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

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Contents

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

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

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

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

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

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

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

. . . . 13. .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . . . . . . . . . . . .1 Grid Search . . . . . .3 Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . 13. . . . . . . . . . . . . . . . . . . B. . . . . . . . . . . . . . . . . A. . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . .9 Maximum Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . A. . . . . . .4 Single Equation from a VAR . . .13 Multivariate Time Series 13.3 Dynamic Panel Regression . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . .1 Kernel Density Estimation . . . . . . A. . . . . . . . . . . . . . . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . A. . . . .8 Cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . 14. . . . 159 16 Nonparametrics 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . .1 Binary Choice . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . . . . . . 160 16. . . . . . . . . . . . . . . . . . . . . .2 Gradient Methods . . . . . . . . . . . . . . . .6 Conditional Distributions and Expectation . . . . . .7 Granger Causality . . . . . . . . . iv . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Sample Selection .3 Censored Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . .7 Transformations . . 15 Panel Data 157 15. . .3 Derivative-Free Methods . . . .6 Selection of Lag Length in an VAR . . . . . . A. . . . . . . . . . . . . .5 Multivariate Random Variables . . . . . . . . . . . . . . . . . .2 Random Variables . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Common Distributions . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . B. . . . . . . . . . . . . . . . . . . . . . 13. . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . . . .1 Individual-Eﬀects Model . . . . . .2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Foundations . . . . . . . . . . . . . . . . . A. . . . . .2 Fixed Eﬀects . . . . . . . .3 Restricted VARs . . . . . 13. . .2 Count Data . . . . . . . . . . . . . . . . . . . . . 157 15. . 13. . 162 A Probability A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . B Numerical Optimization B. . . .

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

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

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

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

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

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

. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . . The following fact about inverting partitioned matrices is sometimes useful. The Moore-Penrose generalized inverse A− satisﬁes (2.1) . the Moore-Penrose generalized inverse A− exists and is unique. then A−1 = A. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. (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.3) The matrix A− is not necessarily unique. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . 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. if there is no c 6= 0 such that Ac = 0. .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.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 . 7 Also. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse.4 Inverse A k × k matrix A has full rank. . (2. . For non-singular A and C. This matrix is called the inverse of A and is denoted by A−1 . if A is an orthogonal matrix. or is nonsingular. . 2. .

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

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

denoted by vec (A) . .9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. The vec of A. . • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. ⎟ .• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. ⎣ ⎦ . The Kronecker product of A and B. denoted A ⊗ B. is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. • If A is orthogonal. an Let B be any matrix. is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . . . . . then det A = ±1 ¢ ¡ = (det D) det A − BD−1 C if det D 6= 0 Qk i=1 aii • If A is triangular (upper or lower). . det(A ⊗ B) = (det (A))n (det (B))m • (A ⊗ B)−1 = A−1 ⊗ B −1 • If A > 0 and B > 0 then A ⊗ B > 0 • vec (ABC) = (C 0 ⊗ A) vec (B) • tr (ABCD) = vec (D0 )0 (C 0 ⊗ A) vec (B) 10 . ⎠ ⎝ . then det A = 2. . am1 B am2 B · · · amn B Some important properties are now summarized. These results hold for matrices for which all matrix multiplications are conformable. .

73. We call yi the dependent variable. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. When a distribution is skewed. m(x) can take any form. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. gender. These are conditional density functions — the density of hourly wages conditional on race. the mean wage for men is $27. . it is useful to have numerical measures of the diﬀerence. xki 3. See Chapter 16. These are indicated in Figure 3. ⎠ ⎝ . We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. While it is easy to observe that the two densities are unequal. and that for women is $20.22. Figure 3. which is a common feature of wage distributions. the mean is not necessarily a good summary of the central tendency. ⎟ . In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation.1) xi = ⎜ . the conditioning variable.1. To illustrate. Take a closer look at the density functions displayed in Figure 3. holding the other variables constant. the conditional density of yi given xi . and exists so long as E |yi | < ∞. These are asymmetric (skewed) densities.2) m(x) = E (yi | xi = x) = −∞ In general.1. The data are from the 2004 Current Population Survey 1 11 . This is used when the goal is to quantify the impact of one set of variables on another variable. In the example presented in Figure 3.1 by the arrows drawn to the x-axis. education and experience.1 displays the density1 of hourly wages for men and women. or the covariates. You can see that the right tail of then density is much thicker than the left tail.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. we can focus on f (y | x) . We call xi alternatively the regressor. xi ) where yi is a scalar (real-valued) and xi is a vector. In this context we partition the observations into the pair (yi . (3. The two density curves show the eﬀect of gender on the distribution of wages.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression.

The comparison in Figure 3. and a Ph.3 is how the conditional expectation describes an important feature of the conditional distribution. For this reason. wage regressions typically use log wages as a dependent variable rather than the level of wages.D. The diﬀerence in the log mean wage between men and women is 0.2) evaluated at the observed value of xi : ei = yi − m(xi ). To illustrate. The main point to be learned from Figure 3. which implies a 30% average wage diﬀerence for this population.1 is facilitated by the fact that the control variable (gender) is discrete. Figure 3. Figure 3. 12 . degree in mean log hourly wages is 0. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. this yields the formula yi = m(xi ) + ei .30. implying an average 36% diﬀerence in wage levels.Figure 3. the solid line displays the conditional expectation of log wages varying with education. Assuming for simplicity that this is the true joint distribution. By construction.A. with mean log hourly wages drawn in with the arrows.36. Of particular interest to graduate students may be the observation that diﬀerence between a B.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. 2 (3. When the distribution of the control variable is continuous. 3.3) White non-military male wage earners with 10-15 years of potential work experience.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 3.3 displays a scatter plot2 of log wages against education levels. then comparisons become more complicated. The conditional expectation function is close to linear.5.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.

E (h(xi )ei ) = 0 for any function h (·) . E(ei ) = 0. most typically. 2.Figure 3. E(xi ei ) = 0. restrictions on the permissible class of regression functions m(x). by the deﬁnition of ei and the linearity of conditional expectations. The remaining parts of the Theorem are left as an exercise. It is important to understand that this is a framework.2: Log Wage Densities Theorem 3.2.1 Properties of the regression error ei 1. The equations yi = m(xi ) + ei E (ei | xi ) = 0. not a model. 3. These equations hold true by deﬁnition. A regression model imposes further restrictions on the joint distribution. 13 . because no restrictions have been placed on the joint distribution of the data. To show the ﬁrst statement. 4. are often stated jointly as the regression framework. E (ei | xi ) = 0. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.

the conditional variance of yi is σ 2 = σ 2 (xi ). in the sense of achieving the lowest mean squared error. when σ 2 (x) is a constant so that ¢ ¡ (3. Given the random variable xi .3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .1.2. let g(x) be an arbitrary predictor of yi given xi = x. The right-hand-side is minimized by setting g(x) = m(x). 3. Thus the mean squared error is minimized by the conditional mean. 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). σ 2 (x) is a non-trivial function of x.3 Conditional Variance Generally.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. subject to the restriction p that it is non-negative. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. To see this.3. and can take any form. it does not provide information about the spread of the distribution. In contrast. i .4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.

we say that the error ei is homoskedastic. Equation (3.5. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .5) xi = ⎜ . i (3.7) is a k × 1 parameter vector. In this case (3. Thus (3. So while men have higher average wages. ⎝ . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . The conditional standard deviation for men is 12.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.8) (3. ⎟ β=⎝ .5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . we assume that x1i = 1.6) (3. where x1i is the ﬁrst element of the vector xi deﬁned in (3.6) as an approximation. βk ⎛ (3. its functional form is typically unknown. ⎠ . it is convenient to augment the regressor vector xi by listing the number “1” as an element. take the conditional wage densities displayed in Figure 3. it is more realistic to view the linear speciﬁcation (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. xki When m(x) is linear in x.4 Linear Regression An important special case of (3.1 and that for women is 10. 15 .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). they are also somewhat more dispersed. and the linear assumption of the previous section is empirically unlikely to accurate. As an example. We call this the “constant” or “intercept”. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .1. 3.9) 3. Instead. Equivalently.8) is called the linear regression model. which we derive in this section.1). ⎠ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. ⎟ . Notationally.

Rewriting. written E (xi x0 ) > 0. Assumption 3. this situation must be excluded. Equivalently. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.5.10). 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. The ﬁrst-order condition for minimization (from Section 2. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. The best linear predictor is obtained by selecting β to minimize S(β).1.10) It is worth taking the time to understand the notation involved in this expression.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. otherwise they are distinct. Given the deﬁnition of β in (3. E (xi x0 ) is invertible. i i (3. E (x0 xi ) < ∞. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . i (3. Therefore. xi contains an intercept.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. by “best” we mean the predictor function with lowest mean squared error. In order for β to be uniquely deﬁned. i 4.12) This completes the derivation of the linear projection model. This occurs when redundant variables are included in xi . i 16 . α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite.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 . As before. It is invertible if and only if it is positive deﬁnite.which is quadratic in β. 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 . α0 E (xi x0 ) α = E (α0 xi )2 > 0. The vector (3. Eyi < ∞. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.5. x0 β is the best linear predictor for yi . i which requires that for all non-zero α. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . i (3. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.1 1. The error is i ei = yi − x0 β. 2 2. Observe i that for any non-zero α ∈ Rk .

Equation (3.2 and 3.1.1. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. For example. 17 .4 is required to ensure that β is uniquely deﬁned.3 are called regularity conditions.5.12) and (3. Figure 3.5.Theorem 3.1 Under Assumption 3. Using the deﬁnitions (3.5.3 ensure that the moments in (3.12) can be alternatively interpreted as a projection decomposition. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Assumption 3. Since ei is mean zero by (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. the orthogonality restriction (3.5.1.9).10) are deﬁned.1.5.4 we know that the regression error has the property E (xi ei ) = 0. E (xi ei ) = 0 and E (ei ) = 0. Let’s compare it with the linear regression model (3.5.2.1. This means that the equation (3. ¥ (3.1 is employed to guarantee that (3.2 and 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 = 0.13) implies that xi and ei are uncorrelated.13) The two equations (3.8)-(3. (3.14) Proof.5. Assumption 3. Since from Theorem 3.1.10) and (3.5.1.14) follows from (3.11) are well deﬁned.5.1.5.5.14) holds. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. By deﬁnition. it follows that linear regression is a special case of the projection model.14).13) and Assumption 3.11) and (3. However.1. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .1 are weak. Furthermore.1.1.13) summarize the linear projection model.4 guarantees that the solution β exits. Assumption 3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. (3. Assumption 3. The ﬁnite variance Assumptions 3.

Returning to the joint distribution displayed in Figure 3.5.10). and the straight dashed line is the linear projection.We have shown that under mild regularity conditions. and under-predicts for the rest.3.4 displays the relationship3 between mean log hourly wages and labor market experience. for any pair (yi . In this case (3. there are no changes in our methods or analysis. The solid line is the conditional mean. for those over 53 in age). This defect in linear projection can be partially corrected through a careful selection of regressors. Most importantly. It over-predicts wages for young and old workers. In this example the linear projection is a close approximation to the conditional mean. In this example it is a much better approximation to the conditional mean than the linear projection. and are discussed in Chapter 11. Other than the redeﬁnition of the regressor vector.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. the dashed line is the linear projection of log wages on eduction. it is important to not misinterpret the generality of this statement.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. We illustrate the issue in Figure 3.10) may not hold and the implications of Theorem 3. In Figure 1.5. In the example just presented.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. in many economic models the parameter β may be deﬁned within the model. since the resulting function is quadratic in experience. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.1 may be false. In contrast. 18 . xi ) we can deﬁne a linear projection equation (3.12) with the properties listed in Theorem 3. A projection of log wages on these two variables can be called a quadratic projection. In this case the linear projection is a poor approximation to the conditional mean. we can augment the regressor vector xi to include both experience and experience2 . These structural models require alternative estimation methods. Figure 3. In other cases the two may be quite diﬀerent. However.4 we display as well this quadratic projection. Figure 3. The linear equation (3. No additional assumptions are required.1.

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

True or False. If yi = x0 β + ei . E(Y 2 | X = x) and V ar(Y | X = x). E(ei | xi ) = 0. taking values only on the non-negative integers. Are they diﬀerent? Hint: If P (Y = j) = 5. µx = Exi . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . 2. then E(x2 ei ) = 0. i 11. m. If yi = x0 β + ei and E(xi ei ) = 0. j! 0 j = 0. then E(x2 ei ) = 0. then E(ei | xi ) = 0. and E(ei | xi ) = 0. σ = . True or False. . and E(e2 | xi ) = σ 2 .6 Exercises 1. Compute the conditional mean m(x) = E (yi | xi = x) . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. True or False. 3. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j .3.1 .. xi ∈ R. i 7. e−λ λj j! . s) = 0 if and only if m = µ and s = σ 2 . i 10.2. True or False. then ei is i i independent of xi . Prove parts 2. 1.1. If yi = x0 β + ei and E(ei | xi ) = 0. xi ∈ R. True or False. If yi = xi β + ei . i 8. Suppose that yi is discrete-valued. (x − µ)2 − σ 2 Show that Eg (X. x 6. Let X be a random variable with µ = EX and σ 2 = V ar(X). Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ.4 . 20 .2 Y =1 . Compute E(yi | xi = x) and V ar(yi | xi = x). σ 2 = V ar(xi ). 9. Suppose that Y and X only take the values 0 and 1. 3 and 4 of Theorem 3. Let xi and yi have the joint density f (x. σ 2 = V ar(yi ) and σ xy = Cov(xi . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. 0 ≤ y ≤ 1. and have the following joint probability distribution X=0 X=1 Y =0 .. a constant. µ. If yi = xi β + ei . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . 2. yi ). and E(xi ei ) = 0. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . ¡ ¢ 4.3 Find E(Y | X = x). then ei is independent of xi .

2) can be written in the parametric 0 β)) = 0.7 and 4.1 Estimation Equation (4. 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 . but for most of the chapter we retain the broader focus on the projection model. Observe that (4. i n i=1 n 21 .3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .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 (4.8.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . 4.2) (4.1) (4. i It follows that the moment estimator of β replaces the population moments in (4.3) In Sections 4. we narrow the focus to the linear regression model.4) i i=1 i=1 ˆ Another way to derive β is as follows. (4.

5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. Let yi be log wages and xi be an intercept and years of education. 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.40 µ ¶µ ¶ 34.3. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.94 −2. 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 (4.117 Educationi .83 ¶−1 µ ¶ .37 µ ¶ 1.4).14 205.117 1 14.14 205. 40 0.2 Least Squares There is another classic motivation for the estimator (4. An interpretation of the estimated equation is that each year of education is associated with an 11. i 22 .30 + 0. with 10-15 years of potential work experience.95 42. 40 2. consider the data used to generate Figure 3.14 14.71 = −2.4).83 µ We often write the estimated equation using the format \ log(W agei ) = 1.ˆ This is a set of k equations which are linear in β.7% increase in mean wages. Then µ ¶ n 1X 2.95 xi yi = 42.14 14. This sample has 988 observations. excluding military. ¶ 2. 4. 0. To illustrate. These are white male wage earners from the March 2004 Current Population Survey.170 37. 30 = .40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.

2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Following convention we will call β the OLS estimator of β. while the residual is a by-product of estimation. the contour lines are ellipses. Since the function Sn (β) is a quadratic function of β. Figure 4. i ˆ ˆ Note that yi = yi + ei . To visualize the sum-of-squared errors function. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. Figure 4.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.4). Figure 4. These two ˆ variables are frequently mislabeled.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). which can cause confusion.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. It is important to understand the distinction between the error ei and the residual ei . 23 . The error is unobservable.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. Matrix calculus (see Appendix 2.

Figure 4.7.2: Sum-of-Squared Error Function Contours Equation (4. It measures the variation in the i “unexplained” part of the regression. Its method of moments estimator is the sample average 1X 2 ei .5) implies that 1X xi ei = 0. These are algebraic results. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. ˆ σ = ˆ n 2 i=1 n (4. one implication is that n 1X ei = 0. The error variance σ 2 = Ee2 is also a parameter of interest. 24 . ˆ n−k 2 i=1 (4. and hold true for all linear regression estimates.6) An alternative estimator uses the formula n 1 X 2 s = ei .7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n i=1 n Since xi contains a constant.

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

Thus the MLE (β. ⎝ ⎝ . . including computation. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. ⎟. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. = β+ XX 26 (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. 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. . . 4. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . For example n X i=1 For many purposes. n or equivalently Y = Xβ + e. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. . residual vector.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β.12) is a system of n equations. . one for each observation. it is matrix notation. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE.4). We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . Sample sums can also be written in matrix notation.8) . en ⎞ Observe that Y and e are n × 1 vectors. yn = x0 β + en . ⎠ xi x0 = X 0 X i xi yi = X 0 Y.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . Due to this equivalence. and X is an n × k matrix. . ⎠ . The linear equation (3. yn ⎟ ⎟ ⎟. x0 n ⎞ ⎛ e1 e2 . and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e. n X i=1 Thus the estimator (4.6).

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

9). Regress X2 on X1 . ⎟ ⎜ ⎟ ⎜ (4. Rather. is the demeaning formula for regression. . and X2 is the vector of observed regressors. ⎠ ⎝ ⎠ ⎝ . 30 . In this case. but in most cases there is little computational advantage to using the two-step algorithm. . . By the independence of the observations and (3. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. Regress Y on X1 . obtain OLS estimates β 2 and residuals e. ˆ which are “demeaned”. . 4. .9). In the model (4.8)(3. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . 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) .6. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. Regress Y on X2 .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. . ¡ ¢−1 0 ι. which you may have seen in an introductory econometrics course. observe that ⎞ ⎛ ⎞ ⎛ . obtain residuals X2 .Theorem 4. obtain residuals Y .13).1 (Frisch-Waugh-Lovell). A common application of the FWL theorem. the primary use is theoretical. In some contexts. . . the FWL theorem can be used to speed computation. ˜ 2.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. In this section we derive the small sample conditional mean and variance of the OLS estimator.14) or via the ˆ following algorithm: ˜ 1. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. ˆ ˜ ˜ ˆ 3. . M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. .

. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0.. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.. we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0.19) ˆ and thus the OLS estimator β is unbiased for β. . ⎝ . Then given (4. . 0 0 ··· 0 0 . the properties of conditional expectations. σ 2 } = ⎜ . 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. and the trace operator observe that.. V ar β | X = X 0 X ⎟ ⎟ ⎟. X 0 DX = X 0 Xσ 2 . . and (4.18). . Next. From (4. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 .12).Using (4.20) . . 1 n ..19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . under the of ˆ ¢ 2 | x = σ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ . ⎠ (4. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . . . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 .8).

In the homoskedastic linear regression model. As an alternative.8)¢ ¡ (3.10). It is not unbiased in the absence of homoskedasticity. ³ ´ ˜ E β | X = A0 Xβ. What is the best choice of A? The Gauss-Markov theorem. which we now present. says that the least-squares estimator is the best choice. = σ2 n the ﬁnal equality by (4. It is important to remember. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. The following result. In this case. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . is a famous statement of the solution. which is (3. the estimator ˆ 2 deﬁned (4. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. By a calculation similar to those of the previous section. 32 . known as the Gauss-Markov theorem. the best (minimumvariance) unbiased linear estimator is OLS. however.1 Gauss-Markov. Theorem 4. 4. as it yields the smallest variance among all unbiased linear estimators.8.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 . Now consider the class of estimators of β which are linear functions of i the vector Y. ˜ β L = A0 Y = A (Xβ + e) = β + Ae.9) plus E e2 | xi = σ 2 . Thus since V ar (e | X) = In σ 2 under homoskedasticity. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. Thus σ 2 is biased towards zero. ˜ so β is unbiased if (and only if) A0 X = Ik .8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense. or in the projection model.7) is unbiased for σ 2 by this calculation.

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

Chamberlain (1987) extends this argument to the case of continuously-distributed data.10 Omitted Variables xi = µ x1i x2i ¶ . 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 . and thus so is the OLS estimator. the maximum likelihood estimator is identical to the OLS estimator.Substituting in the expressions for π j . if the data have a discrete distribution. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .10) for the class of models satisfying Assumption 3. He observes that the above argument holds for all multinomial distributions.1. (4. He proves that generically the OLS estimator (4.22) 34 . ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.5.9).

. First. Typically there are limits. For example.22). the general model will be free of the omitted variables problem. this arises when sets of regressors are included which are identically related. least-squares estimation of (4. Goldberger (1991) calls (4. or second.Now suppose that instead of estimating equation (4. In this case. 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 . we regress yi on x1i only. log(p2 ) and log(p1 /p2 ). as many desired variables are not available in a given dataset. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. then β is not deﬁned.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. except in special cases. This deﬁnition is not precise. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). 35 . This is the situation when the X 0 X matrix is near singular. there is some α such that Xα = 0.22) the long regression and (4. if X includes both the logs of two prices and the log of the relative prices. When this happens. β 1 6= γ 1 . In general. we calculate γ1 = ¡ ¡ ¢¢−1 E x1i x0 E (x1i yi ) 1i ¡ ¡ ¢¢−1 ¡ ¡ 0 ¢¢ 0 E x1i x1i β 1 + x0 β 2 + ei = E x1i x1i 2i ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 β 2 = β 1 + E x1i x0 1i 2i = β 1 + Γβ 2 ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 Γ = E x1i x0 1i 2i (4. the coeﬃcient on x2i in (4.23) where is the coeﬃcient from a regression of x2i on x1i . This is called strict multicollinearity. The diﬀerence Γβ 2 is known as omitted variable bias. It is the consequence of omission of a relevant correlated variable. Most commonly. This happens when the columns of X are linearly dependent.e. 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. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions.23) the short regression to emphasize the distinction. Typically. By construction.22) by least-squares. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. and the error as ui rather than ei . the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . log(p1 ).11 Multicollinearity ˆ If rank(X 0 X) < k + 1. i. 4. To see this.22) is zero. this is rarely a problem for applied econometric practice. The more relevant issue is near multicollinearity. Since the error is discovered quickly. because we have not said what it means for a matrix to be “near singular”. This is because the model being estimated is diﬀerent than (4. which is often called “multicollinearity” for brevity.

the OLS estimator based on the sample excluding the i’th observation. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. 1] and sum to k. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . deﬁne the leave-one-out least-squares estimator of β. ˆ ˆ (4. the worse the precision of the individual coeﬃcient estimates. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1. ˆ i A simple comparison yields that ˆ ei − ei. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . We derive expression (4.−i = yi − x0 β (−i) = (1 − hi )−1 ei .26) As we can see. As a consequence. The hi take values in [0.25) below. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . We can also deﬁne the leave-one-out residual ˆ ˆ ei.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. since as ρ approaches 1 the matrix becomes singular. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. the precision of individual estimates are reduced. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. To investigate the possibility of inﬂuential observations.−i = (1 − hi )−1 hi ei . In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.27) (4. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 .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. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. What is happening is that when the regressors are highly dependent. If the i’th observation 36 . that is.

which is considerably more informative than plots of the uncorrected residuals ei . Investigations into the presence of inﬂuential observations can plot the values of (4.25).1) in Section 2. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei . The key is equation (2. then this observation is a leverage point and has the potential to be an inﬂuential observation.27). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . ˆ We now derive equation (4.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .This implies has a large value of hi .

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

n→∞ lim P (|Zn − Z| > δ) = 0. Note EU = EV = 1.4) Proof of Jensen’s Inequality. Since g(x) is convex. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. tangent lines lie below it. =E U V p q p q Proof of Markov’s Inequality. P (g(X) > α) ≤ α−1 Eg(X).3). Set Y = g(X) and let f denote the density function of Y. Let a + bx be the tangent line to g(x) at x = EX. ¥ 5. as stated. ¥ Proof of Holder’s Inequality. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . (5. 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 ) = + . 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}. Applying expectations.Markov’s Inequality. We say that Zn converges in probability to Z as n → ∞. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. The WLLN shows that sample averages converge in probability to the population average. Theorem 5. n i=1 42 . denoted Zn →p Z as n → ∞. Eg(X) ≥ a + bEX = g(EX).2. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. p p p q which is (5. then as n → ∞ n 1X Xn = Xi →p E(X). So for all x. If Xi ∈ Rk is iid and E |Xi | < ∞.1 Weak Law of Large Numbers (WLLN). if for all δ > 0. For any strictly increasing function g(X) ≥ 0.

1 Central Limit Theorem (CLT). Fix δ and η. if for all x at which F (x) is continuous.6) By Jensen’s inequality (5. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. 43 . the triangle inequality. Theorem 5. V ) . ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. 5. ¡¯ ¯ P ¯X n ¯ > δ ≤ η.Proof: Without loss of generality.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . If Xi ∈ Rk is iid and E |Xi |2 < ∞. we can set E(X) = 0 (by recentering Xi on its expectation). Fn (x) → F (x) as n → ∞. the fact that X n = W n + Z n . We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N.6) and (5. Jensen’s inequality (5. by Markov’s inequality (5.1).7). n i=1 0 where µ = EX and V = E (X − µ) (X − µ) .3. Finally. and the bound |Wi | ≤ 2C. P ¯X n ¯ > δ ≤ η. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. We say that Zn converges in distribution to Z as n → ∞.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. where Z has distribution F (x) = P (Z ≤ x) . (5. the fact that the Wi are iid and mean zero.5). ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) .1) and (5. as needed.4). denoted Zn →d Z. Set ε = δη/3.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) .

Proof: Without loss of generality. ∂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. By a second-order Taylor series expansion of c(λ) about λ = 0. so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). the deﬁnition of c(λ) and (5.8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 . the independence of the Xi . ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . By the properties of the exponential function. 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 . 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. it is suﬃcient to consider the case µ = 0 and V = Ik .

Ik ) distribution.√ where λn → 0 lies on the line segment joining 0 and λ/ n. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. This is suﬃcient to establish the theorem. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. √ Theorem 5. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Theorem 5. Σ) = N 0. k ≤ m. If Zn →d Z as n → ∞ and g (·) is continuous. then g(Zn ) →d g(Z) as n → ∞. we see that as n → ∞. and g(θ) : Rm → Rk .4. Proof: Since g is continuous at c.2 Continuous Mapping Theorem 2. 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 . Stacking across elements of g.4 Asymptotic Transformations Theorem 5. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. Σ) . Hence g(Zn ) →p g(c) as n → ∞. for each element of g. Since cλλ (λn ) → cλλ (0) = −Ik .3 Delta Method: If n (θn − θ0 ) →d N (0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.4. Recall that A ⊂ B implies P (A) ≤ P (B). If Zn →p c as n → ∞ and g (·) is continuous at c. gθ Σgθ . Proof : By a vector Taylor series expansion. 45 . where θ is m × 1 and Σ is m × m.1 Continuous Mapping Theorem 1 (CMT).4. ¥ 5. then g(Zn ) →p g(c) as n → ∞.

ˆ Figure 6. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density. xi ) and the sample size n. The verticle line marks the true value of the projection coeﬃcient. 46 . and therefore has a sampling distribution. the density function of β 2 was computed and plotted in Figure 6.1 Sampling Distribution The least-squares estimator is a random vector. 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.1 for sample sizes of n = 25.1: Sampling Density of β 2 To illustrate the possibilities in one example. n = 100 and n = 800. In general. since it is a function of the random data. Using ˆ simulation methods.Chapter 6 Inference 6. its distribution is a complicated function of the joint distribution of (yi .

the OLS estimator β is has a statistical distribution which is unknown.1 and the WLLN (Theorem 5.5. we can conclude ˆ that β →p β.2. First. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.1) and ˆ We now deduce the consistency of β. 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 .3) Ã where g(A. To characterize the sampling distribution more fully. Assumption 3. ·) is continuous at (Q. using (6.1).2 Consistency ˆ As discussed in Section 6. β →p β as n → ∞. Equation (4.1 by the fact that the sampling densities become more concentrated as n gets larger.2. For a complete argument. 0). xi ei →p g (Q.3).5.1. Ã n ! n X 1X 0 1 ˆ xi xi . Assumption 3.1).1.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. n i=1 (6. ˆ 47 .4. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. and the continuous mapping theorem (Theorem 5.5. 6.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . (6. we will use the methods of asymptotic approximation.2). Hence by the continuous mapping theorem (Theorem 5.4 implies that Q−1 exists and thus g(·. ˆ Theorem 6.1.2) i i n i=1 n From (6. This is illustrated in Figure 6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.1). Proof. As the sample size increases the density becomes more concentrated about the population coeﬃcient. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1 Under Assumption 3. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. (6.4. 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. (6.1).

5. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.1).1 In addition to Assumption 3.2 Under Assumption 3. E ¯ei ¯ E ¯e4 ¯ i i i i (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. 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 .5) Thus xi ei is iid with mean zero and has covariance matrix Ω.3. n 1 X √ xi ei →d N (0.1 guarantees that the elements of Ω are ﬁnite. Ee4 < ∞ and E |xi |4 < ∞.2).2. Assumption 6.1. By the central limit theorem (Theorem 5. Thus σ 2 is consistent for σ 2 .3. by the Cauchy-Schwarz inequality (5. Ω) . To see this. (6.6) n i=1 48 . We need a strengthening of the moment conditions. it follows that s2 = ¥ n σ 2 →p σ 2 . ˆ Proof.1.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.3) and Theorem (6. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . (6.2).Theorem 6. (6. since n/(n − k) → 1 as n → ∞.1).2. ˆ Finally. ˆ n−k 6. (6.5.3.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. i i Assumption 6.

1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. its variance diverges q ³ ´ ˆ to inﬁnity. when xi and ei are independent. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . otherwise V 6= V 0 . for example. The trouble is that no matter how large is the sample size.7) is true then V = V 0 .9) we deﬁne V 0 = Q−1 σ 2 whether (6.1 states that the sampling distribution of the least-squares estimator. V is often referred to as ˆ the asymptotic covariance matrix of β. When (6.1. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. is approximately normal when the sample size n is suﬃciently large. there is no simple answer to this reasonable question. (6.3. We say that ei is a Homoskedastic Projection Error when (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1 Under Assumption 6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . after rescaling. and (6.2). If α > 2 the 2 error εi has zero mean and variance α/(α − 2).1). The expression V = Q−1 ΩQ−1 is called a sandwich form.Then using (6.3. xi ) which satisfy the conditions of Assumption 6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. We call V 0 the homoskedastic covariance matrix.3. There is a special case where Ω and V simplify. e2 ) = 0. Under (6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. 1) asymptotic distibution. V ) where V = Q−1 ΩQ−1 .1. The asymptotic distribution ´ Theorem 6. The approximation may be poor when n is small. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. setting n = 100 and varying the parameter α. 1).7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . How large should n be in order for the approximation to be useful? Unfortunately. |ε| ≥ 1.6). but this is not a necessary condition. Let yi = β 0 + β 1 xi + εi where xi is N (0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. 1 X √ xi ei n i=1 n ! the N (0. Theorem 6. Ω) ¡ ¢ = N 0. however.3. We illustrate this problem using a simulation. In´Figure 6. As α approaches 2. However.9) In (6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. This holds true for all joint distibutions of (yi . For α 49 .7) holds.7) is true or false. Q−1 ΩQ−1 .3.7) Cov(xi x0 . In Figure 6. i i Condition (6.

we need an estimate of Ω = E xi x0 e2 . 4. 1) asymptotic approximation is never guaranteed to be accurate. The estimator 2 2 in (6.3. We show the sampling distribution of n β 1 − β 1 setting n = 100.2) and Theorem 6.10) without changing this result.1) it is clear that V 0 →p V 0 . The lesson from Figures 6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. 6 and 8. concentrating most of the probability mass around zero. 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 (0.10) V 0 = Q−1 s2 .Figure 6. As α diminishes the density changes signiﬁcantly.2. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. for k = 1.3 is that the N (0. Another example is shown in Figure 6.0 the density is very close to the N (0.11) 50 . the sampling distribution becomes highly skewed and non-normal. 1). 1) density. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2: Density of Normalized OLS estimator α = 3.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 6.2 and 6. As k increases.

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

035 ¶ .020.14 6.199 2.480 ˆ0 = 0.20 = V 14. from which it follows that V →p V as n → ∞. (6.5 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. The standard errors for β 0 are 7.14 205.12) in turn. and then the square roots.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.14 14.085) (.020) 6. Using (6. i i i i n i=1 Second.20 −0. We calculate that s2 = 0.83 ¶−1 µ .used by an author when studying their work.80 40.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.80 .98 −0. (6.80 40.480 .20 and µ ¶ ˆ = 0.199 2. To illustrate.14 14.039 and ˆ V = µ 1 14. then take the diagonal elements. First. From a computational standpoint.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.6 ¶µ 1 14.30 + 0.2/988 = .6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. we return to the log wage regression of Section 4.14 205.085 p ˆ and that for β 1 is .493 −0. n n i=1 52 . just as any other estimator. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.2. Ω 2.493 0. p ˆ In this case the two estimates are quite similar.1. (.80 2. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.83 −0.35/988 = .14 205.83 ¶−1 = µ 7.117 Educationi .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 .5) and the WLLN (Theorem 5. by Holder’s inequality (5. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . but not under another set of assumptions.

¯ ¯n ¯ n i=1 so Together. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6.13) Using formula (4. Using this substitution. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.5. n i=1 n ˆ ˆ Theorem 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.1 As n → ∞. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.13) of Efron (1982). Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .26). From equation (3.25). n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. 6. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. these establish consistency. i=1 Third. by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi .11) with the leave-one-out estimator ei.−i = (1 − hi )−1 ei ˆ presented in (4. Ω →p Ω and V →p V.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 (1991) suggested an similar estimator based on cross-validation. Recall from Section 4. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .

Ω∗∗ = i ˆi n i=1 n 6.7 Functions of Parameters Sometimes we are interested in some lower-dimensional function of the parameter vector β = (β 1 . Let h : Rk → Rq denote this function and let θ = h(β) denote the parameter of interest. Hβ = ∂β In many cases. 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. 54 . so Vθ = R0 V R. β k+1 ). = N (0. Andrews ˆ ˆ (1991) argues that simulation evidence indicates that V ∗∗ is an improvement on V ∗ . ˆ θ What is an appropriate standard error for ˆ Assume that h(β) is diﬀerentiable at the true θ? value of β. .. Hβ = R and Hβ = R. In this case.. V ) where ∂ h(β) ∂β (k + 1) × q. Vθ ). the function h(β) is linear: h(β) = R0 β ˆ ˆ ˆ for some k × q matrix R. (6. By a ﬁrst-order Taylor series approximation: ³ ´ 0 ˆ ˆ h(β) ' h(β) + Hβ β − β . The estimate of θ is ˆ = h(β). then the natural estimate for the variance of ˆ is θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). we may be interested in a single coeﬃcient β j or a ratio β j /β l . but omits the mean correction.. 1X ˆ (1 − hi )−2 xi x0 e2 .where ˆ It is similar to the MacKinnon-White estimator V ∗ . In these cases we can write the parameter of interest as a function of β. For example. ˆ ˆ If V is the estimated covariance matrix for β.15) where 0 Vθ = Hβ V Hβ .

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

A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . It is designed to cover θ with high probability.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . Let zα/2 is the upper α/2 quantile of the standard normal distribution. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. An alternative approach. under H0 . in that the reader is allowed to pick the level of signiﬁcance α. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α.025 = 1. associated with Fisher. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . In a sense. 1]. tn →d N (0. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. 1). That is. or “accepts” H0 . If the p-value pn is small (close to zero) then the evidence against H0 is strong. is to report an asymptotic p-value. 1]. 1]. For example. That is. however. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. and is a function of the data and hence is / random. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . z. Either θ ∈ Cn or θ ∈ Cn . regardless of the complication of the distribution of the original test statistic. Deﬁne the tail probability. Then the asymptotic p-value of the statistic tn is pn = p(tn ). The p-value is more general. To see this fact. if Z ∼ N (0. 56 . note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). from which it follows that pn →d U [0.645. pn →d U [0.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ.05 = 1. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. 6. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. Otherwise the test does not reject. The coverage probability is P (θ ∈ Cn ).96 and z. s(ˆ θ) Under H0 . The asymptotic p-value for the above statistic is constructed as follows. 1). The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing.

However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value.05. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). ˆ + zα/2 s(ˆ . Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . and it is desired to test the joint restrictions simultaneously. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.18) . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.16) and zα/2 is the upper α/2 quantile of the standard normal distribution.96s(ˆ ≈ ˆ ± 2s(ˆ . = n h(β) − θ0 Hβ V Hβ 57 (6. θ θ) (6. the most common professional choice isi95%. or α = . θ The interval has been constructed so that as n → ∞. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. In this case the t-statistic approach does not work. This corresponds to selecting the conﬁdence h i h ˆ ± 1. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ). 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).17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. 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. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. 6.

15) showed that n ˆ − θ →d Z ∼ N (0. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 .84 = z. The null hypothesis is H0 : β 2 = 0. Hβ (β) is a continuous function of β.1.1 showed θ ˆ that V →p V. ˆ Wn = n θ θ q θ θ Theorem 6. As before. a chiq square random variable with q degrees of freedom. For example.5. 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.3. the upper-α quantile q 2 of the χ2 distribution. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .1 Under H0 and Assumption 6. and Theorem 6. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. if rank(Hβ ) = q. The asymptotic p-value for Wn is pn = p(Wn ). 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. h(β) = R0 β.19) σ2 ˆ where σ2 = ˜ 1 0 e e. χ2 (.When h is a linear function of β. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).025 . θ = β 2 .05) = 3. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . Furthermore. Vθ ). so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. 1] under H0 .2. and there are q = k2 restrictions. the test rejects at the α% level iﬀ pn < α. Also h(β) = a selector matrix.8. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . Hence β β by Theorem A. In this case. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). then Wn →d χ2 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . q and pn is asymptotically U[0. 6. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.10. Hβ (β) →p Hβ . ˜˜ n ˜ e = Y − X1 β 1 .

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

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

σ2 ˆ 61 . As inference (conﬁdence intervals) are based on the t-ratio. n−k • ∼ tn−k ˆ In Theorem 6. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . β 2 . β 2 . σ 2 ) discussed above. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .3. We summarize these ﬁndings Theorem 6. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. the notable distinction is between the N (0. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . and standard errors are calculated using the homoskedastic formula (6.8.1 shows that under the strong assumption of ˆ normality. 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. In contrast.1 and Theorem 6. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . β has an exact normal distribution and t has an exact t distribution.12. σ 2 ) − Ln (β 1 . 0. Theorem 6.10) then ´ ³ ˆ • β ∼ N 0. β and t are approximately normally distributed. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .12. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . if standard errors are calculated using the homoskedastic formula (6. σ ˆ ˆ βj − βj βj − βj N (0. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. β 2 . 1) and tn−k distributions.a chi-square distribution with n − k degrees of freedom. a good testing procedure is based on the likelihood ratio statistic. 0.1 we showed that in large samples. The critical values are quite close if n − k ≥ 30. with residual variance σ . 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. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 .1 If ei is independent of xi and distributed N(0. σ 2 ). σ 2 ) = − log σ − log (2π) − . Furthermore.) Now let us partition β = (β 1 . so as a practical matter it does not matter which distribution is used. (Unless the sample size is unreasonably small.10) µ h i ¶ 2 (X 0 X)−1 N 0.

The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. In the present context of the Wald statistic. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Through repetition. Letting h(β) = β s . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. To demonstrate this eﬀect.8.4 the Wald statistic Wn (s) as a function ˆ of s. This is an unfortunate feature of the Wald statistic.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n .7. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Take the model yi = β + ei ei ∼ N (0. and noting Hβ = sβ s−1 .84 — the probability of a false rejection. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. while there are other values of s for which test test statistic is insigniﬁcant. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. The decreasing dashed ˆ = 1. 62 . This produces random draws from the sampling distribution of interest. the statistic Wn (s) varies with s. features of this distribution can be calculated. they can work quite poorly when the restrictions are nonlinear. we have plotted in Figure 6. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. Our ﬁrst-order asymptotic theory is not useful to help pick s.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . as Wn (s) →d χ2 under H0 for 1 any s. This can be seen by a simple example introduced by Lafontaine and White (1986). The increasing solid line is for the case β = 0. σ 2 ) and consider the hypothesis H0 : β = 1. 6. ˆ Let β and σ 2 be the sample mean and variance of yi . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. setting n/σ 2 = 10.

When comparing statistical procedures. however. the Type I error probability improves towards 5% as the sample size n increases.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .1 reports the simulation estimate of the Type I error probability from 50. These probabilities are calculated as the percentage of the 50. remember that the ideal Type I error probability is 5% (. There is. In each case. this probability depends only on s. Table 4. Table 4.84.Figure 6. Given the simplicity of the model.4. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. n. and rarely fall outside of the 3%-8% range. looking for tests for which rate rejection rates are close to 5%. the only test which meets this criterion is the conventional Wn = Wn (1) test. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. we compare the rates row by row. so these probabilities are Type I error. In Table 2.4: Wald Statistic as a function of s P (Wn (s) > 3. and σ is varied among 1 and 3. For this particular example. To interpret the table.84 | β = 1) . n is varied among 20. The value of s is varied from 1 to 10.1 you can also see the impact of variation in sample size.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Typically. Error rates avove 10% are considered excessive. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Type I error rates between 3% and 8% are considered reasonable. Test performance deteriorates as s increases. 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. The null hypothesis β s = 1 is true. Rates above 20% are unexceptable. In Table 4. 100 and 500. no magic choice of n for which all tests perform uniformly well.05) with deviations indicating+ distortion. and σ 2 .000 random samples.

07 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .25 . 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. 64 .34 . This point can be illustrated through another example.10 .13 .23 .15 .20). Equivalently. An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.08 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. so the hypothesis can be stated as H0 : θ = r.13 .14 .13 .07 .25 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.24 .12 .15 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .06 .07 .15 . β 2 ) be the least-squares estimates of (6.06 .18 .05 .22 .08 .10 .06 .16 Rejection frequencies from 50.06 .05 .20 .06 .05 .s 1 2 3 4 5 6 7 8 9 10 Note: σ=1 σ=3 n = 20 n = 100 n = 500 n = 20 n = 100 n = 500 .06 .21 .31 .07 .35 .11 .14 .15 .08 .06 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.09 .17 . β 1 .06 .30 .22 . While this is clear in this particular example.26 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .08 . Other choices are arbitrary and would not be used in practice.20 .07 .05 .12 .10 .28 .05 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .05 .08 .19 .33 . deﬁne θ = β 1 /β 2 .

02 .12 . . 6.14 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.7.00 . the rejection rates for the t1n statistic diverge greatly from this value.06 .06 . and normalize β 0 = 0 and β 1 = 1.00 .00 .15 .06 .75.09 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . ei be an independent N (0. this formulation should be used. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.25.05 .0 and n among 100 and 500. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.645) and P (tn > 1.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.10 .00 .05 . . along with sample size n.645) t1n t2n t1n t2n t1n t2n t1n t2n .50. Ideally. especially for small values of β 2 .07 . In this section we describe the method in more detail.05.00 .00 .15 .645) P (tn > 1. This leaves β 2 as a free parameter.05 . σ 2 ) draw with σ = 3.05 .00 . The implication of Table 4.2. In all cases. if the hypothesis can be expressed as a linear restriction on the model parameters.06 .06 .05 .06 .10 . such as the GMM distance statistic which will be presented in Section 9. while the right tail probabilities P (t1n > 1.05 .645) are calculated from 50. Table 4.05 β2 .06 .645) are close to zero in most cases. and alternatives to asymptotic critical values should be considered.05 . The results are presented in Table 4. We vary β 2 among . the entries in the table should be 0.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.645) P (tn < −1.645) greatly exceed 5%. 65 .28 . If no linear formulation is feasible.00 The one-sided Type I error probabilities P (tn < −1.000 simulated samples. and 1. The left tail probabilities P (t1n < −1.06 .00 .1. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . and are close to the ideal 5% rate for both sample sizes. It is also prudent to consider alternative tests to the Wald statistic.47 .25 .06 . In contrast.645) P (tn > 1. However.26 . . We let x1i and x2i be mutually independent N (0. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .10 . then the “most linear” formulation should be selected.50 .06 .75 1.05 .05 . 1) variables.00 .

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

For regressors we include years of education. The average (6. and poorly for others. this may ˆ be approximated by replacing P with P or with an hypothesized value. therefore.022.007. If the standard error is too large to make a reliable inference. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. potential work experience. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. an estimator or test may perform wonderfully for some values. . In practice. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. experience squared. Again our dependent variable is the natural log of wages. are. and . Then qα is the N ’th number in this ordered sequence. and dummy variable indicators for the following: married.05) (. In many cases. and estimate a multivariate regression. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. In particular. union member. then we can set s P = (. union member. It is therefore useful to conduct a variety of experiments. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test.003. We separately estimate equations for white and non-whites. and therefore it is straightforward to calculate standard errors for any quantity of interest. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. if we set B = 999. we included a dummy 67 . It is therefore convenient to pick B so that N is an integer. Quite simply. For the dependent variable we use the natural log of wages. and dummy variable indicators for the following: married. Generally. immigrant. 1000. We now expand the sample all non-military wage earners. immigrant. and our regressors include years of education. B b=1 (6.22/ B.96) . and 90% sample quantiles of the sample {Tnb }. 6. s P = . but requires more computational time. the researcher must select the number of experiments. potential work experience.95) /B ' . female. Hence the ³ ´ ˆ standard errors for B = 100. Furthermore. it is simple to make inferences about rejection probabilities from statistical tests. then B will have to be increased. B. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. The α% sample quantile is a number qα such that α% of the sample are less than qα . such as the percentage estimate reported in (6. respectively. the choice of B is often guided by the computational demands of the statistical procedure.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. experience squared. excluding military. female. so that coeﬃcients may be interpreted as semi-elasticities.96) . As discussed above. hispanic. equalling 1 with probability P = E1 (Tnb ≥ 1. As P is unknown.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. For example. Often this is called the number of replications. We us the sample of wage earners from the March 2004 Current Population Survey. the performance will depend on n and F. a larger B results in more precise estimates of the features of interest of Gn .21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. and 5000. The random variable 1 (Tnb ≥ 1.15 Estimating a Wage Equation We again return to our wage equation.21). For example. and hispanic. where N = (B +1)α. and non-white. for a selection of choices of n and F.96) is iid Bernoulli.

reestimating the model with the 50 state dummies excluded.002 . θ ˆ 2β 3 β2 . the restricted standard deviation estimate is σ = .032 . Computing the Wald statistic (6.070 .008 . Ignoring the other coeﬃcients.102 −.027 . The available sample is 18. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.1. Wn = n 1 − 2 = 18. 2β 3 68 .101 . this adds 50 regressors).69.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant.014 .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.variable for state of residence (including the District of Columbia. but not equal.097 −.007 . excluding the coeﬃcients on the state dummy variables.4945. 808 1 − .49452 σ ˜ Notice that the two statistics are close.232 .18) that the state coeﬃcients are jointly zero.010 .808 so the parameter estimates are quite precise and reported in Table 4.033 −.19) is ˜ µ ¶ µ ¶ σ2 ˆ . Using either statistic the hypothesis is easily rejected.48772 = 515.00057 .00002 .34 ˆ s(β) .102 −. Table 4. Alternatively. The F form of the Wald statistic (6. 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 .121 −.4877 18. as the 1% critical value for the χ2 distribution is 76. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.001 .013 . we ﬁnd Wn = 550.

but the lower end is substantially lower. we can calculate a standard error of s(ˆ = . Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.5]. this is a poor choice. 69 . we found better Type I error rates by reformulating the hypothesis as a linear restriction. Since tn (θ) is a non-linear function of θ. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. In the previous section we discovered that such t-tests had very poor Type I error rates. not testing a hypothesis. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. but it can be found numerically quite easily.96. Instead. This set is [27. so we have to go one step further.0. there is not a simple expression for this set. implying a 95% conﬁdence θ) interval of [27. This is the set of θ such that |tn (θ)| ≤ 1. 29.Using the Delta Method. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ).40. In the present context we are interested in forming a conﬁdence interval. 29.5].9. However.

show that the least-squares estimate of β = (β 1 . β 2 ). β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. the following deﬁnition is used. show that the least-squares estimate of β = (β 1 . subject to the constraint that β 1 = −β 2 . β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . (d) Under the ´ standard assumptions plus R0 β = r. then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. In the model Y = X1 β 1 + X2 β 2 + e. r ˜ is a known s × 1 vector. (a) Show that the solution is ´ ¢−1 h 0 ¡ 0 ¢−1 i−1 ³ 0 ¡ ˆ ˜ ˆ Rβ−r R R XX R β = β − X 0X ´ h ¡ ¢−1 i−1 ³ 0 ˆ ˆ Rβ−r R λ = R0 X 0 X ¢−1 0 ¡ ˆ XY β = X 0X where is the unconstrained OLS estimator. ˜ (b) Verify that R0 β = r. 0 < s < k. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix.16 Exercises For exercises 1-4.6. (c) Show that if R0 β = r is true. and rank(R) = s. ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. ˜ That is. In the model Y = X1 β 1 + X2 β 2 + e. 1. β − β = Ik − X 0 X 70 . ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. the least-squares estimate of β subject to the restriction h(β) = 0 is ˜ β = argmin Sn (β) h(β)=0 Sn (β) = (Y − Xβ)0 (Y − Xβ) . 3. λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. In the model Y = X1 β 1 + X2 β 2 + e. subject to the constraint that β 1 = c (where c is some given vector) is simply the OLS regression of Y − X1 c on X2 . In the model Y = Xβ + e. 2. ﬁnd the least-squares estimate of β = (β 1 . β 2 ). 4.

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

. This suggests 75 . We have shown that α is consistently estimated by a simple procedure. 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. which is typically undesirable. estimator of β. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi .. then the FGLS estimator will force ˜i the regression equation through the point (yi . Vα ) (7.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. if σ 2 ≈ 0 for some i. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. or FGLS. This is the feasible GLS. and will depend on the model (and estimation method) for the skedastic regression. Then set ˜i ˜ D = diag{˜ 2 . and hence we can estimate 0 σ 2 = zi α by i ˜ (7. ˜i Suppose that σ 2 > 0 for all i. then the FGLS ˜i estimator is not well deﬁned.Suppose ei (and thus η i ) were observed. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). xi ). We may call (7. If σ 2 < 0 for some i.4) the skedastic regression. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. Vα = E zi zi (7. Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi .3) ˆ ˆ While ei is not observed. Furthermore.6) σ 2 = α0 zi . . Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . as it is estimating the conditional variance of the regression of yi on xi . ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. there is no guarantee that σ 2 > 0 for all i..5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant.

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

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

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

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

In particular. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B.For θ close to the true value θ0 . ¥ Based on Theorem 7. 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 . m(xi . ˆ ˆ θ) ˆ θ). and this is often a useful hypothesis (sub-model) to consider. 80 . θ) ' (ei + m(xi . θ))2 ' n X¡ ¢2 0 yi − m0 θ θi i=1 0 and the right-hand-side is the SSE function for a linear regression of yi on mθi . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . 7.4. ˆ and ei = yi − m(xi . However. the parameter estimates are not asymptotically normally distributed. This renders the distribution theory presented in the previous section invalid. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ which is that stated in the theorem. θ0 ) + m0 (θ − θ0 ) . tests of H0 do not have asymptotic normal or chi-square distributions.1.5 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 . An alternative good measure is the conditional median. under H0 . γ is not identiﬁed. by a ﬁrst-order Taylor series approximation. Furthermore. θi Thus ¡ ¢ yi − m(xi . but these are not the only measures of central tendency. 1 2 The model is linear when β 2 = 0. Identiﬁcation is often tricky in nonlinear regression models. Hansen (1996). θ0 )) − m(xi . Thus when the truth is that β 2 = 0. Suppose that m(xi . Thus we want to test H0 : β 2 = 0. This means that under H0 . θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. θ) ' m(xi . θ) = β 0 zi + β 0 xi (γ). Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . We have discussed projections and conditional means.

and the substantive assumption is that the median function is linear in x.5. i n n i=1 (7. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. These distinctions are illusory. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. the linear function M ed (yi | xi = x) = x0 β is the conditional median function.To recall the deﬁnition and properties of the median. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. Now let’s consider the conditional median of Y given a random variable X. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. let Y be a continuous random variable. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . These facts deﬁnitions motivate three estimators of θ. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. as i=1 these estimators are indeed identical. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) .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 linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model.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. Two useful facts about the median are that (7.10) The LAD estimator has the asymptotic distribution 81 . Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . however. The second is the value which minimizes n n |yi − θ| .

5.10) is equivalent to g n (β) = 0. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . When f (0 | x) is large. While a complete proof of Theorem 7. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . The main diﬃculty is the estimation of f (0).3. First.Theorem 7. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. ∂β 0 so Third. In the special case where the error is independent of xi .1 ´ √ ³ˆ n β − β 0 →d N (0.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. the conditional density of the error at its median. See Chapter 16. we provide a sketch here for completeness.5. then there are many innovations near to the median.5. (7. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . V ).11). Let g(β) = Eg (β). Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . where V = and f (e | x) is the conditional density of ei given xi = x. Computation of standard error for LAD estimates typically is based on equation (7. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. the height of the error density at its median. and this improves estimation of the median. by the central limit theorem (Theorm 5. Pn −1 0 β)) .1 is advanced. This can be done with kernel estimation techniques. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . ˆ Proof of Theorem 7.

We then have the linear quantile regression model yi = x0 β τ + ei i 83 . The following alternative representation is useful. the quantile regression functions can take any shape. then (7.Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. 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. Again. If the random variable U has τ ’th quantile Qτ . (7. ¥ 7. then F (Qτ ) = τ . so you can think of the quantile as the inverse of the distribution function. V ).9) for the median to all quantiles.12) Qτ = argmin Eρτ (U − θ) . For ﬁxed τ . For the random variables (yi . then F (Qτ (x) | x) = τ . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. As functions of x. For τ ∈ [0. The median is the special case τ = .13) This generalizes representation (7.6 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 . 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)) . Exi x0 ) →d i 2 = N (0. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ .5. The third line follows from an asymptotic empirical process argument. when F (y | x) is continuous and strictly monotonic in y. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } .

6. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Fortunately. ´ √ ³ˆ Theorem 7. let zi = h(xi ) denote functions of xi which are not linear functions of xi (perhaps 0˜ ˜ ˜ squares of non-binary regressors) and then ﬁt yi = x0 β +zi γ + ei by OLS. the 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 (7.5. the unconditional density of ei at 0. if the model yi = x0 β + ei has i been ﬁt by OLS. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). where and f (e | x) is the conditional density of ei given xi = x. Vτ ). n numerical methods are necessary for its minimization.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . the asymptotic variance depends on the conditional density of the quantile regression error. The null model is yi = x0 β + εi i 84 . ¡ ¡ ¢¢−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. then f (0 | xi ) = f (0) . the τ ’th conditional quantile of ei is zero.13). and form a Wald statistic i for γ = 0.1 n β τ − β τ →d N (0. and test their signiﬁcance using a Wald test. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . When the error ei is independent of xi . i By construction. otherwise its properties are unspeciﬁed without further restrictions. it is useful to have a general test of the adequacy of the speciﬁcation. ˆ Given the representation (7. fast linear programming methods have been developed for this problem.12). A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. Another popular approach is the RESET test proposed by Ramsey (1969). Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . since it has discontinuous derivatives. Furthermore. Thus. conventional Newton-type optimization methods are inappropriate. and are widely available. 7.1.

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

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

A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . this rule only makes sense when the true model is ﬁnite dimensional. if α is set to be a small number. let cα satisfy ¢ ¡ P χ22 > cα . LRn →p 0. based on Bayesian arguments. BIC model selection is consistent. and km is the number of coeﬃcients in the model. In contrast to the AIC.15) then where σ 2 is the variance estimate for model m. n (7. One popular choice is the Akaike Information Criterion (AIC). the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. AIC selection is inconsistent. If the truth is inﬁnite dimensional. For some critical level α. Indeed.17) Since log(n) > 2 (if n > 8). Then select M1 if Wn ≤ cα . else select M2 . then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. M)) between the true density and the model density. the most popular to be one proposed by Schwarz. then this model selection procedure is inconsistent. 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 < 1.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . 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.However. as ³ ´ c P M = M1 | M1 → 1 − α < 1. since (7. as the rule tends to overﬁt. 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. depending on the sample size. The model selection rule is as follows. log(n) 87 . Another common approach to model selection is to to a selection criterion. ¢ ¡ ˆ1 ˆ2 (7. That is. else select M2 . etc. k = While many modiﬁcations of the AIC have been proposed. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . Indeed. The rule is to select M1 if AIC1 < AIC2 . His criterion.16) holds under M1 . since under M1 . n (7. k A major problem with this approach is that the critical level α is indeterminate. known as the BIC. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. Another problem is that if α is held ﬁxed.

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

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

. Find an asymptotic 95% conﬁdence interval for g(x). add the variable (ln Qi )2 to the regression. Exercise 13. calculate zi and estimate the model by OLS. For values much above a7 . For each value of a7 . 90 . This model is called a smooth threshold model. a7 ). Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . The model is non-linear because of the parameter a7 . θ is the NLLS estimator. n xi i=1 (a) Under the stated assumptions. Do so. the variable ln Qi has a regression slope of a2 . I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. The model works best when a7 is selected so that several values (in this example. and V is the = g(x estimate of V ar ˆ . The equation you estimated was ln T Ci = β 1 + β 2 ln Qi + β 3 ln P Li + β 4 ln P Ki + β 5 ln P Fi + ei . In addition. the regression slope is a2 + a6 .. 8.18) plus the extra term a6 zi . impose the restriction a3 + a4 + a5 = 1. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. and ﬁnd the value of a7 for which the sum of squared errors is minimized. at least 10 to 15) of ln Qi are both below and above a7 . are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9.. Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. Examine the data and pick an appropriate range for a7 . Record the sum of squared errors. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. and the model imposes a smooth transition between these regimes.ˆ ˆ 7. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . . For values of ln Qi much below a7 . you estimated a cost function on a cross-section of electric companies. In Chapter 6. (iii) BIC criterion. Assess the merits of this new speciﬁcation using (i) a hypothesis test. (7.18) (a) Following Nerlove. (c) Estimate the model by non-linear least squares. θ) + ei with E (ei | xi ) = 0. (ii) AIC criterion. Consider model (7. (d) Calculate standard errors for all the parameters (a1 . Suppose that yi ³ ´ i .

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

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

∗ P (yi ≤ y.1). Thus by the WLLN (Theorem 5. and 100. The random draws are from the N (0. . In general. Fn is a nonparametric estimate of F. x))) . x)) →d N (0. x). √ n (Fn (y. where 1(·) is the indicator function. Fn (y. x) . The EDF is a consistent estimator of the CDF. For n = 25. x) = P (yi ≤ y. i = 1. but the approximation appears to improve for the large n. x) = n i=1 Figure 8. the EDF step function gets uniformly close to the true CDF. n. x) →p F (y.2) Fn (y. This is a population moment. by the CLT (Theorem 5. 50. 1) distribution. Furthermore..2. x). To see this.3.8. x). I have plotted the EDF and true CDF for three random samples of size n = 25. (8. note that for any (y.1). That is. the EDF is only a crude approximation to the CDF.2 The Empirical Distribution Function Fn (y.. F (y. Notationally. x) is called the empirical distribution function (EDF). To see the eﬀect of sample size on the EDF. Fn is by construction a step function. as the sample size gets larger. x) (1 − F (y. xi ). x) − F (y. Recall that F (y. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . x∗ ≤ x) = Fn (y. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . Note that while F may be either discrete or continuous.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x∗ ) with the i distribution Fn .. i 93 . 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. in the Figure below. it is helpful to think of a random pair (yi .

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

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

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

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

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

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

1 as follows. F ). adding leptokurtosis). F0 )) + O(n−1 ). ³x´ Gn (x. F ) ≈ Φ + n−1/2 g1 (x. To the second order. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. Theorem 8. Fn ) − g1 (x. the diﬀerence √ (g1 (x.1. We can interpret Theorem 8. A bootstrap test is based on G∗ (x). An asymptotic test is based on Φ(x). 1/2 1 n Because Φ(x) appears in both expansions.8. which from Theorem 8.uniformly over x. F0 ) ≈ ∂ g1 (x. Fn ) = Φ(x) + n 1 g (x.1 has the expansion n G∗ (x) = Gn (x. ³x´ 1 1 + 1/2 g1 (x. F0 ) = n 1 n1/2 (g1 (x. Moreover. F ) converges to the normal limit at rate n1/2 . the density function is skewed. and g2 is an odd function of x. Gn (x. the exact distribution is P (Tn < x) = Gn (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. where g1 is an even function of x. v Since the derivative of g1 is odd. Fn ) + O(n−1 ). F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). F ) + g2 (x. so the order of the error is O(n−1/2 ).8.9 One-Sided Tests Using the expansion of Theorem 8. F0 )) converges to 0 at rate n. To a third order of approximation. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . F ) + O(n−3/2 ) Gn (x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). √ Since Fn converges to F at rate n. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. F ) v which adds a symmetric non-normal component to the approximate density (for example. 100 . To a second order of approximation.8. and g1 is continuous with respect to F. F ) + n−1 g2 (x.8. The diﬀerence is Φ(x) − Gn (x. F0 ) = Φ(x) + since v = 1. Heuristically. g1 (x. Fn ) − g1 (x. F0 ) = 1 g (x. Fn ) − g1 (x.1 Under regularity conditions and (8. F ) ≈ Φ + n−1/2 g1 (x.3). ³x´ Gn (x. First. F ) = Φ v n n 8.

n (8.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). F ) + g2 (x. then |Tn | →d |Z| ∼ Φ. 101 2 g2 (x. F ) is only heuristic. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). and exact critical values are taken from the Gn (x. Thus asymptotic critical values are taken from the Φ distribution. then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x). F ) − Gn (−x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. A two-sided hypothesis test rejects H0 for large values of |Tn | . Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. 8.The “derivative” ∂ ∂F g1 (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. = P (X ≤ x) − P (X ≤ −x) For example.8.1. 1). F ) = Gn (x. if Tn has exact distribution Gn (x. F ) + g2 (−x.5) where the simpliﬁcations are because g1 is even and g2 is odd. F ) + O(n−3/2 ). F ). which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). as F is a function. 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. F0 ) = O(n−1 ). n . F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F ). Since Tn →d Z. F ) = Gn (x. F0 ) distribution. We conclude that G∗ (x) − Gn (x. F0 ) + O(n−3/2 ) = O(n−1 ). F ) − Gn (−x. we can calculate that Gn (x. then |Tn | has the distribution function Gn (x. From Theorem 8. if Z ∼ N (0. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F0 ) = The order of the error is O(n−1 ). Similarly.

Theorem 8. we ﬁnd Gn (x) = Gn (x. √ the last equality because Fn converges to F0 at rate n. V ). and for the bootstrap ³x´ + O(n−1/2 ). Applying (8.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. Two-sided tests have better rates of convergence than the one-sided tests. and g2 is continuous in F. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. 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 . whose error is O(n−1 ). F0 )) + O(n−3/2 ) n = O(n−3/2 ). Fn ) − g2 (x. This is because the ﬁrst term in the asymptotic expansion.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. Therefore. is an even function. G∗ (x) = Gn (x. but one-sided tests might have more power against alternatives of interest. This is in contrast to the use of the asymptotic distribution. and bootstrap tests have better rates of convergence than asymptotic tests. which is not pivotal. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. Fn ) + O(n−3/2 ). Gn (x. We know that θ Tn →d N (0.5) to the bootstrap distribution. meaning that the errors in the two directions exactly cancel out.8. 8. F ) = Φ v √ where v = V . A reader might get confused between the two simultaneous eﬀects. F0 ) = ∗ 2 (g2 (x. set Tn = n ˆ − θ0 . as it depends on the unknown V. Twosided tests will have more accurate size (Reported Type I error). n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. 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 ). Fn ) = Φ(x) + ∗ 2 g2 (x. 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.Interestingly. and needs to be determined on a case-by-case basis. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. g1 . similar to a one-sided test.

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

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

95). What is wrong with this procedure? Tn = θ/s(θ) n 6. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. and the 2.95). size of house. can you report the 95% Percentile-t interval for θ? 7. 105 .pdf. The ˆ are sorted.75 and 1. Using the non-parametric bootstrap. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. Suppose that in an application.05) . θ respectively. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. Estimate a linear regression of price on the number of bedrooms. (b) Report the 95% Alternative Percentile interval for θ. with variables listed in the ﬁle hprice1. You want to test H0 : θ = 0 against H1 : θ > 0. you generate bootstrap samples.95) denote the 95% quantile of Tn . The dataﬁle hprice1. Using the non-parametric ∗ bootstrap.05) and qn (. lot size. ∗ ∗ where s(ˆ is the standard error in the original data. Let qn (. ˆ = 1. (c) With the given information.5% quantiles of the ˆ are . You replace c with qn (. ∗ ∗ ∗ Let qn (.dat contains data on house prices (sales). and ˆ is calculated on each θ ∗ ∗ θ sample.5% and 97. and the colonial dummy. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. ˆ − s(ˆ n (.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).2 and s(ˆ = . (a) Report the 95% Efron Percentile interval for θ. and thus reject H0 if ˆ ˆ > q ∗ (.2. You do this as follows.95).3.95) denote the 5% θ) ∗ and 95% quantiles of Tn . Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.

is not necessarily eﬃcient. If k = the model is just identiﬁed. As an important special case we will devote special attention to linear moment condition models. an asymptotically eﬃcient estimator of β is the OLS estimator. where the dimensions of zi and xi are k × 1 and × 1 . In the statistics literature. In econometrics. but this is not required. as their are restrictions in E (xi ei ) = 0. g(y. z. z. In this case. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . This situation is called overidentiﬁed.1) by setting g(y. x. Now suppose that we are given the information that β 2 = 0. In our previous example. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. β 0 ) = x(y − z 0 β) 106 (9.1 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. This is a special case of a more general class of moment condition models. while β 1 is of dimension k < . x. however. with ≥ k. otherwise it is overidentiﬁed.1) where β 0 is the true value of β. This model falls in the class (9. 1 this class of models are called moment condition models. This method.Chapter 9 Generalized Method of Moments 9. zi . β) = x(y − x0 β). β 0 ) = 0 (9.2) . We know that without further restrictions. xi . The variables zi may be components and functions of xi . Let g(y. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. x. these are known as estimating equations. There are − k = r more moment restrictions than free parameters. We call r the number of overidentifying restrictions.

then g n (β) = 0. for if Wn is replaced ˆ by cWn for some c > 0. let Jn (β) = n · g n (β)0 Wn g n (β). then. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. Proposition 9. i i . but this is generally not possible when > k. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. For some × weight matrix Wn > 0. β GMM = Z 0 XWn X 0 Z 9. the square of the Euclidean length. the dependence is only up to scale. β ˆ Note that if k = .2. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . For example. The GMM estimator minimizes Jn (β).3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.1 β GMM = argmin Jn (β).2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .9. and the GMM estimator is the MME. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. ˆ Deﬁnition 9. if Wn = I. ¡ ¢−1 0 ˆ Z XWn X 0 Y. This is a non-negative measure of the “length” of the vector g n (β).2. Let and where gi = xi ei . β GMM does not change.2) g n (β) = (9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn .

For any Wn →p W0 . In the linear model. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . However.3. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. This turns out to be W0 = Ω−1 . β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . W0 = Ω−1 is not known in practice. it is semiparametrically eﬃcient. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . If it is known that E (gi (β)) = 0.2 For the eﬃcient GMM estimator. the GMM estimator β is consistent yet ineﬃcient. as the distribution of the data is unknown. and this is all that is known. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. β). but it can be estimated consistently.1 ´ √ ³ˆ n β − β →d N (0. n n We conclude: Theorem 9. For example. Chamberlain showed that in this context. ˆ n i=1 gi = gi − g n . this is a semi-parametric problem. it turns out that the GMM estimator is semiparametrically eﬃcient. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. Ω) . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances.3. ˆ Construct n 1X ˆ g n = g n (β) = gi .and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. a better choice is Wn = (X 0 X)−1 . This results shows that in the linear model. 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 weak concept of optimality. where In general. No estimator can do better (in this ﬁrst-order asymptotic sense). n β − β →d N 0. as shown by Gary Chamberlain (1987). ˆ we still call β the eﬃcient GMM estimator. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . as it has the same asymptotic distribution. The optimal weight matrix W0 is one which minimizes V. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. as we are only considering alternative weight matrices Wn . we can set Wn = I . without imposing additional assumptions. The proof is left as an exercise. V ) .4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. ˆ∗ ˆ 108 . 9.

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

G0 Ω−1 G . Theorem 9. ˆ J = J(β) →d χ2−k . 110 . and is thus a natural test statistic for H0 : Egi = 0. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. 9. often the weight ˆ matrix Wn is updated. The general theory of GMM estimation and testing was exposited by L. Note that g n →p Egi .5. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. and in this case it would be impossible to ﬁnd a value of β 1 so that both E (x1i (yi − x0 β 1 )) = 0 and E (x2i (yi − x0 β 1 )) = 0 hold simultaneously.1 Under general regularity conditions. n β − β →d N 0. However. 1 2 It is possible that β 2 = 0. β) = 0 holds. and if the weight matrix is asymptotically eﬃcient. Under the hypothesis of correct speciﬁcation. For example. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. ˆˆ n is a quadratic form in g n .Often. This estimator can be iterated if needed. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . Hansen (1982). where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Identiﬁcation requires l ≥ k = dim(β). perhaps obtained by ﬁrst ˆ setting Wn = I.6.1 (Sargan-Hansen). In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. Since the GMM estimator depends upon the ﬁrst-stage estimator. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not.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 . 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). 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 . Thus the model — the overidentifying restrictions — are testable. this is all that is known. and then β recomputed. so that the linear equation may be written as yi = β 0 x1i + ei . 1 it is possible that β 2 6= 0.

This reasoning is not compelling. and by L. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). If h is linear in β. Hansen (1982) for the general case. 111 . the Wald statistic can work quite poorly. a better approach is to directly use the GMM criterion function. it is unclear what is wrong. and it is advisable to report the statistic J whenever GMM is the estimation method. If the hypothesis is non-linear. we can reject the model. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). If h is non-linear. current evidence suggests that the D statistic appears to have quite good sampling properties. In contrast. This result was established by Sargan (1958) for a specialized case. When over-identiﬁed models are estimated by GMM. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. but it is typically cause for concern. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr .The proof of the theorem is left as an exercise. This is sometimes called the GMM Distance statistic. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). D →d χ2 r 3. For a given weight matrix Wn . 1. the hypothesis is H0 : h(β) = 0. If the statistic J exceeds the chi-square critical value. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. and is the preferred test statistic. These may be used to construct Wald tests of statistical hypotheses.7. Proposition 9. however.1 If the same weight matrix Wn is used for both null and alternative. The idea was ﬁrst put forward by Newey and West (1987). it is customary to report the J statistic as a general test of model adequacy. 9. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. Based on this information alone. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. D ≥ 0 2. and some current research suggests that this restriction is not necessary for good performance of the test. as this ensures that D ≥ 0.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. then D equals the Wald statistic. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β).

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

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

(b) We want to show that for any W. i 0 0ˆ ˆ 3.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. Letting H = CQ and G = C 0−1 W Q. (c) Since Ω is positive deﬁnite. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . V − V0 is positive semi-deﬁnite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the eﬃcient weight matrix). there exists a nonsingular matrix C such that C 0 C = Ω−1 . Show that V0 = Q0 Ω−1 Q . Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . and therefore positive semideﬁnite. γ ) for (β. Show that Wn →p Ω i i i 4. From matrix algebra. In the linear model estimated by GMM with general weight matrix W.g. 114 . the asymptotic variˆ ance of β GMM is ¡ ¢−1 0 ¡ ¢−1 V = Q0 W Q Q W ΩW Q Q0 W Q ¡ ¢−1 (a) Let V0 be this matrix when W = Ω−1 . Let ei = yi − zi β where β is consistent for ˆ β (e. Write out the matrix A. a GMM estimator with arbitrary weight matrix). γ). verify that A can be written as ³ ¡ ¢−1 0 ´ G H. Take the model yi = zi β + ei with E (xi ei ) = 0. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . ˆ ˆ Find the method of moments estimators (β.9. 2. Take the model E (zi ηi ) = 0.

zi ). h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β).5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . Vn = X X i=1 ˜ and hence R0 β = r. h(β)=0 (9.5. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. The observed data is (yi . the distance statistic D in (9. The equation of interest is yi = g(xi . β) + ei E (zi ei ) = 0.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. In the linear model Y = Xβ + e with E(xi ei ) = 0. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . 115 . 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 . VR = V − V R R0 V R (d) Show that in this setting. subject ˆ i ˆi i=1 to the restriction h(β) = 0. 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. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. The GMM estimator of β. xi . is deﬁned as Jn (β) = ˜ β = argmin Jn (β). l ≥ k.6) equals the Wald statistic. zi is l × 1 and β is k × 1. 6. Deﬁne the Lagrangian L(β.6) (a) Show that you can rewrite Jn (β) in (9. VR ) where ¡ ¢−1 0 R V. Show how to construct an eﬃcient GMM estimator for β.

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

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

λ). µ) = n i=1 i=1 i=1 L∗ n with respect to pi . pi gi (β) = 0. p1 . Ln (β) = Rn (β. summing over i.1) and (10. (see section 6.4) (10. Multiplying the ﬁrst equation by pi . (10. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). probabilities 1 ³ ´´ . we also obtain the Lagrange multiplier λ = λ(β). λ ¡ ¢ ln 1 + λ0 gi (β) .2) subject to the restrictions (10. and using the second and third equations. . or equivalently minimizes its negative ˆ (10.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. pn . This yields the (proﬁle) empirical log-likelihood function for β. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . λ) : λ(β) = argmin Rn (β. The solution (when it exists) is well deﬁned since Rn (β. p (10. λ.5) This minimization problem is the dual of the constrained maximization problem.where λ and µ are Lagrange multipliers.7) 118 .. λ) = −n ln (n) − n X i=1 For given β.5). λ) is a convex function of λ. but must be obtained numerically (see section 6. µ. we ﬁnd µ = n and 1 ¢.3). 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 (10.5) ˆ ˆ As a by-product of estimation. the Lagrange multiplier λ(β) minimizes Rn (β. The solution cannot be obtained explicitly. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β... pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β.

λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. i i Theorem 10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. ˆ ˆ Proof.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . i=1 i=1 i=1i Expanding (10. in the linear model. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .13) Premultiplying by G0 Ω−1 and using (10. λ) = − (10. Thus the EL estimator is asymptotically eﬃcient. and n β − β 0 and nλ are asymptotically independent. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. Gi (.2. and Ω = E xi x0 e2 .8) and ¢ 0 0 For example.1 Under regularity conditions.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. β) = −xi zi . n (10.10) ¡ Ω−1 N (0.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . β λ ∂ ³ ´.9) (10. G = −E (xi zi ).10). λ) = − (10.9) and (10.10. (β. 0 = Rn (β. 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 (10.13) yields n n Expanding (10.

and have the same interpretation.3.17) 2 ln 1 + λ gi β . The same statistic can be constructed for empirical likelihood. and (10.7) is n ³ ´´ ³ X ˆ ˆ0 (10. 120 .16). Ω) GΩ G →d = N (0. tests are based on the diﬀerence in the log likelihood functions. LRn = i=1 Theorem 10.15). Proof. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . They are asymptotically ﬁrst-order equivalent. Since the EL estimator achieves this bound. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. and it is advisable to report the statistic LRn whenever EL is the estimation method. Vλ ) Furthermore.15) (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. First.14) for λ and using (10. (10. V ) ˆ Solving (10.1 If Eg(wi . Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. it is an asymptotically eﬃcient estimator for β. by a Taylor expansion.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.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. β 0 ) = 0 then LRn →d χ2−k . Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. The overidentiﬁcation test is a very useful by-product of EL estimation.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. 10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .3 Overidentifying Restrictions In a parametric likelihood context.

prc 121 . The hypothesis of interest is h(β) = 0.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. This test statistic is a natural analog of the GMM distance statistic.18) Let the maintained model be where g is × 1 and β is k × 1.17) is not appropriate. Theorem 10. 10. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).ssc.4. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.1 Under (10. LRn →d χ2 . 10. so there is no fundamental change in the distribution theory for β relative to β.18). the simple overidentifying restrictions test (10.4 Testing Egi (β) = 0 (10. where h : Rk → Ra . Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. To test the hypothesis h(β) while maintaining (10. 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. a The proof of this result is more challenging and is omitted.Second. By “maintained” we mean that the overidentfying restrictions contained in (10.wisc. h(β)=0 ˜ Fundamentally. Vλ )0 Ω−1 N (0. since ln(1 + x) ' x − x2 /2 for x small.18) and H0 : h(β) = 0. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .edu/~bhansen/progs/elike.

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

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

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

this can be written as Y = Zβ + e.2) Any solution to the problem of endogeneity requires additional information which we call instruments. 11.1) where zi is k × 1. In matrix notation. So we have the partition µ ¶ z1i k1 (11. z1i is an instrumental variable for (11.1) the structural equation. which does not equal either β 1 or β 2 . at least the intercept). and x2i are the excluded exogenous variables. Deﬁnition 11. We call (11.1) if E (xi ei ) = 0.1). β →p β ∗ . and assume that E(zi ei ) 6= 0 so there is endogeneity. In a typical set-up. some regressors in zi will be uncorrelated with ei (for example.1. (11. Thus we make the partition ¶ µ k1 z1i (11. This is called simultaneous equations bias. so should be included in xi .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 ¶ . ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. That is x2i are variables which could be included in the equation for yi (in the sense 125 .4) xi = x2i 2 where z1i = x1i are the included exogenous variables. By the above deﬁnition.1 The × 1 random vector xi is an instrumental variable for (11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. We call z1i exogenous and z2i endogenous.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

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

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

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

5. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. 6. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). X is n × l. (Find an expression for xi . 133 . xi is l × 1. Explain why this is true.) 3. 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) . Take the linear model Y = Zβ + e. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. Z is n × k. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. u is n × k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. 2. where xi and β are 1 × 1. That is. Take the linear model yi = xi β + ei E (ei | xi ) = 0.8 Exercises yi = zi β + ei . In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known.11. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). in the sense that e ˜ ˜ least in large samples? 4. and Γ is l × k. Find a simple expression for the IV estimator in this context. show that if rank(Γ) < k then β cannot be identiﬁed. l ≥ k. ˜ 0 e < e0 e. at ˆˆ If X is indeed endogeneous. will IV “ﬁt” better than OLS. 1.

using zi as an instrument for xi . The data ﬁle card.pdf. and South and Black are regional and racial dummy variables. (d) Re-estimate the model by eﬃcient GMM. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). (a) Estimate the model by OLS. Suppose that price and quantity are determined by the intersection of the linear demand and supply curves Demand : Supply : Q = a0 + a1 P + a2 Y + e1 Q = b0 + b1 P + b2 W + e2 ¡ ¢ (a) Show that E (xi ei ) = 0 and E x2 ei = 0. and then calculate the GMM estimator from this weight matrix without further iteration. Report estimates and standard errors.. listed in card. 134 . Report estimates and standard errors.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). using the instrument near4. 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). I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix.(b) Deﬁne the 2SLS estimator of β. in years. Estimate the model by 2SLS. There are 2215 observations with 19 variables. of the father) and motheduc (the education. Report the estimates and standard errors. are the parameters identiﬁed? 8. f atheduc (the education. of the mother). (b) Now treat Education as endogenous. in years. In this model. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market. a dummy indicating that the observation lives near a 4-year college. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. and the remaining variables as exogenous. (f) Discuss your ﬁndings. Does this diﬀer from 2SLS and/or OLS? 7. (e) Calculate and report the J statistic for overidentiﬁcation.

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

then as T → ∞. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). ˆ 2. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. If Xt is strictly stationary and ergodic and E |Xt | < ∞. T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) . γ (k) →p γ(k).1. 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 . Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).1. and it has a ﬁnite mean by the assumption that EYt2 < ∞. γ (0) ˆ Theorem 12.3 If Yt is strictly stationary and ergodic and EYt2 < ∞.2 (Ergodic Theorem).Theorem 12. T 1X Xt →p E(Xt ). ρ(k) →p ρ(k). 1. ˆ ˆ γ ¥ 136 . then as T → ∞. For Part (2). the sequence Yt Yt−k is strictly stationary and ergodic. 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 Proof. ˆ 3.1 above. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). µ →p E(Yt ).1.

Thus for k > 0. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .2. Y2 . The last property deﬁnes a special time-series process. ∞ X = ρk et−k . The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression.} are jointly random.. it is even more important in the time-series context. . the series {. Y1 . A linear AR model (the most common type used in practice) speciﬁes linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k . or consumption growth rates. should be a MDS.. Deﬁnition 12. .. YT . as it is diﬃcult to derive distribution theories without this property. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS.. Yt−2 .. Letting et = Yt − E (Yt | It−1 ) .. Regression errors are naturally a MDS.. 137 . . this series converges if the sequence ρk et−k gets small as k → ∞.. This occurs when |ρ| < 1.12. In fact. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. . Some time-series processes may be a MDS as a consequence of optimizing behavior.. k=0 Loosely speaking.. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + .. For example.. t By back-substitution.} is the past history of the series.. Yt−k ) . E(Yt−k et ) = 0. some versions of the life-cycle hypothesis imply that either changes in consumption.. E(et ) = 0 and Ee2 = σ 2 < ∞. A mean-zero AR(1) is Assume that et is iid.. 12.2 Autoregressions In time-series.3 Stationarity of AR(1) Process Yt = ρYt−1 + et .1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 .

The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . 12. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . We say that the root of the polynomial is 1/ρ. In general. Deﬁning L2 = LL.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. the above results are unchanged. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept.Theorem 12.1. We call ρ(L) the autoregressive polynomial of Yt . Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . ∞ X k=0 ρ2k V ar (et−k ) = 12. From Theorem 12. we see that L2 Yt = LYt−1 = Yt−2 .4.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. Deﬁnition 12.1 The lag operator L satisﬁes LYt = Yt−1 . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). since ρ(z) = 0 when z = 1/ρ. The AR(k) model is Using the lag operator. 138 .3. Lk Yt = Yt−k . We call ρ(L) the autoregressive polynomial of Yt . an AR(1) is stationary iﬀ |ρ| < 1.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 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).3.

. λk are the complex roots of ρ(z). which satisfy ρ(λj ) = 0. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. and by Theorem 12. By Theorem 12. β = X 0X (12.1. Note that ut is a MDS. . 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. Thus t by the Ergodic Theorem. t t T t=1 ¥ Combined with (12. it is also strictly stationary and ergodic.1) and the continuous mapping theorem.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . t T t=1 T t=1 139 . ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.1) Theorem 12. and hence Yt ..1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. we say that ρ(L). One way of stating this is that “All roots lie outside the unit circle. t Yt−k ¢0 ρk . This is a special case of non-stationarity.1.6. so is xt x0 . the requirement is that all roots are larger than one. The vector xt is strictly stationary and ergodic.1..1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. Proof. For an AR(k).5.1. then ˆ β →p β as T → ∞. and is of great interest in applied time series. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. Let |λ| denote the modulus of a complex number λ. “has a unit root”.” If one of the roots equals 1.where the λ1 . Theorem 12. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. it is helpful to deﬁne the process ut = xt et .

e ˆ 3..1 MDS CLT. .7. as this imposes inappropriate independence. Y0 ). Fix an initial condition (Y−k+1 . Y−k+2 . we can apply Theorem 12. the asymptotic covariance matrix is estimated just as in the cross-section case. 12. eT }. T t=1 Since xt et is a MDS..8 Bootstrap for Autoregressions In the non-parametric bootstrap. Method 1: Model-Based (Parametric) Bootstrap. .. Create the bootstrap series Yt∗ by the recursive formula ˆ ˆ ∗ ˆ ∗ ˆ ∗ Yt∗ = α + ρ1 Yt−1 + ρ2 Yt−2 + · · · + ρk Yt−k + e∗ . t t Theorem 12.12. 140 . Estimate β and residuals et . t This construction imposes homoskedasticity on the errors e∗ . Q−1 ΩQ−1 . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. It also presumes that the AR(k) structure is the truth. i 4.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. Ω) . Method 2: Block Resampling 1. Ω) . we constructed the bootstrap sample by randomly resampling from the data values {yt . The implication is that asymptotic inference is the same. ˆ 1.7.1 to see that T 1 X √ xt et →d N (0. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Divide the sample into T /m blocks of length m. This creates an iid bootstrap sample. In particular. T t=1 where Ω = E(xt x0 e2 ).7. xt }. T 1 X √ ut →d N (0. then as T → ∞. this cannot work in a time-series application.7 Asymptotic Distribution Theorem 12. Clearly. there are two popular methods to implement bootstrap resampling for time-series data. This is identical in form to the asymptotic distribution of OLS in cross-section regression. t then as T → ∞.. ˆ 2.. which may be diﬀerent than the i properties of the actual ei .. Brieﬂy. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .

4) by OLS. This is a ﬂexible approach which can extract a wide range of seasonal factors. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. Seasonal Eﬀects There are three popular methods to deal with seasonal data. This presumes that “seasonality” does not change over the sample.3) replacing St with St . 3. For each simulated sample.2. May not work well in small samples. • Include dummy variables for each season. • You can estimate (12. ρk ).3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .2). • First apply a seasonal diﬀerencing operator. That is. This allows for arbitrary stationary serial correlation. The series ∆s Yt is clearly free of seasonality. ﬁrst estimate (12. Thus the seasonally adjusted data is a “ﬁltered” series. 141 . or the season-to-season change. This procedure is sometimes called Detrending. heteroskedasticity. 5. If s is the number of seasons (typically s = 4 or s = 12).2)-(12. Paste the blocks together to create the bootstrap time-series Yt∗ . . Resample complete blocks.3) sequentially by OLS. ∆s Yt = Yt − Yt−s . and then perform regression (12. 12. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . 6. get the ˆ ˆ residual St .. • Use “seasonally adjusted” data.. and perhaps this was of relevance. But the long-run trend is also eliminated. 4. and the way that the data are partitioned into blocks. also alters the time-series correlations of the data. The seasonal adjustment. draw T /m blocks.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . The results may be sensitive to the block length. and for modelmisspeciﬁcation. (12. • You can estimate (12.2) (12. however. (12..

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

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

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

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

For example. some regressors may be excluded from some of the equations. Consider the moment conditions j = 1. and was originally derived by Zellner (1962) ¢ 13. ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 . 13. . The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj . each with the same set of regressors. The GMM framework gives a convenient method to impose such restrictions on estimation.. or as a linear projection. j Unrestricted VARs were introduced to econometrics by Sims (1980).then Yt = Axt + et ..2 Estimation E (xt ejt ) = 0.2 ⎟ X(X 0 X)−1 A ⎜ . we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ .. m. or across equations. ˆj ˆ And if we stack these to create the estimate A. ⎟ ⎝ . 146 . either as a regression.3 Restricted VARs The unrestricted VAR is a system of m equations. Note that a0 = Yj0 X(X 0 X)−1 . A restricted VAR imposes restrictions on the system. Then the VAR system can be written as the equations Yjt = a0 xt + ejt . These are implied by the VAR model. ˆ An alternative way to compute this is as follows. One way to write this is to let a0 be the jth row j of A. Restrictions may be imposed on individual equations. This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator. ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt . The VAR model is a system of m equations.

Another interesting fact is that (13. may be tested if desired.3) which is a valid regression model. under the restriction γ = −βθ. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).1) yt = x0 β + et . to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 . the model (13.4 Single Equation from a VAR Yjt = a0 xt + et . it is convenient to re-deﬁne the variables. We see that an appropriate. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. Then the single equation takes the form (13.2) may be estimated by iterated GLS. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors.) Since the common factor restriction appears arbitrary.2) Take the equation yt = x0 β + et . t or yt = θyt−1 + x0 β + x0 γ + ut . t t−1 (13. xt−1 ) to the regression. and is typically rejected empirically.3). If valid.13. Let yt = Yjt . t and et is iid N (0. Otherwise it is invalid.1). (13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. j Often. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . we are only interested in a single equation out of a VAR system. with time series data. direct estimation of (13. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . general. (A simple version of this estimator is called Cochrane-Orcutt. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. This restriction.2) is uncommon in recent applications. 13. 147 .2) is a special case of (13. Let et = ejt and β = aj . In this case. 1). which once was very popular. You may have heard of the Durbin-Watson test for omitted serial correlation. This can be done by a Wald test. t and xt = This is just a conventional regression. and is still routinely reported by conventional regression packages. which is called a common factor restriction. and subtract oﬀ the equation once lagged multiplied by θ. Suppose that et is an AR(1). and Zt be the other variables. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s.

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

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

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

i As P (Yi = 1 | xi ) = E (Yi | xi ) . 1. 1}. 1. however.. A major practical issue is construction of the likelihood function. 2. They still constitute the majority of LDV applications. eliminating the dependence on a parametric distributional assumption. k} • Integer: Y = {0. you were to write a thesis involving LDV estimation.. 1} • Multinomial: Y = {0. due to time constraints. The linear probability model speciﬁes that P (Yi = 1 | xi ) = x0 β. 14.1 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. so that F (z) = 1 − F (−z). as this is the full conditional distribution. allowing the construction of the likelihood function.. For the parametric approach. Even so estimation of a linear probability model is a useful starting point for subsequent analysis. this yields the regression: Yi = x0 β + ei which can be estimated by i OLS. The standard alternative is to use a function of the form ¡ ¢ P (Yi = 1 | xi ) = F x0 β i where F (·) is a known CDF. you would be advised to consider employing a semi-parametric estimation approach. typically assumed to be symmetric about zero. .. However.Chapter 14 Limited Dependent Variables A “limited dependent variable” Y is one which takes a “limited” set of values. . estimation is by MLE.. the goal is to describe P (Yi = 1 | xi ) . Given some regressors xi . This represents a Yes/No outcome. The two standard choices for F are 151 . 2. the linear probability model does not impose the restriction that 0 ≤ P (Yi | xi ) ≤ 1. If. We will discuss only the ﬁrst (parametric) approach. The most common cases are • Binary: Y = {0. A parametric model is constructed. A more modern approach is semi-parametric.

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

The functional form for λi has been picked to ensure that λi > 0. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. . but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. In surveys.14. 1. i If Y = {0. An example of a data collection censoring is top-coding of income. This may be considered restrictive. i i i=1 ˆ The MLE is the value β which maximizes ln (β). 1.. The conditional density is the Poisson with parameter λi .. 0 if yi (This is written for the case of the threshold being zero. Thus the model is that there is some latent process yi with unbounded support.) The observed data yi therefore come from a mixed continuous/discrete distribution. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. k! = exp(x0 β). 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 !) . Tobin observed that for many households. or it may be a by-product of economic constraints. the consumption level (purchases) in a particular period was zero. this motivates the label Poisson “regression. incomes above a threshold are typically reported at the threshold..1). The censoring process may be explicit in data collection. This model speciﬁes that P (Yi = k | xi ) = λi k = 0..3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. i so the model imposes the restriction that the conditional mean and variance of Yi are the same.}. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. . A generalization is the negative binomial.1) yi = ∗ <0 . 2. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . 2.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. 14.2 Count Data exp (−λi ) λk i . σ 2 ) with the observed variable yi generated by the censoring equation (14. a typical approach is to employ Poisson regression. any known value can substitute.

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

For example. Zi ¢ ¡ ¢ ¡ 0 0 = ρE e0i | {e0i > −zi γ}. e1i ρ σ2 It is presumed that we observe {xi . Or. The dependent variable yi is observed if (and only if) Ti = 1. where vi is independent of e0i ∼ N (0. 155 . ρ from OLS of yi on xi and λ(z 0 γ ). ¡ 0 ¢ yi = x0 β + ρλ zi γ + ui i (14. but also can be consistently estimated by a Probit model for selection. The equation for Ti is an equation specifying the probability that the person is employed. Heckman (1979) observed that we could consistently estimate β and ρ from this equation. ¡ ¢ 0 E (e1i | Ti = 1. Thus E (ui | Ti = 1.2) is a valid regression equation for the observations for which Ti = 1. E (e0i | e0i > −x) = λ(x) = Φ(x) and the function λ(x) is called the inverse Mills ratio. using regressors zi . Zi ) = 0. However. The binary dependent variable is Ti . Ti } for all observations. Zi ¡ 0 ¢ = ρλ zi γ . Under the normality assumption. as this is a two-step estimator. yi could be a wage. where Hence ¡ 0 ¢ e1i = ρλ zi γ + ui . i • The OLS standard errors will be incorrect. which is non-zero. which can be observed only if a person is employed. alternatively. . The problem is that this is equivalent to conditioning on the event {Ti = 1}. ˆ ³ ´ ˆ ˆ ˆ • Estimate β. A useful fact about the standard normal distribution is that φ(x) . Else it is unobserved. zi . if γ were known. Zi ) = E e1i | {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. It is unknown. They can be corrected using a more complicated formula. The “Heckit” estimator is thus calculated as follows • Estimate γ from a Probit. 1). by viewing the Probit/OLS estimation equations as a large joint GMM problem. The model is often completed by specifying that the errors are jointly normal ¶ µ µ ¶¶ µ 1 ρ e0i ∼ N 0. The naive estimator of β is OLS regression of yi on xi for those observations for which yi is available. Zi + E vi | {e0i > −zi γ}. e1i = ρe0i + vi .

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

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

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

Taking ﬁrst-diﬀerences of (15. it However. we use lags of the dependent variable. 159 (15.4) . the ﬁxed eﬀects estimator is inconsistent. This is conveniently organized by the GMM principle. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. two periods back.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . But if there are valid instruments.4) will be inconsistent. it it which is free of the individual-eﬀect ui . if eit is iid.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). but loses a time-series observation). Hence a valid estimator of α and β is to estimate (15.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. 15. and the residual is the demean value ∗ yit = yit − yi . then IV or GMM can be used to estimate the equation. at least if T is held ﬁnite as n → ∞. Unfortunately. there are more instruments available. it and then take individual-speciﬁc means by taking the average for the i0 th individual: ti ti ti 1 X 1 X 0 1 X yit = x β + ui + eit Ti t=t Ti t=t it Ti t=t i i i or Subtracting.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. as yt−2 is uncorrelated with ∆eit . Thus values of yit−k . ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. we ﬁnd y i = x0 β + ui + ei . This is because the sample mean of yit−1 is correlated with that of eit . Typically. k ≥ 2. Alternatively. A more sophisticated GMM estimator recognizes that for time-periods later in the sample. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. 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 . are valid instruments. it (15. e So OLS on (15. the predicted value from these regressions is the individual speciﬁc mean y i .3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . A simple application of GMM yields the parameter estimates and standard errors. the dependent variable and regressors in deviationit from-mean form. i ∗ yit = x∗0 β + e∗ . so the instrument list should be diﬀerent for each equation.

The kernel functions are used to smooth the data. The kernel density estimator of f (x) is 1X ˆ f (x) = Kh (Xi − x) . . we can simply focus on the problem where x is a speciﬁc ﬁxed number.. Three common choices for kernels include the Gaussian µ 2¶ x 1 K(x) = √ exp − 2 2π the Epanechnikov K(x) = and the Biweight or Quartic K(x) = 15 16 3 4 ¡ ¢ 1 − x2 . The goal is to estimateP(x) from a random sample (X1 . |x| ≤ 1 0 |x| > 1 ¡ ¢2 1 − x2 . The ˆ ˆ EDF F i=1 dx standard nonparametric method to estimate f (x) is based on smoothing using a kernel.. we cannot deﬁne d F (x) since F (x) is a step function. |x| ≤ 1 0 |x| > 1 In practice.. The amount of smoothing is controlled by the bandwidth h > 0. While we are typically interested in estimating the entire function f (x). and then see how the method generalizes to estimating the entire function. Let 1 ³u´ . Xn } While F (x) can be estimated by the f ˆ (x) = n−1 n 1 (Xi ≤ x) . n i=1 n 160 . Kh (u) = K h h be the kernel K rescaled by the bandwidth h. the choice between these three rarely makes a meaningful diﬀerence in the estimates. Deﬁnition 1 K(u) is a second-order kernel function if it is a symmetric zero-mean density function.Chapter 16 Nonparametrics 16.1 Kernel Density Estimation d Let X be a random variable with continuous distribution F (x) and density f (x) = dx F (x).

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

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

1) distribution and σ 2 is an estimate of σ 2 = V ar(X). h must tend to zero. (16. Together with the above table. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. ˆ It uses formula (16. We thus say that the optimal bandwidth is of order O(n−1/5 ). This choice for h gives an optimal rule when f (x) is ˆ normal. 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) . That is. we ﬁnd the reference rules for the three kernel functions introduced earlier. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb.2) depends on R(K).06n−1/5 163 . The ﬁrst two are determined by the kernel function. (16. Thus for the AMISE to decline with n.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. Their K values for the three functions introduced in the previous section are given here. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. 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.Together. h0 = argmin AM ISEh h It can be found by solving the ﬁrst order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 . Note that this h declines to zero. but at a slower rate than n−1 . the rule-of-thumb h can be quite ineﬃcient. σ 2 .1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . but at a very slow rate. The asymptotically optimal choice given in (16. and gives a nearly optimal rule when f (x) is close to normal. Equation (16. That is. and R(f 00 ). where φ is the N (0.2) but replaces R(f 00 ) with σ −5 R(φ00 ).1) is an asymptotic approximation to the MSE. In practice. We can calculate that √ R(φ00 ) = 3/ (8 π) . how should the bandwidth be selected? This is a diﬃcult problem. AM SEh (x) = f 00 (x)2 h4 σ 4 + K 4 nh A global measure of precision is the asymptotic mean integrated squared error (AMISE) Z h4 σ 4 R(f 00 ) R(K) K + . but not of n. The downside is that if the density is very far from normal. and there is a large and continuing literature on the subject. Gaussian Kernel: hrule = 1. we need h → 0 but nh → ∞.

34n−1/5 Biweight (Quartic) Kernel: hrule = 2.2).78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice. However. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x). I now discuss some of these choices. Another popular choice for selection of h is cross-validation. There are other approaches. The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. Fortunately there are remedies.Epanechnikov Kernel: hrule = 2. which are known as smoothed cross-validation which is a close cousin of the bootstrap. There are some desirable properties of cross-validation bandwidths. 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). in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates. but implementation can be delicate. and then plug this estimate into the formula (16. This is more treacherous than may ﬁrst appear. This works by constructing an estimate of the MISE using leave-one-out estimators. in particular the iterative method of Sheather and Jones (1991). 164 . They are also quite ill-behaved when the data has some discretization (as is common in economics). but they are also known to converge very slowly to the optimal values.

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

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

a These expressions only make sense if F (x) is diﬀerentiable. and use lower case letters such as x for potential values and realized values. the range of X consists of a countable set of real numbers τ 1 . . In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1.2 Random Variables A random variable X is a function from a sample space S into the real line. 167 . We say that the random variable X is continuous if F (x) is continuous in x.3) P (X = τ j ) = π j .. of the sample space. This induces a new sample space — the real line — and a new probability function on the real line. . A2 . ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx.. r (A. F (x) is nondecreasing in x 3. The probability function for X takes the form j = 1. we denote random variables by uppercase letters such as X. these cases are unusualRand are typically ignored. A function F (x) is a CDF if and only if the following three properties hold: 1.. . limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function..3) is unavailable. . τ r .. 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.Theorem 2 (Bayes’ Rule).. For any set B and any partition A1 .. then for each i = 1. 2. In the latter case. While there are examples of continuous random variables which do not possess a PDF. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. Typically. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . Instead... (A..

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

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

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

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

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

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

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

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

k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . then by the change-of-variables formula. Since it is symmetric about zero all odd moments are zero. Ir ) and set Q = X 0 X. Theorem A. σ 2 ). By iterated integration by parts. y ≥ 0. respectively. If Z is standard normal and X = µ + σZ. −∞ < x < ∞. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . A) with A > 0. x ∈ Rk .8. It is conventional to write X ∼ N (0.11) and is known as the chi-square density with r degrees of freedom. f (x) = √ 2σ 2 2πσ which is the univariate normal density. (A. then Σ = diag{σ 2 } is a diagonal matrix. X has density Ã ! (x − µ)2 1 exp − . Σ) and Y = a + BX with B an invertible matrix. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . Theorem A. then they are mutually independent. For x ∈ Rk . Another useful fact is that if X ∼ N (µ. The mean and variance of the distribution are µ and σ 2 . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) .2 If Z ∼ N(0.This density has all moments ﬁnite. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. ¢ ¡ 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 . Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) .1 Let X ∼ N (0. Σ).8. This shows that linear transformations of normals are also normal. q × q. and it is conventional to write X ∼ N(µ. denoted χ2 . In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. we can also show that EX 2 = 1 and EX 4 = 3. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. This shows that if X is multivariate normal with uncorrelated elements. 1). and it is conventional to write X ∼ N (µ. then Z 0 A−1 Z ∼ χ2 . Its mean and r variance are µ = r and σ 2 = 2r. then using the change-of-variables formula. x ∈ Rk . q 176 . and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). The latter has no closed-form solution.

which can be found by applying change-of-variables to the gamma function.8.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. 1) and Q ∼ χ2 be independent. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. (A.8. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. C −1 CC 0 C −10 ) = N (0.13).Theorem A.1.3 Let Z ∼ N (0. C −1 AC −10 ) = N (0. Set r Z . tr has distribution 177 . Thus the density of Z 2 is (A. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. From (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .11) 2 with r = 1. we see that the MGF of Z 2 is (1 − 2t)−1/2 .8.11). Using the simple law of iterated expectations. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. 1).8. 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 . q Proof of Theorem A. The MGF for the density (A.13) is the MGF of the density (A. which we showed in (A. For Z ∼ N(0. Iq ).3. Proof of Theorem A.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.2.12) E exp (tQ) = 0 Γ (A.

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

∂θ ∂θ (A.16). we can ﬁnd an explicit expression for θ as a function of the data. We can write this as ˆ = argmax Ln (θ). n n i=1 n As the MLE ˆ maximizes the left-hand-side. θ) The Cramer-Rao Theorem gives a lower bound for estimation. More typically.9.15) Two important features of the likelihood are Theorem A.14) ¶ ∂ ∂ 0 ln f (Yi . θ Theorem A.9.16) (A. θ) ∂θ ∂θ which holds at θ = θ0 by (A. Theorem A. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. but these ˆ must be found by numerical methods. and the equality (A.17) is often called the information matrix equality. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ) ≡ L(θ). under conventional regularity conditions. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi .2 Cramer-Rao Lower Bound. cases are rare. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. 179 . If ˜ is an unbiased estimator of θ ∈ R. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. then θ V ar(˜ ≥ (nI0 )−1 .3 Under regularity conditions. which maximizes the log-likelihood).9. θ) →p E ln f (Yi .Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .1 ¯ ¯ ∂ E ln f (Yi . ˆ →p θ0 as n → ∞. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. we can see that it is an estimator of the maximizer θ of the right-hand-side. ˆ is consistent θ for this value. θ0 ) ln f (Yi . θ0 ) ∂θ∂θ 0 (A. In fact. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . However. θ θ∈Θ ˆ In some simple cases. I0 . θ0 ) .17) The matrix I0 is called the information.

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

¯ ¯ ∂ E ln f (Yi . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A.9.9. θ0 ) ∂ ∂ − ln f (Yi . θ0 )0 f (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜.. θ0 ) f (Yi . ∂θ ¯θ=θ0 Z ! = 0. function of the data.. .2. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 )2 (Yi . θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ) d˜ = ˜ y ) ∂ ln f (˜. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 = ln f (Yi . θ0 ) ln f (Yi . (Yi .16). we can show that E By direction computation. To see (A. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. Proof of Theorem A. θ0 ) ¯ ∂ f (y. θ0 ) ∂θ f (Yi . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. ∂2 ln f (Yi . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y.1) has mean zero and variance nH.1.17). θ0 )0 .9. θ) f (˜. θ0 ) − f (Yi .Proof of Theorem A. yn ). θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ0 ) ∂ ∂θ f ∂ (Yi . θ) dy ¯ ∂θ f (y. f (Yi .. Since θ Z ˜ = ˜ y)f (˜. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ) f (y. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . V ar (S) nH so ¥ 181 . θ0 ) (Yi . θ0 ) d˜ = E ˜ .

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

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

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

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

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