored Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Maximum Likelihood . . . . . .1 Grid Search . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B. . . 157 15. . . . . .3 Expectation . . . . . . . . . . . . . . . . . . . . . iv . . . . . . . .2 Random Variables . . . . . . . . . 14. . 14. . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . A. . . . . . . . . . . . . . . . . B. . .1 Foundations . . . . . . . . . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . .3 Derivative-Free Methods . .6 Conditional Distributions and Expectation . . . . . . . . . . . . . .4 Sample Selection . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.1 Individual-Eﬀects Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . .8 Cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . 159 16 Nonparametrics 160 16. . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . 162 A Probability A. . . . . . . . . . . . . . . . . . . . . . . . . B Numerical Optimization B. . . . . . . . . . .2 Fixed Eﬀects . . . . . . . .8 Normal and Related Distributions . . . . . . . . .3 Restricted VARs .7 Transformations . . . . . . . . . . . . . . A. . . . . .1 Kernel Density Estimation . . . . . . . . 157 15. . . . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . .13 Multivariate Time Series 13. . . . . . . . . . . . . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . .4 Single Equation from a VAR . . . . . . . . . . . . .7 Granger Causality . . . . . . . . . 13. . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . .4 Common Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . .5 Multivariate Random Variables . . . . . 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

If a is a k × 1 vector. . . . ⎦ ⎣ . ⎥ . A square matrix is symmetric if A = A0 . . ⎥ . . a0 b1 a0 b2 · · · k k a0 bs k . then we deﬁne their product AB by writing A as a set of row vectors and B as a set of column vectors (each of length r). . then A0 is r × k. ⎤ ⎡ a11 a21 · · · ak1 ⎢ a12 a22 · · · ak2 ⎥ ⎥ ⎢ B = A0 = ⎢ . vectors and/or scalars. 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. denoted B = A0 . a1r a2r · · · akr £ aj1 aj2 · · · ajr ¤ Thus bij = aji for all i and j. a0 k ⎡ 0 ⎤ a1 b1 a0 b2 · · · a0 bs 1 1 ⎢ a0 b1 a0 b2 · · · a0 bs ⎥ 2 2 ⎢ 2 ⎥ = ⎢ . which implies aij = aji . . and this is the only case where this product is deﬁned. are conformable. Then ⎡ 0 ⎤ a1 ⎢ a0 ⎥ £ ¤ ⎢ 2 ⎥ AB = ⎢ . . . . . . 5 Note that a0 b = b0 a. Ak1 Ak2 · · · Akr where the Aij denote matrices. then a0 is a 1 × k row vector. we say that A and B. If A is k × r and B is r × s. A square matrix is diagonal if the only non-zero elements appear on the diagonal. ⎦ . . A matrix is square if k = r.are column vectors and α0 = j are row vectors. A partitioned matrix takes the form ⎤ ⎡ A11 A12 · · · A1r ⎢ A21 A22 · · · A2r ⎥ ⎥ ⎢ A=⎢ . . Note that if A is k × r. . . . so that aij = 0 if i 6= j. . ⎦ ⎣ . The transpose of a matrix. ⎥ b1 b2 · · · bs ⎣ . ⎦ ⎣ . 2. then their inner product is a0 b = a1 b1 + a2 b2 + · · · + ak bk = aj bj When the number of columns of A equals the number of rows of B. ⎥ . or the product AB. is obtained by ﬂipping the matrix on its 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. ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . For example. are said to be orthogonal if A0 A = Ir . ⎥ . A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . then AIr = A and Ik A = A. . which has ones on the diagonal. We say that two vectors a and b are orthogonal if a0 b = 0. . .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. r ≤ k.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. . . . A square matrix A is called orthogonal if A0 A = Ik . ⎦ ⎣ . The columns of a k × r matrix A. Also. . for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . .

. The following fact about inverting partitioned matrices is sometimes useful. The Moore-Penrose generalized inverse A− satisﬁes (2. . if there is no c 6= 0 such that Ac = 0.3) The matrix A− is not necessarily unique. if A is an orthogonal matrix. 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. . the Moore-Penrose generalized inverse A− exists and is unique. 7 Also. (2. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 .The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . . . or is nonsingular. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . For non-singular A and C. This matrix is called the inverse of A and is denoted by A−1 .4 Inverse A k × k matrix A has full rank.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. In this case there exists a unique matrix B such that AB = BA = Ik . (2.1) . . If A − BD−1 C and D − CA−1 B are non-singular. then A−1 = A.

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

. then its determinant is det A = a11 a22 − a12 a21 .. .. Let π = (j1 .8 Determinant The determinant is deﬁned for square matrices. we deduce that Λ2 = Λ and λ2 = λi for i = 1... . . 2. There are k! such permutations.. xk ) : Rk → R.4) H0 M =H 0 0 with H 0 H = In .. . There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1... k. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2. k) .. we can deﬁne the determinant as follows. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. If A is 2 × 2.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 .By the uniqueness of the characteristic roots. ... i Hence they must equal either 0 or 1. .. . jk ) denote a permutation of (1.... The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . k))... xk ) be k × 1 and g(x) = g(x1 . For a general k × k matrix A = [aij ] . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . Additionally. and let επ = +1 if this count is even and επ = −1 if the count is odd. tr(A) = rank(A). ⎠ .

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

which is a common feature of wage distributions. You can see that the right tail of then density is much thicker than the left tail. ⎠ ⎝ . In the example presented in Figure 3.2) m(x) = E (yi | xi = x) = −∞ In general. (3.22. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. and exists so long as E |yi | < ∞. These are asymmetric (skewed) densities. and that for women is $20. ⎟ . The two density curves show the eﬀect of gender on the distribution of wages. or the covariates. To illustrate. m(x) can take any form. While it is easy to observe that the two densities are unequal. . The data are from the 2004 Current Population Survey 1 11 . holding the other variables constant. xki 3. We call yi the dependent variable. These are conditional density functions — the density of hourly wages conditional on race. xi ) where yi is a scalar (real-valued) and xi is a vector.1. This is used when the goal is to quantify the impact of one set of variables on another variable. gender. In this context we partition the observations into the pair (yi . the mean wage for men is $27.1) xi = ⎜ . we can focus on f (y | x) . the mean is not necessarily a good summary of the central tendency. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. the conditioning variable. education and experience.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. These are indicated in Figure 3. Take a closer look at the density functions displayed in Figure 3. See Chapter 16. it is useful to have numerical measures of the diﬀerence. 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 conditional density of yi given xi .1. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.73.1 by the arrows drawn to the x-axis. When a distribution is skewed.1 displays the density1 of hourly wages for men and women. Figure 3.

By construction.36.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. 2 (3.1 is facilitated by the fact that the control variable (gender) is discrete. the dashed line is a linear projection approximation which will be discussed in the Section 3. When the distribution of the control variable is continuous. To illustrate. and a Ph. For this reason.3) White non-military male wage earners with 10-15 years of potential work experience.2) evaluated at the observed value of xi : ei = yi − m(xi ).Figure 3. wage regressions typically use log wages as a dependent variable rather than the level of wages. The main point to be learned from Figure 3. 3.A. implying an average 36% diﬀerence in wage levels. which implies a 30% average wage diﬀerence for this population. The conditional expectation function is close to linear.2 shows the density of log hourly wages for the same population. Figure 3. then comparisons become more complicated. this yields the formula yi = m(xi ) + ei . degree in mean log hourly wages is 0. 12 . Of particular interest to graduate students may be the observation that diﬀerence between a B. The diﬀerence in the log mean wage between men and women is 0. the solid line displays the conditional expectation of log wages varying with education. The comparison in Figure 3. Assuming for simplicity that this is the true joint distribution.3 displays a scatter plot2 of log wages against education levels.5. with mean log hourly wages drawn in with the arrows.30.3 is how the conditional expectation describes an important feature of the conditional distribution. Figure 3.D.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.

restrictions on the permissible class of regression functions m(x). 3. not a model. The equations yi = m(xi ) + ei E (ei | xi ) = 0. These equations hold true by deﬁnition. E(ei ) = 0. A regression model imposes further restrictions on the joint distribution.2: Log Wage Densities Theorem 3. 13 . E (ei | xi ) = 0. 4.2. It is important to understand that this is a framework.Figure 3. E (h(xi )ei ) = 0 for any function h (·) . E(xi ei ) = 0. most typically. The remaining parts of the Theorem are left as an exercise. are often stated jointly as the regression framework. because no restrictions have been placed on the joint distribution of the data. 2. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.1 Properties of the regression error ei 1. To show the ﬁrst statement. by the deﬁnition of ei and the linearity of conditional expectations.

The conditional standard deviation is its square root σ(x) = σ 2 (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.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. Given the random variable xi . and can take any form. in the sense of achieving the lowest mean squared error.3 Conditional Variance Generally.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. let g(x) be an arbitrary predictor of yi given xi = x. it does not provide information about the spread of the distribution. The right-hand-side is minimized by setting g(x) = m(x). when σ 2 (x) is a constant so that ¢ ¡ (3.2.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .Figure 3. σ 2 (x) is a non-trivial function of x.1. To see this. i . subject to the restriction p that it is non-negative. 3. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . In contrast. the conditional variance of yi is σ 2 = σ 2 (xi ).

Equivalently.8) (3. it is more realistic to view the linear speciﬁcation (3.6) as an approximation. Notationally.7) is a k × 1 parameter vector. and the linear assumption of the previous section is empirically unlikely to accurate. which we derive in this section.5. The conditional standard deviation for men is 12. As an example. take the conditional wage densities displayed in Figure 3. it is convenient to augment the regressor vector xi by listing the number “1” as an element. So while men have higher average wages.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). its functional form is typically unknown. ⎟ β=⎝ . This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . ⎠ .3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. ⎟ .9) 3. we assume that x1i = 1. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.5) xi = ⎜ . 3.6) (3. 15 . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.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 .8) is called the linear regression model. ⎠ . Equation (3.1. In this case (3. Thus (3. i (3. βk ⎛ (3.1 and that for women is 10. xki When m(x) is linear in x.1). Instead. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . We call this the “constant” or “intercept”.we say that the error ei is homoskedastic.4 Linear Regression An important special case of (3. where x1i is the ﬁrst element of the vector xi deﬁned in (3. they are also somewhat more dispersed. ⎝ .

which is quadratic in β. i 16 .7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.1. E (xi x0 ) is invertible. x0 β is the best linear predictor for yi . xi contains an intercept. i i (3. E (x0 xi ) < ∞. In order for β to be uniquely deﬁned. by “best” we mean the predictor function with lowest mean squared error. The ﬁrst-order condition for minimization (from Section 2. This occurs when redundant variables are included in xi .10). The vector (3. written E (xi x0 ) > 0. Therefore. 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. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . there cannot i exist a non-zero vector α such that α0 xi = 0 identically. As before. Assumption 3.1 1. i (3. this situation must be excluded. Rewriting. It is invertible if and only if it is positive deﬁnite. Eyi < ∞. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi .10) It is worth taking the time to understand the notation involved in this expression. α0 E (xi x0 ) α = E (α0 xi )2 > 0. The error is i ei = yi − x0 β. Observe i that for any non-zero α ∈ Rk . Given the deﬁnition of β in (3.5. 3. i (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . Equivalently. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. The best linear predictor is obtained by selecting β to minimize S(β). We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. otherwise they are distinct. 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 . 2 2. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. i 4.5.12) This completes the derivation of the linear projection model. i which requires that for all non-zero α.

Since ei is mean zero by (3.13) and Assumption 3.1. the orthogonality restriction (3.13) implies that xi and ei are uncorrelated.8)-(3.5. (3.5. However.13) The two equations (3. Furthermore.4 is required to ensure that β is uniquely deﬁned.1.3 are called regularity conditions.5.2 and 3. Assumption 3.1.1.10) and (3.11) are well deﬁned. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.1 is employed to guarantee that (3.1 are weak.2 and 3. (3.5.1.5. Assumption 3. ¥ (3.11) and (3. Figure 3.1 Under Assumption 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.10) are deﬁned. Since from Theorem 3.5. it follows that linear regression is a special case of the projection model.9).3 ensure that the moments in (3. Equation (3. Assumption 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .14) follows from (3.1.5.2.4 we know that the regression error has the property E (xi ei ) = 0.5.12) and (3. Let’s compare it with the linear regression model (3.1.5.1.5. By deﬁnition. Assumption 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .1.1.Theorem 3. This means that the equation (3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.12) can be alternatively interpreted as a projection decomposition.14) Proof. 17 . The ﬁnite variance Assumptions 3. For example.1. E (xi ei ) = 0 and E (ei ) = 0.5.13) summarize the linear projection model.14).4 guarantees that the solution β exits.14) holds.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. Using the deﬁnitions (3.

Returning to the joint distribution displayed in Figure 3. Other than the redeﬁnition of the regressor vector. In contrast.10). 18 . In this case the linear projection is a poor approximation to the conditional mean. it is important to not misinterpret the generality of this statement.10) may not hold and the implications of Theorem 3. A projection of log wages on these two variables can be called a quadratic projection. This defect in linear projection can be partially corrected through a careful selection of regressors. 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. Most importantly. and under-predicts for the rest. In this example the linear projection is a close approximation to the conditional mean. and the straight dashed line is the linear projection.4 we display as well this quadratic projection.1 may be false. the dashed line is the linear projection of log wages on eduction. Figure 3. for any pair (yi . These structural models require alternative estimation methods. It over-predicts wages for young and old workers. The linear equation (3. for those over 53 in age).1.3.5. The solid line is the conditional mean. However.12) with the properties listed in Theorem 3. No additional assumptions are required. In this example it is a much better approximation to the conditional mean than the linear projection. In this case (3. we can augment the regressor vector xi to include both experience and experience2 . it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. and are discussed in Chapter 11.5. In other cases the two may be quite diﬀerent. xi ) we can deﬁne a linear projection equation (3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.We have shown that under mild regularity conditions. since the resulting function is quadratic in experience.4 displays the relationship3 between mean log hourly wages and labor market experience. Figure 3. in many economic models the parameter β may be deﬁned within the model. We illustrate the issue in Figure 3. In Figure 1. there are no changes in our methods or analysis.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.

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

σ 2 = V ar(xi ). (x − µ)2 − σ 2 Show that Eg (X. µ. i 8. If yi = x0 β + ei and E(ei | xi ) = 0. 2. Are they diﬀerent? Hint: If P (Y = j) = 5. Suppose that yi is discrete-valued. taking values only on the non-negative integers. and E(ei | xi ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. and E(e2 | xi ) = σ 2 . then E(ei | xi ) = 0. Compute the conditional mean m(x) = E (yi | xi = x) . j! 0 j = 0.3. 20 . then ei is independent of xi . . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . 0 ≤ y ≤ 1. yi ). Let xi and yi have the joint density f (x. Compute E(yi | xi = x) and V ar(yi | xi = x). and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . and have the following joint probability distribution X=0 X=1 Y =0 .4 .3 Find E(Y | X = x). True or False. ¡ ¢ 4. x 6. then ei is i i independent of xi . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . Let X be a random variable with µ = EX and σ 2 = V ar(X).2 Y =1 . E(Y 2 | X = x) and V ar(Y | X = x). True or False.. If yi = xi β + ei . 2. and E(xi ei ) = 0. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. s) = 0 if and only if m = µ and s = σ 2 .1.. Prove parts 2. 9.1 . i 10. True or False. then E(x2 ei ) = 0. True or False. 1. xi ∈ R. If yi = x0 β + ei and E(xi ei ) = 0. then E(x2 ei ) = 0. i 11. True or False. a constant.2. m.6 Exercises 1. 3. E(ei | xi ) = 0. xi ∈ R. σ = . e−λ λj j! . µx = Exi . If yi = x0 β + ei . 3 and 4 of Theorem 3. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Suppose that Y and X only take the values 0 and 1. If yi = xi β + ei . i 7.

4) i i=1 i=1 ˆ Another way to derive β is as follows. but for most of the chapter we retain the broader focus on the projection model. i It follows that the moment estimator of β replaces the population moments in (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . (4.8.3) In Sections 4. 4.2) can be written in the parametric 0 β)) = 0.2) (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. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .1 Estimation Equation (4.1) (4. i n i=1 n 21 .7 and 4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 . we narrow the focus to the linear regression model. Observe that (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .

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.ˆ This is a set of k equations which are linear in β.14 14.14 205.3. with 10-15 years of potential work experience.30 + 0. 40 2.117 1 14.94 −2.4).14 205. Then µ ¶ n 1X 2. 4. ¶ 2. Let yi be log wages and xi be an intercept and years of education.83 ¶−1 µ ¶ . An interpretation of the estimated equation is that each year of education is associated with an 11. 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. 30 = . excluding military.117 Educationi . 40 0.4).40 µ ¶µ ¶ 34.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. 0.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.37 µ ¶ 1.14 14.170 37.95 xi yi = 42. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.95 42. To illustrate. consider the data used to generate Figure 3.2 Least Squares There is another classic motivation for the estimator (4. i 22 .71 = −2. This sample has 988 observations.7% increase in mean wages. These are white male wage earners from the March 2004 Current Population Survey.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.

while the residual is a by-product of estimation. These two ˆ variables are frequently mislabeled. 23 . Figure 4. Following convention we will call β the OLS estimator of β. i ˆ ˆ Note that yi = yi + ei .The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Figure 4. To visualize the sum-of-squared errors function. It is important to understand the distinction between the error ei and the residual ei . Since the function Sn (β) is a quadratic function of β. Matrix calculus (see Appendix 2.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. the contour lines are ellipses.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. which can cause confusion.4).1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. Figure 4. The error is unobservable.

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

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 . It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. Instead. 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 ). where likelihood methods can be used for estimation. testing. σ 2 ) is a function of β only through the sum of squared errors Sn (β). The R2 is frequently mislabeled as a measure of “ﬁt”. maximizing the likelihood is identical to minimizing Sn (β). Hence the MLE for β equals the OLS estimator. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . The log-likelihood function for the normal regression model is Ã ¶! µ n X ¢2 1 1 ¡ 2 0 log exp − 2 yi − xi β Ln (β.where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. Since Ln (β. σ 2 ). This is a parametric model. σ 2 ). This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. 4.3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . σ 2 ) maximize Ln (β. and distribution theory. 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 . ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β.

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

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

. obtain residuals X2 . is the demeaning formula for regression. . . In the model (4. 4. 30 . In this section we derive the small sample conditional mean and variance of the OLS estimator. obtain residuals Y . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.1 (Frisch-Waugh-Lovell). In this case. Rather.14) or via the ˆ following algorithm: ˜ 1. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. . .13).6.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. ˆ which are “demeaned”.8)(3. ⎟ ⎜ ⎟ ⎜ (4. In some contexts. . ˜ 2. observe that ⎞ ⎛ ⎞ ⎛ . the primary use is theoretical. and X2 is the vector of observed regressors. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. ⎠ ⎝ ⎠ ⎝ .Theorem 4. Regress Y on 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) . . but in most cases there is little computational advantage to using the two-step algorithm. .9).9). A common application of the FWL theorem. ¡ ¢−1 0 ι. ˆ ˜ ˜ ˆ 3. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . . Regress Y on X1 . By the independence of the observations and (3. obtain OLS estimates β 2 and residuals e. which you may have seen in an introductory econometrics course. Regress X2 on X1 . 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. 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.

X 0 DX = X 0 Xσ 2 . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.8).. the properties of conditional expectations. 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 additional assumption of conditional homoskedasticity E ei i of projection matrices. 0 0 ··· 0 0 . Then given (4.19) ˆ and thus the OLS estimator β is unbiased for β. under the of ˆ ¢ 2 | x = σ 2 .20) . and (4. 1 n . From (4.. V ar β | X = X 0 X ⎟ ⎟ ⎟. ¡ 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. . .18). Next. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ .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 .12). 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.. 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. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 .Using (4. and the trace operator observe that.. ⎠ (4. . . . . σ 2 } = ⎜ . . ⎝ . .

says that the least-squares estimator is the best choice. Theorem 4.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. or in the projection model.9) plus E e2 | xi = σ 2 . The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . ˜ so β is unbiased if (and only if) A0 X = Ik . 4.8)¢ ¡ (3. In the homoskedastic linear regression model.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . and thus can be written as ˜ β = A0 Y where A is an n × k function of X. ³ ´ ˜ E β | X = A0 Xβ. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. Thus since V ar (e | X) = In σ 2 under homoskedasticity. It is important to remember. What is the best choice of A? The Gauss-Markov theorem. is a famous statement of the solution.10). As an alternative. as it yields the smallest variance among all unbiased linear estimators. we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense. however. In this case. which we now present.8. Now consider the class of estimators of β which are linear functions of i the vector Y. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. It is not unbiased in the absence of homoskedasticity. the estimator ˆ 2 deﬁned (4. Thus σ 2 is biased towards zero. The following result. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. By a calculation similar to those of the previous section. = σ2 n the ﬁnal equality by (4. known as the Gauss-Markov theorem. the best (minimumvariance) unbiased linear estimator is OLS. 32 . which is (3.1 Gauss-Markov.7) is unbiased for σ 2 by this calculation. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .

¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. . This latter restriction is particularly unsatisfactory. π j is the percentage of the observations ˆ ˆ which fall in each category. the deﬁnition (4..9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator.21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ . j = 1. That is. ˆ β mle = ⎝ j j=1 j=1 33 .. 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. Let A be any n×k function of X such that A0 X = Ik . xi ) is discrete. This property is called semiparametric eﬃciency. and is a strong justiﬁcation for the least-squares estimator. r for some constant vectors τ j . xi = ξ j = π j . It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. . π r ) . Not only has the class of models has been restricted to homoskedastic linear regressions. Set C = A − X (X 0 X)−1 . who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators.. Note that X 0 C = 0. but the π j are unknown.) In this discrete setting. ¡ ¢ P yi = τ j . A broader justiﬁcation is provided in Chamberlain (1987). (We know the values yi and xi can take.. where 1 (·) is the indicator function... The MLE β mle for β is then the analog of (4. .. for ﬁnite r.. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. Suppose that the joint distribution of (yi . r. ξ j . but it is quite limited in scope.. 4. That is. the class of potential estimators has been restricted to linear unbiased estimators. As the data are multinomial. but we don’t know the probabilities. Assume that the τ j and ξ j are known.21) j j=1 j=1 Thus β is a function of (π 1 .Proof.5) as required.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. and π j . as the theorem leaves open the possibility that a non-linear or biased estimator could have lower mean squared error than the least-squares estimator. We discuss the intuition behind his result in this section.

1. 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. 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 4.5.9).10) for the class of models satisfying Assumption 3. He proves that generically the OLS estimator (4. the maximum likelihood estimator is identical to the OLS estimator. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words.22) 34 . and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. and thus so is the OLS estimator.Substituting in the expressions for π j . (4.10 Omitted Variables xi = µ x1i x2i ¶ . Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi . if the data have a discrete distribution.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.

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

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

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

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

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

The WLLN shows that sample averages converge in probability to the population average. If Xi ∈ Rk is iid and E |Xi | < ∞. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . then as n → ∞ n 1X Xn = Xi →p E(X). ¥ 5.1 Weak Law of Large Numbers (WLLN). Let a + bx be the tangent line to g(x) at x = EX. denoted Zn →p Z as n → ∞. Set Y = g(X) and let f denote the density function of Y. Note EU = EV = 1. n i=1 42 . So for all x. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. n→∞ lim P (|Zn − Z| > δ) = 0. ¥ Proof of Holder’s Inequality. P (g(X) > α) ≤ α−1 Eg(X). =E U V p q p q Proof of Markov’s Inequality. Since g(x) is convex. Applying expectations. tangent lines lie below it. 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}.Markov’s Inequality. Theorem 5. (5. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. Eg(X) ≥ a + bEX = g(EX).4) Proof of Jensen’s Inequality. if for all δ > 0. For any strictly increasing function g(X) ≥ 0.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. We say that Zn converges in probability to Z as n → ∞. 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 ) = + . as stated. p p p q which is (5.3).2.

the fact that the Wi are iid and mean zero. Theorem 5. we can set E(X) = 0 (by recentering Xi on its expectation). ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . 5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) .4). P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. P ¯X n ¯ > δ ≤ η. as needed.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . If Xi ∈ Rk is iid and E |Xi |2 < ∞. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. Fn (x) → F (x) as n → ∞.7). the fact that X n = W n + Z n . We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . ¡¯ ¯ P ¯X n ¯ > δ ≤ η. denoted Zn →d Z. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . the triangle inequality. Finally. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. if for all x at which F (x) is continuous. Jensen’s inequality (5. 43 . by Markov’s inequality (5.5).1 Central Limit Theorem (CLT).3.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞.6) and (5.6) By Jensen’s inequality (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. Fix δ and η. and the bound |Wi | ≤ 2C. We say that Zn converges in distribution to Z as n → ∞. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.1).1) and (5. Set ε = δη/3. where Z has distribution F (x) = P (Z ≤ x) . (5. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. V ) .Proof: Without loss of generality.

let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . For ¡ ¢ λ ∈ Rk . Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . ∂λ∂λ cλ (λ) = cλλ (λ) = ∂ ∂ c(λ) = C(λ)−1 C(λ) ∂λ ∂λ ∂ ∂2 ∂2 −2 ∂ C(λ) 0 C(λ) c(λ) = C(λ)−1 0 0 C(λ) − C(λ) ∂λ ∂λ∂λ ∂λ∂λ ∂λ so when evaluated at λ = 0 Furthermore.8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 . By the properties of the exponential function. ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n .Proof: Without loss of generality. it is suﬃcient to consider the case µ = 0 and V = Ik . 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. the independence of the Xi . the deﬁnition of c(λ) and (5. By a second-order Taylor series expansion of c(λ) about λ = 0.8) where λ∗ lies on the line segment joining 0 and λ.

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

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

(6. xi ei →p g (Q. and the continuous mapping theorem (Theorem 5. using (6. (6. Equation (4.1). This is illustrated in Figure 6. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . n i=1 (6.5. ˆ 47 . xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. 6.3). ·) is continuous at (Q. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.4.1. Assumption 3.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.1). Hence by the continuous mapping theorem (Theorem 5.1) and ˆ We now deduce the consistency of β.1 Under Assumption 3. the OLS estimator β is has a statistical distribution which is unknown.3) Ã where g(A.2. 0). β →p β as n → ∞. 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 .1 and the WLLN (Theorem 5. we can conclude ˆ that β →p β. Assumption 3.2) i i n i=1 n From (6.5.2).4.1 by the fact that the sampling densities become more concentrated as n gets larger. ˆ Theorem 6.1.1).4 implies that Q−1 exists and thus g(·. To characterize the sampling distribution more fully. For a complete argument.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1). (6.5. Proof. First.1. we will use the methods of asymptotic approximation. Ã n ! n X 1X 0 1 ˆ xi xi . As the sample size increases the density becomes more concentrated about the population coeﬃcient.2.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.2 Consistency ˆ As discussed in Section 6.

(6.1). E ¯ei ¯ E ¯e4 ¯ i i i i (6.1 guarantees that the elements of Ω are ﬁnite.2). (6. By the central limit theorem (Theorem 5. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . ˆ n−k 6.2 Under Assumption 3. ˆ Proof. by the Cauchy-Schwarz inequality (5.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. ˆ Finally.2). Assumption 6. (6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .3.3.Theorem 6. To see this.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. We need a strengthening of the moment conditions.5.1. Ω) .3) and Theorem (6.5. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.2.1. Ee4 < ∞ and E |xi |4 < ∞. Thus σ 2 is consistent for σ 2 .1). it follows that s2 = ¥ n σ 2 →p σ 2 . σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.3.2.6) n i=1 48 . i i Assumption 6.1 In addition to Assumption 3. since n/(n − k) → 1 as n → ∞. (6. n 1 X √ xi ei →d N (0.

´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. Ω) ¡ ¢ = N 0.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . Theorem 6. V ) where V = Q−1 ΩQ−1 . Q−1 ΩQ−1 . We say that ei is a Homoskedastic Projection Error when (6. when xi and ei are independent. The trouble is that no matter how large is the sample size.1. However.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. however.7) Cov(xi x0 .2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . If α > 2 the 2 error εi has zero mean and variance α/(α − 2). otherwise V 6= V 0 . (6.Then using (6.3. its variance diverges q ³ ´ ˆ to inﬁnity.1 states that the sampling distribution of the least-squares estimator. Under (6. How large should n be in order for the approximation to be useful? Unfortunately.3. There is a special case where Ω and V simplify. 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 (6.2). 1) asymptotic distibution. for example.7) holds. e2 ) = 0. In Figure 6. V is often referred to as ˆ the asymptotic covariance matrix of β. The approximation may be poor when n is small. 1). In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.9) In (6. The expression V = Q−1 ΩQ−1 is called a sandwich form. In´Figure 6.7) is true or false. As α approaches 2. For α 49 .7) is true then V = V 0 . We call V 0 the homoskedastic covariance matrix. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.3. is approximately normal when the sample size n is suﬃciently large. Let yi = β 0 + β 1 xi + εi where xi is N (0.3. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . This holds true for all joint distibutions of (yi . |ε| ≥ 1.1).1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. i i Condition (6. but this is not a necessary condition. We illustrate this problem using a simulation. xi ) which satisfy the conditions of Assumption 6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. 1 X √ xi ei n i=1 n ! the N (0. there is no simple answer to this reasonable question. The asymptotic distribution ´ Theorem 6.9) we deﬁne V 0 = Q−1 σ 2 whether (6.1. after rescaling. and (6.3.6). When (6.1 Under Assumption 6.

3 is that the N (0.10) V 0 = Q−1 s2 . 6 and 8.0 the density is very close to the N (0. 1). 1) asymptotic approximation is never guaranteed to be accurate.2 and 6.3. The estimator 2 2 in (6. for k = 1.10) without changing this result. 1) density. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. 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. 4.11) 50 . The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.2: Density of Normalized OLS estimator α = 3.1) it is clear that V 0 →p V 0 . As k increases.2) and Theorem 6. concentrating most of the probability mass around zero. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . As α diminishes the density changes signiﬁcantly. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. the sampling distribution becomes highly skewed and non-normal. The lesson from Figures 6.2.Figure 6. Another example is shown in Figure 6. 6. we need an estimate of Ω = E xi x0 e2 . We show the sampling distribution of n β 1 − β 1 setting n = 100.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.

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

To illustrate. Ω 2. by Holder’s inequality (5.020. n n i=1 52 .83 ¶−1 = µ 7.35/988 = .80 . i i i i n i=1 Second. (6.2/988 = .1. then take the diagonal elements.14 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.14 6.085 p ˆ and that for β 1 is .80 40. p ˆ In this case the two estimates are quite similar.98 −0. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .2.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.used by an author when studying their work. First.199 2. (6. and then the square roots.493 0. Using (6.80 40.83 ¶−1 µ .117 Educationi . From a computational standpoint.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.493 −0.20 and µ ¶ ˆ = 0.199 2. from which it follows that V →p V as n → ∞.20 = V 14.20 −0. but not under another set of assumptions. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .5) and the WLLN (Theorem 5. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.4) 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 .83 −0.480 .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.30 + 0.14 205.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.6 ¶µ 1 14. just as any other estimator.035 ¶ .480 ˆ0 = 0.14 14. (.14 205.039 and ˆ V = µ 1 14.14 205. We calculate that s2 = 0.020) 6. The standard errors for β 0 are 7. we return to the log wage regression of Section 4.085) (.12) in turn. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.80 2.

you can show that 1 Xˆ ¯ β= β (−i) . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi .25). Andrews (1991) suggested an similar estimator based on cross-validation. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. 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. Recall from Section 4.5. Ω →p Ω and V →p V. ¯ 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. i=1 Third.1 As n → ∞. 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. which.26).−i = (1 − hi )−1 ei ˆ presented in (4.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. these establish consistency. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. From equation (3.11) with the leave-one-out estimator ei.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. n i=1 n ˆ ˆ Theorem 6.13) of Efron (1982). 6.13) Using formula (4. Using this substitution. ¯ ¯n ¯ n i=1 so Together.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .

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

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

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

However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). 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 → ∞.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. and it is desired to test the joint restrictions simultaneously. or α = .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. 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.05. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. θ θ) (6.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). = n h(β) − θ0 Hβ V Hβ 57 (6. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. This corresponds to selecting the conﬁdence h i h ˆ ± 1. In this case the t-statistic approach does not work. ˆ + zα/2 s(ˆ . While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.18) . the most common professional choice isi95%. θ The interval has been constructed so that as n → ∞.96s(ˆ ≈ ˆ ± 2s(ˆ . 6.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .

19) σ2 ˆ where σ2 = ˜ 1 0 e e.3. Furthermore.1 showed θ ˆ that V →p V. In this case. ˜˜ n ˜ e = Y − X1 β 1 . then Wn →d χ2 . χ2 (. Hβ (β) →p Hβ . Vθ ).2. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . if rank(Hβ ) = q. a chiq square random variable with q degrees of freedom. 1] under H0 . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 .15) showed that n ˆ − θ →d Z ∼ N (0. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.05) = 3. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. and Theorem 6. 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. Also h(β) = a selector matrix. The null hypothesis is H0 : β 2 = 0. and there are q = k2 restrictions. 6. Hence β β by Theorem A. q and pn is asymptotically U[0. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. the upper-α quantile q 2 of the χ2 distribution. Hβ (β) is a continuous function of β. As before.025 .10. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).84 = z. For example.5. ˆ Wn = n θ θ q θ θ Theorem 6. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).8. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . h(β) = R0 β. the test rejects at the α% level iﬀ pn < α. θ = β 2 .1.1 Under H0 and Assumption 6.When h is a linear function of β. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity. The asymptotic p-value for Wn is pn = p(Wn ).

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

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

which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. 0.10) then ´ ³ ˆ • β ∼ N 0.8. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. We summarize these ﬁndings Theorem 6. β 2 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . β has an exact normal distribution and t has an exact t distribution. σ 2 ) − Ln (β 1 . As inference (conﬁdence intervals) are based on the t-ratio. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . a good testing procedure is based on the likelihood ratio statistic. and standard errors are calculated using the homoskedastic formula (6. if standard errors are calculated using the homoskedastic formula (6.3.12. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . Furthermore. In contrast. Theorem 6. σ ˆ ˆ βj − βj βj − βj N (0.10) µ h i ¶ 2 (X 0 X)−1 N 0.1 If ei is independent of xi and distributed N(0. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.) Now let us partition β = (β 1 .1 we showed that in large samples. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . σ 2 ) = − log σ − log (2π) − . The critical values are quite close if n − k ≥ 30. β 2 .1 shows that under the strong assumption of ˆ normality.12. 1) and tn−k distributions. σ 2 ) discussed above. β 2 . σ2 ˆ 61 . β and t are approximately normally distributed. the notable distinction is between the N (0. with residual variance σ . σ 2 ).1 and Theorem 6. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .a chi-square distribution with n − k degrees of freedom. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (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. 0. (Unless the sample size is unreasonably small. 0. so as a practical matter it does not matter which distribution is used. n−k • ∼ tn−k ˆ In Theorem 6.

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

and σ 2 . Table 4.05) with deviations indicating+ distortion. There is. however.Figure 6. n is varied among 20. Any other choice of s leads to a test with unacceptable Type I error probabilities. For this particular example. this probability depends only on s.4: Wald Statistic as a function of s P (Wn (s) > 3. and σ is varied among 1 and 3. In Table 2. The null hypothesis β s = 1 is true.000 random samples. These probabilities are calculated as the percentage of the 50.1 we report the results of a Monte Carlo simulation where we vary these three parameters. so these probabilities are Type I error. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Given the simplicity of the model. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. the only test which meets this criterion is the conventional Wn = Wn (1) test.1 you can also see the impact of variation in sample size. The value of s is varied from 1 to 10. n. we compare the rates row by row. Type I error rates between 3% and 8% are considered reasonable. Test performance deteriorates as s increases.84. Typically. In Table 4. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. To interpret the table.1 reports the simulation estimate of the Type I error probability from 50.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . 100 and 500. Rates above 20% are unexceptable. When comparing statistical procedures. Error rates avove 10% are considered excessive. the Type I error probability improves towards 5% as the sample size n increases. In each case. and rarely fall outside of the 3%-8% range. no magic choice of n for which all tests perform uniformly well.84 | β = 1) . remember that the ideal Type I error probability is 5% (.4. Table 4. looking for tests for which rate rejection rates are close to 5%.000 simulated Wald statistics Wn (s) which are larger than 3.

let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .07 .26 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.15 .25 .14 .28 .06 .10 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . so the hypothesis can be stated as H0 : θ = r.05 .06 .20).05 .15 .33 .07 .15 .07 .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 .14 .11 .08 .23 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .34 .08 .12 .24 .07 .20 .06 .05 .06 .17 .22 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. 64 .08 .06 .15 . deﬁne θ = β 1 /β 2 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.05 .22 .16 Rejection frequencies from 50.13 . While this is clear in this particular example.31 .09 .13 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.21 .10 . Equivalently.06 .12 .35 .19 . Other choices are arbitrary and would not be used in practice.08 .06 . This point can be illustrated through another example.08 . β 1 .05 .20 .10 .25 .07 .05 . β 2 ) be the least-squares estimates of (6.18 .30 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .13 .

7. .00 .05 .00 The one-sided Type I error probabilities P (tn < −1.00 .645) t1n t2n t1n t2n t1n t2n t1n t2n .75 1.2. and 1. Ideally. this formulation should be used.00 .75.25 . along with sample size n.2 is that the two t-ratios have dramatically diﬀerent sampling behavior. 65 . if the hypothesis can be expressed as a linear restriction on the model parameters.05.05 .645) P (tn < −1.06 .26 . In this section we describe the method in more detail. 6.15 .00 .06 . The left tail probabilities P (t1n < −1.05 .0 and n among 100 and 500.15 .05 . ei be an independent N (0.06 .07 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . The implication of Table 4. .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.06 . and are close to the ideal 5% rate for both sample sizes.000 simulated samples. the entries in the table should be 0. 1) variables. σ 2 ) draw with σ = 3.00 .06 .06 .06 .14 Monte Carlo Simulation In the previous section we introduced the method of Monte Carlo simulation to illustrate the small sample problems with tests of nonlinear hypotheses. .645) P (tn > 1.10 .05 . especially for small values of β 2 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.645) are calculated from 50.645) are close to zero in most cases. We vary β 2 among .25. and alternatives to asymptotic critical values should be considered.06 . In contrast.10 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .06 .12 .05 . However. If no linear formulation is feasible. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .645) P (tn > 1. while the right tail probabilities P (t1n > 1.05 .00 . such as the GMM distance statistic which will be presented in Section 9.28 .47 .645) greatly exceed 5%.10 .05 .05 β2 .645) and P (tn > 1. and normalize β 0 = 0 and β 1 = 1.06 .00 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.02 .05 . This leaves β 2 as a free parameter.50.09 . In all cases. It is also prudent to consider alternative tests to the Wald statistic.00 . The results are presented in Table 4. We let x1i and x2i be mutually independent N (0. then the “most linear” formulation should be selected. Table 4.00 . the rejection rates for the t1n statistic diverge greatly from this value.1.50 .

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

such as the percentage estimate reported in (6.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. if we set B = 999. Furthermore. equalling 1 with probability P = E1 (Tnb ≥ 1. As discussed above. and dummy variable indicators for the following: married.95) /B ' .96) . Then qα is the N ’th number in this ordered sequence.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. Often this is called the number of replications.21).Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. female. are. potential work experience. and poorly for others. potential work experience. It is therefore useful to conduct a variety of experiments. For example. For the dependent variable we use the natural log of wages. excluding military. and dummy variable indicators for the following: married. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. union member. this may ˆ be approximated by replacing P with P or with an hypothesized value. It is therefore convenient to pick B so that N is an integer. for a selection of choices of n and F. Quite simply. then B will have to be increased. respectively. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. experience squared. and estimate a multivariate regression.96) is iid Bernoulli. the choice of B is often guided by the computational demands of the statistical procedure. we included a dummy 67 . We separately estimate equations for white and non-whites. and therefore it is straightforward to calculate standard errors for any quantity of interest. and . Generally. therefore. Again our dependent variable is the natural log of wages. then we can set s P = (. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.22/ B. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. where N = (B +1)α. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. and hispanic. the researcher must select the number of experiments. . a larger B results in more precise estimates of the features of interest of Gn . immigrant. and 5000. Hence the ³ ´ ˆ standard errors for B = 100. In many cases. We us the sample of wage earners from the March 2004 Current Population Survey. 1000. the performance will depend on n and F. and our regressors include years of education. For example. female.15 Estimating a Wage Equation We again return to our wage equation. We now expand the sample all non-military wage earners. The α% sample quantile is a number qα such that α% of the sample are less than qα . and non-white. but requires more computational time. and 90% sample quantiles of the sample {Tnb }. B. hispanic.022. an estimator or test may perform wonderfully for some values. s P = .96) . The random variable 1 (Tnb ≥ 1. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. B b=1 (6. it is simple to make inferences about rejection probabilities from statistical tests. In practice. 6. so that coeﬃcients may be interpreted as semi-elasticities. For regressors we include years of education. In particular. experience squared. immigrant.05) (.007. The average (6. As P is unknown. If the standard error is too large to make a reliable inference. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. union member.003.

49452 σ ˜ Notice that the two statistics are close. 808 1 − .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.69.808 . θ ˆ 2β 3 β2 .002 . The F form of the Wald statistic (6. we can write this eﬀect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model. Table 4.102 −.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.032 . Alternatively.008 . The available sample is 18.027 .variable for state of residence (including the District of Columbia. Wn = n 1 − 2 = 18.001 .101 .014 . we ﬁnd Wn = 550. as the 1% critical value for the χ2 distribution is 76.48772 = 515. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.097 −.033 −. Ignoring the other coeﬃcients.00057 .19) is ˜ µ ¶ µ ¶ σ2 ˆ . Using either statistic the hypothesis is easily rejected.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.808 so the parameter estimates are quite precise and reported in Table 4.34 ˆ s(β) .00002 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.070 .013 .102 −.18) that the state coeﬃcients are jointly zero. 2β 3 68 . the restricted standard deviation estimate is σ = .232 . Computing the Wald statistic (6.4945.010 . but not equal.4877 18.007 . reestimating the model with the 50 state dummies excluded. this adds 50 regressors). excluding the coeﬃcients on the state dummy variables.1.121 −.

Notice that the upper end of the conﬁdence interval is the same as that from the delta method. so we have to go one step further. there is not a simple expression for this set.5]. but the lower end is substantially lower.5]. this is a poor choice. we found better Type I error rates by reformulating the hypothesis as a linear restriction.96. 69 .Using the Delta Method. Since tn (θ) is a non-linear function of θ. 29. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. but it can be found numerically quite easily.40. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.9. 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 ). not testing a hypothesis.0. This is the set of θ such that |tn (θ)| ≤ 1. 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. Instead. However. This set is [27. 29. we can calculate a standard error of s(ˆ = . implying a 95% conﬁdence θ) interval of [27.

ﬁnd the least-squares estimate of β = (β 1 . (d) Under the ´ standard assumptions plus R0 β = r. r ˜ is a known s × 1 vector. ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. (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. ˜ That is. 3. 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 . and rank(R) = s. In the model Y = X1 β 1 + X2 β 2 + e. 4.6. 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) . ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. In the model Y = X1 β 1 + X2 β 2 + e. subject to the constraint that β 1 = −β 2 . ˜ (b) Verify that R0 β = r. (c) Show that if R0 β = r is true. β 2 ). 2. show that the least-squares estimate of β = (β 1 . β 2 ). In the model Y = Xβ + e. λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. show that the least-squares estimate of β = (β 1 .16 Exercises For exercises 1-4. the following deﬁnition is used. then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. 1. In the model Y = X1 β 1 + X2 β 2 + e. β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . β − β = Ik − X 0 X 70 . 0 < s < k.

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

. Furthermore.. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. 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 .5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . as it is estimating the conditional variance of the regression of yi on xi . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . ˜i Suppose that σ 2 > 0 for all i. .Suppose ei (and thus η i ) were observed. If σ 2 < 0 for some i. 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. Vα ) (7.. estimator of β.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0.3) ˆ ˆ While ei is not observed. We have shown that α is consistently estimated by a simple procedure. there is no guarantee that σ 2 > 0 for all i. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. or FGLS. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). We may call (7. Then set ˜i ˜ D = diag{˜ 2 . Vα = E zi zi (7. xi ). which is typically undesirable. then the FGLS estimator will force ˜i the regression equation through the point (yi . One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. and hence we can estimate 0 σ 2 = zi α by i ˜ (7.4) the skedastic regression. and will depend on the model (and estimation method) for the skedastic regression. This suggests 75 . then the FGLS ˜i estimator is not well deﬁned. if σ 2 ≈ 0 for some i. This is the feasible GLS.6) σ 2 = α0 zi .

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

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

σ 2 ). we want to estimate m(x) at a particular point x.g. Notice that this is diﬀerent from the standard ˆ ˆ error for the conditional mean. ¡ ¢ ˆ Assuming E e2 | xi = σ 2 . this would require the asymptotic normality of the ratio ³ ´ ˆ ei − x0 β − β .In some cases. We would also like a measure of uncertainty for ˆ the forecast. If we have an estimate of the conditional variance function. many applied forecasters focus h i ˆ on the simple approximate interval x0 β ± 2ˆ(x) . but this turns out to be incorrect. we need to estimate the conditional distribution of ei given xi = x. which is generally invalid.6). ³ ´ ˆ ˆ The forecast error is ei = yi − m(x) = ei − x0 β − β . A point forecast ˆ is the estimated conditional mean m(x) = x0 β. s 7. so a standard ˆ i p ˆ error for the forecast is s(x) = σ 2 + n−1 x0 V x. p h i ˆ ˆ x0 β ± 2 n−1 x0 V x . 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) . s(x) ˆ But no such asymptotic approximation can be made. For a given value of xi = x. The only special exception is the case where ei has the exact distribution N (0. A reasonable rule is the conditional mean m(x) as it is the mean-square-minimizing forecast. We describe this setting as non-linear regression. In general. 78 . the validity of an asymptotic conﬁdence interval is based on the asymptotic normality of the studentized ratio. Thus an asymptotic 95% conﬁdence interval for m(x) is θ) It is interesting to observe that if this is viewed as a function of x. Letting h(β) = x0 β and θ = h(β). this has variance ³ ´³ ´0 ¡ ¢ ˆ ˆ Eˆ2 = E e2 | xi = x + x0 E β − β β − β x ei i = σ 2 (x) + n−1 x0 V x. we see that m(x) = ˆ = x0 β and Hβ = x. To get an accurate forecast interval. Notice that this is a (linear) ˆ ˆ θ function of β. we may want to forecast (guess) yi out-of-sample.4 NonLinear Least Squares In some cases we might use a parametric regression function m(x. θ) = E (yi | xi = x) which is a non-linear function of the parameters θ. the natural estimate of this variance is σ 2 + n−1 x0 V x. e. q 2 0 0 ˆ ˜ ˆ ˜ σ (x) = α z from (7. As the out-of-sample error ei is ˆ ˆ independent of the in-sample estimate β. Given the diﬃculty. the width of the conﬁdence set is dependent on x. which is a much more diﬃcult task. In the present case. so p ˆ s(ˆ = n−1 x0 V x.

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

However. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. Suppose that m(xi . and this is often a useful hypothesis (sub-model) to consider. 7.5 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 . In particular. θ which is that stated in the theorem. This renders the distribution theory presented in the previous section invalid. Thus we want to test H0 : β 2 = 0. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. Identiﬁcation is often tricky in nonlinear regression models. m(xi . θ) = β 0 zi + β 0 xi (γ). ˆ ˆ θ) ˆ θ). θ))2 ' n X¡ ¢2 0 yi − m0 θ θi i=1 0 and the right-hand-side is the SSE function for a linear regression of yi on mθi . the parameter estimates are not asymptotically normally distributed. θ0 )) − m(xi . under H0 . 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 . An alternative good measure is the conditional median. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . tests of H0 do not have asymptotic normal or chi-square distributions. θ) ' m(xi . by a ﬁrst-order Taylor series approximation. γ is not identiﬁed. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. but these are not the only measures of central tendency. Hansen (1996). This means that under H0 .1. ˆ and ei = yi − m(xi . Furthermore. θ0 ) + m0 (θ − θ0 ) . We have discussed projections and conditional means. 1 2 The model is linear when β 2 = 0. Thus when the truth is that β 2 = 0. 80 .4. θi Thus ¡ ¢ yi − m(xi . θ) ' (ei + m(xi . ¥ Based on Theorem 7.For θ close to the true value θ0 .

The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. Two useful facts about the median are that (7. i n n i=1 (7. These facts deﬁnitions motivate three estimators of θ. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x.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.10) The LAD estimator has the asymptotic distribution 81 .5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. These distinctions are illusory. Now let’s consider the conditional median of Y given a random variable X. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. however. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . The ﬁrst deﬁnition is the 50th empirical 1 P quantile. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . The second is the value which minimizes n n |yi − θ| .To recall the deﬁnition and properties of the median. let Y be a continuous random variable. and the substantive assumption is that the median function is linear in x. as i=1 these estimators are indeed identical.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 ) . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . the conditional density of the error at its median.Theorem 7. The main diﬃculty is the estimation of f (0). then there are many innovations near to the median. In the special case where the error is independent of xi . See Chapter 16.11). Computation of standard error for LAD estimates typically is based on equation (7.3. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.1 is advanced.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. V ). First. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. by the central limit theorem (Theorm 5. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . Pn −1 0 β)) . This can be done with kernel estimation techniques.10) is equivalent to g n (β) = 0. ˆ Proof of Theorem 7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. While a complete proof of Theorem 7. (7. we provide a sketch here for completeness. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .5. the height of the error density at its median. where V = and f (e | x) is the conditional density of ei given xi = x.5.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .1 ´ √ ³ˆ n β − β 0 →d N (0.5. Let g(β) = Eg (β). then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. ∂β 0 so Third. ¢¢−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) . When f (0 | x) is large. and this improves estimation of the median.

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

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

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

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

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

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

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

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

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

we say that Tn is asymptotically pivotal and use the distribution function G(x) for inferential purposes. That is. yn . F ). The bootstrap distribution is itself random. ∗ . 92 . x∗ ) denote random variables with the distribution Fn .Chapter 8 The Bootstrap 8. inference would be based on Gn (x. Fn ). In a seminal contribution. The unknown F is replaced by a consistent estimate Fn (one choice is discussed in the next section). which makes a diﬀerent approximation. F ) with G(x. In the next sections we describe computation of the bootstrap distribution. The statistic Tn = Tn (y1 . n (8.1) We call G∗ the bootstrap distribution. xi ) . for example an estimator ˆ or a t-statistic ˆ − θ /s(ˆ Note that we θ θ θ). F ) = P (Tn ≤ x | F ) In general. F ) ³ ´ be a statistic of interest. the t-statistic is a function of the parameter θ which itself is a function of F. Fn ) constructed on n 1. For example. Efron (1979) proposed the bootstrap. Ideally. The exact CDF of Tn when the data are sampled from the distribution F is Gn (x. xn . Gn (x. write Tn as possibly a function of F . as it depends on the sample through the estimator Fn . n n ∗ Let (yi . This is generally impossible since F is unknown... x∗ . Asymptotic inference is based on approximating Gn (x. F ) = G(x) does not depend on F. x1... . meaning that G changes as F changes. The distribution of Tn is identical to that of Tn when the true CDF of Fn rather than F. x∗ . yn . Let Tn = Tn (y1 . We call T ∗ this sample is a random variable with distribution Gn n n n ∗ the bootstrap statistic. Plugged into Gn (x. F ) = limn→∞ Gn (x. P (T ∗ ≤ x) = G∗ (x). F ) we obtain G∗ (x) = Gn (x.. Bootstrap inference is based on G∗ (x). F ). A random sample from this i ∗ ∗ ∗ distribution is call the bootstrap data.. When G(x. F ) depends on F.1 Deﬁnition of the Bootstrap Let F denote a distribution function for the population of observations (yi .

Fn is by construction a step function. 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) . the EDF step function gets uniformly close to the true CDF. Note that while F may be either discrete or continuous. note that for any (y.3. x) − F (y. i 93 .1). x) = n i=1 Figure 8. This is a population moment. but the approximation appears to improve for the large n. ∗ P (yi ≤ y. 1) distribution. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . To see the eﬀect of sample size on the EDF. 50. Furthermore. x) →p F (y. as the sample size gets larger. x) .1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . Fn (y. I have plotted the EDF and true CDF for three random samples of size n = 25. xi ). 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y.. Notationally. x∗ ≤ x) = Fn (y. Thus by the WLLN (Theorem 5. The EDF is a consistent estimator of the CDF. x∗ ) with the i distribution Fn .1). x))) . by the CLT (Theorem 5.2. To see this. x) (1 − F (y. x) = P (yi ≤ y. in the Figure below. √ n (Fn (y. and 100.2 The Empirical Distribution Function Fn (y. where 1(·) is the indicator function. the EDF is only a crude approximation to the CDF. n. Recall that F (y.8.. i = 1..2) Fn (y. it is helpful to think of a random pair (yi . . F (y. (8. The random draws are from the N (0. For n = 25. x)) →d N (0. x) is called the empirical distribution function (EDF). That is. In general. x). x). x).

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

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

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

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

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

] 8. Deﬁnition 8. F ) then ³x´ .3 an = o(n−r ) if nr |an | → 0 as n → ∞. about the rate v of convergence. the critical value qn (α) is found as the quantile from simulated values of W´ . If θ is a vector. C4 is called the symmetric percentile-t interval. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . Deﬁnition 8. Thus here Tn (θ) = Wn (θ).2 an = O(1) if |an | is uniformly bounded.8. Basically. not ˆ − θ0 . 99 . F ) = Φ + o (1) . an = O(n−r ) if it declines to zero like n−r . where qn (α) is the (1 − α)% quantile of the distribution of Wn . θ θ θ ˆ θ ∗ ∗ Computationally. it says nothing.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. We say that a function g(x) is even if g(−x) = g(x). then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. Let an be a sequence. θ [This is a typical mistake made by practitioners. The ideal test rejects if Wn ≥ qn (α). v 2 ). 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. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).8. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α. The following notation will be helpful.8.4) v ¡ ¢ While (8. A better asymptotic approximation may be obtained through an asymptotic expansion. and a function h(x) is odd if h(−x) = −h(x). and vice-versa. Equivalently.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. lim Gn (x. Let Tn be a statistic such that (8. writing Tn ∼ Gn (x. or the size of the divergence for any particular sample size n.8 Asymptotic Expansions Tn →d N (0.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. however. (8. F ) = Φ n→∞ v or ³x´ Gn (x. The derivative of an even function is odd. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .4) says that Gn converges to Φ x as n → ∞.

Gn (x. Heuristically. To a third order of approximation. ³x´ Gn (x.uniformly over x.1 has the expansion n G∗ (x) = Gn (x. 100 . F ) converges to the normal limit at rate n1/2 . F ) + O(n−3/2 ) Gn (x. F0 ) = Φ(x) + since v = 1.1 as follows.1 Under regularity conditions and (8.1. We can interpret Theorem 8. ³x´ 1 1 + 1/2 g1 (x.9 One-Sided Tests Using the expansion of Theorem 8. and g1 is continuous with respect to F. F0 ) = n 1 n1/2 (g1 (x. F ) ≈ Φ + n−1/2 g1 (x. Theorem 8.8. F0 )) + O(n−1 ). we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . the exact distribution is P (Tn < x) = Gn (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. Fn ) − g1 (x. F ) + g2 (x. F ) ≈ Φ + n−1/2 g1 (x.8. A bootstrap test is based on G∗ (x). Fn ) − g1 (x. F ). F ) v which adds a symmetric non-normal component to the approximate density (for example. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. adding leptokurtosis). F ) + n−1 g2 (x. ³x´ Gn (x. F0 ) ≈ ∂ g1 (x. √ Since Fn converges to F at rate n. To the second order. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). where g1 is an even function of x. the density function is skewed. so the order of the error is O(n−1/2 ). The diﬀerence is Φ(x) − Gn (x. g1 (x.8. v Since the derivative of g1 is odd.3). Moreover. Fn ) = Φ(x) + n 1 g (x. which from Theorem 8. F ) = Φ v n n 8. An asymptotic test is based on Φ(x). and g2 is an odd function of x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). First.8. the diﬀerence √ (g1 (x. 1/2 1 n Because Φ(x) appears in both expansions. To a second order of approximation. Fn ) − g1 (x. Fn ) + O(n−1 ). F0 )) converges to 0 at rate n. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F0 ) = 1 g (x.

F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. n (8. F ) − Gn (−x. 101 2 g2 (x. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). then |Tn | has the distribution function Gn (x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). F ) + g2 (−x. Since Tn →d Z. if Tn has exact distribution Gn (x. F ) = Gn (x. n . F ). F ) + g2 (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). Similarly. F ) = Gn (x.5) where the simpliﬁcations are because g1 is even and g2 is odd. F ).8. From Theorem 8. = P (X ≤ x) − P (X ≤ −x) For example. F0 ) = The order of the error is O(n−1 ). We conclude that G∗ (x) − Gn (x. if Z ∼ N (0. 8. 1). which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). F ) is only heuristic. A two-sided hypothesis test rejects H0 for large values of |Tn | . F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. F0 ) + O(n−3/2 ) = O(n−1 ). and exact critical values are taken from the Gn (x. we can calculate that Gn (x. F0 ) distribution. F ) + O(n−3/2 ). Thus asymptotic critical values are taken from the Φ distribution. F0 ) = O(n−1 ). This rate can be used to show that one-tailed bootstrap inference based on the tratio achieves a so-called asymptotic reﬁnement — the Type I error of the test converges at a faster rate than an analogous asymptotic test.1.The “derivative” ∂ ∂F g1 (x. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. then |Tn | →d |Z| ∼ Φ. as F is a function. F ) − Gn (−x.

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

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

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

∗ ∗ where s(ˆ is the standard error in the original data.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).75 and 1. Let qn (. and the colonial dummy. and thus reject H0 if ˆ ˆ > q ∗ (. size of house. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. What is wrong with this procedure? Tn = θ/s(θ) n 6. You replace c with qn (. with variables listed in the ﬁle hprice1. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).95).2. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. you generate bootstrap samples. and the 2. lot size. The dataﬁle hprice1. and ˆ is calculated on each θ ∗ ∗ θ sample.95) denote the 5% θ) ∗ and 95% quantiles of Tn . Suppose that in an application.5% quantiles of the ˆ are . Using the non-parametric ∗ bootstrap. You do this as follows.05) . Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.pdf. You want to test H0 : θ = 0 against H1 : θ > 0.95).95).3. ˆ = 1. (b) Report the 95% Alternative Percentile interval for θ. Estimate a linear regression of price on the number of bedrooms. can you report the 95% Percentile-t interval for θ? 7.2 and s(ˆ = .dat contains data on house prices (sales). 105 . Using the non-parametric bootstrap.95) denote the 95% quantile of Tn . θ θ) ∗ 1000 samples are generated from the bootstrap distribution. The ˆ are sorted. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. ∗ ∗ ∗ Let qn (. θ respectively.05) and qn (. ˆ − s(ˆ n (.5% and 97. (a) Report the 95% Efron Percentile interval for θ. (c) With the given information.

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

β ˆ Note that if k = . The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . let Jn (β) = n · g n (β)0 Wn g n (β). 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. For example. ˆ Deﬁnition 9. β GMM = Z 0 XWn X 0 Z 9. but this is generally not possible when > k. then. 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. β GMM does not change. This is a non-negative measure of the “length” of the vector g n (β).2. Let and where gi = xi ei .3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.1 β GMM = argmin Jn (β). and the GMM estimator is the MME. Proposition 9. i i . then g n (β) = 0. For some × weight matrix Wn > 0. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.2) g n (β) = (9. The GMM estimator minimizes Jn (β).9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . for if Wn is replaced ˆ by cWn for some c > 0. ¡ ¢−1 0 ˆ Z XWn X 0 Y. the dependence is only up to scale.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. if Wn = I.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . the square of the Euclidean length.

but it can be estimated consistently. However. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. The proof is left as an exercise. This results shows that in the linear model. the GMM estimator β is consistent yet ineﬃcient. as the distribution of the data is unknown. ˆ Construct n 1X ˆ g n = g n (β) = gi . For any Wn →p W0 . and this is all that is known. 9.3. without imposing additional assumptions. ˆ n i=1 gi = gi − g n .and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. Chamberlain showed that in this context. The optimal weight matrix W0 is one which minimizes V. this is a semi-parametric problem. as we are only considering alternative weight matrices Wn . This turns out to be W0 = Ω−1 . as it has the same asymptotic distribution.3. n n We conclude: Theorem 9.2 For the eﬃcient GMM estimator. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ .1 ´ √ ³ˆ n β − β →d N (0. V ) . Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. β). ˆ∗ ˆ 108 . For example. Ω) . ˆ we still call β the eﬃcient GMM estimator. a better choice is Wn = (X 0 X)−1 . Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. This is a weak concept of optimality. 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. as shown by Gary Chamberlain (1987). no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ .4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. n β − β →d N 0. where In general. we can set Wn = I . W0 = Ω−1 is not known in practice. If it is known that E (gi (β)) = 0. it turns out that the GMM estimator is semiparametrically eﬃcient. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. No estimator can do better (in this ﬁrst-order asymptotic sense). ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . In the linear model. it is semiparametrically eﬃcient.

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

Thus the model — the overidentifying restrictions — are testable. and in this case it would be impossible to ﬁnd a value of β 1 so that both E (x1i (yi − x0 β 1 )) = 0 and E (x2i (yi − x0 β 1 )) = 0 hold simultaneously. ˆ J = J(β) →d χ2−k . 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). where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). 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 . this is all that is known. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. Under the hypothesis of correct speciﬁcation. G0 Ω−1 G . take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0.1 Under general regularity conditions. 110 .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 . Hansen (1982). The general theory of GMM estimation and testing was exposited by L.5. β) = 0 holds. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . and if the weight matrix is asymptotically eﬃcient.Often. For example.1 (Sargan-Hansen). and then β recomputed. Since the GMM estimator depends upon the ﬁrst-stage estimator. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. 1 2 It is possible that β 2 = 0. However. Theorem 9. 1 it is possible that β 2 6= 0. so that the linear equation may be written as yi = β 0 x1i + ei . and is thus a natural test statistic for H0 : Egi = 0.6. This estimator can be iterated if needed. ˆˆ n is a quadratic form in g n . perhaps obtained by ﬁrst ˆ setting Wn = I. n β − β →d N 0. often the weight ˆ matrix Wn is updated. Note that g n →p Egi . 9. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. Identiﬁcation requires l ≥ k = dim(β).

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

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

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

ˆ ˆ Find the method of moments estimators (β. (c) Since Ω is positive deﬁnite. Write out the matrix A. Letting H = CQ and G = C 0−1 W Q. γ). Take the model yi = zi β + ei with E (xi ei ) = 0. a GMM estimator with arbitrary weight matrix). 114 . V − V0 is positive semi-deﬁnite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the eﬃcient weight matrix). Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent.9. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). Show that V0 = Q0 Ω−1 Q . we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. Show that Wn →p Ω i i i 4. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . In the linear model estimated by GMM with general weight matrix W. there exists a nonsingular matrix C such that C 0 C = Ω−1 . 2. γ ) for (β. Take the model E (zi ηi ) = 0. and therefore positive semideﬁnite. A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. From matrix algebra. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . 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 Ã n !−1 1X 0 2 xi xi ei ˆ . verify that A can be written as ³ ¡ ¢−1 0 ´ G H. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0.g. Let ei = yi − zi β where β is consistent for ˆ β (e. (b) We want to show that for any W. i 0 0ˆ ˆ 3.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1.

6. Show how to construct an eﬃcient GMM estimator for β. is deﬁned as Jn (β) = ˜ β = argmin Jn (β).5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . In the linear model Y = Xβ + e with E(xi ei ) = 0. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). zi is l × 1 and β is k × 1. xi .5. VR = V − V R R0 V R (d) Show that in this setting. h(β)=0 (9. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . VR ) where ¡ ¢−1 0 R V. the distance statistic D in (9. zi ). The observed data is (yi . 115 . Deﬁne the Lagrangian L(β.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. The equation of interest is yi = g(xi . λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. subject ˆ i ˆi i=1 to the restriction h(β) = 0. β) + ei E (zi ei ) = 0. Vn = X X i=1 ˜ and hence R0 β = r. The GMM estimator of β. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.6) equals the Wald statistic.6) (a) Show that you can rewrite Jn (β) in (9. 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 . l ≥ k. 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.

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

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

(see section 6. pn .7) 118 . we ﬁnd µ = n and 1 ¢.1) and (10. or equivalently minimizes its negative ˆ (10. and using the second and third equations. This yields the (proﬁle) empirical log-likelihood function for β. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . λ. we also obtain the Lagrange multiplier λ = λ(β). p (10. The solution (when it exists) is well deﬁned since Rn (β.. 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. the Lagrange multiplier λ(β) minimizes Rn (β..where λ and µ are Lagrange multipliers.4) (10. λ). Multiplying the ﬁrst equation by pi .5) This minimization problem is the dual of the constrained maximization problem. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. . pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β.2) subject to the restrictions (10. pi gi (β) = 0. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). (10. λ) = −n ln (n) − n X i=1 For given β. λ) : λ(β) = argmin Rn (β. µ.5) ˆ ˆ As a by-product of estimation.5). λ ¡ ¢ ln 1 + λ0 gi (β) . but must be obtained numerically (see section 6. Ln (β) = Rn (β. λ) is a convex function of λ. p1 . The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. summing over i. probabilities 1 ³ ´´ .3). µ) = n i=1 i=1 i=1 L∗ n with respect to pi .

8) and ¢ 0 0 For example. i i Theorem 10. ˆ ˆ Proof.10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . λ) = − (10.9) (10. 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 (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . β) = −xi zi .10). Gi (. and Ω = E xi x0 e2 .2.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . n (10.1 Under regularity conditions. 0 = Rn (β. (β. G = −E (xi zi ).11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .13) Premultiplying by G0 Ω−1 and using (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.10) ¡ Ω−1 N (0. λ) = − (10.9) and (10. β λ ∂ ³ ´. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. Thus the EL estimator is asymptotically eﬃcient. and n β − β 0 and nλ are asymptotically independent. i=1 i=1 i=1i Expanding (10. in the linear model. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.13) yields n n Expanding (10.

by a Taylor expansion.17) 2 ln 1 + λ gi β . The overidentiﬁcation test is a very useful by-product of EL estimation. 10.16) ´ √ 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.7) is n ³ ´´ ³ X ˆ ˆ0 (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. The same statistic can be constructed for empirical likelihood. and (10. Ω) GΩ G →d = N (0.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 (0.3 Overidentifying Restrictions In a parametric likelihood context. and have the same interpretation.14) for λ and using (10. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. They are asymptotically ﬁrst-order equivalent. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Proof.15). 120 .16).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. (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.1 If Eg(wi . and it is advisable to report the statistic LRn whenever EL is the estimation method. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .3. First. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.15) (10. Vλ ) Furthermore. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. LRn = i=1 Theorem 10. Since the EL estimator achieves this bound. V ) ˆ Solving (10. it is an asymptotically eﬃcient estimator for β. β 0 ) = 0 then LRn →d χ2−k .

To test the hypothesis h(β) while maintaining (10.prc 121 .wisc. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .4 Testing Egi (β) = 0 (10. h(β)=0 ˜ Fundamentally.18).ssc. so there is no fundamental change in the distribution theory for β relative to β. 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. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). By “maintained” we mean that the overidentfying restrictions contained in (10.18) and H0 : h(β) = 0.4.edu/~bhansen/progs/elike. 10.18) Let the maintained model be where g is × 1 and β is k × 1. Theorem 10. 10. This test statistic is a natural analog of the GMM distance statistic. since ln(1 + x) ' x − x2 /2 for x small.Second.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. the simple overidentifying restrictions test (10. The hypothesis of interest is h(β) = 0. Vλ )0 Ω−1 N (0. LRn →d χ2 . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. a The proof of this result is more challenging and is omitted.17) is not appropriate. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. where h : Rk → Ra .18) are assumed to hold and are not being challenged (at least for the test discussed in this section).

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

where λβ = ∂ −1 λ(β) = −Rλλ Rλβ .6) is Lβ = ∂ ∂ Ln (β) = Rn (β. the stepsize δ needs to be decreased. λ(β)) = 0. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. The gradient for (10. the eigenvalues of Lββ should be adjusted so that all are positive. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. Outer Loop The outer loop is the minimization (10. It is not guaranteed that Lββ > 0.20) fails. λ(β)) + λ0 Rλ (β.6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β.6). λ) = 0 at λ = λ(β).for all i. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize. If not. and the rule is iterated until convergence. This can be done by the modiﬁed Newton method described in the previous section. If (10. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. 123 . λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ . The Hessian for (10.

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

some regressors in zi will be uncorrelated with ei (for example. By the above deﬁnition. this can be written as Y = Zβ + e. In a typical set-up.1) if E (xi ei ) = 0.1) where zi is k × 1.2) Any solution to the problem of endogeneity requires additional information which we call instruments. We call (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. Deﬁnition 11. We call z1i exogenous and z2i endogenous.1) the structural equation.1). and x2i are the excluded exogenous variables. In matrix notation.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. So we have the partition µ ¶ z1i k1 (11. z1i is an instrumental variable for (11.1 The × 1 random vector xi is an instrumental variable for (11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. at least the intercept).1. (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 .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 ¶ . 11. β →p β ∗ . and assume that E(zi ei ) 6= 0 so there is endogeneity. which does not equal either β 1 or β 2 . This is called simultaneous equations bias. Thus we make the partition ¶ µ k1 z1i (11. so should be included in xi .

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

X2 ]. Thus in the second stage. the model is Y = Zβ + e (11. We now derive a similar result for the 2SLS estimator. Z = [Z1 .12) Z = XΓ + u ξ = (e. we regress Y on Z1 and Z2 . Using (11. Recall. Z2 = [PX Z1 .11). In our notation. Z2 ] and X = [Z1 . let’s analyze the approximate bias of OLS applied to (11.12). ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) .11) (11. ˆ since Z1 lies in the span of X. X is n × l so there are l instruments. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . First. Then i h ˆ ˆ ˆ Z = Z1 . 11. PX Z2 ] = [Z1 .13) which is zero only when S21 = 0 (when Z is exogenous). 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. 129 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . Z2 . Here we present a simpliﬁed version of one of his results.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. PX Z2 ] h i ˆ = Z1 . u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before.ˆ It is useful to scrutinize the projection Z.

l . the bias in the 2SLS estimator will be large.14) is the probability limit of β 2SLS − β 11.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .12) and this result. 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. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 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 and (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. except when S21 = 0 (when Z is exogenous). 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 . 0). 130 .14) In general this is non-zero.14) approaches that in (11. P = HΛH 0 0 0 where Λ = diag(Il . The consequences of identiﬁcation failure for inference are quite severe. By the spectral decomposition of an idempotent matrix. It is also close to zero when α = 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 .Let PX = X (X 0 X)−1 X 0 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.13). Indeed as α → 1. the expression in (11. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.

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

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

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

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

we expect that Yt and Yt−1 are not independent. and use the subscript t to denote the individual observation. however. and T to denote the number of observations.) is a random variable. . 135 .1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. There proofs are rather diﬃcult. . γ(k) is called the autocovariance function.. We can separate time series into two categories: univariate (yt ∈ R is scalar).1 If Yt is strictly stationary and ergodic and Xt = f (Yt .. Theorem 12.. The primary model for multivariate time series is vector autoregressions (VARs).Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. The primary model for univariate time series is autoregressions (ARs). Yt−k ) is the autocorrelation function. Because of the sequential nature of time series.1 Stationarity and Ergodicity Deﬁnition 12.2 {Yt } is strictly stationary if the joint distribution of (Yt . The following two theorems are essential to the analysis of stationary time series.4 (loose).. then Xt is strictly stationary and ergodic.1.1. and Cov (Yt . . Deﬁnition 12.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . To indicate the dependence on time. Yt−k ) = γ(k) is independent of t for all k. T . A stationary time series is ergodic if γ(k) → 0 as k → ∞. we adopt new notation.1.1. Yt−1 . 12. t = 1.. and multivariate (yt ∈ Rm is vector-valued).. Deﬁnition 12..1.. so classical assumptions are not valid. Yt−k ) is independent of t for all k. Deﬁnition 12.

1. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). the sequence Yt Yt−k is strictly stationary and ergodic. If Xt is strictly stationary and ergodic and E |Xt | < ∞. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. ˆ 3. For Part (2). T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). T 1X Xt →p E(Xt ).1. Part (1) is a direct consequence of the Ergodic theorem. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . and it has a ﬁnite mean by the assumption that EYt2 < ∞.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. γ (0) ˆ Theorem 12.1.2 (Ergodic Theorem). 1. then as T → ∞. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).Theorem 12. µ →p E(Yt ). then as T → ∞. ˆ ˆ γ ¥ 136 . ˆ Proof.1 above. ˆ 2. ρ(k) →p ρ(k). γ (k) →p γ(k). note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . 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) .

Some time-series processes may be a MDS as a consequence of optimizing behavior.. 137 .. or consumption growth rates. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 .. Y1 . t By back-substitution. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + .. A linear AR model (the most common type used in practice) speciﬁes linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k . Yt−2 . YT .. Thus for k > 0. . 12. Yt−k ) . . . The last property deﬁnes a special time-series process. ... We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .2 Autoregressions In time-series. should be a MDS. Regression errors are naturally a MDS. This occurs when |ρ| < 1. k=0 Loosely speaking. In fact. Y2 .. Deﬁnition 12.} are jointly random..3 Stationarity of AR(1) Process Yt = ρYt−1 + et . the series {. Letting et = Yt − E (Yt | It−1 ) . ∞ X = ρk et−k . A mean-zero AR(1) is Assume that et is iid.} is the past history of the series. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 .2. The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression. some versions of the life-cycle hypothesis imply that either changes in consumption. as it is diﬃcult to derive distribution theories without this property.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. it is even more important in the time-series context..... Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. E(Yt−k et ) = 0.12... this series converges if the sequence ρk et−k gets small as k → ∞. For example. E(et ) = 0 and Ee2 = σ 2 < ∞.

the above results are unchanged.1.3. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). 12. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . The AR(k) model is Using the lag operator. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . Deﬁnition 12. We call ρ(L) the autoregressive polynomial of Yt . We say that the root of the polynomial is 1/ρ.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 138 .1 If |ρ| < 1 then Yt is strictly stationary and ergodic.1 The lag operator L satisﬁes LYt = Yt−1 . we see that L2 Yt = LYt−1 = Yt−2 . Deﬁning L2 = LL. 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). since ρ(z) = 0 when z = 1/ρ. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L.4. In general. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. We call ρ(L) the autoregressive polynomial of Yt .3. Lk Yt = Yt−k . an AR(1) is stationary iﬀ |ρ| < 1. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . ∞ X k=0 ρ2k V ar (et−k ) = 12.Theorem 12. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . From Theorem 12.

6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . . t Yt−k ¢0 ρk . One way of stating this is that “All roots lie outside the unit circle..1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.1. so is xt x0 . By Theorem 12.. which satisfy ρ(λj ) = 0. we say that ρ(L).1. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. Let |λ| denote the modulus of a complex number λ. β = X 0X (12. The vector xt is strictly stationary and ergodic. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. then ˆ β →p β as T → ∞. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. and is of great interest in applied time series.1.. Thus t by the Ergodic Theorem. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. This is a special case of non-stationarity. λk are the complex roots of ρ(z).6. Theorem 12. Note that ut is a MDS.1) Theorem 12. and by Theorem 12.1. the requirement is that all roots are larger than one. it is helpful to deﬁne the process ut = xt et . Proof.” If one of the roots equals 1. “has a unit root”. 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. t t T t=1 ¥ Combined with (12. For an AR(k). ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. it is also strictly stationary and ergodic.where the λ1 . We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.5.1) and the continuous mapping theorem. and hence Yt . t T t=1 T t=1 139 .

7. . Y−k+2 . then as T → ∞.. there are two popular methods to implement bootstrap resampling for time-series data. It also presumes that the AR(k) structure is the truth. ˆ 2. t t Theorem 12. Estimate β and residuals et . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. we constructed the bootstrap sample by randomly resampling from the data values {yt . Y0 ). 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∗ . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞..12. Method 2: Block Resampling 1. . e ˆ 3. ˆ 1. Brieﬂy. the asymptotic covariance matrix is estimated just as in the cross-section case. 140 . Method 1: Model-Based (Parametric) Bootstrap.7 Asymptotic Distribution Theorem 12. Clearly.7. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . t This construction imposes homoskedasticity on the errors e∗ .8 Bootstrap for Autoregressions In the non-parametric bootstrap. i 4.1 MDS CLT. t then as T → ∞. This creates an iid bootstrap sample.. we can apply Theorem 12. T 1 X √ ut →d N (0. Q−1 ΩQ−1 . eT }.. Ω) . The implication is that asymptotic inference is the same. Ω) . which may be diﬀerent than the i properties of the actual ei . In particular. Fix an initial condition (Y−k+1 ... T t=1 where Ω = E(xt x0 e2 ). 12. This is identical in form to the asymptotic distribution of OLS in cross-section regression.1 to see that T 1 X √ xt et →d N (0. this cannot work in a time-series application.7. xt }. T t=1 Since xt et is a MDS. Divide the sample into T /m blocks of length m. as this imposes inappropriate independence.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.

The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. and perhaps this was of relevance. For each simulated sample.3) replacing St with St . . or the season-to-season change. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. also alters the time-series correlations of the data. get the ˆ ˆ residual St . Seasonal Eﬀects There are three popular methods to deal with seasonal data. If s is the number of seasons (typically s = 4 or s = 12).. ∆s Yt = Yt − Yt−s . • Include dummy variables for each season.3) sequentially by OLS.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . The series ∆s Yt is clearly free of seasonality.. But the long-run trend is also eliminated. ﬁrst estimate (12. ρk ). draw T /m blocks. May not work well in small samples.2)-(12. (12. 6.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .2.. • Use “seasonally adjusted” data. 3. This presumes that “seasonality” does not change over the sample. The seasonal adjustment. This allows for arbitrary stationary serial correlation. This is a ﬂexible approach which can extract a wide range of seasonal factors.2) (12. (12. The results may be sensitive to the block length.2). however. • You can estimate (12.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . That is.4) by OLS. This procedure is sometimes called Detrending. • You can estimate (12. and then perform regression (12. 12. 141 . Thus the seasonally adjusted data is a “ﬁltered” series. • First apply a seasonal diﬀerencing operator. and for modelmisspeciﬁcation. Resample complete blocks. 4. and the way that the data are partitioned into blocks. 5. heteroskedasticity. Paste the blocks together to create the bootstrap time-series Yt∗ .

We then multiply this by θ and subtract from (12. (12.5). 142 ... An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. One approach to model selection is to choose k based on a Wald tests.. Another is to minimize the AIC or BIC information criterion. AR(2). We model this as an AR(1): ut = θut−1 + et with et a MDS. if the null hypothesis is that Yt is an AR(k). let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . Yt is an AR(1). H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.6) 12. Yt−k−m are jointly zero.5) We are interested in the question if the error ut is serially correlated. Thus under H0 . to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . and the alternative is that the error is an AR(m). (A simple exclusion test).10 Testing for Omitted Serial Correlation For simplicity... you need more initial conditions. e.6). 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.g.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . . We want to test H0 against H1 . To combine (12. and then reserve the ﬁrst k as initial conditions. (If you increase k.. this is the same as saying that under the alternative Yt is an AR(k+m). The best remedy is to ﬁx a upper value k. and then estimate the models AR(1). and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . (12. AR(k) on this (uniﬁed) sample. . we take (12.5) and (12. In general.) 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.12. AIC(k) = log σ 2 (k) + ˆ 2k . and under H1 it is an AR(2). or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). An appropriate test is the Wald test of this restriction.

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

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

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

This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator. Then the VAR system can be written as the equations Yjt = a0 xt + ejt . One way to write this is to let a0 be the jth row j of A. . each with the same set of regressors.. or as a linear projection. Restrictions may be imposed on individual equations. Note that a0 = Yj0 X(X 0 X)−1 . The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj . j Unrestricted VARs were introduced to econometrics by Sims (1980).. These are implied by the VAR model. ˆj ˆ And if we stack these to create the estimate A. either as a regression. ⎟ ⎝ . 13. The VAR model is a system of m equations. Consider the moment conditions j = 1.3 Restricted VARs The unrestricted VAR is a system of m equations. or across equations.then Yt = Axt + et . A restricted VAR imposes restrictions on the system. The GMM framework gives a convenient method to impose such restrictions on estimation. 146 . ˆ An alternative way to compute this is as follows. m. ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 . we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ .2 Estimation E (xt ejt ) = 0. and was originally derived by Zellner (1962) ¢ 13. ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt .. For example.2 ⎟ X(X 0 X)−1 A ⎜ . some regressors may be excluded from some of the equations.

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

In a linear VAR. for example.. This idea can be applied to blocks of variables.13.6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR.. then we say that Zt Granger-causes Yt .) I2t = (Yt . and et (k) is the OLS residual vector from the ˆ model with k lags. Zt−1 . conditional on information in lagged Yt . Yt−1 . This may be tested using an exclusion (Wald) test. lagged Zt does not help to forecast Yt . 148 . that Zt may still be useful to explain other features of Yt . This deﬁnition of causality was developed by Granger (1969) and Sims (1972). If it is found that Zt does not Granger-cause Yt . Yt−1 . Zt−2 . Zt . the equation for Yt is 0 0 Yt = α + ρ1 Yt−1 + · · · + ρk Yt−k + Zt−1 γ 1 + · · · + Zt−k γ k + et . you may either use a testingbased approach (using.. In this equation. The log determinant is the criterion from the multivariate normal likelihood. Deﬁne the two information sets I1t = (Yt . Yt and/or Zt can be vectors. Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0. . If this condition does not hold.) The information set I1t is generated only by the history of Yt .7 Granger Causality Partition the data vector into (Yt . then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt . 13. Note. The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure deﬁnition of causality.t−1 ) = E (Yt | I2. the Wald statistic). such as the conditional variance. then Zt may help to forecast Yt even though it does not “cause” Yt . and the information set I2t is generated by both Yt and Zt . . That is. Zt ). or an information criterion approach. however.t−1 ) . We say that Zt does not Granger-cause Yt if E (Yt | I1. such as a futures price. If Zt is some sort of forecast of the future. . 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.. Yt−2 . The hypothesis can be tested by using the appropriate multivariate Wald test. Yt−2 . The latter has more information. That is.

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

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

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

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

1) yi = ∗ <0 .2 Count Data exp (−λi ) λk i . This may be considered restrictive. the consumption level (purchases) in a particular period was zero. σ 2 ) with the observed variable yi generated by the censoring equation (14. The functional form for λi has been picked to ensure that λi > 0. i i i=1 ˆ The MLE is the value β which maximizes ln (β). 2. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. The censoring process may be explicit in data collection. 1.14. An example of a data collection censoring is top-coding of income. any known value can substitute. 0 if yi (This is written for the case of the threshold being zero. incomes above a threshold are typically reported at the threshold. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.) The observed data yi therefore come from a mixed continuous/discrete distribution. a typical approach is to employ Poisson regression. The conditional density is the Poisson with parameter λi .}. i If Y = {0. Tobin observed that for many households. 2. . k! = exp(x0 β). i so the model imposes the restriction that the conditional mean and variance of Yi are the same. 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 model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . 14. 1.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). In surveys. this motivates the label Poisson “regression. .3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold.. A generalization is the negative binomial.. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. or it may be a by-product of economic constraints. Thus the model is that there is some latent process yi with unbounded support. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) ..1)..

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

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

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

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

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

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

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

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

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

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

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

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

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

3) is unavailable.. Typically. .. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) .. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. Instead. τ r . then for each i = 1. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. The probability function for X takes the form j = 1.. We say that the random variable X is continuous if F (x) is continuous in x.. (A.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. and use lower case letters such as x for potential values and realized values.. 167 . For any set B and any partition A1 . 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.. . A2 .2 Random Variables A random variable X is a function from a sample space S into the real line. F (x) is nondecreasing in x 3.3) P (X = τ j ) = π j . Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1.. these cases are unusualRand are typically ignored. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.. . we denote random variables by uppercase letters such as X. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. While there are examples of continuous random variables which do not possess a PDF. 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.Theorem 2 (Bayes’ Rule). 2. the range of X consists of a countable set of real numbers τ 1 . . r (A. a These expressions only make sense if F (x) is diﬀerentiable. of the sample space.. In the latter case.

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

.. 0≤p≤1 x = 0.A. 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 .. n. x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx . 2. EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x . . 1. 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 . 2... .... X2 = x2 . 1. 1.. m x1 !x2 ! · · · xm ! 1 2 = n.. Bernoulli P (X = x) = px (1 − p)1−x . Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . x! EX = λ x = 0. we now list some important discrete distribution function.. λ>0 x = 1.. . . x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 .. 0≤p≤1 x = 0. x = 1.4 Common Distributions For reference. 0≤p≤1 V ar(X) = λ We now list some important continuous distributions. 169 .. . 2..

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

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

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

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

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

but its justiﬁcation requires deeper results from analysis.A.10) holds for k > 1. If g(x) is an increasing function. an exponential density. 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). diﬀerentiable. dy dy If g(x) is a decreasing function. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y).∞).7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). Here. J(y) = det ∂y 0 Consider the univariate case k = 1. and invertible. 1]. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. then g(X) ≤ Y if and only if X ≤ h(Y ). A. Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. that for Y is [0.10) shows that fY (y) = exp(−y). This same formula (A. The Jacobian is ¶ µ ∂ h(y) . Let Y = g(X) where g(x) : Rk → Rk is one-to-one. As one example.10) d h(y). 1] and Y = − ln(X). so FY (y) = P (g(X) ≤ y) = 1 − P (X ≥ h(Y )) = 1 − FX (h(Y )) and the density of Y is fY (y) = −fX (h(Y )) We can write these two cases jointly as fY (y) = fX (h(Y )) |J(y)| . As the range of X is [0. .8 Normal and Related Distributions µ 2¶ 1 x . dy This is known as the change-of-variables formula. (A. Let h(y) denote the inverse of g(x). then g(X) ≤ Y if and only if X ≥ h(Y ). 0 ≤ y ≤ ∞. take the case X ∼ U [0.

(A. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . Since it is symmetric about zero all odd moments are zero.2 If Z ∼ N(0. If Z is standard normal and X = µ + σZ. σ 2 ). then Σ = diag{σ 2 } is a diagonal matrix. and it is conventional to write X ∼ N (µ. and it is conventional to write X ∼ N(µ. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . we can also show that EX 2 = 1 and EX 4 = 3.1 Let X ∼ N (0. Σ) and Y = a + BX with B an invertible matrix. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. This shows that linear transformations of normals are also normal.8. q 176 . −∞ < x < ∞. Σ). f (x) = √ 2σ 2 2πσ which is the univariate normal density. In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. A) with A > 0. Another useful fact is that if X ∼ N (µ. denoted χ2 . Theorem A. The latter has no closed-form solution. X has density Ã ! (x − µ)2 1 exp − . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . Its mean and r variance are µ = r and σ 2 = 2r. For x ∈ Rk . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . Theorem A. x ∈ Rk . This shows that if X is multivariate normal with uncorrelated elements.11) and is known as the chi-square density with r degrees of freedom. It is conventional to write X ∼ N (0. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). x ∈ Rk . ¢ ¡ 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 . the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . then by the change-of-variables formula. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. 1). Ir ) and set Q = X 0 X. q × q. y ≥ 0. then Z 0 A−1 Z ∼ χ2 . then using the change-of-variables formula.8. By iterated integration by parts.This density has all moments ﬁnite. then they are mutually independent. respectively. The mean and variance of the distribution are µ and σ 2 .

13) is the MGF of the density (A.8.11).3.8.Theorem A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. q Proof of Theorem A.12) E exp (tQ) = 0 Γ (A. 1) and Q ∼ χ2 be independent. Proof of Theorem A. tr has distribution 177 .2.1. which we showed in (A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.3 Let Z ∼ N (0. 1). For Z ∼ N(0. which can be found by applying change-of-variables to the gamma function. (A. Iq ). Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . The fact that A > 0 means that we can write A = CC 0 where C is non-singular. 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 .8.11) 2 with r = 1. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. we see that the MGF of Z 2 is (1 − 2t)−1/2 . C −1 CC 0 C −10 ) = N (0. Set r Z .8.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. From (A. C −1 AC −10 ) = N (0.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Thus the density of Z 2 is (A. Using the simple law of iterated expectations.13). The MGF for the density (A.

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

´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. θ0 ) ln f (Yi . we can see that it is an estimator of the maximizer θ of the right-hand-side.16) (A. θ0 ) ∂θ∂θ 0 (A. θ) ∂θ ∂θ which holds at θ = θ0 by (A.3 Under regularity conditions. ˆ →p θ0 as n → ∞.15) Two important features of the likelihood are Theorem A. ˆ is consistent θ for this value.17) The matrix I0 is called the information.14) ¶ ∂ ∂ 0 ln f (Yi .9.1 ¯ ¯ ∂ E ln f (Yi . θ0 ) . θ θ∈Θ ˆ In some simple cases. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. cases are rare. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ) ≡ L(θ). More typically. and the equality (A. We can write this as ˆ = argmax Ln (θ). The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .9. Theorem A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . then θ V ar(˜ ≥ (nI0 )−1 . I0 .2 Cramer-Rao Lower Bound. n n i=1 n As the MLE ˆ maximizes the left-hand-side. However. ∂θ ∂θ (A. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. In fact. θ) The Cramer-Rao Theorem gives a lower bound for estimation. but these ˆ must be found by numerical methods.17) is often called the information matrix equality. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . we can ﬁnd an explicit expression for θ as a function of the data. which maximizes the log-likelihood). θ Theorem A. under conventional regularity conditions. θ) →p E ln f (Yi . If ˜ is an unbiased estimator of θ ∈ R. 179 .9.16).

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

yn ). θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.9.17). θ) f (y. To see (A. θ) f (˜. Since θ Z ˜ = ˜ y)f (˜.. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ) dy ¯ ∂θ f (y..Proof of Theorem A. we can show that E By direction computation. θ0 ) ∂ ∂ − ln f (Yi . f (Yi . θ0 )0 f (Yi . θ0 ) ln f (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. ∂2 ln f (Yi . θ0 ) d˜ = E ˜ . θ0 ) ∂θ f (Yi .9. 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 = . V ar (S) nH so ¥ 181 .16). . Proof of Theorem A. function of the data. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. ∂θ ¯θ=θ0 Z ! = 0. (Yi . θ0 ) − f (Yi . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 = ln f (Yi . θ0 ) (Yi .. θ0 ) ¯ ∂ f (y. θ0 ) f (Yi .9. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. ¯ ¯ ∂ E ln f (Yi .1.1) has mean zero and variance nH. θ0 ) ∂ ∂θ f ∂ (Yi . θ0 )0 . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 )2 (Yi .2.

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

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

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

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

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