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Chapter 6

EXTENSIONS OF THE

TWO-VARIABLE LINEAR

REGRESSION MODEL

1

Prof. Himayatullah May 2004

Chapter 6

EXTENSIONS OF THE TWO-VARIABLE

LINEAR REGRESSION MODELS

The SRF form of regression:

Yi = b^2X i + u^ i (6.1.5)

* Regression through-origin model and

* Regression with intercept

2

Prof. Himayatullah May 2004

Chapter 6

EXTENSIONS OF THE TWO-VARIABLE

LINEAR REGRESSION MODELS

Comparison two types of regressions:

b^2 = Sxiyi/Sx2i (3.1.6) I

var(b^2) = s2/ SX2i (6.1.7) O

var(b^2) = s2/ Sx2i (3.3.1) I

s^2 = S(u^i)2/(n-1) (6.1.8) O

s^2 = S(u^i)2/(n-2) (3.3.5) I

3

Prof. Himayatullah May 2004

Chapter 6

EXTENSIONS OF THE TWO-VARIABLE LINEAR

REGRESSION MODELS

6-1. Regression through the origin

r2 for regression through-origin model

Raw r2 = (SXiYi)2 /SX2i SY2i (6.1.9)

Note: Without very strong a priory expectation, well

advise is sticking to the conventional, intercept-

present model. If intercept equals to zero

statistically, for practical purposes we have a

regression through the origin. If in fact there is an

intercept in the model but we insist on fitting a

regression through the origin, we would be

committing a specification error

4

Prof. Himayatullah May 2004

Chapter 6

EXTENSIONS OF THE TWO-VARIABLE

LINEAR REGRESSION MODELS

Illustrative Examples:

1) Capital Asset Pricing Model - CAPM (page 156)

2) Market Model (page 157)

3) The Characteristic Line of Portfolio Theory

(page 159)

5

Prof. Himayatullah May 2004

Chapter 6

EXTENSIONS OF THE TWO-VARIABLE LINEAR

REGRESSION MODELS

6-2. Scaling and units of measurement

Define Y*i=w 1 Y i and X*i=w 2 X i then:

b*^2 = (w1/w2) b^2 (6.2.15)

b*^1 = w1b^1 (6.2.16)

s*^2 = w12s^2 (6.2.17)

Var(b*^1) = w21 Var(b^1) (6.2.18)

Var(b*^2) = (w1/w2)2 Var(b^2) (6.2.19)

r2xy = r2x*y* (6.2.20)

6

Prof. Himayatullah May 2004

Chapter 6

EXTENSIONS OF THE TWO-VARIABLE

LINEAR REGRESSION MODELS

6-2. Scaling and units of measurement

From one scale of measurement, one can derive the results

based on another scale of measurement. If w1= w2 the

intercept and standard error are both multiplied by w1. If

w2=1 and scale of Y changed by w1, then all coefficients and

standard errors are all multiplied by w1. If w1=1 and scale of

X changed by w2, then only slope coefficient and its standard

error are multiplied by 1/w2. Transformation from (Y,X) to

(Y*,X*) scale does not affect the properties of OLS

Estimators

A numerical example: (pages 161, 163-165)

7

Prof. Himayatullah May 2004

6-3. Functional form of regression model

Semi-log model

Reciprocal model

8

Prof. Himayatullah May 2004

6-4. How to measure elasticity

The log-linear model

Exponential regression model:

Yi= b1Xi b2 e u i (6.4.1)

By taking log to the base e of both side:

lnYi = lnb1 +b2lnXi + ui , by setting lnb1 = a =>

lnYi = a +b2lnXi + ui (6.4.3)

(log-log, or double-log, or log-linear model)

This can be estimated by OLS by letting

Y*i = a +b2X*i + ui , where Y*i=lnYi, X*i=lnXi ;

b2 measures the ELASTICITY of Y respect to X, that is,

percentage change in Y for a given (small) percentage

change in X.

9

Prof. Himayatullah May 2004

6-4. How to measure elasticity

The elasticity E of a variable Y with

respect to variable X is defined as:

E=dY/dX=(% change in Y)/(% change in X)

~ [(Y/Y) x 100] / [(X/X) x100]=

= (Y/X)x (X/Y) = slope x (X/Y)

demand function (pages 167-168)

10

Prof. Himayatullah May 2004

6-5. Semi-log model:

Log-lin and Lin-log Models

Y t = Y0 (1+r) t (6.5.1)

lnYt = lnY0 + t ln(1+r) (6.5.2)

lnYt = b1 + b2t , called constant growth model (6.5.5)

where b1 = lnY0 ; b2 = ln(1+r)

lnYt = b1 + b2t + ui (6.5.6)

It is Semi-log model, or log-lin model. The slope

coefficient measures the constant proportional or

relative change in Y for a given absolute change in the

value of the regressor (t)

b2 = (Relative change in regressand)/(Absolute change

in regressor) (6.5.7)

11

Prof. Himayatullah May 2004

6-5. Semi-log model:

Log-lin and Lin-log Models

Instantaneous Vs. compound rate of growth

b2 is instantaneous rate of growth

antilog(b2) – 1 is compound rate of growth

The linear trend model

Yt = b1 + b2t + ut (6.5.9)

If b2 > 0, there is an upward trend in Y

If b2 < 0, there is an downward trend in Y

Note: (i) Cannot compare the r2 values of

models (6.5.5) and (6.5.9) because the

regressands in the two models are different,

(ii) Such models may be appropriate only if a

time series is stationary.

12

Prof. Himayatullah May 2004

6-5. Semi-log model:

Log-lin and Lin-log Models

The lin-log model:

Yi = b1 +b2lnXi + ui (6.5.11)

b2 = (Change in Y) / Change in lnX =

(Change in Y)/(Relative change in X) ~

(Y)/(X/X) (6.5.12)

or Y = b2 (X/X) (6.5.13)

That is, the absolute change in Y equal

to b2 times the relative change in X.

13

Prof. Himayatullah May 2004

6-6. Reciprocal Models:

Log-lin and Lin-log Models

Yi = b1 + b2( 1/Xi ) + ui (6.5.14)

As X increases definitely, the term

b2( 1/Xi ) approaches to zero and Yi

approaches the limiting or asymptotic value

b1 (See figure 6.5 in page 174)

An Illustrative example: The Phillips Curve

for the United Kingdom 1950-1966

14

Prof. Himayatullah May 2004

6-7. Summary of Functional Forms

Table 6.5 (page 178)

dY/dX (dY/dX).(X/Y)

Linear Y = b1 + b2 X b2 b2(X/Y) */

(log-log)

Log-lin lnY = b1 + b2 X b2 (Y) b2 X */

Lin-log Y = b1 + b2 lnX b2(1/X) b2 (1/Y) */

Reciprocal Y = b1 + b2 (1/X) - b2(1/X2) - b2 (1/XY) */

15

Prof. Himayatullah May 2004

6-7. Summary of Functional Forms

Note: */ indicates that the elasticity

coefficient is variable, depending on the

value taken by X or Y or both. when no X

and Y values are specified, in practice, very

often these elasticities are measured at the

mean values E(X) and E(Y).

-----------------------------------------------

6-8. A note on the stochastic error term

6-9. Summary and conclusions

(pages 179-180)

16

Prof. Himayatullah May 2004

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