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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

. . . . . . . . iii . . . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . .6 Estimation . . 11. . . 9. . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . .11 8.8 Conditional Moment Restrictions . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. 12. . . . . . . . 12. . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . 9. . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . 9. . . . . . . . . . . . . . . . . . . . 12. . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . .9 8. . . . . . . . .3 Identiﬁcation . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. . . .2 GMM Estimator . . . . . .3 Overidentifying Restrictions . . . . 12. . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . .12 8. . . . . . . . . . . . 9. . . . . . 12. . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . .2 Reduced Form .6 Over-Identiﬁcation Test . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . .8 Exercises . . . . . .2 Autoregressions . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . 12. .6 Bekker Asymptotics . . . . . . . . 9. . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . .5 Numerical Computation .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . 11. . . . . . . . . . . . 9. . 12. . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . . .4 Lag Operator . . . . 12.

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

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

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

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

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

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

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

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

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

. Additionally. .. k)).. xk ) be k × 1 and g(x) = g(x1 . (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2.. k. . ⎠ ... 2. we can deﬁne the determinant as follows.. Let π = (j1 . k) . . For a general k × k matrix A = [aij ] ..8 Determinant The determinant is deﬁned for square matrices. ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. we deduce that Λ2 = Λ and λ2 = λi for i = 1. and let επ = +1 if this count is even and επ = −1 if the count is odd. tr(A) = rank(A).7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . jk ) denote a permutation of (1. xk ) : Rk → R.. ... .... If A is 2 × 2. then its determinant is det A = a11 a22 − a12 a21 . i Hence they must equal either 0 or 1. There are k! such permutations.By the uniqueness of the characteristic roots. . The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1.4) H0 M =H 0 0 with H 0 H = In . . It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.. 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 ´ ..

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

An important summary measure is the conditional mean Z ∞ yf (y | x) dy. education and experience. The two density curves show the eﬀect of gender on the distribution of wages.1. which is a common feature of wage distributions. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. These are asymmetric (skewed) densities. You can see that the right tail of then density is much thicker than the left tail.1. and that for women is $20. Figure 3. While it is easy to observe that the two densities are unequal. or the covariates. xi ) where yi is a scalar (real-valued) and xi is a vector.2) m(x) = E (yi | xi = x) = −∞ In general. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. The data are from the 2004 Current Population Survey 1 11 . This is used when the goal is to quantify the impact of one set of variables on another variable. m(x) can take any form. we can focus on f (y | x) . In the example presented in Figure 3. ⎠ ⎝ . We call yi the dependent variable.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. To illustrate. (3.1) xi = ⎜ . In this context we partition the observations into the pair (yi . Take a closer look at the density functions displayed in Figure 3. These are indicated in Figure 3. We call xi alternatively the regressor. the conditioning variable. it is useful to have numerical measures of the diﬀerence.73.1 displays the density1 of hourly wages for men and women. See Chapter 16. the conditional density of yi given xi . When a distribution is skewed. holding the other variables constant. xki 3. and exists so long as E |yi | < ∞. the mean is not necessarily a good summary of the central tendency.22. gender. . ⎟ .1 by the arrows drawn to the x-axis.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. the mean wage for men is $27. These are conditional density functions — the density of hourly wages conditional on race.

2 (3. When the distribution of the control variable is continuous.2) evaluated at the observed value of xi : ei = yi − m(xi ). For this reason.1 is facilitated by the fact that the control variable (gender) is discrete. The diﬀerence in the log mean wage between men and women is 0. Figure 3. By construction.5.3 displays a scatter plot2 of log wages against education levels.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. the dashed line is a linear projection approximation which will be discussed in the Section 3. The main point to be learned from Figure 3. The conditional expectation function is close to linear.Figure 3. 12 . This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.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.2 shows the density of log hourly wages for the same population. The comparison in Figure 3.A. which implies a 30% average wage diﬀerence for this population. Of particular interest to graduate students may be the observation that diﬀerence between a B. 3. degree in mean log hourly wages is 0. the solid line displays the conditional expectation of log wages varying with education.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. with mean log hourly wages drawn in with the arrows. and a Ph.30.D. Figure 3. this yields the formula yi = m(xi ) + ei .3 is how the conditional expectation describes an important feature of the conditional distribution. then comparisons become more complicated. To illustrate. implying an average 36% diﬀerence in wage levels.36. wage regressions typically use log wages as a dependent variable rather than the level of wages.

13 . 2. These equations hold true by deﬁnition. restrictions on the permissible class of regression functions m(x). 4.Figure 3.2. most typically. The equations yi = m(xi ) + ei E (ei | xi ) = 0. E (h(xi )ei ) = 0 for any function h (·) .1 Properties of the regression error ei 1. 3. E (ei | xi ) = 0. E(ei ) = 0. E(xi ei ) = 0. because no restrictions have been placed on the joint distribution of the data. The remaining parts of the Theorem are left as an exercise. It is important to understand that this is a framework.2: Log Wage Densities Theorem 3. To show the ﬁrst statement. A regression model imposes further restrictions on the joint distribution. by the deﬁnition of ei and the linearity of conditional expectations. are often stated jointly as the regression framework. not a model. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.

let g(x) be an arbitrary predictor of yi given xi = x. Thus the mean squared error is minimized by the conditional mean. To see this.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. Given the random variable xi . in the sense of achieving the lowest mean squared error. when σ 2 (x) is a constant so that ¢ ¡ (3. The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. σ 2 (x) is a non-trivial function of x. The right-hand-side is minimized by setting g(x) = m(x). it does not provide information about the spread of the distribution.Figure 3.3 Conditional Variance Generally. In contrast. the conditional variance of yi is σ 2 = σ 2 (xi ).1. and can take any form. The conditional standard deviation is its square root σ(x) = σ 2 (x). A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . i . subject to the restriction p that it is non-negative. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. 3.2.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .3.

6) as an approximation. So while men have higher average wages. ⎠ .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). βk ⎛ (3. Equation (3. 15 . it is convenient to augment the regressor vector xi by listing the number “1” as an element.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. Thus (3.8) is called the linear regression model. which we derive in this section.8) (3. 3.1 and that for women is 10. The conditional standard deviation for men is 12. As an example.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 . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . ⎠ .5. they are also somewhat more dispersed. Instead. Notationally.6) (3. ⎟ . take the conditional wage densities displayed in Figure 3.5) xi = ⎜ . where x1i is the ﬁrst element of the vector xi deﬁned in (3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. it is more realistic to view the linear speciﬁcation (3. its functional form is typically unknown. xki When m(x) is linear in x. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. Equivalently.7) is a k × 1 parameter vector.9) 3.we say that the error ei is homoskedastic.4 Linear Regression An important special case of (3. We call this the “constant” or “intercept”.1).1. ⎝ . ⎟ β=⎝ . we assume that x1i = 1. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . i (3. and the linear assumption of the previous section is empirically unlikely to accurate. In this case (3.

i ∂β ¢¢−1 ¡ ¡ E (xi 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.1. 3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. xi contains an intercept. x0 β is the best linear predictor for yi . i which requires that for all non-zero α. The ﬁrst-order condition for minimization (from Section 2.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. In order for β to be uniquely deﬁned. Therefore.10) It is worth taking the time to understand the notation involved in this expression. by “best” we mean the predictor function with lowest mean squared error.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. Observe i that for any non-zero α ∈ Rk . Rewriting. this situation must be excluded. α0 E (xi x0 ) α = E (α0 xi )2 > 0.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . Given the deﬁnition of β in (3. Eyi < ∞. E (xi x0 ) is invertible.which is quadratic in β. It is invertible if and only if it is positive deﬁnite. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. written E (xi x0 ) > 0. This occurs when redundant variables are included in xi . As before.10). i i (3. The best linear predictor is obtained by selecting β to minimize S(β). i (3.5.12) This completes the derivation of the linear projection model. The error is i ei = yi − x0 β. i (3. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.1 1. Assumption 3.5. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . The vector (3. 2 2. Equivalently. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. i 16 . i 4. 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 . 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. otherwise they are distinct. E (x0 xi ) < ∞.

5.11) are well deﬁned.1.13) summarize the linear projection model.13) implies that xi and ei are uncorrelated. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.8)-(3. Assumption 3. Assumption 3.5.14) holds.Theorem 3.1 is employed to guarantee that (3.2.5.1.3 ensure that the moments in (3.5. The ﬁnite variance Assumptions 3. However.14).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. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .2 and 3.4 guarantees that the solution β exits. Figure 3.1. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. By deﬁnition.5. Equation (3. E (xi ei ) = 0 and E (ei ) = 0. Since ei is mean zero by (3.1.4 is required to ensure that β is uniquely deﬁned.5.3 are called regularity conditions.1 Under Assumption 3.5. (3.5.5. Assumption 3. For example.10) and (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. 17 .12) can be alternatively interpreted as a projection decomposition.10) are deﬁned.1.13) The two equations (3.1. Using the deﬁnitions (3.1.5. Let’s compare it with the linear regression model (3.12) and (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .1. the orthogonality restriction (3.1.14) Proof.4 we know that the regression error has the property E (xi ei ) = 0.5.1. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.13) and Assumption 3. Since from Theorem 3.14) follows from (3.1. ¥ (3. (3. This means that the equation (3. Furthermore.11) and (3. Assumption 3.2 and 3.9).1 are weak.

for any pair (yi . Most importantly. and under-predicts for the rest. and are discussed in Chapter 11. it is important to not misinterpret the generality of this statement. In the example just presented. In Figure 1. the dashed line is the linear projection of log wages on eduction. In contrast. and the straight dashed line is the linear projection.4 we display as well this quadratic projection.10) may not hold and the implications of Theorem 3.10). This defect in linear projection can be partially corrected through a careful selection of regressors. there are no changes in our methods or analysis.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. for those over 53 in age). we can augment the regressor vector xi to include both experience and experience2 . We illustrate the issue in Figure 3. in many economic models the parameter β may be deﬁned within the model. Returning to the joint distribution displayed in Figure 3.3.5.12) with the properties listed in Theorem 3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. No additional assumptions are required. The linear equation (3. In this case the linear projection is a poor approximation to the conditional mean. A projection of log wages on these two variables can be called a quadratic projection. In this example the linear projection is a close approximation to the conditional mean.We have shown that under mild regularity conditions.5. Other than the redeﬁnition of the regressor vector. In other cases the two may be quite diﬀerent. Figure 3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.4 displays the relationship3 between mean log hourly wages and labor market experience. However. Figure 3. 18 .1 may be false. In this example it is a much better approximation to the conditional mean than the linear projection. It over-predicts wages for young and old workers. xi ) we can deﬁne a linear projection equation (3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. The solid line is the conditional mean.1. since the resulting function is quadratic in experience. These structural models require alternative estimation methods. In this case (3.

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

x 6. i 11. σ = . then E(ei | xi ) = 0. Let X be a random variable with µ = EX and σ 2 = V ar(X). 2. i 10. a constant. xi ∈ R. True or False. yi ). Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. 9. then ei is independent of xi . s) = 0 if and only if m = µ and s = σ 2 . taking values only on the non-negative integers.1 . µx = Exi .6 Exercises 1. True or False. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. then E(x2 ei ) = 0. and E(ei | xi ) = 0. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . and E(e2 | xi ) = σ 2 . and have the following joint probability distribution X=0 X=1 Y =0 . Suppose that yi is discrete-valued. If yi = x0 β + ei and E(ei | xi ) = 0. E(ei | xi ) = 0. 1. If yi = x0 β + ei .3. then E(x2 ei ) = 0. True or False. xi ∈ R. Compute E(yi | xi = x) and V ar(yi | xi = x). m. σ 2 = V ar(xi ). (x − µ)2 − σ 2 Show that Eg (X. 0 ≤ y ≤ 1.. 20 ..2. i 7. 3 and 4 of Theorem 3. Suppose that Y and X only take the values 0 and 1. i 8.2 Y =1 . 3. σ 2 = V ar(yi ) and σ xy = Cov(xi . If yi = x0 β + ei and E(xi ei ) = 0. Compute the conditional mean m(x) = E (yi | xi = x) . e−λ λj j! . True or False. Prove parts 2.1.4 . 2. E(Y 2 | X = x) and V ar(Y | X = x). . If yi = xi β + ei . Let xi and yi have the joint density f (x.3 Find E(Y | X = x). If yi = xi β + ei . ¡ ¢ 4. j! 0 j = 0. True or False. then ei is i i independent of xi . Are they diﬀerent? Hint: If P (Y = j) = 5. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . and E(xi ei ) = 0. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . µ.

2) can be written in the parametric 0 β)) = 0. 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 .7 and 4.8. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . i n i=1 n 21 .3) In Sections 4. (4. i It follows that the moment estimator of β replaces the population moments in (4. we narrow the focus to the linear regression model. 4.1 Estimation Equation (4.1) (4. but for most of the chapter we retain the broader focus on the projection model.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . Observe that (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .2) (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.4) i i=1 i=1 ˆ Another way to derive β is as follows.

95 xi yi = 42. These are white male wage earners from the March 2004 Current Population Survey.83 ¶−1 µ ¶ . 30 = .117 1 14. To illustrate. consider the data used to generate Figure 3. 4.7% increase in mean wages. 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. An interpretation of the estimated equation is that each year of education is associated with an 11.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.117 Educationi . Let yi be log wages and xi be an intercept and years of education. This sample has 988 observations.37 µ ¶ 1.14 14.14 205.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 205. 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. i 22 . 0.94 −2. Then µ ¶ n 1X 2.170 37. excluding military.ˆ This is a set of k equations which are linear in β. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.30 + 0. 40 0. 40 2. ¶ 2.2 Least Squares There is another classic motivation for the estimator (4. with 10-15 years of potential work experience.4).83 µ We often write the estimated equation using the format \ log(W agei ) = 1.71 = −2.4).95 42.3.40 µ ¶µ ¶ 34.14 14.

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

ˆ n−k 2 i=1 (4.6) An alternative estimator uses the formula n 1 X 2 s = ei .Figure 4.7. It measures the variation in the i “unexplained” part of the regression. Its method of moments estimator is the sample average 1X 2 ei . 24 . These are algebraic results. 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.5) implies that 1X xi ei = 0. ˆ n i=1 n Since xi contains a constant.7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ σ = ˆ n 2 i=1 n (4.2: Sum-of-Squared Error Function Contours Equation (4. one implication is that n 1X ei = 0. and hold true for all linear regression estimates. The error variance σ 2 = Ee2 is also a parameter of interest.

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

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

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

Regress Y on X2 . obtain residuals X2 . ⎟ ⎜ ⎟ ⎜ (4.14) or via the ˆ following algorithm: ˜ 1. obtain OLS estimates β 2 and residuals e. In this case. and X2 is the vector of observed regressors. . ⎠ ⎝ ⎠ ⎝ . A common application of the FWL theorem.1 (Frisch-Waugh-Lovell). ˆ which are “demeaned”.13). ˆ ˜ ˜ ˆ 3. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. 4. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. . ˜ 2. .9). Regress X2 on X1 . 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) . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. . the FWL theorem can be used to speed computation.Theorem 4. In the model (4. . but in most cases there is little computational advantage to using the two-step algorithm. which you may have seen in an introductory econometrics course. . obtain residuals Y . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . 30 . ¡ ¢−1 0 ι. the primary use is theoretical. .8)(3.9). . In some contexts. observe that ⎞ ⎛ ⎞ ⎛ . Regress Y on X1 . . is the demeaning formula for regression. Rather. In this section we derive the small sample conditional mean and variance of the OLS estimator.6.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. By the independence of the observations and (3. . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.

and (4.18).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 . . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. Then given (4.20) . . under the of ˆ ¢ 2 | x = σ 2 .8).19) ˆ and thus the OLS estimator β is unbiased for β. V ar β | X = X 0 X ⎟ ⎟ ⎟. . and the trace operator observe that. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 .Using (4. Next. 0 0 ··· 0 0 .. 1 n . ⎝ . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. .. .12). .. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model. . From (4. σ 2 } = ⎜ . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. .. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . ⎠ (4. X 0 DX = X 0 Xσ 2 . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . the properties of conditional expectations. we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0. and ³ ´ ¡ ¢−1 2 ˆ σ . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 .

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

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

9). 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. and thus so is the OLS estimator. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.1. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .22) 34 . He observes that the above argument holds for all multinomial distributions. if the data have a discrete distribution.Substituting in the expressions for π j .5. 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 proves that generically the OLS estimator (4.10) for the class of models satisfying Assumption 3.10 Omitted Variables xi = µ x1i x2i ¶ . (4. Chamberlain (1987) extends this argument to the case of continuously-distributed data. the maximum likelihood estimator is identical to the OLS estimator. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .

log(p1 ). 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 .Now suppose that instead of estimating equation (4. Typically there are limits. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). This happens when the columns of X are linearly dependent. least-squares estimation of (4. To see this. It is the consequence of omission of a relevant correlated variable. For example. In this case. i. except in special cases. there is some α such that Xα = 0.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. 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. 4. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.. or second. which is often called “multicollinearity” for brevity. Typically. This deﬁnition is not precise. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 .23) where is the coeﬃcient from a regression of x2i on x1i . we regress yi on x1i only. This is called strict multicollinearity. Since the error is discovered quickly. log(p2 ) and log(p1 /p2 ). First.22). the coeﬃcient on x2i in (4. the general model will be free of the omitted variables problem. and the error as ui rather than ei . This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. Goldberger (1991) calls (4. then β is not deﬁned. 35 . Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. Most commonly.23) the short regression to emphasize the distinction. because we have not said what it means for a matrix to be “near singular”.22) the long regression and (4. β 1 6= γ 1 . This is because the model being estimated is diﬀerent than (4.e.22) by least-squares. if X includes both the logs of two prices and the log of the relative prices. This is the situation when the X 0 X matrix is near singular. when the columns of X are close to linearly dependent. When this happens. In general. as many desired variables are not available in a given dataset. this is rarely a problem for applied econometric practice. this arises when sets of regressors are included which are identically related.22) is zero. The diﬀerence Γβ 2 is known as omitted variable bias. By construction. The more relevant issue is near multicollinearity.

What is happening is that when the regressors are highly dependent. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.−i = yi − x0 β (−i) = (1 − hi )−1 ei . the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . 1] and sum to k. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.−i = (1 − hi )−1 hi ei . deﬁne the leave-one-out least-squares estimator of 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 . that is.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. We derive expression (4. We can also deﬁne the leave-one-out residual ˆ ˆ ei. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. 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. ˆ i A simple comparison yields that ˆ ei − ei. the precision of individual estimates are reduced. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . The hi take values in [0. If the i’th observation 36 . A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. To investigate the possibility of inﬂuential observations. ˆ ˆ (4.26) As we can see. the worse the precision of the individual coeﬃcient estimates.25) β (−i) = β − (1 − hi )−1 X 0 X where ¢−1 ¡ xi hi = x0 X 0 X i The i’th observation is inﬂuential on the least-squares estimate if the deletion of the observation ˆ from the sample results in a meaningful change in β. the OLS estimator based on the sample excluding the i’th observation.25) below. since as ρ approaches 1 the matrix becomes singular.27) (4. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 .12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . As a consequence.

1) in Section 2. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .27). Investigations into the presence of inﬂuential observations can plot the values of (4. then this observation is a leverage point and has the potential to be an inﬂuential observation.This implies has a large value of hi . ˆ We now derive equation (4.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . which is considerably more informative than plots of the uncorrected residuals ei .25). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . The key is equation (2.

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

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

7). denoted Zn →d Z. Jensen’s inequality (5.6) and (5. if for all x at which F (x) is continuous. the fact that X n = W n + Z n . by Markov’s inequality (5. ¡¯ ¯ P ¯X n ¯ > δ ≤ η.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . Fn (x) → F (x) as n → ∞.6) By Jensen’s inequality (5. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. the triangle inequality. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Finally. and the bound |Wi | ≤ 2C. If Xi ∈ Rk is iid and E |Xi |2 < ∞. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.Proof: Without loss of generality. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. we can set E(X) = 0 (by recentering Xi on its expectation). 5. 43 . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. We say that Zn converges in distribution to Z as n → ∞. Set ε = δη/3. the fact that the Wi are iid and mean zero. P ¯X n ¯ > δ ≤ η.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . V ) .5). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . Theorem 5. as needed. (5.4). ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) .1). Fix δ and η.3.1) and (5. where Z has distribution F (x) = P (Z ≤ x) .1 Central Limit Theorem (CLT).

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

k ≤ m. Theorem 5. If Zn →d Z as n → ∞ and g (·) is continuous. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).1 Continuous Mapping Theorem 1 (CMT).4. Since cλλ (λn ) → cλλ (0) = −Ik .4. then g(Zn ) →p g(c) as n → ∞. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. ¥ 5. If Zn →p c as n → ∞ and g (·) is continuous at c. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.2 Continuous Mapping Theorem 2. Proof : By a vector Taylor series expansion. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Hence g(Zn ) →p g(c) as n → ∞. for each element of g. 45 . we see that as n → ∞. gθ Σgθ . Recall that A ⊂ B implies P (A) ≤ P (B). Ik ) distribution. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. where θ is m × 1 and Σ is m × m. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0.√ where λn → 0 lies on the line segment joining 0 and λ/ n. Σ) .3 Delta Method: If n (θn − θ0 ) →d N (0. This is suﬃcient to establish the theorem. √ Theorem 5. then g(Zn ) →d g(Z) as n → ∞.4 Asymptotic Transformations Theorem 5.4. Stacking across elements of g. Σ) = N 0. and g(θ) : Rm → Rk . gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 . Proof: Since g is continuous at c. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0.

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

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. (6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. xi ei →p g (Q.5.1). First. ˆ Theorem 6.2 Consistency ˆ As discussed in Section 6.1.5.4. For a complete argument. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. 6. Equation (4.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1 and the WLLN (Theorem 5. ˆ 47 . and the continuous mapping theorem (Theorem 5.1). Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 .2. To characterize the sampling distribution more fully.4 implies that Q−1 exists and thus g(·. the OLS estimator β is has a statistical distribution which is unknown.2. using (6.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. 0). ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . β →p β as n → ∞. As the sample size increases the density becomes more concentrated about the population coeﬃcient.1 Under Assumption 3. Proof.3). ·) is continuous at (Q. we will use the methods of asymptotic approximation.4. Ã n ! n X 1X 0 1 ˆ xi xi . This is illustrated in Figure 6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. Assumption 3. (6.2) i i n i=1 n From (6.2). n i=1 (6.5.1) and ˆ We now deduce the consistency of β. Assumption 3. Hence by the continuous mapping theorem (Theorem 5. (6.1).1.1.3) Ã where g(A.1 by the fact that the sampling densities become more concentrated as n gets larger. we can conclude ˆ that β →p β.1).

it follows that s2 = ¥ n σ 2 →p σ 2 . To see this. ˆ Finally.1 In addition to Assumption 3.2).Theorem 6. E ¯ei ¯ E ¯e4 ¯ i i i i (6.3. Ee4 < ∞ and E |xi |4 < ∞. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .2.1 guarantees that the elements of Ω are ﬁnite. Ω) .1. We need a strengthening of the moment conditions. n 1 X √ xi ei →d N (0. Thus σ 2 is consistent for σ 2 .3) and Theorem (6. since n/(n − k) → 1 as n → ∞.6) n i=1 48 .3. 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 . Assumption 6. (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. by the Cauchy-Schwarz inequality (5. i i Assumption 6. (6.2. ˆ Proof.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.2 Under Assumption 3. (6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.3. ˆ n−k 6.1).5.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. By the central limit theorem (Theorem 5.2). (6. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.1.5.1).

In´Figure 6. 1 X √ xi ei n i=1 n ! the N (0. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). This holds true for all joint distibutions of (yi . after rescaling. For α 49 . In Figure 6. e2 ) = 0. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.1). We illustrate this problem using a simulation. 1).1 Under Assumption 6.1. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .7) is true or false. however.3.1. (6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. Theorem 6. otherwise V 6= V 0 .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.9) we deﬁne V 0 = Q−1 σ 2 whether (6. for example.Then using (6. The trouble is that no matter how large is the sample size. when xi and ei are independent. setting n = 100 and varying the parameter α. its variance diverges q ³ ´ ˆ to inﬁnity.3.3. Q−1 ΩQ−1 .7) is true then V = V 0 . V is often referred to as ˆ the asymptotic covariance matrix of β. When (6.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β .7) Cov(xi x0 . The approximation may be poor when n is small. The expression V = Q−1 ΩQ−1 is called a sandwich form. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. We call V 0 the homoskedastic covariance matrix. The asymptotic distribution ´ Theorem 6.6).7) holds. How large should n be in order for the approximation to be useful? Unfortunately.2).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. there is no simple answer to this reasonable question. i i Condition (6.9) In (6. Let yi = β 0 + β 1 xi + εi where xi is N (0. 1) asymptotic distibution.3. xi ) which satisfy the conditions of Assumption 6. V ) where V = Q−1 ΩQ−1 . Under (6. There is a special case where Ω and V simplify. is approximately normal when the sample size n is suﬃciently large. and (6. but this is not a necessary condition.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. |ε| ≥ 1. Ω) ¡ ¢ = N 0.1 states that the sampling distribution of the least-squares estimator. We say that ei is a Homoskedastic Projection Error when (6.3. However. As α approaches 2.

Another example is shown in Figure 6. 1).2. concentrating most of the probability mass around zero. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. we need an estimate of Ω = E xi x0 e2 . We show the sampling distribution of n β 1 − β 1 setting n = 100. As k increases.0 the density is very close to the N (0.2) and Theorem 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2: Density of Normalized OLS estimator α = 3. 4. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. As α diminishes the density changes signiﬁcantly. 6.11) 50 . the sampling distribution becomes highly skewed and non-normal.3.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.2 and 6. The estimator 2 2 in (6. 6 and 8.3 is that the N (0. 1) asymptotic approximation is never guaranteed to be accurate. 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. The lesson from Figures 6. 1) density. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.1) it is clear that V 0 →p V 0 .10) without changing this result.Figure 6.10) V 0 = Q−1 s2 . for k = 1.

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

80 40. The standard errors for β 0 are 7.80 2.80 40. We calculate that s2 = 0.5 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.83 ¶−1 = µ 7.83 ¶−1 µ . (6.1. just as any other estimator. p ˆ In this case the two estimates are quite similar.2/988 = .14 14.2. n n i=1 52 .20 −0.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .5) and the WLLN (Theorem 5.480 .98 −0.20 and µ ¶ ˆ = 0.12) in turn. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . Using (6.20 = V 14.80 .14 205. Ω 2. then take the diagonal elements.117 Educationi .199 2.020) 6. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.6 ¶µ 1 14. To illustrate.14 205. First. from which it follows that V →p V as n → ∞.30 + 0. (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 .035 ¶ . i i i i n i=1 Second. From a computational standpoint.039 and ˆ V = µ 1 14.14 14. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.35/988 = .used by an author when studying their work.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.83 −0.020. (.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.480 ˆ0 = 0.085) (. by Holder’s inequality (5.493 0.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.14 6. we return to the log wage regression of Section 4. but not under another set of assumptions.199 2.085 p ˆ and that for β 1 is .493 −0.14 205. and then the square roots.

which. 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. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.13) Using formula (4.25). 6.11) with the leave-one-out estimator ei.5.1 As n → ∞. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. i=1 Third. ¯ ¯n ¯ n i=1 so Together.13) of Efron (1982).6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. 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. you can show that 1 Xˆ ¯ β= β (−i) . is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. Recall from Section 4. n i=1 n ˆ ˆ Theorem 6. Andrews (1991) suggested an similar estimator based on cross-validation.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 . From equation (3.26). 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.−i = (1 − hi )−1 ei ˆ presented in (4. Ω →p Ω and V →p V. these establish consistency. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . Using this substitution.

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

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

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

18) .16) and zα/2 is the upper α/2 quantile of the standard normal distribution.05.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. = n h(β) − θ0 Hβ V Hβ 57 (6. or α = . This corresponds to selecting the conﬁdence h i h ˆ ± 1. ˆ + zα/2 s(ˆ . In this case the t-statistic approach does not work. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. 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). 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).96s(ˆ ≈ ˆ ± 2s(ˆ . A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. θ θ) (6. 6.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. and it is desired to test the joint restrictions simultaneously. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). θ The interval has been constructed so that as n → ∞. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. the most common professional choice isi95%. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .

ˆ Wn = n θ θ q θ θ Theorem 6. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .1 showed θ ˆ that V →p V.15) showed that n ˆ − θ →d Z ∼ N (0. For example.When h is a linear function of β.1 Under H0 and Assumption 6.05) = 3. Furthermore.8. In this case. θ = β 2 . Hence β β by Theorem A. Also h(β) = a selector matrix. Hβ (β) is a continuous function of β. the upper-α quantile q 2 of the χ2 distribution.5. then Wn →d χ2 .84 = z. ˜˜ n ˜ e = Y − X1 β 1 . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . the test rejects at the α% level iﬀ pn < α. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2. The null hypothesis is H0 : β 2 = 0. χ2 (. h(β) = R0 β. The asymptotic p-value for Wn is pn = p(Wn ). Vθ ).025 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6.1.19) σ2 ˆ where σ2 = ˜ 1 0 e e. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. 1] under H0 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . 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.10.2. q and pn is asymptotically U[0. 6. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. As before. Hβ (β) →p Hβ . where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. a chiq square random variable with q degrees of freedom. and Theorem 6.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 .3. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. and there are q = k2 restrictions. if rank(Hβ ) = q.

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

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

The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . In contrast.3. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. We summarize these ﬁndings Theorem 6. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 ) = − log σ − log (2π) − . 0. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . β has an exact normal distribution and t has an exact t distribution. β 2 . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. 0. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ 2 ) − Ln (β 1 . Furthermore. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ2 ˆ 61 . β and t are approximately normally distributed. 0. with residual variance σ . σ 2 ) discussed above.1 we showed that in large samples. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. As inference (conﬁdence intervals) are based on the t-ratio. (Unless the sample size is unreasonably small.12.1 and Theorem 6. n−k • ∼ tn−k ˆ In Theorem 6.1 shows that under the strong assumption of ˆ normality. σ ˆ ˆ βj − βj βj − βj N (0. if standard errors are calculated using the homoskedastic formula (6.12. The critical values are quite close if n − k ≥ 30. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . β 2 .) Now let us partition β = (β 1 . and standard errors are calculated using the homoskedastic formula (6.10) µ h i ¶ 2 (X 0 X)−1 N 0.a chi-square distribution with n − k degrees of freedom. so as a practical matter it does not matter which distribution is used. σ 2 ). a good testing procedure is based on the likelihood ratio statistic. β 2 . 1) and tn−k distributions.1 If ei is independent of xi and distributed N(0. the notable distinction is between the N (0. Theorem 6.10) then ´ ³ ˆ • β ∼ N 0.8.

σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. The increasing solid line is for the case β = 0. 6.4 the Wald statistic Wn (s) as a function ˆ of s. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . and noting Hβ = sβ s−1 . The decreasing dashed ˆ = 1. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. the statistic Wn (s) varies with s. This is an unfortunate feature of the Wald statistic. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.7. 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. 62 . This produces random draws from the sampling distribution of interest. Letting h(β) = β s . we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . ˆ Let β and σ 2 be the sample mean and variance of yi .8. In the present context of the Wald statistic. This can be seen by a simple example introduced by Lafontaine and White (1986). we have plotted in Figure 6. as Wn (s) →d χ2 under H0 for 1 any s. Our ﬁrst-order asymptotic theory is not useful to help pick s. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. features of this distribution can be calculated. Take the model yi = β + ei ei ∼ N (0. To demonstrate this eﬀect. they can work quite poorly when the restrictions are nonlinear. setting n/σ 2 = 10. Through repetition. 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.84 — the probability of a false rejection.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. σ 2 ) and consider the hypothesis H0 : β = 1. while there are other values of s for which test test statistic is insigniﬁcant. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest.

n is varied among 20. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. and σ is varied among 1 and 3. To interpret the table. this probability depends only on s. however. For this particular example.Figure 6. These probabilities are calculated as the percentage of the 50. the only test which meets this criterion is the conventional Wn = Wn (1) test. looking for tests for which rate rejection rates are close to 5%. In Table 2.000 random samples.1 we report the results of a Monte Carlo simulation where we vary these three parameters. When comparing statistical procedures.1 reports the simulation estimate of the Type I error probability from 50. Given the simplicity of the model. Typically. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.84. The null hypothesis β s = 1 is true. no magic choice of n for which all tests perform uniformly well. Type I error rates between 3% and 8% are considered reasonable. In each case. Error rates avove 10% are considered excessive. and σ 2 . so these probabilities are Type I error. Any other choice of s leads to a test with unacceptable Type I error probabilities.4: Wald Statistic as a function of s P (Wn (s) > 3.84 | β = 1) . Test performance deteriorates as s increases.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . and rarely fall outside of the 3%-8% range.1 you can also see the impact of variation in sample size.4. The value of s is varied from 1 to 10. n. remember that the ideal Type I error probability is 5% (. Table 4.05) with deviations indicating+ distortion.000 simulated Wald statistics Wn (s) which are larger than 3. the Type I error probability improves towards 5% as the sample size n increases. we compare the rates row by row. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Rates above 20% are unexceptable. 100 and 500. There is. Table 4. In Table 4.

12 .06 . Other choices are arbitrary and would not be used in practice.13 .25 .10 .08 .33 .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 .06 .05 .07 .19 .08 .06 .08 .11 . deﬁne θ = β 1 /β 2 .05 .34 . β 2 ) be the least-squares estimates of (6.07 .26 .09 .18 .10 .06 .14 .23 .08 .05 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.15 .15 . so the hypothesis can be stated as H0 : θ = r.25 .06 . 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. An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.15 .21 .20).000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.05 .24 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .15 .35 .10 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .13 .31 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.08 .05 .05 .22 .06 . While this is clear in this particular example.17 .16 Rejection frequencies from 50.13 .06 .07 .12 .07 . 64 . Equivalently.28 .06 .20 .30 .22 .07 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . β 1 . This point can be illustrated through another example.14 .20 .

the rejection rates for the linear t2n statistic are invariant to the value of β 2 .05 .645) greatly exceed 5%. this formulation should be used.1. and alternatives to asymptotic critical values should be considered.07 . 6.00 .47 . then the “most linear” formulation should be selected.06 . along with sample size n.05 . and normalize β 0 = 0 and β 1 = 1.50 .06 . If no linear formulation is feasible. We let x1i and x2i be mutually independent N (0. .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. σ 2 ) draw with σ = 3.05 . The left tail probabilities P (t1n < −1. while the right tail probabilities P (t1n > 1.25 .645) are calculated from 50. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . In all cases.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.05.26 .09 .05 β2 .7. 65 .75. However. Ideally. Table 4.06 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.00 .05 . In this section we describe the method in more detail.05 .06 .645) are close to zero in most cases.12 . This leaves β 2 as a free parameter. .02 .15 .10 .10 .06 .06 .25.000 simulated samples. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.05 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .645) P (tn > 1.05 .00 . especially for small values of β 2 .00 . It is also prudent to consider alternative tests to the Wald statistic.50.00 The one-sided Type I error probabilities P (tn < −1. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.00 .06 .00 .645) and P (tn > 1.05 .645) t1n t2n t1n t2n t1n t2n t1n t2n . if the hypothesis can be expressed as a linear restriction on the model parameters. such as the GMM distance statistic which will be presented in Section 9.2.06 .28 . . The implication of Table 4. 1) variables. and 1. the rejection rates for the t1n statistic diverge greatly from this value.645) P (tn > 1. The results are presented in Table 4.06 . In contrast. the entries in the table should be 0.00 .15 . and are close to the ideal 5% rate for both sample sizes.05 .00 .00 .10 .06 .0 and n among 100 and 500. We vary β 2 among .75 1.645) P (tn < −1. ei be an independent N (0.

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

. We us the sample of wage earners from the March 2004 Current Population Survey. Often this is called the number of replications. In practice. and 5000. immigrant. s P = . female. It is therefore useful to conduct a variety of experiments. The random variable 1 (Tnb ≥ 1. and 90% sample quantiles of the sample {Tnb }. equalling 1 with probability P = E1 (Tnb ≥ 1. union member. therefore. and dummy variable indicators for the following: married. In many cases. potential work experience. 6. As P is unknown. such as the percentage estimate reported in (6. Again our dependent variable is the natural log of wages. 1000.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. and non-white. We now expand the sample all non-military wage earners. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. Hence the ³ ´ ˆ standard errors for B = 100. and dummy variable indicators for the following: married. In particular. we included a dummy 67 . For example. If the standard error is too large to make a reliable inference. We separately estimate equations for white and non-whites. Quite simply. Generally.96) . It is therefore convenient to pick B so that N is an integer. hispanic. this may ˆ be approximated by replacing P with P or with an hypothesized value.96) is iid Bernoulli. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.003. The average (6. and our regressors include years of education. then B will have to be increased. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. the choice of B is often guided by the computational demands of the statistical procedure. union member. Then qα is the N ’th number in this ordered sequence. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings.05) (.22/ B. and estimate a multivariate regression.95) /B ' . a larger B results in more precise estimates of the features of interest of Gn . and hispanic. experience squared. where N = (B +1)α. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. experience squared. respectively. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. if we set B = 999.96) . Furthermore.15 Estimating a Wage Equation We again return to our wage equation. For the dependent variable we use the natural log of wages. and poorly for others. and . it is simple to make inferences about rejection probabilities from statistical tests.21).022. and therefore it is straightforward to calculate standard errors for any quantity of interest. an estimator or test may perform wonderfully for some values. but requires more computational time. B b=1 (6. the researcher must select the number of experiments. then we can set s P = (.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. For regressors we include years of education.007. are. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. so that coeﬃcients may be interpreted as semi-elasticities. The α% sample quantile is a number qα such that α% of the sample are less than qα . B. the performance will depend on n and F. female. immigrant. excluding military. potential work experience.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. for a selection of choices of n and F. As discussed above. For example.

232 .00057 .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.101 .808 so the parameter estimates are quite precise and reported in Table 4.4877 18. 808 1 − . reestimating the model with the 50 state dummies excluded. we can write this eﬀect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model.18) that the state coeﬃcients are jointly zero.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. this adds 50 regressors). 2β 3 68 . Alternatively. The F form of the Wald statistic (6. excluding the coeﬃcients on the state dummy variables.4945.19) is ˜ µ ¶ µ ¶ σ2 ˆ . we ﬁnd Wn = 550.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.49452 σ ˜ Notice that the two statistics are close. the restricted standard deviation estimate is σ = . θ ˆ 2β 3 β2 . Computing the Wald statistic (6.033 −. Table 4.027 .102 −.34 ˆ s(β) . Ignoring the other coeﬃcients. Wn = n 1 − 2 = 18.097 −.008 .007 .013 .48772 = 515. Using either statistic the hypothesis is easily rejected.001 .002 .121 −.808 . but not equal.032 .010 .070 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.variable for state of residence (including the District of Columbia.00002 .69. The available sample is 18.102 −. as the 1% critical value for the χ2 distribution is 76.1.014 .

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

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

If σ 2 < 0 for some i.. ˜i Suppose that σ 2 > 0 for all i. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). estimator of β. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. which is typically undesirable. Then set ˜i ˜ D = diag{˜ 2 . xi ).4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0..4) the skedastic regression. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . 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 . and hence we can estimate 0 σ 2 = zi α by i ˜ (7.3) ˆ ˆ While ei is not observed. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0. Vα ) (7. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Furthermore.Suppose ei (and thus η i ) were observed.6) σ 2 = α0 zi . then the FGLS ˜i estimator is not well deﬁned.. as it is estimating the conditional variance of the regression of yi on xi . This suggests 75 . there is no guarantee that σ 2 > 0 for all i. then the FGLS estimator will force ˜i the regression equation through the point (yi . We may call (7. Vα = E zi zi (7. We have shown that α is consistently estimated by a simple procedure. and will depend on the model (and estimation method) for the skedastic regression. This is the feasible GLS. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. . if σ 2 ≈ 0 for some i.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. or FGLS. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique.

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

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

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

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

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

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

In the special case where the error is independent of xi . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . This can be done with kernel estimation techniques. the height of the error density 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. V ).1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. ∂β 0 so Third. First.1 ´ √ ³ˆ n β − β 0 →d N (0. ˆ Proof of Theorem 7.5. and this improves estimation of the median. then there are many innovations near to the median. (7. the conditional density of the error at its median.10) is equivalent to g n (β) = 0. Let g(β) = Eg (β). then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.5. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . The main diﬃculty is the estimation of f (0). ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .3. See Chapter 16. When f (0 | x) is large. While a complete proof of Theorem 7. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . Second using the law of iterated expectations and the chain rule of i diﬀerentiation. Computation of standard error for LAD estimates typically is based on equation (7.11).5. Pn −1 0 β)) . where V = and f (e | x) is the conditional density of ei given xi = x.1 is advanced.Theorem 7. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . by the central limit theorem (Theorm 5. we provide a sketch here for completeness.

¥ 7. The third line follows from an asymptotic empirical process argument.13) This generalizes representation (7.9) for the median to all quantiles. For τ ∈ [0. when F (y | x) is continuous and strictly monotonic in y. then F (Qτ (x) | x) = τ . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . (7.Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. the quantile regression functions can take any shape. For ﬁxed τ . The median is the special case τ = . We then have the linear quantile regression model yi = x0 β τ + ei i 83 . Exi x0 ) →d i 2 = N (0.5. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). V ). then F (Qτ ) = τ . so you can think of the quantile as the inverse of the distribution function. 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)) .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. Again. If the random variable U has τ ’th quantile Qτ . As functions of x. 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. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . For the random variables (yi . then (7. The following alternative representation is useful.12) Qτ = argmin Eρτ (U − θ) .

1.13). ´ √ ³ˆ Theorem 7. ¡ ¡ ¢¢−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. the τ ’th conditional quantile of ei is zero. Furthermore. and form a Wald statistic i for γ = 0.12). if the model yi = x0 β + ei has i been ﬁt by OLS. the asymptotic variance depends on the conditional density of the quantile regression error.5. since it has discontinuous derivatives. the unconditional density of ei at 0. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. When the error ei is independent of xi . conventional Newton-type optimization methods are inappropriate. The null model is yi = x0 β + εi i 84 . 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. then f (0 | xi ) = f (0) . 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. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. fast linear programming methods have been developed for this problem. otherwise its properties are unspeciﬁed without further restrictions. n numerical methods are necessary for its minimization. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. and are widely available. 7. ˆ Given the representation (7. i By construction. and test their signiﬁcance using a Wald test. Vτ ).6.1 n β τ − β τ →d N (0.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Thus.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). it is useful to have a general test of the adequacy of the speciﬁcation. Another popular approach is the RESET test proposed by Ramsey (1969). where and f (e | x) is the conditional density of ei given xi = x. Fortunately. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 .

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

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

is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . AIC selection is inconsistent. BIC model selection is consistent. this rule only makes sense when the true model is ﬁnite dimensional. else select M2 . ¢ ¡ ˆ1 ˆ2 (7. and km is the number of coeﬃcients in the model. then this model selection procedure is inconsistent. let cα satisfy ¢ ¡ P χ22 > cα . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . n (7. That is. the most popular to be one proposed by Schwarz. since under M1 . A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . based on Bayesian arguments. as the rule tends to overﬁt. In contrast to the AIC. 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. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. Another common approach to model selection is to to a selection criterion. For some critical level α. Indeed. Then select M1 if Wn ≤ cα . known as the BIC. depending on the sample size. His criterion.However. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. else select M2 . M)) between the true density and the model density.16) holds under M1 . as ³ ´ c P M = M1 | M1 → 1 − α < 1.17) Since log(n) > 2 (if n > 8). etc.15) then where σ 2 is the variance estimate for model m. n (7. Indeed. log(n) 87 . The reasoning which helps guide the choice of α in hypothesis testing (controlling Type I error) is ´ not ³ c = M1 | M1 ≈ relevant for model selection. k A major problem with this approach is that the critical level α is indeterminate. The rule is to select M1 if AIC1 < AIC2 . if α is set to be a small number. ˆm The AIC can be derived as an estimate of the KullbackLeibler information distance K(M) = E (log f (Y | X) − log f (Y | X. If the truth is inﬁnite dimensional. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. Another problem is that if α is held ﬁxed. One popular choice is the Akaike Information Criterion (AIC).16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . The model selection rule is as follows. since (7. k = While many modiﬁcations of the AIC have been proposed. LRn →p 0.

the models are M1 : β 1 6= 0. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0.. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi .. The methods extend readily to the issue of selection among multiple regressors. 88 . and 220 = 1.. . The AIC selection criteria estimates the K models by OLS. and then selects the model with the lowest AIC (7.15). β 2 6= 0. 576. 210 = 1024. which can be a very large number. In the unordered case. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. Similarly for ˆ the BIC. We have discussed model selection between two models. In the latter case.17). a model consists of any possible subset of the regressors {x1i .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. . Also under M2 . which regressors enter the regression). one can show that thus LRn →p ∞. selecting based on (7. . and the AIC or BIC in principle can be implemented by estimating all possible subset models. β 3 = · · · = β K = 0 . xKi }. which are nested. β 2 6= 0. There are two leading cases: ordered regressors and unordered. 048. In the ordered case. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. . . For example. there are 2K such models. . β K 6= 0. stores the residual variance σ 2 for each model. MK : β 1 6= 0. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. . However.

. Let σ 2 be the estimate of σ 2 . xi ) be a random sample with E(Y | X) = Xβ. V ar(e | X) = σ 2 Ω with Ω known. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . wn ) and wi = x−2 . x. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . .12). 4. the residuals e. ˆ (a) Find a point forecast of y.10 Exercises 1. Let (yi . E(e | X) = 0. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true.. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. Is θ a quantile of the distribution of Yi ? 3. (b) Find an estimate of the variance of this forecast.. ˜ the residual vector is e = Y − X β. In a linear model Y = Xβ + e. 5. and the out-of-sample value of the regressors. 2. Thus the available information is the sample (Y. where xji is one of the xi . For any predictor g(xi ) for y. X). (b) Prove that e = M1 e. Let θ satisfy Eg(Yi − θ) = 0.7. . σ 2 ). Show that the function g(x) which minimizes the MAE is the conditional median M (x). 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 . the estimates (β. ˆ ˆ n−k 6. V . based on a sample of size n. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. Verify equation (7. 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 . the mean absolute error (MAE) is E |yi − g(xi )| . else equals zero).

at least 10 to 15) of ln Qi are both below and above 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 . Assess the merits of this new speciﬁcation using (i) a hypothesis test. The model is non-linear because of the parameter a7 . Consider model (7. calculate zi and estimate the model by OLS. (c) Estimate the model by non-linear least squares.18) (a) Following Nerlove. 8. are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9. Find an asymptotic 95% conﬁdence interval for g(x). This model is called a smooth threshold model. In addition. θ is the NLLS estimator. and V is the = g(x estimate of V ar ˆ . (d) Calculate standard errors for all the parameters (a1 . the variable ln Qi has a regression slope of a2 .. θ) + ei with E (ei | xi ) = 0. . a7 ).. Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. Exercise 13. you estimated a cost function on a cross-section of electric companies. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . and ﬁnd the value of a7 for which the sum of squared errors is minimized. For values of ln Qi much below a7 . I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range.ˆ ˆ 7.. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. For each value of a7 . Record the sum of squared errors. (iii) BIC criterion. For values much above a7 . 90 . add the variable (ln Qi )2 to the regression. Examine the data and pick an appropriate range for a7 . The model works best when a7 is selected so that several values (in this example. and the model imposes a smooth transition between these regimes. Suppose that yi ³ ´ i . The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. (7. impose the restriction a3 + a4 + a5 = 1. the regression slope is a2 + a6 . n xi i=1 (a) Under the stated assumptions. In Chapter 6.18) plus the extra term a6 zi . (ii) AIC criterion. Do so.

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

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

50. 1) distribution. That is. the EDF is only a crude approximation to the CDF.1). n. ∗ P (yi ≤ y. In general. x) →p F (y. the EDF step function gets uniformly close to the true CDF. Fn (y. For n = 25. Thus by the WLLN (Theorem 5.. x) − F (y. x) = P (yi ≤ y. x))) . x∗ ≤ x) = Fn (y. To see this. note that for any (y. . x). it is helpful to think of a random pair (yi . Note that while F may be either discrete or continuous. as the sample size gets larger.3. Notationally.8.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . The EDF is a consistent estimator of the CDF. x) (1 − F (y. xi ).2. The random draws are from the N (0. x) . I have plotted the EDF and true CDF for three random samples of size n = 25. but the approximation appears to improve for the large n.. √ n (Fn (y.. x) = n i=1 Figure 8. where 1(·) is the indicator function.2 The Empirical Distribution Function Fn (y. F (y. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. and 100. x) is called the empirical distribution function (EDF). The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) .2) Fn (y. x)) →d N (0. i 93 . x). by the CLT (Theorem 5. This is a population moment. Fn is by construction a step function. x∗ ) with the i distribution Fn . To see the eﬀect of sample size on the EDF. i = 1.1). Furthermore. x). Fn is a nonparametric estimate of F. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . in the Figure below. (8. Recall that F (y.

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

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

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

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

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

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

F0 ) = Φ(x) + since v = 1.9 One-Sided Tests Using the expansion of Theorem 8.1 Under regularity conditions and (8. F0 )) converges to 0 at rate n. the exact distribution is P (Tn < x) = Gn (x. F ) + n−1 g2 (x. F ) ≈ Φ + n−1/2 g1 (x. so the order of the error is O(n−1/2 ). An asymptotic test is based on Φ(x). the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x.1 has the expansion n G∗ (x) = Gn (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). F0 ) + O(n−1 ) 1/2 1 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 . Fn ) − g1 (x. To a third order of approximation. ³x´ Gn (x. Fn ) − g1 (x. A bootstrap test is based on G∗ (x).8. v Since the derivative of g1 is odd.3). Fn ) − g1 (x. and g1 is continuous with respect to F. Heuristically. F ) ≈ Φ + n−1/2 g1 (x. F ) + g2 (x. F ) v which adds a symmetric non-normal component to the approximate density (for example. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). F0 ) = 1 g (x.8. √ Since Fn converges to F at rate n. where g1 is an even function of x. g1 (x. F0 )) + O(n−1 ). Fn ) = Φ(x) + n 1 g (x. We can interpret Theorem 8. adding leptokurtosis). To a second order of approximation.1. 1/2 1 n Because Φ(x) appears in both expansions.1 as follows. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. Theorem 8. which from Theorem 8. The diﬀerence is Φ(x) − Gn (x. and g2 is an odd function of x. Moreover. Gn (x. F ) converges to the normal limit at rate n1/2 . the diﬀerence √ (g1 (x. F0 ) ≈ ∂ g1 (x. the density function is skewed.8. F ) = Φ v n n 8. F ).8. ³x´ 1 1 + 1/2 g1 (x.uniformly over x. To the second order. ³x´ Gn (x. F ) + O(n−3/2 ) Gn (x. 100 . Fn ) + O(n−1 ). F0 ) = n 1 n1/2 (g1 (x. First.

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

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

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

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

and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. and the colonial dummy. Let qn (. θ respectively.05) and qn (. 105 .3. (c) With the given information.dat contains data on house prices (sales). and the 2. (b) Report the 95% Alternative Percentile interval for θ. The ˆ are sorted. You replace c with qn (. ∗ ∗ where s(ˆ is the standard error in the original data. ˆ = 1.95).2. (a) Report the 95% Efron Percentile interval for θ. lot size. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. Suppose that in an application. with variables listed in the ﬁle hprice1. You want to test H0 : θ = 0 against H1 : θ > 0.95).pdf. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). You do this as follows.95). What is wrong with this procedure? Tn = θ/s(θ) n 6. ˆ − s(ˆ n (. Using the non-parametric bootstrap. size of house. Using the non-parametric ∗ bootstrap. Estimate a linear regression of price on the number of bedrooms. can you report the 95% Percentile-t interval for θ? 7. and thus reject H0 if ˆ ˆ > q ∗ (.05) . you generate bootstrap samples. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).2 and s(ˆ = .75 and 1.95) denote the 95% quantile of Tn .95) denote the 5% θ) ∗ and 95% quantiles of Tn . and ˆ is calculated on each θ ∗ ∗ θ sample. The dataﬁle hprice1. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. ∗ ∗ ∗ Let qn (.5% quantiles of the ˆ are .5% and 97.

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

¡ ¢−1 0 ˆ Z XWn X 0 Y. Let and where gi = xi ei .1 β GMM = argmin Jn (β). The GMM estimator minimizes Jn (β). then. let Jn (β) = n · g n (β)0 Wn g n (β). β GMM does not change.2. This is a non-negative measure of the “length” of the vector g n (β). the dependence is only up to scale. For example. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . β GMM = Z 0 XWn X 0 Z 9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . and the GMM estimator is the MME. For some × weight matrix Wn > 0. but this is generally not possible when > k.9. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. i i . if Wn = I.2.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . for if Wn is replaced ˆ by cWn for some c > 0. Proposition 9. β ˆ Note that if k = . then g n (β) = 0. ˆ Deﬁnition 9. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.2) g n (β) = (9. the square of the Euclidean length.

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

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

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

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

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

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

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

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

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

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

where λ and µ are Lagrange multipliers. but must be obtained numerically (see section 6.5) ˆ ˆ As a by-product of estimation. This yields the (proﬁle) empirical log-likelihood function for β. the Lagrange multiplier λ(β) minimizes Rn (β. we ﬁnd µ = n and 1 ¢.1) and (10. The solution cannot be obtained explicitly... summing over i. 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..3). pn . (10. The solution (when it exists) is well deﬁned since Rn (β. (see section 6.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. λ) = −n ln (n) − n X i=1 For given β. p1 . µ) = n i=1 i=1 i=1 L∗ n with respect to pi . and using the second and third equations. λ) is a convex function of λ. probabilities 1 ³ ´´ . p (10.4) (10. λ) : λ(β) = argmin Rn (β. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. λ. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . or equivalently minimizes its negative ˆ (10. .5) This minimization problem is the dual of the constrained maximization problem.5). λ). Multiplying the ﬁrst equation by pi . Ln (β) = Rn (β. λ ¡ ¢ ln 1 + λ0 gi (β) .7) 118 . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). we also obtain the Lagrange multiplier λ = λ(β). µ.2) subject to the restrictions (10. pi 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. β) = −xi zi .9) and (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 . ˆ ˆ Proof. λ) = − (10. in the linear model.10. i=1 i=1 i=1i Expanding (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. G = −E (xi zi ). and n β − β 0 and nλ are asymptotically independent.9) (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .10) ¡ Ω−1 N (0.13) Premultiplying by G0 Ω−1 and using (10.10). ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.13) yields n n Expanding (10. λ) = − (10. Gi (.2. Thus the EL estimator is asymptotically eﬃcient. (β. β λ ∂ ³ ´. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. i i Theorem 10. 0 = Rn (β.1 Under regularity conditions.8) and ¢ 0 0 For example. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. n (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . and Ω = E xi x0 e2 .

¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. First. Proof.16). The same statistic can be constructed for empirical likelihood. 120 . by a Taylor expansion. (10. LRn = i=1 Theorem 10. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .15) (10.3 Overidentifying Restrictions In a parametric likelihood context. 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. Ω) GΩ G →d = N (0.1 If Eg(wi . Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. and have the same interpretation. β 0 ) = 0 then LRn →d χ2−k . They are asymptotically ﬁrst-order equivalent.14) for λ and using (10. 10. Vλ ) Furthermore.7) is n ³ ´´ ³ X ˆ ˆ0 (10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. and it is advisable to report the statistic LRn whenever EL is the estimation method. Since the EL estimator achieves this bound. The overidentiﬁcation test is a very useful by-product of EL estimation. V ) ˆ Solving (10.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. tests are based on the diﬀerence in the log likelihood functions. it is an asymptotically eﬃcient estimator for β.3. and (10.15).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. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.17) 2 ln 1 + λ gi β .

5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. The hypothesis of interest is h(β) = 0.18). 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. Theorem 10.prc 121 .18) are assumed to hold and are not being challenged (at least for the test discussed in this section).4.4 Testing Egi (β) = 0 (10.ssc.18) Let the maintained model be where g is × 1 and β is k × 1.Second.1 Under (10. h(β)=0 ˜ Fundamentally. since ln(1 + x) ' x − x2 /2 for x small. where h : Rk → Ra . so there is no fundamental change in the distribution theory for β relative to β. Vλ )0 Ω−1 N (0.wisc. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) and H0 : h(β) = 0. By “maintained” we mean that the overidentfying restrictions contained in (10. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). To test the hypothesis h(β) while maintaining (10.edu/~bhansen/progs/elike.17) is not appropriate. This test statistic is a natural analog of the GMM distance statistic. 10. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. the simple overidentifying restrictions test (10. LRn →d χ2 . a The proof of this result is more challenging and is omitted. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . 10.

λ) ∂λ i=1 n ∂ Rn (β. λ) . For p = 0. δ 1 = 1 and δ 2 = 1. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. The iteration (10. λ) = − ∂β n X i=1 G∗ (β. λ) = i The ﬁrst derivatives of (10. λ)0 0 Rn (β. λ) = G∗ (β.20) .Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λj ))−1 Rλ (β. λj ) is smaller than some prespeciﬁed tolerance.19) is continued until the gradient Rλ (β. λj ))−1 Rλ (β. The starting value λ1 can be set to the zero vector. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. 1. λj )) Rp = Rn (β. i Rββ = Inner Loop The so-called “inner loop” solves (10.5) for given β. λ) G∗ (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λ) gi (β. λ)0 − ∂β∂β Rn (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λ) = − gi (β. One method uses the following quadratic approximation. λp ) A quadratic function can be ﬁt exactly through these three points.4). Set δ 0 = 0. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λ) G∗ (β.19) X ∂2 ∗ ∗ gi (β.19). set 2 λp = λj − δ p (Rλλ (β. (10. Eﬃcient convergence requires a good choice of steplength δ..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. 2. 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)0 − Rn (β. λj ) . Deﬁne ∗ gi (β.

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

then i ¡ ¡ ¢¢−1 ¡ 0 ¢ ˆ E ui ui β 6= β. Suppose that (yi . E(yi | x∗ ) = x∗0 β is linear. x∗ ) are joint random i variables. Example: Measurement error in the regressor. Then i i yi = x∗0 β + ei i = (xi − ui )0 β + ei = x0 β + vi i where vi = ei − u0 β. ¸µ ¶ µ ¶ ∙ qi e1i 1 β1 = 1 −β 2 pi e2i 124 Assume that ei = . and the supply equation e1i is iid. Eei = 0. and x∗ is not observed. This cannot happen if β is deﬁned by linear projection.Chapter 11 Endogeneity 0 We say that there is endogeneity in the linear model y = zi β + ei if β is the parameter of interest and E(zi ei ) 6= 0. β 1 + β 2 = 1 and Eei e0 = I2 (the latter for simplicity). β is the parameter of interest. i The problem is that £ ¡ ¢¤ ¡ ¢ E (xi vi ) = E (x∗ + ui ) ei − u0 β = −E ui u0 β 6= 0 i i i ˆ if β 6= 0 and E (ui u0 ) 6= 0. Example: Supply and Demand. what happens? It is helpful to solve for qi and pi in terms of the errors. 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 . so requires a structural interpretation. independent of yi and x∗ . i e2i The question is. if we regress qi on pi . It follows that if β is the OLS estimator. Instead i i i we observe xi = x∗ + ui where ui is an k × 1 measurement error. The coeﬃcient β must have meaning separately from the deﬁnition of a conditional mean or linear projection. β →p β ∗ = β − E xi x0 i This is called measurement error bias. In matrix notation.

z1i is an instrumental variable for (11. this can be written as Y = Zβ + e. We call z1i exogenous and z2i endogenous. In a typical set-up.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 ¶ .4) xi = x2i 2 where z1i = x1i are the included exogenous variables. some regressors in zi will be uncorrelated with ei (for example. So we have the partition µ ¶ z1i k1 (11.1 The × 1 random vector xi is an instrumental variable for (11. Deﬁnition 11. (11. In matrix notation. so should be included in xi . at least the intercept). ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. 11.1.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. By the above deﬁnition. and assume that E(zi ei ) 6= 0 so there is endogeneity.2) Any solution to the problem of endogeneity requires additional information which we call instruments. We call (11. and x2i are the excluded exogenous variables. This is called simultaneous equations bias. β →p β ∗ .1).1) the structural equation. Thus we make the partition ¶ µ k1 z1i (11.1) where zi is k × 1. which does not equal either β 1 or β 2 .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. That is x2i are variables which could be included in the equation for yi (in the sense 125 .1) if E (xi ei ) = 0.

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

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

indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases.13).7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .14) In general this is non-zero. Indeed as α → 1. l . Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. By the spectral decomposition of an idempotent matrix. P = HΛH 0 0 0 where Λ = diag(Il .14) approaches that in (11. n and (11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. 130 . 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. 0).14) is the probability limit of β 2SLS − β 11. the bias in the 2SLS estimator will be large.12) and this result. The consequences of identiﬁcation failure for inference are quite severe. except when S21 = 0 (when Z is exogenous). The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. 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. It is also close to zero when α = 0.Let PX = X (X 0 X)−1 X 0 . the expression in (11. n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .

but is weak.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. so E (zi xi ) = 0. This occurs when Γ22 is full rank. Qc + N2 ˆ As in the case of complete identiﬁcation failure. the instrument xi is weak for zi if γ = n−1/2 c. once again take the simple case k = l = 1. Suppose this condition fails. 131 . but small. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. standard test statistics have non-standard asymptotic distribution of β distributions.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . Suppose that identiﬁcation does not complete fail. This can be handled in an asymptotic analysis by modeling it as local-to-zero. but (11. In addition. meaning that inferences about parameters of interest can be misleading. which occurs i when E (zi xi ) 6= 0.15) is unaﬀected. as the Cauchy distribution does not have a ﬁnite mean. This result carries over to more general settings. To see the consequences. E x2 e2 i i n i=1 n (11. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. where C is a full rank matrix. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. N2 since the ratio of two normals is Cauchy. and was examined by Phillips (1989) and Choi and Phillips (1992). Then (11.16) 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 .Take the simplest case where k = l = 1 (so there is no X1 ). Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. This is particularly nasty. E x2 u2 i i n n i=1 i=1 n n (11. Here. viz Γ22 = n−1/2 C.

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

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

listed in card. of the father) and motheduc (the education. (a) Estimate the model by OLS. (b) Now treat Education as endogenous.. (f) Discuss your ﬁndings. (d) Re-estimate the model by eﬃcient GMM. (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). Report estimates and standard errors. in years. Report the estimates and standard errors. Report estimates and standard errors. using zi as an instrument for xi . Estimate the model by 2SLS. (e) Calculate and report the J statistic for overidentiﬁcation. 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. In this model. a dummy indicating that the observation lives near a 4-year college. of the mother). 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. and the remaining variables as exogenous. are the parameters identiﬁed? 8. using the instrument near4. in years. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. 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. Does this diﬀer from 2SLS and/or OLS? 7. and South and Black are regional and racial dummy variables. 134 . f atheduc (the education.pdf. and then calculate the GMM estimator from this weight matrix without further iteration. 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. The data ﬁle card.(b) Deﬁne the 2SLS estimator of β.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).

Deﬁnition 12. t = 1.. and Cov (Yt . The primary model for multivariate time series is vector autoregressions (VARs). The following two theorems are essential to the analysis of stationary time series.. . Yt−k ) is independent of t for all k.1.4 (loose). however. T . Yt−1 . we expect that Yt and Yt−1 are not independent. and use the subscript t to denote the individual observation.2 {Yt } is strictly stationary if the joint distribution of (Yt .. We can separate time series into two categories: univariate (yt ∈ R is scalar). Because of the sequential nature of time series. Deﬁnition 12. . There proofs are rather diﬃcult. The primary model for univariate time series is autoregressions (ARs). .1.. γ(k) is called the autocovariance function.1. To indicate the dependence on time.1. Theorem 12.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .) is a random variable. 135 .1 Stationarity and Ergodicity Deﬁnition 12..1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. Yt−k ) is the autocorrelation function. so classical assumptions are not valid..1 If Yt is strictly stationary and ergodic and Xt = f (Yt . and T to denote the number of observations. A stationary time series is ergodic if γ(k) → 0 as k → ∞. we adopt new notation.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. then Xt is strictly stationary and ergodic. Yt−k ) = γ(k) is independent of t for all k. Deﬁnition 12.1.. 12.. and multivariate (yt ∈ Rm is vector-valued).

ˆ ˆ γ ¥ 136 . then as T → ∞.1. 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) . γ (k) →p γ(k). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . Part (1) is a direct consequence of the Ergodic theorem. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. For Part (2). ˆ 2. then as T → ∞. the sequence Yt Yt−k is strictly stationary and ergodic.Theorem 12. and it has a ﬁnite mean by the assumption that EYt2 < ∞. µ →p E(Yt ). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).1 above. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k).3 If Yt is strictly stationary and ergodic and EYt2 < ∞. γ (0) ˆ Theorem 12. ρ(k) →p ρ(k). If Xt is strictly stationary and ergodic and E |Xt | < ∞. 1.1. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). ˆ 3.1. ˆ Proof.2 (Ergodic Theorem). T 1X Xt →p E(Xt ).

... Regression errors are naturally a MDS..2. this series converges if the sequence ρk et−k gets small as k → ∞... then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. the series {. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 .. . Letting et = Yt − E (Yt | It−1 ) . Yt−2 . Y1 . as it is diﬃcult to derive distribution theories without this property.} is the past history of the series. 137 . t By back-substitution. YT ..3 Stationarity of AR(1) Process Yt = ρYt−1 + et .... Yt−k ) .. A mean-zero AR(1) is Assume that et is iid. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . . 12.. it is even more important in the time-series context. ∞ X = ρk et−k .} are jointly random. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .. This occurs when |ρ| < 1. E(et ) = 0 and Ee2 = σ 2 < ∞.. Y2 . E(Yt−k et ) = 0. In fact. should be a MDS. For example. 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 . or consumption growth rates. k=0 Loosely speaking. . A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . some versions of the life-cycle hypothesis imply that either changes in consumption.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. 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. The last property deﬁnes a special time-series process. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS.2 Autoregressions In time-series. Some time-series processes may be a MDS as a consequence of optimizing behavior. Thus for k > 0. Deﬁnition 12.12. .

1 If |ρ| < 1 then Yt is strictly stationary and ergodic.4. ∞ X k=0 ρ2k V ar (et−k ) = 12.1 The lag operator L satisﬁes LYt = Yt−1 . We call ρ(L) the autoregressive polynomial of Yt . 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. we see that L2 Yt = LYt−1 = Yt−2 . We call ρ(L) the autoregressive polynomial of Yt . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. We say that the root of the polynomial is 1/ρ. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . In general. The AR(k) model is Using the lag operator.3. 12.3. Deﬁning L2 = LL.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.1.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 138 . Deﬁnition 12.Theorem 12. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). an AR(1) is stationary iﬀ |ρ| < 1. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . 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). The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . since ρ(z) = 0 when z = 1/ρ. Lk Yt = Yt−k . We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . the above results are unchanged. From Theorem 12.

the requirement is that all roots are larger than one. . “has a unit root”. Note that ut is a MDS. then ˆ β →p β as T → ∞.” If one of the roots equals 1.1. t t T t=1 ¥ Combined with (12.1. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. This is a special case of non-stationarity. and by Theorem 12. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.1.5. The vector xt is strictly stationary and ergodic. Theorem 12. λk are the complex roots of ρ(z).1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.1) and the continuous mapping theorem. and is of great interest in applied time series. and hence Yt . Thus t by the Ergodic Theorem.. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. it is helpful to deﬁne the process ut = xt et . t Yt−k ¢0 ρk . We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. Proof. which satisfy ρ(λj ) = 0. t T t=1 T t=1 139 .6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et .6. By Theorem 12. β = X 0X (12. For an AR(k). ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. we say that ρ(L).1) Theorem 12..where the λ1 . it is also strictly stationary and ergodic. 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.. so is xt x0 .1. One way of stating this is that “All roots lie outside the unit circle. Let |λ| denote the modulus of a complex number λ.

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

and the way that the data are partitioned into blocks..3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . • First apply a seasonal diﬀerencing operator. • You can estimate (12. or the season-to-season change. This presumes that “seasonality” does not change over the sample. and then perform regression (12. ﬁrst estimate (12.3) replacing St with St . (12. • You can estimate (12. and perhaps this was of relevance.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . Thus the seasonally adjusted data is a “ﬁltered” series. May not work well in small samples. That is. Resample complete blocks. This allows for arbitrary stationary serial correlation. ρk ).2) (12. 6. get the ˆ ˆ residual St .. The series ∆s Yt is clearly free of seasonality. 3. This procedure is sometimes called Detrending. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. Paste the blocks together to create the bootstrap time-series Yt∗ . The results may be sensitive to the block length. draw T /m blocks. But the long-run trend is also eliminated.2. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. heteroskedasticity. 4. 5.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .3) sequentially by OLS. and for modelmisspeciﬁcation. The seasonal adjustment. If s is the number of seasons (typically s = 4 or s = 12). 12. also alters the time-series correlations of the data. 141 .2). however. For each simulated sample. Seasonal Eﬀects There are three popular methods to deal with seasonal data. (12. • Use “seasonally adjusted” data.2)-(12.4) by OLS. • Include dummy variables for each season. . This is a ﬂexible approach which can extract a wide range of seasonal factors. ∆s Yt = Yt − Yt−s ..

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

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

rather than the ˆ 1/2 .12. this means that the evidence points to Yt being stationary. where c is the critical value from the ADF table. Since the alternative hypothesis is one-sided. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . 144 . but does not depend on the parameters α. If the series has a linear trend (e. as the AR model cannot conceivably describe this data. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included. The natural solution is to include a time trend in the ﬁtted OLS equation. When conducting the ADF test. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal. (12. then the series itself is nonstationary. This distribution has been extensively α tabulated. If a time trend is included. If the test rejects H0 . a common conclusion is that the data suggests that Yt is non-stationary. but it may be stationary around the linear time trend.Theorem 12.1 (Dickey-Fuller Theorem).8). As T → ∞. Another popular setting includes as well a linear time trend. If the test does not reject H0 . this means that it is computed as the t-ratio for α0 from OLS estimation of (12. Assume α0 = 0. All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. They are skewed to the left. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. but diﬀerent critical values are required. however. and a diﬀerent table should be consulted. This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . The ADF test has a diﬀerent distribution when the time trend has been included. the ADF test rejects H0 in favor of H1 when ADF < c. the test procedure is the same.g. This is called a “super-consistent” rate of convergence. and may be used for testing the hypothesis H0 . and have negative means.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. We have described the test for the setting of with an intercept. In this context. But the theorem does not require an assumption of homoskedasticity. Stock Prices). Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error. This is not really a correct conclusion. Thus the Dickey-Fuller test is robust to heteroskedasticity. GDP. conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal.

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

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

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

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

When β is unknown. it may be believed that β is known a priori. If the series Yt is not cointegrated.8. In some cases. If Y = (log(Consumption) log(Income))0 . then Yt is I(0). If Yt is cointegrated with a single cointegrating vector (r = 1). 149 . if Yt is a pair of interest rates. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Thus Yt = ˆ (Y1t . then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. as ﬁrst shown by Stock (1987).13. in general. 13. from OLS of Y1t on Y2t . so the ADF critical values are not appropriate. When the data have time trends. Then under H0 zt is I(1). Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt .9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . The asymptotic distribution was worked out by Phillips and Ouliaris (1990). β = (1 − 1)0 . If r = m. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . β may not be known. For 0 < r < m. of rank r. Suppose that β is known. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . Yt is I(1) and cointegrated. a good method to estimate β. Under H0 . Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. The r vectors in β are called the cointegrating vectors.8 Cointegration The idea of cointegration is due to Granger (1981). so zt = β 0 Yt is known.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. This is not. Whether or not the time trend is included. Often. yet under H1 zt is I(0). then r = 0. In other cases. Hansen (1992). β is not consistent. such that zt = β 0 Yt is I(0). but it is useful in the construction of alternative estimators and tests. Deﬁnition 13. the asymptotic distribution of the test is aﬀected by the presence of the time trend. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. it may be necessary to include a time trend in the estimated cointegrating regression. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. m × r. The asymptotic distribution was worked out in B. Thus H0 can be tested using a univariate ADF test on zt . however. For example. and was articulated in detail by Engle and Granger (1987). then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others.

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

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

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

A generalization is the negative binomial. the consumption level (purchases) in a particular period was zero.}. i i i=1 ˆ The MLE is the value β which maximizes ln (β). . This model speciﬁes that P (Yi = k | xi ) = λi k = 0. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. . Thus the model is that there is some latent process yi with unbounded support. Tobin observed that for many households. incomes above a threshold are typically reported at the threshold. 2.1) yi = ∗ <0 . 1. 14.2 Count Data exp (−λi ) λk i . this motivates the label Poisson “regression. The functional form for λi has been picked to ensure that λi > 0. k! = exp(x0 β). σ 2 ) with the observed variable yi generated by the censoring equation (14.. or it may be a by-product of economic constraints. In surveys..14. a typical approach is to employ Poisson regression.1).3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. 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. i If Y = {0. 1.. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . The conditional density is the Poisson with parameter λi .. The censoring process may be explicit in data collection.) The observed data yi therefore come from a mixed continuous/discrete distribution. An example of a data collection censoring is top-coding of income. any known value can substitute.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). i so the model imposes the restriction that the conditional mean and variance of Yi are the same. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. This may be considered restrictive. 2. 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.

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

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

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

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

. • There are n + k regression parameters. Computationally. Observe that • This is generally consistent. ˆ ˆ OLS on (15. 158 . ⎠. OLS estimation of β proceeds by the FWL theorem. Conventional inference applies. ⎟ u = ⎝ . which is quite large as typically n is very large. so (15. as the parameter space is too large. din Observe that E (eit | xit . i yit = x0 β + d0 u + eit . un ui = d0 u. with di as a regressor along with xi . let dij = and ⎧ ⎨ 1 ⎩ 0 ⎛ if i = j . their gender) will be collinear with di . else Then note that and an n × 1 dummy vector with a “1” in the i0 th place. Let ⎛ ⎞ u1 ⎜ . Stacking the observations together: Y = Xβ + Du + e. you do not want to actually implement conventional OLS estimation.g.2) is a valid regression.First. • Any regressor in xit which is constant over time for all individuals (e. then by the FWL theorem. it i (15. Y ∗ = Y − D(D0 D)−1 D0 Y where X ∗ = X − D(D0 D)−1 D0 X. ⎠ .. it will be collinear with di . u). so the intercept is typically omitted from xit . di ) = 0.2) ⎞ di1 ⎜ .2) yields estimator (β. ⎟ di = ⎝ . ˆ β = ¢−1 ¡ 0 ¢ ¡ 0 X (1 − PD ) Y X (1 − PD ) X ¡ ¢−1 ¡ ∗0 ∗ ¢ = X ∗0 X ∗ X Y . so will have to be omitted. • If xit contains an intercept. .

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 . k ≥ 2. Thus values of yit−k .3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . at least if T is held ﬁnite as n → ∞. the ﬁxed eﬀects estimator is inconsistent. as yt−2 is uncorrelated with ∆eit . so the instrument list should be diﬀerent for each equation. Taking ﬁrst-diﬀerences of (15. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. there are more instruments available. Unfortunately. 15. we ﬁnd y i = x0 β + ui + ei . Hence a valid estimator of α and β is to estimate (15. This is because the sample mean of yit−1 is correlated with that of eit . Alternatively. But if there are valid instruments. we use lags of the dependent variable. 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. This is conveniently organized by the GMM principle. the dependent variable and regressors in deviationit from-mean form. A simple application of GMM yields the parameter estimates and standard errors. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ .4) will be inconsistent. e So OLS on (15. 159 (15.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). are valid instruments. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . the predicted value from these regressions is the individual speciﬁc mean y i . and the residual is the demean value ∗ yit = yit − yi . A more sophisticated GMM estimator recognizes that for time-periods later in the sample. it it which is free of the individual-eﬀect ui . it (15.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. but loses a time-series observation).4) . Typically. two periods back. if eit is iid.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. it However.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . then IV or GMM can be used to estimate the equation. i ∗ yit = x∗0 β + e∗ .

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

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

ˆ the greater the bias. nh (x)2 dx is called the roughness of K. The bias results from this smoothing. The sharper the derivative. 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). so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. This integral (typically) is not analytically solvable.16. so is estimating a smoothed version of f (x). 162 . Intuitively. using ﬁrst-order Taylor approximations and the fact that n−1 is of smaller order than (nh)−1 V ar (x) = = ' = ' = where R(K) = R∞ −∞ K 1 V ar (Kh (Xi − x)) n 1 1 EKh (Xi − x)2 − (EKh (Xi − x))2 n n ¶ Z ∞ µ z−x 2 1 1 K f (z)dz − f (x)2 2 nh −∞ h n Z ∞ 1 K (u)2 f (x + hu) du nh −∞ Z f (x) ∞ K (u)2 du nh −∞ f (x) R(K) . the estimator f (x) smooths data local to Xi = x. Since it is an average of iid random variables. ˆ We now examine the variance of f (x). and is larger the greater the curvature in f (x). which is valid as h → 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 . Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . The 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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. q Proof of Theorem A. C −1 AC −10 ) = N (0.2. tr has distribution 177 .11).8. 1) and Q ∼ χ2 be independent.11) 2 with r = 1. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.1.8. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.13) is the MGF of the density (A. 1). From (A. Set r Z . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .8. which we showed in (A. which can be found by applying change-of-variables to the gamma function. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. (A. Proof of Theorem A. The MGF for the density (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. For Z ∼ N(0. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.12) E exp (tQ) = 0 Γ (A.3 Let Z ∼ N (0. Using the simple law of iterated expectations.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . Iq ).8. Thus the density of Z 2 is (A.13). we see that the MGF of Z 2 is (1 − 2t)−1/2 .3. C −1 CC 0 C −10 ) = N (0.Theorem A.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).

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

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

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

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

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

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

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

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

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