Evaluating Regression Models

Joint Regional Training Center for Latin America (BTC)

Course on Macroeconomic Forecasting
BT11.09

Presenter
Ruy Lama

Outline
1.

Revision of Basic Econometrics

2.

Coefficient Tests
A. Linear Restrictions ( Wald Test)
B. Omitted Variables ( Likelihood Ratio )
C. Redundant Variables ( Likelihood Ratio )

3.

Residual Tests
A Jarque-Bera
A.
Jarque Bera Test

4.

Stability Tests
A. Recursive Coefficients
B. CUSUM Test
C. CUSUM of Squares Test
D. Chows Breakpoint Test
E Chows
E.
Chow s Forecast Test
2

Economic Application
Money Demand Function (Friedman,
(Friedman 1956)
1

, ,

Relevant for:
A Monetary Targeting (70s and 80s)
A.
B. Two Pillar Approach (ECB)
3

Economic Application
Lets
Let s consider a log-linear
log linear version of the
money demand function:
2

In this version of the model we will evaluate :

coefficients, residuals, and stability tests.

Stages of Applied Econometric Analysis

1. Revision of Basic Econometrics

General Model
3

OLS Estimation
4

1. Revision of Basic Econometrics

Moreover, if
6 ~

0,

Then
7 ~

Where the unbiased estimator of is given

by:

2
7

1. Revision of Basic Econometrics

Before estimating: Check the series !
MP

11.6

12.0

11 4
11.4

11 8
11.8

11.2

11.6

11.0

11.4

10.8

11.2

10.6

11.0
1965

1970

1975

1980

1985

1990

1965

1970

DP

1975

1980

1985

1990

1985

1990

RNET

.08

.20

.06

.16

.04

.12

.02

.08

.00

.04

-.02

.00
1965

1970

1975

1980

1985

1990

1965

1970

1975

1980

1. Revision of Basic Econometrics

Estimation of the Money Demand Function in
Eviews.

1. Revision of Basic Econometrics

Behavior of the residuals.
residuals
11.6
11.4
11.2
11.0
.3

10.8

.2

10.6

.1

10.4

.0
-.1
1
-.2
-.3
64

66

68

70

72

Residual

74

76

78

Actual

10

80

82

84

Fitted

86

88

2. Coefficient Tests
We can evaluate alternative theories of money
demand:
A. Quantityy Theoryy of Moneyy
B. Transaction Theory of Money (Baumol-Tobin
Model)
What are the restrictions on the parameters?
11

2. Coefficient Tests
G
Given
e this
t s specification
spec cat o of
o money
o ey demand:
de a d:
9

A Quantity Theory of Money :

A.
10

1, 2, 3

1,0,0

B. Transaction Theory of Money (Baumol-Tobin

Model)
11

1, 2, 3

0.5, 0.5,0
12

2. Coefficient Tests
A Linear Restrictions ( Wald Test) :
A.
12

Lets evaluate a set of linear restrictions:

13

0 :
0

13

2. Coefficient Tests
Wald Test:
2

14

The corresponding hypothesis F-test is:

15

14

2. Coefficient Tests
Wald Test: What are the matrices R and r in
the hypothesis testing?
16

1
2
3

0
1
0
0

15

2. Coefficient Tests
A. Linear Restrictions ( Wald Test) : Quantity
A
Theory of Money

16

2. Coefficient Tests
A. Linear Restrictions ( Wald Test) : Quantity
A
Theory of Money. We reject the Null
Hypothesis

17

2. Coefficient Tests
B Omitted Variables (Likelihood Ratio)
B.
S
Start
with
i h the
h regression:
i
17

Then evaluate if t and rt are omitted from

regression equation (17).
18

2. Coefficient Tests
B. Omitted Variables (Likelihood Ratio)
B
Likelihood Function:
20

1
2

1
/2

1
2 2

/2

21

Log-likelihood
Log
likelihood function:
22

2
19

1
2 2

2. Coefficient Tests
B. Omitted Variables (Likelihood Ratio)
B
Likelihood Ratio:
2

q: Number of omitted Variables

Corresponding F-statistic
24

20

2. Coefficient Tests
B. Omitted Variables (Likelihood Ratio) : Are
B
we omitting the variables t and rt ?

21

2. Coefficient Tests
B. Omitted Variables (Likelihood Ratio) : We
B
reject the null hypothesis.

22

2. Coefficient Tests
C Redundant Variables (Likelihood Ratio)
C.
S
Start
with
i h the
h regression:
i
25

Then evaluated if t and rt are redundant in

equation (13).
23

2. Coefficient Tests
C Redundant Variables (Likelihood Ratio)
C.

Likelihood Ratio:
26

q: Number of omitted Variables

Corresponding F-statistic
27

24

2. Coefficient Tests
C. Redundant Variables (Likelihood Ratio) : Are
C
variables t and rt redundant?

25

2. Coefficient Tests
C. Redundant Variables (Likelihood Ratio) : We
C
reject the null hypothesis. Notice that the
redundant and omitted variables test gave
exactly the same result !

26

3. Residual Tests
A. Jarque-Bera Test: Are the residuals normally distributed?
JB test statistic:

28

3 2

2
6

where:
N: Number of Observations
k: number of estimated coefficients
S: Skewness
K: Kurtosis
27

3. Residual Tests
A. Jarque-Bera
Jarque Bera Test: Are the residuals normally
distributed?
Under the assumption of normality:
3,

0.

Then
Then,
0.
28

3. Residual Tests

29

4. Stability Tests

How stable are the parameters over time?

Alt
Alternative
ti TTests
t
A. Recursive Coefficients
B. CUSUM Test
C. CUSUM of Squares Test
D. Chow Breakpoint Test
E. Chow Forecast Test
30

4. Stability Tests
A. Recursive Coefficients:
Given a sample with time period t=1,2,3,,m.
t 1,2,3,,m.
Estimate the coefficient vector recursively
with m= t1, t1 +1,
+1 t1 +2,,T.
+2 T
29
30

31

4. Stability Tests
A. Recursive Coefficients
20

2.5

15

2.0

10

1.5

1.0

0.5

-5

0.0

-10

-0.5

-15

-1.0
64

66

68

70

72

74

76

78

80

82

84

86

88

64

66

68

70

Recursive C(1) Estimates

2 S.E.
SE

72

74

76

78

80

82

84

86

88

84

86

88

Recursive C(2) Estimates

2 S.E.
SE

-2

-4

-4

-8

-6

-12
64

66

68

70

72

74

76

78

80

82

84

86

88

64

Recursive C(3) Estimates

2 S.E.

66

68

70

72

74

76

78

80

82

Recursive C(4) Estimates

2 S.E.

32

4. Stability Tests
B CUSUM Test
B.
Recursive
i Residual
id l ( em ):
)
31

Variance:
32

1
33

4. Stability Tests
B CUSUM Test
B.
Normalized Recursive Residual ( wm+1 ):

33

1
1

34

4. Stability Tests
B CUSUM Test
B.

34
1

35

1, , .

1
1

2
1

35

4. Stability Tests
B CUSUM Test
B.
30
20
10
0
-10
-20
-30
64

66

68

70

72

74

76

CUSUM

78

80

82

84

5% Significance

36

86

88

4. Stability Tests
C CUSUM of Squares Test
C.
36

37

1
1

1
1
1

37

1, , .

4. Stability Tests
C CUSUM of Squares Test
C.
1.2
1.0
0.8
0.6
0.4
0.2
00
0.0
-0.2
64

66

68

70

72

74

76

CUSUM of Squares

38

78

80

82

84

86

5% Significance

88

4. Stability Tests
D Chow Breakpoint Test
D.
Restricted Model
38

1,2, ,

Unrestricted Model
39

1 1

40

2 2

12 ,
1,2,

1,

39

2, ,

4. Stability Tests
D Chow Breakpoint Test
D.

41

40

4. Stability Tests
D Chow Breakpoint Test
D.

41

4. Stability Tests
E Chow Forecast Test
E.
Restricted Model
42

1,2, ,

Unrestricted Model
43

1 1

1,2, ,

42

4. Stability Tests
E Chow Forecast Test
E.
1

44

1
1

43

4. Stability Tests
E Chow Forecast Test
E.

44