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

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Contents

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

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

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

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

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

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

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ii

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

. . . . . . . . . . . B. . . . . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 Multivariate Time Series 13. . .1 Individual-Eﬀects Model . . . . . . . . . . .2 Random Variables . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B Numerical Optimization B. . . . . . . . . . . . . . . .4 Single Equation from a VAR . . . A. . . 157 15. . . .6 Conditional Distributions and Expectation . . 13. . . . . . . . . . . . . . . 14.5 Multivariate Random Variables . . . . . . . . 13. . . . . . . . . . . . . . . . .3 Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . 14. . . . . . . . . .2 Fixed Eﬀects . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . .1 Binary Choice . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . 14. . . . . . .7 Transformations . . . . . . . .1 Grid Search . . 13. . . . . .4 Sample Selection . . . . . . . . . . . A. . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . .2 Count Data . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 A Probability A. . . . . . . . . . 157 15. . . 160 16. . . . . . . . . . 13.8 Cointegration . .2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Gradient Methods . . . .1 Foundations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv . . . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . .7 Granger Causality . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. . . . . . . . . . A. . . . . . . . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Kernel Density Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Common Distributions . . . . .3 Censored Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Restricted VARs . A. . . . . . B. . . . . . . 13. .9 Maximum Likelihood . . . . .

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

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

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

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

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

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

or is nonsingular. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . (2.1) . 7 Also.3) The matrix A− is not necessarily unique. . . if there is no c 6= 0 such that Ac = 0. (2. In this case there exists a unique matrix B such that AB = BA = Ik . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.4 Inverse A k × k matrix A has full rank. .The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . . The Moore-Penrose generalized inverse A− satisﬁes (2. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . . the Moore-Penrose generalized inverse A− exists and is unique.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 (2.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. . if A is an orthogonal matrix. This matrix is called the inverse of A and is denoted by A−1 . 2. If A − BD−1 C and D − CA−1 B are non-singular. The following fact about inverting partitioned matrices is sometimes useful. For non-singular A and C. then A−1 = A. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . .

c0 Ac ≥ 0. 2.. In this case. i = 1. • If A has distinct characteristic roots. We now state some useful properties. c0 Ac > 0.5 Eigenvalues det (A − λIk ) = 0. To see this. then A − λi Ik is singular so there exists a non-zero vector hi such that (A − λi Ik ) hi = 0 The vector hi is called a latent vector or characteristic vector or eigenvector of A corresponding to λi . We say that A is positive deﬁnite if for all non-zero c. We call B a matrix square root of A. This is written as A ≥ 0. If λi is an eigenvalue of A. then A is non-singular and A−1 exists. Let Λ be a diagonal matrix with the characteristic roots in the diagonal.2. then A = HΛH 0 and H 0 AH = Λ. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal.. k denote the k eigenvalues and eigenvectors of a square matrix A. then A > 0 if and only if all its characteristic roots are positive. λ−1 . which are not necessarily distinct and may be real or complex. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. (For any c 6= 0. If A > 0 we can ﬁnd a matrix B such that A = BB 0 . λ−1 . Let λi and hi . there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. If A is symmetric. Q • det(A) = k λi i=1 Pk • tr(A) = i=1 λi • A is non-singular if and only if all its characteristic roots are non-zero. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. They are called the latent roots or characteristic roots or eigenvalues of A. A square matrix A is idempotent if AA = A. • If A is symmetric..) If A is positive deﬁnite. • The characteristic roots of A−1 are λ−1 . X 0 X is symmetric and positive deﬁnite. The matrix B need not be unique. The characteristic equation of a square matrix A is The left side is a polynomial of degree k in λ so it has exactly k roots. This is written as A > 0. If A = G0 G. and the characteristic roots are all real. and let H = [h1 · · · hk ]. A−1 > 0.6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots. .. Furthermore. k < n.. then A is positive semi-deﬁnite. has full rank k if there is no non-zero c such that Xc = 0. and then set B = HΛ1/2 .. c0 Ac = α0 a ≥ 0 where α = Gc. 8 . . We say that X is n × k.

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

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

In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. See Chapter 16. and exists so long as E |yi | < ∞.1) xi = ⎜ . We call yi the dependent variable. When a distribution is skewed.1 by the arrows drawn to the x-axis. The two density curves show the eﬀect of gender on the distribution of wages. education and experience. the conditional density of yi given xi . xi ) where yi is a scalar (real-valued) and xi is a vector.2) m(x) = E (yi | xi = x) = −∞ In general. ⎟ . the conditioning variable. it is useful to have numerical measures of the diﬀerence.1 displays the density1 of hourly wages for men and women. The data are from the 2004 Current Population Survey 1 11 . gender. which is a common feature of wage distributions. holding the other variables constant. the mean is not necessarily a good summary of the central tendency.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. While it is easy to observe that the two densities are unequal. or the covariates. In this context we partition the observations into the pair (yi .73. We call xi alternatively the regressor. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. (3. .1. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. m(x) can take any form. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. Figure 3. In the example presented in Figure 3. This is used when the goal is to quantify the impact of one set of variables on another variable. These are asymmetric (skewed) densities. These are indicated in Figure 3. Take a closer look at the density functions displayed in Figure 3. These are conditional density functions — the density of hourly wages conditional on race.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression.1.22. To illustrate. we can focus on f (y | x) . the mean wage for men is $27. xki 3. ⎠ ⎝ . and that for women is $20. You can see that the right tail of then density is much thicker than the left tail.

3 displays a scatter plot2 of log wages against education levels.1 is facilitated by the fact that the control variable (gender) is discrete.2 shows the density of log hourly wages for the same population. the solid line displays the conditional expectation of log wages varying with education. The conditional expectation function is close to linear.A. then comparisons become more complicated. The comparison in Figure 3. The main point to be learned from Figure 3. and a Ph. By construction.30.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. The diﬀerence in the log mean wage between men and women is 0.2) evaluated at the observed value of xi : ei = yi − m(xi ).3) White non-military male wage earners with 10-15 years of potential work experience. Assuming for simplicity that this is the true joint distribution. this yields the formula yi = m(xi ) + ei . 3. 2 (3.3 is how the conditional expectation describes an important feature of the conditional distribution. For this reason. wage regressions typically use log wages as a dependent variable rather than the level of wages. Figure 3. degree in mean log hourly wages is 0.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3.D. Figure 3.5. When the distribution of the control variable is continuous. which implies a 30% average wage diﬀerence for this population. To illustrate.36. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. Of particular interest to graduate students may be the observation that diﬀerence between a B. 12 . the dashed line is a linear projection approximation which will be discussed in the Section 3. with mean log hourly wages drawn in with the arrows.Figure 3. implying an average 36% diﬀerence in wage levels.

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

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

βk ⎛ (3. its functional form is typically unknown. ⎠ . ⎝ .5) xi = ⎜ . take the conditional wage densities displayed in Figure 3. it is more realistic to view the linear speciﬁcation (3. Equivalently. The conditional standard deviation for men is 12.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . Thus (3.6) (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . it is convenient to augment the regressor vector xi by listing the number “1” as an element. Instead. ⎟ . Notationally. We call this the “constant” or “intercept”.8) (3.1). where x1i is the ﬁrst element of the vector xi deﬁned in (3.7) is a k × 1 parameter vector.5. which we derive in this section. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .1 and that for women is 10. 3. they are also somewhat more dispersed. ⎠ . In this case (3. and the linear assumption of the previous section is empirically unlikely to accurate.8) is called the linear regression model.9) 3.we say that the error ei is homoskedastic.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). So while men have higher average wages. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . xki When m(x) is linear in x.6) as an approximation. 15 . i (3. ⎟ β=⎝ . Equation (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.4 Linear Regression An important special case of (3. As an example.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.1. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. we assume that x1i = 1.

E (xi x0 ) is invertible. i (3. This occurs when redundant variables are included in xi . 3. this situation must be excluded. α0 E (xi x0 ) α = E (α0 xi )2 > 0. written E (xi x0 ) > 0. Observe i that for any non-zero α ∈ Rk . Rewriting.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.12) This completes the derivation of the linear projection model. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . Equivalently.1. In order for β to be uniquely deﬁned. 2 2. The best linear predictor is obtained by selecting β to minimize S(β).10). Therefore. Given the deﬁnition of β in (3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. As before. The ﬁrst-order condition for minimization (from Section 2. i (3. The vector (3.5. The error is i ei = yi − x0 β. i 16 .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 . Assumption 3. by “best” we mean the predictor function with lowest mean squared error. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.which is quadratic in β. xi contains an intercept. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. i i (3. i which requires that for all non-zero α. Eyi < ∞. E (x0 xi ) < ∞. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . x0 β is the best linear predictor for yi . α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. otherwise they are distinct. 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.1 1. i 4.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.10) It is worth taking the time to understand the notation involved in this expression. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.5. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . It is invertible if and only if it is positive deﬁnite.

8)-(3.13) implies that xi and ei are uncorrelated.1.12) can be alternatively interpreted as a projection decomposition. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.1.11) and (3.14) follows from (3. This means that the equation (3.3 ensure that the moments in (3.1. However. (3.4 we know that the regression error has the property E (xi ei ) = 0.1.5. Assumption 3.2 and 3.2 and 3. ¥ (3.1. Assumption 3.11) are well deﬁned.5.3 are called regularity conditions. the orthogonality restriction (3.13) and Assumption 3.1.1.1 Under Assumption 3. Figure 3.14) holds.5.1. 17 . Using the deﬁnitions (3.5.1.1.5. Since from Theorem 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 = 0.4 is required to ensure that β is uniquely deﬁned.5. Equation (3. E (xi ei ) = 0 and E (ei ) = 0.13) The two equations (3.14).1 are weak.10) are deﬁned. Assumption 3.Theorem 3.1 is employed to guarantee that (3.5. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. For example.13) summarize the linear projection model.1. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Assumption 3.12) and (3.9).10) and (3.5. The ﬁnite variance Assumptions 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. it follows that linear regression is a special case of the projection model.5. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. (3.5. Since ei is mean zero by (3.5.2.4 guarantees that the solution β exits. By deﬁnition.14) Proof. Furthermore. Let’s compare it with the linear regression model (3.

Figure 3. These structural models require alternative estimation methods.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.1. xi ) we can deﬁne a linear projection equation (3. No additional assumptions are required.We have shown that under mild regularity conditions.3. and are discussed in Chapter 11. and the straight dashed line is the linear projection.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. In this case (3. it is important to not misinterpret the generality of this statement. there are no changes in our methods or analysis. Most importantly. A projection of log wages on these two variables can be called a quadratic projection. and under-predicts for the rest.12) with the properties listed in Theorem 3. In contrast.1 may be false. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.5. In this example it is a much better approximation to the conditional mean than the linear projection. In the example just presented. the dashed line is the linear projection of log wages on eduction. This defect in linear projection can be partially corrected through a careful selection of regressors. We illustrate the issue in Figure 3.5. In Figure 1. for any pair (yi .4 displays the relationship3 between mean log hourly wages and labor market experience. 18 . In other cases the two may be quite diﬀerent. It over-predicts wages for young and old workers.10) may not hold and the implications of Theorem 3.10). Figure 3. in many economic models the parameter β may be deﬁned within the model.4 we display as well this quadratic projection. In this example the linear projection is a close approximation to the conditional mean. Returning to the joint distribution displayed in Figure 3. However. since the resulting function is quadratic in experience. The solid line is the conditional mean. Other than the redeﬁnition of the regressor vector. for those over 53 in age). In this case the linear projection is a poor approximation to the conditional mean. The linear equation (3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. we can augment the regressor vector xi to include both experience and experience2 .

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

i 11. µx = Exi . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x.. Let X be a random variable with µ = EX and σ 2 = V ar(X).1. True or False. i 8. Compute E(yi | xi = x) and V ar(yi | xi = x). If yi = x0 β + ei and E(ei | xi ) = 0. If yi = x0 β + ei . s) = 0 if and only if m = µ and s = σ 2 . True or False. 3. Prove parts 2. then ei is independent of xi .3. If yi = xi β + ei . j! 0 j = 0.2. σ 2 = V ar(yi ) and σ xy = Cov(xi . and E(ei | xi ) = 0. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . Are they diﬀerent? Hint: If P (Y = j) = 5. σ = . then E(x2 ei ) = 0. . (x − µ)2 − σ 2 Show that Eg (X. 1. 0 ≤ y ≤ 1. then E(ei | xi ) = 0. m. 2. Compute the conditional mean m(x) = E (yi | xi = x) . True or False. a constant. E(Y 2 | X = x) and V ar(Y | X = x). and E(xi ei ) = 0. 9. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. ¡ ¢ 4. yi ). i 10. then E(x2 ei ) = 0. Suppose that yi is discrete-valued. Suppose that Y and X only take the values 0 and 1. If yi = xi β + ei . xi ∈ R.4 . and E(e2 | xi ) = σ 2 .2 Y =1 . xi ∈ R. E(ei | xi ) = 0. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. True or False. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx ..1 .3 Find E(Y | X = x). σ 2 = V ar(xi ). If yi = x0 β + ei and E(xi ei ) = 0. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . 20 .6 Exercises 1. taking values only on the non-negative integers. x 6. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . µ. and have the following joint probability distribution X=0 X=1 Y =0 . 2. 3 and 4 of Theorem 3. True or False. then ei is i i independent of xi . i 7. e−λ λj j! . Let xi and yi have the joint density f (x.

i n i=1 n 21 . i It follows that the moment estimator of β replaces the population moments in (4.2) can be written in the parametric 0 β)) = 0.8. 4.1 Estimation Equation (4.7 and 4. (4. but for most of the chapter we retain the broader focus on the projection model.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 (4.3) In Sections 4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .1) (4. we narrow the focus to the linear regression model. 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 .2) (4. Observe that (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .4) i i=1 i=1 ˆ Another way to derive β is as follows.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 .

30 = . 40 2. Then µ ¶ n 1X 2.14 14.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.14 14. An interpretation of the estimated equation is that each year of education is associated with an 11.117 Educationi .170 37.30 + 0. 4. This sample has 988 observations.4).7% increase in mean wages.95 xi yi = 42. with 10-15 years of potential work experience.2 Least Squares There is another classic motivation for the estimator (4.117 1 14. Let yi be log wages and xi be an intercept and years of education. These are white male wage earners from the March 2004 Current Population Survey.4).71 = −2.40 µ ¶µ ¶ 34.14 205. To illustrate.3.95 42. 40 0. consider the data used to generate Figure 3. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.37 µ ¶ 1.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.94 −2.ˆ This is a set of k equations which are linear in β. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.83 ¶−1 µ ¶ . 0. ¶ 2. i 22 . excluding military.14 205. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β.

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

These are algebraic results. The error variance σ 2 = Ee2 is also a parameter of interest. It measures the variation in the i “unexplained” part of the regression.5) implies that 1X xi ei = 0. 24 .7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n−k 2 i=1 (4. and hold true for all linear regression estimates.2: Sum-of-Squared Error Function Contours Equation (4.7.6) An alternative estimator uses the formula n 1 X 2 s = ei . one implication is that n 1X ei = 0. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. Its method of moments estimator is the sample average 1X 2 ei . ˆ σ = ˆ n 2 i=1 n (4.Figure 4. ˆ n i=1 n Since xi contains a constant.

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

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

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

0 Recalling the deﬁnition M = I − X (X 0 X)−1 X 0 , observe that X1 M1 = 0 and thus ¡ 0 ¢−1 0 M1 M = M − X1 X1 X1 X1 M = M

It follows that

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

2

(4.15)

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

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

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

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

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

which you may have seen in an introductory econometrics course. ˆ ˜ ˜ ˆ 3. . ¡ ¢−1 0 ι. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. ˜ 2. Regress Y on X2 . . Rather. Regress Y on X1 . .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. . .14) or via the ˆ following algorithm: ˜ 1.9). . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ⎟ ⎜ ⎟ ⎜ (4. . In some contexts. observe that ⎞ ⎛ ⎞ ⎛ . . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. In the model (4. . Regress X2 on X1 . 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. obtain residuals X2 . A common application of the FWL theorem.6. 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) .13). By the independence of the observations and (3.8)(3.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. obtain OLS estimates β 2 and residuals e. 30 . In this case. ⎠ ⎝ ⎠ ⎝ .1 (Frisch-Waugh-Lovell). 4. and X2 is the vector of observed regressors.Theorem 4. . but in most cases there is little computational advantage to using the two-step algorithm.9). obtain residuals Y . is the demeaning formula for regression. the primary use is theoretical. ˆ which are “demeaned”. the FWL theorem can be used to speed computation. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . In this section we derive the small sample conditional mean and variance of the OLS estimator.

. . 1 n . .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 . 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. . 0 0 ··· 0 0 . V ar β | X = X 0 X ⎟ ⎟ ⎟.12). ⎝ . ¡ 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. . σ 2 } = ⎜ . and (4. we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 .. and the trace operator observe that. . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . Then given (4. under the of ˆ ¢ 2 | x = σ 2 . the properties of conditional expectations.. and ³ ´ ¡ ¢−1 2 ˆ σ . From (4. . .20) . . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. Next.8).19) ˆ and thus the OLS estimator β is unbiased for β.18)..Using (4. X 0 DX = X 0 Xσ 2 . ⎠ (4.

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

and is a strong justiﬁcation for the least-squares estimator. As the data are multinomial. It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. Then we calculate that ³ ¡ ¡ ¢−1 ¡ ¢−1 ´0 ³ ¢−1∗ ´ ¡ 0 ¢−1 C + X X 0X − XX = C + X X 0X A0 A − X 0 X ¡ 0 ¢−1 ¡ 0 ¢−1 0 ¡ ¢−1 0 ¡ 0 ¢−1 ¡ 0 ¢−1 = C 0C + C 0X X X + XX X C + X 0X XX XX − XX = C 0C The matrix C 0 C is positive semi-deﬁnite (see Appendix 2. The MLE β mle for β is then the analog of (4.Proof... This latter restriction is particularly unsatisfactory.21) j j=1 j=1 Thus β is a function of (π 1 . That is. Suppose that the joint distribution of (yi .. Set C = A − X (X 0 X)−1 .. . This property is called semiparametric eﬃciency. but the π j are unknown. j = 1.. Not only has the class of models has been restricted to homoskedastic linear regressions. and π j . but it is quite limited in scope. xi = ξ j = π j .. xi ) is discrete. ¡ ¢ P yi = τ j . π r ) ... (We know the values yi and xi can take. π j is the percentage of the observations ˆ ˆ which fall in each category. r for some constant vectors τ j . who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. A broader justiﬁcation is provided in Chamberlain (1987). 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. 4.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. ˆ β mle = ⎝ j j=1 j=1 33 . We discuss the intuition behind his result in this section. Note that X 0 C = 0. .5) as required. the class of potential estimators has been restricted to linear unbiased estimators. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. r. but we don’t know the probabilities. for ﬁnite r. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. Assume that the τ j and ξ j are known. Let A be any n×k function of X such that A0 X = Ik . That is.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4.. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . ξ j . the deﬁnition (4.21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ .) In this discrete setting. where 1 (·) is the indicator function. .

1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. (4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.Substituting in the expressions for π j . 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. and thus so is the OLS estimator.10) for the class of models satisfying Assumption 3. the maximum likelihood estimator is identical to the OLS estimator. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.9).22) 34 . ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. He observes that the above argument holds for all multinomial distributions.5.1.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. 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 . Chamberlain (1987) extends this argument to the case of continuously-distributed data.10 Omitted Variables xi = µ x1i x2i ¶ . He proves that generically the OLS estimator (4.

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

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

ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . ¢−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 . which is considerably more informative than plots of the uncorrected residuals ei .27).1) in Section 2. then this observation is a leverage point and has the potential to be an inﬂuential observation.This implies has a large value of hi .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . Investigations into the presence of inﬂuential observations can plot the values of (4. The key is equation (2.25). ˆ We now derive equation (4.

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

(5. Then Z ∞ −1 P (Y > α) = α αf (y)dy Zα∞ ≤ α−1 yf (y)dy α Z ∞ ≤ α−1 yf (y)dy = α−1 E(Y ) −∞ the second-to-last inequality using the region of integration {y > α}. if for all δ > 0. n i=1 42 . g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX.3). as stated. tangent lines lie below it. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. n→∞ lim P (|Zn − Z| > δ) = 0. Since 1 + 1 = 1 an application of Jensen’s inequality shows that p q U Then 1/p V 1/q 1 1 ln U + ln V = exp p q E |XY | ∙ ¸ ≤ 1 1 U V exp (ln U ) + exp (ln V ) = + . ¥ 5.2.Markov’s Inequality. Set Y = g(X) and let f denote the density function of Y. For any strictly increasing function g(X) ≥ 0. Eg(X) ≥ a + bEX = g(EX). ¥ Proof of Holder’s Inequality. denoted Zn →p Z as n → ∞. then as n → ∞ n 1X Xn = Xi →p E(X). p p p q which is (5. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . The WLLN shows that sample averages converge in probability to the population average.1 Weak Law of Large Numbers (WLLN). Theorem 5. Since g(x) is convex. If Xi ∈ Rk is iid and E |Xi | < ∞. P (g(X) > α) ≤ α−1 Eg(X). Note EU = EV = 1. So for all x. Let a + bx be the tangent line to g(x) at x = EX.4) Proof of Jensen’s Inequality. =E U V p q p q Proof of Markov’s Inequality. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. We say that Zn converges in probability to Z as n → ∞.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Applying expectations.

We say that Zn converges in distribution to Z as n → ∞. where Z has distribution F (x) = P (Z ≤ x) . Set ε = δη/3. P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. as needed. by Markov’s inequality (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . the fact that the Wi are iid and mean zero. Fn (x) → F (x) as n → ∞.5). ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. (5. Theorem 5.3.6) By Jensen’s inequality (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . V ) . if for all x at which F (x) is continuous.6) and (5. Fix δ and η. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. ¡¯ ¯ P ¯X n ¯ > δ ≤ η.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.7).Proof: Without loss of generality. 43 . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. and the bound |Wi | ≤ 2C.4). Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. 5.1). the triangle inequality.1 Central Limit Theorem (CLT). We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. If Xi ∈ Rk is iid and E |Xi |2 < ∞. denoted Zn →d Z. we can set E(X) = 0 (by recentering Xi on its expectation). ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) .7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . Finally. the fact that X n = W n + Z n . ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. Jensen’s inequality (5.1) and (5.

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. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5.8) where λ∗ lies on the line segment joining 0 and λ. it is suﬃcient to consider the case µ = 0 and V = Ik . By the properties of the exponential function. By a second-order Taylor series expansion of c(λ) about λ = 0. the deﬁnition of c(λ) and (5.Proof: Without loss of generality.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 . the independence of the Xi . ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . For ¡ ¢ λ ∈ Rk . 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 .

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

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

n i=1 (6.4 implies that Q−1 exists and thus g(·. the OLS estimator β is has a statistical distribution which is unknown.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1) and ˆ We now deduce the consistency of β. 6. Equation (4. xi ei →p g (Q. For a complete argument. This is illustrated in Figure 6. Proof.1. Hence by the continuous mapping theorem (Theorem 5.1). To characterize the sampling distribution more fully.1).From the ﬁgure we can see that the density functions are dispersed and highly non-normal. (6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1). Assumption 3.1). β →p β as n → ∞.1 Under Assumption 3. ˆ Theorem 6.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. ·) is continuous at (Q. 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.2.1 and the WLLN (Theorem 5. Assumption 3.1 by the fact that the sampling densities become more concentrated as n gets larger.3).5. As the sample size increases the density becomes more concentrated about the population coeﬃcient. 0). (6. we will use the methods of asymptotic approximation. we can conclude ˆ that β →p β. and the continuous mapping theorem (Theorem 5. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .5. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. ˆ 47 .4.4. Ã n ! n X 1X 0 1 ˆ xi xi .3) Ã where g(A. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.2.2 Consistency ˆ As discussed in Section 6.1. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 . First.2) i i n i=1 n From (6.2).5. using (6. (6.1.

2). 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) and Theorem (6. (6.3.1.1). by the Cauchy-Schwarz inequality (5.3. Assumption 6. it follows that s2 = ¥ n σ 2 →p σ 2 . ˆ Proof. We need a strengthening of the moment conditions.5.Theorem 6.1). (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. Thus σ 2 is consistent for σ 2 . since n/(n − k) → 1 as n → ∞. ˆ Finally. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . (6. ˆ n−k 6.2 Under Assumption 3. Ee4 < ∞ and E |xi |4 < ∞.1 guarantees that the elements of Ω are ﬁnite. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.6) n i=1 48 . n 1 X √ xi ei →d N (0. To see this.2. i i Assumption 6.1 In addition to Assumption 3. (6.2).3. By the central limit theorem (Theorem 5.1.4) 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.5.2. Ω) .5) Thus xi ei is iid with mean zero and has covariance matrix Ω. E ¯ei ¯ E ¯e4 ¯ i i i i (6.

for example.7) holds. Q−1 ΩQ−1 . We say that ei is a Homoskedastic Projection Error when (6.7) Cov(xi x0 . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. As α approaches 2.1.1 states that the sampling distribution of the least-squares estimator.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. In´Figure 6. 1) asymptotic distibution. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. after rescaling. The trouble is that no matter how large is the sample size. When (6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. The expression V = Q−1 ΩQ−1 is called a sandwich form. there is no simple answer to this reasonable question.7) is true then V = V 0 .Then using (6. However.9) we deﬁne V 0 = Q−1 σ 2 whether (6. How large should n be in order for the approximation to be useful? Unfortunately. i i Condition (6. e2 ) = 0.6). 1 X √ xi ei n i=1 n ! the N (0. (6. is approximately normal when the sample size n is suﬃciently large. We call V 0 the homoskedastic covariance matrix.3.7) is true or false.3. We illustrate this problem using a simulation. |ε| ≥ 1. however. otherwise V 6= V 0 . V is often referred to as ˆ the asymptotic covariance matrix of β. The approximation may be poor when n is small. V ) where V = Q−1 ΩQ−1 . but this is not a necessary condition. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).1). xi ) which satisfy the conditions of Assumption 6. its variance diverges q ³ ´ ˆ to inﬁnity.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. setting n = 100 and varying the parameter α.3. when xi and ei are independent. Theorem 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. The asymptotic distribution ´ Theorem 6. Let yi = β 0 + β 1 xi + εi where xi is N (0. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . For α 49 . In Figure 6. Under (6.1. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .9) In (6. This holds true for all joint distibutions of (yi . In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. There is a special case where Ω and V simplify.2).3.3.1 Under Assumption 6. and (6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . 1). Ω) ¡ ¢ = N 0.

4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. the sampling distribution becomes highly skewed and non-normal. 4.2 and 6. 1) density. 1) asymptotic approximation is never guaranteed to be accurate.0 the density is very close to the N (0.2. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2) and Theorem 6.Figure 6. concentrating most of the probability mass around zero. We show the sampling distribution of n β 1 − β 1 setting n = 100.3 is that the N (0. As α diminishes the density changes signiﬁcantly. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.2: Density of Normalized OLS estimator α = 3. 6 and 8. we need an estimate of Ω = E xi x0 e2 .1) it is clear that V 0 →p V 0 . 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. 6. 1). The estimator 2 2 in (6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. Another example is shown in Figure 6. As k increases. The lesson from Figures 6.10) V 0 = Q−1 s2 . for k = 1.3.10) without changing this result.11) 50 .

these all mean the same thing. standard errors are not unique. the “Eicker-White formula”. we set s(β) = n−1/2 V .Figure 6. j = 0.3: Sampling distribution where ei are the OLS residuals. or that they use the “White formula”. When β is a vector. and was still the standard choice for much empirical work done in the early 1980s. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. or that they use a “heteroskedasticity-robust covariance matrix estimator”. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. . A more easily interpretable measure of spread is its square root — the standard deviation. the “Huber formula”. many authors will state that their “standard errors have been corrected for heteroskedasticity”. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. we focus on individual elements of β one-at-a-time. The methods switched during ˆ the late 1980s and early 1990s. and V is an estimator of the variance of n β − β . It is therefore important to understand what formula and method is 51 . In most cases. k. vis. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator.. it is important to pay ˆ ˆ attention to the distinction between V 0 and V .4. as it is not always clear which has been computed.. ˆ ˆ When V is used rather than the traditional choice V 0 . 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). This motivates the deﬁnition of a standard error.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. When reading and reporting applied work.. the “Huber-White formula” or the “GMM covariance matrix”.. ˆ ˆ Deﬁnition 6. 1. β j . Generically. as there may be more than one estimator of the variance of the estimator. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj .

12) in turn.199 2.5) and the WLLN (Theorem 5.83 ¶−1 µ .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. (6. but not under another set of assumptions.30 + 0.2. from which it follows that V →p V as n → ∞.98 −0.14 205.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. The standard errors for β 0 are 7.020) 6.4) 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 . then take the diagonal elements.35/988 = .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. we return to the log wage regression of Section 4.039 and ˆ V = µ 1 14.493 0. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .80 2. i i i i n i=1 Second. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. First. and then the square roots.20 and µ ¶ ˆ = 0. by Holder’s inequality (5. just as any other estimator.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. n n i=1 52 . p ˆ In this case the two estimates are quite similar. Using (6.14 6.2/988 = .83 −0.480 ˆ0 = 0.83 ¶−1 = µ 7.493 −0. To illustrate.used by an author when studying their work.020.1.14 205.80 40. (.80 .085) (.14 14. (6.20 −0.6 ¶µ 1 14.14 14. We calculate that s2 = 0.14 205. Ω 2.085 p ˆ and that for β 1 is .480 .80 40. From a computational standpoint. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.117 Educationi .20 = V 14.199 2.035 ¶ .

14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi .6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.26). 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. Using this substitution. you can show that 1 Xˆ ¯ β= β (−i) .−i = (1 − hi )−1 ei ˆ presented in (4.11) with the leave-one-out estimator ei. Recall from Section 4. which. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . these establish consistency.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. 6. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.25). From equation (3.13) of Efron (1982). is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. ¯ ¯n ¯ n i=1 so Together.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. 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 (6.5. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . n i=1 n ˆ ˆ Theorem 6. Andrews (1991) suggested an similar estimator based on cross-validation. Ω →p Ω and V →p V. i=1 Third.13) Using formula (4.

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

1) Proof. the statistic tn has an exact t distribution. and θ = h(β) is some function of the parameter vector. θ) β 6. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . Consider the studentized statistic tn (θ) = Theorem 6.For example. µ I 0 ¶ ˆ the upper-left block of V . β 2 ). pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. By (6.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. however. In general. that (so θ ˆ ˆ ˆ is. if R is a “selector matrix” R= so that if β = (β 1 . the standard error for ˆ is the square root of n−1 Vθ . we say that tn is an exactly pivotal statistic. In this case. we say that tn (θ) is asymptotically pivotal. s(ˆ = n−1/2 H 0 V Hβ . ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. θ could be a single element of β). Vθ ) √ Vθ = N (0. In special cases (such as the normal regression model.8.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. (For example. 1) →d ˆ−θ θ . Since the standard normal distribution does not depend on the parameters. ˆ When q = 1q h(β) is real-valued).1 tn (θ) →d N (0. and is therefore exactly free of unknowns. 55 . see Section X). s(ˆ θ) (6.

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

We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . 6. θ The interval has been constructed so that as n → ∞. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). the most common professional choice isi95%. This corresponds to selecting the conﬁdence h i h ˆ ± 1.96s(ˆ ≈ ˆ ± 2s(ˆ . While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. 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 . 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). In this case the t-statistic approach does not work. and it is desired to test the joint restrictions simultaneously. ˆ + zα/2 s(ˆ . = n h(β) − θ0 Hβ V Hβ 57 (6. Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.05. or α = . 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.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.18) .We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). θ θ) (6. 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).17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.

if rank(Hβ ) = q. ˜˜ n ˜ e = Y − X1 β 1 . the test rejects at the α% level iﬀ pn < α. Hβ (β) →p Hβ . 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. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .8. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. the upper-α quantile q 2 of the χ2 distribution.3.1 showed θ ˆ that V →p V. θ = β 2 . For example. As before. The asymptotic p-value for Wn is pn = p(Wn ). Vθ ). q and pn is asymptotically U[0.When h is a linear function of β. χ2 (. 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. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . Furthermore. In this case. and Theorem 6.84 = z.19) σ2 ˆ where σ2 = ˜ 1 0 e e. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). ˆ Wn = n θ θ q θ θ Theorem 6. 1] under H0 .1 Under H0 and Assumption 6.15) showed that n ˆ − θ →d Z ∼ N (0. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. 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 . Hβ (β) is a continuous function of β. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. h(β) = R0 β. a chiq square random variable with q degrees of freedom.5. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. Hence β β by Theorem A. The null hypothesis is H0 : β 2 = 0. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .1. 6.2. Also h(β) = a selector matrix. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). and there are q = k2 restrictions.025 .10. then Wn →d χ2 .05) = 3.

˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. X2 ). since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. the residual is ˜ ˜ e = M1 Y. 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. 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 . Because of this connection we call (6. 2 2 2 or alternatively. This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . The elegant feature about (6. We now derive expression (6. ˆˆ n ˆ e = Y − X β. note that partitioned matrix inversion (2.19). as the sum of squared errors is a typical output from statistical packages. still this formula often ﬁnds good use in reading applied papers.2) ¢−1 ¡ R = R0 R X 0X 0 µ 0 0 X1 X1 X1 X2 0X 0 X2 1 X2 X2 ¶−1 0 0 where M1 = I − X1 (X1 X1 )−1 X1 .are from OLS of Y on X1 . Now consider the residual regression of e on X2 = M1 X2 .19) the F form of the Wald statistic. By the FWL theorem. First. Also. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ .19) is that it is directly computable from the standard output from two simple OLS regressions. = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. 2 σ ˆ To simplify this expression further. 59 . and σ2 = ˆ 1 0 e e. note that if we regress Y on X1 alone. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ .

where In many statistical packages. these cases are atypical. Since uncorrelated normal variables are independent. when an OLS regression is reported. equivalently the residual variance from an intercept-only model. 6. including the estimated error variance 2. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . This is rarely an issue today. The modelling assumption that the error ei is independent of xi and N (0. it follows ˆ that β is independent of any function of the OLS residuals.3. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . there is an exact distribution theory available for the normal linear regression model. H 0 H) ∼ N (0. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. Let u = σ −1 H 0 e ∼ N (0. n−k 60 . an “F statistic” is reported. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0.4)) where H 0 H = In . This was a popular statistic in the early days of econometric reporting. σ 2 ) can be be used to calculate a set of exact distribution results. In σ 2 .12 Normal Regression Model As an alternative to asymptotic distribution theory. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . In particular. Since linear functions of normals are also normal. 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. introduced in Section 4. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. While there are special cases where this F statistic is useful. In ) . e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 .

σ 2 ) discussed above. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . In contrast. Furthermore. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.3. Theorem 6. β 2 . n−k • ∼ tn−k ˆ In Theorem 6. We summarize these ﬁndings Theorem 6. 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. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . with residual variance σ .10) then ´ ³ ˆ • β ∼ N 0. σ 2 ) − Ln (β 1 .10) µ h i ¶ 2 (X 0 X)−1 N 0. the notable distinction is between the N (0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . β 2 .1 If ei is independent of xi and distributed N(0. and standard errors are calculated using the homoskedastic formula (6. σ 2 ). ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 .8.1 we showed that in large samples. 1) and tn−k distributions. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . 0.) Now let us partition β = (β 1 .1 and Theorem 6. β and t are approximately normally distributed. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models.a chi-square distribution with n − k degrees of freedom. if standard errors are calculated using the homoskedastic formula (6. β has an exact normal distribution and t has an exact t distribution. so as a practical matter it does not matter which distribution is used.12. As inference (conﬁdence intervals) are based on the t-ratio. σ 2 ) = − log σ − log (2π) − . β 2 . (Unless the sample size is unreasonably small.1 shows that under the strong assumption of ˆ normality. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. a good testing procedure is based on the likelihood ratio statistic.12. σ2 ˆ 61 . The critical values are quite close if n − k ≥ 30. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ ˆ ˆ βj − βj βj − βj N (0. 0. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . 0. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .

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

05) with deviations indicating+ distortion. this probability depends only on s.4: Wald Statistic as a function of s P (Wn (s) > 3.84 | β = 1) . For this particular example. In Table 2. 100 and 500. There is.1 you can also see the impact of variation in sample size. When comparing statistical procedures.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Given the simplicity of the model. however. In each case. no magic choice of n for which all tests perform uniformly well. so these probabilities are Type I error. Rates above 20% are unexceptable. Table 4. looking for tests for which rate rejection rates are close to 5%. These probabilities are calculated as the percentage of the 50. The null hypothesis β s = 1 is true. Table 4. n is varied among 20. Type I error rates between 3% and 8% are considered reasonable. To interpret the table. remember that the ideal Type I error probability is 5% (. the Type I error probability improves towards 5% as the sample size n increases. Any other choice of s leads to a test with unacceptable Type I error probabilities.4. Typically.1 reports the simulation estimate of the Type I error probability from 50.84. Error rates avove 10% are considered excessive. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Test performance deteriorates as s increases. and σ is varied among 1 and 3. and σ 2 . n. 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.000 random samples. The value of s is varied from 1 to 10. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .Figure 6.000 simulated Wald statistics Wn (s) which are larger than 3. we compare the rates row by row. and rarely fall outside of the 3%-8% range. In Table 4.

12 .35 .20 .26 .07 .13 .05 .20 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .30 . 64 .10 .08 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.10 .12 .15 .31 .18 . Other choices are arbitrary and would not be used in practice.06 .25 .22 .34 .13 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. Equivalently.08 . This point can be illustrated through another example. Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.14 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. While this is clear in this particular example.13 .33 .21 . β 1 .11 .14 .08 .17 .05 .08 .06 .06 .24 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .10 .25 .09 .06 .16 Rejection frequencies from 50. so the hypothesis can be stated as H0 : θ = r.20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .05 .15 .05 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.15 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .05 .06 .15 . β 2 ) be the least-squares estimates of (6.19 .22 .s 1 2 3 4 5 6 7 8 9 10 Note: σ=1 σ=3 n = 20 n = 100 n = 500 n = 20 n = 100 n = 500 .23 .05 .08 .20).07 .06 .06 .28 .07 .06 .07 .07 . deﬁne θ = β 1 /β 2 .

06 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.06 .1.0 and n among 100 and 500. 6.10 .05 . However. The implication of Table 4.06 .00 .05 . In all cases.645) are calculated from 50. 65 .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. this formulation should be used.05 . In this section we describe the method in more detail.00 .50 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .00 .645) P (tn > 1. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .06 .00 . If no linear formulation is feasible.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .00 .06 . along with sample size n.06 . then the “most linear” formulation should be selected. the rejection rates for the t1n statistic diverge greatly from this value. .00 . It is also prudent to consider alternative tests to the Wald statistic.25 .05 .25.000 simulated samples.05 . We let x1i and x2i be mutually independent N (0.75.2. Ideally. Table 4.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.15 .645) and P (tn > 1. especially for small values of β 2 .05 .15 .05 . The results are presented in Table 4.09 .10 . . and alternatives to asymptotic critical values should be considered. In contrast.7.645) P (tn < −1. The left tail probabilities P (t1n < −1.26 .50.00 . while the right tail probabilities P (t1n > 1. 1) variables.05 . ei be an independent N (0.06 .05 β2 .05. .645) greatly exceed 5%.47 .00 .645) t1n t2n t1n t2n t1n t2n t1n t2n .12 .02 .07 .05 . such as the GMM distance statistic which will be presented in Section 9.06 . and normalize β 0 = 0 and β 1 = 1.00 . the entries in the table should be 0. σ 2 ) draw with σ = 3.06 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior. if the hypothesis can be expressed as a linear restriction on the model parameters. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. and 1. We vary β 2 among .00 The one-sided Type I error probabilities P (tn < −1.645) P (tn > 1. and are close to the ideal 5% rate for both sample sizes.75 1.10 .645) are close to zero in most cases. This leaves β 2 as a free parameter.06 .28 .

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

and 90% sample quantiles of the sample {Tnb }. this may ˆ be approximated by replacing P with P or with an hypothesized value. Then qα is the N ’th number in this ordered sequence. the choice of B is often guided by the computational demands of the statistical procedure. for a selection of choices of n and F.96) . and therefore it is straightforward to calculate standard errors for any quantity of interest. are. the performance will depend on n and F. Quite simply. We now expand the sample all non-military wage earners. so that coeﬃcients may be interpreted as semi-elasticities. experience squared. B b=1 (6.007. where N = (B +1)α. .21).Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. 6. s P = . immigrant. Again our dependent variable is the natural log of wages. In many cases. For example. As P is unknown. We separately estimate equations for white and non-whites. union member. if we set B = 999. The average (6. In particular. and 5000. and dummy variable indicators for the following: married. but requires more computational time.15 Estimating a Wage Equation We again return to our wage equation. and hispanic. such as the percentage estimate reported in (6. and dummy variable indicators for the following: married. Furthermore. It is therefore useful to conduct a variety of experiments. and non-white. Generally.05) (.003. equalling 1 with probability P = E1 (Tnb ≥ 1. a larger B results in more precise estimates of the features of interest of Gn . if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. union member. immigrant. For example. the researcher must select the number of experiments.22/ B. potential work experience. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. then B will have to be increased. female. Often this is called the number of replications. If the standard error is too large to make a reliable inference. excluding military.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. and our regressors include years of education. The α% sample quantile is a number qα such that α% of the sample are less than qα . and poorly for others. 1000. In practice. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. It is therefore convenient to pick B so that N is an integer. hispanic. and . We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. therefore. For the dependent variable we use the natural log of wages. and estimate a multivariate regression. potential work experience. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. respectively. experience squared. an estimator or test may perform wonderfully for some values. For regressors we include years of education. Hence the ³ ´ ˆ standard errors for B = 100. female.96) is iid Bernoulli. we included a dummy 67 . Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. We us the sample of wage earners from the March 2004 Current Population Survey. it is simple to make inferences about rejection probabilities from statistical tests.022. B.95) /B ' . then we can set s P = (.96) . As discussed above. The random variable 1 (Tnb ≥ 1.

69. Alternatively.102 −. we ﬁnd Wn = 550.032 . this adds 50 regressors). if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.070 .4877 18. excluding the coeﬃcients on the state dummy variables.013 . the restricted standard deviation estimate is σ = . 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.121 −.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. Wn = n 1 − 2 = 18. Computing the Wald statistic (6.19) is ˜ µ ¶ µ ¶ σ2 ˆ .808 so the parameter estimates are quite precise and reported in Table 4. 808 1 − . Ignoring the other coeﬃcients.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.027 .808 .002 .49452 σ ˜ Notice that the two statistics are close. The F form of the Wald statistic (6.008 . but not equal.1.007 .014 .00002 .48772 = 515.102 −.001 .010 .00057 . reestimating the model with the 50 state dummies excluded.4945. The available sample is 18. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. Table 4. θ ˆ 2β 3 β2 .variable for state of residence (including the District of Columbia.18) that the state coeﬃcients are jointly zero. 2β 3 68 .033 −.34 ˆ s(β) .097 −.101 . as the 1% critical value for the χ2 distribution is 76. Using either statistic the hypothesis is easily rejected.232 .

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

(c) Show that if R0 β = r is true. show that the least-squares estimate of β = (β 1 . 3. and rank(R) = s. then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e.16 Exercises For exercises 1-4. show that the least-squares estimate of β = (β 1 . λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. 1. β 2 ). In the model Y = X1 β 1 + X2 β 2 + e. subject to the constraint that β 1 = c (where c is some given vector) is simply the OLS regression of Y − X1 c on X2 . r ˜ is a known s × 1 vector. 4. ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. (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. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . β 2 ). (d) Under the ´ standard assumptions plus R0 β = r. ˜ That is. subject to the constraint that β 1 = −β 2 . 2.6. β − β = Ik − X 0 X 70 . In the model Y = Xβ + e. the least-squares estimate of β subject to the restriction h(β) = 0 is ˜ β = argmin Sn (β) h(β)=0 Sn (β) = (Y − Xβ)0 (Y − Xβ) . the following deﬁnition is used. ﬁnd the least-squares estimate of β = (β 1 . Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix. In the model Y = X1 β 1 + X2 β 2 + e. 0 < s < k. ˜ (b) Verify that R0 β = r. ˜ (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.

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

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

and hence we can estimate 0 σ 2 = zi α by i ˜ (7. Vα = E zi zi (7. or FGLS. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7..5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. We have shown that α is consistently estimated by a simple procedure.3) ˆ ˆ While ei is not observed. Vα ) (7. then the FGLS estimator will force ˜i the regression equation through the point (yi .4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. This suggests 75 . σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0.4) the skedastic regression.. as it is estimating the conditional variance of the regression of yi on xi . This is the feasible GLS. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi ..Suppose ei (and thus η i ) were observed. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). ˜i Suppose that σ 2 > 0 for all i.6) σ 2 = α0 zi . then the FGLS ˜i estimator is not well deﬁned. . Then set ˜i ˜ D = diag{˜ 2 . there is no guarantee that σ 2 > 0 for all i. Furthermore. if σ 2 ≈ 0 for some i. xi ). estimator of β. and will depend on the model (and estimation method) for the skedastic regression. which is typically undesirable. We may call (7. 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 . If σ 2 < 0 for some i.

This estimator V 0 is appropriate when the skedastic regression (7. and was proposed by Cragg (Journal of Econometrics. V n n i=1 . σ 2 ] σi i for some σ 2 > 0. but the proof of this can be tricky. β should perhaps be i i called a quasi-FGLS estimator of β. 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 . V = E α0 zi i i Examining the asymptotic distribution of Theorem 7..1.1 If the skedastic regression is correctly speciﬁed. Unless σ 2 = α0 zi .1.. and it may be estimated with considerable 76 V takes a sandwich form√. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . . Why then do we not exclusively estimate regression models by FGLS? This is a good question. Theorem 7.that there is a need to bound the estimated variances away from zero. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞. Instead. Since the form of the skedastic regression is unknown. A trimming rule might make sense: σ 2 = max[˜ 2 .1. FGLS is asymptotically superior to OLS. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). First. similar to the covariance matrix of the OLS estimator. Its asymptotic variance is not that given in Theorem 7. 1992). This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. the natural estimator of the asympˆ totic variance of β is Ã n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . e2 }. then FGLS is asymptotically equivalent to GLS.2) is correctly speciﬁed. We just state the result without proof. In this case we interpret α0 zi as a linear projection of e2 on zi .1. ¢¢−1 ¡ ¡ . There are three reasons. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.1. i ˜ 0 is inconsistent for V . In the linear regression model. V ).

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

In general. but this turns out to be incorrect. Letting h(β) = x0 β and θ = h(β). If we have an estimate of the conditional variance function. q 2 0 0 ˆ ˜ ˆ ˜ σ (x) = α z from (7.4 NonLinear Least Squares In some cases we might use a parametric regression function m(x. A reasonable rule is the conditional mean m(x) as it is the mean-square-minimizing forecast. ³ ´ ˆ ˆ The forecast error is ei = yi − m(x) = ei − x0 β − β . We describe this setting as non-linear regression. s 7.g.In some cases. e. we see that m(x) = ˆ = x0 β and Hβ = x. Given the diﬃculty. 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. so p ˆ s(ˆ = n−1 x0 V x. ¡ ¢ ˆ Assuming E e2 | xi = σ 2 . the validity of an asymptotic conﬁdence interval is based on the asymptotic normality of the studentized ratio. which is generally invalid. In the present case. we want to estimate m(x) at a particular point x. we need to estimate the conditional distribution of ei given xi = x. 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. p h i ˆ ˆ x0 β ± 2 n−1 x0 V x . σ 2 ). s(x) ˆ But no such asymptotic approximation can be made. so a standard ˆ i p ˆ error for the forecast is s(x) = σ 2 + n−1 x0 V x. we may want to forecast (guess) yi out-of-sample. 78 . 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) . the natural estimate of this variance is σ 2 + n−1 x0 V x. Notice that this is a (linear) ˆ ˆ θ function of β. this would require the asymptotic normality of the ratio ³ ´ ˆ ei − x0 β − β . As the out-of-sample error ei is ˆ ˆ independent of the in-sample estimate β. We would also like a measure of uncertainty for ˆ the forecast. For a given value of xi = x. Notice that this is diﬀerent from the standard ˆ ˆ error for the conditional mean. θ) = E (yi | xi = x) which is a non-linear function of the parameters θ. A point forecast ˆ is the estimated conditional mean m(x) = x0 β.6). which is a much more diﬃcult task. many applied forecasters focus h i ˆ on the simple approximate interval x0 β ± 2ˆ(x) . To get an accurate forecast interval. The only special exception is the case where ei has the exact distribution N (0. the width of the conﬁdence set is dependent on x.

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

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

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

5. In the special case where the error is independent of xi .11). ∂β 0 so Third. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . (7.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. ˆ Proof of Theorem 7. the conditional density of the error at its median. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. the height of the error density at its median.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .Theorem 7. This can be done with kernel estimation techniques.1 is advanced. The main diﬃculty is the estimation of f (0). See Chapter 16. we provide a sketch here for completeness. then there are many innovations near to the median. by the central limit theorem (Theorm 5. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . Computation of standard error for LAD estimates typically is based on equation (7. ¢¢−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) . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .10) is equivalent to g n (β) = 0. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. where V = and f (e | x) is the conditional density of ei given xi = x. and this improves estimation of the median.5. When f (0 | x) is large.5.3. Let g(β) = Eg (β).1 ´ √ ³ˆ n β − β 0 →d N (0. While a complete proof of Theorem 7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. Pn −1 0 β)) . V ). First. ∂ 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 ) .

V ).6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. then (7. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors.9) for the median to all quantiles.5. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . Exi x0 ) →d i 2 = N (0. The median is the special case τ = . Again. For ﬁxed τ . As functions of x. (7. For the random variables (yi . 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)) . then F (Qτ ) = τ . 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. the quantile regression functions can take any shape. The following alternative representation is useful. For τ ∈ [0. The third line follows from an asymptotic empirical process argument. when F (y | x) is continuous and strictly monotonic in y. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . ¥ 7. then F (Qτ (x) | x) = τ . 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic.13) This generalizes representation (7.12) Qτ = argmin Eρτ (U − θ) .Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . If the random variable U has τ ’th quantile Qτ .

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. 7.6. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. where and f (e | x) is the conditional density of ei given xi = x. fast linear programming methods have been developed for this problem. Furthermore. conventional Newton-type optimization methods are inappropriate. 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. ´ √ ³ˆ Theorem 7. Thus. it is useful to have a general test of the adequacy of the speciﬁcation. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. Another popular approach is the RESET test proposed by Ramsey (1969). otherwise its properties are unspeciﬁed without further restrictions. the asymptotic variance depends on the conditional density of the quantile regression error. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. then f (0 | xi ) = f (0) . Vτ ). if the model yi = x0 β + ei has i been ﬁt by OLS. since it has discontinuous derivatives. the unconditional density of ei at 0. ˆ Given the representation (7. and form a Wald statistic i for γ = 0.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) .where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). ¡ ¡ ¢¢−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. When the error ei is independent of xi . the τ ’th conditional quantile of ei is zero.1 n β τ − β τ →d N (0. n numerical methods are necessary for its minimization. Fortunately. i By construction.5. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 .13).1. and test their signiﬁcance using a Wald test. and are widely available. The null model is yi = x0 β + εi i 84 .12).

β 2 ). they will (typically) have diﬀerence asymptotic variances.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. m must be selected in advance. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. and consequently 22 ¡ ¢−1 2 σ . To see why this is the case. and form the Wald statistic Wn for γ = 0. yielding ˆ ˜ ˆ ˆ (β 1 . Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. Another is to regress yi on x1i and x2i jointly. ⎠ . Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. Wn →d χ2 . Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . 1i 2i 2i 1i 22 . 7. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal.be an (m − 1)-vector of powers of yi . and n→∞ say. 3. 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. then 22 Q11 > Q11 − Q12 Q−1 Q21 . It is easy (although somewhat tedious) to show that under the null hypothesis. note that (7. yielding predicted values yi = x0 β. β 1 = (X1 X1 )−1 (X1 Y ) . 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. since Q12 Q−1 Q21 > 0.14) 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. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . Typically. To implement the test. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . or 4 seem to work best. However. 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 . ⎟ zi = ⎝ . Otherwise. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. small values such as m = 2.14) by OLS. yi ˆm (7. and the two estimators have equal asymptotic eﬃciency.

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

since (7.17) Since log(n) > 2 (if n > 8).16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . based on Bayesian arguments. Another problem is that if α is held ﬁxed. and km is the number of coeﬃcients in the model. if α is set to be a small number. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . That is. For some critical level α. Then select M1 if Wn ≤ cα . n (7. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically.15) then where σ 2 is the variance estimate for model m. the most popular to be one proposed by Schwarz. depending on the sample size. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. The reasoning which helps guide the choice of α in hypothesis testing (controlling Type I error) is ´ not ³ c = M1 | M1 ≈ relevant for model selection. else select M2 . ¢ ¡ ˆ1 ˆ2 (7. LRn →p 0. Indeed. let cα satisfy ¢ ¡ P χ22 > cα . BIC model selection is consistent. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. In contrast to the AIC. known as the BIC. log(n) 87 . His criterion. else select M2 . as ³ ´ c P M = M1 | M1 → 1 − α < 1.16) holds under M1 . AIC selection is inconsistent. 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. k A major problem with this approach is that the critical level α is indeterminate. M)) between the true density and the model density. n (7. The model selection rule is as follows. then this model selection procedure is inconsistent. this rule only makes sense when the true model is ﬁnite dimensional. Another common approach to model selection is to to a selection criterion. Indeed. If the truth is inﬁnite dimensional. since under M1 . k = While many modiﬁcations of the AIC have been proposed. The rule is to select M1 if AIC1 < AIC2 .However. etc. One popular choice is the Akaike Information Criterion (AIC). as the rule tends to overﬁt. 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.

. MK : β 1 6= 0. . xKi }. and the AIC or BIC in principle can be implemented by estimating all possible subset models. . and 220 = 1. which can be a very large number. . In the unordered case. The methods extend readily to the issue of selection among multiple regressors. and then selects the model with the lowest AIC (7. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . a model consists of any possible subset of the regressors {x1i . selecting based on (7. 576. For example. Similarly for ˆ the BIC. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive.17). In the ordered case. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. However. β 3 = · · · = β K = 0 . β K 6= 0. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. . 210 = 1024.15). . there are 2K such models.. 88 . We have discussed model selection between two models. Also under M2 . The AIC selection criteria estimates the K models by OLS. which are nested. the models are M1 : β 1 6= 0.. one can show that thus LRn →p ∞. . There are two leading cases: ordered regressors and unordered. In the latter case. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. stores the residual variance σ 2 for each model. β 2 6= 0.. 048.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. which regressors enter the regression). β 2 6= 0.

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

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

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

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

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

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

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

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

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

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

The following notation will be helpful. Equivalently.2 an = O(1) if |an | is uniformly bounded. The derivative of an even function is odd. If θ is a vector. however. about the rate v of convergence. A better asymptotic approximation may be obtained through an asymptotic expansion. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. 99 . and a function h(x) is odd if h(−x) = −h(x). and vice-versa.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . 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.8 Asymptotic Expansions Tn →d N (0. C4 is called the symmetric percentile-t interval. lim Gn (x. the critical value qn (α) is found as the quantile from simulated values of W´ . The ideal test rejects if Wn ≥ qn (α).8. or the size of the divergence for any particular sample size n. v 2 ). F ) = Φ + o (1) . F ) = Φ n→∞ v or ³x´ Gn (x. Thus here Tn (θ) = Wn (θ).] 8. Basically.8. Let an be a sequence. θ [This is a typical mistake made by practitioners. We say that a function g(x) is even if g(−x) = g(x).1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. Deﬁnition 8. where qn (α) is the (1 − α)% quantile of the distribution of Wn .3 an = o(n−r ) if nr |an | → 0 as n → ∞. not ˆ − θ0 .3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.8. F ) then ³x´ . θ θ θ ˆ θ ∗ ∗ Computationally. an = O(n−r ) if it declines to zero like n−r . (8. Deﬁnition 8.4) says that Gn converges to Φ x as n → ∞. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . it says nothing. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). 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. Let Tn be a statistic such that (8. writing Tn ∼ Gn (x.4) v ¡ ¢ While (8.

Heuristically. F ) + O(n−3/2 ) Gn (x. A bootstrap test is based on G∗ (x).1 has the expansion n G∗ (x) = Gn (x. 1/2 1 n Because Φ(x) appears in both expansions.8. First. F ) v which adds a symmetric non-normal component to the approximate density (for example.1 as follows. To a third order of approximation. F ) + g2 (x. Gn (x. F0 ) = 1 g (x. F0 ) = n 1 n1/2 (g1 (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). Fn ) − g1 (x. the density function is skewed. and g1 is continuous with respect to F.uniformly over x. Theorem 8.8. v Since the derivative of g1 is odd. We can interpret Theorem 8.3). Fn ) − g1 (x.1 Under regularity conditions and (8. ³x´ 1 1 + 1/2 g1 (x. F ) ≈ Φ + n−1/2 g1 (x. Fn ) = Φ(x) + n 1 g (x. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn .8. where g1 is an even function of x. F0 )) + O(n−1 ). 100 . To the second order. ³x´ Gn (x. F0 )) converges to 0 at rate n. the diﬀerence √ (g1 (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions.1. An asymptotic test is based on Φ(x).8. √ Since Fn converges to F at rate n. adding leptokurtosis). The diﬀerence is Φ(x) − Gn (x. To a second order of approximation. F0 ) + O(n−1 ) 1/2 1 n 1 g (x.9 One-Sided Tests Using the expansion of Theorem 8. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. Moreover. F0 ) ≈ ∂ g1 (x. g1 (x. F ) + n−1 g2 (x. Fn ) − g1 (x. F0 ) = Φ(x) + since v = 1. F ) converges to the normal limit at rate n1/2 . the exact distribution is P (Tn < x) = Gn (x. F ) = Φ v n n 8. which from Theorem 8. Fn ) + O(n−1 ). F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). and g2 is an odd function of x. so the order of the error is O(n−1/2 ). ³x´ Gn (x. F ). F ) ≈ Φ + n−1/2 g1 (x.

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

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

it imposes no conditions. 2002) tends to advocate the use of the percentile-t bootstrap methods rather than percentile methods. 1992. n Any other consistent estimate of F0 may be used to deﬁne a feasible bootstrap estimator. A third approach sets x∗ = xi . x∗ ) from the EDF. ∗ The non-parametric bootstrap distribution resamples the observations (yi . To impose independence.. The advantage of the EDF is that it is fully nonparametric. σ 2 ).. There are diﬀerent ways to impose independence. and then create i i ∗ = x∗0 β + ε∗ . Therefore if standard errors are available. √ The good news is that the percentile-type methods (if appropriately used) can yield nconvergent asymptotic inference. A parametric i method is to generate the bootstrap errors ε∗ from a parametric distribution. The disadvantage is that the bootstrap distribution may be a poor approximation when the error is not independent of the regressors. xn }. a nonparametric method is to sample the x∗ randomly from the EDF i i or sample values {x1 .) One approach to this problem is to impose the very strong assumption that the error εi is independent of the regressor xi . But since it is fully nonparametric. and is thus an ineﬃcient estimator of the true distribution (when in fact the regression assumption is true. The advantage is that in this case it is straightforward to construct bootstrap distributions. it is suﬃcient to sample the x∗ and ε∗ independently... i For the regressors x∗ . and works in nearly any context.. It is no better than the rate obtained from an asymptotic one-sided conﬁdence region. If this is done. We discuss some bootstrap methods appropriate for the case of a regression model where yi = x0 β + εi i E (ei | xi ) = 0.12 Bootstrap Methods for Regression Models The bootstrap methods we have discussed have set G∗ (x) = Gn (x.. the percentile bootstrap methods provide an attractive inference method. en }. 8. the theoretical literature (e. A non-parametric method is ˆ yi i i e ˆ to sample the bootstrap errors ε∗ randomly from the OLS residuals {ˆ1 . it may be ineﬃcient in contexts where more is known about F. i which implies ∗ ˆ yi = x∗0 β + ε∗ i i E (x∗ ε∗ ) = 0 i i but generally E (ε∗ | x∗ ) 6= 0. Fn ). . This is equivalent to treating the regressors as ﬁxed i in repeated samples. such as the normal i ˆ ε∗ ∼ N (0. where Fn is the EDF. it is unclear if there are any beneﬁts from using the percentile bootstrap over simple asymptotic methods. A parametric method is to sample x∗ from an estimated parametric i distribution. Based on these arguments.g. 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. Horowitz. then all inferential statements are made conditionally on the 103 . . i i The the bootstrap distribution does not impose the regression assumption. The bad news is that the rate of convergence is disappointing. Hall.Hence the order of the error is O(n−1/2 ).

Let Fn (x) denote the EDF of a random sample. ˆ∗ (b) Regress Y ∗ on X ∗ .. Set y∗ = x∗0 β + e∗ . 2. Take a random sample {y1 . Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. That is. 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 . however. Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. n]. One proposal which imposes the regression condition without independence is the Wild Bootstrap. e∗ ) from the pair {(xi .. It does not really matter. The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent.. n} . Let β denote the ˆ the OLS residuals. yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. and set x∗ = xi0 and e∗ = ei0 . . X ∗ ). creating a random bootstrap data set (Y ∗ . Consider the following bootstrap procedure.. 2. draw a ˆ ˆ random integer i0 from [1. .observed values of the regressors. ˆi A conditional distribution with these features will preserve the main important features of the data.13 Exercises 1... Let ∗ ∗ ∗ {y1 . whether or not the xi are really “ﬁxed” or random. Let the statistic of interest be the sample mean Tn = y n . . Find the bootstrap moments ETn and V ar(Tn ). .. which is a valid statistical approach. OLS estimator from the regression of Y on X... The idea is to construct a conditional distribution for ε∗ so that i E (ε∗ | xi ) = 0 i ¡ ∗2 ¢ E εi | xi = e2 ˆi ¡ ∗3 ¢ E εi | xi = e3 . i 8. generate ∗ bootstrap samples. Show that √ n (Fn (x) − F0 (x)) →d N (0.. Unfortunately this is a harder problem. and e = Y − X β ˆ (a) Draw a random vector (x∗ .. Consider the following bootstrap procedure for a regression of yi on xi . yielding OLS estimates β and any other statistic of interest. Tn = (ˆ − ˆ 104 . you sample ε∗ using this two-point distribution. Find the population moments ETn and V ar(Tn ). yn } with µ = Eyi and σ 2 = V ar(yi ). F0 (x) (1 − F0 (x))) . Using the non-parametric bootstrap. ei ) : i = 1. ˆ 3.. calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). 4. ˆ Draw (with replacement) n such vectors.

pdf. Let qn (. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. Estimate a linear regression of price on the number of bedrooms. The ˆ are sorted.5% quantiles of the ˆ are .75 and 1.2.95). You replace c with qn (. can you report the 95% Percentile-t interval for θ? 7. size of house. 105 . with variables listed in the ﬁle hprice1.95). Suppose that in an application.95) denote the 5% θ) ∗ and 95% quantiles of Tn . The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. ˆ = 1. ∗ ∗ ∗ Let qn (. you generate bootstrap samples. You do this as follows. You want to test H0 : θ = 0 against H1 : θ > 0. The dataﬁle hprice1.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). Using the non-parametric ∗ bootstrap. (b) Report the 95% Alternative Percentile interval for θ.dat contains data on house prices (sales). and the 2.2 and s(ˆ = . (a) Report the 95% Efron Percentile interval for θ. What is wrong with this procedure? Tn = θ/s(θ) n 6. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. ∗ ∗ where s(ˆ is the standard error in the original data. ˆ − s(ˆ n (. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.05) .95) denote the 95% quantile of Tn .5% and 97.3. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. θ respectively. and the colonial dummy. Using the non-parametric bootstrap. (c) With the given information.95). lot size.05) and qn (. and ˆ is calculated on each θ ∗ ∗ θ sample. and thus reject H0 if ˆ ˆ > q ∗ (.

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

then g n (β) = 0. if Wn = I. The GMM estimator minimizes Jn (β). ˆ Deﬁnition 9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.9. and the GMM estimator is the MME. the dependence is only up to scale. let Jn (β) = n · g n (β)0 Wn g n (β). 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. Let and where gi = xi ei . i i .2.1 β GMM = argmin Jn (β). ¡ ¢−1 0 ˆ Z XWn X 0 Y. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . β GMM = Z 0 XWn X 0 Z 9. For some × weight matrix Wn > 0.2. for if Wn is replaced ˆ by cWn for some c > 0. This is a non-negative measure of the “length” of the vector g n (β). β GMM does not change.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . For example.2) g n (β) = (9. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. Proposition 9. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi .3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. but this is generally not possible when > k. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. the square of the Euclidean length. then.

n n We conclude: Theorem 9. as it has the same asymptotic distribution.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. This is a weak concept of optimality. ˆ∗ ˆ 108 . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ .and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0.3. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. as shown by Gary Chamberlain (1987). Chamberlain showed that in this context. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . we can set Wn = I . No estimator can do better (in this ﬁrst-order asymptotic sense). The proof is left as an exercise. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . this is a semi-parametric problem.2 For the eﬃcient GMM estimator.1 ´ √ ³ˆ n β − β →d N (0. β). as the distribution of the data is unknown. This turns out to be W0 = Ω−1 . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. ˆ we still call β the eﬃcient GMM estimator. and this is all that is known. without imposing additional assumptions. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. ˆ Construct n 1X ˆ g n = g n (β) = gi . we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . ˆ n i=1 gi = gi − g n . W0 = Ω−1 is not known in practice. as we are only considering alternative weight matrices Wn . Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. V ) . where In general. However. the GMM estimator β is consistent yet ineﬃcient. For any Wn →p W0 . but it can be estimated consistently. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. Ω) . no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. 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. For example. In the linear model. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. it is semiparametrically eﬃcient. The optimal weight matrix W0 is one which minimizes V. a better choice is Wn = (X 0 X)−1 . 9.3. If it is known that E (gi (β)) = 0. This results shows that in the linear model. n β − β →d N 0. it turns out that the GMM estimator is semiparametrically eﬃcient.

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

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

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

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

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

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

115 . The observed data is (yi . the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9.6) equals the Wald statistic. the distance statistic D in (9. zi is l × 1 and β is k × 1.6) (a) Show that you can rewrite Jn (β) in (9. subject ˆ i ˆi i=1 to the restriction h(β) = 0.5. zi ). xi . is deﬁned as Jn (β) = ˜ β = argmin Jn (β). h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). 6. l ≥ k. The equation of interest is yi = g(xi . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. β) + ei E (zi ei ) = 0. The GMM estimator of β. Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . In the linear model Y = Xβ + e with E(xi ei ) = 0. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. Show how to construct an eﬃcient GMM estimator for 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. Vn = X X i=1 ˜ and hence R0 β = r.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . h(β)=0 (9. Deﬁne the Lagrangian L(β. VR = V − V R R0 V R (d) Show that in this setting. VR ) where ¡ ¢−1 0 R V.

7. 116 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. 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.. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. ˆ and consider the GMM estimator β of β. we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 .

(10.Chapter 10 Empirical Likelihood 10. pn ) = i=1 An alternative to GMM is empirical likelihood.1 Non-Parametric Likelihood Since each observation is observed once in the sample..2) Ln (p1 . the log-likelihood function for this multinomial distribution is n X ln(pi ). xi . The idea is to construct a multinomial distribution F (p1 ... β)... It is a non-parametric analog of likelihood estimation. 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 . 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.. To be a valid multinomial distribution. (10. 2001) and has been extended to moment condition models by Qin and Lawless (1994). pn ) are those which maximize the log-likelihood subject to the constraint (10. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. . pn ) which places probability pi at each observation. In this case the moment condition places no additional restrictions on the multinomial distribution.. xi . these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. Combined with i the constraint (10.. The idea is due to Art Owen (1988.3) i=1 117 . . The n ﬁrst order conditions are 0 = p−1 − µ. The maximum likelihood estimator of the probabilities (p1 . .1) i=1 First let us consider a just-identiﬁed model.1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n). zi ..1). The multinomial distribution which places probability pi at each observation (yi .

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

β λ ∂ ³ ´. and n β − β 0 and nλ are asymptotically independent.2. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. i=1 i=1 i=1i Expanding (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . 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 (10.14) 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 .8) and ¢ 0 0 For example. λ) = − (10. Thus the EL estimator is asymptotically eﬃcient. in the linear model. λ) = − (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .10). Gi (.9) and (10. i i Theorem 10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.9) (10. β) = −xi zi . and Ω = E xi x0 e2 . G = −E (xi zi ).10. 0 = Rn (β. ˆ ˆ Proof. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.13) Premultiplying by G0 Ω−1 and using (10.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.10) ¡ Ω−1 N (0.13) yields n n Expanding (10. n (10.1 Under regularity conditions. (β.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.

and have the same interpretation.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. LRn = i=1 Theorem 10. 10.16). This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Vλ ) Furthermore. and it is advisable to report the statistic LRn whenever EL is the estimation method. and (10. The same statistic can be constructed for empirical likelihood. (10.15). n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .14) for λ and using (10.15) (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.17) 2 ln 1 + λ gi β .15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. 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. Proof. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. 120 . ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.1 If Eg(wi . The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. Ω) GΩ G →d = N (0. it is an asymptotically eﬃcient estimator for β. They are asymptotically ﬁrst-order equivalent.7) is n ³ ´´ ³ X ˆ ˆ0 (10. tests are based on the diﬀerence in the log likelihood functions. V ) ˆ Solving (10. First. Since the EL estimator achieves this bound. by a Taylor expansion. β 0 ) = 0 then LRn →d χ2−k .3 Overidentifying Restrictions In a parametric likelihood context. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. The overidentiﬁcation test is a very useful by-product of EL estimation.3.

4. To test the hypothesis h(β) while maintaining (10. a The proof of this result is more challenging and is omitted.1 Under (10. This test statistic is a natural analog of the GMM distance statistic. where h : Rk → Ra . Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. 10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.18).ssc.prc 121 .Second.4 Testing Egi (β) = 0 (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) and H0 : h(β) = 0. Theorem 10. The hypothesis of interest is h(β) = 0. Vλ )0 Ω−1 N (0. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). 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. the simple overidentifying restrictions test (10. LRn →d χ2 .18) are assumed to hold and are not being challenged (at least for the test discussed in this section). since ln(1 + x) ' x − x2 /2 for x small.18) Let the maintained model be where g is × 1 and β is k × 1. h(β)=0 ˜ Fundamentally.wisc. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . By “maintained” we mean that the overidentfying restrictions contained in (10.17) is not appropriate. 10.edu/~bhansen/progs/elike.

The modiﬁed Newton method takes a quadratic approximation to Rn (β.. λ) . The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 .4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. Deﬁne ∗ gi (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λ) G∗ (β. λ) gi (β. λ) = − gi (β. λ) ∂λ i=1 n ∂ Rn (β. set 2 λp = λj − δ p (Rλλ (β. 2. Eﬃcient convergence requires a good choice of steplength δ. For p = 0. λ) G∗ (β. λ)0 − ∂β∂β Rn (β. 1. λj ))−1 Rλ (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. Set δ 0 = 0. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.19) is continued until the gradient Rλ (β. The iteration (10. (10.20) .4). The starting value λ1 can be set to the zero vector. λ) = G∗ (β. λ) = − ∂β n X i=1 G∗ (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10.19) X ∂2 ∗ ∗ gi (β. δ 1 = 1 and δ 2 = 1. λ) = i The ﬁrst derivatives of (10. λj )) Rp = Rn (β. λ)0 − Rn (β. One method uses the following quadratic approximation. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λj ))−1 Rλ (β. λj ) is smaller than some prespeciﬁed tolerance. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β.19). λj ) . λp ) A quadratic function can be ﬁt exactly through these three points.5) for given β. λ)0 0 Rn (β.

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

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

1). and assume that E(zi ei ) 6= 0 so there is endogeneity.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 ¶ . this can be written as Y = Zβ + e.2) Any solution to the problem of endogeneity requires additional information which we call instruments. and x2i are the excluded exogenous variables. some regressors in zi will be uncorrelated with ei (for example. (11. We call z1i exogenous and z2i endogenous. β →p β ∗ .1) if E (xi ei ) = 0. Thus we make the partition ¶ µ k1 z1i (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. which does not equal either β 1 or β 2 . In a typical set-up.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. This is called simultaneous equations bias. That is x2i are variables which could be included in the equation for yi (in the sense 125 . so should be included in xi .1. Deﬁnition 11. z1i is an instrumental variable for (11. By the above deﬁnition.1) the structural equation.1 The × 1 random vector xi is an instrumental variable for (11. In matrix notation. at least the intercept). 11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. We call (11.1) where zi is k × 1.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. So we have the partition µ ¶ z1i k1 (11.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

PX Z2 ] = [Z1 . let’s analyze the approximate bias of OLS applied to (11.11).ˆ It is useful to scrutinize the projection Z. Z = [Z1 . X2 ]. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before.12) Z = XΓ + u ξ = (e.12). In our notation. X is n × l so there are l instruments.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. Thus in the second stage. Hence by a ﬁrst-order approximation i µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ OLS − β E β ZZ Ze ≈ E E n n ¡ ¢−1 = Γ0 QΓ + S22 S21 (11. we regress Y on Z1 and Z2 .13) which is zero only when S21 = 0 (when Z is exogenous). ¶ 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 ) . Z2 . Z2 = [PX Z1 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . Using (11. First. Here we present a simpliﬁed version of one of his results. Then i h ˆ ˆ ˆ Z = Z1 . PX Z2 ] h i ˆ = Z1 . the model is Y = Zβ + e (11. We now derive a similar result for the 2SLS estimator. Recall. Z2 ] and X = [Z1 . ˆ since Z1 lies in the span of X. 11. 129 .11) (11. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 .

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

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

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

The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). show that if rank(Γ) < k then β cannot be identiﬁed. 6. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. in the sense that e ˜ ˜ least in large samples? 4. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. 2. Z is n × k. Take the linear model yi = xi β + ei E (ei | xi ) = 0. will IV “ﬁt” better than OLS. Explain why this is true. where xi and β are 1 × 1. xi is l × 1.8 Exercises yi = zi β + ei . Take the linear model Y = Zβ + e. That is. 1. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi .11. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . (Find an expression for xi . l ≥ k. and Γ is l × k. 5.) 3. Find a simple expression for the IV estimator in this context. ˜ 0 e < e0 e. X is n × l. at ˆˆ If X is indeed endogeneous. u is n × k. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. 133 .

in years.. 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.pdf. 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). There are 2215 observations with 19 variables. In this model. and then calculate the GMM estimator from this weight matrix without further iteration. in years. a dummy indicating that the observation lives near a 4-year college. (d) Re-estimate the model by eﬃcient GMM. Estimate the model by 2SLS. Report the estimates and standard errors. Report estimates and standard errors.(b) Deﬁne the 2SLS estimator of β. listed in card. of the mother). Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market.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). 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. f atheduc (the education. and the remaining variables as exogenous. of the father) and motheduc (the education. (b) Now treat Education as endogenous. The data ﬁle card. and South and Black are regional and racial dummy variables. are the parameters identiﬁed? 8. 134 . Does this diﬀer from 2SLS and/or OLS? 7. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. (e) Calculate and report the J statistic for overidentiﬁcation. using the instrument near4. Report estimates and standard errors. (a) Estimate the model by OLS. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). (f) Discuss your ﬁndings. using zi as an instrument for xi .

. 12.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.2 {Yt } is strictly stationary if the joint distribution of (Yt . t = 1. Deﬁnition 12. Theorem 12. We can separate time series into two categories: univariate (yt ∈ R is scalar). T .1. .1 If Yt is strictly stationary and ergodic and Xt = f (Yt .1 Stationarity and Ergodicity Deﬁnition 12. we expect that Yt and Yt−1 are not independent. Yt−k ) is independent of t for all k. Deﬁnition 12. we adopt new notation. 135 . γ(k) is called the autocovariance function.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. so classical assumptions are not valid. . and multivariate (yt ∈ Rm is vector-valued). To indicate the dependence on time. .) is a random variable.1.1. Deﬁnition 12.. and Cov (Yt . The primary model for univariate time series is autoregressions (ARs).1.. The following two theorems are essential to the analysis of stationary time series...4 (loose). The primary model for multivariate time series is vector autoregressions (VARs).. Yt−k ) = γ(k) is independent of t for all k.. then Xt is strictly stationary and ergodic.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . however. Yt−k ) is the autocorrelation function. and T to denote the number of observations. A stationary time series is ergodic if γ(k) → 0 as k → ∞.1. Yt−1 . There proofs are rather diﬃcult. and use the subscript t to denote the individual observation. Because of the sequential nature of time series..

ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12.2 (Ergodic Theorem). γ (0) ˆ Theorem 12. the sequence Yt Yt−k is strictly stationary and ergodic.Theorem 12. γ (k) →p γ(k). ˆ Proof.1 above. 1. and it has a ﬁnite mean by the assumption that EYt2 < ∞. µ →p E(Yt ). then as T → ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). T 1X Xt →p E(Xt ).1. For Part (2). 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 . T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). then as T → ∞. ˆ 3.1. If Xt is strictly stationary and ergodic and E |Xt | < ∞. T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) .1. ρ(k) →p ρ(k). ˆ ˆ γ ¥ 136 .3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ˆ 2. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 .

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

an AR(1) is stationary iﬀ |ρ| < 1. We call ρ(L) the autoregressive polynomial of Yt . the above results are unchanged. We call ρ(L) the autoregressive polynomial of Yt . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . Deﬁning L2 = LL.3. The AR(k) model is Using the lag operator. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept.Theorem 12. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . In general. 12.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . We say that the root of the polynomial is 1/ρ. From Theorem 12. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . we see that L2 Yt = LYt−1 = Yt−2 . 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). or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . ∞ X k=0 ρ2k V ar (et−k ) = 12. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. Lk Yt = Yt−k .1 The lag operator L satisﬁes LYt = Yt−1 .4.3. Deﬁnition 12. 138 . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). since ρ(z) = 0 when z = 1/ρ.1.

Thus t by the Ergodic Theorem. Theorem 12. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. t T t=1 T t=1 139 .. By Theorem 12. Let |λ| denote the modulus of a complex number λ. t t T t=1 ¥ Combined with (12.1. the requirement is that all roots are larger than one.. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.1.5. One way of stating this is that “All roots lie outside the unit circle.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . we say that ρ(L). and is of great interest in applied time series.6. The vector xt is strictly stationary and ergodic. and hence Yt . Proof. This is a special case of non-stationarity. which satisfy ρ(λj ) = 0. λk are the complex roots of ρ(z).1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞..1.” If one of the roots equals 1. then ˆ β →p β as T → ∞. For an AR(k).where the λ1 . and by Theorem 12.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. t Yt−k ¢0 ρk . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. β = X 0X (12. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. Note that ut is a MDS. it is helpful to deﬁne the process ut = xt et . we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. .1) and the continuous mapping theorem. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. it is also strictly stationary and ergodic.1.1) Theorem 12. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. “has a unit root”. so is xt x0 .

140 . This creates an iid bootstrap sample.. Estimate β and residuals et . T t=1 Since xt et is a MDS. xt }. i 4. then as T → ∞. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Q−1 ΩQ−1 .12. t then as T → ∞. 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∗ .1 to see that T 1 X √ xt et →d N (0. It also presumes that the AR(k) structure is the truth. The implication is that asymptotic inference is the same.. t t Theorem 12. In particular.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. T 1 X √ ut →d N (0. Method 2: Block Resampling 1. Divide the sample into T /m blocks of length m. ˆ 2. Clearly. the asymptotic covariance matrix is estimated just as in the cross-section case.. e ˆ 3. This is identical in form to the asymptotic distribution of OLS in cross-section regression. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . T t=1 where Ω = E(xt x0 e2 ). Ω) . Method 1: Model-Based (Parametric) Bootstrap. eT }. we constructed the bootstrap sample by randomly resampling from the data values {yt .. Y0 ).7. this cannot work in a time-series application. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. . there are two popular methods to implement bootstrap resampling for time-series data. 12.7. t This construction imposes homoskedasticity on the errors e∗ . Y−k+2 . Fix an initial condition (Y−k+1 ..8 Bootstrap for Autoregressions In the non-parametric bootstrap.7 Asymptotic Distribution Theorem 12. as this imposes inappropriate independence. Ω) . ˆ 1. .. Brieﬂy. which may be diﬀerent than the i properties of the actual ei .1 MDS CLT. we can apply Theorem 12.7.

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

The best remedy is to ﬁx a upper value k. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . if the null hypothesis is that Yt is an AR(k). An appropriate test is the Wald test of this restriction.. . Yt−k−m are jointly zero. AR(k) on this (uniﬁed) sample. . AIC(k) = log σ 2 (k) + ˆ 2k . and then estimate the models AR(1). An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero.12. Yt is an AR(1). One approach to model selection is to choose k based on a Wald tests. and the alternative is that the error is an AR(m).11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. we take (12.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . 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. 142 . and under H1 it is an AR(2).10 Testing for Omitted Serial Correlation For simplicity.g. (A simple exclusion test).. e. (12. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2).6) 12. Another is to minimize the AIC or BIC information criterion. this is the same as saying that under the alternative Yt is an AR(k+m).5). you need more initial conditions.. and then reserve the ﬁrst k as initial conditions.. (12.. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.5) We are interested in the question if the error ut is serially correlated. AR(2).) This can induce strange behavior in the AIC. We want to test H0 against H1 . We then multiply this by θ and subtract from (12.. In general. To combine (12.6). (If you increase k.5) and (12. We model this as an AR(1): ut = θut−1 + et with et a MDS. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. Thus under H0 .

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

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

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

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

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

then Zt may help to forecast Yt even though it does not “cause” Yt ... the equation for Yt is 0 0 Yt = α + ρ1 Yt−1 + · · · + ρk Yt−k + Zt−1 γ 1 + · · · + Zt−k γ k + et .t−1 ) ..13. 148 .7 Granger Causality Partition the data vector into (Yt . . Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0. The latter has more information. If Zt is some sort of forecast of the future. that Zt may still be useful to explain other features of Yt .) The information set I1t is generated only by the history of Yt . .) I2t = (Yt . If it is found that Zt does not Granger-cause Yt . such as the conditional variance. This idea can be applied to blocks of variables. then we say that Zt Granger-causes Yt . Yt−2 . and the information set I2t is generated by both Yt and Zt . Zt−1 . Deﬁne the two information sets I1t = (Yt . 13.t−1 ) = E (Yt | I2. Zt ). Zt−2 . lagged Zt does not help to forecast Yt .. . This deﬁnition of causality was developed by Granger (1969) and Sims (1972). or an information criterion approach. In this equation. The formula for the AIC and BIC are ³ ´ p ˆ AIC(k) = log det Ω(k) + 2 T ³ ´ p log(T ) ˆ BIC(k) = log det Ω(k) + T T X 1 ˆ et (k)ˆt (k)0 ˆ e Ω(k) = T t=1 p = m(km + 1) where p is the number of parameters in the model.6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR. That is. That is. This may be tested using an exclusion (Wald) test. In a linear VAR. Yt−1 . Yt−2 . The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure deﬁnition of causality. and et (k) is the OLS residual vector from the ˆ model with k lags. for example. Zt . Note. If this condition does not hold. then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt . The log determinant is the criterion from the multivariate normal likelihood. such as a futures price. conditional on information in lagged Yt . We say that Zt does not Granger-cause Yt if E (Yt | I1. The hypothesis can be tested by using the appropriate multivariate Wald test. however. you may either use a testingbased approach (using. Yt−1 . the Wald statistic). Yt and/or Zt can be vectors.

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

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

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

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

In surveys.1) yi = ∗ <0 . any known value can substitute. 2. σ 2 ) with the observed variable yi generated by the censoring equation (14.. Tobin observed that for many households.) The observed data yi therefore come from a mixed continuous/discrete distribution. A generalization is the negative binomial. An example of a data collection censoring is top-coding of income.1).” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). or it may be a by-product of economic constraints. i If Y = {0. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. 1. .14. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . 0 if yi (This is written for the case of the threshold being zero. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. k! = exp(x0 β).. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. 14. 1. the consumption level (purchases) in a particular period was zero. . Thus the model is that there is some latent process yi with unbounded support. i i i=1 ˆ The MLE is the value β which maximizes ln (β). a typical approach is to employ Poisson regression. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. The censoring process may be explicit in data collection. 2. This may be considered restrictive. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.2 Count Data exp (−λi ) λk i . incomes above a threshold are typically reported at the threshold. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.. The conditional density is the Poisson with parameter λi . i so the model imposes the restriction that the conditional mean and variance of Yi are the same. The functional form for λi has been picked to ensure that λi > 0. 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.}..

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

zi . where vi is independent of e0i ∼ N (0. where Hence ¡ 0 ¢ e1i = ρλ zi γ + ui . ρ from OLS of yi on xi and λ(z 0 γ ). ˆ ³ ´ ˆ ˆ ˆ • Estimate β. Under the normality assumption. which is non-zero. as this is a two-step estimator. e1i = ρe0i + vi . e1i ρ σ2 It is presumed that we observe {xi . The equation for Ti is an equation specifying the probability that the person is employed. using regressors zi . The dependent variable yi is observed if (and only if) Ti = 1. Zi ¡ 0 ¢ = ρλ zi γ . by viewing the Probit/OLS estimation equations as a large joint GMM problem. yi could be a wage. which can be observed only if a person is employed. ¡ ¢ 0 E (e1i | Ti = 1. It is unknown. They can be corrected using a more complicated formula. The “Heckit” estimator is thus calculated as follows • Estimate γ from a Probit. Else it is unobserved. . if γ were known. Ti } for all observations. Heckman (1979) observed that we could consistently estimate β and ρ from this equation. Zi ) = E e1i | {e0i > −zi γ}. However. Zi ) = 0. Or. The binary dependent variable is Ti . Zi ¢ ¡ ¢ ¡ 0 0 = ρE e0i | {e0i > −zi γ}. The problem is that this is equivalent to conditioning on the event {Ti = 1}. The model is often completed by specifying that the errors are jointly normal ¶ µ µ ¶¶ µ 1 ρ e0i ∼ N 0. but also can be consistently estimated by a Probit model for selection. For example. ¡ 0 ¢ yi = x0 β + ρλ zi γ + ui i (14.2) is a valid regression equation for the observations for which Ti = 1. Thus E (ui | Ti = 1. E (e0i | e0i > −x) = λ(x) = Φ(x) and the function λ(x) is called the inverse Mills ratio. 1). i • The OLS standard errors will be incorrect. The naive estimator of β is OLS regression of yi on xi for those observations for which yi is available. Zi + E vi | {e0i > −zi γ}. 155 .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. A useful fact about the standard normal distribution is that φ(x) . alternatively.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

12) E exp (tQ) = 0 Γ (A. which we showed in (A. C −1 AC −10 ) = N (0. Iq ). tr has distribution 177 . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .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). Thus the density of Z 2 is (A.8.Theorem A. we see that the MGF of Z 2 is (1 − 2t)−1/2 . ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. 1) and Q ∼ χ2 be independent.11) 2 with r = 1. (A.11). tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. The MGF for the density (A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Set r Z . Proof of Theorem A. Using the simple law of iterated expectations.3 Let Z ∼ N (0. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.8. From (A. C −1 CC 0 C −10 ) = N (0. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. For Z ∼ N(0.8.8. which can be found by applying change-of-variables to the gamma function.1. 1).13) is the MGF of the density (A.3.13). 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 .2. q Proof of Theorem A.

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

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

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

∂2 ln f (Yi . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 .. θ) dy ¯ ∂θ f (y. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A.17).. θ0 = ln f (Yi . θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ0 ) ∂θ f (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ) d˜ = ˜ y ) ∂ ln f (˜. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. (Yi . yn ). . To see (A. θ0 )0 f (Yi . θ0 ) − f (Yi . θ0 ) (Yi . θ0 ) ∂ ∂θ f ∂ (Yi . θ) f (y. Since θ Z ˜ = ˜ y)f (˜. θ0 ) f (Yi .9. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. function of the data. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. Proof of Theorem A.16). θ) f (˜.9.1) has mean zero and variance nH. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ0 ) ln f (Yi .1. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 )2 (Yi .2. we can show that E By direction computation. V ar (S) nH so ¥ 181 . θ0 ) d˜ = E ˜ . θ0 ) ∂ ∂ − ln f (Yi . θ0 )0 . f (Yi . θ0 ) ¯ ∂ f (y. ∂θ ¯θ=θ0 Z ! = 0. ¯ ¯ ∂ E ln f (Yi .9. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y.Proof of Theorem A.

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

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

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

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

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