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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

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

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

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

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

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

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

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

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

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

This is written as A > 0. then A is positive semi-deﬁnite. If λi is an eigenvalue of A. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. which are not necessarily distinct and may be real or complex. • If A is symmetric. c0 Ac = α0 a ≥ 0 where α = Gc. 8 . • If A has distinct characteristic roots. and then set B = HΛ1/2 . The matrix B need not be unique. • The characteristic roots of A−1 are λ−1 . This is written as A ≥ 0. Furthermore.. (For any c 6= 0. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ.. If A is symmetric... If A = G0 G. 2.2. and let H = [h1 · · · hk ]. has full rank k if there is no non-zero c such that Xc = 0. We say that X is n × k. A square matrix A is idempotent if AA = A. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. To see this. 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. k denote the k eigenvalues and eigenvectors of a square matrix A. then A is non-singular and A−1 exists. k < n. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal. i = 1. A−1 > 0. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. Let λi and hi . We say that A is positive deﬁnite if for all non-zero c.6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots.5 Eigenvalues det (A − λIk ) = 0.) If A is positive deﬁnite. c0 Ac > 0. then A = HΛH 0 and H 0 AH = Λ. They are called the latent roots or characteristic roots or eigenvalues of A. We now state some useful properties. 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. . then A > 0 if and only if all its characteristic roots are positive.. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . In this case. . λ−1 . c0 Ac ≥ 0. X 0 X is symmetric and positive deﬁnite. then A − λi Ik is singular so there exists a non-zero vector hi such that (A − λi Ik ) hi = 0 The vector hi is called a latent vector or characteristic vector or eigenvector of A corresponding to λi . We say that a square matrix A is positive semi-deﬁnite if for all non-zero c.. We call B a matrix square root of A. If A > 0 we can ﬁnd a matrix B such that A = BB 0 . λ−1 . and the characteristic roots are all real. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix.

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

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

from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. An important summary measure is the conditional mean Z ∞ yf (y | x) dy.1 displays the density1 of hourly wages for men and women. We call xi alternatively the regressor. xki 3. the conditional density of yi given xi .1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. which is a common feature of wage distributions. or the covariates. The two density curves show the eﬀect of gender on the distribution of wages. the mean is not necessarily a good summary of the central tendency. (3. xi ) where yi is a scalar (real-valued) and xi is a vector. we can focus on f (y | x) . Take a closer look at the density functions displayed in Figure 3. it is useful to have numerical measures of the diﬀerence.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. While it is easy to observe that the two densities are unequal.22. See Chapter 16. education and experience.1 by the arrows drawn to the x-axis. ⎟ . This is used when the goal is to quantify the impact of one set of variables on another variable. m(x) can take any form. These are indicated in Figure 3. the mean wage for men is $27.1.1. The data are from the 2004 Current Population Survey 1 11 . We call yi the dependent variable. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. ⎠ ⎝ . You can see that the right tail of then density is much thicker than the left tail. and that for women is $20. and exists so long as E |yi | < ∞. When a distribution is skewed. In the example presented in Figure 3. Figure 3. These are asymmetric (skewed) densities. the conditioning variable. To illustrate.73. These are conditional density functions — the density of hourly wages conditional on race. In this context we partition the observations into the pair (yi . holding the other variables constant.1) xi = ⎜ .2) m(x) = E (yi | xi = x) = −∞ In general. gender. .

which implies a 30% average wage diﬀerence for this population.30.1 is facilitated by the fact that the control variable (gender) is discrete. Of particular interest to graduate students may be the observation that diﬀerence between a B. The conditional expectation function is close to linear. Figure 3.3 displays a scatter plot2 of log wages against education levels.5. the solid line displays the conditional expectation of log wages varying with education. Figure 3. and a Ph. the dashed line is a linear projection approximation which will be discussed in the Section 3.3 is how the conditional expectation describes an important feature of the conditional distribution. degree in mean log hourly wages is 0. When the distribution of the control variable is continuous.D. The diﬀerence in the log mean wage between men and women is 0. By construction. with mean log hourly wages drawn in with the arrows. The comparison in Figure 3.Figure 3.A. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. wage regressions typically use log wages as a dependent variable rather than the level of wages.36. The main point to be learned from Figure 3. this yields the formula yi = m(xi ) + ei .2 shows the density of log hourly wages for the same population.2) evaluated at the observed value of xi : ei = yi − m(xi ).3) White non-military male wage earners with 10-15 years of potential work experience. 12 . To illustrate.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. 3. Assuming for simplicity that this is the true joint distribution. implying an average 36% diﬀerence in wage levels.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. For this reason. 2 (3. then comparisons become more complicated.

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

let g(x) be an arbitrary predictor of yi given xi = x. it does not provide information about the spread of the distribution.1.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. subject to the restriction p that it is non-negative.Figure 3. the conditional variance of yi is σ 2 = σ 2 (xi ). The right-hand-side is minimized by setting g(x) = m(x). To see this. The conditional standard deviation is its square root σ(x) = σ 2 (x).3. In contrast.2. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. 3. in the sense of achieving the lowest mean squared error. Given the random variable xi . σ 2 (x) is a non-trivial function of x. when σ 2 (x) is a constant so that ¢ ¡ (3. and can take any form. i .3 Conditional Variance Generally.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . Thus the mean squared error is minimized by the conditional mean. 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.

xki When m(x) is linear in x. So while men have higher average wages. Thus (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . ⎠ .1. where x1i is the ﬁrst element of the vector xi deﬁned in (3. We call this the “constant” or “intercept”.we say that the error ei is homoskedastic. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.9) 3. which we derive in this section. 15 . Instead.5. it is convenient to augment the regressor vector xi by listing the number “1” as an element.8) (3. ⎠ . βk ⎛ (3. and the linear assumption of the previous section is empirically unlikely to accurate.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. Notationally.8) is called the linear regression model. Equation (3. Equivalently. ⎟ β=⎝ . they are also somewhat more dispersed.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x).7) is a k × 1 parameter vector. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . we assume that x1i = 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 .1). Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. In this case (3. its functional form is typically unknown.5) xi = ⎜ .6) (3.1 and that for women is 10. 3. The conditional standard deviation for men is 12.6) as an approximation.4 Linear Regression An important special case of (3. As an example. take the conditional wage densities displayed in Figure 3. ⎟ . it is more realistic to view the linear speciﬁcation (3. i (3.

α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite.1 1.10) It is worth taking the time to understand the notation involved in this expression.which is quadratic in β. Therefore. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i which requires that for all non-zero α. this situation must be excluded.1. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. Assumption 3. It is invertible if and only if it is positive deﬁnite. 2 2. E (xi x0 ) is invertible. 3.11) 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 .12) This completes the derivation of the linear projection model. i (3. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. 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. written E (xi x0 ) > 0. i (3. i 16 . xi contains an intercept.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. by “best” we mean the predictor function with lowest mean squared error.5. Eyi < ∞. otherwise they are distinct. The vector (3.5. In order for β to be uniquely deﬁned. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . Observe i that for any non-zero α ∈ Rk .10). Given the deﬁnition of β in (3. i i (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . This occurs when redundant variables are included in xi . The error is i ei = yi − x0 β.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. As before. i 4. The best linear predictor is obtained by selecting β to minimize S(β). Rewriting. The ﬁrst-order condition for minimization (from Section 2. Equivalently. E (x0 xi ) < ∞. x0 β is the best linear predictor for yi .

This means that the equation (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Assumption 3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .8)-(3.13) and Assumption 3.4 is required to ensure that β is uniquely deﬁned. Assumption 3.1.5. The ﬁnite variance Assumptions 3.1.2 and 3.5.4 we know that the regression error has the property E (xi ei ) = 0.2.14) Proof. Figure 3. Since from Theorem 3. E (xi ei ) = 0 and E (ei ) = 0.1.5. However.13) implies that xi and ei are uncorrelated.3 are called regularity conditions.5.9). the orthogonality restriction (3.13) The two equations (3. Since ei is mean zero by (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. Using the deﬁnitions (3.5.1.1 are weak.1.1.1.14) follows from (3. (3.1.1 is employed to guarantee that (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) holds.Theorem 3. (3. Furthermore.10) and (3. Assumption 3. Equation (3. it follows that linear regression is a special case of the projection model.5. For example.1 Under Assumption 3. Let’s compare it with the linear regression model (3.5.3 ensure that the moments in (3.13) summarize the linear projection model. ¥ (3.5.14).11) are well deﬁned.1.4 guarantees that the solution β exits.5.12) and (3.1.1. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.5.2 and 3.5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. Assumption 3. By deﬁnition. 17 .10) are deﬁned.12) can be alternatively interpreted as a projection decomposition.11) and (3.

Most importantly. and under-predicts for the rest. In other cases the two may be quite diﬀerent.1 may be false. This defect in linear projection can be partially corrected through a careful selection of regressors.3.4 we display as well this quadratic projection. and the straight dashed line is the linear projection. It over-predicts wages for young and old workers. xi ) we can deﬁne a linear projection equation (3.We have shown that under mild regularity conditions. there are no changes in our methods or analysis.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear.5. since the resulting function is quadratic in experience.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. we can augment the regressor vector xi to include both experience and experience2 . 18 . In the example just presented. and are discussed in Chapter 11.10). Figure 3. In Figure 1.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. No additional assumptions are required. The solid line is the conditional mean.12) with the properties listed in Theorem 3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.4 displays the relationship3 between mean log hourly wages and labor market experience. for those over 53 in age). These structural models require alternative estimation methods. Other than the redeﬁnition of the regressor vector. In this case the linear projection is a poor approximation to the conditional mean. for any pair (yi . Figure 3. Returning to the joint distribution displayed in Figure 3. In this example the linear projection is a close approximation to the conditional mean. The linear equation (3. In this case (3. it is important to not misinterpret the generality of this statement. the dashed line is the linear projection of log wages on eduction. A projection of log wages on these two variables can be called a quadratic projection.1. In this example it is a much better approximation to the conditional mean than the linear projection. in many economic models the parameter β may be deﬁned within the model.5.10) may not hold and the implications of Theorem 3. We illustrate the issue in Figure 3. However. In contrast.

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

1.6 Exercises 1. i 8. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . True or False. If yi = xi β + ei . Suppose that yi is discrete-valued. 0 ≤ y ≤ 1.2 Y =1 . yi ). taking values only on the non-negative integers. and E(e2 | xi ) = σ 2 . σ 2 = V ar(yi ) and σ xy = Cov(xi .3. x 6. True or False. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . 9. and E(ei | xi ) = 0. If yi = xi β + ei . 20 . 2. Compute E(yi | xi = x) and V ar(yi | xi = x). 3. and E(xi ei ) = 0. s) = 0 if and only if m = µ and s = σ 2 . σ 2 = V ar(xi ).4 . i 11. Suppose that Y and X only take the values 0 and 1. E(Y 2 | X = x) and V ar(Y | X = x).2. j! 0 j = 0. True or False. e−λ λj j! . 2. µx = Exi . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. then E(x2 ei ) = 0. If yi = x0 β + ei and E(ei | xi ) = 0. 3 and 4 of Theorem 3. Let X be a random variable with µ = EX and σ 2 = V ar(X). Let xi and yi have the joint density f (x. then ei is i i independent of xi . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. If yi = x0 β + ei and E(xi ei ) = 0.3 Find E(Y | X = x). and have the following joint probability distribution X=0 X=1 Y =0 . i 7. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . Compute the conditional mean m(x) = E (yi | xi = x) . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. a constant. µ. then E(x2 ei ) = 0. xi ∈ R. E(ei | xi ) = 0.. Prove parts 2. xi ∈ R. True or False. True or False. (x − µ)2 − σ 2 Show that Eg (X.1 .1. Are they diﬀerent? Hint: If P (Y = j) = 5. m.. . σ = . ¡ ¢ 4. then E(ei | xi ) = 0. i 10. then ei is independent of xi . If yi = x0 β + ei .

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 ) .1) (4. 4. Observe that (4. i n i=1 n 21 .2) (4.3) In Sections 4. i It follows that the moment estimator of β replaces the population moments in (4.8.4) i i=1 i=1 ˆ Another way to derive β is as follows.7 and 4. (4. we narrow the focus to the linear regression model. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . but for most of the chapter we retain the broader focus on the projection model.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 .1 Estimation Equation (4.2) can be written in the parametric 0 β)) = 0. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .

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. excluding military.37 µ ¶ 1.4). with 10-15 years of potential work experience.14 14.7% increase in mean wages.14 14.94 −2.71 = −2.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.30 + 0.95 xi yi = 42. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.40 µ ¶µ ¶ 34.170 37. 40 0.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. 30 = .83 ¶−1 µ ¶ . To illustrate.117 1 14. 0.14 205.95 42.2 Least Squares There is another classic motivation for the estimator (4. consider the data used to generate Figure 3. These are white male wage earners from the March 2004 Current Population Survey. An interpretation of the estimated equation is that each year of education is associated with an 11. Then µ ¶ n 1X 2. Let yi be log wages and xi be an intercept and years of education. 40 2.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. This sample has 988 observations.14 205.3. 4. i 22 . 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. ¶ 2.117 Educationi .4).ˆ This is a set of k equations which are linear in β.

Since the function Sn (β) is a quadratic function of β. i ˆ ˆ Note that yi = yi + ei . while the residual is a by-product of estimation.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. the contour lines are ellipses.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. which can cause confusion.4). 23 .7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. Figure 4. Figure 4. Matrix calculus (see Appendix 2. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. These two ˆ variables are frequently mislabeled. Figure 4.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Following convention we will call β the OLS estimator of β. To visualize the sum-of-squared errors function. It is important to understand the distinction between the error ei and the residual ei . The error is unobservable.

one implication is that n 1X ei = 0. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero.7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n−k 2 i=1 (4.7.2: Sum-of-Squared Error Function Contours Equation (4. 24 . ˆ n i=1 n Since xi contains a constant. It measures the variation in the i “unexplained” part of the regression. These are algebraic results. and hold true for all linear regression estimates.6) An alternative estimator uses the formula n 1 X 2 s = ei . The error variance σ 2 = Ee2 is also a parameter of interest. ˆ σ = ˆ n 2 i=1 n (4.5) implies that 1X xi ei = 0. Its method of moments estimator is the sample average 1X 2 ei .Figure 4.

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

σ 2 ) = − 2 + ¡ ¢2 e2 = 0. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. one for each observation. n or equivalently Y = Xβ + e. including computation. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. yn = x0 β + en . The linear equation (3. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. . and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e. . .12) is a system of n equations.6). ⎟. n X i=1 Thus the estimator (4.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . . residual vector. . en ⎞ Observe that Y and e are n × 1 vectors. yn ⎟ ⎟ ⎟. it is matrix notation. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. . We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . 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. ⎠ .Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. = β+ XX 26 (4. and X is an n × k matrix. Due to this equivalence. ⎝ ⎝ . Thus the MLE (β. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . Sample sums can also be written in matrix notation.8) .4). x0 n ⎞ ⎛ e1 e2 . 4. For example n X i=1 For many purposes.

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

observe that ⎞ ⎛ ⎞ ⎛ .14) or via the ˆ following algorithm: ˜ 1.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. is the demeaning formula for regression. Regress X2 on X1 . . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. obtain residuals Y . . ⎟ ⎜ ⎟ ⎜ (4. Regress Y on X1 . . ⎠ ⎝ ⎠ ⎝ . . 4. Rather. ˜ 2. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. .6.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. Regress Y on X2 .9).9). the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. A common application of the FWL theorem. but in most cases there is little computational advantage to using the two-step algorithm. 30 . and X2 is the vector of observed regressors. the FWL theorem can be used to speed computation. . ¡ ¢−1 0 ι. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 .8)(3. In some contexts. which you may have seen in an introductory econometrics course.Theorem 4. . In this case. obtain residuals X2 . By the independence of the observations and (3. . In the model (4. 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) . obtain OLS estimates β 2 and residuals e. 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.13).1 (Frisch-Waugh-Lovell). . ˆ which are “demeaned”. In this section we derive the small sample conditional mean and variance of the OLS estimator. the primary use is theoretical. . ˆ ˜ ˜ ˆ 3.

Then given (4.19) ˆ and thus the OLS estimator β is unbiased for β. ⎝ . . ⎠ (4.20) .18). X 0 DX = X 0 Xσ 2 . and (4. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. ¡ 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.. under the of ˆ ¢ 2 | x = σ 2 .. . and the trace operator observe that.8).. the properties of conditional expectations. .12). for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 .Using (4. . . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . . σ 2 } = ⎜ . . From (4. we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0. V ar β | X = X 0 X ⎟ ⎟ ⎟. Next. 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. 1 n .. and ³ ´ ¡ ¢−1 2 ˆ σ . 0 0 ··· 0 0 .

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

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

5. 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 .1.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. He proves that generically the OLS estimator (4. the maximum likelihood estimator is identical to the OLS estimator.22) 34 . Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.9). and thus so is the OLS estimator.Substituting in the expressions for π j . Chamberlain (1987) extends this argument to the case of continuously-distributed data. if the data have a discrete distribution.10) for the class of models satisfying Assumption 3. (4. He observes that the above argument holds for all multinomial distributions.10 Omitted Variables xi = µ x1i x2i ¶ . 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. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.

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

ˆ ˆ (4. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . the precision of individual estimates are reduced. ˆ i A simple comparison yields that ˆ ei − ei. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. To investigate the possibility of inﬂuential observations. The hi take values in [0. We derive expression (4. We can also deﬁne the leave-one-out residual ˆ ˆ ei.−i = yi − x0 β (−i) = (1 − hi )−1 ei .−i = (1 − hi )−1 hi ei . In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.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.25) below. If the i’th observation 36 .26) As we can see. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . since as ρ approaches 1 the matrix becomes singular. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. 1] and sum to k. deﬁne the leave-one-out least-squares estimator of β.27) (4.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . 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. As a consequence. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . that is.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. What is happening is that when the regressors are highly dependent. the OLS estimator based on the sample excluding the i’th observation. the worse the precision of the individual coeﬃcient estimates.

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

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

If g(·) : R → R is convex.1) (5. Cauchy-Schwarz Inequality. Jensen’s Inequality. then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . |a| = a a i i=1 If A is a m × n matrix.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. Triangle inequality |X + Y | ≤ |X| + |Y | . These approximations are bounded through the use of mathematical inequalities.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 . then g(E(X)) ≤ E(g(X)). ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality. ij i=1 j=1 (5.1 Inequalities Asymptotic theory is based on a set of approximations. We list here some of the most critical deﬁnitions and inequalities.2) + 1 q = 1. then (5. 41 . 5.

then as n → ∞ n 1X Xn = Xi →p E(X). 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 |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. (5. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX.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. We say that Zn converges in probability to Z as n → ∞. Theorem 5. P (g(X) > α) ≤ α−1 Eg(X). Eg(X) ≥ a + bEX = g(EX).1 Weak Law of Large Numbers (WLLN).2.3). If Xi ∈ Rk is iid and E |Xi | < ∞. denoted Zn →p Z as n → ∞. Applying expectations. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . 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}. Let a + bx be the tangent line to g(x) at x = EX.Markov’s Inequality. Note EU = EV = 1. The WLLN shows that sample averages converge in probability to the population average. n i=1 42 . Set Y = g(X) and let f denote the density function of Y. p p p q which is (5. n→∞ lim P (|Zn − Z| > δ) = 0. So for all x. as stated.4) Proof of Jensen’s Inequality. ¥ Proof of Holder’s Inequality. Since g(x) is convex. =E U V p q p q Proof of Markov’s Inequality. For any strictly increasing function g(X) ≥ 0. if for all δ > 0. ¥ 5. tangent lines lie below it.

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

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

¥ 5. If Zn →d Z as n → ∞ and g (·) is continuous. for each element of g. Stacking across elements of g.4. If Zn →p c as n → ∞ and g (·) is continuous at c. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Recall that A ⊂ B implies P (A) ≤ P (B). Proof: Since g is continuous at c.4 Asymptotic Transformations Theorem 5.3 Delta Method: If n (θn − θ0 ) →d N (0. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Since cλλ (λn ) → cλλ (0) = −Ik .2 Continuous Mapping Theorem 2. where θ is m × 1 and Σ is m × m.4. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Σ) . 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 . we see that as n → ∞. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. This is suﬃcient to establish the theorem. gθ Σgθ .1 Continuous Mapping Theorem 1 (CMT). Theorem 5. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. √ Theorem 5. 45 . Ik ) distribution.√ where λn → 0 lies on the line segment joining 0 and λ/ n. and g(θ) : Rm → Rk . Proof : By a vector Taylor series expansion. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Σ) = N 0.4. then g(Zn ) →d g(Z) as n → ∞. then g(Zn ) →p g(c) as n → ∞. Hence g(Zn ) →p g(c) as n → ∞. k ≤ m.

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

1. Equation (4.4.4 implies that Q−1 exists and thus g(·. the OLS estimator β is has a statistical distribution which is unknown. ˆ 47 .1). Proof.3) Ã where g(A.1. Assumption 3. To characterize the sampling distribution more fully.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.1 Under Assumption 3. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.2). using (6. 6. For a complete argument.2 Consistency ˆ As discussed in Section 6.1. Assumption 3.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. β →p β as n → ∞. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 . As the sample size increases the density becomes more concentrated about the population coeﬃcient. Ã n ! n X 1X 0 1 ˆ xi xi . and the continuous mapping theorem (Theorem 5.2) i i n i=1 n From (6. we will use the methods of asymptotic approximation. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. (6.5. (6. (6. we can conclude ˆ that β →p β.2. n i=1 (6.4. Hence by the continuous mapping theorem (Theorem 5. This is illustrated in Figure 6.5. ·) is continuous at (Q.1) and ˆ We now deduce the consistency of β.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1).1). First.1 and the WLLN (Theorem 5.2. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. 0). ˆ Theorem 6. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.3).1 by the fact that the sampling densities become more concentrated as n gets larger. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . xi ei →p g (Q. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1).5.

2). Ω) . it follows that s2 = ¥ n σ 2 →p σ 2 . Assumption 6.1 In addition to Assumption 3. by the Cauchy-Schwarz inequality (5. ˆ Proof. Ee4 < ∞ and E |xi |4 < ∞.3.2.3. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.2.5. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . Thus σ 2 is consistent for σ 2 . (6.5.2 Under Assumption 3.2). By the central limit theorem (Theorem 5. ˆ Finally.1).1).6) n i=1 48 . (6.3. ˆ n−k 6. To see this.1 guarantees that the elements of Ω are ﬁnite. i i Assumption 6. (6.1. since n/(n − k) → 1 as n → ∞. n 1 X √ xi ei →d N (0. 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 . We need a strengthening of the moment conditions.Theorem 6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.3) and Theorem (6.1. E ¯ei ¯ E ¯e4 ¯ i i i i (6. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.

How large should n be in order for the approximation to be useful? Unfortunately. setting n = 100 and varying the parameter α.1. This holds true for all joint distibutions of (yi . We say that ei is a Homoskedastic Projection Error when (6. In Figure 6. We illustrate this problem using a simulation.3. 1). V ) where V = Q−1 ΩQ−1 . V is often referred to as ˆ the asymptotic covariance matrix of β.9) we deﬁne V 0 = Q−1 σ 2 whether (6. When (6. 1 X √ xi ei n i=1 n ! the N (0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. there is no simple answer to this reasonable question. The approximation may be poor when n is small. e2 ) = 0. In´Figure 6.7) holds.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . otherwise V 6= V 0 .Then using (6. However. There is a special case where Ω and V simplify. Q−1 ΩQ−1 .7) is true or false. The trouble is that no matter how large is the sample size. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. for example.9) In (6.1 Under Assumption 6. The expression V = Q−1 ΩQ−1 is called a sandwich form. and (6.3. As α approaches 2.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.3. however.3. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. Let yi = β 0 + β 1 xi + εi where xi is N (0.7) Cov(xi x0 .2). The asymptotic distribution ´ Theorem 6. We call V 0 the homoskedastic covariance matrix. Ω) ¡ ¢ = N 0. (6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . after rescaling. its variance diverges q ³ ´ ˆ to inﬁnity.7) is true then V = V 0 . For α 49 .6).1 states that the sampling distribution of the least-squares estimator.3. but this is not a necessary condition.1). |ε| ≥ 1. xi ) which satisfy the conditions of Assumption 6. when xi and ei are independent. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 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. is approximately normal when the sample size n is suﬃciently large. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . Theorem 6. Under (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . 1) asymptotic distibution.1. i i Condition (6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).

for k = 1. 1). ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.2 and 6. 6.2) and Theorem 6. concentrating most of the probability mass around zero. The estimator 2 2 in (6.2: Density of Normalized OLS estimator α = 3. we need an estimate of Ω = E xi x0 e2 .10) without changing this result.2.3 is that the N (0.11) 50 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .0 the density is very close to the N (0. the sampling distribution becomes highly skewed and non-normal. 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 (0.1) it is clear that V 0 →p V 0 . 1) density.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. As α diminishes the density changes signiﬁcantly. 4.Figure 6. As k increases. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. Another example is shown in Figure 6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. 6 and 8.10) V 0 = Q−1 s2 . The lesson from Figures 6.3. We show the sampling distribution of n β 1 − β 1 setting n = 100. 1) asymptotic approximation is never guaranteed to be accurate.

When β is a vector. and V is an estimator of the variance of n β − β . or that they use the “White formula”. 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). β j . as there may be more than one estimator of the variance of the estimator. j = 0.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. It is therefore important to understand what formula and method is 51 . it is important to pay ˆ ˆ attention to the distinction between V 0 and V . as it is not always clear which has been computed. 1..3: Sampling distribution where ei are the OLS residuals. the “Huber formula”. we set s(β) = n−1/2 V .Figure 6. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. many authors will state that their “standard errors have been corrected for heteroskedasticity”. k. When reading and reporting applied work. Generically. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. or that they use a “heteroskedasticity-robust covariance matrix estimator”. vis. A more easily interpretable measure of spread is its square root — the standard deviation. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. the “Eicker-White formula”.4. The methods switched during ˆ the late 1980s and early 1990s. ˆ ˆ When V is used rather than the traditional choice V 0 . the “Huber-White formula” or the “GMM covariance matrix”. standard errors are not unique. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . these all mean the same thing. . we focus on individual elements of β one-at-a-time. In most cases.... This motivates the deﬁnition of a standard error. and was still the standard choice for much empirical work done in the early 1980s. ˆ ˆ Deﬁnition 6.

039 and ˆ V = µ 1 14.493 0. The standard errors for β 0 are 7.493 −0.480 ˆ0 = 0. (6. n n i=1 52 . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.14 205. we return to the log wage regression of Section 4.199 2.020) 6.085 p ˆ and that for β 1 is .2/988 = .14 14.2.80 . Ω 2. by Holder’s inequality (5.480 .5) and the WLLN (Theorem 5.83 −0.80 40. (. We calculate that s2 = 0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.14 205.14 6.14 14.035 ¶ .80 2.5 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.used by an author when studying their work. then take the diagonal elements.199 2.14 205.4) 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 .30 + 0.35/988 = . and then the square roots. To illustrate. From a computational standpoint. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.80 40. p ˆ In this case the two estimates are quite similar.020. just as any other estimator. First.83 ¶−1 = µ 7.085) (. from which it follows that V →p V as n → ∞. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . but not under another set of assumptions.20 and µ ¶ ˆ = 0.83 ¶−1 µ . (6. Using (6.117 Educationi .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.12) in turn.20 −0.98 −0.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.6 ¶µ 1 14. i i i i n i=1 Second.1.20 = V 14.

which. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6.11) with the leave-one-out estimator ei.5.−i = (1 − hi )−1 ei ˆ presented in (4. Recall from Section 4.26). Andrews (1991) suggested an similar estimator based on cross-validation. i=1 Third. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . you can show that 1 Xˆ ¯ β= β (−i) . n i=1 n ˆ ˆ Theorem 6.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. Ω →p Ω and V →p V. Using this substitution. 6. 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 0.14) 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 . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.13) of Efron (1982). is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . these establish consistency. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. ¯ ¯n ¯ n i=1 so Together. From equation (3.13) Using formula (4.25).1 As n → ∞. 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.

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

Consider the studentized statistic tn (θ) = Theorem 6. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. In this case. By (6. the standard error for ˆ is the square root of n−1 Vθ . however. 55 . Since the standard normal distribution does not depend on the parameters.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. that (so θ ˆ ˆ ˆ is. s(ˆ θ) (6. In general. and θ = h(β) is some function of the parameter vector. s(ˆ = n−1/2 H 0 V Hβ .16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . we say that tn is an exactly pivotal statistic. µ I 0 ¶ ˆ the upper-left block of V . A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. 1) Proof.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. see Section X). and is therefore exactly free of unknowns. the statistic tn has an exact t distribution.For example. θ) β 6.8. 1) →d ˆ−θ θ . β 2 ). Vθ ) √ Vθ = N (0. if R is a “selector matrix” R= so that if β = (β 1 .1 tn (θ) →d N (0. ˆ When q = 1q h(β) is real-valued). we say that tn (θ) is asymptotically pivotal. In special cases (such as the normal regression model. (For example. θ could be a single element of β).

1]. z. For example. If the p-value pn is small (close to zero) then the evidence against H0 is strong. The coverage probability is P (θ ∈ Cn ). from which it follows that pn →d U [0. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. or “accepts” H0 . That is.645. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. 1]. associated with Fisher. The p-value is more general. however. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . The asymptotic p-value for the above statistic is constructed as follows. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . Let zα/2 is the upper α/2 quantile of the standard normal distribution. Deﬁne the tail probability. In a sense. 1). An alternative approach. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . regardless of the complication of the distribution of the original test statistic. 1). P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. and is a function of the data and hence is / random. is to report an asymptotic p-value. under H0 . 1]. Then the asymptotic p-value of the statistic tn is pn = p(tn ). then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. That is. Otherwise the test does not reject. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic.96 and z.025 = 1. 6.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. pn →d U [0. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. in that the reader is allowed to pick the level of signiﬁcance α. Either θ ∈ Cn or θ ∈ Cn . It is designed to cover θ with high probability. 56 . This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. tn →d N (0. s(ˆ θ) Under H0 . if Z ∼ N (0. To see this fact.05 = 1.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing.

The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. 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 .05. 6.96s(ˆ ≈ ˆ ± 2s(ˆ . and it is desired to test the joint restrictions simultaneously. θ The interval has been constructed so that as n → ∞. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. = n h(β) − θ0 Hβ V Hβ 57 (6.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). the most common professional choice isi95%. 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). ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. In this case the t-statistic approach does not work.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. or α = . We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . 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). θ θ) (6. This corresponds to selecting the conﬁdence h i h ˆ ± 1. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.18) .17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. ˆ + zα/2 s(ˆ .

Also h(β) = a selector matrix. For example. the upper-α quantile q 2 of the χ2 distribution. the test rejects at the α% level iﬀ pn < α.5. As before.1.1 Under H0 and Assumption 6.025 . χ2 (.8. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . if rank(Hβ ) = q.When h is a linear function of β.2. Hβ (β) →p Hβ . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity. Hβ (β) is a continuous function of β.3. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . Furthermore. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Wn = n R0 β − θ0 ´ √ ³ The delta method (6. The asymptotic p-value for Wn is pn = p(Wn ). ˆ Wn = n θ θ q θ θ Theorem 6. 6.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.15) showed that n ˆ − θ →d Z ∼ N (0. Hence β β by Theorem A. and Theorem 6.19) σ2 ˆ where σ2 = ˜ 1 0 e e. Vθ ). and there are q = k2 restrictions. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.10. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).1 showed θ ˆ that V →p V.05) = 3. 1] under H0 . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. then Wn →d χ2 .84 = z. h(β) = R0 β. θ = β 2 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . a chiq square random variable with q degrees of freedom. The null hypothesis is H0 : β 2 = 0. In this case. 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. ˜˜ n ˜ e = Y − X1 β 1 . q and pn is asymptotically U[0.

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

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

The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . 0. σ 2 ) − Ln (β 1 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . The critical values are quite close if n − k ≥ 30. if standard errors are calculated using the homoskedastic formula (6. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. and standard errors are calculated using the homoskedastic formula (6. σ 2 ) = − log σ − log (2π) − . σ2 ˆ 61 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ). In contrast. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. β and t are approximately normally distributed.3. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. β has an exact normal distribution and t has an exact t distribution. 0. β 2 . σ ˆ ˆ βj − βj βj − βj N (0. (Unless the sample size is unreasonably small.10) then ´ ³ ˆ • β ∼ N 0.1 we showed that in large samples. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 .12. β 2 . a good testing procedure is based on the likelihood ratio statistic. n−k • ∼ tn−k ˆ In Theorem 6. We summarize these ﬁndings Theorem 6. so as a practical matter it does not matter which distribution is used. Theorem 6.1 If ei is independent of xi and distributed N(0. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .12. β 2 . 1) and tn−k distributions. 0.a chi-square distribution with n − k degrees of freedom.1 shows that under the strong assumption of ˆ normality.10) µ h i ¶ 2 (X 0 X)−1 N 0. Furthermore. As inference (conﬁdence intervals) are based on the t-ratio.8.1 and Theorem 6.) Now let us partition β = (β 1 . with residual variance σ . σ 2 ) discussed above. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . the notable distinction is between the N (0.

The decreasing dashed ˆ = 1. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Through repetition. This produces random draws from the sampling distribution of interest. while there are other values of s for which test test statistic is insigniﬁcant. 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. In the present context of the Wald statistic. 6.7. and noting Hβ = sβ s−1 . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.8. as Wn (s) →d χ2 under H0 for 1 any s.84 — the probability of a false rejection. The increasing solid line is for the case β = 0. This is an unfortunate feature of the Wald statistic. the statistic Wn (s) varies with s.4 the Wald statistic Wn (s) as a function ˆ of s. ˆ Let β and σ 2 be the sample mean and variance of yi . Take the model yi = β + ei ei ∼ N (0. 62 . we have plotted in Figure 6. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. To demonstrate this eﬀect. setting n/σ 2 = 10. Letting h(β) = β s . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. features of this distribution can be calculated. σ 2 ) and consider the hypothesis H0 : β = 1. This can be seen by a simple example introduced by Lafontaine and White (1986). they can work quite poorly when the restrictions are nonlinear.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . Our ﬁrst-order asymptotic theory is not useful to help pick s. 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.

Any other choice of s leads to a test with unacceptable Type I error probabilities. no magic choice of n for which all tests perform uniformly well. Error rates avove 10% are considered excessive. For this particular example. so these probabilities are Type I error. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. The null hypothesis β s = 1 is true.Figure 6.4: Wald Statistic as a function of s P (Wn (s) > 3. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. The value of s is varied from 1 to 10.1 reports the simulation estimate of the Type I error probability from 50. In Table 4. In Table 2.84 | β = 1) . remember that the ideal Type I error probability is 5% (. Typically. To interpret the table. Table 4. looking for tests for which rate rejection rates are close to 5%. Table 4. however. Given the simplicity of the model. In each case. Type I error rates between 3% and 8% are considered reasonable. we compare the rates row by row. and σ 2 . and rarely fall outside of the 3%-8% range. When comparing statistical procedures.1 we report the results of a Monte Carlo simulation where we vary these three parameters. These probabilities are calculated as the percentage of the 50. and σ is varied among 1 and 3. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. 100 and 500. There is.1 you can also see the impact of variation in sample size. the only test which meets this criterion is the conventional Wn = Wn (1) test. n is varied among 20.84.4. Rates above 20% are unexceptable. the Type I error probability improves towards 5% as the sample size n increases.000 simulated Wald statistics Wn (s) which are larger than 3. this probability depends only on s.05) with deviations indicating+ distortion. Test performance deteriorates as s increases. n.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .000 random samples.

12 .34 . β 2 ) be the least-squares estimates of (6. Equivalently.26 .13 .30 .05 .20). β 1 .25 .06 .25 .22 .08 .14 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .10 . This point can be illustrated through another example.06 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .15 .10 .13 .19 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.07 .12 .06 .05 .07 .16 Rejection frequencies from 50. 64 .35 . so the hypothesis can be stated as H0 : θ = r.15 .18 .17 .20 .10 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.05 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.06 .20 .06 .06 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .28 .22 .05 .08 .24 .14 .31 .05 .05 . While this is clear in this particular example. Other choices are arbitrary and would not be used in practice.08 .08 .08 .07 .07 .15 .21 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.06 .23 .07 .13 .06 .11 .33 .09 .15 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . deﬁne θ = β 1 /β 2 .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 .

02 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .50. this formulation should be used. the rejection rates for the t1n statistic diverge greatly from this value. .25 . if the hypothesis can be expressed as a linear restriction on the model parameters. Table 4.00 .1. while the right tail probabilities P (t1n > 1.28 . In this section we describe the method in more detail.10 .05.06 .05 .09 . the entries in the table should be 0.05 .645) P (tn > 1. especially for small values of β 2 .25.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . In contrast.15 .00 .645) are calculated from 50. then the “most linear” formulation should be selected. 65 . This leaves β 2 as a free parameter.05 .06 . and are close to the ideal 5% rate for both sample sizes. However.06 .00 .75 1.50 .12 .05 β2 .07 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.00 . ei be an independent N (0. such as the GMM distance statistic which will be presented in Section 9.15 . .06 .05 . 6.7.2.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.06 .00 The one-sided Type I error probabilities P (tn < −1.47 .645) greatly exceed 5%. along with sample size n. We let x1i and x2i be mutually independent N (0.06 .00 .0 and n among 100 and 500.75. .06 .05 .06 . The left tail probabilities P (t1n < −1.00 .10 . We vary β 2 among .00 .26 . σ 2 ) draw with σ = 3.06 .05 .645) and P (tn > 1. Ideally.10 .000 simulated samples. and normalize β 0 = 0 and β 1 = 1.06 .645) t1n t2n t1n t2n t1n t2n t1n t2n . and 1. 1) variables.00 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.05 .00 . In all cases. If no linear formulation is feasible.645) P (tn < −1. The implication of Table 4. and alternatives to asymptotic critical values should be considered. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.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.05 . It is also prudent to consider alternative tests to the Wald statistic.645) are close to zero in most cases. The results are presented in Table 4.05 .645) P (tn > 1.

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

union member. an estimator or test may perform wonderfully for some values. We us the sample of wage earners from the March 2004 Current Population Survey.96) . if we set B = 999. then B will have to be increased. for a selection of choices of n and F. therefore. The random variable 1 (Tnb ≥ 1.022. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. B b=1 (6. In practice. and 5000. In particular. experience squared. potential work experience. B. this may ˆ be approximated by replacing P with P or with an hypothesized value. potential work experience. female.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. and estimate a multivariate regression.21). s P = . then we can set s P = (. For the dependent variable we use the natural log of wages. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. female. it is simple to make inferences about rejection probabilities from statistical tests.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test.22/ B. immigrant. but requires more computational time. the choice of B is often guided by the computational demands of the statistical procedure. Furthermore. and therefore it is straightforward to calculate standard errors for any quantity of interest. . experience squared.05) (. We now expand the sample all non-military wage earners. and non-white. and . It is therefore useful to conduct a variety of experiments.003.95) /B ' . The α% sample quantile is a number qα such that α% of the sample are less than qα . union member. and 90% sample quantiles of the sample {Tnb }. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. respectively. and our regressors include years of education. the performance will depend on n and F.007. We separately estimate equations for white and non-whites. Hence the ³ ´ ˆ standard errors for B = 100. Again our dependent variable is the natural log of wages. As P is unknown. In many cases. and hispanic.96) . The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. For regressors we include years of education. For example. Generally. the researcher must select the number of experiments. a larger B results in more precise estimates of the features of interest of Gn . we included a dummy 67 . are. It is therefore convenient to pick B so that N is an integer. For example. 1000. 6. Then qα is the N ’th number in this ordered sequence. excluding military. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. If the standard error is too large to make a reliable inference. and poorly for others. The average (6. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. and dummy variable indicators for the following: married. where N = (B +1)α. equalling 1 with probability P = E1 (Tnb ≥ 1. As discussed above. Quite simply. such as the percentage estimate reported in (6. Often this is called the number of replications. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. and dummy variable indicators for the following: married. immigrant. so that coeﬃcients may be interpreted as semi-elasticities.96) is iid Bernoulli. hispanic.15 Estimating a Wage Equation We again return to our wage equation.

014 .102 −.808 so the parameter estimates are quite precise and reported in Table 4. we ﬁnd Wn = 550.007 . 2β 3 68 .070 . 808 1 − .4877 18.010 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.121 −.101 .18) that the state coeﬃcients are jointly zero. Computing the Wald statistic (6. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.48772 = 515. Alternatively.001 .00002 .033 −.00057 . this adds 50 regressors).4945.variable for state of residence (including the District of Columbia.002 . excluding the coeﬃcients on the state dummy variables. The available sample is 18. Table 4.008 .013 .097 −.19) is ˜ µ ¶ µ ¶ σ2 ˆ .232 .1.49452 σ ˜ Notice that the two statistics are close. 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. The F form of the Wald statistic (6.010 .69. reestimating the model with the 50 state dummies excluded.34 ˆ s(β) . Ignoring the other coeﬃcients.032 .808 . 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. θ ˆ 2β 3 β2 . but not equal.027 . as the 1% critical value for the χ2 distribution is 76. Using either statistic the hypothesis is easily rejected.102 −. Wn = n 1 − 2 = 18. the restricted standard deviation estimate is σ = .

so we have to go one step further. Instead. not testing a hypothesis. However. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. This set is [27. but the lower end is substantially lower. 29. we can calculate a standard error of s(ˆ = . we found better Type I error rates by reformulating the hypothesis as a linear restriction.Using the Delta Method. In the previous section we discovered that such t-tests had very poor Type I error rates. 29. there is not a simple expression for this set.40.96. 69 .5]. In the present context we are interested in forming a conﬁdence interval. this is a poor choice.0. implying a 95% conﬁdence θ) interval of [27. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.9. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ). Since tn (θ) is a non-linear function of θ. but it can be found numerically quite easily.5]. This is the set of θ such that |tn (θ)| ≤ 1. Notice that the upper end of the conﬁdence interval is the same as that from the delta method.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. Vα ) (7. then the FGLS estimator will force ˜i the regression equation through the point (yi . ˜i Suppose that σ 2 > 0 for all i. This suggests 75 . We may call (7. Furthermore. . 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 .4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. and hence we can estimate 0 σ 2 = zi α by i ˜ (7.6) σ 2 = α0 zi . Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . and will depend on the model (and estimation method) for the skedastic regression. 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. This is the feasible GLS. xi ). which is typically undesirable..4) the skedastic regression.. then the FGLS ˜i estimator is not well deﬁned. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). Then set ˜i ˜ D = diag{˜ 2 .Suppose ei (and thus η i ) were observed. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say.3) ˆ ˆ While ei is not observed.. if σ 2 ≈ 0 for some i. there is no guarantee that σ 2 > 0 for all i. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Vα = E zi zi (7. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. We have shown that α is consistently estimated by a simple procedure.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. estimator of β. If σ 2 < 0 for some i. or FGLS. as it is estimating the conditional variance of the regression of yi on xi . Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi .

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

The asymptotic distribution (7. If the equation of interest is a linear projection. The GLS and FGLS estimators. Third. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . σ 2 ). 7.2. the two tests coincide.4) and constructing a Wald statistic. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . FGLS will do worse than OLS in practice. as they will be estimating two diﬀerent projections.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7.1 Under H0 and ei independent of xi .3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β.error. This introduces an element of arbitrariness which is unsettling to empirical researchers. In this case.5) and the asymptotic variance (7. In the linear regression model the conditional mean of yi given xi = x is 77 . If i this simpliﬁcation is replaced by the standard formula (under independence of the error). and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. and all cross-products. OLS is a more robust estimator of the parameter vector. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. Theorem 7. individual estimated conditional variances may be negative.2). the Wald test of H0 is asymptotically χ2 . the estimated conditional variances may contain more noise than information about the true conditional variances. however. and not a conditional mean. require the assumption of a correct conditional mean. Vα = E zi zi (7. Typically. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi .7) under independence show that this test has an asymptotic chi-square distribution. We may therefore test this hypothesis by the estimation (7. its squares. or equivalently that i H0 : α1 = 0 in the regression (7. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. It is consistent not only in the regression model. and the cost is a reduction of robustness to misspeciﬁcatio 7.4). Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. and this requires trimming to solve. The main diﬀerences between popular “tests” is which transformations of xi enter zi . on the other hand. but also under the assumptions of linear projection. but the only diﬀerence is that they a ¢ allowed for general choice of zi . q Most tests for heteroskedasticity take this basic form.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . This hypothesis does not imply that ξ i is independent of xi . Second.

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

θ) is suggested by an economic model. θ) = θ1 + θ2 xθ3 m(x. which alters some of the analysis. θ). ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. θi 79 . θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. θ) = θ1 + θ2 m(x. Let 0 yi = ei + m0 θ0 . θ) = θ1 + θ2 exp(θ3 x) m(x. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. When the regression function is nonlinear. it is adopted as a ﬂexible approximation to an unknown regression function. ˆ ei . it must be shown that ˆ →p θ0 . V ) θ where mθi = mθ (xi . Since ˆ →p θ0 . mθ (x. estimator. then the FOC for minimization are 0= n X i=1 mθ (xi . ´ √ ³ n ˆ − θ0 →d N (0. ˆ must be found by numerical θ methods. In the ﬁnal two examples. When m(x. θ) is diﬀerentiable. m is not diﬀerentiable with respect to θ3 . In other cases. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . θ) is diﬀerentiable with respect to θ. The NLLS residuals are ei = yi − m(xi . θ))2 . This can be done using arguments θ for optimization estimators. G known x2 − θ5 m(x. ˆ is close to θ θ θ0 for n large. θ) is (generically) diﬀerentiable in the parameters θ. we call this the nonlinear least squares (NLLS) θ). When it exists. let ∂ m(x. θ)ˆ (7.1 If the model is identiﬁed and m(x.4. The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . m(x. See Appendix E.8) Theorem 7. θ0 ). but we won’t cover that argument here. θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x.Examples of nonlinear regression functions include x 1 + θ3 x m(x. θ) = G(x0 θ). First. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 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 . θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples.

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

Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x.5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . These distinctions are illusory. however. These facts deﬁnitions motivate three estimators of θ. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. 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 least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model.10) The LAD estimator has the asymptotic distribution 81 .To recall the deﬁnition and properties of the median.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. The second is the value which minimizes n n |yi − θ| . as i=1 these estimators are indeed identical. i n n i=1 (7. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0.5. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . Now let’s consider the conditional median of Y given a random variable X. let Y be a continuous random variable. Two useful facts about the median are that (7.

The main diﬃculty is the estimation of f (0). the height of the error density at its median. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. V ). While a complete proof of Theorem 7. then there are many innovations near to the median.1 ´ √ ³ˆ n β − β 0 →d N (0. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . (7. In the special case where the error is independent of xi . ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. the conditional density of the error at its median. where V = and f (e | x) is the conditional density of ei given xi = x. ˆ Proof of Theorem 7. Computation of standard error for LAD estimates typically is based on equation (7. When f (0 | x) is large. and this improves estimation of the median.1 is advanced. Let g(β) = Eg (β). Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . This can be done with kernel estimation techniques. ∂β 0 so Third.11). Second using the law of iterated expectations and the chain rule of i diﬀerentiation.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.5. First. ¢¢−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) . by the central limit theorem (Theorm 5.5. we provide a sketch here for completeness.Theorem 7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. Pn −1 0 β)) .5.3.10) is equivalent to g n (β) = 0. See Chapter 16.

then F (Qτ ) = τ . For τ ∈ [0. For the random variables (yi . As functions of x.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice.5. If the random variable U has τ ’th quantile Qτ . when F (y | x) is continuous and strictly monotonic in y. so you can think of the quantile as the inverse of the distribution function.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. then (7. 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . Exi x0 ) →d i 2 = N (0.12) Qτ = argmin Eρτ (U − θ) .13) This generalizes representation (7. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . The third line follows from an asymptotic empirical process argument. then F (Qτ (x) | x) = τ . Again. For ﬁxed τ . We then have the linear quantile regression model yi = x0 β τ + ei i 83 . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. the quantile regression functions can take any shape. (7. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . The following alternative representation is useful. ¥ 7. The median is the special case τ = . V ). θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) .9) for the median to all quantiles.

1. i By construction. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. and are widely available. since it has discontinuous derivatives. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. fast linear programming methods have been developed for this problem. Furthermore. and test their signiﬁcance using a Wald test. if the model yi = x0 β + ei has i been ﬁt by OLS. 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 τ ’th conditional quantile of ei is zero. conventional Newton-type optimization methods are inappropriate. then f (0 | xi ) = f (0) . and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . ˆ Given the representation (7.6. ´ √ ³ˆ Theorem 7. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Another popular approach is the RESET test proposed by Ramsey (1969).5.1 n β τ − β τ →d N (0. When the error ei is independent of xi . Thus. it is useful to have a general test of the adequacy of the speciﬁcation. n numerical methods are necessary for its minimization.12).where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . the asymptotic variance depends on the conditional density of the quantile regression error. Fortunately. where and f (e | x) is the conditional density of ei given xi = x. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). ¡ ¡ ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ Exi x0 E xi x0 f (0 | xi ) Vτ = τ (1 − τ ) E xi x0 f (0 | xi ) i i i ¢ 1X ¡ ρτ yi − x0 β i n i=1 In general. 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 (7.13). The null model is yi = x0 β + εi i 84 . Vτ ). 7. the unconditional density of ei at 0.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . otherwise its properties are unspeciﬁed without further restrictions. and form a Wald statistic i for γ = 0.

In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . ⎠ . Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. 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. yi ˆm (7.14) 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. To implement the test. It is easy (although somewhat tedious) to show that under the null hypothesis. yielding predicted values yi = x0 β. To see why this is the case. yielding ˆ ˜ ˆ ˆ (β 1 . 7. 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. Typically. and consequently 22 ¡ ¢−1 2 σ . since Q12 Q−1 Q21 > 0.14) by OLS. m must be selected in advance. Otherwise. It is particularly powerful at detecting single-index models of the form yi = G(x0 β) + εi i where G(·) is a smooth “link” function. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. However. or 4 seem to work best. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. note that (7.be an (m − 1)-vector of powers of yi . One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. small values such as m = 2. Wn →d χ2 . they will (typically) have diﬀerence asymptotic variances. β 2 ). Another is to regress yi on x1i and x2i jointly. 3.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. β 1 = (X1 X1 )−1 (X1 Y ) . Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . and form the Wald statistic Wn for γ = 0. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. ⎟ zi = ⎝ . lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. 1i 2i 2i 1i 22 . then 22 Q11 > Q11 − Q12 Q−1 Q21 . and n→∞ say.

when economic theory does not provide complete guidance? This is the question of model selection. Let Exi = µ. and E (xi − µ)2 = σ 2 . One useful property is consistency.. “Which subset of (x1 . estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 . For example.... this result can be reversed when the error is conditionally heteroskedastic.). x2i = σ 2 . To be concrete. . we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i ..7). In contrast. We c can write this as M. and β 1 0 (The least-squares estimate with the intercept omitted. because it does not make clear the conditioning set. we say that M2 is true if β 2 6= 0.˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . How does a researcher go about selecting an econometric speciﬁcation. Let β 1 be the ˜ be the estimate under the constraint β = 0. i A model selection procedure is a data-dependent rule which selects one of the two models. the question: “What is the right model for y?” is not well posed. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 . To simplify some of ¢ statistical discussion. E (ε | X1 . In the absence of the homoskedasticity assumption. estimate of β 1 from the unconstrained model. . xKi = xK )?” is well posed. x Then under (6. We conclude that the inclusion of irrelevant variable reduces estimation eﬃciency if these variables are correlated with the relevant variables. X2 ) = 0 Note that M1 ⊂ M2 . This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. there is no clear ranking of the eﬃciency of the ˜ restricted estimator β 1 versus the unrestricted estimator. models 1 and 2 are estimated by OLS. X2 ) = 0. take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0. the question. n→∞ σx ˜ When µ 6= 0. It is important that the model selection question be well-posed. ˆ For example. Y = X1 β 1 + X2 β 2 + ε. etc. that it selects the true model with probability one if the sample is suﬃciently large. We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε. where X1 is n × k1 and X2 is n × k2 . E (ε | X1 . There are many possible desirable properties for a model selection procedure.. respectively.. 7.9 Model Selection In earlier sections we discussed the costs and beneﬁts of inclusion/exclusion of variables. we see that β 1 has a lower asymptotic variance. However. σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 . To ﬁx notation. xK ) enters the regression function E(yi | x1i = x1 . In many cases the problem of model selection can be reduced to the comparison of two nested models. with residual vectors e1 and e2 . as the larger problem can be written as a sequence of such comparisons.

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

. . which regressors enter the regression). E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. 210 = 1024. . one can show that thus LRn →p ∞. Similarly for ˆ the BIC. There are two leading cases: ordered regressors and unordered.17). MK : β 1 6= 0. 048. which can be a very large number.. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . In the ordered case. . β 2 6= 0. Also under M2 .. . . the models are M1 : β 1 6= 0. 88 . The methods extend readily to the issue of selection among multiple regressors. selecting based on (7. xKi }. β K 6= 0.. a model consists of any possible subset of the regressors {x1i . which are nested. there are 2K such models. However. The AIC selection criteria estimates the K models by OLS. In the latter case. For example. and 220 = 1. stores the residual variance σ 2 for each model. 576. 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. and then selects the model with the lowest AIC (7. β 2 6= 0. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. . β 3 = · · · = β K = 0 . We have discussed model selection between two models. In the unordered case.15). and the AIC or BIC in principle can be implemented by estimating all possible subset models.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.

You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x.. . Let (yi . and the out-of-sample value of the regressors.. (b) Prove that e = M1 e. For any predictor g(xi ) for y. x. Let θ satisfy Eg(Yi − θ) = 0. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . 2. where xji is one of the xi . X). Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. Verify equation (7. Show that the function g(x) which minimizes the MAE is the conditional median M (x). Let σ 2 be the estimate of σ 2 . ˆ ˆ n−k 6. xi ) be a random sample with E(Y | X) = Xβ.. based on a sample of size n. 4. else equals zero). V . In a linear model Y = Xβ + e. 5.10 Exercises 1. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . . the estimates (β. σ 2 ). ˜ the residual vector is e = Y − X β. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y .7. the mean absolute error (MAE) is E |yi − g(xi )| . Is θ a quantile of the distribution of Yi ? 3. Thus the available information is the sample (Y.12). V ar(e | X) = σ 2 Ω with Ω known. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . wn ) and wi = x−2 . 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 . ˆ (a) Find a point forecast of y. (b) Find an estimate of the variance of this forecast. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. the residuals e. E(e | X) = 0.

For each value of a7 . Examine the data and pick an appropriate range for a7 . . The equation you estimated was ln T Ci = β 1 + β 2 ln Qi + β 3 ln P Li + β 4 ln P Ki + β 5 ln P Fi + ei . θ is the NLLS estimator. Consider model (7. impose the restriction a3 + a4 + a5 = 1. The model works best when a7 is selected so that several values (in this example. (iii) BIC criterion. the regression slope is a2 + a6 . where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . calculate zi and estimate the model by OLS. (7. a7 ). The model is non-linear because of the parameter a7 .ˆ ˆ 7. the variable ln Qi has a regression slope of a2 . This model is called a smooth threshold model. 90 . Exercise 13. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . In addition. For values much above a7 . 8. I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range... Do so. are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9. n xi i=1 (a) Under the stated assumptions. (ii) AIC criterion. you estimated a cost function on a cross-section of electric companies. In Chapter 6. add the variable (ln Qi )2 to the regression..18) plus the extra term a6 zi . For values of ln Qi much below a7 . and V is the = g(x estimate of V ar ˆ . Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. Suppose that yi ³ ´ i . (d) Calculate standard errors for all the parameters (a1 . Find an asymptotic 95% conﬁdence interval for g(x).18) (a) Following Nerlove. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. and ﬁnd the value of a7 for which the sum of squared errors is minimized. and the model imposes a smooth transition between these regimes. (c) Estimate the model by non-linear least squares. Record the sum of squared errors. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. Assess the merits of this new speciﬁcation using (i) a hypothesis test. θ) + ei with E (ei | xi ) = 0. at least 10 to 15) of ln Qi are both below and above a7 .

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

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

.1). the EDF is only a crude approximation to the CDF. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. Furthermore. 1) distribution. x) (1 − F (y. In general. I have plotted the EDF and true CDF for three random samples of size n = 25. To see this.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . xi ).2. To see the eﬀect of sample size on the EDF. x) = P (yi ≤ y. it is helpful to think of a random pair (yi . x). x) . Recall that F (y. (8. Fn is by construction a step function. x). i = 1. where 1(·) is the indicator function. x)) →d N (0. note that for any (y. x∗ ) with the i distribution Fn . ∗ P (yi ≤ y.2 The Empirical Distribution Function Fn (y. as the sample size gets larger. F (y..1). x) = n i=1 Figure 8.8. by the CLT (Theorem 5. but the approximation appears to improve for the large n. x))) . n. Note that while F may be either discrete or continuous. i 93 . x) − F (y. The random draws are from the N (0. x∗ ≤ x) = Fn (y.3. the EDF step function gets uniformly close to the true CDF. √ n (Fn (y. This is a population moment. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . Notationally.. in the Figure below.. Fn (y. x). x) is called the empirical distribution function (EDF). and 100. Thus by the WLLN (Theorem 5. Fn is a nonparametric estimate of F. The EDF is a consistent estimator of the CDF. For n = 25. 50. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x) →p F (y.2) Fn (y. That is.

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

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

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

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

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

then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .4) says that Gn converges to Φ x as n → ∞. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . F ) then ³x´ . v 2 ). The ideal test rejects if Wn ≥ qn (α). we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic.] 8. Let an be a sequence. Let Tn be a statistic such that (8. an = O(n−r ) if it declines to zero like n−r . The derivative of an even function is odd. θ θ θ ˆ θ ∗ ∗ Computationally.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. A better asymptotic approximation may be obtained through an asymptotic expansion. it says nothing.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. Basically. Thus here Tn (θ) = Wn (θ).8 Asymptotic Expansions Tn →d N (0. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). We say that a function g(x) is even if g(−x) = g(x). The following notation will be helpful. Equivalently. and a function h(x) is odd if h(−x) = −h(x). θ [This is a typical mistake made by practitioners. C4 is called the symmetric percentile-t interval.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.8. F ) = Φ + o (1) . about the rate v of convergence. and vice-versa.8.3 an = o(n−r ) if nr |an | → 0 as n → ∞. lim Gn (x. (8. Deﬁnition 8. or the size of the divergence for any particular sample size n. the critical value qn (α) is found as the quantile from simulated values of W´ . where qn (α) is the (1 − α)% quantile of the distribution of Wn . writing Tn ∼ Gn (x. Deﬁnition 8. however.8. not ˆ − θ0 .4) v ¡ ¢ While (8. 99 . If θ is a vector. F ) = Φ n→∞ v or ³x´ Gn (x. 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.2 an = O(1) if |an | is uniformly bounded.

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

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

is an even function. meaning that the errors in the two directions exactly cancel out.Interestingly. F ) = Φ v √ where v = V . whose error is O(n−1 ). Fn ) − g2 (x. similar to a one-sided test. This is because the ﬁrst term in the asymptotic expansion. and for the bootstrap ³x´ + O(n−1/2 ). which is not pivotal. Gn (x. We know that θ Tn →d N (0. F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . Theorem 8. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. Two-sided tests have better rates of convergence than the one-sided tests. V ). F0 ) = ∗ 2 (g2 (x. set Tn = n ˆ − θ0 . and g2 is continuous in F. G∗ (x) = Gn (x. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. but one-sided tests might have more power against alternatives of interest. Fn ) = Φ(x) + ∗ 2 g2 (x. as it depends on the unknown V. and bootstrap tests have better rates of convergence than asymptotic tests. Conﬁdence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. Twosided tests will have more accurate size (Reported Type I error).8. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. we ﬁnd Gn (x) = Gn (x. A reader might get confused between the two simultaneous eﬀects. This is in contrast to the use of the asymptotic distribution. g1 . Fn ) + O(n−3/2 ). √ the last equality because Fn converges to F0 at rate n. Therefore. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. Applying (8. 8.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. and needs to be determined on a case-by-case basis.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). F0 )) + O(n−3/2 ) n = O(n−3/2 ). Another way of writing this is ∗ P (|Tn | < x) = P (|Tn | < x) + O(n−3/2 ) so the error from using the bootstrap distribution (relative to the true unknown distribution) is O(n−3/2 ).5) to the bootstrap distribution. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test.

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

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

Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.95).05) . Using the non-parametric ∗ bootstrap.dat contains data on house prices (sales). (c) With the given information. ∗ ∗ where s(ˆ is the standard error in the original data.5% quantiles of the ˆ are . ˆ = 1.05) and qn (. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. (a) Report the 95% Efron Percentile interval for θ. (b) Report the 95% Alternative Percentile interval for θ. Let qn (. θ respectively. ˆ − s(ˆ n (. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. can you report the 95% Percentile-t interval for θ? 7. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. Using the non-parametric bootstrap. Estimate a linear regression of price on the number of bedrooms. 105 . calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and ˆ is calculated on each θ ∗ ∗ θ sample. You do this as follows. size of house. you generate bootstrap samples. ∗ ∗ ∗ Let qn (.95).3.5% and 97. What is wrong with this procedure? Tn = θ/s(θ) n 6. with variables listed in the ﬁle hprice1. You replace c with qn (.2 and s(ˆ = .95) denote the 95% quantile of Tn .95). You want to test H0 : θ = 0 against H1 : θ > 0.75 and 1. The ˆ are sorted. Suppose that in an application.pdf.95) denote the 5% θ) ∗ and 95% quantiles of Tn . The dataﬁle hprice1. and the colonial dummy. and thus reject H0 if ˆ ˆ > q ∗ (.2. and the 2. lot size.

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

the square of the Euclidean length. then.9. The GMM estimator minimizes Jn (β). This is a non-negative measure of the “length” of the vector g n (β).2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . for if Wn is replaced ˆ by cWn for some c > 0. and the GMM estimator is the MME. the dependence is only up to scale. if Wn = I.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.1 β GMM = argmin Jn (β).1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . Proposition 9. i i . ¡ ¢−1 0 ˆ Z XWn X 0 Y. For example. Let and where gi = xi ei .2) g n (β) = (9.2. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . β GMM = Z 0 XWn X 0 Z 9. let Jn (β) = n · g n (β)0 Wn g n (β). gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. then g n (β) = 0.2. β GMM does not change. but this is generally not possible when > k. For some × weight matrix Wn > 0. 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 . β ˆ Note that if k = . The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. ˆ Deﬁnition 9. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following.

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

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

take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). so that the linear equation may be written as yi = β 0 x1i + ei . For example. Hansen (1982). β) = 0 holds. The general theory of GMM estimation and testing was exposited by L.Often.1 Under general regularity conditions. this is all that is known.6. 1 it is possible that β 2 6= 0. often the weight ˆ matrix Wn is updated. 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). Theorem 9. n β − β →d N 0. Since the GMM estimator depends upon the ﬁrst-stage estimator. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 .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 . Note that g n →p Egi . Under the hypothesis of correct speciﬁcation. ˆ J = J(β) →d χ2−k . 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. However. perhaps obtained by ﬁrst ˆ setting Wn = I. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9.1 (Sargan-Hansen). and then β recomputed. and if the weight matrix is asymptotically eﬃcient. 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 . G0 Ω−1 G . Identiﬁcation requires l ≥ k = dim(β). 110 . 1 2 It is possible that β 2 = 0. Thus the model — the overidentifying restrictions — are testable. This estimator can be iterated if needed. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. ˆˆ n is a quadratic form in g n . 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.5. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. 9. and is thus a natural test statistic for H0 : Egi = 0.

The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). For a given weight matrix Wn . the Wald statistic can work quite poorly. and is the preferred test statistic. If the hypothesis is non-linear. however. If h is non-linear. Based on this information alone.7. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). it is customary to report the J statistic as a general test of model adequacy. Proposition 9.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates.The proof of the theorem is left as an exercise. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology.1 If the same weight matrix Wn is used for both null and alternative. and some current research suggests that this restriction is not necessary for good performance of the test. D →d χ2 r 3. If h is linear in β. as this ensures that D ≥ 0. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . and it is advisable to report the statistic J whenever GMM is the estimation method. D ≥ 0 2. If the statistic J exceeds the chi-square critical value. a better approach is to directly use the GMM criterion function. it is unclear what is wrong. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. 1. current evidence suggests that the D statistic appears to have quite good sampling properties. but it is typically cause for concern. we can reject the model. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). then D equals the Wald statistic. Hansen (1982) for the general case. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). These may be used to construct Wald tests of statistical hypotheses. 9. This is sometimes called the GMM Distance statistic. 111 . This reasoning is not compelling. When over-identiﬁed models are estimated by GMM. the hypothesis is H0 : h(β) = 0. This result was established by Sargan (1958) for a specialized case. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. In contrast. The idea was ﬁrst put forward by Newey and West (1987). and by L.

0 In the linear model ei (β) = yi − zi β. Take the case s = 1. and then use the ﬁrst k instruments. A recent study of this problem is Donald and Newey (2001). Ai is unknown. x3 . Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β). Setting gi (β) to be this choice (which is k × 1. The obvious problem is that the class of functions φ is inﬁnite. i Ai = −σ −2 Ri i . note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi . In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i .. It is also helpful to realize that conventional regression models also fall into this class. In many cases. etc. but its form does help us think about construction of optimal instruments.. β)ei (β) which satisﬁes Egi (β) = 0 and hence deﬁnes a GMM estimator. and restrictive. 0 Our linear model yi = zi β + ei with instruments xi falls into this class under the stronger 0 assumption E (ei | xi ) = 0. so is just-identiﬁed) yields the best GMM estimator possible. except that in this case zi = xi . ei (β. Which should be selected? This is equivalent to the problem of selection of the best instruments. in linear regression. Then ei (β) = yi − zi β.8 Conditional Moment Restrictions In many contexts. If xi is a valid instrument satisfying E (ei | xi ) = 0. The form was uncovered by Chamberlain (1987). 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. than the unconditional moment restriction discussed above. an unconditional moment restriction can always be constructed. are all valid instruments. Given a conditional moment restriction. β). we can set gi (β) = φ(xi . That is for any × 1 function φ(xi . Which should be used? i i One solution is to construct an inﬁnite list of potent instruments. then xi . ei (β) = yi − x0 β.. while in a nonlinear i regression model ei (β) = yi − g(xi . x2 . the model implies more than an unconditional moment restriction of the form Egi (β) = 0.9. γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2. How is k to be determined? This is an area of theory still under development.. β). s = 1. In practice. Another approach is to construct the optimal instrument. . For example. It turns out that this conditional moment restriction is much more powerful.

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

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

the distance statistic D in (9. 6. xi .6) equals the Wald statistic. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . Deﬁne the Lagrangian L(β. zi is l × 1 and β is k × 1. In the linear model Y = Xβ + e with E(xi ei ) = 0. l ≥ k. VR = V − V R R0 V R (d) Show that in this setting. Show how to construct an eﬃcient GMM estimator for β. β) + ei E (zi ei ) = 0. Vn = X X i=1 ˜ and hence R0 β = r. 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 . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. subject ˆ i ˆi i=1 to the restriction h(β) = 0. The GMM estimator of β.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β).5. zi ). The observed data is (yi . h(β)=0 (9. VR ) where ¡ ¢−1 0 R V. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). 115 . the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9.6) (a) Show that you can rewrite Jn (β) in (9.

ˆ and consider the GMM estimator β of β. 116 . Deﬁne ¶µ ¶−1 µ 1 0 ˆ −1 1 0 1 0 ˆ −1 0−1 0 1 0 XZ Z XΩ XZ Z XΩ C Dn = Il − C n n n n 1 0 Xe g n (β 0 ) = n ¡ ¢ 0 R = C 0 E xi zi Show that Jn →d χ2 as n → ∞ by demonstrating each of the following: l−k (a) Since Ω > 0. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix.7.. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions.

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

(10.6) 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. Multiplying the ﬁrst equation by pi . λ) is a convex function of λ. probabilities 1 ³ ´´ . the Lagrange multiplier λ(β) minimizes Rn (β. .4) (10.. λ ¡ ¢ ln 1 + λ0 gi (β) .2) subject to the restrictions (10. λ) : λ(β) = argmin Rn (β. λ. This yields the (proﬁle) empirical log-likelihood function for β. λ).3).7) 118 .5). µ. The solution cannot be obtained explicitly.. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). and using the second and third equations. Ln (β) = Rn (β. p1 . (see section 6. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. but must be obtained numerically (see section 6.5) ˆ ˆ As a by-product of estimation. summing over i. p (10. or equivalently minimizes its negative ˆ (10. we ﬁnd µ = n and 1 ¢. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . pn .1) and (10. The solution (when it exists) is well deﬁned since Rn (β. λ) = −n ln (n) − n X i=1 For given β.5) This minimization problem is the dual of the constrained maximization problem. we also obtain the Lagrange multiplier λ = λ(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 Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. pi gi (β) = 0..where λ and µ are Lagrange multipliers. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .

11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. and Ω = E xi x0 e2 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. λ) = − (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. 0 = Rn (β.10). (β.1 Under regularity conditions. Thus the EL estimator is asymptotically eﬃcient.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . β λ ∂ ³ ´. n (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 . i i Theorem 10.2.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. and n β − β 0 and nλ are asymptotically independent.9) (10. G = −E (xi zi ). ˆ ˆ Proof. in the linear model. β) = −xi zi .10.13) yields n n Expanding (10. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10.8) and ¢ 0 0 For example.13) Premultiplying by G0 Ω−1 and using (10.9) and (10. λ) = − (10.10) ¡ Ω−1 N (0. 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. i=1 i=1 i=1i Expanding (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . Gi (.

17) 2 ln 1 + λ gi β .3 Overidentifying Restrictions In a parametric likelihood context.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. and have the same interpretation. 120 . ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. β 0 ) = 0 then LRn →d χ2−k .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. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. by a Taylor expansion. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . it is an asymptotically eﬃcient estimator for β. Vλ ) Furthermore. and (10. tests are based on the diﬀerence in the log likelihood functions. The overidentiﬁcation test is a very useful by-product of EL estimation. The same statistic can be constructed for empirical likelihood.15) (10. Proof.15).1 If Eg(wi . First. V ) ˆ Solving (10. (10. and it is advisable to report the statistic LRn whenever EL is the estimation method.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 (0.3. LRn = i=1 Theorem 10. Ω) GΩ G →d = N (0.16). 10. Since the EL estimator achieves this bound. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ.7) is n ³ ´´ ³ X ˆ ˆ0 (10.14) for λ and using (10. They are asymptotically ﬁrst-order equivalent.

Theorem 10.4 Testing Egi (β) = 0 (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). a The proof of this result is more challenging and is omitted. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. 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 × 1.18).17) is not appropriate. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . 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. h(β)=0 ˜ Fundamentally. The hypothesis of interest is h(β) = 0. the simple overidentifying restrictions test (10.Second.ssc.4. 10.1 Under (10. where h : Rk → Ra . Vλ )0 Ω−1 N (0. 10.prc 121 . Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. To test the hypothesis h(β) while maintaining (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).wisc. This test statistic is a natural analog of the GMM distance statistic.18) and H0 : h(β) = 0.edu/~bhansen/progs/elike. LRn →d χ2 . since ln(1 + x) ' x − x2 /2 for x small. so there is no fundamental change in the distribution theory for β relative to β.

Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10.4). 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) = − ∂β n X i=1 G∗ (β.20) . λj ) . λj ))−1 Rλ (β. λ) ∂λ i=1 n ∂ Rn (β. λ) = − gi (β. 1.19). i Rββ = Inner Loop The so-called “inner loop” solves (10. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. Deﬁne ∗ gi (β. λ) = i The ﬁrst derivatives of (10. Set δ 0 = 0. For p = 0. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. The starting value λ1 can be set to the zero vector. λ)0 − ∂β∂β Rn (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) G∗ (β. Eﬃcient convergence requires a good choice of steplength δ. λ) gi (β. λ)0 − Rn (β.5) for given β. λj ) is smaller than some prespeciﬁed tolerance. λ) = G∗ (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λp ) A quadratic function can be ﬁt exactly through these three points..19) is continued until the gradient Rλ (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. 2. λ)0 0 Rn (β. set 2 λp = λj − δ p (Rλλ (β. δ 1 = 1 and δ 2 = 1. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β.19) X ∂2 ∗ ∗ gi (β. λ) . λ) G∗ (β. λj ))−1 Rλ (β. λj )) Rp = Rn (β. One method uses the following quadratic approximation. (10. The iteration (10. The modiﬁed Newton method takes a quadratic approximation to Rn (β.

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

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

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

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

Z2 = [PX Z1 . Hence by a ﬁrst-order approximation i µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ OLS − β E β ZZ Ze ≈ E E n n ¡ ¢−1 = Γ0 QΓ + S22 S21 (11. Recall. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 .12). ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) .12) Z = XΓ + u ξ = (e. Thus in the second stage. First. Z = [Z1 . Then i h ˆ ˆ ˆ Z = Z1 . We now derive a similar result for the 2SLS estimator. In our notation.13) which is zero only when S21 = 0 (when Z is exogenous).11). we regress Y on Z1 and Z2 . Here we present a simpliﬁed version of one of his results. X is n × l so there are l instruments. 11. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. PX Z2 ] h i ˆ = Z1 .ˆ It is useful to scrutinize the projection Z. Z2 ] and X = [Z1 . Z2 . 129 . X2 ]. the model is Y = Zβ + e (11. Using (11.11) (11. PX Z2 ] = [Z1 .6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. let’s analyze the approximate bias of OLS applied to (11. ˆ since Z1 lies in the span of X. ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y .

14) is the probability limit of β 2SLS − β 11. n and (11.12) and this result. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 130 . Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. except when S21 = 0 (when Z is exogenous). Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. the bias in the 2SLS estimator will be large. l .Let PX = X (X 0 X)−1 X 0 . Indeed as α → 1. 0). 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 . Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .14) approaches that in (11. P = HΛH 0 0 0 where Λ = diag(Il . the expression in (11. By the spectral decomposition of an idempotent matrix. It is also close to zero when α = 0. The consequences of identiﬁcation failure for inference are quite severe.13).14) In general this is non-zero. 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.

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

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

Take the linear model yi = xi β + ei E (ei | xi ) = 0. show that if rank(Γ) < k then β cannot be identiﬁed.11. u is n × k. xi is l × 1. That is. 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. Z is n × k. ˜ 0 e < e0 e. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. l ≥ k. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . and Γ is l × k. 5. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . 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). 133 . Take the linear model Y = Zβ + e.8 Exercises yi = zi β + ei . In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k.) 3. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). Find a simple expression for the IV estimator in this context. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. X is n × l. 6. will IV “ﬁt” better than OLS. Explain why this is true. 2. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. where xi and β are 1 × 1. at ˆˆ If X is indeed endogeneous. in the sense that e ˜ ˜ least in large samples? 4. 1. (Find an expression for xi .

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

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

1. ˆ 2. ˆ 3. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . For Part (2).1 above. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. the sequence Yt Yt−k is strictly stationary and ergodic. γ (0) ˆ Theorem 12. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). 1. ρ(k) →p ρ(k). ˆ ˆ γ ¥ 136 . µ →p E(Yt ). ˆ Proof.2 (Ergodic Theorem).1.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. 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) . then as T → ∞.Theorem 12.1. γ (k) →p γ(k). and it has a ﬁnite mean by the assumption that EYt2 < ∞. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . Part (1) is a direct consequence of the Ergodic theorem. then as T → ∞. T 1X Xt →p E(Xt ). If Xt is strictly stationary and ergodic and E |Xt | < ∞. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).

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

Theorem 12. In general. we see that L2 Yt = LYt−1 = Yt−2 . 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 . Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value). or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .3. 138 .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. an AR(1) is stationary iﬀ |ρ| < 1. Deﬁnition 12. We call ρ(L) the autoregressive polynomial of Yt .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 12.4. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. since ρ(z) = 0 when z = 1/ρ.1.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Deﬁning L2 = LL.3. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . the above results are unchanged. We call ρ(L) the autoregressive polynomial of Yt . We say that the root of the polynomial is 1/ρ. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . The AR(k) model is Using the lag operator. From Theorem 12. Lk Yt = Yt−k . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .1 The lag operator L satisﬁes LYt = Yt−1 . ∞ X k=0 ρ2k V ar (et−k ) = 12.

we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β... and is of great interest in applied time series.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. which satisfy ρ(λj ) = 0. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.” If one of the roots equals 1. One way of stating this is that “All roots lie outside the unit circle. β = X 0X (12. t Yt−k ¢0 ρk . t T t=1 T t=1 139 . For an AR(k). Thus T T 1X 1X xt et = ut →p E (ut ) = 0. t t T t=1 ¥ Combined with (12.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et .1) Theorem 12. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. “has a unit root”. By Theorem 12. Proof. and by Theorem 12.1.1. . the requirement is that all roots are larger than one. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. then ˆ β →p β as T → ∞.. λk are the complex roots of ρ(z). The vector xt is strictly stationary and ergodic. we say that ρ(L). so is xt x0 .1) and the continuous mapping theorem. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. Note that ut is a MDS. This is a special case of non-stationarity. Theorem 12. it is also strictly stationary and ergodic.1. it is helpful to deﬁne the process ut = xt et .where the λ1 . Thus t by the Ergodic Theorem. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. Let |λ| denote the modulus of a complex number λ.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. and hence Yt .1.6.5.

This creates an iid bootstrap sample. Y0 ). Brieﬂy. i 4. . Method 1: Model-Based (Parametric) Bootstrap...7. t This construction imposes homoskedasticity on the errors e∗ .1 to see that T 1 X √ xt et →d N (0. then as T → ∞. which may be diﬀerent than the i properties of the actual ei . this cannot work in a time-series application. Q−1 ΩQ−1 .12. t t Theorem 12. Estimate β and residuals et . e ˆ 3.7... t then as T → ∞.7. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. Ω) . 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∗ ..7 Asymptotic Distribution Theorem 12. the asymptotic covariance matrix is estimated just as in the cross-section case. 140 . Ω) . T t=1 where Ω = E(xt x0 e2 ). Y−k+2 . This is identical in form to the asymptotic distribution of OLS in cross-section regression.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. It also presumes that the AR(k) structure is the truth. Divide the sample into T /m blocks of length m. T 1 X √ ut →d N (0. 12. . we constructed the bootstrap sample by randomly resampling from the data values {yt . ˆ 2. ˆ 1.8 Bootstrap for Autoregressions In the non-parametric bootstrap. Method 2: Block Resampling 1. there are two popular methods to implement bootstrap resampling for time-series data.1 MDS CLT. xt }. In particular. The implication is that asymptotic inference is the same. we can apply Theorem 12.. Clearly. T t=1 Since xt et is a MDS. Fix an initial condition (Y−k+1 . eT }. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. as this imposes inappropriate independence.

• Include dummy variables for each season. This is a ﬂexible approach which can extract a wide range of seasonal factors.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .3) replacing St with St . • You can estimate (12.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . That is. (12. • First apply a seasonal diﬀerencing operator. heteroskedasticity.2) (12. and then perform regression (12. 4. also alters the time-series correlations of the data. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. 141 .4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . (12. 12. Seasonal Eﬀects There are three popular methods to deal with seasonal data. But the long-run trend is also eliminated. If s is the number of seasons (typically s = 4 or s = 12). ∆s Yt = Yt − Yt−s . and the way that the data are partitioned into blocks. ρk ). Thus the seasonally adjusted data is a “ﬁltered” series.3) sequentially by OLS.. . For each simulated sample.. The results may be sensitive to the block length. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. ﬁrst estimate (12.. and perhaps this was of relevance. 5.4) by OLS. This procedure is sometimes called Detrending. or the season-to-season change. Resample complete blocks. • Use “seasonally adjusted” data. The series ∆s Yt is clearly free of seasonality. This presumes that “seasonality” does not change over the sample. • You can estimate (12. 3. draw T /m blocks. 6. however.2). Paste the blocks together to create the bootstrap time-series Yt∗ . May not work well in small samples. The seasonal adjustment. This allows for arbitrary stationary serial correlation.2. get the ˆ ˆ residual St .2)-(12. and for modelmisspeciﬁcation.

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

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

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

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

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

t and et is iid N (0. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . (A simple version of this estimator is called Cochrane-Orcutt. t or yt = θyt−1 + x0 β + x0 γ + ut . This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s.2) may be estimated by iterated GLS. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . 1). Let yt = Yjt .3) which is a valid regression model. and Zt be the other variables. general. In this case. Then the single equation takes the form (13. Another interesting fact is that (13. j Often.13. We see that an appropriate. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. You may have heard of the Durbin-Watson test for omitted serial correlation. we are only interested in a single equation out of a VAR system. t t−1 (13. may be tested if desired. Let et = ejt and β = aj . which is called a common factor restriction.2) is a special case of (13.) Since the common factor restriction appears arbitrary. If valid. (13.1) yt = x0 β + et . under the restriction γ = −βθ. 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 . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. direct estimation of (13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. t and xt = This is just a conventional regression. with time series data. This restriction.2) is uncommon in recent applications. the model (13. Suppose that et is an AR(1). which once was very popular. it is convenient to re-deﬁne the variables. and subtract oﬀ the equation once lagged multiplied by θ. 147 . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).4 Single Equation from a VAR Yjt = a0 xt + et . and is still routinely reported by conventional regression packages.2) Take the equation yt = x0 β + et .1). xt−1 ) to the regression. and is typically rejected empirically. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.3). Otherwise it is invalid. 13. This can be done by a Wald test.

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

such that zt = β 0 Yt is I(0). Whether or not the time trend is included. Deﬁnition 13. When β is unknown. Often. but it is useful in the construction of alternative estimators and tests. In some cases. This is not. then Yt is I(0). Suppose that β is known. If r = m. from OLS of Y1t on Y2t . then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. so zt = β 0 Yt is known. The asymptotic distribution was worked out in B. it may be believed that β is known a priori.8. β may not be known. in general. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. Hansen (1992). yet under H1 zt is I(0). We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0.9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak .8 Cointegration The idea of cointegration is due to Granger (1981).1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. For 0 < r < m. Then under H0 zt is I(1). β = (1 − 1)0 . Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . so the ADF critical values are not appropriate. of rank r. and was articulated in detail by Engle and Granger (1987). When the data have time trends. If Yt is cointegrated with a single cointegrating vector (r = 1). In other cases. 149 . For example. Thus Yt = ˆ (Y1t . as ﬁrst shown by Stock (1987). then r = 0. The r vectors in β are called the cointegrating vectors. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . 13. The asymptotic distribution was worked out by Phillips and Ouliaris (1990).13. Under H0 . however. If the series Yt is not cointegrated. m × r. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . if Yt is a pair of interest rates. the asymptotic distribution of the test is aﬀected by the presence of the time trend. Thus H0 can be tested using a univariate ADF test on zt . a good method to estimate β. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. it may be necessary to include a time trend in the estimated cointegrating regression. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Yt is I(1) and cointegrated. If Y = (log(Consumption) log(Income))0 . β is not consistent.

and are similar to the Dickey-Fuller distributions. we typically just normalize one element to equal unity. When r = 1. they are typically called the “Johansen Max and Trace” tests. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. One diﬃculty is that β is not identiﬁed without normalization. If β is known. then estimation is done by “reduced rank regression”. Ω). 1995). As they were discovered by Johansen (1988. In the context of a cointegrated VAR estimated by reduced rank regression. Their asymptotic distributions are non-standard. 150 . it is simple to test for cointegration by testing the rank of Π. this is the MLE of the restricted parameters under the assumption that et is iid N (0. Equivalently. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . 1991. Thus cointegration imposes a restriction upon the parameters of a VAR. When r > 1.9.Theorem 13. These tests are constructed as likelihood ratio (LR) tests. 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 . which is least-squares subject to the stated restriction.1 (Granger Representation Theorem). and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. rank(α) = r. If β is unknown. this does not work.

eliminating the dependence on a parametric distributional assumption. k} • Integer: Y = {0. however. 1} • Multinomial: Y = {0. If. estimation is by MLE.} • Censored: Y = {x : x ≥ 0} The traditional approach to the estimation of limited dependent variable (LDV) models is parametric maximum likelihood. typically assumed to be symmetric about zero. so that F (z) = 1 − F (−z). 1.. 2. the linear probability model does not impose the restriction that 0 ≤ P (Yi | xi ) ≤ 1.1 Binary Choice The dependent variable Yi = {0. 1. Given some regressors xi . 2. A parametric model is constructed. the goal is to describe P (Yi = 1 | xi ) . We will discuss only the ﬁrst (parametric) approach... Even so estimation of a linear probability model is a useful starting point for subsequent analysis. this yields the regression: Yi = x0 β + ei which can be estimated by i OLS.. A major practical issue is construction of the likelihood function. 1}. This represents a Yes/No outcome. . due to time constraints. 14. allowing the construction of the likelihood function. 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. you were to write a thesis involving LDV estimation. A more modern approach is semi-parametric.. i As P (Yi = 1 | xi ) = E (Yi | xi ) . The most common cases are • Binary: Y = {0. However. For the parametric approach. They still constitute the majority of LDV applications. . The two standard choices for F are 151 . as this is the full conditional distribution. you would be advised to consider employing a semi-parametric estimation approach.Chapter 14 Limited Dependent Variables A “limited dependent variable” Y is one which takes a “limited” set of values. The linear probability model speciﬁes that P (Yi = 1 | xi ) = x0 β.

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

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

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

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

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

There are several derivations of the estimator. 15. The motivation is to allow ui to be arbitrary. Condition (15. The goal is to eliminate ui from the estimator.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . and that eit is uncorrelated with xit . An observation is the pair {yit . n. xit } : t = 1. It is a strong assumption.. however. and thus achieve invariance. and most applied researchers try to avoid its use. It is consistent if E (xit ui ) = 0 (15. T .1 Individual-Eﬀects Model The standard panel data speciﬁcation is that there is an individual-speciﬁc eﬀect which enters linearly in the regression yit = x0 β + ui + eit . where the i subscript denotes the individual. then OLS is inconsistent. 157 .. . and have arbitrary correlated with xi ... OLS can be improved upon via a GLS technique...Chapter 15 Panel Data A panel is a set of observations on individuals. or unbalanced : {yit . it The typical maintained assumptions are that the individuals i are mutually independent. OLS appears a poor estimation choice. t = ti . ti . xit }. that eit is iid across individuals and time.. xit } : For i = 1... 15. . This is often believed to be plausible if ui is an omitted variable. .. (15. OLS of yit on xit is called pooled estimation. . and the t subscript denotes time. In either event. n.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions.1) is true. A panel may be balanced : {yit .1) is called the random eﬀects hypothesis. i = 1.. If (15. that ui and eit are independent. collected over time..1) If this condition fails.

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

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

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

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

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

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 + . we need h → 0 but nh → ∞. but at a slower rate than n−1 . σ 2 . Thus for the AMISE to decline with n.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 .Together. The ﬁrst two are determined by the kernel function. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. Gaussian Kernel: hrule = 1.06n−1/5 163 . 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). We can calculate that √ R(φ00 ) = 3/ (8 π) . Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. the rule-of-thumb h can be quite ineﬃcient. but not of n. In practice.2) but replaces R(f 00 ) with σ −5 R(φ00 ). That is. we ﬁnd the reference rules for the three kernel functions introduced earlier. Note that this h declines to zero. We thus say that the optimal bandwidth is of order O(n−1/5 ). 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) . and there is a large and continuing literature on the subject. h must tend to zero. The downside is that if the density is very far from normal. The asymptotically optimal choice given in (16. (16. (16. This choice for h gives an optimal rule when f (x) is ˆ normal.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. Their K values for the three functions introduced in the previous section are given here. Together with the above table. and gives a nearly optimal rule when f (x) is close to normal. R∞ R∞ K σ 2 = −∞ x2 K (x) dx R(K) = −∞ K (x)2 dx K √ Gaussian 1 1/(2 π) Epanechnikov 1/5 1/5 Biweight 1/7 5/7 An obvious diﬃculty is that R(f 00 ) is unknown. where φ is the N (0. ˆ It uses formula (16. how should the bandwidth be selected? This is a diﬃcult problem. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE.1) is an asymptotic approximation to the MSE. but at a very slow rate. and R(f 00 ). That is.2) depends on R(K). 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 .

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

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

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

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

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

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

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

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

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

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

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

A. Let h(y) denote the inverse of g(x). so FY (y) = P (g(X) ≤ y) = 1 − P (X ≥ h(Y )) = 1 − FX (h(Y )) and the density of Y is fY (y) = −fX (h(Y )) We can write these two cases jointly as fY (y) = fX (h(Y )) |J(y)| . dy This is known as the change-of-variables formula.8 Normal and Related Distributions µ 2¶ 1 x . then g(X) ≤ Y if and only if X ≥ h(Y ). and invertible.∞). 1]. that for Y is [0. 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 ). Let Y = g(X) where g(x) : Rk → Rk is one-to-one.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). This same formula (A. If g(x) is an increasing function. but its justiﬁcation requires deeper results from analysis. The Jacobian is ¶ µ ∂ h(y) .10) d h(y). 0 ≤ y ≤ ∞. J(y) = det ∂y 0 Consider the univariate case k = 1.10) shows that fY (y) = exp(−y).A. take the case X ∼ U [0. . φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞.10) holds for k > 1. an exponential density. diﬀerentiable. Here. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). (A. As one example. Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. 1] and Y = − ln(X). dy dy If g(x) is a decreasing function. As the range of X is [0.

The latter has no closed-form solution. 1). 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. and it is conventional to write X ∼ N (µ. y ≥ 0. respectively. Its mean and r variance are µ = r and σ 2 = 2r.11) and is known as the chi-square density with r degrees of freedom. X has density Ã ! (x − µ)2 1 exp − . x ∈ Rk . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 .1 Let X ∼ N (0. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . σ 2 ). This shows that if X is multivariate normal with uncorrelated elements. (A. −∞ < x < ∞. This shows that linear transformations of normals are also normal. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . Theorem A. Ir ) and set Q = X 0 X. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . then by the change-of-variables formula. then Z 0 A−1 Z ∼ χ2 .8.2 If Z ∼ N(0. It is conventional to write X ∼ N (0.This density has all moments ﬁnite. ¢ ¡ 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 . and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). By iterated integration by parts. f (x) = √ 2σ 2 2πσ which is the univariate normal density. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. For x ∈ Rk . exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. then using the change-of-variables formula. q 176 . x ∈ Rk . Σ) and Y = a + BX with B an invertible matrix. Since it is symmetric about zero all odd moments are zero. denoted χ2 .8. Σ). Another useful fact is that if X ∼ N (µ. then Σ = diag{σ 2 } is a diagonal matrix. q × q. then they are mutually independent. The mean and variance of the distribution are µ and σ 2 . A) with A > 0. Theorem A. and it is conventional to write X ∼ N(µ. If Z is standard normal and X = µ + σZ. we can also show that EX 2 = 1 and EX 4 = 3.

For Z ∼ N(0.8. Thus the density of Z 2 is (A.11). The MGF for the density (A.13) is the MGF of the density (A.2. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. which we showed in (A.8.8.13). C −1 AC −10 ) = N (0. Proof of Theorem A. tr has distribution 177 . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Set r Z . q Proof of Theorem A. Iq ). Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. From (A. C −1 CC 0 C −10 ) = N (0.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). 1) and Q ∼ χ2 be independent. (A.3.8. which can be found by applying change-of-variables to the gamma function. 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 .3 Let Z ∼ N (0.1.Theorem A. Using the simple law of iterated expectations. we see that the MGF of Z 2 is (1 − 2t)−1/2 . ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.12) E exp (tQ) = 0 Γ (A. 1). Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.11) 2 with r = 1.

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

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

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

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

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

Let Θ = [a.1 Grid Search Many optimization problems are either one dimensional (m = 1) or involve one-dimensional optimization as a sub-problem (for example. Grid Search. ¯θ(ˆ) − θ¯ method is quite robust but potentially costly. For example NLLS. 183 . B. b] with G gridpoints.. In this context grid search may be employed.. but ˆ is not available in closed form. which is {θ(j) = a + j(b − a)/G : j = 0.Appendix B Numerical Optimization Many econometric estimators are deﬁned by an optimization problem of the form ˆ = argmin Q(θ) θ θ∈Θ (B. which is θ(ˆ) j j θ. The gridsearch method can be reﬁned by a two-step execution. G}. Construct an equally spaced grid on the region [a.. The estimate of ˆ is j 0 ˆ θ (k).. In this case.. where j = argmin0≤j≤G Q(θ(j)). Let k = argmin0≤k≤G Q(θ0 (k)). to ¯ ¯ ˆ¯ ≤ 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... 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. Q(θ) can be computed for given θ.1) where the parameter is θ ∈ Θ ⊂ Rm and the criterion function is Q(θ) : Θ → R. b] with G gridpoints. This j that is. GLS. At each point evaluate the criterion function and ﬁnd the gridpoint which yields the smallest value of the criterion. MLE and GMM estimators take this form. In most cases. which is {θ(j) = a + j(b − a)/G : j = 0. Plots of Q(θ(j)) against θ(j) can help diagnose errors in grid selection. G}. For the second ˆ step deﬁne an equally spaced grid on [θ(ˆ − 1). . G}. a line search). This value θ(ˆ) is the gridpoint estimate of ˆ If the grid is ˆ suﬃciently ﬁne ¯ capture small oscillations in Q(θ). Pick some ε > 0 and set G = (b − a)/ε to be the number of gridpoints. b] be an interval. The disadvantage is that if the function Q(θ) is irregular. Two-Step Grid Search. which is {θ0 (k) = j j ˆ θ θ(ˆ − 1) + 2k(b − a)/G2 : k = 0... . At each point evaluate the criterion function and let j = argmin0≤j≤G Q(θ(j)). the approximation error is bounded by ε. θ(ˆ + 1)] with G gridpoints. . the ﬁrst-step grid may not bracket ˆ θ which thus would be missed. numerical methods are required to θ obtain ˆ 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..2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(θ) . they can be calculated numerically. however. . Another productive modiﬁcation is to add a scalar steplength λi . of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). numerical derivatives can work well but can be computationally costly relative to analytic derivatives. θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive deﬁnite. 2.2 Gradient Methods Gradient Methods are iterative methods which produce a sequence θi : i = 1. numerical derivatives can be quite unstable. One modiﬁcation to prevent this possibility is quadratic hill-climbing which sets ˆi+1 = θi − (H(θi ) + αi Im )−1 g(θi ). In this case the iteration rule takes the form (B. Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation. Allowing the steplength to be a free parameter allows for a line search. To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 . and all require the computation θ. In some cases. Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row). ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available. θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ). Q(θ + δ j ε + δ k ε) − Q(θ + δ k ε) − Q(θ + δ j ε) + Q(θ) ε2 In many cases. 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. Take the j 0 th element of g(θ). Then for ε small gj (θ) ' Similarly. 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. which are designed to converge to ˆ All require the choice of a starting value θ1 .B.

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

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