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

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Contents

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

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

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

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

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

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

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ii

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . 10. . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . .2 GMM Estimator . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Lag Operator . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10.6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . 10. . . . . . 11. . 12. . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . .13 One-Sided Tests . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . . . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . 9. . . . . . . . . Bootstrap Methods for Regression Models Exercises . . 11. . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . 12. . iii . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . .1 Overidentiﬁed Linear Model . 11. . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . 9. . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . .11 8. . 11.8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . . . . . . .2 Reduced Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . .1 Instrumental Variables .10 8. . . . . . . . . . . . 12. . . . . . . . . 12. . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . .4 Estimation . . . . . . .6 Over-Identiﬁcation Test . . . . . . .5 GMM: The General Case . . . . . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . .12 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . 12. . . . . . . 9. . . . . .7 Identiﬁcation Failure . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

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

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

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

Additionally. ⎠ . then its determinant is det A = a11 a22 − a12 a21 ... There are k! such permutations. we deduce that Λ2 = Λ and λ2 = λi for i = 1. tr(A) = rank(A).. . 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 . There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1... we can deﬁne the determinant as follows.By the uniqueness of the characteristic roots.. k)). k) . k. xk ) : Rk → R. .... For a general k × k matrix A = [aij ] . .7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . Let π = (j1 .. If A is 2 × 2.4) H0 M =H 0 0 with H 0 H = In . and let επ = +1 if this count is even and επ = −1 if the count is odd. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.... 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. .8 Determinant The determinant is deﬁned for square matrices.. .. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.. jk ) denote a permutation of (1. . 2.. .. i Hence they must equal either 0 or 1.

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

1) xi = ⎜ . In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. which is a common feature of wage distributions.1. and that for women is $20. or the covariates. ⎟ . These are asymmetric (skewed) densities. Figure 3. We call yi the dependent variable. holding the other variables constant. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. See Chapter 16. xi ) where yi is a scalar (real-valued) and xi is a vector. In the example presented in Figure 3. it is useful to have numerical measures of the diﬀerence. In this context we partition the observations into the pair (yi . the mean is not necessarily a good summary of the central tendency.1.2) m(x) = E (yi | xi = x) = −∞ In general. You can see that the right tail of then density is much thicker than the left tail.1 by the arrows drawn to the x-axis. These are conditional density functions — the density of hourly wages conditional on race. the mean wage for men is $27. These are indicated in Figure 3. we can focus on f (y | x) . The data are from the 2004 Current Population Survey 1 11 . An important summary measure is the conditional mean Z ∞ yf (y | x) dy. m(x) can take any form. the conditional density of yi given xi . The two density curves show the eﬀect of gender on the distribution of wages.22. and exists so long as E |yi | < ∞. We call xi alternatively the regressor. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. When a distribution is skewed. ⎠ ⎝ . Take a closer look at the density functions displayed in Figure 3. While it is easy to observe that the two densities are unequal. the conditioning variable. education and experience.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. To illustrate.73. (3. gender. xki 3. . This is used when the goal is to quantify the impact of one set of variables on another variable.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression.1 displays the density1 of hourly wages for men and women.

3 displays a scatter plot2 of log wages against education levels. the solid line displays the conditional expectation of log wages varying with education. 2 (3. Figure 3. and a Ph.30.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. which implies a 30% average wage diﬀerence for this population.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3.36. To illustrate. The diﬀerence in the log mean wage between men and women is 0. implying an average 36% diﬀerence in wage levels. For this reason.3 is how the conditional expectation describes an important feature of the conditional distribution.5. Of particular interest to graduate students may be the observation that diﬀerence between a B.A. When the distribution of the control variable is continuous. 3. Assuming for simplicity that this is the true joint distribution. The conditional expectation function is close to linear. this yields the formula yi = m(xi ) + ei . wage regressions typically use log wages as a dependent variable rather than the level of wages. Figure 3.D. the dashed line is a linear projection approximation which will be discussed in the Section 3.Figure 3. 12 .2 shows the density of log hourly wages for the same population.2) evaluated at the observed value of xi : ei = yi − m(xi ). then comparisons become more complicated. By construction. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. degree in mean log hourly wages is 0. The comparison in Figure 3.1 is facilitated by the fact that the control variable (gender) is discrete.3) White non-military male wage earners with 10-15 years of potential work experience. with mean log hourly wages drawn in with the arrows. The main point to be learned from Figure 3.

E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. 4.2: Log Wage Densities Theorem 3. These equations hold true by deﬁnition. The equations yi = m(xi ) + ei E (ei | xi ) = 0. E (h(xi )ei ) = 0 for any function h (·) . restrictions on the permissible class of regression functions m(x).1 Properties of the regression error ei 1. most typically. It is important to understand that this is a framework. by the deﬁnition of ei and the linearity of conditional expectations. E (ei | xi ) = 0. because no restrictions have been placed on the joint distribution of the data. E(xi ei ) = 0. are often stated jointly as the regression framework. To show the ﬁrst statement. 2. not a model. 3.2. A regression model imposes further restrictions on the joint distribution. The remaining parts of the Theorem are left as an exercise. E(ei ) = 0.Figure 3. 13 .

In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. and can take any form. In contrast. in the sense of achieving the lowest mean squared error. Given the random variable xi . The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. To see this.3 Conditional Variance Generally. Thus the mean squared error is minimized by the conditional mean. it does not provide information about the spread of the distribution. i . The right-hand-side is minimized by setting g(x) = m(x). A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x .3.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . the conditional variance of yi is σ 2 = σ 2 (xi ). let g(x) be an arbitrary predictor of yi given xi = x.1. subject to the restriction p that it is non-negative. σ 2 (x) is a non-trivial function of x. The conditional standard deviation is its square root σ(x) = σ 2 (x).2. 3. when σ 2 (x) is a constant so that ¢ ¡ (3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.Figure 3.

it is convenient to augment the regressor vector xi by listing the number “1” as an element.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). i (3. Equivalently.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. and the linear assumption of the previous section is empirically unlikely to accurate.4 Linear Regression An important special case of (3. We call this the “constant” or “intercept”. βk ⎛ (3. So while men have higher average wages. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . As an example. ⎟ β=⎝ . where x1i is the ﬁrst element of the vector xi deﬁned in (3. xki When m(x) is linear in x. we assume that x1i = 1. ⎠ .8) (3. Thus (3. ⎠ .8) is called the linear regression model. Notationally.7) is a k × 1 parameter vector. it is more realistic to view the linear speciﬁcation (3. ⎟ . 15 .1.5) xi = ⎜ .9) 3. Equation (3. they are also somewhat more dispersed.6) (3. Instead. The conditional standard deviation for men is 12.we say that the error ei is homoskedastic.1).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 . its functional form is typically unknown.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.6) as an approximation. In this case (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . take the conditional wage densities displayed in Figure 3. ⎝ .1 and that for women is 10. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. 3.5. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . which we derive in this section.

5. written E (xi x0 ) > 0. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. x0 β is the best linear predictor for yi .which is quadratic in β. Rewriting. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. The vector (3. i i (3. i (3.10). This occurs when redundant variables are included in xi . Given the deﬁnition of β in (3. Therefore. i 16 . 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 . The best linear predictor is obtained by selecting β to minimize S(β). Equivalently. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . As before. E (xi x0 ) is invertible.12) This completes the derivation of the linear projection model. 2 2.1 1. In order for β to be uniquely deﬁned. xi contains an intercept.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. i (3. Assumption 3. E (x0 xi ) < ∞. Eyi < ∞. i which requires that for all non-zero α.10) It is worth taking the time to understand the notation involved in this expression. i 4. this situation must be excluded. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. The ﬁrst-order condition for minimization (from Section 2. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .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 . It is invertible if and only if it is positive deﬁnite. 3. otherwise they are distinct. Observe i that for any non-zero α ∈ Rk . The error is i ei = yi − x0 β.5. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β.1. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. α0 E (xi x0 ) α = E (α0 xi )2 > 0. by “best” we mean the predictor function with lowest mean squared error.

it follows that linear regression is a special case of the projection model.1.1 is employed to guarantee that (3.2 and 3. (3. Assumption 3.1.14) follows from (3.3 are called regularity conditions. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.5.5.4 we know that the regression error has the property E (xi ei ) = 0.5. Since from Theorem 3.12) can be alternatively interpreted as a projection decomposition.5. E (xi ei ) = 0 and E (ei ) = 0. This means that the equation (3. Figure 3.1. 17 . However.12) and (3.5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. For example.14) holds.1.5.1. Equation (3.1.14).5. the orthogonality restriction (3.9). Furthermore. Assumption 3.10) and (3.1.1.1.4 guarantees that the solution β exits.1 Under Assumption 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. The ﬁnite variance Assumptions 3. By deﬁnition. Using the deﬁnitions (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. Since ei is mean zero by (3.1. Assumption 3.13) The two equations (3.10) are deﬁned. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .5.1 are weak.3 ensure that the moments in (3.8)-(3.13) implies that xi and ei are uncorrelated. Let’s compare it with the linear regression model (3.11) are well deﬁned.5.Theorem 3.13) summarize the linear projection model. ¥ (3. Assumption 3.2 and 3.5.4 is required to ensure that β is uniquely deﬁned. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .13) and Assumption 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.14) Proof.2.11) and (3.5.1. (3.

4 displays the relationship3 between mean log hourly wages and labor market experience.10) may not hold and the implications of Theorem 3. 18 . The solid line is the conditional mean.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.4 we display as well this quadratic projection. In this example it is a much better approximation to the conditional mean than the linear projection. These structural models require alternative estimation methods.5. it is important to not misinterpret the generality of this statement. Figure 3. No additional assumptions are required. In contrast. It over-predicts wages for young and old workers. Other than the redeﬁnition of the regressor vector. In this case the linear projection is a poor approximation to the conditional mean. In this example the linear projection is a close approximation to the conditional mean.10).12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. since the resulting function is quadratic in experience.3. We illustrate the issue in Figure 3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. In the example just presented. and under-predicts for the rest. there are no changes in our methods or analysis. in many economic models the parameter β may be deﬁned within the model. In this case (3. In other cases the two may be quite diﬀerent. the dashed line is the linear projection of log wages on eduction. Returning to the joint distribution displayed in Figure 3.1. However. This defect in linear projection can be partially corrected through a careful selection of regressors.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.12) with the properties listed in Theorem 3. and are discussed in Chapter 11. A projection of log wages on these two variables can be called a quadratic projection. for those over 53 in age). In Figure 1. Most importantly.We have shown that under mild regularity conditions. we can augment the regressor vector xi to include both experience and experience2 . for any pair (yi . The linear equation (3. Figure 3. and the straight dashed line is the linear projection.5.1 may be false. xi ) we can deﬁne a linear projection equation (3.

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

Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . 9. σ = . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . 0 ≤ y ≤ 1. Compute the conditional mean m(x) = E (yi | xi = x) . 2. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . If yi = x0 β + ei and E(ei | xi ) = 0. then E(x2 ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi . s) = 0 if and only if m = µ and s = σ 2 . 2. If yi = x0 β + ei and E(xi ei ) = 0. 1. i 10.2 Y =1 .. i 8. Let X be a random variable with µ = EX and σ 2 = V ar(X). (x − µ)2 − σ 2 Show that Eg (X. and E(xi ei ) = 0. 3.3. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. Suppose that yi is discrete-valued. If yi = xi β + ei . µ. and have the following joint probability distribution X=0 X=1 Y =0 . ¡ ¢ 4. taking values only on the non-negative integers.. True or False. x 6. µx = Exi . e−λ λj j! . True or False. If yi = xi β + ei . Are they diﬀerent? Hint: If P (Y = j) = 5. E(ei | xi ) = 0. then ei is i i independent of xi .1. Suppose that Y and X only take the values 0 and 1. Let xi and yi have the joint density f (x. yi ). Prove parts 2. i 7. j! 0 j = 0. and E(ei | xi ) = 0. . 20 . xi ∈ R. i 11.2. a constant. σ 2 = V ar(xi ). True or False. then E(ei | xi ) = 0. E(Y 2 | X = x) and V ar(Y | X = x). 3 and 4 of Theorem 3.3 Find E(Y | X = x). and E(e2 | xi ) = σ 2 . True or False.4 .6 Exercises 1. then ei is independent of xi . If yi = x0 β + ei . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. Compute E(yi | xi = x) and V ar(yi | xi = x).1 . m. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . True or False. xi ∈ R. then E(x2 ei ) = 0.

2) can be written in the parametric 0 β)) = 0.3) 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 . Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .3) In Sections 4.2) (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 (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .4) i i=1 i=1 ˆ Another way to derive β is as follows.8. i It follows that the moment estimator of β replaces the population moments in (4.7 and 4. i n i=1 n 21 . Observe that (4. but for most of the chapter we retain the broader focus on the projection model. 4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . (4.1 Estimation Equation (4.1) (4. we narrow the focus to the linear regression model.

95 xi yi = 42.4). 40 0.3.7% increase in mean wages.4).14 205. 40 2.170 37.14 205.14 14. excluding military.2 Least Squares There is another classic motivation for the estimator (4.14 14.40 µ ¶µ ¶ 34. 0. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4. i 22 . ¶ 2. These are white male wage earners from the March 2004 Current Population Survey.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.37 µ ¶ 1.117 1 14. 4.95 42. Let yi be log wages and xi be an intercept and years of education. To illustrate.30 + 0. Then µ ¶ n 1X 2. with 10-15 years of potential work experience.71 = −2.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. consider the data used to generate Figure 3. This sample has 988 observations.83 ¶−1 µ ¶ . An interpretation of the estimated equation is that each year of education is associated with an 11. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β.ˆ This is a set of k equations which are linear in β.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. 30 = .94 −2.117 Educationi .

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

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

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

Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. n X i=1 Thus the estimator (4. For example n X i=1 For many purposes.6). σ 2 ) = − 2 + ¡ ¢2 e2 = 0. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . it is matrix notation. ⎟. en ⎞ Observe that Y and e are n × 1 vectors.4). yn ⎟ ⎟ ⎟. 4. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. ⎠ . 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. Due to this equivalence. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. and X is an n × k matrix. Thus the MLE (β. including computation. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. x0 n ⎞ ⎛ e1 e2 . yn = x0 β + en .12) is a system of n equations. . 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. . n or equivalently Y = Xβ + e. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. = β+ XX 26 (4.8) . . ⎝ ⎝ . residual vector. . one for each observation. Sample sums can also be written in matrix notation. . The linear equation (3.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. .

4.5

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

. In this section we derive the small sample conditional mean and variance of the OLS estimator.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. Regress X2 on X1 . obtain residuals X2 . is the demeaning formula for regression. Regress Y on X1 . . ⎠ ⎝ ⎠ ⎝ . ˆ ˜ ˜ ˆ 3. By the independence of the observations and (3. . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. Rather.8)(3. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. In this case. A common application of the FWL theorem. the FWL theorem can be used to speed computation. 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. . In some contexts. In the model (4. which you may have seen in an introductory econometrics course. ⎟ ⎜ ⎟ ⎜ (4.14) or via the ˆ following algorithm: ˜ 1. . . obtain OLS estimates β 2 and residuals e. . .6. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . Regress Y on X2 . observe that ⎞ ⎛ ⎞ ⎛ .Theorem 4. ˆ which are “demeaned”.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. obtain residuals Y . but in most cases there is little computational advantage to using the two-step algorithm. ¡ ¢−1 0 ι.9). ˜ 2. 30 . 4. and X2 is the vector of observed regressors.9).13). . .1 (Frisch-Waugh-Lovell). the primary use is theoretical. 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.

we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0. . σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model. V ar β | X = X 0 X ⎟ ⎟ ⎟. the properties of conditional expectations. under the of ˆ ¢ 2 | x = σ 2 . ..12).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 . and ³ ´ ¡ ¢−1 2 ˆ σ .18). . ⎝ . Next.. 1 n . . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . .. Then given (4. and (4. . X 0 DX = X 0 Xσ 2 .8).. 0 0 ··· 0 0 . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.19) ˆ and thus the OLS estimator β is unbiased for β. . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . . σ 2 } = ⎜ .Using (4. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. ⎠ (4. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. and the trace operator observe that. From (4.20) .

or in the projection model.1 Gauss-Markov. however. the best (minimumvariance) unbiased linear estimator is OLS.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. ˜ so β is unbiased if (and only if) A0 X = Ik . Thus σ 2 is biased towards zero. which is (3. Theorem 4.10). as it yields the smallest variance among all unbiased linear estimators. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . known as the Gauss-Markov theorem. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. 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. In the homoskedastic linear regression model. By a calculation similar to those of the previous section. is a famous statement of the solution.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. It is important to remember. It is not unbiased in the absence of homoskedasticity. 4. says that the least-squares estimator is the best choice. which we now present.9) plus E e2 | xi = σ 2 . Thus since V ar (e | X) = In σ 2 under homoskedasticity. Now consider the class of estimators of β which are linear functions of i the vector Y. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. ³ ´ ˜ E β | X = A0 Xβ. What is the best choice of A? The Gauss-Markov theorem.8)¢ ¡ (3.7) is unbiased for σ 2 by this calculation. 32 . = σ2 n the ﬁnal equality by (4. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . the estimator ˆ 2 deﬁned (4. In this case.8. The following result. ˜ β L = A0 Y = A (Xβ + e) = β + Ae.

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

He observes that the above argument holds for all multinomial distributions.9).10 Omitted Variables xi = µ x1i x2i ¶ .5. (4. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .1.Substituting in the expressions for π j . 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 . Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. if the data have a discrete distribution. He proves that generically the OLS estimator (4. and thus so is the OLS estimator.10) for the class of models satisfying Assumption 3. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words.22) 34 .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. the maximum likelihood estimator is identical to the OLS estimator. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. Chamberlain (1987) extends this argument to the case of continuously-distributed data.

the coeﬃcient on x2i in (4. which is often called “multicollinearity” for brevity. In general. First.. The more relevant issue is near multicollinearity. This deﬁnition is not precise. The diﬀerence Γβ 2 is known as omitted variable bias. if X includes both the logs of two prices and the log of the relative prices. this is rarely a problem for applied econometric practice. least-squares estimation of (4.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. Typically there are limits.22) is zero. Typically. because we have not said what it means for a matrix to be “near singular”. except in special cases. This happens when the columns of X are linearly dependent. this arises when sets of regressors are included which are identically related. Since the error is discovered quickly.22) the long regression and (4. β 1 6= γ 1 . When this happens. For example. 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. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. It is the consequence of omission of a relevant correlated variable. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. By construction. 4. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . log(p1 ). log(p2 ) and log(p1 /p2 ).22). the general model will be free of the omitted variables problem. This is because the model being estimated is diﬀerent than (4. This is the situation when the X 0 X matrix is near singular. To see this.23) the short regression to emphasize the distinction.22) by least-squares. or second. we regress yi on x1i only. and the error as ui rather than ei .23) where is the coeﬃcient from a regression of x2i on x1i .23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . as many desired variables are not available in a given dataset. 35 . when the columns of X are close to linearly dependent. 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 . In this case. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. Most commonly. there is some α such that Xα = 0. This is called strict multicollinearity.e. then β is not deﬁned. i. Goldberger (1991) calls (4.Now suppose that instead of estimating equation (4. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions.

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

then this observation is a leverage point and has the potential to be an inﬂuential observation. Investigations into the presence of inﬂuential observations can plot the values of (4.27). The key is equation (2.This implies has a large value of hi .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .25).1) in Section 2. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . which is considerably more informative than plots of the uncorrected residuals ei . ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei . ˆ We now derive equation (4.

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

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

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

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

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

and g(θ) : Rm → Rk . gθ Σgθ .4. Proof : By a vector Taylor series expansion. Σ) . then g(Zn ) →d g(Z) as n → ∞. Σ) = N 0. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. If Zn →d Z as n → ∞ and g (·) is continuous.√ where λn → 0 lies on the line segment joining 0 and λ/ n.4. Ik ) distribution. 45 . Since cλλ (λn ) → cλλ (0) = −Ik . for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. for each element of g. then g(Zn ) →p g(c) as n → ∞. Stacking across elements of g. Hence g(Zn ) →p g(c) as n → ∞. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Proof: Since g is continuous at c.4 Asymptotic Transformations Theorem 5. This is suﬃcient to establish the theorem.1 Continuous Mapping Theorem 1 (CMT). If Zn →p c as n → ∞ and g (·) is continuous at c. where θ is m × 1 and Σ is m × m. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. √ Theorem 5. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). 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 .2 Continuous Mapping Theorem 2. Recall that A ⊂ B implies P (A) ≤ P (B). we see that as n → ∞.4.3 Delta Method: If n (θn − θ0 ) →d N (0. Theorem 5. k ≤ m. ¥ 5.

Using ˆ simulation methods. 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. xi ) and the sample size n. ˆ Figure 6.Chapter 6 Inference 6. The verticle line marks the true value of the projection coeﬃcient. the density function of β 2 was computed and plotted in Figure 6.1 for sample sizes of n = 25. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density. its distribution is a complicated function of the joint distribution of (yi . n = 100 and n = 800.1: Sampling Density of β 2 To illustrate the possibilities in one example. and therefore has a sampling distribution. In general. since it is a function of the random data. 46 .1 Sampling Distribution The least-squares estimator is a random vector.

using (6. and the continuous mapping theorem (Theorem 5. n i=1 (6.1). β →p β as n → ∞. To characterize the sampling distribution more fully. the OLS estimator β is has a statistical distribution which is unknown. ˆ 47 .2.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .2 Consistency ˆ As discussed in Section 6.4.1. (6.5.2). (6. Hence by the continuous mapping theorem (Theorem 5. (6.1 by the fact that the sampling densities become more concentrated as n gets larger.5.4. Proof. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.1). b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.1) and ˆ We now deduce the consistency of β. ·) is continuous at (Q.1).4 implies that Q−1 exists and thus g(·. Equation (4. we will use the methods of asymptotic approximation. 0). xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. Assumption 3.3) Ã where g(A. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .5. we can conclude ˆ that β →p β. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. Ã n ! n X 1X 0 1 ˆ xi xi . 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. This is illustrated in Figure 6.2) i i n i=1 n From (6.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. For a complete argument. xi ei →p g (Q.1 Under Assumption 3. 6.3).1). we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 .1. As the sample size increases the density becomes more concentrated about the population coeﬃcient.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.2. ˆ Theorem 6.1 and the WLLN (Theorem 5. First. Assumption 3.1.

since n/(n − k) → 1 as n → ∞.3. n 1 X √ xi ei →d N (0.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. Ee4 < ∞ and E |xi |4 < ∞. To see this.2).3.1.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.3.2.4) 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. (6. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. it follows that s2 = ¥ n σ 2 →p σ 2 . (6.5. ˆ n−k 6.2 Under Assumption 3. ˆ Finally. by the Cauchy-Schwarz inequality (5. Thus σ 2 is consistent for σ 2 . E ¯ei ¯ E ¯e4 ¯ i i i i (6.1).1 In addition to Assumption 3.2). ˆ Proof.3) and Theorem (6. (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. Assumption 6. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .1). Ω) .Theorem 6.5.1.2.1 guarantees that the elements of Ω are ﬁnite. (6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .6) n i=1 48 . We need a strengthening of the moment conditions. i i Assumption 6. By the central limit theorem (Theorem 5.

Theorem 6.9) we deﬁne V 0 = Q−1 σ 2 whether (6. i i Condition (6. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. however.7) is true then V = V 0 . The approximation may be poor when n is small. Ω) ¡ ¢ = N 0. there is no simple answer to this reasonable question.7) is true or false. V ) where V = Q−1 ΩQ−1 .1.3.3. As α approaches 2. 1). V is often referred to as ˆ the asymptotic covariance matrix of β.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.Then using (6.7) Cov(xi x0 . (6.3.1 Under Assumption 6. There is a special case where Ω and V simplify. The trouble is that no matter how large is the sample size. Let yi = β 0 + β 1 xi + εi where xi is N (0. We say that ei is a Homoskedastic Projection Error when (6. after rescaling. but this is not a necessary condition. In Figure 6. otherwise V 6= V 0 . |ε| ≥ 1. 1) asymptotic distibution.1). The asymptotic distribution ´ Theorem 6. Q−1 ΩQ−1 . for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. Under (6.2).7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. We illustrate this problem using a simulation. when xi and ei are independent. for example. 1 X √ xi ei n i=1 n ! the N (0.3.7) holds. When (6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).1.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β .1 states that the sampling distribution of the least-squares estimator. and (6. xi ) which satisfy the conditions of Assumption 6. is approximately normal when the sample size n is suﬃciently large. e2 ) = 0. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.3. We call V 0 the homoskedastic covariance matrix.6).1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. ´ √ 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.9) In (6. However. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . its variance diverges q ³ ´ ˆ to inﬁnity. This holds true for all joint distibutions of (yi . The expression V = Q−1 ΩQ−1 is called a sandwich form. For α 49 . In´Figure 6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . setting n = 100 and varying the parameter α. How large should n be in order for the approximation to be useful? Unfortunately.

ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.3. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.Figure 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2 and 6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.1) it is clear that V 0 →p V 0 . Another example is shown in Figure 6. 1) density. for k = 1.10) V 0 = Q−1 s2 . the sampling distribution becomes highly skewed and non-normal.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.11) 50 . 6.3 is that the N (0. As α diminishes the density changes signiﬁcantly. As k increases. The estimator 2 2 in (6. 1). The lesson from Figures 6. We show the sampling distribution of n β 1 − β 1 setting n = 100.10) without changing this result. 6 and 8. we need an estimate of Ω = E xi x0 e2 . 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 (0.2. concentrating most of the probability mass around zero.2: Density of Normalized OLS estimator α = 3.2) and Theorem 6. 4.0 the density is very close to the N (0.

and V is an estimator of the variance of n β − β . and was still the standard choice for much empirical work done in the early 1980s. Generically. A more easily interpretable measure of spread is its square root — the standard deviation. as there may be more than one estimator of the variance of the estimator. vis. 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”. it is important to pay ˆ ˆ attention to the distinction between V 0 and V .3: Sampling distribution where ei are the OLS residuals.. ˆ ˆ When V is used rather than the traditional choice V 0 .. or that they use the “White formula”. many authors will state that their “standard errors have been corrected for heteroskedasticity”. This motivates the deﬁnition of a standard error. we focus on individual elements of β one-at-a-time. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. the “Eicker-White formula”.Figure 6. the “Huber formula”. standard errors are not unique. ˆ ˆ Deﬁnition 6.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. The estimator of V is then ˆ ˆ ˆ ˆˆ V = Q−1 ΩQ−1 This estimator was introduced to the econometrics literature by White (1980). ˆ The estimator V 0 was the dominate covariance estimator used before 1980. The methods switched during ˆ the late 1980s and early 1990s. or that they use a “heteroskedasticity-robust covariance matrix estimator”.. j = 0.. k. 1. When reading and reporting applied work. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . as it is not always clear which has been computed. we set s(β) = n−1/2 V . these all mean the same thing.4. β j . In most cases. It is therefore important to understand what formula and method is 51 . When β is a vector. .

We calculate that s2 = 0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. and then the square roots.14 14.80 2.83 ¶−1 = µ 7.20 = V 14.2/988 = .30 + 0.020) 6. n n i=1 52 . From a computational standpoint. i i i i n i=1 Second.1. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .493 0. The standard errors for β 0 are 7.6 ¶µ 1 14.199 2.480 .14 14. by Holder’s inequality (5. Using (6.83 ¶−1 µ . we return to the log wage regression of Section 4.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.480 ˆ0 = 0. p ˆ In this case the two estimates are quite similar. (6.80 40.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.20 −0. First. Ω 2.085 p ˆ and that for β 1 is .12) in turn.085) (.80 40.2.20 and µ ¶ ˆ = 0.35/988 = .14 6. To illustrate.98 −0. just as any other estimator.14 205.493 −0.199 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .035 ¶ . (.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.14 205. from which it follows that V →p V as n → ∞.83 −0. but not under another set of assumptions.14 205.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β . then take the diagonal elements.117 Educationi . (6.020.used by an author when studying their work.039 and ˆ V = µ 1 14.5) and the WLLN (Theorem 5.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.80 . It is also important to understand that a particular standard error may be relevant under one set of model assumptions.

¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. ¯ 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. 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. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . you can show that 1 Xˆ ¯ β= β (−i) . 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 (6.13) Using formula (4.25).26). They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. Andrews (1991) suggested an similar estimator based on cross-validation. ¯ ¯n ¯ n i=1 so Together. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . 6. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. From equation (3. Using this substitution. Recall from Section 4. these establish consistency. n i=1 n ˆ ˆ Theorem 6.11) with the leave-one-out estimator ei.5.−i = (1 − hi )−1 ei ˆ presented in (4.1 As n → ∞.13) of Efron (1982). i=1 Third. Ω →p Ω and V →p V. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. which.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.

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

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

if Z ∼ N (0.96 and z.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. s(ˆ θ) Under H0 . 1]. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. z. or “accepts” H0 .05 = 1. 6. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. 1). A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . 1]. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. Otherwise the test does not reject. The asymptotic p-value for the above statistic is constructed as follows. It is designed to cover θ with high probability. That is. in that the reader is allowed to pick the level of signiﬁcance α. from which it follows that pn →d U [0.025 = 1.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. To see this fact. An alternative approach. In a sense. Let zα/2 is the upper α/2 quantile of the standard normal distribution. regardless of the complication of the distribution of the original test statistic. however. Either θ ∈ Cn or θ ∈ Cn . under H0 . This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. associated with Fisher. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. pn →d U [0. The p-value is more general. is to report an asymptotic p-value. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 .645. For example. 1). and is a function of the data and hence is / random. 56 . note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). That is. Deﬁne the tail probability. tn →d N (0. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. Then the asymptotic p-value of the statistic tn is pn = p(tn ). The coverage probability is P (θ ∈ Cn ). If the p-value pn is small (close to zero) then the evidence against H0 is strong. 1].

05. In this case the t-statistic approach does not work. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. ˆ + zα/2 s(ˆ . We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. 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. 6. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. and it is desired to test the joint restrictions simultaneously.96s(ˆ ≈ ˆ ± 2s(ˆ . This corresponds to selecting the conﬁdence h i h ˆ ± 1.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ). 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). θ The interval has been constructed so that as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6.18) . θ θ) (6. or α = . Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 .17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. the most common professional choice isi95%. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.

1.15) showed that n ˆ − θ →d Z ∼ N (0. As before.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 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6.2. if rank(Hβ ) = q.1 Under H0 and Assumption 6. The null hypothesis is H0 : β 2 = 0. then Wn →d χ2 . and Theorem 6. q and pn is asymptotically U[0. h(β) = R0 β. 6. ˜˜ n ˜ e = Y − X1 β 1 .5. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. the test rejects at the α% level iﬀ pn < α. 1] under H0 . Furthermore. For example. θ = β 2 .10.When h is a linear function of β. and there are q = k2 restrictions. the upper-α quantile q 2 of the χ2 distribution. a chiq square random variable with q degrees of freedom. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .8. the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). Hβ (β) →p Hβ . Hence β β by Theorem A.84 = z. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . Also h(β) = a selector matrix. χ2 (.025 . ˆ Wn = n θ θ q θ θ Theorem 6. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. Hβ (β) is a continuous function of β. The asymptotic p-value for Wn is pn = p(Wn ). In this case. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . Vθ ).3.19) σ2 ˆ where σ2 = ˜ 1 0 e e. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.1 showed θ ˆ that V →p V.05) = 3.

since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. 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. 59 .19) is that it is directly computable from the standard output from two simple OLS regressions. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . as the sum of squared errors is a typical output from statistical packages.19). First.are from OLS of Y on X1 . ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . By the FWL theorem. 2 2 2 or alternatively. note that if we regress Y on X1 alone. We now derive expression (6. Because of this connection we call (6. This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . Also.19) the F form of the Wald statistic. ˆˆ n ˆ e = Y − X β. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. still this formula often ﬁnds good use in reading applied papers.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ .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 . and σ2 = ˆ 1 0 e e. The elegant feature about (6. Now consider the residual regression of e on X2 = M1 X2 . X2 ). Thus ¡ 0 ¢−1 R = X2 M1 X2 and ³ ¡ ´−1 ³ ¢−1 ´−1 ¡ 0 ¢ ˆ = σ −2 n−1 R0 X 0 X ˆ R = σ −2 n−1 X2 M1 X2 ˆ R0 V 0 R ³ ´−1 ˆ0 ˆ ˆ Wn = nβ 2 R0 V 0 R β2 = 0 ˆ ˆ0 β 2 (X2 M1 X2 ) β 2 . 2 σ ˆ To simplify this expression further. = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. note that partitioned matrix inversion (2. the residual is ˜ ˜ e = M1 Y.

6. there is an exact distribution theory available for the normal linear regression model. these cases are atypical. 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 ) . an “F statistic” is reported. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. This was a popular statistic in the early days of econometric reporting. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . σ 2 ) can be be used to calculate a set of exact distribution results. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. Since uncorrelated normal variables are independent. equivalently the residual variance from an intercept-only model. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. The modelling assumption that the error ei is independent of xi and N (0.12 Normal Regression Model As an alternative to asymptotic distribution theory. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . when an OLS regression is reported.3. This is rarely an issue today. it follows ˆ that β is independent of any function of the OLS residuals.where In many statistical packages. While there are special cases where this F statistic is useful. including the estimated error variance 2. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . H 0 H) ∼ N (0. In particular. introduced in Section 4.4)) where H 0 H = In . In σ 2 . n−k 60 . Since linear functions of normals are also normal. Let u = σ −1 H 0 e ∼ N (0. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero.

β and t are approximately normally distributed.10) then ´ ³ ˆ • β ∼ N 0. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .3. 0. σ2 ˆ 61 . 0.12. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . In contrast. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ 2 ) = − log σ − log (2π) − .) Now let us partition β = (β 1 . β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. As inference (conﬁdence intervals) are based on the t-ratio. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. with residual variance σ .10) µ h i ¶ 2 (X 0 X)−1 N 0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 .8. β has an exact normal distribution and t has an exact t distribution. σ ˆ ˆ βj − βj βj − βj N (0. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .1 we showed that in large samples. so as a practical matter it does not matter which distribution is used. σ 2 ). 1) and tn−k distributions.1 If ei is independent of xi and distributed N(0.1 shows that under the strong assumption of ˆ normality. Theorem 6. β 2 . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. n−k • ∼ tn−k ˆ In Theorem 6.12. a good testing procedure is based on the likelihood ratio statistic. the notable distinction is between the N (0. β 2 . and standard errors are calculated using the homoskedastic formula (6. σ 2 ) − Ln (β 1 . Furthermore.a chi-square distribution with n − k degrees of freedom. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . if standard errors are calculated using the homoskedastic formula (6. We summarize these ﬁndings Theorem 6. 0. σ 2 ) discussed above. The critical values are quite close if n − k ≥ 30. (Unless the sample size is unreasonably small. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses.1 and Theorem 6. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . β 2 .

This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. This produces random draws from the sampling distribution of interest. and noting Hβ = sβ s−1 .8. Our ﬁrst-order asymptotic theory is not useful to help pick s.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . ˆ Let β and σ 2 be the sample mean and variance of yi . they can work quite poorly when the restrictions are nonlinear. In the present context of the Wald statistic.84 — the probability of a false rejection.7. 6. features of this distribution can be calculated. To demonstrate this eﬀect. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . while there are other values of s for which test test statistic is insigniﬁcant. setting n/σ 2 = 10. 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. Through repetition. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. the statistic Wn (s) varies with s. 62 . The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . 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. The increasing solid line is for the case β = 0. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Letting h(β) = β s . σ 2 ) and consider the hypothesis H0 : β = 1. we have plotted in Figure 6.4 the Wald statistic Wn (s) as a function ˆ of s. This can be seen by a simple example introduced by Lafontaine and White (1986). σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. This is an unfortunate feature of the Wald statistic. Take the model yi = β + ei ei ∼ N (0. The decreasing dashed ˆ = 1. as Wn (s) →d χ2 under H0 for 1 any s.

remember that the ideal Type I error probability is 5% (. Typically.000 random samples. 100 and 500. Test performance deteriorates as s increases. To interpret the table. so these probabilities are Type I error. the only test which meets this criterion is the conventional Wn = Wn (1) test. The value of s is varied from 1 to 10. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. These probabilities are calculated as the percentage of the 50.4. Table 4.1 we report the results of a Monte Carlo simulation where we vary these three parameters. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.05) with deviations indicating+ distortion.000 simulated Wald statistics Wn (s) which are larger than 3. When comparing statistical procedures. Any other choice of s leads to a test with unacceptable Type I error probabilities.84.1 you can also see the impact of variation in sample size. In Table 2. Type I error rates between 3% and 8% are considered reasonable. and σ 2 . Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.Figure 6. In each case. looking for tests for which rate rejection rates are close to 5%. For this particular example. and σ is varied among 1 and 3. There is. Given the simplicity of the model. no magic choice of n for which all tests perform uniformly well. and rarely fall outside of the 3%-8% range. this probability depends only on s. Rates above 20% are unexceptable. n.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . Error rates avove 10% are considered excessive. however.1 reports the simulation estimate of the Type I error probability from 50. The null hypothesis β s = 1 is true. n is varied among 20. we compare the rates row by row.4: Wald Statistic as a function of s P (Wn (s) > 3.84 | β = 1) . Table 4. the Type I error probability improves towards 5% as the sample size n increases. In Table 4.

ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .15 .15 .20 .24 .21 .13 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.35 . 64 . Other choices are arbitrary and would not be used in practice.20 . β 2 ) be the least-squares estimates of (6.06 .13 .08 .07 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.12 .05 .10 .09 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.31 .06 .05 .33 . Equivalently.08 .05 . This point can be illustrated through another example.10 .07 . deﬁne θ = β 1 /β 2 .14 .26 . While this is clear in this particular example.23 .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 .16 Rejection frequencies from 50. β 1 .05 .05 .07 .19 .15 .08 .22 .08 .11 .25 . so the hypothesis can be stated as H0 : θ = r.06 .20).06 .06 .06 .22 .07 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .25 .17 .18 .05 .10 .06 .34 .15 .30 .06 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .07 .12 .14 .08 .13 .28 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.

07 .645) P (tn < −1.645) greatly exceed 5%.06 .06 . this formulation should be used. 1) variables.28 .05 β2 .1.25.05 .25 . The results are presented in Table 4.06 .00 .50. The left tail probabilities P (t1n < −1.05 . In this section we describe the method in more detail.00 . .26 . .06 . In contrast.10 . the rejection rates for the t1n statistic diverge greatly from this value. then the “most linear” formulation should be selected.05 . and normalize β 0 = 0 and β 1 = 1.06 . In all cases.05 .47 .00 The one-sided Type I error probabilities P (tn < −1. Ideally. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.645) are close to zero in most cases.05 . This leaves β 2 as a free parameter.06 . If no linear formulation is feasible.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . if the hypothesis can be expressed as a linear restriction on the model parameters.10 .12 .2.000 simulated samples.05.645) are calculated from 50.2 is that the two t-ratios have dramatically diﬀerent sampling behavior. ei be an independent N (0. .645) and P (tn > 1.14 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.50 .7.06 .06 . 6. σ 2 ) draw with σ = 3. while the right tail probabilities P (t1n > 1. and alternatives to asymptotic critical values should be considered.00 . Table 4. and 1.00 .75 1. and are close to the ideal 5% rate for both sample sizes. We vary β 2 among .05 .05 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.00 .09 . It is also prudent to consider alternative tests to the Wald statistic.06 .15 .00 .00 . The implication of Table 4. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . the entries in the table should be 0.645) P (tn > 1.06 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.05 . However.00 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .00 .0 and n among 100 and 500. especially for small values of β 2 . 65 .10 .15 . along with sample size n.02 .75.05 . such as the GMM distance statistic which will be presented in Section 9. We let x1i and x2i be mutually independent N (0.645) P (tn > 1.645) t1n t2n t1n t2n t1n t2n t1n t2n .

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

In particular. immigrant. Furthermore. Hence the ³ ´ ˆ standard errors for B = 100. For the dependent variable we use the natural log of wages.22/ B. For regressors we include years of education. It is therefore convenient to pick B so that N is an integer. We now expand the sample all non-military wage earners.96) . and 5000. B b=1 (6. We separately estimate equations for white and non-whites. union member. female. female. In practice.96) is iid Bernoulli. Quite simply. and estimate a multivariate regression. and . excluding military. It is therefore useful to conduct a variety of experiments. The average (6. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. are. where N = (B +1)α. hispanic. it is simple to make inferences about rejection probabilities from statistical tests. an estimator or test may perform wonderfully for some values. Generally. this may ˆ be approximated by replacing P with P or with an hypothesized value. the researcher must select the number of experiments. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. and therefore it is straightforward to calculate standard errors for any quantity of interest. If the standard error is too large to make a reliable inference.003.05) (. 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. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. equalling 1 with probability P = E1 (Tnb ≥ 1. B. immigrant. . but requires more computational time. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. respectively. the choice of B is often guided by the computational demands of the statistical procedure. and dummy variable indicators for the following: married. We us the sample of wage earners from the March 2004 Current Population Survey. so that coeﬃcients may be interpreted as semi-elasticities. For example. and non-white. 1000. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. In many cases. Again our dependent variable is the natural log of wages. 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. As P is unknown. potential work experience. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. a larger B results in more precise estimates of the features of interest of Gn .007. and 90% sample quantiles of the sample {Tnb }. and hispanic. The random variable 1 (Tnb ≥ 1. and our regressors include years of education. 6. and poorly for others. then B will have to be increased. For example. As discussed above. and dummy variable indicators for the following: married.022. The α% sample quantile is a number qα such that α% of the sample are less than qα . if we set B = 999. therefore.95) /B ' . the performance will depend on n and F. experience squared.15 Estimating a Wage Equation We again return to our wage equation. then we can set s P = (. experience squared.21).96) . Often this is called the number of replications. we included a dummy 67 .21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. s P = . such as the percentage estimate reported in (6. union member.

010 .variable for state of residence (including the District of Columbia. Table 4. the restricted standard deviation estimate is σ = . Wn = n 1 − 2 = 18.032 .34 ˆ s(β) .18) that the state coeﬃcients are jointly zero.48772 = 515.101 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.19) is ˜ µ ¶ µ ¶ σ2 ˆ .007 .102 −. The available sample is 18. excluding the coeﬃcients on the state dummy variables.010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant.014 . Computing the Wald statistic (6.002 .102 −.121 −.097 −.013 . Ignoring the other coeﬃcients. The F form of the Wald statistic (6. Alternatively. θ ˆ 2β 3 β2 .808 so the parameter estimates are quite precise and reported in Table 4.69.001 .808 . we ﬁnd Wn = 550.033 −. reestimating the model with the 50 state dummies excluded.027 .00057 . but not equal.1.4945.070 .232 .008 . 808 1 − . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.4877 18. 2β 3 68 .49452 σ ˜ Notice that the two statistics are close. as the 1% critical value for the χ2 distribution is 76.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. 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. this adds 50 regressors). Using either statistic the hypothesis is easily rejected.00002 .

69 .5]. we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further. there is not a simple expression for this set. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. This set is [27. 29. This is the set of θ such that |tn (θ)| ≤ 1. In the previous section we discovered that such t-tests had very poor Type I error rates. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. Since tn (θ) is a non-linear function of θ. 29.5]. we can calculate a standard error of s(ˆ = .96.0. not testing a hypothesis. Instead.Using the Delta Method.9. this is a poor choice. In the present context we are interested in forming a conﬁdence interval. but it can be found numerically quite easily. implying a 95% conﬁdence θ) interval of [27. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ).40. However. but the lower end is substantially lower.

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

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

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

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

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

This introduces an element of arbitrariness which is unsettling to empirical researchers. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. q Most tests for heteroskedasticity take this basic form. Second. We may therefore test this hypothesis by the estimation (7. or equivalently that i H0 : α1 = 0 in the regression (7. Vα = E zi zi (7.4) and constructing a Wald statistic.error. but also under the assumptions of linear projection. its squares. The main diﬀerences between popular “tests” is which transformations of xi enter zi . in which case ξ i is ˜ independent of xi and the asymptotic variance (7. In this case.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . Third. and all cross-products. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. If the equation of interest is a linear projection. the two tests coincide. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. If i this simpliﬁcation is replaced by the standard formula (under independence of the error).7) under independence show that this test has an asymptotic chi-square distribution. and this requires trimming to solve. as they will be estimating two diﬀerent projections. the estimated conditional variances may contain more noise than information about the true conditional variances. The GLS and FGLS estimators.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . FGLS will do worse than OLS in practice. on the other hand. OLS is a more robust estimator of the parameter vector. Typically.2). 7. require the assumption of a correct conditional mean.5) and the asymptotic variance (7. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . the Wald test of H0 is asymptotically χ2 . and not a conditional mean. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . individual estimated conditional variances may be negative. and the cost is a reduction of robustness to misspeciﬁcatio 7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β.4). In the linear regression model the conditional mean of yi given xi = x is 77 . It is consistent not only in the regression model. This hypothesis does not imply that ξ i is independent of xi . Theorem 7.2.1 Under H0 and ei independent of xi . but the only diﬀerence is that they a ¢ allowed for general choice of zi . And the FGLS probability limit will depend on the particular function selected for the skedastic regression. however. The asymptotic distribution (7. σ 2 ). BreuschPagan (1979) proposed what might appear to be ¡ distinct test.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7.

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

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

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

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

See Chapter 16. First. When f (0 | x) is large. and this improves estimation of the 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.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. then there are many innovations near to the median.3. the conditional density of the error at its median. Let g(β) = Eg (β).11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . While a complete proof of 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 ) . ˆ Proof of Theorem 7. The main diﬃculty is the estimation of f (0). then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. by the central limit theorem (Theorm 5. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .1 ´ √ ³ˆ n β − β 0 →d N (0. ¢¢−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) . we provide a sketch here for completeness.Theorem 7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . Pn −1 0 β)) . ∂β 0 so Third. This can be done with kernel estimation techniques.11).5. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.5.1 is advanced. the height of the error density at its median.10) is equivalent to g n (β) = 0. Computation of standard error for LAD estimates typically is based on equation (7. V ). (7. In the special case where the error is independent of xi . where V = and f (e | x) is the conditional density of ei given xi = x. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .5.

The median is the special case τ = . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . If the random variable U has τ ’th quantile Qτ . (7. Again. so you can think of the quantile as the inverse of the distribution function. then F (Qτ (x) | x) = τ . then (7. For the random variables (yi . We then have the linear quantile regression model yi = x0 β τ + ei i 83 . Exi x0 ) →d i 2 = N (0.12) Qτ = argmin Eρτ (U − θ) .13) This generalizes representation (7. the quantile regression functions can take any shape.5.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. V ). the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. then F (Qτ ) = τ . This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ .Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. ¥ 7.9) for the median to all quantiles. when F (y | x) is continuous and strictly monotonic in y. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) . For τ ∈ [0. For ﬁxed τ . The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . The third line follows from an asymptotic empirical process argument. The following alternative representation is useful. 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.

Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. if the model yi = x0 β + ei has i been ﬁt by OLS.13).6.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . 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. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). and test their signiﬁcance using a Wald test. Thus. where and f (e | x) is the conditional density of ei given xi = x. since it has discontinuous derivatives. and are widely available. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression.1 n β τ − β τ →d N (0. and form a Wald statistic i for γ = 0. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. ¡ ¡ ¢¢−1 ¡ ¢¢−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 unconditional density of ei at 0. ˆ Given the representation (7. n numerical methods are necessary for its minimization. Furthermore. fast linear programming methods have been developed for this problem. Vτ ). then f (0 | xi ) = f (0) . it is useful to have a general test of the adequacy of the speciﬁcation.12). ´ √ ³ˆ Theorem 7.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . When the error ei is independent of xi . 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. the asymptotic variance depends on the conditional density of the quantile regression error. 7.5. Fortunately. The null model is yi = x0 β + εi i 84 . i By construction. Another popular approach is the RESET test proposed by Ramsey (1969). otherwise its properties are unspeciﬁed without further restrictions. conventional Newton-type optimization methods are inappropriate.1. the τ ’th conditional quantile of ei is zero.

⎠ . Wn →d χ2 . then 22 Q11 > Q11 − Q12 Q−1 Q21 . 3. It is easy (although somewhat tedious) to show that under the null hypothesis. It is particularly powerful at detecting single-index models of the form yi = G(x0 β) + εi i where G(·) is a smooth “link” function. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . yielding ˆ ˜ ˆ ˆ (β 1 . Q−1 σ 2 < Q11 − Q12 Q−1 Q21 11 22 85 ¡ ¡ ¢ ¢−1 2 ¡ ¢−1 2 ˆ lim nV ar(β 1 ) = Ex1i x0 − Ex1i x0 Ex2i x0 Ex2i x0 σ = Q11 − Q12 Q−1 Q21 σ . and the two estimators have equal asymptotic eﬃciency. or 4 seem to work best. Another is to regress yi on x1i and x2i jointly.14) by OLS. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. and form the Wald statistic Wn for γ = 0.14) may be written as ³ ´3 ³ ´m ³ ´2 ˜ ˆ ˜ ˆ ˜ ˆ yi = x0 β + x0 β γ 1 + x0 β γ 2 + · · · x0 β γ m−1 + ei ˜ ˜ i i i i which has essentially approximated G(·) by a m’th order polynomial. ⎟ zi = ⎝ . To implement the test. However. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. note that (7. m must be selected in advance. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . β 2 ). To see why this is the case. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. and consequently 22 ¡ ¢−1 2 σ . yi ˆm (7. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . β 1 = (X1 X1 )−1 (X1 Y ) . lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. yielding predicted values yi = x0 β. Otherwise. 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. small values such as m = 2. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . 7. since Q12 Q−1 Q21 > 0. and n→∞ say.be an (m − 1)-vector of powers of yi .8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. Typically. they will (typically) have diﬀerence asymptotic variances. 1i 2i 2i 1i 22 .

9 Model Selection In earlier sections we discussed the costs and beneﬁts of inclusion/exclusion of variables. X2 ) = 0. the question: “What is the right model for y?” is not well posed. x2i = σ 2 . xKi = xK )?” is well posed. and β 1 0 (The least-squares estimate with the intercept omitted.. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 . the question. E (ε | X1 . We c can write this as M. Let Exi = µ. 7. In the absence of the homoskedasticity assumption. models 1 and 2 are estimated by OLS. For example. when economic theory does not provide complete guidance? This is the question of model selection. i A model selection procedure is a data-dependent rule which selects one of the two models. we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . where X1 is n × k1 and X2 is n × k2 .). we say that M2 is true if β 2 6= 0.7). this result can be reversed when the error is conditionally heteroskedastic. because it does not make clear the conditioning set.. x Then under (6. E (ε | X1 . To simplify some of ¢ statistical discussion. . respectively. One useful property is consistency. We conclude that the inclusion of irrelevant variable reduces estimation eﬃciency if these variables are correlated with the relevant variables. take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0. How does a researcher go about selecting an econometric speciﬁcation. . Let β 1 be the ˜ be the estimate under the constraint β = 0.. estimate of β 1 from the unconstrained model.. estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 . σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 . we see that β 1 has a lower asymptotic variance. with residual vectors e1 and e2 .. To ﬁx notation. In contrast. Y = X1 β 1 + X2 β 2 + ε. There are many possible desirable properties for a model selection procedure. xK ) enters the regression function E(yi | x1i = x1 . ˆ For example. It is important that the model selection question be well-posed. X2 ) = 0 Note that M1 ⊂ M2 . This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε.. n→∞ σx ˜ When µ 6= 0. that it selects the true model with probability one if the sample is suﬃciently large. there is no clear ranking of the eﬃciency of the ˜ restricted estimator β 1 versus the unrestricted estimator.˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . etc. In many cases the problem of model selection can be reduced to the comparison of two nested models. and E (xi − µ)2 = σ 2 . We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε.. “Which subset of (x1 . To be concrete. However. as the larger problem can be written as a sequence of such comparisons.

and km is the number of coeﬃcients in the model. The rule is to select M1 if AIC1 < AIC2 . n (7. then this model selection procedure is inconsistent. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . Another common approach to model selection is to to a selection criterion. 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. since under M1 . since (7. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . BIC model selection is consistent. If the truth is inﬁnite dimensional. In contrast to the AIC. M)) between the true density and the model density. else select M2 . as the rule tends to overﬁt. if α is set to be a small number. let cα satisfy ¢ ¡ P χ22 > cα . depending on the sample size. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. as ³ ´ c P M = M1 | M1 → 1 − α < 1. Then select M1 if Wn ≤ cα . 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. LRn →p 0.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . One popular choice is the Akaike Information Criterion (AIC).16) holds under M1 . it is more appropriate to view model selection as determining the best ﬁnite sample approximation. n (7. For some critical level α. AIC selection is inconsistent. Indeed. based on Bayesian arguments. ¢ ¡ ˆ1 ˆ2 (7. k A major problem with this approach is that the critical level α is indeterminate. His criterion. known as the BIC. Another problem is that if α is held ﬁxed. k = While many modiﬁcations of the AIC have been proposed. That is. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. etc. else select M2 . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . Indeed. the most popular to be one proposed by Schwarz.17) Since log(n) > 2 (if n > 8). this rule only makes sense when the true model is ﬁnite dimensional. 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. The model selection rule is as follows.15) then where σ 2 is the variance estimate for model m.However. log(n) 87 .

.. β 2 6= 0. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. . . there are 2K such models. . MK : β 1 6= 0. β K 6= 0.. However. β 2 6= 0. a model consists of any possible subset of the regressors {x1i . stores the residual variance σ 2 for each model. one can show that thus LRn →p ∞. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . Similarly for ˆ the BIC. 210 = 1024. which regressors enter the regression). There are two leading cases: ordered regressors and unordered. In the latter case. β 3 = · · · = β K = 0 . log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. In the unordered case.. and 220 = 1. which are nested. The methods extend readily to the issue of selection among multiple regressors. . 048. We have discussed model selection between two models. . the models are M1 : β 1 6= 0. Also under M2 . The AIC selection criteria estimates the K models by OLS. . For example. selecting based on (7. xKi }. which can be a very large number. 576.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 ) = 1.17).15). and the AIC or BIC in principle can be implemented by estimating all possible subset models. In the ordered case. 88 . and then selects the model with the lowest AIC (7. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive.

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

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

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

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

To see this. This is a population moment. I have plotted the EDF and true CDF for three random samples of size n = 25. That is. Thus by the WLLN (Theorem 5. x) = P (yi ≤ y. Fn (y. Fn is by construction a step function. x) . note that for any (y. The random draws are from the N (0. x) = n i=1 Figure 8.. x). √ n (Fn (y. i = 1. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. In general. 1) distribution. i 93 . it is helpful to think of a random pair (yi . Fn is a nonparametric estimate of F. Notationally.2.. F (y.1). as the sample size gets larger. x) →p F (y. where 1(·) is the indicator function. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) .2 The Empirical Distribution Function Fn (y. Recall that F (y. To see the eﬀect of sample size on the EDF. Furthermore. and 100.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . the EDF step function gets uniformly close to the true CDF. the EDF is only a crude approximation to the CDF. n. x) (1 − F (y. x). The EDF is a consistent estimator of the CDF. x))) .3. ∗ P (yi ≤ y. x) is called the empirical distribution function (EDF). . x∗ ≤ x) = Fn (y.1).8. x) − F (y. by the CLT (Theorem 5. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . 50. x)) →d N (0.2) Fn (y. but the approximation appears to improve for the large n. Note that while F may be either discrete or continuous. For n = 25.. in the Figure below. (8. x). xi ). x∗ ) with the i distribution Fn .

. (When in doubt use θ. xi ) P (yi = yi . (yn .. the parameter ˆ estimate.. the t-ratio ˆ − θ /s(ˆ depends on θ. with the following points of clariﬁcation: • The sample size n used for the simulation is the same as the sample size. xi ) from the observed data with replacement. It is desireable for B to be large. so long as the computational costs are reasonable. B = 1000 typically suﬃces. As the bootstrap statistic replaces F with θ θ) ˆ Fn . the value of θ implied by Fn . x∗ = xi ) i n 1X h (yi . In consequence. Since Fn is a discrete probability distribution putting probability mass 1/n at each sample point. Fn ) is calculated for each bootstrap sample. . When the statistic Tn³is a function of F. x∗ . xi ) . x) i = = the empirical sample average. Typically θn = θ. in principle the distribution G∗ n ∗ ∗ could be calculated by direct methods. sampling from the EDF is equivalent to random sampling a pair (yi . Since the EDF Fn is a multinomial (with n support points)..) at the sample estimate ˆ θ.. yn . x∗ ) . Sampling from the EDF is particularly easy. n 1 such a calculation is computationally infeasible. as there are 2n possible samples {(y1 . a bootstrap ∗ ∗ sample {y1 . which is generally n 1 not a problem.. it similarly replaces θ with θn . The algorithm is identical to our discussion of Monte Carlo simulation. A theory for the determination of the number of bootstrap replications B has been developed by Andrews and Buchinsky (2000). x∗ )) = h(y. x∗ ) : i Z ∗ Eh (yi . x∗ } will necessarily have some ties and multiple values.∗ We can easily calculate the moments of functions of (yi . x)dFn (y. 94 The bias of ˆ is θ . x∗ .4 Bootstrap Estimation of Bias and Variance θ τ n = E(ˆ − θ0 ). . n i This is repeated B times. 8. n X i=1 ∗ h (yi . The popular alternative is to use simulation to approximate the distribution... B is known as the number of bootstrap replications. ∗ • The random vectors (yi . x∗ ) are drawn randomly from the empirical distribution.1) is deﬁned using the EDF (8. x∗ . n i=1 8.2) as the estimate Fn of F.. ´ For example. x∗ )}. yn . . However. it is typically through dependence on a parameter. This is i equivalent to sampling a pair (yi . ∗ ∗ ∗ The bootstrap statistic Tn = Tn (y1 . xi ) randomly from the sample.3 Nonparametric Bootstrap The nonparametric bootstrap is obtained when the bootstrap distribution (8.

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

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

θ ˆ − qn (α/2)]. The problems with the percentile method can be circumvented by an alternative method. We would set Tn (θ) = ´ ³ ˆ − θ /s(ˆ and reject H0 in favor of H1 if Tn (θ0 ) < c.025) and q ∗ (. θ sample. θ This motivates a bootstrap analog ∗ θ C2 = [ˆ − qn (1 − α/2). ∗ Similarly. θ) then the idealized percentile bootstrap method will be accurate. θ ˆn qn ˆ This conﬁdence interval is discussed in most theoretical treatments of the bootstrap. These t-statistics are sorted to ﬁnd the estimated quantiles qn (α) and/or qn (1 − α). ∗ (. θ 1 − α = P (qn (α/2) ≤ Tn (θ0 ) ≤ qn (1 − α/2)) ´ ³ θ = P ˆ − qn (1 − α/2) ≤ θ0 ≤ ˆ − qn (α/2) . Then so an exact (1 − α)% conﬁdence interval for θ0 would be 0 C2 = [ˆ − qn (1 − α/2). but is not widely used in practice. θ n Notice that generally this is very diﬀerent from the Efron interval C1 ! They coincide in the special case that G∗ (x) is symmetric about ˆ but otherwise they diﬀer. the bootstrap test rejects if Tn (θ0 ) > qn (1 − α). a bootstrap test replaces qn (α) with the bootstrap estimate ∗ ∗ qn (α). if the alternative is H1 : θ > θ0 . where c would be selected so that θ θ) P (Tn (θ0 ) < c) = α. Thus c = qn (α). C1 and C1 are designed for the case that ˆ has a symmetric distribution about θ0 . ˆ − q ∗ (. Note. and the test rejects if Tn (θ0 ) < qn (α). which are centered at the sample estimate ˆ These are sorted θ θ θ. 8.975). it also follows that if there exists some monotonic transformation f (·) such that f (ˆ is symmetrically distributed about f (θ0 ). ˆ∗ ˆ∗ 97 . Based on these arguments. Therefore. Computationally. θ However. θ When ˆ does not have a symmetric distribution. The 95% conﬁdence interval is then [θ − ˆ to yield the quantile estimates qn ˆ ˆn ∗ (. θ.6 Percentile-t Equal-Tailed Interval Suppose we want to test H0 : θ = θ0 against H1 : θ < θ0 at size α.025)]. ˆ − q ∗ (α/2)].0 and this idealized conﬁdence interval is accurate. 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. and this is important. this³interval can be estimated from a bootstrap simulation by sorting the ´ ∗ ∗ bootstrap statistics Tn = ˆ − ˆ . by the translation invariance argument presented above. many argue that the percentile interval should not be used unless the sampling distribution is close to unbiased and symmetric.975). θ Let Tn (θ) = ˆ − θ. C1 may perform quite poorly. these critical values can be estimated from a bootstrap simulation by sorting ³ ∗ ´ ∗ ∗ the bootstrap t-statistics Tn = ˆ − ˆ /s(ˆ ). n Computationally. Since this is unknown.

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

] 8. Let Tn be a statistic such that (8. or the size of the divergence for any particular sample size n. lim Gn (x.8. not ˆ − θ0 . 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.4) v ¡ ¢ While (8. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α. A better asymptotic approximation may be obtained through an asymptotic expansion.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. 99 . θ [This is a typical mistake made by practitioners. v 2 ). Deﬁnition 8. F ) then ³x´ . F ) = Φ + o (1) . The ideal test rejects if Wn ≥ qn (α). where qn (α) is the (1 − α)% quantile of the distribution of Wn . The following notation will be helpful. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. If θ is a vector. C4 is called the symmetric percentile-t interval.4) says that Gn converges to Φ x as n → ∞. and vice-versa. Deﬁnition 8.3 an = o(n−r ) if nr |an | → 0 as n → ∞. about the rate v of convergence. Let an be a sequence. Thus here Tn (θ) = Wn (θ). Basically. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . 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. Equivalently. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). an = O(n−r ) if it declines to zero like n−r . θ θ θ ˆ θ ∗ ∗ Computationally.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. (8. however. The derivative of an even function is odd. We say that a function g(x) is even if g(−x) = g(x).1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. and a function h(x) is odd if h(−x) = −h(x).8 Asymptotic Expansions Tn →d N (0.2 an = O(1) if |an | is uniformly bounded. the critical value qn (α) is found as the quantile from simulated values of W´ .8.8. writing Tn ∼ Gn (x.

F0 )) converges to 0 at rate n. Fn ) − g1 (x. adding leptokurtosis). We can interpret Theorem 8. F ) converges to the normal limit at rate n1/2 . F0 ) = 1 g (x. and g2 is an odd function of x. the diﬀerence √ (g1 (x. Fn ) − g1 (x. To a third order of approximation. the density function is skewed. ³x´ Gn (x. √ Since Fn converges to F at rate n.8.8.3). 100 . F0 )) + O(n−1 ). F0 ) = Φ(x) + since v = 1. Gn (x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). An asymptotic test is based on Φ(x). F0 ) = n 1 n1/2 (g1 (x. F ) ≈ Φ + n−1/2 g1 (x. so the order of the error is O(n−1/2 ). F ) v which adds a symmetric non-normal component to the approximate density (for example.1 has the expansion n G∗ (x) = Gn (x. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F ). A bootstrap test is based on G∗ (x). and g1 is continuous with respect to F. The diﬀerence is Φ(x) − Gn (x. F ) + O(n−3/2 ) Gn (x. F ) + n−1 g2 (x. g1 (x.1 Under regularity conditions and (8.8. ³x´ 1 1 + 1/2 g1 (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. Fn ) + O(n−1 ). the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. F0 ) ≈ ∂ g1 (x. To a second order of approximation. v Since the derivative of g1 is odd. the exact distribution is P (Tn < x) = Gn (x. F ) + g2 (x.8. which from Theorem 8. F ) = Φ v n n 8. Moreover. ³x´ Gn (x.uniformly over x.1.1 as follows. where g1 is an even function of x. To the second order. F ) ≈ Φ + n−1/2 g1 (x. Heuristically. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ).9 One-Sided Tests Using the expansion of Theorem 8. First. Fn ) − g1 (x. Fn ) = Φ(x) + n 1 g (x. Theorem 8. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . 1/2 1 n Because Φ(x) appears in both expansions.

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

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

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

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

Estimate a linear regression of price on the number of bedrooms.dat contains data on house prices (sales). You do this as follows. ∗ ∗ where s(ˆ is the standard error in the original data. lot size. and the colonial dummy. (b) Report the 95% Alternative Percentile interval for θ. Using the non-parametric bootstrap. (c) With the given information.95). θ respectively. Let qn (. ˆ = 1. 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. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. What is wrong with this procedure? Tn = θ/s(θ) n 6.3. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. and thus reject H0 if ˆ ˆ > q ∗ (. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.95) denote the 95% quantile of Tn . You replace c with qn (. The ˆ are sorted. and ˆ is calculated on each θ ∗ ∗ θ sample. with variables listed in the ﬁle hprice1.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).5% and 97.2 and s(ˆ = . ˆ − s(ˆ n (. Suppose that in an application.pdf. can you report the 95% Percentile-t interval for θ? 7. size of house. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. Using the non-parametric ∗ bootstrap. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).05) .05) and qn (.75 and 1.5% quantiles of the ˆ are . you generate bootstrap samples. 105 .95) denote the 5% θ) ∗ and 95% quantiles of Tn . (a) Report the 95% Efron Percentile interval for θ. ∗ ∗ ∗ Let qn (. and the 2.95).2. You want to test H0 : θ = 0 against H1 : θ > 0.95).

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

i i .3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. the dependence is only up to scale. but this is generally not possible when > k.1 β GMM = argmin Jn (β). Let and where gi = xi ei . if Wn = I. β GMM does not change. ¡ ¢−1 0 ˆ Z XWn X 0 Y. ˆ Deﬁnition 9. then g n (β) = 0. β GMM = Z 0 XWn X 0 Z 9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.2) g n (β) = (9. then. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . 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 . 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. let Jn (β) = n · g n (β)0 Wn g n (β). This is a non-negative measure of the “length” of the vector g n (β). β ˆ Note that if k = . For example.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .2. Proposition 9. The GMM estimator minimizes Jn (β). the square of the Euclidean length. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.2. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . and the GMM estimator is the MME.9. For some × weight matrix Wn > 0. for if Wn is replaced ˆ by cWn for some c > 0.

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

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

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

The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. the hypothesis is H0 : h(β) = 0. it is customary to report the J statistic as a general test of model adequacy. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. it is unclear what is wrong. D →d χ2 r 3. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). For a given weight matrix Wn . current evidence suggests that the D statistic appears to have quite good sampling properties. If the statistic J exceeds the chi-square critical value. This reasoning is not compelling. This result was established by Sargan (1958) for a specialized case. The idea was ﬁrst put forward by Newey and West (1987). the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . and sometimes called a LR-like statistic (the LR is for likelihood-ratio). These may be used to construct Wald tests of statistical hypotheses. 111 . and by L. however. If the hypothesis is non-linear. Based on this information alone. the Wald statistic can work quite poorly. Hansen (1982) for the general case. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. If h is non-linear.The proof of the theorem is left as an exercise. but it is typically cause for concern. 1.7. 9. When over-identiﬁed models are estimated by GMM. If h is linear in β. In contrast. and is the preferred test statistic. a better approach is to directly use the GMM criterion function. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models.1 If the same weight matrix Wn is used for both null and alternative. then D equals the Wald statistic. D ≥ 0 2. and some current research suggests that this restriction is not necessary for good performance of the test. as this ensures that D ≥ 0.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. This is sometimes called the GMM Distance statistic. Proposition 9. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). and it is advisable to report the statistic J whenever GMM is the estimation method. we can reject the model.

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

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

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

6. 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 . The equation of interest is yi = g(xi . The observed data is (yi . Show how to construct an eﬃcient GMM estimator for β. h(β)=0 (9.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . β) + ei E (zi ei ) = 0. 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. zi ). zi is l × 1 and β is k × 1. the distance statistic D in (9.5. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. xi . VR = V − V R R0 V R (d) Show that in this setting.6) equals the Wald statistic. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. Deﬁne the Lagrangian L(β. Vn = X X i=1 ˜ and hence R0 β = r. 115 .6) (a) Show that you can rewrite Jn (β) in (9. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). VR ) where ¡ ¢−1 0 R V. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . In the linear model Y = Xβ + e with E(xi ei ) = 0. subject ˆ i ˆi i=1 to the restriction h(β) = 0. The GMM estimator of β. l ≥ k. is deﬁned as Jn (β) = ˜ β = argmin Jn (β).

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

Combined with i the constraint (10.1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n). The multinomial distribution which places probability pi at each observation (yi . 2001) and has been extended to moment condition models by Qin and Lawless (1994).1). The n ﬁrst order conditions are 0 = p−1 − µ. The idea is to construct a multinomial distribution F (p1 . The idea is due to Art Owen (1988.1 Non-Parametric Likelihood Since each observation is observed once in the sample. .. 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.Chapter 10 Empirical Likelihood 10. It is a non-parametric analog of likelihood estimation. The maximum likelihood estimator of the probabilities (p1 .. (10. β). pn ) are those which maximize the log-likelihood subject to the constraint (10.. these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. pn ) = i=1 An alternative to GMM is empirical likelihood....1) i=1 First let us consider a just-identiﬁed model. xi . zi . 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 . .. . the log-likelihood function for this multinomial distribution is n X ln(pi ). In this case the moment condition places no additional restrictions on the multinomial distribution. To be a valid multinomial distribution. pn ) which places probability pi at each observation.. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10.. xi . (10.2) Ln (p1 .3) i=1 117 .

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

G = −E (xi zi ).2. i=1 i=1 i=1i Expanding (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . and n β − β 0 and nλ are asymptotically independent. 0 = Rn (β.9) (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.9) and (10.10). β) = −xi zi . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. in the linear model.13) Premultiplying by G0 Ω−1 and using (10.10. ˆ ˆ Proof. Gi (. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .8) and ¢ 0 0 For example. β λ ∂ ³ ´. n (10. i i Theorem 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 . and Ω = E xi x0 e2 .11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .10) ¡ Ω−1 N (0.1 Under regularity conditions. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.13) yields n n Expanding (10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. (β. Thus the EL estimator is asymptotically eﬃcient. λ) = − (10. λ) = − (10.

10. β 0 ) = 0 then LRn →d χ2−k . LRn = i=1 Theorem 10. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.1 If Eg(wi .15) (10.3 Overidentifying Restrictions In a parametric likelihood context. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. it is an asymptotically eﬃcient estimator for β.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. (10. and have the same interpretation.15). This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .17) 2 ln 1 + λ gi β .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 (0.16). and it is advisable to report the statistic LRn whenever EL is the estimation method. Proof. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.3. Vλ ) Furthermore. V ) ˆ Solving (10. Ω) GΩ G →d = N (0. 120 . The overidentiﬁcation test is a very useful by-product of EL estimation. Since the EL estimator achieves this bound. The same statistic can be constructed for empirical likelihood.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 (0.14) for λ and using (10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. tests are based on the diﬀerence in the log likelihood functions. and (10. They are asymptotically ﬁrst-order equivalent.7) is n ³ ´´ ³ X ˆ ˆ0 (10. First. by a Taylor expansion.

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).17) is not appropriate. To test the hypothesis h(β) while maintaining (10.edu/~bhansen/progs/elike. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . since ln(1 + x) ' x − x2 /2 for x small.Second. h(β)=0 ˜ Fundamentally. 10. so there is no fundamental change in the distribution theory for β relative to β.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. LRn →d χ2 .18) and H0 : h(β) = 0. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18). Vλ )0 Ω−1 N (0.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).4 Testing Egi (β) = 0 (10. where h : Rk → Ra . The hypothesis of interest is h(β) = 0.4. This test statistic is a natural analog of the GMM distance statistic.wisc.prc 121 .ssc. a The proof of this result is more challenging and is omitted. 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. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. the simple overidentifying restrictions test (10. By “maintained” we mean that the overidentfying restrictions contained in (10.18) Let the maintained model be where g is × 1 and β is k × 1.1 Under (10.

4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β.. λ)0 0 Rn (β. 1. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. One method uses the following quadratic approximation. λ)0 − Rn (β. Eﬃcient convergence requires a good choice of steplength δ. λj ))−1 Rλ (β. λ) gi (β. λ) . A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λj ) . For p = 0. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λj )) Rp = Rn (β. λ) = − gi (β. λ) G∗ (β. Deﬁne ∗ gi (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λj ))−1 Rλ (β.20) . 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) ∂λ i=1 n ∂ Rn (β.19) X ∂2 ∗ ∗ gi (β. The starting value λ1 can be set to the zero vector. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. δ 1 = 1 and δ 2 = 1.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) = G∗ (β.19) is continued until the gradient Rλ (β. λ) G∗ (β. λ)0 − ∂β∂β Rn (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . set 2 λp = λj − δ p (Rλλ (β. λ) = − ∂β n X i=1 G∗ (β.4). λ) = i The ﬁrst derivatives of (10.5) for given β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. (10. 2.19). i Rββ = Inner Loop The so-called “inner loop” solves (10. λj ) is smaller than some prespeciﬁed tolerance. λp ) A quadratic function can be ﬁt exactly through these three points. The iteration (10. Set δ 0 = 0.

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

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

1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.1) if E (xi ei ) = 0. In a typical set-up. some regressors in zi will be uncorrelated with ei (for example. We call (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. and x2i are the excluded exogenous variables. z1i is an instrumental variable for (11.1 The × 1 random vector xi is an instrumental variable for (11.1. That is x2i are variables which could be included in the equation for yi (in the sense 125 . So we have the partition µ ¶ z1i k1 (11. This is called simultaneous equations bias. Deﬁnition 11. By the above deﬁnition. so should be included in xi . (11. Thus we make the partition ¶ µ k1 z1i (11.1). In matrix notation. β →p β ∗ .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. at least the intercept).1) where zi is k × 1. which does not equal either β 1 or β 2 .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 ¶ . and assume that E(zi ei ) 6= 0 so there is endogeneity. We call z1i exogenous and z2i endogenous. this can be written as Y = Zβ + e. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.1) the structural equation. 11.2) Any solution to the problem of endogeneity requires additional information which we call instruments.

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

We now derive a similar result for the 2SLS estimator. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . 129 .ˆ It is useful to scrutinize the projection Z. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before.12) Z = XΓ + u ξ = (e. Z2 ] and X = [Z1 .11) (11.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. let’s analyze the approximate bias of OLS applied to (11. Here we present a simpliﬁed version of one of his results. Recall. 11. Z2 = [PX Z1 . X2 ]. First. we regress Y on Z1 and Z2 . PX Z2 ] = [Z1 .11). X is n × l so there are l instruments. Thus in the second stage.13) which is zero only when S21 = 0 (when Z is exogenous). ˆ since Z1 lies in the span of X.12). 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. the model is Y = Zβ + e (11. ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . Using (11. Then i h ˆ ˆ ˆ Z = Z1 . PX Z2 ] h i ˆ = Z1 . Z = [Z1 . ¶ 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 ) . In our notation. Z2 .

¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .Let PX = X (X 0 X)−1 X 0 . the bias in the 2SLS estimator will be large. It is also close to zero when α = 0. Indeed as α → 1. 0). By the spectral decomposition of an idempotent matrix. 130 .13).12) and this result. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.14) is the probability limit of β 2SLS − β 11. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . l . The consequences of identiﬁcation failure for inference are quite severe. except when S21 = 0 (when Z is exogenous).14) In general this is non-zero. n and (11. P = HΛH 0 0 0 where Λ = diag(Il . n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 .14) approaches that in (11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. the expression in (11. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .

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

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

11.) 3. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). (Find an expression for xi . That is. where xi and β are 1 × 1. at ˆˆ If X is indeed endogeneous. Take the linear model Y = Zβ + e. X is n × l. 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. 133 . Z is n × k. ˜ 0 e < e0 e. 2.8 Exercises yi = zi β + ei . in the sense that e ˜ ˜ least in large samples? 4. 5. Explain why this is true. show that if rank(Γ) < k then β cannot be identiﬁed. xi is l × 1. 6. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. 1. and Γ is l × k. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. Find a simple expression for the IV estimator in this context. u is n × k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. l ≥ k. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). Take the linear model yi = xi β + ei E (ei | xi ) = 0. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . will IV “ﬁt” better than OLS. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) .

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

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

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

This occurs when |ρ| < 1..12. Some time-series processes may be a MDS as a consequence of optimizing behavior. Yt−2 .2.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. E(Yt−k et ) = 0. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. . we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . Letting et = Yt − E (Yt | It−1 ) . 12. or consumption growth rates. should be a MDS. ∞ X = ρk et−k . A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 .} are jointly random. k=0 Loosely speaking. Y2 . Yt−k ) . Deﬁnition 12. 137 .. For example. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .. .... YT .} is the past history of the series. the series {. Y1 .. E(et ) = 0 and Ee2 = σ 2 < ∞. it is even more important in the time-series context. 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 .. some versions of the life-cycle hypothesis imply that either changes in consumption. A mean-zero AR(1) is Assume that et is iid.. The last property deﬁnes a special time-series process. t By back-substitution.. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 ..3 Stationarity of AR(1) Process Yt = ρYt−1 + et . In fact. . Regression errors are naturally a MDS.. this series converges if the sequence ρk et−k gets small as k → ∞. The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression... Thus for k > 0. as it is diﬃcult to derive distribution theories without this property. .2 Autoregressions In time-series..

3. we see that L2 Yt = LYt−1 = Yt−2 .3. Deﬁnition 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. 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. We call ρ(L) the autoregressive polynomial of Yt . 138 . ∞ X k=0 ρ2k V ar (et−k ) = 12. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. From Theorem 12. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Deﬁning L2 = LL. The AR(k) model is Using the lag operator.Theorem 12. 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 . We call ρ(L) the autoregressive polynomial of Yt . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . We say that the root of the polynomial is 1/ρ. since ρ(z) = 0 when z = 1/ρ.4. Lk Yt = Yt−k .1 The lag operator L satisﬁes LYt = Yt−1 . In general.1. an AR(1) is stationary iﬀ |ρ| < 1. 12.

1. t t T t=1 ¥ Combined with (12. By Theorem 12. Proof. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. Theorem 12.5. One way of stating this is that “All roots lie outside the unit circle. t Yt−k ¢0 ρk .1.where the λ1 .6. β = X 0X (12.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.” If one of the roots equals 1.. so is xt x0 . it is helpful to deﬁne the process ut = xt et . The vector xt is strictly stationary and ergodic. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. then ˆ β →p β as T → ∞. For an AR(k). 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 12.1.1) and the continuous mapping theorem. and is of great interest in applied time series.1) Theorem 12. Note that ut is a MDS. t T t=1 T t=1 139 . the requirement is that all roots are larger than one. and hence Yt .6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . λk are the complex roots of ρ(z). This is a special case of non-stationarity. Thus t by the Ergodic Theorem. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.. Let |λ| denote the modulus of a complex number λ. and by Theorem 12. it is also strictly stationary and ergodic. we say that ρ(L). . We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.1. which satisfy ρ(λj ) = 0.. “has a unit root”. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.

t This construction imposes homoskedasticity on the errors e∗ . Fix an initial condition (Y−k+1 .12. . which may be diﬀerent than the i properties of the actual ei . 12. Brieﬂy. This creates an iid bootstrap sample.. In particular. as this imposes inappropriate independence. t then as T → ∞. we constructed the bootstrap sample by randomly resampling from the data values {yt . the asymptotic covariance matrix is estimated just as in the cross-section case..2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. Q−1 ΩQ−1 . T t=1 Since xt et is a MDS. 140 . Y0 ). T t=1 where Ω = E(xt x0 e2 ). Y−k+2 . ˆ 2.7 Asymptotic Distribution Theorem 12.7. Divide the sample into T /m blocks of length m. Ω) . eT }.7. Clearly. there are two popular methods to implement bootstrap resampling for time-series data. Estimate β and residuals et . It also presumes that the AR(k) structure is the truth. Create the bootstrap series Yt∗ by the recursive formula ˆ ˆ ∗ ˆ ∗ ˆ ∗ Yt∗ = α + ρ1 Yt−1 + ρ2 Yt−2 + · · · + ρk Yt−k + e∗ . T 1 X √ ut →d N (0. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. xt }.. Method 2: Block Resampling 1. .. we can apply Theorem 12. This is identical in form to the asymptotic distribution of OLS in cross-section regression.1 MDS CLT. t t Theorem 12.. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Ω) . this cannot work in a time-series application.. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.1 to see that T 1 X √ xt et →d N (0. e ˆ 3. ˆ 1. then as T → ∞. i 4. Method 1: Model-Based (Parametric) Bootstrap. The implication is that asymptotic inference is the same.8 Bootstrap for Autoregressions In the non-parametric bootstrap.7.

The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. • Include dummy variables for each season. This procedure is sometimes called Detrending. and the way that the data are partitioned into blocks. For each simulated sample. (12. This presumes that “seasonality” does not change over the sample. Resample complete blocks. The results may be sensitive to the block length. 12. heteroskedasticity.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . Thus the seasonally adjusted data is a “ﬁltered” series. • You can estimate (12. ρk ). 141 . get the ˆ ˆ residual St . and perhaps this was of relevance. ﬁrst estimate (12.. Paste the blocks together to create the bootstrap time-series Yt∗ . .4) by OLS.. (12. Seasonal Eﬀects There are three popular methods to deal with seasonal data. • You can estimate (12. The seasonal adjustment. 3.2) (12. This allows for arbitrary stationary serial correlation. and then perform regression (12. or the season-to-season change.. • First apply a seasonal diﬀerencing operator. also alters the time-series correlations of the data. ∆s Yt = Yt − Yt−s . That is. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years.3) replacing St with St . • Use “seasonally adjusted” data.2). If s is the number of seasons (typically s = 4 or s = 12). and for modelmisspeciﬁcation. This is a ﬂexible approach which can extract a wide range of seasonal factors. But the long-run trend is also eliminated. 6. however.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et .3) sequentially by OLS.2. 5. May not work well in small samples. 4. draw T /m blocks.2)-(12. The series ∆s Yt is clearly free of seasonality.

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

Yt is non-stationary.12. we say that if Yt is non-stationary but ∆d Yt is stationary. Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . To see this. Since α0 is the parameter of a linear regression. as the models are equivalent. Thus a time series with unit root is I(1). Because of this property. The ergodic theorem and MDS CLT do not apply. (12. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . 143 . Yt has a unit root when ρ(1) = 0. Yt is non-stationary. 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 . As we discussed before. Indeed. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0.7). the natural test statistic is the t-statistic for H0 from OLS estimation of (12. Hence. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. Note that the model is stationary if α0 < 0. this is the most popular unit root test. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. Under H0 . so conventional normal asymptotics are invalid. then Yt is “integrated of order d”. However. then ∆Yt is a stationary AR process. observe that the lag polynomial for the Yt computed from (12.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . Thus if Yt has a (single) unit root. or I(d). but simply assert the main results. and test statistics are asymptotically non-normal. In this case. or ρ1 + ρ2 + · · · + ρk = 1. under H0 . the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . We do not have the time to develop this theory in detail.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. since ρ(1) = −α0 . An alternative asymptotic framework has been developed to deal with non-stationary data.7) These models are equivalent linear transformations of one another. So the natural alternative is H1 : α0 < 0.

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

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

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

We see that an appropriate. xt−1 ) to the regression. (A simple version of this estimator is called Cochrane-Orcutt. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. and Zt be the other variables. Suppose that et is an AR(1).1) yt = x0 β + et .2) may be estimated by iterated GLS.13. direct estimation of (13.1). and is typically rejected empirically. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . You may have heard of the Durbin-Watson test for omitted serial correlation. If valid. Otherwise it is invalid. with time series data. general.3) which is a valid regression model. which once was very popular. 147 .) Since the common factor restriction appears arbitrary. may be tested if desired. Let et = ejt and β = aj . Then the single equation takes the form (13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.3). Another interesting fact is that (13. and subtract oﬀ the equation once lagged multiplied by θ. This can be done by a Wald test. j Often.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 . (13. and is still routinely reported by conventional regression packages. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0.4 Single Equation from a VAR Yjt = a0 xt + et . we are only interested in a single equation out of a VAR system. t and xt = This is just a conventional regression. In this case. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). 1). Let yt = Yjt . t t−1 (13. t and et is iid N (0.2) is uncommon in recent applications. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. t or yt = θyt−1 + x0 β + x0 γ + ut . which is called a common factor restriction.2) Take the equation yt = x0 β + et . it is convenient to re-deﬁne the variables. the model (13. under the restriction γ = −βθ.2) is a special case of (13. This restriction. 13.

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

the asymptotic distribution of the test is aﬀected by the presence of the time trend. Hansen (1992). In other cases. m × r. 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. In some cases. such that zt = β 0 Yt is I(0). Under H0 . 13.8 Cointegration The idea of cointegration is due to Granger (1981). of rank r. If the series Yt is not cointegrated. but it is useful in the construction of alternative estimators and tests. as ﬁrst shown by Stock (1987). When the data have time trends. If r = m. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . then r = 0. For 0 < r < m. Yt is I(1) and cointegrated. Whether or not the time trend is included.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 . For example. If Y = (log(Consumption) log(Income))0 . so the ADF critical values are not appropriate. then Yt is I(0).13. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 .8. however. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). so zt = β 0 Yt is known. yet under H1 zt is I(0). If Yt is cointegrated with a single cointegrating vector (r = 1). from OLS of Y1t on Y2t . in general. β = (1 − 1)0 . and was articulated in detail by Engle and Granger (1987). The asymptotic distribution was worked out in B. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. Thus H0 can be tested using a univariate ADF test on zt . 149 . if Yt is a pair of interest rates. The r vectors in β are called the cointegrating vectors. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. a good method to estimate β. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. Thus Yt = ˆ (Y1t . Suppose that β is known.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. Deﬁnition 13. β is not consistent. it may be believed that β is known a priori. Often. β may not be known. Then under H0 zt is I(1). When β is unknown. This is not. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary.

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

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

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

In surveys. any known value can substitute. 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. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. Tobin observed that for many households. this motivates the label Poisson “regression. Thus the model is that there is some latent process yi with unbounded support.. the consumption level (purchases) in a particular period was zero. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . i so the model imposes the restriction that the conditional mean and variance of Yi are the same. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. σ 2 ) with the observed variable yi generated by the censoring equation (14.) The observed data yi therefore come from a mixed continuous/discrete distribution. The conditional density is the Poisson with parameter λi . This may be considered restrictive. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. The censoring process may be explicit in data collection. A generalization is the negative binomial.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β)... or it may be a by-product of economic constraints.14. . An example of a data collection censoring is top-coding of income. 2. i If Y = {0.2 Count Data exp (−λi ) λk i . 1.}. incomes above a threshold are typically reported at the threshold. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. . 1. 0 if yi (This is written for the case of the threshold being zero.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.. The functional form for λi has been picked to ensure that λi > 0. 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 !) . 2.1) yi = ∗ <0 . a typical approach is to employ Poisson regression. k! = exp(x0 β). i i i=1 ˆ The MLE is the value β which maximizes ln (β).1). 14.

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

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

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

n. OLS can be improved upon via a GLS technique.. In either event. then OLS is inconsistent. 157 .. that eit is iid across individuals and time. The motivation is to allow ui to be arbitrary.. ti .Chapter 15 Panel Data A panel is a set of observations on individuals. This is often believed to be plausible if ui is an omitted variable. The goal is to eliminate ui from the estimator. OLS appears a poor estimation choice.. n. and thus achieve invariance. where the i subscript denotes the individual. . 15. . or unbalanced : {yit . (15. .1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit ..1) is true..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 . An observation is the pair {yit . A panel may be balanced : {yit .. It is consistent if E (xit ui ) = 0 (15.. xit }. i = 1. 15.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. T . If (15. There are several derivations of the estimator. . it The typical maintained assumptions are that the individuals i are mutually independent. and the t subscript denotes time.1) If this condition fails. and that eit is uncorrelated with xit . Condition (15. and most applied researchers try to avoid its use.. that ui and eit are independent.. It is a strong assumption. and have arbitrary correlated with xi . xit } : For i = 1.. collected over time. t = ti . however.. xit } : t = 1.1) is called the random eﬀects hypothesis. OLS of yit on xit is called pooled estimation.

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

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

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

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

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

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

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

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

¢ counting is unordered and without replacement. . n ≥ r. it is useful to have simple rules to count the number of objects in a set.. P (B) With Replacement nr ¡n+r−1¢ r For any B.. For example. 816... and is with replacement if this is allowed. as µ ¶ n n! = . i∈I i∈I 166 . Furthermore. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery. in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A. Rearranging the deﬁnition. consider a lottery where you pick six numbers from the set 1.1) We say that the events A and B are statistically independent when (A. . Depending on these two distinctions. there are two important distinctions. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. 2. Ak are mutually independent when for any subset {Ai : i ∈ I}. the number of ¡49 if potential combinations is 6 = 13.. r r! (n − r)! When counting the number of objects in a set. These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r. we say that the collection of events A1 . 49.• 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. Ã ! \ Y P Ai = P (Ai ) . Counting may be ordered or unordered. If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) .. we have four expressions for the number of objects (possible arrangements) of size r from n objects. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. the conditional probability function is a valid probability function where S has been replaced by B. Counting may be with replacement or without replacement.1) holds. We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A). 983. This selection is without replacement if you are not allowed to select the same number twice.

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

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

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

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

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

then Cov(X. An implication is that if X and Y are independent. however. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. y) = fX (x)fY (y). The covariance between X and Y is Cov(X. if EX = 0 and EX 3 = 0. Furthermore. 172 . If X and Y are independent. For example. Another implication of (A. the marginal density of Y is fY (y) = Z ∞ f (x.Similarly.5) if the expectations exist. then MZ (λ) = E exp (λ (X + Y )) = E (exp (λX) exp (λY )) ¡ ¢ ¡ ¢ = E exp λ0 X E exp λ0 Y = MX (λ)MY (λ). The reverse. is not true. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y. σxσY (A.6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1.5) is that if X and Y are independent and Z = X + Y. X 2 ) = 0. if X and Y are independent then E(XY ) = EXEY. free of units of measurement. then V ar (X + Y ) = V ar(X) + V ar(Y ). the variance of the sum is the sum of the variances. For example. Y ). (A. If X and Y are independent. −∞ The random variables X and Y are deﬁned to be independent if f (x. Y ) = ρXY = σ XY . X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x. The correlation between X and Y is Corr(X. 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 ) . A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X. then σ XY = 0 and ρXY = 0.The correlation is a measure of linear dependence. y) = g(x)h(y). y)dx.

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

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

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

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

Theorem A.13). Using the simple law of iterated expectations. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .2. Set r Z . we see that the MGF of Z 2 is (1 − 2t)−1/2 . 1). Proof of Theorem A. Iq ). q Proof of Theorem A.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.11) 2 with r = 1.8. Thus the density of Z 2 is (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 . C −1 AC −10 ) = N (0. The MGF for the density (A. which we showed in (A.1.11). tr has distribution 177 .13) is the MGF of the density (A.12) E exp (tQ) = 0 Γ (A.8.3 Let Z ∼ N (0.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. which can be found by applying change-of-variables to the gamma function. 1) and Q ∼ χ2 be independent. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.8. For Z ∼ N(0. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. From (A.8.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. C −1 CC 0 C −10 ) = N (0.3.

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

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

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

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

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

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

Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation. To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 . Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row). Another productive modiﬁcation is to add a scalar steplength λi . One modiﬁcation to prevent this possibility is quadratic hill-climbing which sets ˆi+1 = θi − (H(θi ) + αi Im )−1 g(θi ). numerical derivatives can be quite unstable. a one-dimensional optimization. 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. Then for ε small gj (θ) ' Similarly. and all require the computation θ.B. which are designed to converge to ˆ All require the choice of a starting value θ1 . θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive deﬁnite. θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ). 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 = 1.2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(θ) .. Take the j 0 th element of g(θ). 2. however. they can be calculated numerically. of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). 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. Allowing the steplength to be a free parameter allows for a line search. Q(θ + δ j ε + δ k ε) − Q(θ + δ k ε) − Q(θ + δ j ε) + Q(θ) ε2 In many cases. In some cases.. In this case the iteration rule takes the form (B. ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available. . 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).

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

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