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respectively, where the latter condition is implied by the rst. Under E{i |xi } = 0,

we can interpret the regression model as describing the conditional expected value of

yi given values for the explanatory variables xi . For example, what is the expected

wage for an arbitrary woman of age 40, with a university education and 14 years of

experience? Or, what is the expected unemployment rate given wage rates, ination

and total output in the economy? The rst consequence of (3.2) is the interpretation

of the individual coefcients. For example, k measures the expected change in yi

if xik changes with one unit but all the other variables in xi do not change. That is

E{yi |xi }

= k .

xik

(3.3)

It is important to realize that we had to state explicitly that the other variables in xi did

not change. This is the so-called ceteris paribus condition. In a multiple regression

model single coefcients can only be interpreted under ceteris paribus conditions. For

example, k could measure the effect of age on the expected wage of a woman, if the

education level and years of experience are kept constant. An important consequence

of the ceteris paribus condition is that it is not possible to interpret a single coefcient

in a regression model without knowing what the other variables in the model are. If

interest is focussed on the relationship between yi and xik , the other variables in xi act

as control variables. For example, we may be interested in the relationship between

house prices and the number of bedrooms, controlling for differences in lot size and

location. Depending upon the question of interest, we may decide to control for some

factors but not for all (see Wooldridge, 2003, Section 6.3, for more discussion).

Sometimes these ceteris paribus conditions are hard to maintain. For example, in

the wage equation case, it may be very common that a changing age almost always

corresponds to changing years of experience. Although the k coefcient in this case

still measures the effect of age keeping years of experience (and the other variables)

xed, it may not be very well identied from a given sample, due to the collinearity

between the two variables. In some cases, it is just impossible to maintain the ceteris

paribus condition, for example if xi includes both age and age-squared. Clearly, it is

ridiculous to say that a coefcient k measures the effect of age given that age-squared

is constant. In this case, one should go back to the derivative (3.3). If xi includes,

say, age i 2 + age 2i 3 , we can derive

E{yi |xi }

= 2 + 2 age i 3 ,

age i

(3.4)

which can be interpreted as the marginal effect of a changing age if the other variables in xi (excluding age 2i ) are kept constant. This shows how the marginal effects

of explanatory variables can be allowed to vary over the observations by including

additional terms involving these variables (in this case age 2i ). For example, we can

allow the effect of age to be different for men and women by including an interaction

term age i male i in the regression, where male i is a dummy for males. Thus, if the

model includes age i 2 + age i male i 3 the effect of a changing age is

E{yi |xi }

= 2 + male i 3 ,

age i

(3.5)

53

which is 2 for females and 2 + 3 for males. Sections 3.4 and 3.5 will illustrate the

use of such interaction terms.

Frequently, economists are interested in elasticities rather than marginal effects.

An elasticity measures the relative change in the dependent variable due to a relative

change in one of the xi variables. Often, elasticities are estimated directly from a linear

regression model involving the logarithms of most explanatory variables (excluding

dummy variables), that is

log yi = (log xi ) + vi ,

(3.6)

where log xi is shorthand notation for a vector with elements (1, log xi2 , . . . , log xiK )

and it is assumed that E{vi | log xi } = 0. We shall call this a loglinear model. In

this case,

E{yi |xi }

xik

E{log yi | log xi }

= k ,

(3.7)

xik

E{yi |xi }

log xik

where the is due to the fact that E{log yi | log xi } = E{log yi |xi } = log E{yi |xi }. Note

that (3.3) implies that in the linear model

E{yi |xi }

xik

x

= ik k ,

xik

E{yi |xi }

xi

(3.8)

which shows that the linear model implies that elasticities are nonconstant and vary

with xi , while the loglinear model imposes constant elasticities. While in many cases

the choice of functional form is dictated by convenience in economic interpretation,

other considerations may play a role. For example, explaining log yi rather than yi

may help reducing heteroskedasticity problems, as illustrated in Section 3.5 below.

In Section 3.3 we shall briey consider statistical tests for a linear versus a loglinear

specication.

If xik is a dummy variable (or another variable that may take nonpositive values)

we cannot take its logarithm and we include the original variable in the model. Thus

we estimate

log yi = xi + i .

(3.9)

Of course, it is possible to include some explanatory variables in logs and some in

levels. In (3.9) the interpretation of a coefcient k is the relative change in yi due

to an absolute change of one unit in xik . So if xik is a dummy for males, k is the

(ceteris paribus) relative wage differential between men and women. Again this holds

only approximately, see Subsection 3.5.2.

The inequality of E{log yi |xi } and log E{yi |xi } also has some consequences for prediction purposes. Suppose we start from the loglinear model (3.6) with E{vi | log xi } =

0. Then, we can determine the predicted value of log yi as (log xi ) . However, if we

are interested in predicting yi rather than log yi , it is not the case that exp{(log xi ) }

is a good predictor for yi in the sense that it corresponds to the expected value of yi ,

given xi . That is, E{yi |xi } = exp{E{log yi |xi }} = exp{(log xi ) }. The reason is that

taking logarithms is a nonlinear transformation, while the expected value of a nonlinear function is not this nonlinear function of the expected value. The only way to get

around this problem is to make distributional assumptions. If, for example, it can be

54

assumed that vi in (3.6) is normally distributed with mean zero and variance v2 , it

implies that the conditional distribution of yi is lognormal (see Appendix B) with mean

E{yi |xi } = exp E{log yi |xi } + 12 v2 = exp (log xi ) + 12 v2 .

(3.10)

Sometimes, the additional half-variance term is also added when the error terms are

not assumed to be normal. Often, it is simply omitted. Additional discussion on predicting yi when the dependent variable is log(yi ) is provided in Wooldridge (2003,

Section 6.4).

It should be noted that the assumption that E{i |xi } = 0 is also important, as it says

that changing xi should not lead to changes in the expected error term. There are many

cases in economics where this is hard to maintain and the models we are interested

in do not correspond to conditional expectations. We shall come back to this issue in

Chapter 5.

Another consequence of (3.2) is often overlooked. If we change the set of explanatory

variables xi to zi , say, and estimate another regression model,

yi = zi + vi

(3.11)

with the interpretation that E{yi |zi } = zi , there is no conict with the previous model

that said that E{yi |xi } = xi . Because the conditioning variables are different, both

conditional expectations could be correct in the sense that both are linear in the conditioning variables. Consequently, if we interpret the regression models as describing

the conditional expectation given the variables that are included there can never be

any conict between them. It is just two different things we might be interested in.

For example, we may be interested in the expected wage as a function of gender only,

but also in the expected wage as a function of gender, education and experience. Note

that, because of a different ceteris paribus condition, the coefcients for gender in

these two models do not have the same interpretation. Often, researchers implicitly

or explicitly make the assumption that the set of conditioning variables is larger than

those that are included. Sometimes, it is suggested that the model contains all relevant

observable variables (implying that observables that are not included in the model are

in the conditioning set but irrelevant). If it would be argued, for example, that the two

linear models above should be interpreted as

E{yi |xi , zi } = zi

and

respectively, then the two models are typically in conict and at most one of them can

be correct.1 Only in such cases, it makes sense to compare the two models statistically

and to test, for example, which model is correct and which one is not. We come back

to this issue in Subsection 3.2.3.

1

3.2

55

If one is (implicitly) assuming that the conditioning set of the model contains more

variables than the ones that are included, it is possible that the set of explanatory

variables is misspecied. This means that one or more of the omitted variables are

relevant, i.e. have nonzero coefcients. This raises two questions: what happens when

a relevant variable is excluded from the model and what happens when an irrelevant

variable is included in the model? To illustrate this, consider the following two models

yi = xi + zi + i ,

(3.12)

yi = xi + vi ,

(3.13)

and

be some additional variables). The model in (3.13) is nested in (3.12) and implicitly

assumes that zi is irrelevant ( = 0). What happens if we estimate model (3.13) while

in fact model (3.12) is the correct model? That is, what happens when we omit zi from

the set of regressors?

The OLS estimator for based on (3.13), denoted b2 , is given by

b2 =

N

1

xi xi

i=1

N

xi yi .

(3.14)

i=1

The properties of this estimator under model (3.12) can be determined by substituting

(3.12) into (3.14) to obtain

b2 = +

N

i=1

1

xi xi

N

i=1

xi zi

N

1

xi xi

i=1

N

xi i .

(3.15)

i=1

Depending upon the assumptions made for model (3.12), the last term in this expression

will have an expectation or probability limit of zero.2 The second term on the right

hand side, however, corresponds to a bias (or asymptotic bias) in the OLS estimator

due to estimating the incorrect model (3.13). This is referred to as an omitted variable

bias. As expected, there will be no bias if = 0 (implying that the two models are

identical), but there

is one more case in which the estimator for will not be biased

and that is when N

i=1 xi zi = 0, or, asymptotically, when E{xi zi } = 0. If this happens

we say that xi and zi are orthogonal. This does not happen very often in economic

applications. Note, for example, that the presence of an intercept in xi implies that

E{zi } should be zero.

The converse is less of a problem. If we estimate model (3.12) while in fact model

(3.13) is appropriate, that is, we needlessly include the irrelevant variables zi , we would

simply be estimating the coefcients, which are zero. In this case, however, it would

2

56

be preferable to estimate from the restricted model (3.13) rather than from (3.12)

because the latter estimator for will usually have a higher variance and thus be less

reliable. While the derivation of this result requires some tedious matrix manipulations,

it is intuitively obvious: model (3.13) imposes more information, so that we can expect

that the estimator that exploits this information is, on average, more accurate than one

which does not. Thus, including irrelevant variables in your model, even though they

have a zero coefcient, will typically increase the variance of the estimators for the

other model parameters. Including as many variables as possible in a model is thus not

a good strategy, while including too few variables has the danger of biased estimates.

This means we need some guidance on how to select the set of regressors.

3.2.2 Selecting Regressors

Again, it should be stressed that if we interpret the regression model as describing the

conditional expectation of yi given the included variables xi , there is no issue of a

misspecied set of regressors, although there might be a problem of functional form

(see the next section). This implies that statistically there is nothing to test here. The

set of xi variables will be chosen on the basis of what we nd interesting and often

economic theory or common sense guides us in our choice. Interpreting the model in a

broader sense implies that there may be relevant regressors that are excluded or irrelevant ones that are included. To nd potentially relevant variables we can use economic

theory again. For example, when specifying an individual wage equation we may use

the human capital theory which essentially says that everything that affects a persons

productivity will affect his or her wage. In addition, we may use job characteristics

(blue or white collar, shift work, public or private sector, etc.) and general labour

market conditions (e.g. sectorial unemployment).

It is good practice to select the set of potentially relevant variables on the basis of

economic arguments rather than statistical ones. Although it is sometimes suggested

otherwise, statistical arguments are never certainty arguments. That is, there is always

a small (but not ignorable) probability of drawing the wrong conclusion. For example,

there is always a probability (corresponding to the size of the test) of rejecting the null

hypothesis that a coefcient is zero, while the null is actually true. Such type I errors

are rather likely to happen if we use a sequence of many tests to select the regressors

to include in the model. This process is referred to as data snooping or data mining

(see Leamer, 1978; Lovell, 1983; or Charemza and Deadman, 1999, Chapter 2), and in

economics it is not a compliment if someone accuses you of doing it. In general, data

snooping refers to the fact that a given set of data is used more than once to choose a

model specication and to test hypotheses. You can imagine, for example, that if you

have a set of 20 potential regressors and you try each one of them, that it is quite likely

to conclude that one of them is signicant, even though there is no true relationship

between any of these regressors and the variable you are explaining. Although statistical

software packages sometimes provide mechanical routines to select regressors, these

are not recommended in economic work. The probability of making incorrect choices

is high and it is not unlikely that your model captures some peculiarities in the

data that have no real meaning outside the sample. In practice, however, it is hard

to avoid that some amount of data snooping enters your work. Even if you do not

perform your own specication search and happen to know which model to estimate,

57

this knowledge may be based upon the successes and failures of past investigations.

Nevertheless, it is important to be aware of the problem. In recent years, the possibility

of data snooping biases plays an important role in empirical studies that model stock

returns. Lo and MacKinlay (1990), for example, analyse such biases in tests of nancial

asset pricing models, while Sullivan, Timmermann and White (2001) analyse to what

extent the presence of calendar effects in stock returns, like the January effect discussed

in Section 2.7, can be attributed to data snooping.

The danger of data mining is particularly high if the specication search is from

simple to general. In this approach, you start with a simple model and you include

additional variables or lags of variables until the specication appears adequate. That

is, until the restrictions imposed by the model are no longer rejected and you are

happy with the signs of the coefcient estimates and their signicance. Clearly, such

a procedure may involve a very large number of tests. An alternative is the generalto-specic modelling approach, advocated by Professor David Hendry and others,

typically referred to as the LSE methodology.3 This approach starts by estimating a

general unrestricted model (GUM), which is subsequently reduced in size and complexity by testing restrictions that can be imposed; see Charemza and Deadman (1999)

for an extensive treatment. The idea behind this approach is appealing. Assuming that

a sufciently general and complicated model can describe reality, any more parsimonious model is an improvement if it conveys all of the same information in a simpler,

more compact form. The art of model specication in the LSE approach is to nd

models that are valid restrictions of the GUM, and that cannot be reduced to even

more parsimonious models that are also valid restrictions. While the LSE methodology involves a large number of (mis)specication tests, it can be argued to be relatively

insensitive to data-mining problems. The basic argument, formalized by White (1990),

is that as the sample size grows to innity only the true specication will survive all

specication tests. This assumes that the true specication is a special case of the

GUM that a researcher starts with. Rather than ending up with a specication that is

most likely incorrect, due to an accumulation of type I and type II errors, the generalto-specic approach in the long run would result in the correct specication. While

this asymptotic result is insufcient to assure that the LSE approach works well with

sample sizes typical for empirical work, Hoover and Perez (1999) show that it may

work pretty well in practice in the sense that the methodology recovers the correct

specication (or a closely related specication) most of the time. An automated version of the general-to-specic approach is developed by Krolzig and Hendry (2001)

and available in PcGets (see Bardsen, 2001, or Owen, 2003, for a review).

In practice, most applied researchers will start somewhere in the middle with a

specication that could be appropriate and, ideally, then test (1) whether restrictions

imposed by the model are correct and test (2) whether restrictions not imposed by the

model could be imposed. In the rst category are misspecication tests for omitted

variables, but also for autocorrelation and heteroskedasticity (see Chapter 4). In the

second category are tests of parametric restrictions, for example that one or more

explanatory variables have zero coefcients.

3

The adjective LSE derives from the fact that there is a strong tradition of time-series econometrics at the

London School of Economics (LSE), starting in the 1960s. Currently, the practitioners of LSE econometrics

are widely dispersed among institutions throughout the world.

58

included in your specication. The fact that your results do not show a signicant

effect on yi of some variable xik is informative to the reader and there is no reason

to hide it by re-estimating the model while excluding xik . Of course, you should be

careful including many variables in your model that are multicollinear so that, in the

end, almost none of the variables appears individually signicant.

Besides formal statistical tests there are other criteria that are sometimes used to

select a set of regressors. First of all, the R 2 , discussed in Section 2.4, measures the

proportion of the sample variation in yi that is explained by variation in xi . It is

clear that if we were to extend the model by including zi in the set of regressors, the

explained variation would never decrease, so that also the R 2 will never decrease if

we include additional variables in the model. Using the R 2 as criterion would thus

favour models with as many explanatory variables as possible. This is certainly not

optimal, because with too many variables we will not be able to say very much about

the models coefcients, as they may be estimated rather inaccurately. Because the R 2

does not punish the inclusion of many variables, one would better use a measure

which incorporates a trade-off between goodness-of-t and the number of regressors

employed in the model. One way to do this is to use the adjusted R 2 (or R 2 ), as

discussed in the previous chapter. Writing it as

R 2 = 1

2

1/(N K) N

i=1 ei

N

1/(N 1) i=1 (yi y)

2

(3.16)

and noting that the denominator in this expression is unaffected by the model under

consideration, shows

the adjusted R 2 provides a trade-off between goodness-of-t,

N that

2

as measured by i=1 ei , and the simplicity or parsimony of the model, as measured by

the number of parameters K. There exist a number of alternative criteria that provide

such a trade-off, the most common ones being Akaikes Information Criterion (AIC),

proposed by Akaike (1973), given by

N

1 2 2K

AIC = log

e +

N i=1 i

N

(3.17)

(1978), which is given by

BIC = log

N

1 2 K

e + log N.

N i=1 i

N

(3.18)

Models with a lower AIC or BIC are typically preferred. Note that both criteria add a

penalty that increases with the number of regressors. Because the penalty is larger for

BIC, the latter criterion tends to favour more parsimonious models than AIC. The use

of either of these criteria is usually restricted to cases where alternative models are not

nested (see Subsection 3.2.3) and economic theory provides no guidance on selecting

the appropriate model. A typical situation is the search for a parsimonious model that

describes the dynamic process of a particular variable (see Chapter 8).

59

Alternatively, it is possible to test whether the increase in R 2 is statistically signicant. Testing this is exactly the same as testing whether the coefcients for the newly

added variables zi are all equal to zero, and we have seen a test for that in the previous

chapter. Recall from (2.59) that the appropriate F-statistic can be written as

f =

,

(1 R12 )/(N K)

(3.19)

where R12 and R02 denote the R 2 in the model with and without zi , respectively, and J

is the number of variables in zi . Under the null hypothesis that zi has zero coefcients,

the f statistic has an F distribution with J and N K degrees of freedom, provided we

can impose conditions (A1)(A5) from Chapter 2. The F-test thus provides a statistical

answer to the question whether the increase in R 2 due to including zi in the model

was signicant or not. It is also possible to rewrite f in terms of adjusted R 2 s. This

would show that R 12 > R 02 if and only if f exceeds a certain threshold. In general, these

thresholds do not correspond to 5% or 10% critical values of the F distribution, but are

substantially smaller. In particular, it can be shown that R 12 > R 02 if and only if the f

statistic is larger than one. For a single variable (J = 1) this implies that the adjusted

R 2 will increase if the additional variable has a t-ratio with an absolute value larger

than unity. (Recall that for a single restriction t 2 = f .) This reveals that the adjusted

R 2 would lead to the inclusion of more variables than standard t or F-tests.

Direct tests of the hypothesis that the coefcients for zi are zero can be obtained

from the t and F-tests discussed in the previous chapter. Compared to f above, a test

statistic can be derived which is more generally appropriate. Let denote the OLS

estimator for and let V { } denote an estimated covariance matrix for . Then, it

can be shown that under the null hypothesis that = 0 the test statistic

= V { }1

(3.20)

Wald test described in Chapter 2 (compare (2.63)). The form of the covariance matrix

of depends upon the assumptions we are willing to make. Under the GaussMarkov

assumptions we would obtain a statistic that satises = Jf .

It is important to recall that two single tests are not equivalent to one joint test. For

example, if we are considering the exclusion of two single variables with coefcients

1 and 2 , the individual t-tests may reject neither 1 = 0 nor 2 = 0, whereas the

joint F-test (or Wald test) rejects the joint restriction 1 = 2 = 0. The message here

is that if we want to drop two variables from the model at the same time, we should

be looking at a joint test rather than at two separate tests. Once the rst variable is

omitted from the model, the second one may appear signicant. This is particularly of

importance if collinearity exists between the two variables.

3.2.3 Comparing Non-nested Models

Sometimes econometricians want to compare two different models that are not nested.

In this case neither of the two models is obtained as a special case of the other. Such

60

a situation may arise if two alternative economic theories lead to different models for

the same phenomenon. Let us consider the following two alternative specications:

and

Model A: yi = xi + i

(3.21)

Model B: yi = zi + vi ,

(3.22)

and zi . The two models are non-nested if zi includes a variable that is not in xi and

vice versa. Because both models are explaining the same endogenous variable, it is

possible to use the R 2 , AIC or BIC criteria, discussed in the previous subsection. An

alternative and more formal idea that can be used to compare the two models is that of

encompassing (see Mizon, 1984; Mizon and Richard, 1986): if model A is believed

to be the correct model it must be able to encompass model B, that is, it must be

able to explain model Bs results. If model A is unable to do so, it has to be rejected.

Vice versa, if model B is unable to encompass model A, it should be rejected as well.

Consequently, it is possible that both models are rejected, because neither of them

is correct. If model A is not rejected, we can test it against another rival model and

maintain it as long as it is not rejected.

The encompassing principle is very general and it is legitimate to require a model

to encompass its rivals. If these rival models are nested within the current model, they

are automatically encompassed by it, because a more general model is always able to

explain results of simpler models (compare (3.15) above). If the models are not nested

encompassing is nontrivial. Unfortunately, encompassing tests for general models are

fairly complicated, but for the regression models above things are relatively simple.

We shall consider two alternative tests. The rst is the non-nested F -test or encom

passing F-test. Writing xi = (x1i

x2i ) where x1i is included in zi (and x2i is not), model

B can be tested by constructing a so-called articial nesting model as

yi = zi + x2i

A + vi .

(3.23)

Thus, the validity of model B (model B encompasses model A) can be tested using

an F-test for the restrictions A = 0. In a similar fashion, we can test the validity of

model A by testing B = 0 in

yi = xi + z2i

B + i ,

(3.24)

where z2i contains the variables from zi that are not included in xi . The null hypotheses

that are tested here state that one model encompasses the other. The outcome of the

two tests may be that both models have to be rejected. On the other hand, it is also

possible that neither of the two models is rejected. Thus the fact that model A is

rejected should not be interpreted as evidence in favour of model B. It just indicates

that something is captured by model B which is not adequately taken into account in

model A.

61

A more parsimonious non-nested test is the J-test. Let us start again from an articial

nesting model that nests both model A and model B, given by

yi = (1 )xi + zi + ui ,

(3.25)

where is a scalar parameter and ui denotes the error term. If = 0, equation (3.25)

corresponds to model A and if = 1 it reduces to model B. Unfortunately, the nesting

model (3.25) cannot be estimated because in general , and cannot be separately

identied. One solution to this problem (suggested by Davidson and MacKinnon, 1981)

is to replace the unknown parameters by , the OLS estimates from model B, and

to test the hypothesis that = 0 in

yi = xi + zi + ui = xi + yiB + ui ,

(3.26)

where yiB is the predicted value from model B and = (1 ). The J-test for the

validity of model A uses the t-statistic for = 0 in this last regression. Computationally,

it simply means that the tted value from the rival model is added to the model that

we are testing and that we test whether its coefcient is zero using a standard t-test.

Compared to the non-nested F-test, the J-test involves only one restriction. This means

that the J-test may be more attractive (have more power) if the number of additional

regressors in the non-nested F-test is large. If the non-nested F-test involves only one

additional regressor, it is equivalent to the J-test. More details on non-nested testing can

be found in Davidson and MacKinnon (1993, Section 11.3) and the references therein.

Another relevant case with two alternative models that are non-nested is the choice

between a linear and loglinear functional form. Because the dependent variable is

different (yi and log yi , respectively) a comparison on the basis of goodness-of-t

measures, including AIC and BIC, is inappropriate. One way to test the appropriateness of the linear and loglinear models involves nesting them in a more general

model using the so-called BoxCox transformation (see Davidson and MacKinnon,

1993, Section 14.6), and comparing them against this more general alternative. Alternatively, an approach similar to the encompassing approach above can be chosen by

making use of an articial nesting model. A very simple procedure is the PE test, suggested by MacKinnon, White and Davidson (1983). First, estimate both the linear and

loglinear models by OLS. Denote the predicted values by yi and log yi , respectively.

Then the linear model can be tested against its loglinear alternative by testing the null

hypothesis that LIN = 0 in the test regression

yi = xi + LIN (log yi log yi ) + ui .

Similarly, the loglinear model corresponds to the null hypothesis LOG = 0 in

log yi = (log xi ) + LOG (yi exp{log yi }) + ui .

Both tests can simply be based on the standard t-statistics, which under the null hypothesis have an approximate standard normal distribution. If LIN = 0 is not rejected, the

linear model may be preferred. If LOG = 0 is not rejected, the loglinear model is

preferred. If both hypotheses are rejected, neither of the two models appears to be

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