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Economics 20 Prof. Patricia M.

Final Review
Binary Dependent Variables
Using OLS on a binary dependent variable is referred to as a linear probability model (LPM.
!"e biggest problem #it" a LPM is t"at t"e predicted val$es are not constrained to be bet#een 0
and %. An alternative to estimating P(y = %|x & 0 + x is to model t"e probability as a f$nction'
G(0 + x), #"ere 0 ( G(z) ( %. )"en G(z) is t"e standard normal cdf #e call t"is a probit
model. )"en G(z) is t"e logistic f$nction' #e call t"is a logit model. *ot" are similar f$nctions
increasing in z. Since t"ese are no# nonlinear in parameters' OLS is inappropriate and #e m$st
$se ma+im$m li,eli"ood estimation.
-nterpreting probits and logits is more complicated t"an interpreting t"e LPM' since
( )
x g
+ =

0 ' #"ere g(z is dG.dz. /or t"e logit' yo$ can estimate g by p(%0p' #"ile for
t"e probit it is best to let Stata comp$te t"e derivative for yo$. A #orse appro+imation' b$t one
yo$ can al#ays do if necessary' is to m$ltiply t"e logit coefficients by .21 and t"e probit
coefficients by .2 to compare t"em bot" to t"e LPM. -n any case' t"e sign and significance of
coefficients can al#ays be compared across models.
Since probits and logits are estimated by ma+im$m li,eli"ood' #e can3t form an / statistic to test
e+cl$sion restrictions. -nstead' #e can $se a li,eli"ood ratio test. Estimate t"e restricted and
$nrestricted models' t"en form L4 & 2(L$r 5 Lr 6
7 #"ere L is t"e log li,eli"ood. Similarly' #e
cannot form an R
as a goodness0of0fit meas$re. One alternative is a pse$do R
defined as % 0
L$r.Lr #"ere t"e restricted model is t"e model #it" 8$st an intercept.
The Tobit Model
S$ppose #e "ave an $nobserved variable y9 s$c" t"at y* = x + u' u|x 6 :ormal(0,
' and #e
only observe y & ma+(c' y9 or y & min(c' y9' #"ere c is constant. !"en a !obit model can be
$sed to estimate and . !"$s' t"e estimated coefficients represent t"e effect of x on t"e latent
variable y9' not on t"e observed variable y. )o$ld need to scale by (x/) to get t"e effect on
y. -f t"e errors are not normal or are "eteros,edastic t"en t"e !obit model #ill $s$ally be
meaningless. !"e best $se of t"e !obit is for t"e case of top0coded data' t"at is #"ere y & min(c'
y9' and c is t"e "ig"est val$e t"e s$rvey fol,s are #illing to report. !"is is $s$ally done for
confidentiality reasons' b$t as researc"ers #e are interested in t"e $nderlying val$es' y9.
)it" eit"er pooled cross0sections or panel data it is possible to do difference0in0differences
estimation. !"e idea is to compare ;treatment< and ;control< gro$ps before and after a
treatment. )e call it difference0in0differences estimation beca$se #it"o$t any ot"er controls it is
8$st t"e difference in t"e means across gro$ps in t"e before0after differences in t"e means. -n a
regression frame#or,' t"is is 8$st yit = 0 + 1treatmentit + 2afterit + 3treatment*afterit + uit
#"ere 3 is t"e difference0in0differences in t"e gro$p means. )"y= !"in, abo$t #"ic" d$mmy
variables #ill be % and #"ic" #ill be 0 for eac" gro$p. !"is implies t"e means for eac" gro$p
are as s"o#n' so t"e differences and difference0in0differences (bottom corner are as s"o#n.
*efore After >ifference
!reatment 0 + 1 0 + 1 + 2+ 3 2+ 3
?ontrol 0 0 + 2 2
>ifference 1 1 + 3 3
!"is met"od can be e+panded to triple differences' t"e idea being yo$ "ave an entire ;control
e+periment< to difference from t"is e+periment. -n t"is case yo$ need to add a d$mmy for being
in t"e tr$e e+periment' interacted #it" all of t"e above. !"e triple difference is t"en t"e
coefficient on t"e interaction of treatment*after*true experiment.
-n all cases' additional x variables can be incl$ded in t"e regression to control for differences
across gro$ps. Only if t"ere is tr$e random assignment to gro$ps #ill it be $nnecessary to
control for ot"er x3s.
Unobserved Fixed Effects
)it" tr$e panel data t"e time dimension is ac"ieved by follo#ing t"e same $nits over time' as
opposed to pooled cross sections' #"ic" $se a ne# random sample in eac" period. !r$e panel
data allo#s $s to address t"e iss$e of $nobserved fi+ed effects. ?onsider a model #it" t"e error
term vit = ai + uit #"ic" is a composite of t"e $s$al error term and a time constant component. -f
t"is $nobserved fi+ed effect' ai' is correlated #it" t"e x3s' t"en it ca$ses OLS to s$ffer from
omitted variable bias. -f t"is omitted variable is tr$ly fi+ed over time' t"en #e can $se panel data
to difference it o$t and obtain consistent estimates. /irst0differences estimation involves
differencing ad8acent periods and $sing OLS on t"e differenced data. /i+ed effects estimation
$ses 7$asi0differencing' #"ere in eac" period #e s$btract o$t t"e mean over time for t"at
individ$al. !"is met"od co$ld be t"o$g"t of as incl$ding a separate intercept for eac" individ$al.
)"en t"ere are 8$st 2 periods' first0differences and fi+ed effects #ill res$lt in t"e same estimated
coefficients' b$t if !@2 t"ere #ill be differences. *ot" met"ods are consistent.
-f ai is not correlated #it" t"e x3s' t"en OLS is $nbiased. Ao#ever' t"e error terms #ill be
serially correlated implying t"at t"e standard errors are #rong. !"e random effect estimator is a
feasible BLS met"od for obtaining t"e correct standard errors. Essentially it involves 7$asi0
demeaning' so t"at yo$ end $p #it" a sort of #eig"ted average of OLS and fi+ed effects. A
Aa$sman test can be $sed to test #"et"er fi+ed effects and random effects estimates are different.
-f t"ey are' t"en #e m$st re8ect t"e n$ll t"at ai is not correlated #it" t"e x3s. An alternative to
random effects is to simply scale t"e standard errors to ta,e into acco$nt alternative forms of
serial correlation (and "eteros,edasticity. !"at is' to allo# for t"e fact t"at t"e observations are
cl$stered' and t"$s may "ave correlated errors #it"in t"e cl$ster.
Instruental Variables
)"enever x is endogeno$s (beca$se of omitted variables' meas$rement error' etc.' OLS is
biased. -n t"is case' instr$mental variables (-C estimation can be $sed to obtain consistent
estimates. A valid instr$ment m$st be strongly correlated #it" x' b$t be completely $ncorrelated
#it" t"e error term. -C is also referred to as t#o0stage least s7$ares (2SLS beca$se t"e -C
estimates can be obtained in t"e follo#ing manner. /irst' regress x on t"e instr$ment and all of
t"e ot"er e+ogeno$s x3s from t"e model and obtain t"e predicted val$es. !"is first stage
regression also allo#s yo$ to test #"et"er yo$r instr$ment is correlated #it" x 5 it m$st be
significant in t"is regression. :o# r$n t"e original model s$bstit$ting t"e predicted val$e of x
for x. )"ile t"is met"od gives t"e e+act same coefficients as -C' t"e standard errors are off a bit'
so it is preferable not to do -C by "and. !"e met"od can be e+tended to m$ltiple endogeno$s
variables' b$t it is necessary to "ave at least one instr$ment for eac" endogeno$s variable.
Testin! for Endo!eneity and "veridentifyin! #estrictions
A version of a Aa$sman test can be $sed to test #"et"er x is really endogeno$s. !"e idea is t"at
OLS and -C are bot" consistent if x is not endogeno$s' so t"e res$lts can be compared. !o do
t"is test' save t"e resid$als from t"e first stage regression' and incl$de t"em in t"e original
str$ct$ral model (leave t"e potentially endogeno$s x in. -f t"e coefficient on t"is resid$al is
significantly different from Dero' yo$ can re8ect t"e n$ll t"at x is e+ogeno$s. :ote t"at t"e
coefficients on t"e ot"er variables #ill be identical to t"e -C coefficients 5 t"is is 8$st anot"er
#ay to t"in, of 2SLS. Aence' if t"e coefficient on t"e resid$al is Dero' -C and OLS are t"e same.
)"ile #e can $se t"e first stage regression to test if o$r instr$ment is correlated #it" x' and #e
can $se t"e Aa$sman test to see if t"e x is tr$ly endogeno$s' in general #e cannot test #"et"er
o$r instr$ment is $ncorrelated #it" t"e error. Ao#ever' if #e "ave more t"an one instr$ment #e
say t"e model is overidentified and #e can test #"et"er some of t"e instr$ments are correlated
#it" t"e error. !o do t"is' #e $se -C to estimate t"e str$ct$ral model' saving t"e resid$als. !"en
#e regress t"e resid$als on all of t"e e+ogeno$s variables. !"e LM statistic nR
6 7
' #"ere is
t"e n$mber of extra instr$ments.
>on3t conf$se t"is overidentifying test #it" t"e special form of t"e *re$sc"0Pagan test for -C
models. )"en testing for "eteros,edasticity after -C' yo$ need to regress t"e resid$als s7$ared
on all of t"e e+ogeno$s variables. Similarly' testing for serial correlation after -C is a bit
different. Eo$ need to save t"e resid$als from t"e -C estimation and t"en $se -C again on t"e
model #it" t"e lagged resid$al incl$ded. -f yo$ "ave serial correlation and plan to 7$asi0
difference to fi+ it' yo$ need to $se -C on t"e 7$asi0differenced model' #"ere t"e instr$ment is
also 7$asi0differenced.
$iultaneous E%uations
Sim$ltaneo$s e7$ations models (SEM are really 8$st anot"er reason #"y x mig"t be
endogeno$s' re7$iring t"e $se of -C. Ao#ever' it can be a bit complicated to t"in, abo$t
identification #"en yo$ "ave SEM. S$ppose yo$ "ave t"e follo#ing str$ct$ral e7$ationsF
y1 = 1y2 +1&1 + u1 and
y2 = 2y1 +2&2 + u2'
#"ere t"e &3s are e+ogeno$s. !"e red$ced form e7$ations e+press t"e endogeno$s variables in
terms of all of t"e e+ogeno$s variables and are y1 = 1&1 +2&2 + u1 and y2 = 1&1 +2&2 + u2.
)"ile #e can al#ays estimate t"ese red$ced from e7$ations' #e can only estimate t"e str$ct$ral
e7$ation if it is identified. !o identify t"e first e7$ation' t"ere m$st be variables in &2 t"at are not
in &1. Similarly to identify t"e second e7$ation t"ere m$st be variables in &1 t"at are not in &2.
Estimation of an identified e7$ation is by -C' #"ere all of t"e e+ogeno$s variables in t"e system
are t"e instr$ments.
$aple $election 'orrection
-f a sample is tr$ncated in a nonrandom #ay' t"en OLS s$ffers from selection bias. -t3s as if
t"ere is an omitted variable for "o# t"e observation #as selected into t"e sample. ?onsistent
estimates can be obtained by incl$ding ' t"e inverse Mills ratio as a sample selection correction
term. After estimating a probit of #"et"er y is observed on variables &' t"ese estimates are $sed
to form . !"en yo$ can regress y on x and to get consistent estimates. /or t"is to be
identified' x m$st be a s$bset of &. !"is is typically referred to as a Aec,man selection correction
model' or sometimes a Aec,it.
Unbiasedness of "($ for Tie $eries Data
!ime series data "as a temporal ordering' so no longer 8$st "ave a random sample. Since it is not
a random sample' #e need to c"ange t"e ass$mptions for $nbiasedness. Still need to ass$me t"e
model is linear in parameters' and t"at t"ere is no perfect collinearity or constant x. :o# t"e
Dero conditional mean ass$mption is strongerF E(ut|) & 0' t & %' 2' G' n. !"at is' t"e error term
in any given period is $ncorrelated #it" all of t"e x3s in all time periods. -n t"is case #e say t"at
t"e x3s are strictly e+ogeno$s. )it" #ea,ly dependent series' contemporary e+ogeneity #ill be
s$fficient 5 meaning t"at t"e error term in any given period is $ncorrelated #it" all of t"e x3s in
t"at time period.
Variance of "($ for Tie $eries Data
Similarly' #e need a stronger ass$mption of "omos,edasticityF Car(ut|) & Car(ut &
. !"is
implies t"at t"e error variance is bot" independent of t"e x3s and constant over time. )e also
need to ass$me t"at t"ere is no serial correlation in t"e errorsF ?orr(ut,u!|) & 0 for t H !. Under
t"ese Ba$ss0Mar,ov Ass$mptions for time series data' OLS is *LUE.
Finite Distributed (a! Models
Since time series data "as a temporal ordering' #e can consider $sing lags of x in o$r model. A
finite distrib$ted lag model of order #ill incl$de lags of x. !"e coefficient on t"e
contemporaneo$s x is referred to as t"e impact propensity and reflects t"e immediate c"ange in y.
!"e long0r$n propensity (L4P' #"ic" reflects t"e long0r$n c"ange in y after a permanent
c"ange' is calc$lated as t"e s$m of t"e coefficients on x and all its lags.
Trends and $easonality
Since #e are $s$ally interested in a ca$sal interpretation of t"e effect of x on y' #it" time series
data it is often necessary to control for general trends and seasonality. -f t#o $nrelated series are
bot" trending' #e may falsely concl$de t"at t"ey are related 5 #e may "ave a case of sp$rio$s
regression. !o avoid t"is problem' #e can incl$de a trend term. Similarly' if #e t"in, t"ere are
seasonal effects' #e can incl$de season d$mmies. /or mont"ly data t"is may be mont"
d$mmies' for 7$arterly data it #ill li,ely be 7$arter d$mmies' etc. )e can obtain t"e same
coefficients by first detrending and.or deseasonaliDing t"e series. !o do t"is' simply regress eac"
series on t"e trend and.or season d$mmies' saving t"e resid$als. !"e resid$als are t"e detrended
series. )"ile t"e coefficients #ill be t"e same' t"e R
#ill be m$c" lo#er. !"is may be $sef$l' if
#"at yo$ really #ant to ,no# is "o# m$c" of y is being e+plained by 8$st x' not t"e trend. !"e
idea "ere is t"at #e are interested in "o# t"e movements aro$nd t"e trend are related.
$erially 'orrelated Errors
!esting for #"et"er t"ere is A4(% serial correlation in t"e errors is straig"t for#ard. )e #ant to
test t"e n$ll t"at & 0 in ut = ut"% I et' t & 2' G' n. )e can $se t"e resid$als as estimates of t"e
errors' so 8$st regress t"e resid$als on t"e lagged resid$als. Ao#ever' t"is test ass$mes t"at t"e
x3s are all strictly e+ogeno$s. An alternative' t"en' is to regress t"e resid$als on t"e lagged
resid$als and all of t"e x3s. !"is is e7$ivalent to 8$st adding t"e lagged resid$al to t"e original
model. Aig"er order serial correlation can be tested for in a similar manner. J$st incl$de more
lags of t"e resid$al and test for t"e 8oint significance. (!"e LM version of t"is e+cl$sion
restriction test is referred to as a *re$sc"0Bodfrey test 5 t"at *re$sc" gets aro$ndK.
?orrecting for A4(% serial correlation involves 7$asi0differencing to transform t"e error term. -f
#e m$ltiply t"e e7$ation for time t0% by ' and s$btract it from t"e e7$ation for time t' #e
obtainF yt " yt"% & (% " )0 I 1(xt " xt"% I et' since et' & ut " ut"%. !"is is a feasible BLS
estimation met"od' since #e m$st $se an estimate of from regressing t"e resid$als on t"e
lagged resid$als. >epending on "o# one treats t"e first observation' t"is feasible BLS
estimation is referred to as ?oc"rane0Orc$tt or Prais0)insten estimation. Eac" of t"ese can be
implemented iteratively.
-n addition to feasible BLS' it is also possible to 8$st scale t"e standard errors to ad8$st for
arbitrary forms of serial correlation. !"is is similar to scaling standard errors to be rob$st to
arbitrary forms of "eteros,edasticity' rat"er t"an doing feasible BLS (i.e. )LS for a ,no#n
form of "eteros,edasticity. -n t"is case' #e refer to serial correlation rob$st standard errors as
:e#ey0)est standard errors.
#ando *al+s
An a$toregressive process of order one' an A4(% is c"aracteriDed as one #"ere yt = yt"% I et' t &
%' 2' G #it" et being an iid se7$ence #it" mean 0 and variance e
. /or t"is process to be
#ea,ly dependent (and "ence s$itable for appropriate analysis and inference #it" OLS it m$st
be t"e case t"at |L ( %. -f & %' t"e series is not #ea,ly dependent beca$se t"e e+pected val$e
of yt is al#ays y0. )e call t"is a random #al,' and say t"at it is "ig"ly persistent. !"is is also
referred to as a case of a $nit root process. -t is possible for t"ere to be a trend as #ell 5 t"is is
referred to as a random #al, #it" drift. )e also refer to a "ig"ly persistent series as being
integrated of order one' or -(%. !o transform s$c" a series into a #ea,ly dependent process 5
referred to as being integrated of order Dero' or -(0 5 #e can first difference it.
-n order to test for a $nit root' t"at is to see if #e "ave a random #al,' #e need to do a >ic,ey0
/$ller test. 4egress yt on yt"1 and $se t"e special >ic,ey0/$ller critical val$es to determine if
t"e t statistic on t"e lag is big eno$g" to re8ect t"e n$ll of a $nit root. -t is also possible to do an
a$gmented >ic,ey0/$ller test' in #"ic" #e add lags of yt in order to allo# for more dynamics.
)e can also incl$de a trend term' if #e t"in, #e "ave a $nit root #it" drift. )"en incl$ding a
trend' #e need a different set of special >ic,ey0/$ller critical val$es.
-f bot" x and y follo# a random #al,' a regression of y on x #ill s$ffer from t"e sp$rio$s
regression problem. !"at is' t"e t statistic on x #ill be significant' even if t"ere is no real
relations"ip. Ao#ever' it may still be possible to discover an interesting relations"ip bet#een
t#o -(% processes. S$ppose t"at t"ere is a s$c" t"at yt # xt is an -(0 process' t"en #e say t"at
y and x are cointegrated #it" a cointegration parameter . -f #e ,no# #"at is' say from
t"eory' t"en #e 8$st calc$late !t & yt # xt and do a >ic,ey0/$ller test on !. -f #e re8ect a $nit root
t"en y and x are cointegrated. Ot"er#ise' #e regress y on x and save t"e resid$als. )e t"en
regress $t on $t"1 and compare t"e t statistic on t"e lagged resid$al to t"e special critical val$es
for t"e cointegration test. -f t"ere is a trend' it can be incl$ded in t"e original regression of y on
x' and a different set of critical val$es is $sed.