ECONOMETRICS

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

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

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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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. . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . 9.6 Over-Identification Test . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . .7 Identification Failure . . .8 Exercises . . . . . . . . . . . . . . . . 10. . . . .4 Estimation of the Efficient Weight Matrix . . 11. . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . 9. . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . .9 Bootstrap GMM Inference . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 8. . . . . .10Testing for Omitted Serial Correlation 12. .4 Estimation . . . . . . . . . . . 12.3 Identification . . . . .7 Asymptotic Distribution . . . . . . .11 8. . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . .2 Reduced Form . . Bootstrap Methods for Regression Models Exercises . . . .3 Stationarity of AR(1) Process . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . .6 Bekker Asymptotics . 11. . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . 9. . . . . . . . . . . . . . 12. . . .2 GMM Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . .8 Conditional Moment Restrictions . . . . . . . . . . Symmetric Two-Sided Tests . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentile Confidence Intervals . . . . . . . . . . . . . . . . . 12. . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . iii . . . . . . . 10. . . . . . . . .4 Testing . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . 11. . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . .2 Autoregressions . . . . . 11. . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentified Linear Model . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Estimation . . . . . . . . A. . . . . . . . . . . . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B Numerical Optimization B. . . . . . . . . . . . . . . . . . . . . .7 Granger Causality . . . . . . . . . . . . . . .13 Multivariate Time Series 13. . . . . . . . . . . . . . . . . .4 Sample Selection . . . . . . . . . . . . . . . . . . . . . 13. . . . 159 16 Nonparametrics 160 16. . . . . . . . . . . . .1 Kernel Density Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . . 162 A Probability A. .6 Conditional Distributions and Expectation . . . . . . . . . . . . . . 13. . . . . . . . . . . . .3 Censored Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Random Variables . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . A. . . . . . . . 14. 13. . . . . . . . . . . . . . 14.5 Multivariate Random Variables . . . A.2 Fixed Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . B. . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . .3 Restricted VARs . . . . . . . . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . A. . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . .1 Binary Choice . . . . . . . . . . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic MSE for Kernel Estimates .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . . . . . . . .8 Cointegration . . . . .1 Grid Search . A. . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . .7 Transformations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Foundations . . . . . 160 16.4 Common Distributions . . .4 Single Equation from a VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B. . . . . . . . . . . . . . . . . . . . . . . . .9 Maximum Likelihood . . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . . . . . . . . . . . . iv . . .1 Individual-Effects Model . . . . . . 157 15. . . . . . . .2 Gradient Methods . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . A. . .3 Expectation . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Derivative-Free Methods .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Ideally. The differences between the groups could be attributed to the different levels of education. Applied econometrics concerns the application of these tools to economic data. 1. an experiment might randomly divide children into groups. The individuals surveyed may be persons. households. or corporations. They are distinguished by the dependence structure across observations. Typical examples include macroeconomic aggregates. 1.1 Economic Data An econometric study requires data for analysis. a concern in labor economics is the returns to schooling — the change in earnings induced by increasing a worker’s education. Time-series data is indexed by time. prices and interest rates. We can measure the joint distribution of these variables. as we are not able to manipulate one variable to see the direct effect on the other. and assess the joint dependence. Cross-sectional data sets are characterized by mutually independent observations. For example. and panel. we would use experimental data to answer these questions. holding other variables constant. However. Each individual (person. most economic data is observational. Panel data combines elements of cross-section and time-series. even immoral! Instead. repeated over time. Econometric theory concerns the study and development of tools and methods for applied econometric applications. mandate different levels of education to the different groups. These data sets consist surveys of a set of individuals. The quality of the study will be largely determined by the data available. To measure the returns to schooling.Chapter 1 Introduction Econometrics is the study of estimation and inference for economic models using economic data. experiments such as this are infeasible. what we observe (through data collection) is the level of a person’s education and their wage. and then follow the children’s wage path as they mature and enter the labor force. Another issue of interest is the earnings gap between men and women. timeseries. Surveys are a typical source for cross-sectional data. There are three major types of economic data sets: cross-sectional. To continue the above example. But we cannot infer causality. 1 . household or corporation) is surveyed on multiple occasions.2 Observational Data A common econometric question is to quantify the impact of one set of variables on another variable. This type of data is characterized by serial dependence.

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

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

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

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

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

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

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

• • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . k) . . xk ) be k × 1 and g(x) = g(x1 .. k)). (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2.4) H0 M =H 0 0 with H 0 H = In .. Additionally. k..By the uniqueness of the characteristic roots. For a general k × k matrix A = [aij ] .. 2... .. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . 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 . ⎠ . we can define the determinant as follows.. . xk ) : Rk → R. i Hence they must equal either 0 or 1. . It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2... There are k! such permutations. tr(A) = rank(A). . If A is 2 × 2. ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.. then its determinant is det A = a11 a22 − a12 a21 ... jk ) denote a permutation of (1. we deduce that Λ2 = Λ and λ2 = λi for i = 1. ....7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 . Let π = (j1 .. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. and let επ = +1 if this count is even and επ = −1 if the count is odd.8 Determinant The determinant is defined for square matrices. ..

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

the mean is not necessarily a good summary of the central tendency.1 by the arrows drawn to the x-axis. holding the other variables constant. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. xi ) where yi is a scalar (real-valued) and xi is a vector. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience.22. . the conditioning variable. See Chapter 16. or the covariates.1) xi = ⎜ . gender. Take a closer look at the density functions displayed in Figure 3. ⎟ . (3. The data are from the 2004 Current Population Survey 1 11 . and exists so long as E |yi | < ∞. We call xi alternatively the regressor. and that for women is $20. In the example presented in Figure 3. These are conditional density functions — the density of hourly wages conditional on race.1. Figure 3. m(x) can take any form.1. This is used when the goal is to quantify the impact of one set of variables on another variable. We call yi the dependent variable. education and experience.2) m(x) = E (yi | xi = x) = −∞ In general. These are indicated in Figure 3. the mean wage for men is $27. While it is easy to observe that the two densities are unequal. we can focus on f (y | x) .1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1 displays the density1 of hourly wages for men and women. To illustrate. the conditional density of yi given xi . it is useful to have numerical measures of the difference. You can see that the right tail of then density is much thicker than the left tail.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. The two density curves show the effect of gender on the distribution of wages. xki 3. In this context we partition the observations into the pair (yi .73. When a distribution is skewed. which is a common feature of wage distributions. These are asymmetric (skewed) densities. ⎠ ⎝ .

3. wage regressions typically use log wages as a dependent variable rather than the level of wages.3) White non-military male wage earners with 10-15 years of potential work experience. By construction. The comparison in Figure 3. the solid line displays the conditional expectation of log wages varying with education. For this reason. Figure 3.D.30. The main point to be learned from Figure 3. To illustrate. When the distribution of the control variable is continuous.2 Regression Equation The regression error ei is defined to be the difference between yi and its conditional mean (3. This is a more robust measure of the typical wage gap between men and women than the difference in the untransformed wage means. Of particular interest to graduate students may be the observation that difference between a B.A. The conditional expectation function is close to linear.1 is facilitated by the fact that the control variable (gender) is discrete. Figure 3. 12 .Figure 3. with mean log hourly wages drawn in with the arrows. degree in mean log hourly wages is 0.36. and a Ph.3 displays a scatter plot2 of log wages against education levels. 2 (3.2 shows the density of log hourly wages for the same population. the dashed line is a linear projection approximation which will be discussed in the Section 3.2) evaluated at the observed value of xi : ei = yi − m(xi ). implying an average 36% difference in wage levels.5. Assuming for simplicity that this is the true joint distribution. which implies a 30% average wage difference for this population. then comparisons become more complicated.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. this yields the formula yi = m(xi ) + ei .3 is how the conditional expectation describes an important feature of the conditional distribution. The difference in the log mean wage between men and women is 0.

The remaining parts of the Theorem are left as an exercise.2. 13 .Figure 3. E(ei ) = 0. 3. These equations hold true by definition. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.1 Properties of the regression error ei 1. are often stated jointly as the regression framework. It is important to understand that this is a framework. E (h(xi )ei ) = 0 for any function h (·) . A regression model imposes further restrictions on the joint distribution. 2. because no restrictions have been placed on the joint distribution of the data. To show the first statement. E (ei | xi ) = 0.2: Log Wage Densities Theorem 3. not a model. 4. by the definition of ei and the linearity of conditional expectations. E(xi ei ) = 0. most typically. The equations yi = m(xi ) + ei E (ei | xi ) = 0. restrictions on the permissible class of regression functions m(x).

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

i (3.8) is called the linear regression model.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). ⎝ . xki When m(x) is linear in x. In this case (3. This concept is less helpful than defining heteroskedasticity as the dependence of the conditional variance on the observables xi .4 Linear Regression An important special case of (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element. We call this the “constant” or “intercept”. Thus (3. So while men have higher average wages.1). Notationally. ⎟ β=⎝ . Equation (3. 3.6) as an approximation.1) has been redefined as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.6) (3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .we say that the error ei is homoskedastic.9) 3. its functional form is typically unknown. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. where x1i is the first element of the vector xi defined in (3. 15 . and the linear assumption of the previous section is empirically unlikely to accurate.5. βk ⎛ (3.7) is a k × 1 parameter vector.8) (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. take the conditional wage densities displayed in Figure 3. As an example. we assume that x1i = 1. which we derive in this section.1 and that for women is 10. they are also somewhat more dispersed. ⎠ .5) xi = ⎜ . The conditional standard deviation for men is 12. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . ⎠ . Instead. it is more realistic to view the linear specification (3.1.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . Equivalently. ⎟ .

2 2. α0 E (xi x0 ) α = E (α0 xi )2 > 0. 3.7) is 0= Solving for β we find ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. i 4. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. Therefore. Assumption 3.which is quadratic in β. The best linear predictor is obtained by selecting β to minimize S(β).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 . written E (xi x0 ) > 0.10) It is worth taking the time to understand the notation involved in this expression. The vector (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. Equivalently. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. This occurs when redundant variables are included in xi . In order for β to be uniquely defined. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . It is invertible if and only if it is positive definite. Observe i that for any non-zero α ∈ Rk . otherwise they are distinct. this situation must be excluded.12) This completes the derivation of the linear projection model. E (xi x0 ) is invertible. i which requires that for all non-zero α. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. i (3. Given the definition of β in (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 . Rewriting. Eyi < ∞.5. i (3.10). by “best” we mean the predictor function with lowest mean squared error. The first-order condition for minimization (from Section 2.5. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-definite. xi contains an intercept. x0 β is the best linear predictor for yi .1. The error is i ei = yi − x0 β. i i (3. i 16 . As before.1 1. E (x0 xi ) < ∞.

5. Furthermore.Theorem 3. (3.14). By definition. Equation (3.5.14) Proof. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Since from Theorem 3.1.5. The finite variance Assumptions 3.13) and Assumption 3.1. However.12) and (3.4 guarantees that the solution β exits. Assumption 3. Figure 3. it follows that linear regression is a special case of the projection model.1. E (xi ei ) = 0 and E (ei ) = 0.5. the orthogonality restriction (3.3 ensure that the moments in (3.11) and (3.5.1 are weak.10) and (3.1.11) are well defined. 17 .5.9).1. Assumption 3.4 is required to ensure that β is uniquely defined. Assumption 3. ¥ (3. Let’s compare it with the linear regression model (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.1. For example.12) can be alternatively interpreted as a projection decomposition.1.1.14) holds.1.5.10) are defined.8)-(3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.5. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.5.14) follows from (3.5. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .13) summarize the linear projection model. (3.4 we know that the regression error has the property E (xi ei ) = 0.13) The two equations (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. This means that the equation (3.1 Under Assumption 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.3 are called regularity conditions.1 is employed to guarantee that (3. Since ei is mean zero by (3. Assumption 3.5.2 and 3. Using the definitions (3.13) implies that xi and ei are uncorrelated.2 and 3.1.1.2.

for those over 53 in age). This defect in linear projection can be partially corrected through a careful selection of regressors. A projection of log wages on these two variables can be called a quadratic projection.1.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. Returning to the joint distribution displayed in Figure 3.3. and are discussed in Chapter 11. 18 . Other than the redefinition of the regressor vector. In other cases the two may be quite different.4 we display as well this quadratic projection.12) is defined by projection and the associated coefficient definition (3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. In the example just presented. We illustrate the issue in Figure 3.We have shown that under mild regularity conditions. and under-predicts for the rest. Figure 3.5.12) with the properties listed in Theorem 3. xi ) we can define a linear projection equation (3. In this example it is a much better approximation to the conditional mean than the linear projection.10) may not hold and the implications of Theorem 3. we can augment the regressor vector xi to include both experience and experience2 . However. In this case the linear projection is a poor approximation to the conditional mean.5. In Figure 1. the dashed line is the linear projection of log wages on eduction. Figure 3. Most importantly. In this case (3.5: 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. since the resulting function is quadratic in experience.4 displays the relationship3 between mean log hourly wages and labor market experience. In this example the linear projection is a close approximation to the conditional mean. and the straight dashed line is the linear projection. for any pair (yi . it is important to not misinterpret the generality of this statement. there are no changes in our methods or analysis. These structural models require alternative estimation methods. It over-predicts wages for young and old workers. The linear equation (3. No additional assumptions are required. in many economic models the parameter β may be defined within the model. The solid line is the conditional mean.10).1 may be false. In contrast.

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

Suppose that yi is discrete-valued. If yi = xi β + ei .6 Exercises 1. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. (x − µ)2 − σ 2 Show that Eg (X. yi ). xi ∈ R. 9. then E(x2 ei ) = 0.1 . µx = Exi . True or False.4 .. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Define µy = Eyi . Let X be a random variable with µ = EX and σ 2 = V ar(X). Compute E(yi | xi = x) and V ar(yi | xi = x). True or False. 0 ≤ y ≤ 1. 3. Suppose that Y and X only take the values 0 and 1. 20 . Prove parts 2. s) = 0 if and only if m = µ and s = σ 2 . e−λ λj j! . σ 2 = V ar(yi ) and σ xy = Cov(xi . 3 and 4 of Theorem 3. Are they different? Hint: If P (Y = j) = 5..2.2 Y =1 . µ. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . σ 2 = V ar(xi ). then E(ei | xi ) = 0. Compute 2 the coefficients of the linear projection yi = β 0 + β 1 xi + ei . m. then ei is independent of xi . . True or False. i 8. and E(xi ei ) = 0.3 Find E(Y | X = x). 2.3. taking values only on the non-negative integers. 1. ¡ ¢ 4. and have the following joint probability distribution X=0 X=1 Y =0 . If yi = x0 β + ei . If yi = x0 β + ei and E(ei | xi ) = 0. x 6.1. σ = . 2. Define µ ¶ ¢ ¡ x−µ 2 g x. If yi = x0 β + ei and E(xi ei ) = 0. True or False. i 7. Let xi and yi have the joint density f (x. If yi = xi β + ei . then E(x2 ei ) = 0. Compute the conditional mean m(x) = E (yi | xi = x) . and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . and E(e2 | xi ) = σ 2 . E(Y 2 | X = x) and V ar(Y | X = x). E(ei | xi ) = 0. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. i 10. a constant. xi ∈ R. and E(ei | xi ) = 0. True or False. i 11. j! 0 j = 0. then ei is i i independent of xi .

7 and 4. Observe that (4.2) can be written in the parametric 0 β)) = 0.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4. 4. (4.3) In Sections 4. i It follows that the moment estimator of β replaces the population moments in (4.4) i i=1 i=1 ˆ Another way to derive β is as follows.1) (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i à n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 à n !−1 n X X = xi x0 xi yi . we narrow the focus to the linear regression model. but for most of the chapter we retain the broader focus on the projection model.2) (4.3) writes the projection coefficient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . 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 .8. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .1 Estimation Equation (4. i n i=1 n 21 .

An interpretation of the estimated equation is that each year of education is associated with an 11.4). 0.7% increase in mean wages.37 µ ¶ 1. 4.30 + 0.170 37. These are white male wage earners from the March 2004 Current Population Survey.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.71 = −2. i 22 . with 10-15 years of potential work experience.3.95 xi yi = 42. 30 = .2 Least Squares There is another classic motivation for the estimator (4.14 205.4).40 µ ¶µ ¶ 34.95 42.14 14. 40 2. 40 0.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. excluding military.117 Educationi .14 14.83 ¶−1 µ ¶ .14 205. Define the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. This sample has 988 observations. To illustrate. ¶ 2.117 1 14. consider the data used to generate Figure 3. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.ˆ This is a set of k equations which are linear in β. Let yi be log wages and xi be an intercept and years of education. Then µ ¶ n 1X 2.94 −2.

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

7. These are algebraic results. 24 . It measures the variation in the i “unexplained” part of the regression. Its method of moments estimator is the sample average 1X 2 ei . one implication is that n 1X ei = 0.2: Sum-of-Squared Error Function Contours Equation (4.7) A justification for the latter choice will be provided in Section 4.6) An alternative estimator uses the formula n 1 X 2 s = ei . ˆ n i=1 n Since xi contains a constant. and hold true for all linear regression estimates. 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. ˆ σ = ˆ n 2 i=1 n (4.Figure 4.5) implies that 1X xi ei = 0. The error variance σ 2 = Ee2 is also a parameter of interest. ˆ n−k 2 i=1 (4.

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

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

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

and X2 is the vector of observed regressors. . . Regress Y on X2 . ! Thus the OLS estimator for the slope coefficients is a regression with demeaned data. .9). . 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. .Theorem 4. obtain residuals Y . . In some contexts. ¡ ¢−1 0 ι. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. ˜ 2. ˆ ˜ ˜ ˆ 3.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. In this case.6. . 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) .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. Regress X2 on X1 . but in most cases there is little computational advantage to using the two-step algorithm. obtain residuals X2 . . Rather. ⎟ ⎜ ⎟ ⎜ (4. In this section we derive the small sample conditional mean and variance of the OLS estimator.1 (Frisch-Waugh-Lovell).14) or via the ˆ following algorithm: ˜ 1. By the independence of the observations and (3. the primary use is theoretical.13).8)(3. is the demeaning formula for regression.9). ⎠ ⎝ ⎠ ⎝ . . 30 . A common application of the FWL theorem. 4. observe that ⎞ ⎛ ⎞ ⎛ . . Regress Y on X1 . which you may have seen in an introductory econometrics course. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. the FWL theorem can be used to speed computation. ˆ which are “demeaned”. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 .

σ2 n ⎞ We now calculate the finite sample bias of the method ¡ moments estimator σ 2 for σ 2 .Using (4. and (4.. V ar β | X = X 0 X ⎟ ⎟ ⎟. Then given (4. for any random vector Z define the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 .. . the properties of conditional expectations.. 1 n . . ¡ 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. 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. .. . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. σ 2 } = ⎜ . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. and ³ ´ ¡ ¢−1 2 ˆ σ .20) . Next. 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 = 0.12). . . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . ⎠ (4. under the of ˆ ¢ 2 | x = σ 2 . ⎝ . . X 0 DX = X 0 Xσ 2 .19) ˆ and thus the OLS estimator β is unbiased for β. .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . and the trace operator observe that. σ 2 = σ 2 and we have the simplii fications D = In σ 2 .8).18). From (4. 0 0 ··· 0 0 .

What is the best choice of A? The Gauss-Markov theorem. which is (3. which we now present.8)¢ ¡ (3. Theorem 4.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. the estimator ˆ 2 defined (4.1 Gauss-Markov. ³ ´ ˜ E β | X = A0 Xβ.9) plus E e2 | xi = σ 2 . known as the Gauss-Markov theorem. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. ˜ so β is unbiased if (and only if) A0 X = Ik . says that the least-squares estimator is the best choice. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. however. By a calculation similar to those of the previous section. = σ2 n the final equality by (4.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . In the homoskedastic linear regression model. Thus since V ar (e | X) = In σ 2 under homoskedasticity. is a famous statement of the solution. 4. Thus σ 2 is biased towards zero. 32 . The following result. Now consider the class of estimators of β which are linear functions of i the vector Y. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. as it yields the smallest variance among all unbiased linear estimators. the best (minimumvariance) unbiased linear estimator is OLS. It is not unbiased in the absence of homoskedasticity. we can write The “best” linear estimator is obtained by finding the matrix A for which this variance is the smallest in the positive definite sense. It is important to remember. or in the projection model.8. In this case. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 .7) is unbiased for σ 2 by this calculation. This is the justification for the common s ˆ preference of s2 over σ 2 in empirical practice. As an alternative. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .10).

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

Let the regressors be partitioned as Suppose we are interested in the coefficient on x1i alone in the regression of yi on the full set xi .1. He observes that the above argument holds for all multinomial distributions.10 Omitted Variables xi = µ x1i x2i ¶ . and thus so is the OLS estimator.5. He proves that generically the OLS estimator (4. if the data have a discrete distribution.10) for the class of models satisfying Assumption 3.4) is an asymptotically efficient estimator for the parameter β defined in (3. (4.Substituting in the expressions for π j . 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.22) 34 . Since this is a regular parametric model the MLE is asymptotically efficient (see Appendix A. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . Chamberlain (1987) extends this argument to the case of continuously-distributed data. the maximum likelihood estimator is identical to the OLS estimator.9).

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

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

then this observation is a leverage point and has the potential to be an influential observation. Investigations into the presence of influential observations can plot the values of (4. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .1) in Section 2. ˆ We now derive equation (4. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .27).This implies has a large value of hi . The key is equation (2.25).4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . which is considerably more informative than plots of the uncorrected residuals ei .

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

then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. Jensen’s Inequality. then g(E(X)) ≤ E(g(X)). then (5. If g(·) : R → R is convex. Cauchy-Schwarz Inequality. 41 . If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . ij i=1 j=1 (5.2) + 1 q = 1. Triangle inequality |X + Y | ≤ |X| + |Y | . The Euclidean norm of an m × 1 vector a is à m !1/2 X ¡ 0 ¢1/2 = a2 .1 Inequalities Asymptotic theory is based on a set of approximations. |a| = a a i i=1 If A is a m × n matrix. We list here some of the most critical definitions and inequalities. 5.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. These approximations are bounded through the use of mathematical inequalities.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality.1) (5.

This is a probabilistic way of generalizing the mathematical definition of a limit. So for all x. ¥ Proof of Holder’s Inequality. Let a + bx be the tangent line to g(x) at x = EX. If Xi ∈ Rk is iid and E |Xi | < ∞. 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}. n→∞ lim P (|Zn − Z| > δ) = 0. (5. Set Y = g(X) and let f denote the density function of Y. We say that Zn converges in probability to Z as n → ∞.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector.3). Since g(x) is convex. Applying expectations.1 Weak Law of Large Numbers (WLLN).Markov’s Inequality. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. The WLLN shows that sample averages converge in probability to the population average. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . ¥ 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 ) = + . g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. P (g(X) > α) ≤ α−1 Eg(X). as stated. =E U V p q p q Proof of Markov’s Inequality. Eg(X) ≥ a + bEX = g(EX). n i=1 42 . p p p q which is (5.4) Proof of Jensen’s Inequality. Note EU = EV = 1. if for all δ > 0. Theorem 5. denoted Zn →p Z as n → ∞. tangent lines lie below it. For any strictly increasing function g(X) ≥ 0.2.

¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Finally. denoted Zn →d Z. where Z has distribution F (x) = P (Z ≤ x) .7) the final inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. If Xi ∈ Rk is iid and E |Xi |2 < ∞. the fact that X n = W n + Z n . V ) . n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . (5. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. we can set E(X) = 0 (by recentering Xi on its expectation).3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . Define the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. 5.6) and (5. 43 .Proof: Without loss of generality.1) and (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. Fn (x) → F (x) as n → ∞. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .6) By Jensen’s inequality (5. and the bound |Wi | ≤ 2C.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞.4).1 Central Limit Theorem (CLT). We say that Zn converges in distribution to Z as n → ∞.1). by Markov’s inequality (5. the triangle inequality. P ¯X n ¯ > δ ≤ δ δ δ the equality by the definition of ε.5). Theorem 5.3. the fact that the Wi are iid and mean zero. Jensen’s inequality (5.7). Set ε = δη/3. if for all x at which F (x) is continuous. Fix δ and η. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. as needed. P ¯X n ¯ > δ ≤ η. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.

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

Stacking across elements of g. Σ) = N 0.4. for each element of g. √ Theorem 5.4. Hence g(Zn ) →p g(c) as n → ∞. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).1 Continuous Mapping Theorem 1 (CMT). then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Proof: Since g is continuous at c.√ where λn → 0 lies on the line segment joining 0 and λ/ n. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. k ≤ m. Recall that A ⊂ B implies P (A) ≤ P (B). Proof : By a vector Taylor series expansion. gθ Σgθ . we see that as n → ∞. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 . Ik ) distribution. for all ε > 0 we can find a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. If Zn →p c as n → ∞ and g (·) is continuous at c. Σ) . 45 . then g(Zn ) →p g(c) as n → ∞. and g(θ) : Rm → Rk . ¥ 5.2 Continuous Mapping Theorem 2.3 Delta Method: If n (θn − θ0 ) →d N (0.4. where θ is m × 1 and Σ is m × m. This is sufficient to establish the theorem. then g(Zn ) →d g(Z) as n → ∞.4 Asymptotic Transformations Theorem 5. If Zn →d Z as n → ∞ and g (·) is continuous. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Since cλλ (λn ) → cλλ (0) = −Ik . Theorem 5. we find jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.

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

(6.2) i i n i=1 n From (6.4. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 . First.1 and the WLLN (Theorem 5.5.1. using (6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. To characterize the sampling distribution more fully. ˆ 47 . ˆ Theorem 6.1) and ˆ We now deduce the consistency of β.1 by the fact that the sampling densities become more concentrated as n gets larger.2 Consistency ˆ As discussed in Section 6. xi ei →p g (Q. and the continuous mapping theorem (Theorem 5. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. 6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.5. This is illustrated in Figure 6.4.1. Hence by the continuous mapping theorem (Theorem 5.2.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to infinity. Ã n ! n X 1X 0 1 ˆ xi xi . we will use the methods of asymptotic approximation.2.2). 0). we can conclude ˆ that β →p β. As the sample size increases the density becomes more concentrated about the population coefficient. Proof. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1). (6.5. n i=1 (6. ·) is continuous at (Q.1). Assumption 3.1). b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.1 Under Assumption 3.1).4 implies that Q−1 exists and thus g(·. Equation (4. For a complete argument.3). the OLS estimator β is has a statistical distribution which is unknown. β →p β as n → ∞.3) Ã where g(A.From the figure we can see that the density functions are dispersed and highly non-normal.1. (6. Assumption 3.

n 1 X √ xi ei →d N (0. Ω) .Theorem 6. We need a strengthening of the moment conditions. ˆ n−k 6.3) and Theorem (6.3. it follows that s2 = ¥ n σ 2 →p σ 2 .3. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.5. Ee4 < ∞ and E |xi |4 < ∞. ˆ Proof. (6.2 Under Assumption 3.1).1 In addition to Assumption 3. since n/(n − k) → 1 as n → ∞. (6. (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 à ! à 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.1. i i Assumption 6.1. E ¯ei ¯ E ¯e4 ¯ i i i i (6.1 guarantees that the elements of Ω are finite. i Now define ¡ ¢ Ω = E xi x0 e2 . by the Cauchy-Schwarz inequality (5.2. ˆ Finally. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. To see this.5.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.2). Thus σ 2 is consistent for σ 2 .1).6) n i=1 48 . ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.2). Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . By the central limit theorem (Theorem 5. Assumption 6.2.3.

i i Condition (6.1. there is no simple answer to this reasonable question.7) Cov(xi x0 . The approximation may be poor when n is small. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.3. In´Figure 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. V ) where V = Q−1 ΩQ−1 . (6. for any ˆ fixed n the sampling distribution of β can be arbitrarily far from the normal distribution.6). When (6.3.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. e2 ) = 0.1 Under Assumption 6.9) we define V 0 = Q−1 σ 2 whether (6. is approximately normal when the sample size n is sufficiently large.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. otherwise V 6= V 0 .3. Ω) ¡ ¢ = N 0. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). 1). In Figure 6. ´ √ ³ ˆ n β−β = à 1X xi x0 i n i=1 n !−1 à Theorem 6.7) is true or false. however. when xi and ei are independent.1.7) is true then V = V 0 . We call V 0 the homoskedastic covariance matrix. The asymptotic distribution ´ Theorem 6. This holds true for all joint distibutions of (yi .1 is commonly used to approximate the finite of √ ³ˆ sample distribution of n β − β .3.7) holds. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.9) In (6. its variance diverges q ³ ´ ˆ to infinity. However. We illustrate this problem using a simulation. and (6. How large should n be in order for the approximation to be useful? Unfortunately. 1) asymptotic distibution.2). V is often referred to as ˆ the asymptotic covariance matrix of β. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. 1 X √ xi ei n i=1 n ! the N (0.1 states that the sampling distribution of the least-squares estimator. Theorem 6. Q−1 ΩQ−1 . We say that ei is a Homoskedastic Projection Error when (6. There is a special case where Ω and V simplify. for example. As α approaches 2. The expression V = Q−1 ΩQ−1 is called a sandwich form. For α 49 . Let yi = β 0 + β 1 xi + εi where xi is N (0.1). after rescaling. setting n = 100 and varying the parameter α.3.Then using (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .2 we display the finite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . The trouble is that no matter how large is the sample size. Under (6. but this is not a necessary condition. xi ) which satisfy the conditions of Assumption 6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . |ε| ≥ 1.

4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 1) density.2) and Theorem 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . we need an estimate of Ω = E xi x0 e2 . The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. As k increases. The estimator 2 2 in (6.3 is that the N (0. the sampling distribution becomes highly skewed and non-normal. 4.2 and 6. 6 and 8.Figure 6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.2.0 the density is very close to the N (0. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. 1) asymptotic approximation is never guaranteed to be accurate. Another example is shown in Figure 6. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. The lesson from Figures 6.11) 50 . 6.3.10) without changing this result. for k = 1. 1). We show the sampling distribution of n β 1 − β 1 setting n = 100. concentrating most of the probability mass around zero.1) it is clear that V 0 →p V 0 .10) V 0 = Q−1 s2 .2: Density of Normalized OLS estimator α = 3. As α diminishes the density changes significantly.

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

117 Educationi .2.1.14 14. Using (6.80 2.14 14.80 40.83 −0.085) (. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. but not under another set of assumptions. then take the diagonal elements.039 and ˆ V = µ 1 14. To illustrate.83 ¶−1 µ .2/988 = . i i i i n i=1 Second.80 .020) 6. First.5) and the WLLN (Theorem 5.80 40. the standard method to calculate the standard errors is to ˆ first calculate n−1 V .14 205. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . we return to the log wage regression of Section 4. The standard errors for β 0 are 7. p ˆ In this case the two estimates are quite similar.480 .30 + 0.4) 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 .14 205.480 ˆ0 = 0.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. (6.used by an author when studying their work. by Holder’s inequality (5.20 and µ ¶ ˆ = 0. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.14 205. and then the square roots.493 0. Ω 2.199 2.199 2. (6.20 −0.98 −0.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.6 ¶µ 1 14.14 6. just as any other estimator.12) in turn.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. n n i=1 52 .83 ¶−1 = µ 7.020. from which it follows that V →p V as n → ∞.493 −0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. (. We calculate that s2 = 0.035 ¶ .35/988 = . From a computational standpoint.085 p ˆ and that for β 1 is .20 = V 14.

Recall from Section 4. ¯ 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. is defined ˆ ˆ by replacing the OLS residual ei in (6. which.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .26). From equation (3.−i = (1 − hi )−1 ei ˆ presented in (4. Using this substitution.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.25). these establish consistency. n i=1 n ˆ ˆ Theorem 6. 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 (6.12 the definition of β (−i) as the least-squares estimator with the i’th observation deleted. you can show that 1 Xˆ ¯ β= β (−i) . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .1 As n → ∞. ¯ ¯n ¯ n i=1 so Together. i=1 Third. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .5. by the WLLN ¯ n ¯ à n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. Andrews (1991) suggested an similar estimator based on cross-validation. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.13) Using formula (4. 6. 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. Ω →p Ω and V →p V.13) of Efron (1982).11) with the leave-one-out estimator ei.14) à 1X (1 − hi )−1 xi ei ˆ n i=1 n !à 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi .

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

8. In this case.8 t tests Let θ = h(β) : Rk → R be any parameter of interest.For example.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. θ) β 6. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . and is therefore exactly free of unknowns. s(ˆ = n−1/2 H 0 V Hβ . see Section X). however. Since the standard normal distribution does not depend on the parameters. and θ = h(β) is some function of the parameter vector. In special cases (such as the normal regression model. (For example. Vθ ) √ Vθ = N (0.1 tn (θ) →d N (0. we say that tn is an exactly pivotal statistic. if R is a “selector matrix” R= so that if β = (β 1 . the standard error for ˆ is the square root of n−1 Vθ . µ I 0 ¶ ˆ the upper-left block of V . 55 . ˆ When q = 1q h(β) is real-valued). pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. β 2 ). ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. By (6. that (so θ ˆ ˆ ˆ is. s(ˆ θ) (6. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-specified value. Consider the studentized statistic tn (θ) = Theorem 6. we say that tn (θ) is asymptotically pivotal. 1) Proof.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. θ could be a single element of β). the statistic tn has an exact t distribution. In general. 1) →d ˆ−θ θ .

is to report an asymptotic p-value. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. z. 1). so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . Either θ ∈ Cn or θ ∈ Cn . That is. Let zα/2 is the upper α/2 quantile of the standard normal distribution. 1). Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. associated with Fisher.025 = 1. in that the reader is allowed to pick the level of significance α. For example. 1].05 = 1. regardless of the complication of the distribution of the original test statistic. To see this fact. under H0 . If the p-value pn is small (close to zero) then the evidence against H0 is strong. In a sense. The coverage probability is P (θ ∈ Cn ). however. s(ˆ θ) Under H0 . tn →d N (0. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . Define the tail probability. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. 1]. The p-value is more general.96 and z. or “accepts” H0 .9 Confidence Intervals A confidence interval Cn is an interval estimate of θ. Otherwise the test does not reject. An alternative approach. The asymptotic p-value for the above statistic is constructed as follows. 1]. 6. from which it follows that pn →d U [0. That is. pn →d U [0. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. Then the asymptotic p-value of the statistic tn is pn = p(tn ). if Z ∼ N (0.645. It is designed to cover θ with high probability. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. A test of asymptotic significance α rejects H0 if |tn | > zα/2 . 56 . then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. and is a function of the data and hence is / random.

While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. A good method for construction of a confidence interval is the collection of parameter values which are not rejected by a statistical test. In this case the t-statistic approach does not work. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. ˆ + zα/2 s(ˆ . The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. = n h(β) − θ0 Hβ V Hβ 57 (6. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. 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).10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. and it is desired to test the joint restrictions simultaneously. This corresponds to selecting the confidence h i h ˆ ± 1. θ θ) (6.96s(ˆ ≈ ˆ ± 2s(ˆ .17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% confidence interval. the most common professional choice isi95%. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . A confidence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ).We typically cannot calculate the exact coverage probability P (θ ∈ Cn ).05. 6. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . or α = . θ The interval has been constructed so that as n → ∞.18) .16) and zα/2 is the upper α/2 quantile of the standard normal distribution.

Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. the upper-α quantile q 2 of the χ2 distribution. For example.1 showed θ ˆ that V →p V. Hence β β by Theorem A. and Theorem 6. Vθ ). then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. Also h(β) = a selector matrix.When h is a linear function of β. θ = β 2 . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. The null hypothesis is H0 : β 2 = 0.05) = 3.8.15) showed that n ˆ − θ →d Z ∼ N (0.10. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).2. The asymptotic p-value for Wn is pn = p(Wn ). 1] under H0 . 6. In this case.1.84 = z. the test rejects at the α% level iff pn < α. ˆ Wn = n θ θ q θ θ Theorem 6. then Wn →d χ2 . Hβ (β) →p Hβ .3. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 .5. Hβ (β) is a continuous function of β. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. As before. and there are q = k2 restrictions. ˜˜ n ˜ e = Y − X1 β 1 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. a chiq square random variable with q degrees of freedom. 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. Furthermore. q and pn is asymptotically U[0. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .1 Under H0 and Assumption 6. h(β) = R0 β.19) σ2 ˆ where σ2 = ˜ 1 0 e e. χ2 (. if rank(Hβ ) = q.025 .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 . 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.

19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.19) the F form of the Wald statistic. 2 2 2 or alternatively.19) is that it is directly computable from the standard output from two simple OLS regressions. This statistic is typically reported as an “F-statistic” which is defined as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn .19). as the sum of squared errors is a typical output from statistical packages. Thus ˜ ˆ e=X ˜ ˆ 2 ³ ´0 ³ ´ ˜ ˆ ˜ ˆ e0 e = X2 β 2 + e ˜˜ ˆ ˆ X2 β 2 + e ˆ0 ˜ 0 ˜ ˆ = β 2 X2 X2 β 2 + e0 e ˆˆ 0 0 ˆ ˆ ˆˆ = β X M1 X2 β + e0 e.2) ¢−1 ¡ R = R0 R X 0X 0 µ 0 0 X1 X1 X1 X2 0X 0 X2 1 X2 X2 ¶−1 0 0 where M1 = I − X1 (X1 X1 )−1 X1 . The elegant feature about (6. 2 σ ˆ To simplify this expression further. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. First. note that if we regress Y on X1 alone. By the FWL theorem. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . still this formula often finds good use in reading applied papers. the residual is ˜ ˜ e = M1 Y. Because of this connection we call (6.are from OLS of Y on X1 . 59 . ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. 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 . and σ2 = ˆ 1 0 e e. Also. We now derive expression (6. Now consider the residual regression of e on X2 = M1 X2 . X2 ). ˆˆ n ˆ e = Y − X β. note that partitioned matrix inversion (2.

there is an exact distribution theory available for the normal linear regression model. In particular. equivalently the residual variance from an intercept-only model.where In many statistical packages. In ) . While there are special cases where this F statistic is useful. H 0 H) ∼ N (0.12 Normal Regression Model As an alternative to asymptotic distribution theory. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. an “F statistic” is reported. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . 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 linear functions of normals are also normal. these cases are atypical. The modelling assumption that the error ei is independent of xi and N (0. This is rarely an issue today. σ 2 ) can be be used to calculate a set of exact distribution results. 6.4)) where H 0 H = In . This was a popular statistic in the early days of econometric reporting. n−k 60 . introduced in Section 4. Let u = σ −1 H 0 e ∼ N (0. including the estimated error variance 2.3. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . Since uncorrelated normal variables are independent. This special F statistic is testing the hypothesis that all slope coefficients (other than the intercept) are zero. as sample sizes are typically sufficiently large that this F statistic is highly “significant”. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. In σ 2 . it follows ˆ that β is independent of any function of the OLS residuals. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . when an OLS regression is reported.

a chi-square distribution with n − k degrees of freedom. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. 0.10) then ´ ³ ˆ • β ∼ N 0. which is twice the difference in the log-likelihood function evaluated under the null and alternative hypotheses. β and t are approximately normally distributed. 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. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .1 we showed that in large samples. β has an exact normal distribution and t has an exact t distribution. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .8. β 2 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . β 2 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ 2 ) discussed above. β 2 . the notable distinction is between the N (0. n−k • ∼ tn−k ˆ In Theorem 6. and standard errors are calculated using the homoskedastic formula (6. σ 2 ). The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 .12. σ 2 ) − Ln (β 1 . σ ˆ ˆ βj − βj βj − βj N (0. 1) and tn−k distributions. In contrast.1 If ei is independent of xi and distributed N(0. with residual variance σ .10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ) = − log σ − log (2π) − . The critical values are quite close if n − k ≥ 30. (Unless the sample size is unreasonably small.12. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .3. so as a practical matter it does not matter which distribution is used. a good testing procedure is based on the likelihood ratio statistic. We summarize these findings Theorem 6. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 .) Now let us partition β = (β 1 . 0. σ2 ˆ 61 . Theorem 6. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.1 and Theorem 6. As inference (confidence intervals) are based on the t-ratio. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . if standard errors are calculated using the homoskedastic formula (6. Furthermore. 0.1 shows that under the strong assumption of ˆ normality.

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

05) with deviations indicating+ distortion. remember that the ideal Type I error probability is 5% (. Each row of the table corresponds to a different value of s — and thus corresponds to a particular choice of test statistic. Typically. Table 4.84 | β = 1) . the Type I error probability improves towards 5% as the sample size n increases.1 you can also see the impact of variation in sample size. this probability depends only on s. For this particular example. Error rates avove 10% are considered excessive. Test performance deteriorates as s increases.84. The second through seventh columns contain the Type I error probabilities for different combinations of n and σ. so these probabilities are Type I error. and σ is varied among 1 and 3.1 reports the simulation estimate of the Type I error probability from 50. the only test which meets this criterion is the conventional Wn = Wn (1) test.4: Wald Statistic as a function of s P (Wn (s) > 3. Any other choice of s leads to a test with unacceptable Type I error probabilities.000 simulated Wald statistics Wn (s) which are larger than 3. and rarely fall outside of the 3%-8% range.1 we report the results of a Monte Carlo simulation where we vary these three parameters. In each case. n. 100 and 500. The null hypothesis β s = 1 is true. In Table 2. In Table 4. There is.000 random samples. Table 4. Given the simplicity of the model. Type I error rates between 3% and 8% are considered reasonable. These probabilities are calculated as the percentage of the 50. and σ 2 . Rates above 20% are unexceptable. however. The value of s is varied from 1 to 10. To interpret the table.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .4. we compare the rates row by row.Figure 6. n is varied among 20. looking for tests for which rate rejection rates are close to 5%. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. no magic choice of n for which all tests perform uniformly well. When comparing statistical procedures.

This point can be illustrated through another example.06 .05 .08 .18 .08 .20 .13 .28 .06 .13 .17 .07 . β 2 ) be the least-squares estimates of (6.10 .05 .33 . β 1 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .14 .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 .21 .22 .05 .10 .15 .06 .16 Rejection frequencies from 50.25 .34 . 64 .24 .06 .11 .09 .13 .25 .08 . so the hypothesis can be stated as H0 : θ = r.15 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. Other choices are arbitrary and would not be used in practice.20). In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.14 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at first.06 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .12 .10 .26 .07 .15 .06 .19 .30 .08 .06 .08 . 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. define θ = β 1 /β 2 .07 .15 . Define θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .05 .23 .06 .31 .07 .07 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . While this is clear in this particular example.22 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. Equivalently.05 .05 .20 .35 .12 .

1) variables.05 .00 .05 . In this section we describe the method in more detail. then the “most linear” formulation should be selected. The results are presented in Table 4.06 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .28 .645) P (tn > 1.00 .00 .06 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.645) are close to zero in most cases. and 1.06 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .47 . This leaves β 2 as a free parameter.05 .00 .06 .05 . along with sample size n. the entries in the table should be 0. .15 .645) are calculated from 50.10 .645) t1n t2n t1n t2n t1n t2n t1n t2n . We let x1i and x2i be mutually independent N (0.00 .05 .10 . . the rejection rates for the t1n statistic diverge greatly from this value.00 . If no linear formulation is feasible. while the right tail probabilities P (t1n > 1.12 .00 . especially for small values of β 2 .06 . and alternatives to asymptotic critical values should be considered. this formulation should be used. and normalize β 0 = 0 and β 1 = 1.00 .0 and n among 100 and 500. σ 2 ) draw with σ = 3.09 .50 .645) and P (tn > 1.25 .07 .000 simulated samples.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. such as the GMM distance statistic which will be presented in Section 9. It is also prudent to consider alternative tests to the Wald statistic. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. ei be an independent N (0. In contrast.75 1. In all cases.645) P (tn > 1. Ideally. The implication of Table 4.00 .00 The one-sided Type I error probabilities P (tn < −1. 6. We vary β 2 among .05 .05 . 65 .05 .06 . and are close to the ideal 5% rate for both sample sizes. However.645) greatly exceed 5%.02 .645) P (tn < −1.06 .26 .2 is that the two t-ratios have dramatically different sampling behavior.50. if the hypothesis can be expressed as a linear restriction on the model parameters. The left tail probabilities P (t1n < −1. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . .06 .06 .05 β2 .05.25.05 .06 .2. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.1.75.10 . Table 4.15 .7.

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

where N = (B +1)α. Quite simply. and non-white. Again our dependent variable is the natural log of wages. potential work experience. excluding military. The α% sample quantile is a number qα such that α% of the sample are less than qα . Furthermore. As P is unknown. Hence the ³ ´ ˆ standard errors for B = 100. We separately estimate equations for white and non-whites. and our regressors include years of education. We us the sample of wage earners from the March 2004 Current Population Survey. if we set B = 999. For regressors we include years of education.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. B. The random variable 1 (Tnb ≥ 1. For example. and poorly for others.95) /B ' . union member. Generally. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. are. union member. a larger B results in more precise estimates of the features of interest of Gn . and 5000. respectively. We now expand the sample all non-military wage earners.96) is iid Bernoulli. for a selection of choices of n and F. It is therefore convenient to pick B so that N is an integer. B b=1 (6. but requires more computational time. 6. s P = .Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. For the dependent variable we use the natural log of wages. and therefore it is straightforward to calculate standard errors for any quantity of interest.05) (. and 90% sample quantiles of the sample {Tnb }. immigrant.022. equalling 1 with probability P = E1 (Tnb ≥ 1. and estimate a multivariate regression. female.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. the choice of B is often guided by the computational demands of the statistical procedure. It is therefore useful to conduct a variety of experiments. and dummy variable indicators for the following: married. this may ˆ be approximated by replacing P with P or with an hypothesized value. and .96) .15 Estimating a Wage Equation We again return to our wage equation. In practice. experience squared. experience squared. As discussed above. In many cases. so that coefficients may be interpreted as semi-elasticities. an estimator or test may perform wonderfully for some values. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. The average (6. the performance will depend on n and F. then B will have to be increased. female. we included a dummy 67 . then we can set s P = (. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. 1000.003.21). For example. In particular. potential work experience. hispanic. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. the researcher must select the number of experiments. immigrant. such as the percentage estimate reported in (6.22/ B. Often this is called the number of replications. and hispanic.96) . then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. therefore. If the standard error is too large to make a reliable inference. Then qα is the N ’th number in this ordered sequence. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. .007. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. and dummy variable indicators for the following: married. it is simple to make inferences about rejection probabilities from statistical tests.

The F form of the Wald statistic (6.010 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. 2β 3 68 .102 −.232 .variable for state of residence (including the District of Columbia.4945.002 . but not equal.007 .48772 = 515.1 we find the point estimate ˆ ˆ = − β 2 = 28.027 . Computing the Wald statistic (6.101 . reestimating the model with the 50 state dummies excluded. θ ˆ 2β 3 β2 . Wn = n 1 − 2 = 18.00057 .00002 .102 −.49452 σ ˜ Notice that the two statistics are close. excluding the coefficients on the state dummy variables.18) that the state coefficients are jointly zero.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. we can write this effect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model.808 .69. The available sample is 18. Using either statistic the hypothesis is easily rejected.032 .033 −. 808 1 − .001 .070 . Ignoring the other coefficients. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.014 . Alternatively.097 −.010 . Table 4.1.19) is ˜ µ ¶ µ ¶ σ2 ˆ . as the 1% critical value for the χ2 distribution is 76. the restricted standard deviation estimate is σ = .4877 18. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.34 ˆ s(β) .008 .808 so the parameter estimates are quite precise and reported in Table 4.013 . this adds 50 regressors). we find Wn = 550.121 −.

96. not testing a hypothesis. Instead. In the present context we are interested in forming a confidence interval. there is not a simple expression for this set. Since tn (θ) is a non-linear function of θ. This is the set of θ such that |tn (θ)| ≤ 1. implying a 95% confidence θ) interval of [27. In the previous section we discovered that such t-tests had very poor Type I error rates.0.5]. we can calculate a standard error of s(ˆ = .Using the Delta Method. Our desired confidence interval will be the set of parameter values θ which are not rejected by the hypothesis test. This set is [27. 69 . 29. However. but it can be found numerically quite easily. this is a poor choice. 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 ). 29.5].9. we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further. but the lower end is substantially lower. as the coverage probability of this confidence interval is one minus the Type I error of the hypothesis test based on the t-test.40. Notice that the upper end of the confidence interval is the same as that from the delta method.

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

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

Since there is not a unique specification for the conditional variance the FGLS estimator is not unique. which is typically undesirable. We may call (7.. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . If σ 2 < 0 for some i... then the FGLS estimator will force ˜i the regression equation through the point (yi . if σ 2 ≈ 0 for some i. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i specification. then the FGLS ˜i estimator is not well defined.4) the skedastic regression. or FGLS. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Vα ) (7.6) σ 2 = α0 zi . Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi . . and will depend on the model (and estimation method) for the skedastic regression. This suggests 75 . Then set ˜i ˜ D = diag{˜ 2 . ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. 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. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β).4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. there is no guarantee that σ 2 > 0 for all i. Furthermore. ˜i Suppose that σ 2 > 0 for all i.3) ˆ ˆ While ei is not observed. This is the feasible GLS. as it is estimating the conditional variance of the regression of yi on xi . xi ). We have shown that α is consistently estimated by a simple procedure. estimator of β. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. Vα = E zi zi (7.Suppose ei (and thus η i ) were observed.

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

and all cross-products. but also under the assumptions of linear projection. Typically. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0.2. It is consistent not only in the regression model. This hypothesis does not imply that ξ i is independent of xi . White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . The main differences between popular “tests” is which transformations of xi enter zi .5) and the asymptotic variance (7.1 Under H0 and ei independent of xi .4). We may therefore test this hypothesis by the estimation (7.error.3) for α simplifies to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . individual estimated conditional variances may be negative. and the cost is a reduction of robustness to misspecificatio 7. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7.7) under independence show that this test has an asymptotic chi-square distribution.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . require the assumption of a correct conditional mean.2). or equivalently that i H0 : α1 = 0 in the regression (7. In this case. This introduces an element of arbitrariness which is unsettling to empirical researchers. The GLS and FGLS estimators. then the OLS and FGLS estimators will converge in probability to different limits. the estimated conditional variances may contain more noise than information about the true conditional variances. on the other hand. Third. FGLS will do worse than OLS in practice. but the only difference is that they a ¢ allowed for general choice of zi . Second. OLS is a more robust estimator of the parameter vector. its squares. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . q Most tests for heteroskedasticity take this basic form. as they will be estimating two different projections. If i this simplification is replaced by the standard formula (under independence of the error). the Wald test of H0 is asymptotically χ2 .3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. The point is that the efficiency gains from FGLS are built on the stronger assumption of a correct conditional mean. Vα = E zi zi (7. however. Theorem 7. and this requires trimming to solve. In the linear regression model the conditional mean of yi given xi = x is 77 . and not a conditional mean. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. The asymptotic distribution (7. the two tests coincide. 7. If the equation of interest is a linear projection. σ 2 ).4) and constructing a Wald statistic.

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

θ) is suggested by an economic model. it is adopted as a flexible approximation to an unknown regression function. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. we call this the nonlinear least squares (NLLS) θ). V ) θ where mθi = mθ (xi . When m(x. θ) is (generically) differentiable in the parameters θ. which alters some of the analysis. θ) = θ1 + θ2 xθ3 m(x. θi 79 . θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. When the regression function is nonlinear.Examples of nonlinear regression functions include x 1 + θ3 x m(x. First. let ∂ m(x. θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. The NLLS residuals are ei = yi − m(xi . ˆ ˆ One motivation for the choice of NLLS as the estimation method is that the parameter θ is the solution to the population problem minθ E (yi − m(xi . In other cases. then the FOC for minimization are 0= n X i=1 mθ (xi . θ0 ). The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . θ) = θ1 + θ2 exp(θ3 x) m(x. mθ (x. Since ˆ →p θ0 . θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the first five examples. ˆ must be found by numerical θ methods. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x.8) Theorem 7. This can be done using arguments θ for optimization estimators. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . estimator. G known x2 − θ5 m(x. m is not differentiable with respect to θ3 . θ) = G(x0 θ). it must be shown that ˆ →p θ0 . ˆ is close to θ θ θ0 for n large. θ)ˆ (7.4. θ) is differentiable with respect to θ. m(x. When it exists.1 If the model is identified and m(x. θ))2 . θ) = θ1 + θ2 m(x. ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. Let 0 yi = ei + m0 θ0 . ˆ ei . In the final two examples. ´ √ ³ n ˆ − θ0 →d N (0. but we won’t cover that argument here. See Appendix E. θ) is differentiable. θ).

the parameter estimates are not asymptotically normally distributed. γ is not identified. θ) ' (ei + m(xi . the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. This renders the distribution theory presented in the previous section invalid. by a first-order Taylor series approximation. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . Thus when the truth is that β 2 = 0. ¥ Based on Theorem 7. θ))2 ' n X¡ ¢2 0 yi − m0 θ θi i=1 0 and the right-hand-side is the SSE function for a linear regression of yi on mθi . However.1. ˆ and ei = yi − m(xi . Suppose that m(xi . θ) ' m(xi . θ0 ) + m0 (θ − θ0 ) . θ0 )) − m(xi .For θ close to the true value θ0 . Thus we want to test H0 : β 2 = 0. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . θi Thus ¡ ¢ yi − m(xi . and this is often a useful hypothesis (sub-model) to consider. m(xi . An alternative good measure is the conditional median. 7.5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi . 1 2 The model is linear when β 2 = 0. but these are not the only measures of central tendency. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. In particular. tests of H0 do not have asymptotic normal or chi-square distributions. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. θ) = β 0 zi + β 0 xi (γ). Hansen (1996). This means that under H0 . We have discussed projections and conditional means. ˆ ˆ θ) ˆ θ). Identification is often tricky in nonlinear regression models. 80 . θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ.4. under H0 . an estimate of the asymptotic variance V is ˆ V = Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 Ã 1X mθi m0 e2 ˆ ˆ θi ˆi n i=1 n !Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 where mθi = mθ (xi . Furthermore. θ which is that stated in the theorem.

The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . These distinctions are illusory. however. and the third definition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) .To recall the definition and properties of the median. Two useful facts about the median are that (7.5. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. i n n i=1 (7.10) The LAD estimator has the asymptotic distribution 81 . Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations.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. as i=1 these estimators are indeed identical. The second is the value which minimizes n n |yi − θ| . These facts definitions motivate three estimators of θ. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0.5 • 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 first definition is the 50th empirical 1 P quantile. let Y be a continuous random variable. Now let’s consider the conditional median of Y given a random variable X. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. and the substantive assumption is that the median function is linear in x.

V ). by the central limit theorem (Theorm 5. When f (0 | x) is large. See Chapter 16. In the special case where the error is independent of xi . This can be done with kernel estimation techniques. and this improves estimation of the median. the height of the error density at its median.5. ∂β 0 so Third. While a complete proof of Theorem 7.5. Computation of standard error for LAD estimates typically is based on equation (7.3. 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. The main difficulty is the estimation of f (0). 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. by a Taylor series expansion and the fact g(β 0 ) = 0 82 .10) is equivalent to g n (β) = 0.1 is advanced. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . the conditional density of the error at its median. we provide a sketch here for completeness. Let g(β) = Eg (β).1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. where V = and f (e | x) is the conditional density of ei given xi = x. then there are many innovations near to the median.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .11). (7.Theorem 7. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . ˆ Proof of Theorem 7.1 ´ √ ³ˆ n β − β 0 →d N (0. First. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .

Exi x0 ) →d i 2 = N (0. The third line follows from an asymptotic empirical process argument.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 (0.13) This generalizes representation (7. The median is the special case τ = . the quantile regression functions can take any shape. when F (y | x) is continuous and strictly monotonic in y. ¥ 7. Again. then (7.12) Qτ = argmin Eρτ (U − θ) .9) for the median to all quantiles. then F (Qτ ) = τ .5. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations).6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . For the random variables (yi . If the random variable U has τ ’th quantile Qτ . then F (Qτ (x) | x) = τ . so you can think of the quantile as the inverse of the distribution function. The following alternative representation is useful. 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. This linear specification assumes that Qτ (x) = β 0 x where the coefficients β τ τ vary across the quantiles τ . As functions of x. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. For fixed τ . 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)) . We then have the linear quantile regression model yi = x0 β τ + ei i 83 . For τ ∈ [0. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . V ). (7.

Vτ ). 7.13). A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. the asymptotic variance depends on the conditional density of the quantile regression error. Fortunately.1. fast linear programming methods have been developed for this problem. n numerical methods are necessary for its minimization. it is useful to have a general test of the adequacy of the specification. since it has discontinuous derivatives. i By construction. ´ √ ³ˆ Theorem 7. and form a Wald statistic i for γ = 0. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Furthermore. ¡ ¡ ¢¢−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. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. the unconditional density of ei at 0. ˆ Given the representation (7.1 n β τ − β τ →d N (0. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is defined in (7.12).7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . where and f (e | x) is the conditional density of ei given xi = x. Another popular approach is the RESET test proposed by Ramsey (1969). When the error ei is independent of xi .where ei is the error defined to be the difference between yi and its τ ’th conditional quantile x0 β τ . then f (0 | xi ) = f (0) . and we have the simplification Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . and are widely available. if the model yi = x0 β + ei has i been fit by OLS. otherwise its properties are unspecified without further restrictions. the τ ’th conditional quantile of ei is zero. 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.5. Thus.6. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). conventional Newton-type optimization methods are inappropriate. The null model is yi = x0 β + εi i 84 . and test their significance using a Wald test.

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

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

else select M2 . In contrast to the AIC. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . The model selection rule is as follows. and km is the number of coefficients in the model. as the rule tends to overfit. One popular choice is the Akaike Information Criterion (AIC). Indeed.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . since under M1 . Another problem is that if α is held fixed. Then select M1 if Wn ≤ cα . If the truth is infinite dimensional. it is more appropriate to view model selection as determining the best finite sample approximation. M)) between the true density and the model density.15) then where σ 2 is the variance estimate for model m. 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.However. BIC model selection is consistent. His criterion. depending on the sample size. AIC selection is inconsistent. if α is set to be a small number. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. log(n) 87 . The rule is to select M1 if AIC1 < AIC2 . n (7. this rule only makes sense when the true model is finite dimensional. etc. since (7. then this model selection procedure is inconsistent. as ³ ´ c P M = M1 | M1 → 1 − α < 1. For some critical level α.16) holds under M1 . k A major problem with this approach is that the critical level α is indeterminate. else select M2 . n (7. let cα satisfy ¢ ¡ P χ22 > cα . based on Bayesian arguments. Another common approach to model selection is to to a selection criterion.17) Since log(n) > 2 (if n > 8). k = While many modifications of the AIC have been proposed. Indeed. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. LRn →p 0. 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. That is. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . ¢ ¡ ˆ1 ˆ2 (7. known as the BIC. the most popular to be one proposed by Schwarz. 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 the ordered case. . There are two leading cases: ordered regressors and unordered. stores the residual variance σ 2 for each model. β K 6= 0. xKi }. . Similarly for ˆ the BIC. which can be a very large number. 88 . We have discussed model selection between two models. and 220 = 1. which regressors enter the regression). In the unordered case. 576. selecting based on (7. . the models are M1 : β 1 6= 0..17). there are 2K such models.15). 210 = 1024. and then selects the model with the lowest AIC (7. β 2 6= 0. . The AIC selection criteria estimates the K models by OLS. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . a model consists of any possible subset of the regressors {x1i . MK : β 1 6= 0.. β 3 = · · · = β K = 0 . log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. The methods extend readily to the issue of selection among multiple regressors. However.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. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. . β 2 6= 0. Also under M2 . 048. . which are nested. In the latter case. and the AIC or BIC in principle can be implemented by estimating all possible subset models. For example. E (εi | xi ) = 0 and the question is which subset of the coefficients are non-zero (equivalently. . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. one can show that thus LRn →p ∞..

where xji is one of the xi . . 2. E(e | X) = 0. the residuals e. Show that the function g(x) which minimizes the MAE is the conditional median M (x). xi ) be a random sample with E(Y | X) = Xβ. Is θ a quantile of the distribution of Yi ? 3.. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. (b) Find an estimate of the variance of this forecast.12). σ 2 ). the mean absolute error (MAE) is E |yi − g(xi )| .10 Exercises 1.7. based on a sample of size n. Verify equation (7. V . x. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . 4. Let σ 2 be the estimate of σ 2 . (b) Prove that e = M1 e. ˜ the residual vector is e = Y − X β. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e.. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . 5. In a linear model Y = Xβ + e. ˆ ˆ n−k 6. Let (yi . . ˆ (a) Find a point forecast of y. else equals zero). i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . Define g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. Thus the available information is the sample (Y.. V ar(e | X) = σ 2 Ω with Ω known. the estimates (β. X). For any predictor g(xi ) for y. and the out-of-sample value of the regressors. Let θ satisfy Eg(Yi − θ) = 0. 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 . 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 . wn ) and wi = x−2 .

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 . and the model imposes a smooth transition between these regimes. Exercise 13. The model works best when a7 is selected so that several values (in this example. (ii) AIC criterion. the regression slope is a2 + a6 . Suppose that yi ³ ´ i . 90 . The model is non-linear because of the parameter a7 . Find an asymptotic 95% confidence interval for g(x).. 8. (7. For values much above a7 . For values of ln Qi much below a7 . at least 10 to 15) of ln Qi are both below and above a7 . You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . (iii) BIC criterion.ˆ ˆ 7.18) plus the extra term a6 zi . (c) Estimate the model by non-linear least squares. This model is called a smooth threshold model. are both estimators consistent for β? (b) Are there conditions under which either estimator is efficient? 9. you estimated a cost function on a cross-section of electric companies. In Chapter 6. . a7 ). In addition. Consider model (7. (d) Calculate standard errors for all the parameters (a1 . and V is the = g(x estimate of V ar ˆ .. Do you agree with this modification? (b) Now try a non-linear specification. θ is the NLLS estimator.. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. Do so.18) (a) Following Nerlove. impose the restriction a3 + a4 + a5 = 1. Examine the data and pick an appropriate range for a7 . I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. n xi i=1 (a) Under the stated assumptions. and find the value of a7 for which the sum of squared errors is minimized. θ) + ei with E (ei | xi ) = 0. the variable ln Qi has a regression slope of a2 . Assess the merits of this new specification using (i) a hypothesis test. Record the sum of squared errors. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . For each value of a7 . calculate zi and estimate the model by OLS. add the variable (ln Qi )2 to the regression.

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

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

Note that while F may be either discrete or continuous. x) (1 − F (y. x)) →d N (0.2) Fn (y. x) →p F (y.1). x). Fn is by construction a step function. The EDF is a consistent estimator of the CDF. i 93 . x∗ ≤ x) = Fn (y. by the CLT (Theorem 5. the EDF is only a crude approximation to the CDF. Notationally. x) − F (y. This is a population moment. where 1(·) is the indicator function.1). x∗ ) with the i distribution Fn . To see this. x). I have plotted the EDF and true CDF for three random samples of size n = 25. Thus by the WLLN (Theorem 5. Fn (y.. xi ). Furthermore. x) = n i=1 Figure 8. in the Figure below. Recall that F (y.. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. n. Fn is a nonparametric estimate of F. That is. For n = 25. ∗ P (yi ≤ y. note that for any (y.3. x) . 1) distribution.2 The Empirical Distribution Function Fn (y. x).8. x) is called the empirical distribution function (EDF). the EDF step function gets uniformly close to the true CDF. The random draws are from the N (0. 50. √ n (Fn (y. and 100. but the approximation appears to improve for the large n. F (y..1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x))) . it is helpful to think of a random pair (yi . i = 1. (8.2. In general. x) = P (yi ≤ y. . To see the effect of sample size on the EDF. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . as the sample size gets larger.

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

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

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

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

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

We say that a function g(x) is even if g(−x) = g(x). 99 . (8.4) says that Gn converges to Φ x as n → ∞. The following notation will be helpful.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.3 an = o(n−r ) if nr |an | → 0 as n → ∞. and vice-versa. C4 is called the symmetric percentile-t interval. The ideal test rejects if Wn ≥ qn (α). F ) then ³x´ . writing Tn ∼ Gn (x. The derivative of an even function is odd. however. θ θ θ ˆ θ ∗ ∗ Computationally. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).4) v ¡ ¢ While (8. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . F ) = Φ n→∞ v or ³x´ Gn (x. Let an be a sequence. A better asymptotic approximation may be obtained through an asymptotic expansion. not ˆ − θ0 .8. θ [This is a typical mistake made by practitioners. Thus here Tn (θ) = Wn (θ).8. Equivalently. about the rate v of convergence.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test.1 an = o(1) if an → 0 as n → ∞ Definition 8. or the size of the divergence for any particular sample size n. Definition 8.8 Asymptotic Expansions Tn →d N (0. Let Tn be a statistic such that (8. an = O(n−r ) if it declines to zero like n−r . 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. F ) = Φ + o (1) . Definition 8. it says nothing.] 8. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. v 2 ).8. lim Gn (x. where qn (α) is the (1 − α)% quantile of the distribution of Wn . where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . 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. If θ is a vector. and a function h(x) is odd if h(−x) = −h(x). Basically. the critical value qn (α) is found as the quantile from simulated values of W´ .

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

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

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

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

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

95).05) . Using the non-parametric bootstrap. You replace c with qn (. you generate bootstrap samples. The datafile hprice1. θ respectively.95). with variables listed in the file hprice1.95).5% quantiles of the ˆ are . What is wrong with this procedure? Tn = θ/s(θ) n 6. (c) With the given information. (b) Report the 95% Alternative Percentile interval for θ. ∗ ∗ ∗ Let qn (. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. The ˆ are sorted.95) denote the 5% θ) ∗ and 95% quantiles of Tn .5% and 97. ˆ = 1.2 and s(ˆ = . and the colonial dummy. ∗ ∗ where s(ˆ is the standard error in the original data. You want to test H0 : θ = 0 against H1 : θ > 0. size of house. (a) Report the 95% Efron Percentile interval for θ.05) and qn (. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and define the bootstrap confidence interval h i C = ˆ − s(ˆ n (. and thus reject H0 if ˆ ˆ > q ∗ (. can you report the 95% Percentile-t interval for θ? 7. 105 . ˆ − s(ˆ n (.dat contains data on house prices (sales).3. Suppose that in an application.75 and 1. Calculate 95% confidence intervals for the regression coefficients using both the asymptotic normal approximation and the percentile-t bootstrap.2. Estimate a linear regression of price on the number of bedrooms. You do this as follows.95) denote the 95% quantile of Tn . Using the non-parametric ∗ bootstrap. lot size. and the 2. Let qn (.pdf. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. and ˆ is calculated on each θ ∗ ∗ θ sample.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).

x. however. z. We know that without further restrictions. 1 this class of models are called moment condition models. Now suppose that we are given the information that β 2 = 0. In the statistics literature. This situation is called overidentified. otherwise it is overidentified.Chapter 9 Generalized Method of Moments 9. In econometrics. 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. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. In our previous example. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . As an important special case we will devote special attention to linear moment condition models. but this is not required. is not necessarily efficient. while β 1 is of dimension k < . If k = the model is just identified. We call r the number of overidentifying restrictions. The variables zi may be components and functions of xi . g(y. β 0 ) = 0 (9. x. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0.1) by setting g(y. z. where the dimensions of zi and xi are k × 1 and × 1 . as their are restrictions in E (xi ei ) = 0. In this case. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. x. β 0 ) = x(y − z 0 β) 106 (9. There are − k = r more moment restrictions than free parameters. β) = x(y − x0 β). This model falls in the class (9. This method. these are known as estimating equations. This is a special case of a more general class of moment condition models. Let g(y.1) where β 0 is the true value of β. with ≥ k. xi .2) .

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

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

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

The general theory of GMM estimation and testing was exposited by L. 1 2 It is possible that β 2 = 0. often the weight ˆ matrix Wn is updated. 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. so that the linear equation may be written as yi = β 0 x1i + ei . 9. and is thus a natural test statistic for H0 : Egi = 0. Since the GMM estimator depends upon the first-stage estimator. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = à 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. Under the hypothesis of correct specification. Thus the model — the overidentifying restrictions — are testable. G0 Ω−1 G .Often. Theorem 9. ˆˆ n is a quadratic form in g n . For example. 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). this is all that is known. However.6. Identification requires l ≥ k = dim(β). 1 it is possible that β 2 6= 0.1 Under general regularity conditions.5.6 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 . and if the weight matrix is asymptotically efficient. n β − β →d N 0. and then β recomputed. This estimator can be iterated if needed. perhaps obtained by first ˆ setting Wn = I. β) = 0 holds. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . Hansen (1982). ˆ J = J(β) →d χ2−k . take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. 110 . 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 .1 (Sargan-Hansen). ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9.

The proof of the theorem is left as an exercise. and is the preferred test statistic. and some current research suggests that this restriction is not necessary for good performance of the test. and by L. D ≥ 0 2. If the statistic J exceeds the chi-square critical value. 1. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). we can reject the model. When over-identified models are estimated by GMM. The idea was first put forward by Newey and West (1987). the hypothesis is H0 : h(β) = 0. These may be used to construct Wald tests of statistical hypotheses. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). as this ensures that D ≥ 0. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). If the hypothesis is non-linear. it is unclear what is wrong. Based on this information alone. Proposition 9. In contrast.7. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. If h is linear in β. This is sometimes called the GMM Distance statistic. current evidence suggests that the D statistic appears to have quite good sampling properties. the Wald statistic can work quite poorly. 111 . a better approach is to directly use the GMM criterion function. D →d χ2 r 3. but it is typically cause for concern. 9.1 If the same weight matrix Wn is used for both null and alternative. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . it is customary to report the J statistic as a general test of model adequacy. Hansen (1982) for the general case. The GMM distance statistic is the difference ˜ ˆ D = J(β) − J(β). If h is non-linear. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. This reasoning is not compelling. For a given weight matrix Wn . The GMM overidentification test is a very useful by-product of the GMM methodology. however. This result was established by Sargan (1958) for a specialized case. and it is advisable to report the statistic J whenever GMM is the estimation method. then D equals the Wald statistic.

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

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

verify that A can be written as ³ ¡ ¢−1 0 ´ G H. Let ei = yi − zi β where β is consistent for ˆ β (e. Show that Wn →p Ω i i i 4. we know that V − V0 is positive semi-definite if and only if V0−1 − V −1 = A is positive semi-definite. a GMM estimator with arbitrary weight matrix). σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). V − V0 is positive semi-definite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the efficient weight matrix). i 0 0ˆ ˆ 3. and therefore positive semidefinite. Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . (b) We want to show that for any W. 2. From matrix algebra. Take the model yi = zi β + ei with E (xi ei ) = 0. A = H 0 I − G G0 G (d) Show that A is positive semidefinite. Letting H = CQ and G = C 0−1 W Q. γ). (c) Since Ω is positive definite. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . Write out the matrix A. 114 . there exists a nonsingular matrix C such that C 0 C = Ω−1 . the asymptotic variˆ ance of β GMM is ¡ ¢−1 0 ¡ ¢−1 V = Q0 W Q Q W ΩW Q Q0 W Q ¡ ¢−1 (a) Let V0 be this matrix when W = Ω−1 . ˆ ˆ Find the method of moments estimators (β. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0.9.g. Show that V0 = Q0 Ω−1 Q . In the linear model estimated by GMM with general weight matrix W. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . γ ) for (β. Define the estimate of the optimal GMM weight matrix à n !−1 1X 0 2 xi xi ei ˆ . Take the model E (zi ηi ) = 0.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1.

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

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. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. ˆ and consider the GMM estimator β of β. 116 . Take the linear model 0 yi = zi β + ei E (xi ei ) = 0.7. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0..

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

pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .. summing over i. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). p1 . the Lagrange multiplier λ(β) minimizes Rn (β.2) subject to the restrictions (10. λ ¡ ¢ ln 1 + λ0 gi (β) . .7) 118 . pi gi (β) = 0. λ) = −n ln (n) − n X i=1 For given β. pn .5).4) (10. The solution cannot be obtained explicitly. λ).where λ and µ are Lagrange multipliers. probabilities 1 ³ ´´ .. we find µ = n and 1 ¢.1) and (10. This yields the (profile) empirical log-likelihood function for β. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we find n Rn (β. λ. 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 à n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. or equivalently minimizes its negative ˆ (10. λ) is a convex function of λ. µ. Ln (β) = Rn (β.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. Multiplying the first equation by pi . (see section 6. p (10.5) This minimization problem is the dual of the constrained maximization problem. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .. but must be obtained numerically (see section 6.5) ˆ ˆ As a by-product of estimation. λ) : λ(β) = argmin Rn (β.3). The solution (when it exists) is well defined since Rn (β. and using the second and third equations. we also obtain the Lagrange multiplier λ = λ(β). (10.

8) and ¢ 0 0 For example.9) (10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are defined in (10. and Ω = E xi x0 e2 .2. G = −E (xi zi ).12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .2 Define Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. λ) = − (10.13) Premultiplying by G0 Ω−1 and using (10. i=1 i=1 i=1i Expanding (10. ˆ ˆ Proof. 0 = Rn (β.9) and (10.1 Under regularity conditions. i i Theorem 10. n (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. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .13) yields n n Expanding (10.10) ¡ Ω−1 N (0.10). Gi (. λ) = − (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 . Thus the EL estimator is asymptotically efficient.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . (β. ˆ The asymptotic variance V for β is the same as for efficient GMM. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. in the linear model.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . β) = −xi zi . β λ ∂ ³ ´.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. and n β − β 0 and nλ are asymptotically independent.10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.

¥ Chamberlain (1987) showed that V is the semiparametric efficiency bound for β in the overidentified moment condition model.15). LRn = i=1 Theorem 10. Ω) GΩ G →d = N (0. by a Taylor expansion. and (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. Twice the difference between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. The EL overidentification test is similar to the GMM overidentification test.15) (10.17) 2 ln 1 + λ gi β . it is an asymptotically efficient estimator for β.3. Vλ ) Furthermore.16). V ) ˆ Solving (10.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. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . and it is advisable to report the statistic LRn whenever EL is the estimation method. The overidentification test is a very useful by-product of EL estimation.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. The same statistic can be constructed for empirical likelihood. Since the EL estimator achieves this bound. 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. 10.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. First. (10. β 0 ) = 0 then LRn →d χ2−k . They are asymptotically first-order equivalent.14) for λ and using (10. Proof.3 Overidentifying Restrictions In a parametric likelihood context. tests are based on the difference in the log likelihood functions. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.7) is n ³ ´´ ³ X ˆ ˆ0 (10. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . and have the same interpretation.1 If Eg(wi . 120 .

18) and H0 : h(β) = 0.18). Vλ )0 Ω−1 N (0. a The proof of this result is more challenging and is omitted. The hypothesis of interest is h(β) = 0. where h : Rk → Ra .edu/~bhansen/progs/elike.ssc.18) Let the maintained model be where g is × 1 and β is k × 1. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). LRn →d χ2 .4.17) is not appropriate. Vλ ) ¥ where the proof of the final equality is left as an exercise.wisc.Second. This test statistic is a natural analog of the GMM distance statistic. the simple overidentifying restrictions test (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. To test the hypothesis h(β) while maintaining (10. Theorem 10. so there is no fundamental change in the distribution theory for β relative to β. 10.4 Testing Egi (β) = 0 (10. By “maintained” we mean that the overidentfying restrictions contained in (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.prc 121 . 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. Instead we use the difference in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . 10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).1 Under (10. since ln(1 + x) ' x − x2 /2 for x small. h(β)=0 ˜ Fundamentally.

λp ) A quadratic function can be fit exactly through these three points. λ)0 0 Rn (β. Set δ 0 = 0. λ) G∗ (β. λ) = i The first derivatives of (10. 2. λj ))−1 Rλ (β.19) is continued until the gradient Rλ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λ)0 − Rn (β. One method uses the following quadratic approximation.19). λj ) is smaller than some prespecified tolerance. The starting value λ1 can be set to the zero vector. For p = 0.. set 2 λp = λj − δ p (Rλλ (β. λ) = − ∂β n X i=1 G∗ (β. λj )) Rp = Rn (β. λ) gi (β. λ) = G∗ (β. Efficient convergence requires a good choice of steplength δ.20) . δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ)0 − ∂β∂β Rn (β. λ) = − gi (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10.4). (10.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. 1. The modified Newton method takes a quadratic approximation to Rn (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (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. The iteration (10.19) X ∂2 ∗ ∗ gi (β. λj ) . λ) G∗ (β. Define ∗ gi (β.5) for given β. δ 1 = 1 and δ 2 = 1. λ) . λ) ∂λ i=1 n ∂ Rn (β. λj ))−1 Rλ (β.

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

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

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

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we find

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

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

11.3

Identification

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

11.4

Estimation
0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. 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 . The parameter β fails to be identified if Γ22 has deficient rank. the bias in the 2SLS estimator will be large. 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 . 130 . 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 (11.14) is the probability limit of β 2SLS − β 11.13). n and (11. l . Let q = H 0 ξS −1/2 which satisfies Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 0). ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . P = HΛH 0 0 0 where Λ = diag(Il . Indeed as α → 1.7 Identification Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .Let PX = X (X 0 X)−1 X 0 . By the spectral decomposition of an idempotent matrix.14) In general this is non-zero. It is also close to zero when α = 0. 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 (11.12) and this result. The consequences of identification failure for inference are quite severe. the expression in (11.14) approaches that in (11. except when S21 = 0 (when Z is exogenous).

standard test statistics have non-standard asymptotic distribution of β distributions. To see the consequences. we find that β is inconsistent for β and the ˆ is non-normal. which occurs i when E (zi xi ) 6= 0. This can be handled in an asymptotic analysis by modeling it as local-to-zero. N2 since the ratio of two normals is Cauchy. the instrument xi is weak for zi if γ = n−1/2 c. but (11. We see that β is identified if and only if Γ22 = γ 6= 0.15) is unaffected. but small. Here.Take the simplest case where k = l = 1 (so there is no X1 ). Qc + N2 ˆ As in the case of complete identification failure. Thus identification hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. Then (11. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 .16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. Suppose this condition fails. meaning that inferences about parameters of interest can be misleading. This is particularly nasty. and was examined by Phillips (1989) and Choi and Phillips (1992). so E (zi xi ) = 0. E x2 e2 i i n i=1 n (11. This result carries over to more general settings. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. where C is a full rank matrix.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0.16) 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 . The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. In addition. E x2 u2 i i n n i=1 i=1 n n (11. once again take the simple case k = l = 1. 131 . as the Cauchy distribution does not have a finite mean. viz Γ22 = n−1/2 C. Suppose that identification does not complete fail. but is weak. This occurs when Γ22 is full rank.

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

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

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. a dummy indicating that the observation lives near a 4-year college.pdf. of the mother). I suggest that you use the 2SLS estimates as the first-step to get the weight matrix. using zi as an instrument for xi . (f) Discuss your findings. in years. 134 . are the parameters identified? 8. (e) Calculate and report the J statistic for overidentification. In this model. Report estimates and standard errors. The data file card. 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. 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. (a) Estimate the model by OLS. and South and Black are regional and racial dummy variables. of the father) and motheduc (the education. Does this differ from 2SLS and/or OLS? 7. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). Report estimates and standard errors.(b) Define the 2SLS estimator of β. There are 2215 observations with 19 variables.. Estimate the model by 2SLS. (d) Re-estimate the model by efficient GMM. listed in card. f atheduc (the education. in years. Report the estimates and standard errors. (b) Now treat Education as endogenous.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995). and the remaining variables as exogenous. 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). and then calculate the GMM estimator from this weight matrix without further iteration.

1. Definition 12.1.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . Because of the sequential nature of time series. The primary model for univariate time series is autoregressions (ARs). A stationary time series is ergodic if γ(k) → 0 as k → ∞... There proofs are rather difficult.. and use the subscript t to denote the individual observation. T . and T to denote the number of observations. we adopt new notation. Yt−k ) = γ(k) is independent of t for all k. To indicate the dependence on time.1.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . so classical assumptions are not valid.1 Stationarity and Ergodicity Definition 12.. Yt−k ) is the autocorrelation function.1.) is a random variable. t = 1.2 {Yt } is strictly stationary if the joint distribution of (Yt . Yt−1 . and Cov (Yt .. 12. . Definition 12. The following two theorems are essential to the analysis of stationary time series.1. Yt−k ) is independent of t for all k.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. and multivariate (yt ∈ Rm is vector-valued).4 (loose). Theorem 12. 135 . .. We can separate time series into two categories: univariate (yt ∈ R is scalar).. however. . γ(k) is called the autocovariance function. The primary model for multivariate time series is vector autoregressions (VARs). we expect that Yt and Yt−1 are not independent..1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. Definition 12. then Xt is strictly stationary and ergodic.

and it has a finite mean by the assumption that EYt2 < ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). the sequence Yt Yt−k is strictly stationary and ergodic.1. then as T → ∞.1 above. γ (0) ˆ Theorem 12.Theorem 12. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). ˆ Proof.1. µ →p E(Yt ). 1. ˆ ˆ γ ¥ 136 .3 If Yt is strictly stationary and ergodic and EYt2 < ∞. If Xt is strictly stationary and ergodic and E |Xt | < ∞. γ (k) →p γ(k).1. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . Part (1) is a direct consequence of the Ergodic theorem. ˆ 2.2 (Ergodic Theorem). 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 → ∞. ρ(k) →p ρ(k). T 1X Xt →p E(Xt ). T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). For Part (2). note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. ˆ 3.

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

except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . Lk Yt = Yt−k .1 The lag operator L satisfies LYt = Yt−1 . We say that the root of the polynomial is 1/ρ. We call ρ(L) the autoregressive polynomial of Yt . Definition 12. We can compute the moments of Yt using the infinite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. we see that L2 Yt = LYt−1 = Yt−2 . Note that an equivalent way to say this is that an AR(1) is stationary iff the root of the autoregressive polynomial is larger than one (in absolute value). 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . the above results are unchanged.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. Defining L2 = LL. We call ρ(L) the autoregressive polynomial of Yt . an AR(1) is stationary iff |ρ| < 1.3. 12. The AR(k) model is Using the lag operator. In general. ∞ X k=0 ρ2k V ar (et−k ) = 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . since ρ(z) = 0 when z = 1/ρ. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .3. 138 . From Theorem 12.Theorem 12. and solving for EYt = EYt−1 we find EYt = α/(1 − ρ).1.4.

we say that ρ(L).1) Theorem 12. The vector xt is strictly stationary and ergodic. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. we see that à !−1 à ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. t Yt−k ¢0 ρk . Let |λ| denote the modulus of a complex number λ. it is helpful to define the process ut = xt et .1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. λk are the complex roots of ρ(z). and is of great interest in applied time series. β = X 0X (12. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.1. then ˆ β →p β as T → ∞.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . For an AR(k).. t T t=1 T t=1 139 .1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. the requirement is that all roots are larger than one.. which satisfy ρ(λj ) = 0.1.5.1. and hence Yt . Proof. “has a unit root”. We know that an AR(1) is stationary iff the absolute value of the root of its autoregressive polynomial is larger than one. One way of stating this is that “All roots lie outside the unit circle.where the λ1 . Thus T T 1X 1X xt et = ut →p E (ut ) = 0. By Theorem 12.6.1. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. and by Theorem 12. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. .” If one of the roots equals 1. t t T t=1 ¥ Combined with (12. so is xt x0 . Note that ut is a MDS.1) and the continuous mapping theorem. This is a special case of non-stationarity. Thus t by the Ergodic Theorem. Theorem 12. it is also strictly stationary and ergodic.. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.

If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. e ˆ 3. Ω) . Estimate β and residuals et .7. Method 2: Block Resampling 1.7 Asymptotic Distribution Theorem 12. This creates an iid bootstrap sample.12. T t=1 where Ω = E(xt x0 e2 ).. t then as T → ∞.7. .. Y0 ). T t=1 Since xt et is a MDS. 140 . Briefly.1 to see that T 1 X √ xt et →d N (0. Q−1 ΩQ−1 . xt }. then as T → ∞. i 4. ˆ 2.. as this imposes inappropriate independence.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.. Y−k+2 . t This construction imposes homoskedasticity on the errors e∗ .7. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. 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∗ . In particular.1 MDS CLT. T 1 X √ ut →d N (0. The implication is that asymptotic inference is the same. there are two popular methods to implement bootstrap resampling for time-series data. we can apply Theorem 12. the asymptotic covariance matrix is estimated just as in the cross-section case. . 12.. this cannot work in a time-series application. t t Theorem 12.8 Bootstrap for Autoregressions In the non-parametric bootstrap. This is identical in form to the asymptotic distribution of OLS in cross-section regression. Fix an initial condition (Y−k+1 . ˆ 1. Method 1: Model-Based (Parametric) Bootstrap. It also presumes that the AR(k) structure is the truth. which may be different than the i properties of the actual ei . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . we constructed the bootstrap sample by randomly resampling from the data values {yt . Divide the sample into T /m blocks of length m. Clearly. eT }. Ω) ..

4. 141 . • You can estimate (12.. (12. That is. This procedure is sometimes called Detrending. This allows for arbitrary stationary serial correlation. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. • Include dummy variables for each season. • You can estimate (12. first estimate (12. 12. Seasonal Effects There are three popular methods to deal with seasonal data. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.3) replacing St with St ..2. draw T /m blocks. ∆s Yt = Yt − Yt−s . • First apply a seasonal differencing operator. get the ˆ ˆ residual St .. 5.2)-(12. If s is the number of seasons (typically s = 4 or s = 12). Resample complete blocks. and then perform regression (12. The results may be sensitive to the block length. also alters the time-series correlations of the data. heteroskedasticity. • Use “seasonally adjusted” data.2). and for modelmisspecification. For each simulated sample.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . This is a flexible approach which can extract a wide range of seasonal factors. and perhaps this was of relevance. 6. ρk ). May not work well in small samples. however. The series ∆s Yt is clearly free of seasonality.4) by OLS. This presumes that “seasonality” does not change over the sample.2) (12. The seasonal adjustment. (12. Thus the seasonally adjusted data is a “filtered” series. . or the season-to-season change.3) sequentially by OLS. Paste the blocks together to create the bootstrap time-series Yt∗ . 3.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . and the way that the data are partitioned into blocks. But the long-run trend is also eliminated.

To combine (12. 142 .5) and (12. this is the same as saying that under the alternative Yt is an AR(k+m).. H0 may be expressed as the restriction that the coefficient on Yt−2 is zero. AIC(k) = log σ 2 (k) + ˆ 2k .12. e. In general. (If you increase k. An appropriate test is the Wald test of this restriction. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). We then multiply this by θ and subtract from (12. AR(k) on this (unified) sample. you need more 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. We model this as an AR(1): ut = θut−1 + et with et a MDS.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . Another is to minimize the AIC or BIC information criterion. Yt−k−m are jointly zero.. Thus under H0 .6) 12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. AR(2). (A simple exclusion test).5).5) We are interested in the question if the error ut is serially correlated.. An appropriate test of H0 against H1 is therefore a Wald test that the coefficient on Yt−2 is zero. (12. and then reserve the first k as initial conditions. and this is equivalent to the restriction that the coefficients on Yt−k−1 . One approach to model selection is to choose k based on a Wald tests. The best remedy is to fix a upper value k. we take (12. (12. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. We want to test H0 against H1 . Yt is an AR(1). and then estimate the models AR(1). and under H1 it is an AR(2).) This can induce strange behavior in the AIC. .. to find Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .. and the alternative is that the error is an AR(m).. if the null hypothesis is that Yt is an AR(k).g. . let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut .6).10 Testing for Omitted Serial Correlation For simplicity.

this is the most popular unit root test. However. as the models are equivalent. Yt is non-stationary. As we discussed before. or I(d). but simply assert the main results. observe that the lag polynomial for the Yt computed from (12. So the natural alternative is H1 : α0 < 0.7). the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . We do not have the time to develop this theory in detail. 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 . which is an AR(k-1) in the first-difference ∆Yt . It would seem natural to assess the significance of the ADF statistic using the normal table. The ergodic theorem and MDS CLT do not apply.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . and test statistics are asymptotically non-normal. Since α0 is the parameter of a linear regression. Under H0 . (12. Indeed. Because of this property. then ∆Yt is a stationary AR process. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. since ρ(1) = −α0 . Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . Yt is non-stationary. In this case. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. 143 . the natural test statistic is the t-statistic for H0 from OLS estimation of (12.7) These models are equivalent linear transformations of one another. so conventional normal asymptotics are invalid. Thus a time series with unit root is I(1). An alternative asymptotic framework has been developed to deal with non-stationary data. or ρ1 + ρ2 + · · · + ρk = 1. Yt has a unit root when ρ(1) = 0. Hence. under H0 .7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L).12. Thus if Yt has a (single) unit root. then Yt is “integrated of order d”. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. To see this. we say that if Yt is non-stationary but ∆d Yt is stationary. Note that the model is stationary if α0 < 0.

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

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

One way to write this is to let a0 be the jth row j of A. This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator. ˆ An alternative way to compute this is as follows. Consider the moment conditions j = 1. The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj . ⎟ ⎝ . The GMM framework gives a convenient method to impose such restrictions on estimation.. ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 . m. 146 . Then the VAR system can be written as the equations Yjt = a0 xt + ejt . and was originally derived by Zellner (1962) ¢ 13.2 Estimation E (xt ejt ) = 0. The VAR model is a system of m equations. we find ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ .then Yt = Axt + et . Note that a0 = Yj0 X(X 0 X)−1 . or across equations. ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt . j Unrestricted VARs were introduced to econometrics by Sims (1980). 13. Restrictions may be imposed on individual equations. A restricted VAR imposes restrictions on the system. each with the same set of regressors. either as a regression. . These are implied by the VAR model. ˆj ˆ And if we stack these to create the estimate A. For example. some regressors may be excluded from some of the equations.3 Restricted VARs The unrestricted VAR is a system of m equations. or as a linear projection..2 ⎟ X(X 0 X)−1 A ⎜ ..

and is typically rejected empirically. Let yt = Yjt . Then the single equation takes the form (13.3). general. t and et is iid N (0. This restriction.) Since the common factor restriction appears arbitrary. under the restriction γ = −βθ. with time series data. So testing H0 versus H1 is equivalent to testing for the significance of adding (yt−1 . Suppose that et is an AR(1). j Often. 147 . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. and subtract off the equation once lagged multiplied by θ. and Zt be the other variables. xt−1 ) to the regression. which once was very popular. which is called a common factor restriction. we are only interested in a single equation out of a VAR system. t or yt = θyt−1 + x0 β + x0 γ + ut .2) Take the equation yt = x0 β + et . We see that an appropriate. You may have heard of the Durbin-Watson test for omitted serial correlation.2) is a special case of (13.1) yt = x0 β + et . it is convenient to re-define the variables.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. In this case.13. the model (13.1). 13. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. direct estimation of (13.2) is uncommon in recent applications. Let et = ejt and β = aj .2) may be estimated by iterated GLS. to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 . and is still routinely reported by conventional regression packages. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). t and xt = This is just a conventional regression. (13.4 Single Equation from a VAR Yjt = a0 xt + et . t t−1 (13. may be tested if desired. 1). h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . This can be done by a Wald test. Otherwise it is invalid. and simple way to test for omitted serial correlation is to test the significance of extra lagged values of the dependent variable and regressors. Another interesting fact is that (13. If valid. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0.3) which is a valid regression model. (A simple version of this estimator is called Cochrane-Orcutt.

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

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

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

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

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

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

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

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

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

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

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

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

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

That is. f (x) ≥ 0 for all x. f (x) is a valid density. It follows that the variance of the density f (x) is à 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. 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. 161 . ˆ We can also calculate the moments of the density f (x). 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 small and f ˆ ˆ Interestingly. if only a few Xi are near 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 . If a large number of the observations Xi are near ˆ x. then the weights are relatively large and f (x) is larger. Conversely. where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h. The bandwidth h controls the meaning of “near”.This estimator is the average of a set of weights. ˆ(x) is small.

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

Note that this h declines to zero.2) depends on R(K). That is. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. That is. but at a very slow rate. In practice.06n−1/5 163 . We define the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. we need h → 0 but nh → ∞. Gaussian Kernel: hrule = 1. Notice that the first term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. The downside is that if the density is very far from normal. ˆ It uses formula (16. The asymptotically optimal choice given in (16. 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. Their K values for the three functions introduced in the previous section are given here. σ 2 . we find the reference rules for the three kernel functions introduced earlier. This choice for h gives an optimal rule when f (x) is ˆ normal. how should the bandwidth be selected? This is a difficult problem. Together with the above table. h must tend to zero. h0 = argmin AM ISEh h It can be found by solving the first order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 . We can calculate that √ R(φ00 ) = 3/ (8 π) . 1) distribution and σ 2 is an estimate of σ 2 = V ar(X).2) but replaces R(f 00 ) with σ −5 R(φ00 ).1) is an asymptotic approximation to the MSE. (16. (16. and R(f 00 ). Thus for the AMISE to decline with n. the rule-of-thumb h can be quite inefficient.Together.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 .2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. The first two are determined by the kernel function. where φ is the N (0. We thus say that the optimal bandwidth is of order O(n−1/5 ). and there is a large and continuing literature on the subject. 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 + . Equation (16. and gives a nearly optimal rule when f (x) is close to normal. but at a slower rate than n−1 . but not of n. 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) .

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

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

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

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

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

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

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

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

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

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

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

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

then they are mutually independent. denoted χ2 . σ 2 ). If Z is standard normal and X = µ + σZ. then Σ = diag{σ 2 } is a diagonal matrix. Theorem A. The latter has no closed-form solution. −∞ < x < ∞. (A. f (x) = √ 2σ 2 2πσ which is the univariate normal density. Theorem A. q × q. Σ). x ∈ Rk . X has density à ! (x − µ)2 1 exp − . the density of Y is à ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . A) with A > 0. Its mean and r variance are µ = r and σ 2 = 2r. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . In this case the density function can be written as j à à !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k à ¡ ¢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. respectively. For x ∈ Rk . then Z 0 A−1 Z ∼ χ2 . This shows that if X is multivariate normal with uncorrelated elements.8. Ir ) and set Q = X 0 X. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). The mean and variance of the distribution are µ and σ 2 . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . It is conventional to write X ∼ N (0. and it is conventional to write X ∼ N(µ. Since it is symmetric about zero all odd moments are zero. then by the change-of-variables formula. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . x ∈ Rk . 1). By iterated integration by parts.11) and is known as the chi-square density with r degrees of freedom.1 Let X ∼ N (0. q 176 . y ≥ 0. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated.2 If Z ∼ N(0.This density has all moments finite.8. ¢ ¡ 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 . This shows that linear transformations of normals are also normal. Σ) and Y = a + BX with B an invertible matrix. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. we can also show that EX 2 = 1 and EX 4 = 3. then using the change-of-variables formula. and it is conventional to write X ∼ N (µ. Another useful fact is that if X ∼ N (µ.

The MGF for the density (A.Theorem A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.8. From (A.13). For Z ∼ N(0.2.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. tr has distribution 177 . which we showed in (A.12) E exp (tQ) = 0 Γ (A. which can be found by applying change-of-variables to the gamma function. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. 1) and Q ∼ χ2 be independent. 1). Using the simple law of iterated expectations. q Proof of Theorem A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .13) is the MGF of the density (A.1. C −1 CC 0 C −10 ) = N (0.8. we see that the MGF of Z 2 is (1 − 2t)−1/2 .11) 2 with r = 1.11).6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.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). Set r Z . (A. Proof of Theorem A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . The fact that A > 0 means that we can write A = CC 0 where C is non-singular. C −1 AC −10 ) = N (0. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Iq ).8.3 Let Z ∼ N (0. Thus the density of Z 2 is (A.8.3.

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

Define the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . However.14) ¶ ∂ ∂ 0 ln f (Yi .3 Under regularity conditions.16).9. In fact. which maximizes the log-likelihood). ˆ is consistent θ for this value. under conventional regularity conditions. θ) ≡ L(θ). ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. θ0 ) ln f (Yi . we can find an explicit expression for θ as a function of the data.9. 179 . ∂θ ∂θ (A. then θ V ar(˜ ≥ (nI0 )−1 .9. We can write this as ˆ = argmax Ln (θ). θ0 ) . the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . but these ˆ must be found by numerical methods. I0 .2 Cramer-Rao Lower Bound.15) Two important features of the likelihood are Theorem A. Theorem A. θ) →p E ln f (Yi .16) (A.17) is often called the information matrix equality.17) The matrix I0 is called the information. the restriction to unbiased estimators means that the theorem has little direct relevance for finite sample efficiency. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. ˆ →p θ0 as n → ∞. θ) ∂θ ∂θ which holds at θ = θ0 by (A. θ0 ) ∂θ∂θ 0 (A. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. and the equality (A. cases are rare. θ Theorem A. we can see that it is an estimator of the maximizer θ of the right-hand-side. More typically. n n i=1 n As the MLE ˆ maximizes the left-hand-side. If ˜ is an unbiased estimator of θ ∈ R. θ θ∈Θ ˆ In some simple cases.1 ¯ ¯ ∂ E ln f (Yi . θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ) The Cramer-Rao Theorem gives a lower bound for estimation. The first-order condition for the latter problem is 0= ∂ ∂ L(θ) = E 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 . but it is not literally believed that the model f (y. In this case there is not a “true” value of the parameter θ. The QMLE is consistent for the pseudo-true value.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0. Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . θ) θ In this case. θ). but has a different covariance matrix than in the pure MLE case. the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. θ) ¶ dy Thus in large samples. V ) . ˆ ln f Yi . θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y. θ (A. Instead we define the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . ˆ elements of n 0 Sometimes a parametric density function f (y.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . θ) is used to approximate the true unknown density f (y). Therefore the MLE is called asymptotically efficient.ˆ ˆ−1 θ We then set I0 = H −1 . we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. A minor adjustment to Theorem (A. Typically.17) does not hold. θ) is necessarily the true density. ˆ . θ) = f (y) ln f (y. since the information matrix equality (A.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi . to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A.9.18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A. 180 . Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance. Thus in large samples the MLE has approximately the best possible variance.

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

θ0 ) + ' 0 ln f (Yi . ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0.3 Taking the first-order condition for maximization of Ln (θ). and making a first-order Taylor series expansion. the specific value of θn varies by row in this expansion. ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . θ0 ) →d N (0.) Rewriting this equation. then since θn →p θ0 we find H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . Ω) = N 0. If it is continuous in θ. H −1 ΩH −1 = N 0.Proof of Theorem A.9.9. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . an application of the CLT yields 1 X ∂ √ ln f (Yi . ¥ 182 . we find ´ ³ ˆ − θ0 = θ Since ∂ ∂θ à !−1 à n ! n X ∂2 X ∂ ln f (Yi . H −1 . − ln f (Yi . θn ) = ln f (Yi .1 . Ω) . θ n ) θ − θ 0 . ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . θ0 ) is mean-zero with covariance matrix Ω. the final equality using Theorem A. (Technically. θ0 ) . θ) . Together. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi .

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

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

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

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