Lectures PowerPoints PDF

Econometrics and Quantitative
Analysis
Using Econometrics: A Practical Guide

A.H. Studenmund
6th Edition. Addison Wesley Longman
Instructor: Dr. Samir Safi

Associate Professor of Statistics
Fall 2011
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Chapter 1
An Overview of
Regression
Analysis
Copyright © 2011 Pearson Addison-Wesley. Slides by Niels-Hugo Blunch

All rights reserved. Washington and Lee University
What is Econometrics?
• Econometrics literally means “economic

measurement”
• It is the quantitative measurement and analysis
of actual economic and business phenomena—
phenomena
and so involves:
– economic theoryy
– Statistics
– Math
– observation/data collection
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What is Econometrics? (cont.)
(cont )
• Three major uses of econometrics:

– Describing
D ibi economic
i reality
lit
– Testing hypotheses about economic theory
– Forecasting future economic activity
• So econometrics is all about questions: the
researcher (YOU!) first asks questions and then
uses econometrics to answer them
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Example
• Consider the general and purely theoretical

relationship:
l ti hi
Q = f(P,
f(P Ps, Yd) (1 1)
(1.1)
• Econometrics allows this g general and purelyy

theoretical relationship to become explicit:
Q = 27.7
27 7 – 0.11P
0 11P + 0.03P
0 03Ps + 0.23Yd
0 23Yd (1 2)
(1.2)
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What is Regression Analysis?
• Economic theory can give us the direction of a

change,
g , e.g.
g the change
g in the demand for dvd’s
following a price decrease (or price increase)
• But what if we want to know not jjust “how?” but also
“how much?”
• Then we need:
– A sample of data
– A way to estimate such a relationship
• one of the most frequently ones used is regression analysis
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What is Regression Analysis?
(cont.)
• Formally, regression analysis is a statistical

t h i
technique th t attempts
that tt t to
t “explain”
“ l i ”
movements in one variable, the dependent
variable, as a function of movements in a set
of other variables, the independent (or
explanatory) variables, through the
quantification of a single equation
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Example
• Return to the example from before:

Q = f(P,
( , Ps, Yd)) ((1.1))
• Here, Q is the dependent variable and P, Ps, Yd are the
independent variables
• Don’t be deceived by the words dependent and independent,
however
– A statistically significant regression result does not necessarily imply
causality
– We also need:
• Economic theory
• Common sense
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Single-Equation Linear Models
• The simplest example is:

Y = β0 +β1 X (1 3)
(1.3)
• The β ' s are denoted “coefficients”
– β0 is the “constant” or “intercept” term
– β1 is the “slope
p coefficient”: the amount that Y will
change when X increases by one unit; for a linear model,
β1 is constant over the entire function
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Figure 1.1
Graphical Representation of the
Coefficients of the Regression Line
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(cont.)
• Application of linear regression techniques requires that the

equation be linear—such as (1.3)
• By contrast, the equation
Y = β0 + β1 X2 (1.4)
is not linear
• What to do? First define
Z = X2 (1 5)
(1.5)
• Substituting into (1.4) yields:
Y = β0 + β1 Z (1 6)
(1.6)
• This redefined equation is now linear (in the coefficients β0 and β1 in
the variables Y and Z)
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(cont.)
• Is (1.3) a complete description of origins of variation in Y?

• No, at least four sources of variation in Y other than the variation in the
included Xs:
• Other potentially important explanatory variables may be missing
(e.g., X2 and X3)
• Measurement error
• Incorrect functional form
• Purely random and totally unpredictable occurrences
• Inclusion of a “stochastic error term” (ε) effectively “takes care”
of all these other sources of variation in Y that are NOT captured
b X
by X, so th
thatt (1.3)
(1 3) b
becomes:
Y = β0 + β1X + ε (1.7)
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(cont.)
• Two components in (1.7):

– dete
deterministic
st c co
component
po e (β0 + β1X))
– stochastic/random component (ε)
• Why
y “deterministic”?
– Indicates the value of Y that is determined by a given value of X
(which is assumed to be non-stochastic)
– Alt
Alternatively,
ti l theth det.
d t comp. can be
b thought
th ht off as the
th
expected value of Y given X—namely E(Y|X)—i.e. the
mean (or average) value of the Ys associated with a
particular value of X
– This is also denoted the conditional expectation (that is,
expectation of Y conditional on X)
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Example: Aggregate
Consumption Function
• Aggregate consumption as a function of aggregate income may

be lower (or higher) than it would otherwise have been due to:
– consumer uncertainty—hard
t i t h d (i
(impossible?)
ibl ?) tto measure, ii.e. iis an
omitted variable
– Observed consumption may be different from actual consumption
due to measurement error
– The “true” consumption function may be nonlinear but a linear one is
estimated (see Figure 1.2 for a graphical illustration)
– Human
H b
behavior
h i always
l contains
t i some element(s)
l t( ) off pure chance;
h
unpredictable, i.e. random events may increase or decrease
consumption at any given time
• Whenever one or more of these factors are at play, the observed
Y will differ from the Y predicted from the deterministic part, β0 +
β1X
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Figure 1.2
Errors Caused by Using a Linear Functional
Form to Model a Nonlinear Relationship
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Extending the Notation
• Include reference to the number of

observations
b ti
– Single-equation
g q linear case:
Yi = β0 + β1Xi + εi (i = 1,2,…,N) (1.10)
• So there are really N equations
equations, one for each
observation
• the coefficients,
coefficients β0 and β1, are the same
• the values of Y, X, and ε differ across observations
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Extending the Notation (cont.)
(cont )
• The general case: multivariate regression

Yi = β0 + β1X1i + β2X2i + β3X3i + εi (i = 1,2,…,N) (1.11)
• Each of the slope coefficients gives the impact of a one-unit
increase in the corresponding X variable on Y, holding the
other included independent variables constant (i.e., ceteris
paribus)
• As an (implicit) consequence of this, the impact of variables
th t are nott included
that i l d d in
i th
the regression
i are nott hheld
ld
constant (we return to this in Ch. 6)
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Example: Wage Regression
• Let wages (WAGE) depend on:

– years of work experience (EXP)
– yyears of education ((EDU))
– gender of the worker (GEND: 1 if male, 0 if female)
• Substituting into equation (1.11) yields:

WAGEi = β0 + β1EXPi + β2EDUi + β3GENDi + εi (1.12)
(1 12)
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Indexing Conventions
• Subscript “i” for data on individuals (so called

“cross section” data)
• Subscript
p “t” for time series data ((e.g.,
g series of
years, months, or days—daily exchange rates, for
example
p )
• Subscript “it” when we have both (for example,
“panel
panel data
data”))
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The Estimated Regression
E
Equation
ti
• The regression equation considered so far is the “true”—but

unknown—theoretical regression equation
• Instead of “true,” might think about this as the population
regression vs. the sample/estimated regression
• How do we obtain the empirical counterpart of the theoretical
regression model (1.14)?
• It has to be estimated
• The empirical counterpart to (1.14) is:
Yˆi = βˆ0 + βˆ1 X i (1.16)
• The signs
Th i on top off the
h estimates
i are denoted
d d “hat,”
“h ” so that
h we h
have
“Y-hat,” for example
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E
Equation
ti (cont.)
( t)
• For each sample we get a different set of estimated

regression
g coefficients
• Y is the estimated value of Yi (i.e. the dependent
variable for observation i);
); similarlyy it is the
prediction of E(Yi|Xi) from the regression equation
• The closer Y is to the observed value of Yi, the
better is the “fit” of the equation
y, the smaller is the estimated error term,, ei,
• Similarly,
often denoted the “residual,” the better is the fit
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E
Equation
ti (cont.)
( t)
• This can also be seen from the fact that

(1 17)
(1.17)
• Note difference with the error term, εi, given as

(1.18)
• This all comes together in Figure 1.3
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Figure 1.3
T
True and
d Estimated
E ti t d Regression
R i Lines
Li
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Example: Using Regression to
Explain Housing prices
• Houses are not homogenous products, like corn or

gold that have generally known market prices
gold,
• So, how to appraise a house against a given
asking
ki price?
i ?
• Yes, it’s true: manyy real estate appraisers
pp actually
y
use regression analysis for this!
• Consider specific case: Suppose the asking price
was $230,000
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Explain Housing prices (cont.)
• Is this fair / too much /too little?

• Depends
D d on size
i off h
house (hi
(higher
h size,
i hi
higher
h price)
i )
• So, collect cross-sectional data on prices
(in thousands of $) and sizes (in square feet)
for, say, 43 houses
• Then say this yields the following estimated regression
line:
PR IˆCE i = 40 .0 + 0 .138 SIZE i (1.23)
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Figure 1.5 A Cross-Sectional
Model of Housing Prices
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• Note that the interpretation of the intercept term

is problematic in this case (we’ll
(we ll get back to this
later, in Section 7.1.2)
• The literal interpretation of the intercept here is the
price of a house with a size of zero square
p q feet…
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• How to use the estimated regression line / estimated

regression coefficients to answer the question?
– Just plug the particular size of the house, you are interested in
(here, 1,600 square feet) into (1.23)
– Alternatively,
Alternatively read off the estimated price using Figure 1.5
15
• Either way, we get an estimated price of $260.8 (thousand,
remember!)
• So, in terms of our original question, it’s a good deal—go
ahead and purchase!!
• N
Note
t that
th t we simplified
i lifi d a llott iin thi
this example
l bby assuming
i ththatt
only size matters for housing prices
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Table 1.1a Data for and Results of the
Weight-Guessing Equation
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Table 1.1b Data for and Results of the
Weight-Guessing Equation
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Figure 1.4
A Weight-Guessing Equation
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Key Terms from Chapter 1
• Regression analysis • Slope coefficient

• Dependent variable • Multivariate regression
model
• Independent (or explanatory) variable(s)
• Expected value
• Causality
• Residual
• Stochastic error term
• Time series
• Linear
• Cross-sectional data set
• Intercept term
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Chapter 2
Ordinary Least Squares
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Estimating Single-Independent-
Variable Models with OLS
• Recall that the objective of regression analysis is to start

from:
(2.1)
• And, through the use of data, to get to:

(2 2)
(2.2)
• Recall that equation 2.1 is purely theoretical, while equation

(2.2) is it empirical counterpart
• How to move from (2
(2.1)
1) to (2.2)?
(2 2)?
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2-٣٣
Variable Models with OLS (cont.)
• One of the most widely used methods is Ordinary Least

Squares (OLS)
• OLS minimizes (i = 1, 2, …., N) (2.3)
• Or, the sum of squared deviations of the vertical distance

between the residuals ((i.e. the estimated error terms)) and
the estimated regression line
• We also denote this term the “Residual
Residual Sum of Squares”
Squares
(RSS)
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2-٣٤
N
• Similarly, OLS minimizes: ∑ i i
(
i
Y − ˆ
Y ) 2
• Why
Wh use OLS?
• Relatively easy to use
• The goal of minimizing RSS is intuitively /
theoretically appealing
• This basically says we want the estimated regression
equation to be as close as possible to the observed data
• OLS estimates have a number of useful
characteristics
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2-٣٥
• OLS estimates have at least two useful

characteristics:
• The sum of the residuals is exactly zero
• OLS can be shown to be the “best”
best estimator when
certain specific conditions hold (we’ll get back to
this in Chapter 4)
– Ordinary Least Squares (OLS) is an estimator
–A g
given produced by
y OLS is an estimate
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2-٣٦
How does OLS work?

• First recall from (2
(2.3)
3) that OLS minimizes the sum of the squared
residuals
• Next
Next, it can be shown (see Exercise 12) that the coefficients that
ensure that for the case of just one independent variable are:
(2 4)
(2.4)
(2.5)
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2-٣٧
Estimating Multivariate
Regression Models with OLS
• In the “real world” one explanatory variable is not enough

• The general multivariate regression model with K
independent variables is:
Yi = β0 + β1X1i + β2X2i + ... + βKXKi + εi (i = 1,2,…,N) (1.13)
• Biggest difference with single-explanatory variable
regression model is in the interpretation of the slope
coefficients
– Now a slope coefficient indicates the change in the dependent
variable associated with a one-unit increase in the explanatory
variable holding the other explanatory variables constant
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2-٣٨
Estimating Multivariate Regression
Models with OLS (cont.)
• Omitted (and relevant!) variables are therefore not

held constant
• The intercept
p term, β0, is the value of Y when all
the Xs and the error term equal zero
• Nevertheless
Nevertheless, the underlying principle of
minimizing the summed squared residuals remains
the same
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2-٣٩
Example: financial aid awards at
a liberal arts college
• Dependent variable:
• FINAIDi: financial aid (measured in dollars of
grant) awarded to the ith applicant
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2-٤٠
a liberal arts college
• Theoretical Model:
(2.9)
(2.10)
where:
h
– PARENTi: The amount (in dollars) that the parents of the ith
student are judged able to contribute to college expenses
– HSRANKi: The ith student’s GPA rank in high school, measured
as a percentage (i.e. between 0 and 100)
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2-٤١
a liberal arts college (cont.)
• Estimate model using the data in Table 2.2 to get:
(2.11)
• Interpretation of the slope coefficients?

– Graphical interpretation in Figures 2.1 and 2.2
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2-٤٢
Figure 2.1 Financial Aid as a
Function of Parents’ Ability to Pay
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2-٤٣
Figure 2.2 Financial Aid as a
Function of High School Rank
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2-٤٤
Total, Explained, and Residual
Sums of Squares
• (2.12)
• (2 13)
(2.13)
• TSS = ESS + RSS

• This is usually called the decomposition of
variance
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2-٤٥
Figure 2.3 Decomposition of the
Variance in Y
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2-٤٦
Evaluating the Quality of a
Regression Equation
Checkpoints here include the following:

1. Is the equation
q supported
pp by
y sound theory?
y
2. How well does the estimated regression fit the data?
3. Is the data set reasonably large and accurate?
4. Is OLS the best estimator to be used for this equation?
5. How well do the estimated coefficients correspond to the expectations
developed by the researcher before the data were collected?
6. Are all the obviously important variables included in the equation?
7. Has the most theoretically logical functional form been used?
8 Does
8. D th
the regression
i appear tto b
be free
f off major
j econometric
ti
problems?
*These numbers roughly correspond to the relevant chapters in the book
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2-٤٧
Describing the Overall Fit of the
Estimated Model
• The simplest commonly used measure of overall fit

is the coefficient of determination
determination, R2:
(2 14)
(2.14)
• Since OLS selects the coefficient estimates that

minimizes RSS, OLS provides the largestg possible
R2 (within the class of linear models)
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2-٤٨
Figure 2.4 Illustration of Case
Where R2 = 0
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2-٤٩
Where R2 = .95
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2-٥٠
Where R2 = 1
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2-٥١
The Simple Correlation
Coefficient, r
• This is a measure related to R2

• r measures the strength and direction of the linear
relationship
p between two variables:
– r = +1: the two variables are perfectly positively
correlated
– r = –1: the two variables are perfectly negatively
correlated
– r = 0: the two variables are totally uncorrelated
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2-٥٢
The adjusted coefficient of
determination
• A major problem with R2 is that it can never

decrease if another independent variable is added
• An alternative to R2 that addresses this issue is the
adjusted R2 or R2:
(2.15)
Where N – K – 1 = degrees of freedom
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2-٥٣
The adjusted coefficient of
determination (cont.)
• So, R2 measures the share of the variation of Y around

its mean that is explained
p by
y the regression
g equation,
q ,
adjusted for degrees of freedom
• R2 can be used to compare
p the fits of regressions
g with
the same dependent variable and different numbers of
independent variables
• As a result, most researchers automatically use instead
of R2 when evaluating the fit of their estimated
regressions equations
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2-٥٤
Table 2.1a
The Calculation of Estimated Regression
Coefficients for the Weight/Height Example
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2-٥٥
Table 2.1b
The Calculation of Estimated Regression
Coefficients for the Weight/Height Example
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2-٥٦
Table 2.2a
Data for the Financial Aid Example
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2-٥٧
Table 2.2b
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2-٥٨
Table 2.2c
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2-٥٩
Table 2.2d
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2-٦٠
• Ordinary Least Squares (OLS)

• Interpretation of a multivariate regression coefficient
• Total sums of squares
• Explained sums of squares
• Residual sums of squares
• Coefficient of determination
determination, R2
• Simple correlation coefficient, r
• Degrees of freedom
• Adjusted coefficient of determination , R2
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2-٦١
Chapter 3
Learning to Use Regression

Analysis
y
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Steps in Applied
Regression Analysis
• The first step is choosing the dependent variable – this step is

determined by the purpose of the research (see Chapter 11 for
details)
• After choosing the dependent variable, it’s logical to follow the
following sequence:
1. Review
1 R i th
the lit
literature
t and
d develop
d l theth theoretical
th ti l model
d l
2. Specify the model: Select the independent variables and the
functional form
3. Hypothesize the expected signs of the coefficients
4. Collect the data. Inspect and clean the data
5 Estimate
5. E ti t and d evaluate
l t the
th equation
ti
6. Document the results
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Step 1: Review the Literature and
Develop the Theoretical Model
• Perhaps counter intuitively, a strong theoretical foundation

is the best start for any empirical project
• Reason: main econometric decisions are determined by the
underlying theoretical model
• Useful starting points:
– Journal of Economic Literature or a business oriented publication of
abstracts
– Internet
I t t search,
h including
i l di G Google
l SScholar
h l
– EconLit, an electronic bibliography of economics literature (for more
details go to www.EconLit.org)
details, www EconLit org)
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Step 2: Specify the Model: Independent
Variables and Functional Form
• After selecting the dependent variable, the

specification of a model involves choosing the
following components:
1 the independent variables and how they should be
1.
measured,
2 the functional (mathematical) form of the variables
2. variables,
and
3 the properties of the stochastic error term
3.
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Step 2: Specify the Model:
Independent Variables and
Functional Form (cont.)
• A mistake in any of the three elements results in a specification error

• For example,
example only theoretically relevant explanatory variables should
be included
• Even so,, researchers frequently
q y have to make choices –also denoted
imposing their priors
• Example:
• when estimating a demand equation, theory informs us that prices of
complements and substitutes of the good in question are important
explanatory variables
• But which complements—and which substitutes?
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Step 3: Hypothesize the Expected
Signs of the Coefficients
• Once the variables are selected, it’s important to

hypothesize the expected signs of the regression
coefficients
• Example:
E l demand
d d equation
ti ffor a fifinall consumption
ti good
d
• First, state the demand equation as a general function:
(3.2)
• The signs above the variables indicate the hypothesized

sign of the respective regression coefficient in a linear
model
d l
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Step 4: Collect the Data & Inspect
and Clean the Data
• A general rule regarding sample size is “the more

observations the better”
• as long as the observations are from the same general
population!
• The reason for this goes back to notion of degrees of
freedom (mentioned first in Section 2.4)
• When there are more degrees of freedom:
• Every positive error is likely to be balanced by a negative error
(
(see Fi
Figure 3.2)
3 2)
• The estimated regression coefficients are estimated with a
greater deal of precision
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Figure 3.1 Mathematical Fit of a
Line to Two Points
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Figure 3.2 Statistical Fit of a Line
to Three Points
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Step 4: Collect the Data & Inspect
and Clean the Data (cont.)
• Estimate model using the data in Table 2.2 to get:

• Inspecting the data
data—obtain
obtain a printout or plot (graph)
of the data
• Reason: to look for outliers
– An outlier is an observation that lies outside the range of the rest of
the observations
• Examples:
– Does a student have a 7.0 GPA on a 4.0 scale?
– Is consumption negative?
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Step 5: Estimate and Evaluate
the Equation
• Once steps 1–4 have been completed, the estimation part

is quick
– using Eviews or Stata to estimate an OLS regression takes less
than a second!
• The evaluation part is more tricky, however, involving
answering the following questions:
– How well did the equation fit the data?
– Were the signs and magnitudes of the estimated coefficients as
expected?
• Afterwards may add sensitivity analysis (see Section 6.4
for details)
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Step 6: Document the Results
• A standard format usually is used to present estimated

regression results:
(3 3)
(3.3)
• The number in parentheses under the estimated coefficient

is the estimated standard error of the estimated
coefficient,
ffi i t and
d th
the t-value
t l is i th
the one usedd tto ttestt the
th
hypothesis that the true value of the coefficient is different
from zero (more on this later!)
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Case Study: Using Regression Analysis
to Pick Restaurant Locations
• Background:
• You have been hired to determine the best location
for the next Woody’s restaurant (a moderately priced,
24 ho r family
24-hour, famil resta
restaurant
rant chain)
• Objective:
j
• How to decide location using the six basic steps of
applied
app ed regression
eg ess o a analysis,
a ys s, discussed
d scussed ea
earlier?
e
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Step 1: Review the Literature and
Develop the Theoretical Model
• Background reading about the restaurant industry

• Talking to various experts within the firm
– All the chain’s restaurants are identical and located in
suburban, retail, or residential environments
– So, lack of variation in potential explanatory variables to help
determine location
– Number of customers most important for locational decision
Æ Dependent variable: number of customers (measured by
the number of checks or bills)
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Variables and Functional Form
• More discussions with in-house experts

reveall th
three major
j d determinants
t i t off sales:
l
– Number of people living near the location
– General income level of the location
– Number of direct competitors near the location
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Variables and Functional Form (cont.)
• Based on this, the exact definitions of the independent

variables you decide to include are:
– N = Competition: the number of direct competitors within a two-
mile radius of the Woody’s location
– P = Population: the number of people living within a three-mile
radius of the location
– I = Income: the average household income of the population
measured in variable P
• With no reason to suspect anything other than linear
functional form and a typical
yp stochastic error term,
that’s what you decide to use
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Step 3: Hypothesize the Expected
Signs of the Coefficients
• After talking some more with the in-house

experts
t and d thinking
thi ki some more, you
come up with the following:
(3.4)
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Step 4: Collect the Data &
Inspect and Clean the Data
• You manage to obtain data on the dependent and

independent variables for all 33 Woody
Woody’s
s restaurants
• Next, you inspect the data
• The data quality is judged as excellent because:
• Each manager measures each variable identically
• All restaurants are included in the sample
• All information is from the same year
y
• The resulting data is as given in Tables 3.1 and 3.3 in the

book ((using
g Eviews and Stata,, respectively)
p y)
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Step 5: Estimate and Evaluate
the Equation
• You take the data set and enter it into the computer
• You then run an OLS regression (after thinking the model over one
last time!)
• The resulting model is:
(3.5)
Estimated coefficients are as expected and the fit is reasonable

• Values for N, P, and I for each potential new location are then
obtained and plugged into (3.5) to predict Y
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Step 6: Document the Results
• The results summarized in Equation 3.5

meet our documentation requirements
• Hence
Hence, youo decide that there’s no need to
take this step any further
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Table 3.1a
Data for the Woody’s
Woody s Restaurants Example
(Using the Eviews Program)
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Table 3.1b
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Table 3.1c
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Table 3.2a
Actual Computer Output
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Table 3.2b
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Table 3.3
(Using the Stata Program)
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Table 3.3b
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Table 3.4a
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Table 3.4b
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• The six steps in applied regression analysis

• Dummy variable
• Cross-sectional data set
• Specification
S ifi ti error
• Degrees of freedom
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Chapter 4
The Classical Model
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The Classical Assumptions
• The classical assumptions must be met in order for OLS estimators to be the
best available
• The seven classical assumptions are:
I. The regression model is linear, is correctly specified, and has an
additive error term
II The error term has a zero population mean
II.
III. All explanatory variables are uncorrelated with the error term
IV. Observations of the error term are uncorrelated with each other
(no serial correlation)
V. The error term has a constant variance (no heteroskedasticity)
VI. No explanatory variable is a perfect linear function of any other
explanatory variable(s) (no perfect multicollinearity)
VII. The error term is normally distributed (this assumption is optional
but usually is invoked)
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4-٩٣
I: linear, correctly specified,
additive error term
• Consider the following regression model:

Yi = β0 + β1X1i + β2X2i + ... + βKXKi + εi (4.1)
• This model:
– is linear (in the coefficients)
– has an additive error term
• If we also assume that all the relevant explanatory variables

are included in (4.1) then the model is also correctly
specified
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4-٩٤
II: Error term has a zero
population mean
• As was pointed out in Section 1.2, econometricians add a

stochastic (random) error term to regression equations
• Reason: to account for variation in the dependent
variable that is not explained by the model
• The specific value of the error term for each observation
is determined purely by chance
• This can be illustrated by Figure 4.1
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4-٩٥
Figure 4.1 An Error Term
Distribution with a Mean of Zero
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4-٩٦
III: All explanatory variables are
uncorrelated with the error term
• If not, the OLS estimates would be likely to attribute to

the X some of the variation in Y that actually came from
the error term
• For example,
example if the error term and X were positively
correlated then the estimated coefficient would probably
be higher
g than it would otherwise have been ((biased
upward)
• This assumption is violated most frequently when a
researcher omits an important independent variable from
an equation
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4-٩٧
IV: No serial correlation of
error term
• If a systematic correlation does exist between one observation of

the error term and another, then it will be more difficult for OLS to
get accurate estimates of the standard errors of the coefficients
• This assumption is most likely to be violated in time-series
models:
– AAn increase
i in
i th
the error tterm iin one ti
time period
i d ((a random
d shock,
h k
for example) is likely to be followed by an increase in the next
period, also
– Example: Hurricane Katrina
• If, over all the observations of the sample εt+1 is correlated with εt then
the error term is said to be serially correlated (or auto-correlated),
and Assumption IV is violated
• Violations of this assumption are considered in more detail in Chapter 9
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4-٩٨
V: Constant variance / No
heteroskedasticity in error term
• The error term must have a constant variance

• That is, the variance of the error term cannot
change
g for each observation or range g of
observations
• If it does,
does there is heteroskedasticity present in the
error term
• An example of this can bee seen from Figure 4.2
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4-٩٩
Figure 4.2 An Error Term Whose
Variance Increases as Z Increases
(Heteroskedasticity)
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4-١٠٠
VI: No perfect multicollinearity
• Perfect collinearity between two independent variables

implies that:
– they are really the same variable, or
– one is a multiple
p of the other,, and/or
– that a constant has been added to one of the variables
• Example:
– Including both annual sales (in dollars) and the annual sales tax
paid in a regression at the level of an individual store, all in the
same city
– Since the stores are all in the same city, there is no variation in the
percentage sales tax
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4-١٠١
VII: The error term is normally
distributed
• Basically implies that the error term follows a

bell-shape
bell shape (see Figure 4.3)
4 3)
• Strictly speaking not required for OLS estimation
( l t d tto the
(related th Gauss-Markov
G M k Theorem:
Th more on
this in Section 4.3)
• Its major application is in hypothesis testing,
which uses the estimated regression coefficient to
i
investigate
ti t hypotheses
h th about
b t economici b
behavior
h i
(see Chapter 5)
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4-١٠٢
Figure 4.3
Normal Distributions
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4-١٠٣
The Sampling
Di t ib ti off
Distribution
• We saw earlier that the error term follows a

probability distribution (Classical Assumption VII)
• But so do the estimates of β!
– The probability distribution of these values across
different samples is called the sampling distribution
of
• We will now look at the properties of the mean,

mean the
variance, and the standard error of this sampling
distribution
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4-١٠٤
Properties of the Mean
• A desirable property of a distribution of estimates in that its mean

equals
q the true mean of the variables being g estimated
• Formally, an estimator is an unbiased estimator if its sampling
distribution has as its expected
p value the true value of .
• We also write this as follows:
(4 9)
(4.9)
• Similarly, if this is not the case, we say that the estimator is
biased
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4-١٠٥
Properties of the Variance
• Just as we wanted the mean of the sampling distribution to be

centered around the true p population
p , so too it is desirable for
the sampling distribution to be as narrow (or precise) as possible.
– Centering around “the truth” but with high variability might be of very
little use.
• One way of narrowing the sampling distribution is to increase the
sampling size (which therefore also increases the degrees of
freedom)
• These
Th points
i t are illustrated
ill t t d iin Fi
Figures 4.4
4 4 and
d 4.5
45
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4-١٠٦
Figure 4.4
Distributions of
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4-١٠٧
Figure 4.5 Sampling Distribution of
for Various Observations (N)
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4-١٠٨
Properties of the
Standard Error
• The standard error of the estimated coefficient, SE( ),

is the square root of the estimated variance of the
estimated coefficients.
• H
Hence, it iis similarly
i il l affected
ff t d b
by th
the sample
l size
i and
d
the other factors discussed previously
– For example, an increase in the sample size will decrease the
standard error
– Similarly, the larger the sample, the more precise the
coefficient estimates will be
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4-١٠٩
The Gauss-Markov Theorem and
the Properties of OLS Estimators
• The Gauss-Markov Theorem states that:

– Given Classical Assumptions I through VI (Assumption VII,
normality, is not needed for this theorem), the Ordinary Least
Squares estimator of –kk is the minimum variance estimator
from among the set of all linear unbiased estimators of –k,
for k = 0, 1, 2, …, K
• We also say that “OLS is BLUE”: “Best (meaning

minimum variance)) Linear Unbiased Estimator”
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4-١١٠
The Gauss-Markov Theorem and the
Properties of OLS Estimators (cont.)
• The Gauss-Markov Theorem only requires the first six classical

assumptions
• If we add the seventh condition, normality, the OLS coefficient
estimators can be shown to have the following properties:
– Unbiased: the OLS estimates coefficients are centered around the true
population values
– Minimum variance: no other unbiased estimator has a lower variance for
each estimated coefficient than OLS
– Consistent: as the sample size gets larger, the variance gets smaller, and
each estimate approaches the true value of the coefficient being estimated
– Normally distributed: when the error term is normally distributed, so are
the estimated coefficients—which enables various statistical tests requiring
normality to be applied (we’ll
(we ll get back to this in Chapter 5)
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4-١١١
Table 4.1a
Notation Conventions
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4-١١٢
Table 4.1b
Notation Conventions
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4-١١٣
• The classical assumptions

• Classical error term
• Standard normal distribution
• SE( ),
• Unbiased estimator
• BLUE
• Sampling distribution
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4-١١٤
Chapter 5
Hypothesis Testing
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What Is Hypothesis Testing?
• Hypothesis testing is used in a variety of settings

– The Food and Drug g Administration ((FDA), ), for example,
p , tests new
products before allowing their sale
• If the sample of people exposed to the new product shows some side effect
significantly more frequently than would be expected to occur by chance,
th FDA is
the i likely
lik l to
t withhold
ithh ld approvall off marketing
k ti that
th t product
d t
– Similarly, economists have been statistically testing various
relationships, for example that between consumption and income
• Note here that while we cannot prove a given hypothesis (for
example the existence of a given relationship), we often can reject a
given hypothesis
g yp ((again,
g for example,
p rejecting
j g the existence of a
given relationship)
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Classical Null and Alternative
Hypotheses
• The researcher first states the hypotheses to be tested

• Here, we distinguish between the null and the alternative
Here
hypothesis:
– Null hypothesis (“H0”): the outcome that the researcher does not
expect (almost always includes an equality sign)
– Alternative hypothesis (“HA”): the outcome the researcher does
expect
• Example:
H0: β ≤ 0 (the values you do not expect)
HA: β > 0 (the values you do expect)
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Type I and Type II Errors
• Two types of errors possible in hypothesis testing:

– Type
yp I: Rejecting
j g a true null hypothesis
yp
– Type II: Not rejecting a false null hypothesis
• Example:
p Suppose
pp we have the following
g null and alternative
hypotheses:
H0: β ≤ 0
HA: β > 0
– Even if the true β really is not positive, in any one sample we might
y positive to lead to
still observe an estimate of β that is sufficiently
the rejection of the null hypothesis
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Figure 5.1 Rejecting a True Null
Hypothesis Is a Type I Error
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Type I and Type II Errors (cont.)
(cont )
• Alternatively, it’s possible to obtain an estimate of β that

is close enough to zero (or negative) to be considered
“not significantly positive”
• S
Such h a result
lt may llead
d th
the researcher
h tto ““accept”
t” th
the
null hypothesis that β ≤ 0 when in truth β > 0
• This is a Type II Error; we have failed to reject a false
null hypothesis!
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Figure 5.2 Failure to Reject a False
Null Hypothesis Is a Type II Error
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Decision Rules of
Hypothesis Testing
• To test a hypothesis, we calculate a sample statistic that determines

when the null hypothesis can be rejected depending on the magnitude
of that sample statistic relative to a preselected critical value (which is
found in a statistical table)
• This procedure is referred to as a decision rule
• The decision rule is formulated before regression estimates are
obtained
• The range of possible values of the estimates is divided into two
regions, an “acceptance” (really, non-rejection) region and a rejection
region
• The critical value effectively separates the “acceptance”/non-rejection
acceptance /non rejection
region from the rejection region when testing a null hypothesis
• Graphs of these “acceptance” and rejection regions are given in
Figures 5.3
5 3 and 5.4
54
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Figure 5.3 “Acceptance” and Rejection
Regions for a One-Sided Test of β
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Figure 5.4 “Acceptance” and Rejection
Regions for a Two-Sided Test of β
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The t-Test
• The t-test is the test that econometricians usually use to test

hypotheses
yp about individual regression
g slope
p coefficients
– Tests of more than one coefficient at a time (joint hypotheses)
are typically
yp y done with the F-test,, presented
p in Section 5.6
• The appropriate test to use when the stochastic error term is
normally
y distributed and when the variance of that distribution
must be estimated
– Since these usually are the case, the use of the t-test for
hypothesis testing has become standard practice in
econometrics
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The t-Statistic
• For a typical multiple regression equation:

(5.1)
we can calculate t-values for each of the estimated
coefficients
– Usually these are only calculated for the slope coefficients, though
(see Section 7.1)
• Specifically, the t-statistic for the kth coefficient is:
(5.2)
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The Critical t-Value and the
t-Test Decision Rule
• To decide whether to reject or not to reject a null hypothesis based

on a calculated t-value, we use a critical t-value
• A critical t-value is the value that distinguishes the “acceptance”
region from the rejection region
• The critical t-value,
-value tc, is selected from a t-table (see Statistical
Table B-1 in the back of the book) depending on:
– whether the test is one-sided or two-sided,
– the level of Type I Error specified and
– the degrees of freedom (defined as the number of observations
minus the number of coefficients estimated (including the constant)
or N – K – 1)
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The Critical t-Value and the
t-Test Decision Rule (cont.)
• The rule to apply when testing a single

regression
i coefficient
ffi i t ends
d up bbeing
i ththatt you
should:
Reject H0 if |tk| > tc and if tk also has the
sign
i implied
i li d b by HA
Do not reject H0 otherwise
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The Critical t-Value and the t-Test
Decision Rule (cont.)
• Note that this decision rule works both for

calculated t-values
values and critical t-values
values for
one-sided hypotheses around zero (or another
hypothesized value, S):
H0: βk ≤ 0 H0: βk ≤ S
HA: βk > 0 HA: βk > S
H0: βk ≥ 0 H0: βk ≥ S
HA: βk < 0 HA: βk < S
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The Critical t-Value and the t-Test
Decision Rule (cont.)
• As well as for two-sided hypotheses around zero

(or another hypothesized value
value, S):
H0: βk = 0 H0: βk = S
HA: βk ≠ 0 HA: βk ≠ S
• From Statistical Table B-1 the critical t-value

for a one-tailed test at a given level of
significance is exactly equal to the critical
t-value for a two-tailed test at twice the level
off significance
i ifi off th
the one-tailed
t il d test—as
t t also
l
illustrated by Figure 5.5
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Figure 5.5 One-Sided and
Two-Sided t-Tests
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Choosing a Level of
Significance
• The level of significance must be chosen before a critical

value can be found,, using
g Statistical Table B
• The level of significance indicates the probability of
observing an estimated t-value greater than the critical
t l if th
t-value the null
ll hypothesis
h th i were correctt
• It also measures the amount of Type I Error implied by a
particular critical t-value
• Which level of significance is chosen?
– 5 percentt is
i recommended,
d d unless
l you know
k something
thi
unusual about the relative costs of making Type I and
Type II Errors
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Confidence Intervals
• A confidence interval is a range that contains the true value of an

item a specified
p p
percentage
g of the time
• It is calculated using the estimated regression coefficient, the
two-sided critical t-value and the standard error of the estimated
coefficient as follows:
( )
(5.5)
• What’s the relationship between confidence intervals and two-
sided hypothesis testing?
• If a hypothesized value fall within the confidence interval, then we
cannot reject the null hypothesis
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p-Values
• This is an alternative to the t-test

• A p-value, or marginal significance level, is the probability of observing
a t-score
t th t size
that i or larger
l (i absolute
(in b l t value)
l ) if th
the null
ll hypothesis
h th i
were true
• Graphically, it’s two times the area under the curve of the t-distribution
between the absolute value of the actual tt-score
score and infinity
infinity.
• In theory, we could find this by combing through pages and
pages of statistical tables
• B t we don’t
But d ’t have
h tto, since
i we hhave EViews
EVi and
d Stata:
St t these
th
(and other) statistical software packages automatically give the
p-values as part of the standard output!
• In light of all this
this, the p-value
p al e decision rrule
le therefore is
is:
Reject H0 if p-valueK < the level of significance and if has the sign
implied by HA
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Examples of t-Tests:
One-Sided
• The most common use of the one-sided t-test is to determine whether
a regression coefficient is significantly different from zero (in the
direction predicted by theory!)
• This involves four steps:
1. Set up the null and alternative hypothesis
2. Choose a level of significance and therefore a critical t-value
3. Run the regression and obtain an estimated t-value (or t-score)
4. Apply
pp y the decision rule by y comparing
p g calculated t-value with the
critical t-value in order to reject or not reject the null hypothesis
• Let’s look at each step in more detail for a specific example:
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One-Sided (cont.)
• Consider the following simple model of the aggregate retail sales

of new cars:
(5.6)
Where:
Y = sales of new cars
X1 = real disposable income
X2 = average retail price of a new car adjusted by the consumer
price index
X3 = number
b off sports
t utility
tilit vehicles
hi l sold
ld
• The four steps for this example then are as follows:
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Step 1: Set up the null and
alternative hypotheses
• From equation 5.6, the one-sided hypotheses are set up

as:
1. H0: β1 ≤ 0
HA: β1 > 0
2. H0: β2 ≥ 0
HA: β2 < 0
3. H0: β3 ≥ 0
HA: β3 < 0
• Remember that a t-test typically is not run on the
estimate of the constant term β0
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Step 2: Choose a level of significance
and therefore a critical t-value
• Assume that you have considered the various costs

in ol ed in making T
involved Type
pe I and T
Type
pe II Errors and ha
have
e
chosen 5 percent as the level of significance
• There are 10 observations in the data set, and so
there are 10 – 3 – 1 = 6 degrees of freedom
• At a 5-percent level of significance, the critical
t-value,, tc, can be found in Statistical Table B-1
to be 1.943
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Step 3: Run the regression and
obtain an estimated t-value
• Use the data (annual from 2000 to 2009) to run

th regression
the i on your OLS computer t package
k
• Again, most statistical software packages
automatically report the t-values
• A
Assume that
th t in
i thi
this case th
the tt-values
l were 2.1,
21
5.6, and –0.1 for β1, β2, and β3, respectively
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Step 4: Apply the t–test
decision rule
• As stated in Section 5.2, the decision rule for the t-test is to:
Reject H0 if |tk| > tc and if tk also has the sign implied by HA
• In this example, this amounts to the following three
conditions:
For β1: Reject
j H0 if ||2.1|| > 1.943 and if 2.1 is p
positive.
For β2: Reject H0 if |5.6| > 1.943 and if 5.6 is positive.
For β3: Reject H0 iff |–0.1|
| | > 1.943 and iff –0.1 is positive.
• Figure 5.6 illustrates all three of these outcomes
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Figure 5.6a One-Sided t-Tests of the
Coefficients of the New Car Sales Model
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Figure 5.6b One-Sided t-Tests of the
Coefficients of the New Car Sales Model
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Two-Sided
• The two-sided test is used when the hypotheses should be
rejected if estimated coefficients are significantly different from
zero or a specific nonzero value
zero, value, in either direction
• So, there are two cases:
1 Two
1. Two-sided
sided tests of whether an estimated coefficient is
significantly different from zero, and
2. Two-sided tests of whether an estimated coefficient is
significantly different from a specific nonzero value
• Let’s take an example to illustrate the first of these (the
second case is merely a generalized case of this this, see the
textbook for details), using the Woody’s restaurant
example in Chapter 3:
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Two-Sided (cont.)
• Again, in the Woody’s restaurant equation of Section 3.2, the

impace of the average income of an area on the expected number
of Woody
Woody’s s customer
customer’s
s in that area is ambiguous:
• A high-income neighborhood might have more total customers
going
g g out to dinner (p
(positive sign),
g ), but those customers might
g
decide to eat at a more formal restaurant that Woody’s (negative
sign)
• The appropriate (two-sided) t-test therefore is:
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Figure 5.7 Two-Sided t-Test of the
Coefficient of Income in the Woody’s Model
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Two-Sided (cont.)
• The four steps are the same as in the one-sided case:

1. Set upp the null and alternative hypothesis
yp
H0: βk = 0
HA: βk ≠ 0
2
2. Choose a level of significance and therefore a critical t-value
t value
Keep the level at significance at 5 percent but this now must be
distributed between two rejection regions for 29 degrees of freedom
hence the correct critical t-value is 2.045
2 045 (found in Statistical Table B-1
for 29 degrees of freedom and a 5-percent, two-sided test)
3. Run the regression and obtain an estimated t-value:
Th t-value
The t l remains i att 2.37
2 37 (from
(f Equation
E ti 5.4)
5 4)
4. Apply the decision rule:
For the two-sided case, this simplifies to:
R j t H0 if |2.37|
Reject |2 37| > 2.045;
2 045 so, reject
j t H0
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Limitations of the t-Test
• With the t-values being automatically printed out by computer

regression packages, there is reason to caution against
potential
i l improper
i use off the
h t-test:
1. The t-Test Does Not Test Theoretical Validity:
If you regress the consumer price index on rainfall in
a time-series regression and find strong statistical
significance
g does that also mean that the
underlying theory is valid? Of course not!
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Limitations of the t-Test
2. The t-Test Does Not Test “Importance”:

The fact that one coefficient is “more
more statistically
significant” than another does not mean that it is
also more important in explaining the dependent
variable—but
variable but merely that we have more evidence
of the sign of the coefficient in question
3. The t-Test Is Not Intended for Tests of the Entire
P
Population:
l ti
From the definition of the t-score, given by Equation
5.2, it is seen that as the sample size approaches
the population (whereby the standard error will
approach zero—since the standard error decreases
as N increases), ) the t-score will approach
pp infinity!
y
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The F-Test of Overall Significance
We can test for the predictive power of the entire model using
the F statistic
• Generally these compare two sources of variation
• F = V1/V2 and
dhhas ttwo df parameters
t
• Here V1 = ESS/K has K df
• And V2 = RSS/(n-K-1) has n-K-1 df
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F Tables
Usually will see several pages of these; one or two pages at

each specific
p level of significance
g ((.10,, .05,, .01).
)
Numerator d.f.
denom.
d.f. Value of F at a
specific significance level
F Test Hypotheses
H0: β1 = β2 = …= βK = 0 (None of the Xs help explain Y)

Ha: Not all βs are 0 (At least one X is useful)
H 0 : R2 = 0 is an equivalent hypothesis
Reject H0 if F≥Fc
Do Not Reject
j H0 if F<Fc
The critical F-value, Fc, is determined from Statistical Tables

B 2 or B3 depending
B-2 d di on a level
l l off significance,
i ifi α, and
d degrees
d
of freedom, df1=K , (K, the number of the independent
variables) and df2=n-k-1
n-k-1
Example: The Woody's
Woody s restaurant
• Since there are 3 independent variables, the null and alternative

hypotheses are:
H0: βN = βP = βI = 0
Ha: Not all β
βs are 0
• From E-Views
E Views output
output, F=15
F=15.65,
65 Fc(0.05;3,29)=2.93
Fc(0 05;3 29)=2 93
• Fc is well below the calculated F-value of 15.65, so we can reject
the null hypothesis
yp and conclude that the Woody's
y equation
q does
indeed have a significance of overall fit.
• Null hypothesis • Decision rule

• Alternative hypothesis • Critical value
• Type I Error • t-statistic
• Level of significance • Confidence interval
• Two-sided test • p-value
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Chapter 6
Model Specification: Choosing

the Independent Variables
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Specifying an Econometric
Equation and Specification Error
• Before any equation can be estimated, it must be completely

specified
• Specifying
S if i an econometric t i equation
ti consists
i t off three
th parts,
t
namely choosing the correct:
– independent variables
– functional form
– form of the stochastic error term
• Again,
A i thithis iis partt off th
the first
fi t classical
l i l assumption
ti from
f Chapter
Ch t 4
• A specification error results when one of these choices is made
incorrectly
• This chapter will deal with the first of these choices (the two other
choices will be discussed in subsequent chapters)
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Omitted Variables
• Two reasons why an important explanatory variable

might have been left out:
– we forgot…
– it is not available in the dataset, we are examining
• Either way, this may lead to omitted variable bias
(or, more generally, specification bias)
• The reason for this is that when a variable is not
included, it cannot be held constant
• Omitting a relevant variable usually is evidence that the
entire equation is a suspect, because of the likely bias of
the coefficients
coefficients.
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The Consequences of an
Omitted Variable
• Suppose the true regression model is:

(6.1)
Where is a classical error term
• If X2 is omitted,, the equation
q becomes instead:
(6.2)
Where:
(6.3)
• Hence, the explanatory variables in the estimated regression (6.2) are not
independent of the error term (unless the omitted variable is uncorrelated
with all the included variables—something which is very unlikely)
• But this violates Classical Assumption III!
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The Consequences of an Omitted
Variable (cont.)
• What happens if we estimate Equation 6.2 when Equation 6.1 is the truth?
• We get bias!
• What this means is that:
(6.4)
• The amount of bias is a function of the impact of the omitted variable on the
dependent variable times a function of the correlation between the included
and the omitted variable
• Or,
Or more formally:
(6.7)
• So, the bias exists unless:
1. the true coefficient equals zero, or
2. the included and omitted variables are uncorrelated
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Correcting for an Omitted
Variable
• In theory, the solution to a problem of specification bias seems easy:

add the omitted variable to the equation!
• Unfortunately, that’s easier said than done, for a couple of reasons
1. Omitted variable bias is hard to detect: the amount of bias introduced can
be small and not immediately detectable
2. Even if it has been decided that a given equation is suffering from omitted
variable bias
bias, how to decide exactly which variable to include?
• Note here that dropping a variable is not a viable strategy to help cure
omitted variable bias:
– If anything you’ll just generate even more omitted variable bias on the
remaining coefficients!
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Variable (cont.)
• What if:
– You have an unexpected result
result, which leads you to believe that you have
an omitted variable
– You have two or more theoretically sound explanatory variables as
potential
t ti l “candidates”
“ did t ” ffor iinclusion
l i as th
the omitted
itt d variable
i bl tto th
the equation
ti iis
to use
• How do you choose between these variables?
• One possibility is expected bias analysis
– Expected bias: the likely bias that omitting a particular variable would have
caused in the estimated coefficient of one of the included variables
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Variable (cont.)
• Expected bias can be estimated with Equation 6.7:

(6 7)
(6.7)
• When do we have a viable candidate?
– When the sign of the expected bias is the same as the sign
of the unexpected result
• Similarly
Similarly, when these signs differ,
differ the variable is
extremely unlikely to have caused the unexpected
result
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Irrelevant Variables
• This refers to the case of including a variable in an equation when it

does not belong there
• This is the opposite of the omitted variables case—and so the impact
can be illustrated using the same model
• Assume that the true regression specification is:
(6.10)
• But the researcher for some reason includes an extra variable:
(
(6.11)
)
• The misspecified equation’s error term then becomes:
(6.12)
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Irrelevant Variables (cont.)
(cont )
• So, the inclusion of an irrelevant variable will not cause bias

((since the true coefficient of the irrelevant variable is zero,, and so
the second term will drop out of Equation 6.12)
• However,, the inclusion of an irrelevant variable will:
– Increase the variance of the estimated coefficients, and this
increased variance will tend to decrease the absolute
magnitude of their t-scores
– Decrease the R2 (but not the R2)
• Table 6.1 summarizes the consequences of the omitted variable
and the included irrelevant variable cases (unless r12 = 0)
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Table 6.1 Effect of Omitted Variables and
Irrelevant Variables on the Coefficient Estimates
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Four Important Specification
Criteria
• We can summarize the previous discussion into four criteria to help

decide whether a given variable belongs in the equation:
1. Theory: Is the variable’s place in the equation unambiguous and theoretically
sound?
2. t-Test: Is the variable’s estimated coefficient significant in the expected direction?
3 R2: Does
3. D th
the overallll fit off th
the equation
ti ((adjusted
dj t d ffor d
degrees off ffreedom)
d ) iimprove
when the variable is added to the equation?
4. Bias: Do other variables’ coefficients change significantly when the variable is
q
added to the equation?
• If all these conditions hold, the variable belongs in the equation
• If none of them hold, it does not belong
• The tricky part is the intermediate cases: use sound judgment!
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Specification Searches
• Almost any result can be obtained from a given

dataset, by simply specifying different regressions until
estimates
ti t with ith th
the d
desired
i d properties
ti are obtained
bt i d
• Hence, the integrity of all empirical work is open to
question
• To counter this, the following three points of Best
Practices in Specification Searches are suggested:
1. Rely on theory rather than statistical fit as much as possible when
choosing variables, functional forms, and the like
2 Minimize the number of equations estimated (except for
2.
sensitivity analysis, to be discussed later in this section)
3. Reveal, in a footnote or appendix, all alternative
specifications estimated
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Sequential Specification
Searches
• The sequential specification search technique allows a researcher to:
– Estimate an undisclosed number of regressions
– Subsequently present a final choice (which is based upon an unspecified
set of expectations about the signs and significance of the coefficients) as if
it were only
l a specification
ifi ti
• Such a method misstates the statistical validity of the regression
results for two reasons:
1. The statistical significance of the results is overestimated because the
estimations of the previous regressions are ignored
2. The expectations used by the researcher to choose between various
regression results rarely, if ever, are disclosed
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Bias Caused by Relying on the
t-Test to Choose Variables
• Dropping variables solely based on low t-statistics may lead to two

different types of errors:
1. An irrelevant explanatory variable may sometimes be included in the
equation (i.e., when it does not belong there)
2. A relevant explanatory variables may sometimes be dropped from the
2
equation (i.e., when it does belong)
• In the first case, there is no bias but in the second case there is bias
• Hence, the estimated coefficients will be biased every time an excluded
variable belongs in the equation, and that excluded variable will be left out
every time its estimated coefficient is not statistically significantly different
from zero
• So, we will have systematic bias in our equation!
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Sensitivity Analysis
• Contrary to the advice of estimating as few equations as possible

(and based on theory, rather than fit!), sometimes we see journal article
authors listing results from five or more specifications
• What’s going on here:
• In almost every case, these authors have employed a technique called
sensitivity analysis
• This essentially consists of purposely running a number of alternative
specifications to determine whether particular results are robust (not
statistical flukes)) to a change
g in specification
• Why is this useful? Because true specification isn’t known!
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Data Mining
• Data mining involves exploring a data set to try to uncover

empirical
p regularities
g that can inform economic theory y
• That is, the role of data mining is opposite that of traditional
econometrics, which instead tests the economic theory on
a data set
• Be careful, however!
– a hypothesis developed using data mining techniques must be
tested on a different data set (or in a different context) than
the one used to develop the hypothesis
– N
Nott doing
d i so would
ld b
be hi
highly
hl unethical:
thi l After
Aft all,
ll the
th researcher
h
already knows ahead of time what the results will be!
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• Omitted variable
• Irrelevant variable
• Specification bias
• Sequential specification search
• Specification
p error
• The four specification criteria
• Expected bias
• Sensitivity analysis
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Chapter 7
Model Specification: Choosing

a Functional Form
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The Use and Interpretation of
the Constant Term
• An estimate of β0 has at least three components:
1. the true β0
2. the constant impact of any specification errors (an omitted variable,
for example)
3 the
3. th mean off ε for
f the
th correctly
tl specified
ifi d equation
ti (if nott equall tto
zero)
• Unfortunately,
y these components
p can’t be distinguished
g from one
another because we can observe only β0, the sum of the three
components
• As a result of this, we usually don
don’tt interpret the constant term
• On the other hand, we should not suppress the constant term,
either, as illustrated by Figure 7.1
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Figure 7.1 The Harmful Effect of
Suppressing the Constant Term
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Alternative Functional Forms
• An equation is linear in the variables if plotting the function in terms of X

and Y generates a straight line
• For example, Equation 7.1:
Y = β0 + β1X + ε (7.1)
is linear in the variables but Equation 7.2:
Y = β0 + β1X2 + ε (7.2)
is not linear in the variables
• Similarly, an equation is linear in the coefficients only if the coefficients
appear in their simplest form—they:
form they:
– are not raised to any powers (other than one)
– are not multiplied or divided by other coefficients
– do not themselves include some sort off function
f (
(like logs or exponents))
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(cont.)
• For example, Equations 7.1 and 7.2 are linear in the

coefficients while Equation 7:3:
coefficients,
(7.3)
is not linear in the coefficients
• In fact,, of all p
possible equations
q for a single
g explanatory
p y
variable, only functions of the general form:
(7.4)
are linear in the coefficients β0 and β1
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Linear Form
• This is based on the assumption that the slope of the

relationship between the independent variable and the
dependent variable is constant:
• For the linear case, the elasticity of Y with respect to X

(the percentage change in the dependent variable
caused by a 1-percent increase in the independent
variable, holding the other variables in the equation
constant) is:
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What Is a Log?
• If e (a constant equal to 2.71828) to the “bth power” produces x, then b is the

log of x:
b is the log of x to the base e if: eb = x
• Thus, a log (or logarithm) is the exponent to which a given base must be taken
in order to produce a specific number
• While logs come in more than one varietyvariety, we’ll
we ll use only natural logs (logs to
the base e) in this text
• The symbol for a natural log is “ln,” so ln(x) = b means that (2.71828) b = x or,
more simply,
ln(x) = b means that eb = x
• For example, since e2 = (2.71828) 2 = 7.389, we can state that:
ln(7 389) = 2
ln(7.389)
Thus, the natural log of 7.389 is 2! Again, why? Two is the power of e that
produces 7.389
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What Is a Log? (cont.)
(cont )
• Let’s look at some other natural log calculations:

ln(100) = 4.605
ln(1000) = 6.908
ln(10000) = 9.210
ln(1000000) = 13.816
n(100000) = 11.513
• Note that as a number goes from 100 to 1,000,000,
1 000 000 its natural log goes from 4.605
4 605 to
only 13.816! As a result, logs can be used in econometrics if a researcher wants to
reduce the absolute size of the numbers associated with the same actual meaning
• One useful property of natural logs in econometrics is that they make it easier to
figure out impacts in percentage terms (we’ll see this when we get to the double-
log specification)
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Double-Log Form
• Here, the natural log of Y is the dependent variable and the natural log
of X is the independent variable:
(7.5)
• IIn a double-log
d bl l equation,ti an iindividual
di id l regression
i coefficient
ffi i t can b
be
interpreted as an elasticity because:
(7 6)
(7.6)
• Note that the elasticities of the model are constant and the slopes are
nott
• This is in contrast to the linear model, in which the slopes are
constant but the elasticities are not
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Figure 7.2
Double-Log Functions
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Semilog Form
• The semilog functional form is a variant of the double-

log
g equation
q in which some but not all of the variables
(dependent and independent) are expressed in terms
of their natural logs.
• It can be
b on the
th right-hand
i ht h d side,
id as iin:
Yi = β0 + β1lnX1i + β2X2i + εi (7.7)
• Or it can be on the left-hand side, as in:
lnY = β0 + β1X1 + β2X2 + ε (7 9)
(7.9)
• Figure 7.3 illustrates these two different cases
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Figure 7.3
Semilog Functions
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Polynomial Form
• Polynomial functional forms express Y as a function of

independent variables, some of which are raised to powers other
than 1
• For example, in a second-degree polynomial (also called a
quadratic)
d ti ) equation,
ti att lleastt one independent
i d d t variable
i bl iis squared:
d
Yi = β0 + β1X1i + β2(X1i)2 + β3X2i + εi (7.10)
• The slope of Y with respect to X1 in Equation 7.10 is:
(7 11)
(7.11)
• Note that the slope depends on the level of X1
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Figure 7.4
Polynomial Functions
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Inverse Form
• The inverse functional form expresses Y as a function of the

reciprocal (or inverse) of one or more of the independent
variables (in this case
case, X1):
Yi = β0 + β1(1/X1i) + β2X2i + εi (7.13)
• So X1 cannot equal zero
• This functional form is relevant when the impact of a particular
independent variable is expected to approach zero as that
independent variable approaches infinity
• The slope with respect to X1 is:
(7 14)
(7.14)
• The slopes for X1 fall into two categories, depending on the sign
of β1 (illustrated in Figure 7.5)
7 5)
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Figure 7.5
7 5 Inverse Functions
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Table 7.1 Summary of
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Lagged Independent
Variables
• Virtually all the regressions we’ve studied so far have been
“instantaneous” in nature
• In other words, they have included independent and
dependent variables from the same time period, as in:
Yt = β0 + β1X1t + β2X2t + εt (7.15)
• Many econometric equations include one or more lagged
independent variables like X1t-1 where “t–1” indicates that
the observation of X1 is from the time period previous to
time period t,
t as in the following equation:
Yt = β0 + β1X1t-1
1t 1 + β2X2t + εt (7 16)
(7.16)
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Using Dummy Variables
• A dummy variable is a variable that takes on the values of 0

or 1, depending
p g on whether a condition for a q
qualitative
attribute (such as gender) is met
• These conditions take the general form:
(7.18)
• This is an example of an intercept dummy (as opposed to

a slope dummy, which is discussed in Section 7.5)
• Figure 7.6 illustrates the consequences of including an
intercept dummy in a linear regression model
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Figure 7.6
An Intercept Dummy
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Slope Dummy Variables
• Contrary to the intercept dummy, which changed only the

intercept
p (and
( not the slope),
p ), the slope
p dummy
y changes
g both
the intercept and the slope
• The general form of a slope dummy equation is:
Yi = β0 + β1Xi + β2Di + β3XiDi + εi (7.20)
p depends
• The slope p on the value of D:
When D = 0, ∆Y/∆X = β1
When D = 1,
1 ∆Y/∆X = (β1 + β3)
• Graphical illustration of how this works in Figure 7.7
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Figure 7.7 Slope and
Intercept Dummies
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Problems with Incorrect
Functional Forms
• If functional forms are similar, and if theory does not specify exactly which form
to use, there are at least two reasons why we should avoid using goodness of fit
over the
th sample l tto determine
d t i which
hi h equation
ti tto use:
1. Fits are difficult to compare if the dependent variable is transformed
2
2. An incorrect function form may provide a reasonable fit within the sample but
have the potential to make large forecast errors when used outside the range of
the sample
• The first of these is essentially due to the fact that when the dependent variable
is transformed, the total sum of squares (TSS) changes as well
• The second is essentially die to the fact that using an incorrect functional
amounts to a specification error similar to the omitted variables bias discussed in
Section 6.1
• Thiss seco
second
d case is
s illustrated
us a ed in Figure
gu e 7.8
8
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Figure 7.8a Incorrect Functional
Forms Outside the Sample Range
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Figure 7.8b Incorrect Functional
Forms Outside the Sample Range
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• Elasticity • Slope dummy

• Double
Double-log
log • Natural log
functional form
• Omitted condition
• Semilog
functional form • Interaction term
y
• Polynomial • Linear in the variables
functional form • Linear in
• Inverse the coefficients
functional form
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Chapter 8
Multicollinearity
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Introduction and Overview
• The next three chapters deal with violations of the Classical

Assumptions and remedies for those violations
• This chapter addresses multicollinearity; the next two chapters are
on serial correlation and heteroskedasticity
• For each of these three problems
problems, we will attempt to answer the
following questions:
1. What is the nature of the problem?
2. What are the consequences of the problem?
3. How is the problem diagnosed?
4. What remedies for the problem are available?
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Perfect Multicollinearity
• Perfect multicollinearity violates Classical Assumption VI, which specifies

that no explanatoryy variable is a perfect linear function of any
y other explanatory
y
variables
• The word perfect in this context implies that the variation in one explanatory
variable can be completely explained by movements in another explanatory
variable
– A special case is that of a dominant variable: an explanatory variable is
definitionally
y related to the dependent
p variable
• An example would be (Notice: no error term!):
X1i = α0 + α1X2i (8.1)
where the αs are constants and the Xs are independent variables in:
Yi = β0 + β1X1i + β2X2i + εi (8.2)
• Figure 8.1 illustrates this case
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Figure 8.1
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(cont.)
• What happens to the estimation of an econometric equation where there is

perfect multicollinearity?
y
– OLS is incapable of generating estimates of the regression coefficients
– most OLS computer programs will print out an error message in such a situation
• What is going on?
• Essentially, perfect multicollinearity ruins our ability to estimate the coefficients
because the perfectly collinear variables cannot be distinguished from each
other:
• You cannot “hold all the other independent variables in the equation constant” if
every time one variable changes
changes, another changes in an identical manner!
• Solution: one of the collinear variables must be dropped (they are essentially
identical, anyway)
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Imperfect Multicollinearity
• Imperfect multicollinearity occurs when two

( more)) explanatory
(or l t variables
i bl are imperfectly
i f tl
linearly related, as in:
X1i = α0 + α1X2i + ui (8.7)
• Compare
C E
Equation
ti 8.7
8 7 to
t Equation
E ti 8.1
81
– Notice that Equation 8.7 includes ui, a stochastic
error term
• This case is illustrated in Figure 8.2

82
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Figure 8.2
Imperfect Multicollinearity
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The Consequences of
Multicollinearity
There are five major consequences of multicollinearity:
1
1. Estimates will remain unbiased
2. The variances and standard errors of the estimates
will increase:
a. Harder to distinguish the effect of one variable from the
effect of another,, so much more likely
y to make largeg
errors in estimating the βs than without multicollinearity
b. As a result, the estimated coefficients, although still
unbiased now come from distributions with much larger
unbiased,
variances and, therefore, larger standard errors (this
point is illustrated in Figure 8.3)
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Figure 8.3 Severe Multicollinearity
Increases the Variances of the s
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The Consequences of
Multicollinearity (cont.)
3. The computed t-scores will fall:
a. Recalling
g Equation
q 5.2,, this is a direct consequence
q of 2. above
4. Estimates will become very sensitive to changes in specification:
a. The addition or deletion of an explanatory variable or of a few observations
will
ill often
ft cause major j changes
h iin th
the values
l off th
the s when
h significant
i ifi t
multicollinearity exists
b. For example, if you drop a variable, even one that appears to be statistically
i i ifi
insignificant,
t th
the coefficients
ffi i t off the
th remaining
i i variables
i bl iin th
the equation
ti
sometimes will change dramatically
c. This is again because with multicollinearity, it is much harder to distinguish
th effect
the ff t off one variable
i bl ffrom th
the effect
ff t off another
th
5. The overall fit of the equation and the estimation of the coefficients of
g y unaffected
nonmulticollinear variables will be largely
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The Detection of
Multicollinearity
• First realize that that some multicollinearity exists in every
equation:
q all variables are correlated to some degree
g ((even if
completely at random)
• So it’s reallyy a question
q of how much multicollinearityy exists in
an equation, rather than whether any multicollinearity exists
• There are basicallyy two characteristics that helpp detect the
degree of multicollinearity for a given application:
1. High simple correlation coefficients
2. High Variance Inflation Factors (VIFs)
• We will now go through each of these in turn:
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High Simple Correlation
Coefficients
• If a simple correlation coefficient, r, between any two explanatory
variables is high in absolute value, these two particular Xs are highly
correlated and multicollinearity is a potential problem
• How high is high?
– Some researchers pick an arbitraryy number, such as 0.80
– A better answer might be that r is high if it causes unacceptably large
variances in the coefficient estimates in which we’re interested.
• Caution in case of more than two explanatory variables:
– Groups of independent variables, acting together, may cause
multicollinearity without any single simple correlation coefficient being high
enough to indicate that multicollinearity is present
– As a result, simple correlation coefficients must be considered to be
sufficient but not necessary tests for multicollinearity
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High Variance Inflation
Factors (VIFs)
The variance inflation factor (VIF) is calculated from two steps:
1
1. Run an OLS regression that has Xi as a function of all the other
explanatory variables in the equation—For i = 1, this equation
would be:
X1 = α1 + α2X2 + α3X3 + … + αKXK + v (8.15)
where v is a classical stochastic error term
2. Calculate the variance inflation factor for :
(8 16)
(8.16)
where is the unadjusted from step one
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High Variance Inflation
Factors (VIFs) (cont.)
• From Equation 8.16, the higher the VIF, the more severe the effects of
mulitcollinearity
• How high is high?
• While there is no table of formal critical VIF values, a common rule of thumb is
that if a given VIF is greater than 5, the multicollinearity is severe
• As the number of independent variables increases, it makes sense to
increase this number slightly
• Note
N t th
thatt the
th authors
th replace
l the
th VIF with
ith its
it reciprocal,
i l , called
ll d
tolerance, or TOL
• Problems with VIF:
– No hard and fast VIF decision rule
– There can still be severe multicollinearity even with small VIFs
– VIF is a sufficient, not necessary, test for multicollinearity
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Remedies for
Multicollinearity
Essentially three remedies for multicollinearity:
1 Do nothing:
1.
a. Multicollinearity will not necessarily reduce the t-
scores enough g to make them statistically y
insignificant and/or change the estimated
coefficients to make them differ from expectations
b the deletion of a multicollinear variable that belongs
b.
in an equation will cause specification bias
2. Drop
p a redundant variable:
a. Viable strategy when two variables measure
essentially the same thing
b Always use theory as the basis for this decision!
b.
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Remedies for
Multicollinearity (cont.)
3. Increase the sample size:
a This is frequently impossible but a useful alternative
a.
to be considered if feasible
b The idea is that the larger sample normally will
b.
reduce the variance of the estimated coefficients,
diminishing the impact of the multicollinearity
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Table 8.1a
8 1a
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Table 8.1a
8 1a
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Table 8.2a
8 2a
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Table 8.2b
8 2b
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Table 8.2c
8 2c
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Table 8.2d
8 2d
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Table 8.3a
8 3a
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Table 8.3b
8 3b
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• Perfect multicollinearity
• Severe imperfect multicollinearity
• Dominant variable
• Auxiliary (or secondary) equation
• Variance inflation factor
• Redundant variable
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Chapter 9
Serial Correlation
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Pure Serial Correlation
• Pure serial correlation occurs when Classical Assumption IV,

which assumes uncorrelated observations of the error term, is
violated (in a correctly specified equation!)
• The most commonly assumed kind of serial correlation is first-
order serial correlation,, in which the current value of the error
term is a function of the previous value of the error term:
εt = ρεt–1 + ut (9.1)
where: ε = the error term of the equation in question
ρ = the first-order autocorrelation coefficient
u = a classical (not serially correlated) error term
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Pure Serial Correlation (cont
(cont.))
• The magnitude of ρ indicates the strength of the serial

correlation:
– If ρ is zero, there is no serial correlation
– As ρ approaches one in absolute value
value, the previous observation
of the error term becomes more important in determining the
current value of εt and a high degree of serial correlation exists
– For ρ to exceed one is unreasonable, since the error term
effectively would “explode”
• As a result of this, we can state that:

–1 < ρ < +1 ((9.2))
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Pure Serial Correlation (cont
(cont.))
• The sign of ρ indicates the nature of the serial correlation in an

equation:
• Positive:
– implies that the error term tends to have the same sign from one
time period to the next
– this is called positive serial correlation
• Negative:
– implies that the error term has a tendency to switch signs from
negative to positive and back again in consecutive observations
– this is called negative serial correlation
• Figures 9.1–9.3 illustrate several different scenarios
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Figure 9.1a
Positive Serial Correlation
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Figure 9.1b
Positive Serial Correlation
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Figure 9.2
No Serial Correlation
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Figure 9.3a
Negative Serial Correlation
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Figure 9.3b
Negative Serial Correlation
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Impure Serial Correlation
• Impure serial correlation is serial correlation that is caused by a

specification error such as:
– an omitted variable and/or
– an incorrect functional form
• How does this happen?
• As an example, suppose that the true equation is:
(9 3)
(9.3)
where εt is a classical error term. As shown in Section 6.1, if X2 is
accidentally omitted from the equation (or if data for X2 are unavailable),
then:
th
(9.4)
• The error term is therefore not a classical error term
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Impure Serial Correlation (cont
(cont.))
• Instead, the error term is also a function of one of the

explanatory variables, X2
• As a result, the new error term, ε* , can be serially correlated
even if the true error term ε, is not
• IIn particular,
i l the h new error term will
ill tend
d to b
be serially
i ll
correlated when:
1 X2 itself is serially correlated (this is quite likely in a time
1.
series) and
2. the size of ε is small compared to the size of
• Figure 9.4 illustrates 1., for the case of U.S. disposable
income
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Figure 9.4 U.S. Disposable
Income as a Function of Time
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Impure Serial Correlation (cont
(cont.))
• Turn now to the case of impure serial correlation caused by an

incorrect functional form
• Suppose that the true equation is polynomial in nature:
( )
(9.7)
but that instead a linear regression is run:
(9 8)
(9.
• The new error term ε* is now a function of the true error term and of
the differences between the linear and the polynomial
y functional
forms
• Figure 9.5 illustrates how these differences often follow fairly
autoregressive
t i patterns
tt
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Figure 9.5a Incorrect Functional Form as a
Source of Impure Serial Correlation
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Figure 9.5b Incorrect Functional Form as a
Source of Impure Serial Correlation
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The Consequences of Serial
Correlation
• The existence of serial correlation in the error term of an equation
violates Classical Assumption IV, and the estimation of the equation
with OLS has at least three consequences:
1. Pure serial correlation does not cause bias in the coefficient estimates
2. Serial correlation causes OLS to no longer be the minimum variance
estimator (of all the linear unbiased estimators)
3
3. Serial correlation causes the OLS estimates of the SE to be biased,
biased
leading to unreliable hypothesis testing. Typically the bias in the SE
estimate is negative, meaning that OLS underestimates the standard
errors of the coefficients (and thus overestimates the tt-scores)
scores)
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The Durbin–Watson d Test
• Two main ways to detect serial correlation:

– Informal: observing a pattern in the residuals like that in Figure 9.1
– Formal: testing for serial correlation using the Durbin–Watson d test
• We will now go through the second of these in detail
• First, it is important to note that the Durbin–Watson
First Durbin Watson d test is only applicable if
the following three assumptions are met:
1. The regression model includes an intercept term
2 The serial correlation is first-order
2. first order in nature:
εt = ρεt–1 + ut
where ρ is the autocorrelation coefficient and u is a classical
(normally distributed) error term
3. The regression model does not include a lagged dependent variable
(discussed in Chapter 12) as an independent variable
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The Durbin–Watson
d Test (cont.)
• The equation for the Durbin–Watson d statistic for T
observations is:
(9 10)
(9.10)
where the ets are the OLS residuals

• There are three main cases:
1. Extreme positive serial correlation: d = 0
2. Extreme negative serial correlation: d ≈ 4
3 No serial correlation: d ≈ 2
3.
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The Durbin–Watson
d Test (cont.)
• To test for positive (note that we rarely, if ever, test for
negative!)
g ) serial correlation,, the following
g steps
p are
required:
1. Obtain the OLS residuals from the equation to be tested and
calculate
l l t the
th d statistic
t ti ti by
b using
i E Equation
ti 9.10
9 10
2. Determine the sample size and the number of explanatory
variables and then consult Statistical Tables B-4,, B-5,, or B-6
in Appendix B to find the upper critical d value, dU, and the
lower critical d value, dL, respectively (instructions for the use of
pp
these tables are also in that appendix) )
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The Durbin–Watson
d Test (cont.)
3. Set up the test hypotheses and decision rule:
H0 : ρ ≤ 0 ( positive
(no iti serial
i l correlation)
l ti )
HA : ρ > 0 (positive serial correlation)
if d < dL Reject H0
if d > dU Do not reject H0
if dL ≤ d ≤ dU Inconclusive
• In rare circumstances, perhaps first differenced
equations, a two-sided d test might be appropriate
• In such a case
case, steps 1 and 2 are still used
used, but step 3 is now:
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The Durbin–Watson
d Test (cont.)
3. Set up the test hypotheses and decision rule:
H0 : ρ = 0 (no serial correlation)
HA : ρ ≠ 0 (serial correlation)
if d < dL Reject H0
if d > 4 – dL Reject H0
if 4 – dU > d > dU Do Not Reject H0
Otherwise Inconclusive
Figure 9.6 gives an example of a one-sided Durbin Watson d test
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Figure 9.6 An Example of a One-
Sided Durbin–Watson d Test
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Remedies for Serial
Correlation
• The place to start in correcting a serial correlation problem is to look
carefully at the specification of the equation for possible errors that
might be causing impure serial correlation:
– Is the functional form correct?
– Are you sure that there are no omitted variables?
– Only after the specification of the equation has bee reviewed carefully
should the possibility of an adjustment for pure serial correlation be
considered
id d
• There are two main remedies for pure serial correlation:
1 Generalized Least Squares
1.
2. Newey-West standard errors
• We will no discuss each of these in turn
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Generalized Least Squares
• Start with an equation that has first-order serial correlation:

(9 15)
(9.15)
• Which, if εt = ρεt–1 + ut (due to pure serial correlation), also equals:
(9 16)
(9.16)
• Multiply Equation 9.15 by ρ and then lag the new equation by one
period obtaining:
period,
(9.17)
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(cont.)
• Next, subtract Equation 9.107 from Equation 9.16, obtaining:
(9 18)
(9.18)
• Finally, rewrite equation 9.18 as:
(9 19)
(9.19)
(9.20)
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(cont.)
• Equation 9.19 is called a Generalized Least Squares
(or “quasi-differenced”) version of Equation 9.16.
• Notice that:
1. The error term is not serially correlated
a. As a result, OLS estimation of Equation 9.19 will be
minimum variance
b. This is true if we know ρ or if we accurately estimate ρ)
2. The slope coefficient β1 is the same as the slope
coefficient of the original serially correlated equation,
E
Equation
ti 9.16.
9 16 Thus
Th coefficients
ffi i t estimated
ti t d with
ith GLS
have the same meaning as those estimated with
OLS.
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(cont.)
3. The dependent variable has changed compared to
that in Equation 9.16. This means that the GLS is
nott directly
di tl comparable bl to
t th
the OLS.
OLS
4. To forecast with GLS, adjustments like those
discussed in Section 15.2
15 2 are required
• Unfortunately, we cannot use OLS to estimate a GLS
model because GLS equations are inherentlyy nonlinear
in the coefficients
• Fortunately, there are at least two other methods
available:
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The Cochrane–Orcutt Method
• Perhaps the best known GLS method

• p iterative technique
This is a two-step q that first p
produces an estimate
of ρ and then estimates the GLS equation using that estimate.
• The two steps are:
1 Estimate ρ by running a regression based on the residuals of the equation suspected
1.
of having serial correlation:
et = ρet–1 + ut (9.21)
where the ets are the OLS residuals from the equation suspected of having pure
serial correlation and ut is a classical error term
2. Use this to estimate the GLS equation by substituting into Equation 9.18 and using
OLS to estimate Equation 9.18 with the adjusted data
• These two steps are repeated (iterated) until further iteration results in little
change in
• Once has converged (usually in just a few iterations), the last estimate of
step 2 is used as a final estimate of Equation 9.18
9 18
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The AR(1) Method
• Perhaps a better alternative than Cochrane–Orcutt for GLS

models
• The AR(1) method estimates a GLS equation like Equation 9.18
by estimating β0, β1 and ρ simultaneously with iterative
nonlinear regression techniques (that are well beyond the
scope off this
thi chapter!)
h t !)
• The AR(1) method tends to produce the same coefficient
estimates as Cochrane–Orcutt
• However, the estimated standard errors are smaller
• This is whyy the AR(1)
( ) approach is recommended as long
g as yyour
software can support such nonlinear regression
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Newey–West Standard Errors
• Again, not all corrections for pure serial correlation involve

• Newey–West standard errors take account of serial
correlation by correcting the standard errors without
changing the estimated coefficients
• The logic begin Newey
Newey–West
West standard errors is powerful:
– If serial correlation does not cause bias in the estimated
coefficients but does impact the standard errors,
errors then it makes
sense to adjust the estimated equation in a way that changes the
standard errors but not the coefficients
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Newey–West Standard Errors
(cont.)
• The Newey–West SEs are biased but generally more
accurate than uncorrected standard errors for large
samples in the face of serial correlation
• As a result
result, Newey
Newey–West
West standard errors can be used for
t-tests and other hypothesis tests in most samples without
the errors of inference p
potentially
y caused by
y serial
correlation
• Typically, Newey–West
Newey West SEs are larger than OLS SEs, thus
producing lower t-scores
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• Impure serial correlation

• First-order serial correlation
• First-order autocorrelation coefficient
• Durbin–Watson d statistic
• Generalized Least Squares (GLS)
• Positive serial correlation
• Newey–West standard errors
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Chapter 10
Heteroskedasticity
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Pure Heteroskedasticity
• Pure heteroskedasticity occurs when Classical

Assumption V, V which assumes constant variance of the
error term, is violated (in a correctly specified equation!)
• Classical Assumption V assumes that:
(10.1)
• With heteroskedasticity, this error term variance is not
constant
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1-٢٥٦
(cont.)
• Instead, the variance of the distribution of the error term

depends on exactly which observation is being
discussed:
(10 2)
(10.2)
• The simplest case is that of discrete heteroskedasticity,
where the observations of the error term can be grouped
into just two different distributions, “wide” and “narrow”
• This
Thi case is
i illustrated
ill t t d iin Fi
Figure 10.1
10 1
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1-٢٥٧
Figure 10.1a Homoskedasticity
versus Discrete Heteroskedasticity
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1-٢٥٨
Figure 10.1b Homoskedasticity
versus Discrete Heteroskedasticity
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1-٢٥٩
(cont.)
• Heteroskedasticity takes on many more complex forms, however,
than the discrete heteroskedasticity case
• Perhaps the most frequently specified model of pure
heteroskedasticity relates the variance of the error term to an
exogenous variable
i bl Zi as follows:
f ll
(10.3)
(10.4)
where Z, the “proportionality factor,” may or may not be in the
equation
• This is illustrated in Figures 10.2 and 10.3
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1-٢٦٠
Figure 10.2 A Homoskedastic
Error Term with Respect to Zi
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1-٢٦١
Figure 10.3 A Heteroskedastic
Error Term with Respect to Zi
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1-٢٦٢
Impure Heteroskedasticity
• Similar to impure serial correlation, impure heteroskedasticity is

heteroskedasticityy that is caused byy a specification error
• Contrary to that case, however, impure heteroskedasticity almost always
originates from an omitted variable (rather than an incorrect functional
form)
– The p
portion of the omitted effect not represented
p by
y one of the included
explanatory variables must be absorbed by the error term.
– So, if this effect has a heteroskedastic component, the error term of the
p
misspecified equation
q might
g be heteroskedastic even if the error term of the true
equation is not!
• This highlights, again, the importance of first checking that the
specification is correct before trying to “fix”
fix things…
things
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1-٢٦٣
The Consequences of
Heteroskedasticity
• The existence of heteroskedasticity in the error term of an
equation violates Classical Assumption V, and the estimation of
th equation
the ti with
ith OLS h
has att least
l t three
th consequences:
1. Pure heteroskedasticity does not cause bias in the coefficient
estimates
2. Heteroskedasticity typically causes OLS to no longer be the
minimum variance estimator ((of all the linear unbiased
estimators)
3. Heteroskedasticity causes the OLS estimates of the SE to be
biased, leading to unreliable hypothesis testing. Typically
the bias in the SE estimate is negative, meaning that OLS
underestimates the standard errors (and thus overestimates the
t-scores)
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1-٢٦٤
Testing for
Heteroskedasticity
• Econometricians do not all use the same test for heteroskedasticity because
heteroskedasticity takes a number of different forms, and its precise
manifestation in a g
given equation
q is almost never known
• Before using any test for heteroskedasticity, however, ask the following:
1. Are there any obvious specification errors?
– Fix
Fi th
those before
b f t ti !
testing!
2. Is the subject of the research likely to be afflicted with heteroskedasticity?
– Not only are cross-sectional studies the most frequent source of
heteroskedasticity but cross-sectional
heteroskedasticity, cross sectional studies with large variations in the size of
the dependent variable are particularly susceptible to heteroskedasticity
3. Does a graph of the residuals show any evidence of heteroskedasticity?
– Specifically
Specifically, plot the residuals against a potential Z proportionality factor
– In such cases, the graph alone can often show that heteroskedasticity is or is
not likely
– Figure 10.4 shows an example of what to look for: an expanding (or contracting)
range off the
th residuals
id l
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1-٢٦٥
Figure 10.4 Eyeballing Residuals
for Possible Heteroskedasticity
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1-٢٦٦
The Park Test
The Park test has three basic steps:

1. Obtain the residuals of the estimated regression equation:
(
(10.6)
)
2. Use these residuals to form the dependent variable in a
second regression:
(10.7)
where: ei = the residual from the ith observation from Equation 10.6
Zi = your best choice as to the possible proportionality factor (Z)
ui = a classical (homoskedastic) error term
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1-٢٦٧
The Park Test
3. Test the significance of the coefficient of Z in

Equation 10.7
10 7 with a tt-test:
test:
– If the coefficient of Z is statistically significantly different from
zero this is evidence of heteroskedastic patterns in the
zero,
residuals with respect to Z
– Potential issue: How do we choose Z in the first place?
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1-٢٦٨
The White Test
• The White test also has three basic steps:

1 Obtain
1. Obt i the
th residuals
id l off the
th estimated
ti t d regression
i equation:
ti
– This is identical to the first step in the Park test
2 U
2. Use th
these residuals
id l ((squared)d) as th
the dependent
d d t variable
i bl in
i a
second equation that includes as explanatory variables each X
from the original equation, the square of each X, and the product of
each X times every other X—for example, in the case of three
explanatory variables:
(10.9)
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1-٢٦٩
The White Test (cont.)
(cont )
3. Test the overall significance of Equation 10.9 with the

chi-square test
– The appropriate test statistic here is NR2, or the sample size (N) times
the coefficient of determination (the unadjusted R2) of Equation 10.9
– This test statistic has a chi-square distribution with degrees of freedom
equal to the number of slope coefficients in Equation 10.9
– If NR2 is larger than the critical chi-square
chi square value found in Statistical
Table B-8, then we reject the null hypothesis and conclude that it's likely
that we have heteroskedasticity
– If NR2 is less than the critical chi
chi-square
square value
value, then we cannot reject
the null hypothesis of homoskedasticity
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1-٢٧٠
Remedies for
Heteroskedasticity
• The place to start in correcting a heteroskedasticity problem is to look
carefully at the specification of the equation for possible errors that
might be causing impure heteroskedasticity :
– Are you sure that there are no omitted variables?
– Only after the specification of the equation has been reviewed carefully
should the possibility of an adjustment for pure heteroskedasticity be
considered
• There are two main remedies for pure heteroskedasticit1
1. Heteroskedasticity-corrected standard errors
2. Redefining the variables
• We will now discuss each of these in turn:
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1-٢٧١
Heteroskedasticity-Corrected
Standard Errors
• Heteroskedasticity-corrected errors take account of

heteroskedasticity correcting the standard errors without
changing the estimated coefficients
• The logic behind heteroskedasticity-corrected
heteroskedasticity corrected standard
errors is power
– If heteroskedasticity does not cause bias in the estimated
coefficients but does impact the standard errors, then it makes
sense to adjust the estimated equation in a way that changes the
standard errors but
b t not the coefficients
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1-٢٧٢
Heteroskedasticity-Corrected
Standard Errors (cont.)
• The heteroskedasticity-corrected SEs are biased but

generally more accurate than uncorrected standard
errors for large samples in the face of heteroskedasticity
• As a result
result, heteroskedasticity-corrected
heteroskedasticity corrected standard errors
can be used for t-tests and other hypothesis tests in most
samples
p without the errors of inference p
potentially
y caused
by heteroskedasticity
• Typically heteroskedasticity-corrected
heteroskedasticity corrected SEs are larger than
OLS SEs, thus producing lower t-scores
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1-٢٧٣
Redefining the Variables
• Sometimes it’s possible to redefine the variables in a way

that avoids heteroskedasticity
• Be careful, however:
– Redefining your variables is a functional form specification
change that can dramatically change your equation!
• IIn some cases, the

th only
l redefinition
d fi iti ththat's
t' needed
d d tto rid
id an
equation of heteroskedasticity is to switch from a linear
functional form to a double-log
double log functional form:
– The double-log form has inherently less variation than the linear
form,, so it's less likelyy to encounter heteroskedasticityy
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1-٢٧٤
(cont.)
• In other situations, it might be necessary to completely
rethink the research project in terms of its underlying
theory
• For example,
example a cross-sectional model of the total
expenditures by the governments of different cities may
generate heteroskedasticity
g y byy containing
g both large
g and
small cities in the estimation sample
• Why?
– Because of the proportionality factor (Z) the size of the cities
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1-٢٧٥
(cont.)
• This is illustrated in Figure 10.5
• In this case, per capita expenditures would be a logical
dependent variable
• Such a transformation is shown in Figure 10.6
• Aside: Note that Weighted
g Least Squares
q (WLS),
( ), that
some authors suggest as a remedy for heteroskedasticity,
has some serious potential drawbacks and can therefore
generally
ll iis nott be
b recommended
d d ((see F
Footnote
t t 14,
14 p. 355,
355
for details)
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1-٢٧٦
Figure 10.5 An Aggregate
City Expenditures Function
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1-٢٧٧
Figure 10.6 A Per Capita City
Expenditures Function
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1-٢٧٨
Table 10.1a
10 1a
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1-٢٧٩
Table 10.1b
10 1b
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1-٢٨٠
Table 10.1c
10 1c
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1-٢٨١
• Impure heteroskedasticity
• Pure heteroskedasticity
• Proportionality factor Z
• The Park test
• The White test
• Heteroskedasticity-corrected standard errors
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1-٢٨٢
Chapter 11
Running Your Own Regression

Project
j
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Choosing Your Topic
• There are at least three keys to choosing a topic:

1 Try
1. T to
t pick
i k a field
fi ld th
thatt you fifind
d iinteresting
t ti and/or
d/ that
th t you know
k
something about
2 Make sure that data are readily available with a reasonable
2.
sample (we suggest at least 25 observations)
3 Make sure that there is some substance to your topic
3.
– Avoid topics that are purely descriptive or virtually tautological in nature
– Instead,, look for topics
p that address an inherently
y interesting
g economic or
behavioral question or choice
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Choosing Your Topic (cont.)
(cont )
• Places to look:
– your textbooks and notes from previous economics classes
– economics journals
• For example, Table 11.1 contains a list of the journals cited so far in this
textbook (in order of the frequency of citation)
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Table 11.1a
Sources of Potential Topic Ideas
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Table 11.1b
Sources of Potential Topic Ideas
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Collecting Your Data
• Before any quantitative analysis can be done, the data must be:
– collected
– organized
– entered into a computer
• Usually, this is a time-consuming and frustrating task because of:
– the difficulty of finding data
– the existence of definitional differences between theoretical variables
and their empirical counterparts
– and the high probability of data entry errors or data transmission errors
• But time spent thinking about and collecting the data is well spent, since a
researcher who knows the data sources and definitions is much less likely
to make mistakes using or interpreting regressions run on that data
• We will now discuss three data collection issues in a bit more detail
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What Data to Look For
• Checking for data availability means deciding what specific variables you
want to study:
y
– dependent variable
– all relevant independent variables
• At least 5 issues to consider here:
1. Time periods:
– If the dependent variable is measured annually, the explanatory variables
should also be measured annually and not, say, monthly
2. Measuring
gqquantity:
y
– If the market and/or quality of a given variable has changed over time, it makes
little sense to use quantity in units
– Example: TVs have changed so much over time that it makes more sense to use
quantity in terms of monetary equivalent: more comparable across time
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What Data to Look For (cont.)
(cont )
3. Nominal or real terms?

– Depends on theor
theory – essentially:
essentiall do we
e want
ant to “clean” for inflation?
– TVs, again: probably use real terms
4 Appropriate variable definitions depend on whether data are cross
4. cross-
sectional or time-series
– TVs,, again:
g national advertising
g would be a g
good candidate for an
explanatory variable in a time-series model, while advertising in or near
each state (or city) would make sense in a cross-sectional model
5 Be careful
5. caref l when
hen reading (and creating!) descriptions of data
data:
– Where did the data originate?
– Are prices and/or income measured in nominal or real terms?
– Are prices retail or wholesale?
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Where to Look for
Economic Data
• Although some researchers generate their own data through
surveys
y or other techniques
q ((see Section 11.3),
), the vast majority
j y
of regressions are run on publicly available data
• Good sources here include:
1. Government publications:
– Statistical Abstract of the U
U.S.
S
– the annual Economic Report of the President
– the Handbook of Labor Statistics
– Historical Statistics of the U.S. (published in 1975)
– Census Catalog and Guide
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Where to Look for
Economic Data (cont.)
2. International data sources:

– U.N.
U N St
Statistical
ti ti l YYearbook
b k
– U.N. Yearbook of National Account Statistics
3. Internet resources:
– “Resources for Economists on the Internet”
– Economagic
– WebEC
– EconLit (www.econlit.org)
– “Dialog”
– Links to these sites and other good sources of data are on the
text’s Web
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reserved. 1-٢٩٢
Missing Data
• Suppose the data aren’t there?

– What happens if you choose the perfect variable and
look in all the right sources and can’t find the data?
– The answer to this question depends on how much
data is missing:
1. A few observations:
– in a cross-section study:
• Can usually afford to drop these observations from the
sample
– in a time-series study:
• May interpolate value (taking the mean of adjacent values)
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Missing Data (cont.)
(cont )
2. No data at all available (for a theoretically relevant

variable!):
– From Chapter 6, we know that this is likely to cause
omitted variables bias
– A possible solution here is to use a proxy variable
– For example, the value of net investment is a variable
that is not measured directly in a number of countries
– Instead, might use the value of gross investment as a
proxy the assumption being that the value of gross
proxy,
investment is directly proportional to the value of net
investment
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Advanced Data Sources
• So far, all the data sets have been:

1. cross-sectional or time-series in nature
2. been collected by observing the world around us, instead being
created
• It turns out,
out however,
however that:
1. time-series and cross-sectional data can be pooled to form panel
data
2. data can be generated through surveys
• We will now briefly introduce these more advanced data
sources and explain why it probably doesn't
doesn t make sense to
use these data sources on your first regression project:
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Surveys
• Surveys are everywhere in our society and are

used for many different purposes
purposes—examples
examples
include:
– marketing firms using surveys to learn more about
products and competition
– political candidates using surveys to finetune their
campaign advertising or strategies
– go
governments
e e ts us
using
g surveys
su eys foro aall so
sorts
ts o
of pu
purposes,
poses,
including keeping track of their citizens with instruments
like the U.S. Census
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Surveys (cont.)
(cont )
• While running your own survey might be tempting as a

way of obtaining data for your own project,
project running a survey
is not as easy as it might seem surveys:
– must be carefully thought through; it’s virtually impossible to go
– back to the respondents and add another question later
– must be worded precisely (and pretested) to avoid confusing the
respondent or "leading"
leading the respondent to a particular answer
– must have samples that are random and avoid the selection,
survivor, and nonresponse biases explained in Section 17.2
• As a result, we don't encourage beginning researchers to
run their own surveys...
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Panel Data
• Again, panel data are formed when cross-sectional and

time-series
time series data sets are pooled to create a single data
set
• Two main reasons for usinggp
panel data:
– To increase the sample size
– To provide an insight into an analytical question that can't be
obtained by using time-series or cross-sectional data alone
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Panel Data (cont.)
(cont )
• Example: suppose we’re interested in the relationship

between budget
g deficits and interest rates but only
y have 10
years’ of annual data to study
– But ten observations is too small a sample for a reasonable
regression!
– However, if we can find time-series data on the same economic
variables-interest rates and budget deficits—for the same ten years
for six different countries
countries, we
we’llll end up with a sample of 10
10*6
6 = 60
observations, which is more than enough
– The result is a pooled cross-section time-series data set—a
panel data set!
– Panel data estimation methods are treated in Chapter 16
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Practical Advice for
Your Project
• We now move to a discussion of practical advice

about actually doing applied econometric work
• This discussion is structured in three parts:
1 The 10 Commandments of Applied Econometrics
1.
(by Peter Kennedy)
2 What to check if you get an unexpected sign
2.
3. A collection of a dozen practical tips, brought
g
together from other sections of this text that are worth
reiterating specifically in the context of actually doing
applied econometric work
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Practical Advice for
Your Project
• We now move to a discussion of practical advice

about actually doing applied econometric work
• This discussion is structured in three parts:
1 The 10 Commandments of Applied Econometrics
1.
(by Peter Kennedy)
2 What to check if you get an unexpected sign
2.
3. A collection of a dozen practical tips, brought
g
together from other sections of this text that are worth
reiterating specifically in the context of actually doing
applied econometric work
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The 10 Commandments of
Applied Econometrics
1. Use common sense and economic theory:
Example:
p match p per capita
p variables with p
per capita
p variables,, use real exchange
g rates to
explain real imports or exports, etc
2. Ask the right questions:
Ask
A k plenty
l t of,f perhaps,
h seemingly
i l silly
ill questions
ti tto ensure th
thatt you ffully
ll understand
d t d th the
goal of the research
3. Know the context:
Be sure to be familiar with the history, institutions, operating constraints, measurement
peculiarities, cultural customs, etc, underlying the object under study
4 Inspect the data:
4.
a. This includes calculating summary statistics, graphs, and data cleaning (including
checking filters)
b. The objective is to get to know the data well
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Applied Econometrics (cont.)
5. Keep it sensibly simple:
a Begin with a simple model and only complicate it if it fails
a.
b. This both goes for the specifications, functional forms, etc and for the
estimation method
6. Look long and hard at your results:
a. Check that the results make sense, including signs and magnitudes
b. Apply the “laugh test”
7. Understand the costs and benefits of data mining:
a. “Bad” data mining: deliberately searching for a specification that “works”
(i.e. “torturing” the data)
b “Good”
b. Good data mining: experimenting with the data to discover empirical
regularities that can inform economic theory and be tested on a second data
set
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8. Be prepared to compromise:
a. The Classical Assumptions are only rarely are satisfied
b. Applied econometricians are therefore forced to compromise and adopt
suboptimal solutions, the characteristics and consequences of which are
not always known
c. Applied econometrics is necessarily ad hoc: we develop our analysis,
including responses to potential problems, as we go along…
9. Do not confuse statistical significance with meaningful magnitude:
a. If the sample size is large enough, any (two-sided) hypothesis can be
rejected (when large enough to make the SEs small enough)
b. Substantive significance—i.e. “how large?”—is also important, not just
statistical significance
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10. Report a sensitivity analysis:
a Dimensions to examine:
a.
i. sample period
ii the functional form
ii.
iii. the set of explanatory variables
i th
iv. the choice
h i off proxies
i
b. If results are not robust across the examined dimensions, then
this casts doubt on the conclusions of the research
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What to Check If You Get an
Unexpected Sign
1. Recheck the expected sign
Were dummy variables computed “upside
upside down
down,” for example?
2. Check your data for input errors and/or outliers
3 Check
3. Ch k ffor an omitted
itt d variable
i bl
The most frequent source of significant unexpected signs
4. Check for an irrelevant variable
Frequent source of insignificant unexpected signs
5. Check for multicollinearity
Multicollinearity increases the variances and standard errors of the
estimated
ti t d coefficients,
ffi i t iincreasing
i ththe chance
h th
thatt a coefficient
ffi i t could
ld
have an unexpected sign
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What to Check If You Get an
Unexpected Sign
6. Check for sample selection bias

An unexpected sign sometimes can be due to the fact that the
observations included in the data were not obtained randomly
7. Check your sample size
The smaller the sample size, the higher the variance on SEs
8. Check your theory
If nothing else is apparently wrong, only two possibilities remain:
the theory is wrong or the data is bad
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A Dozen Practical Tips Worth
Reiterating
1. Don’t attempt to maximize R2 (Chapter 2)

2. Always review the literature and hypothesize the signs
of your coefficients before estimating a model (Chapter 3)
3. Inspect and clean your data before estimating a model.
Know that outliers should not be automatically omitted;
instead, they should be investigated to make sure that
they belong in the sample (Chapter 3)
4. Know the Classical Assumptions cold! (Chapter 4)
5. In g
general,, use a one-sided t-test unless the expected
p
sign of the coefficient actually is in doubt (Chapter 5)
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Reiterating (cont.)
6. Don’t automatically discard a variable with an

insignificant t-score.
t score In general,
general be willing to live with a
variable with a t-score lower than the critical value in order
to decrease the chance of omitting g a relevant variable
(Chapter 6)
7 Know how to analyze the size and direction of the bias
7.
caused by an omitted variable (Chapter 6)
8 Understand all the different functional form options and
8.
their common uses, and remember to choose your
functional form p
primarily
y on the basis of theory
y, not fit
(Chapter 7)
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Reiterating (cont.)
9. Multicollinearity doesn’t create bias; the estimated
variances are large
large, but the estimated coefficients
themselves are unbiased: So, the most-used remedy for
multicollinearity is to do nothing (Chapter 8)
10. If you get a significant Durbin–Watson, Park, or White
test,, remember to consider the possibility
p y that a
specification error might be causing impure serial
correlation or heteroskedasticity. Don’t change your
estimation
ti ti ttechnique
h i ffrom OLS tto GLS or use adjusted
dj t d
standard errors until you have the best possible
specification (Chapters 9 and 10)
specification.
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Reiterating (cont.)
11. Adjusted standard errors like Newey–West standard
errors or HC standard errors use the OLS coefficient
estimates. It’s the standard errors of the estimated
coefficients that change, not the estimated coefficients
themselves. (Chapters 9 and 10)
12. Finally,
y, if in doubt,, rely
y on common sense and
economic theory, not on statistical tests
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The Ethical Econometrician
• We think that there are two reasonable goals for

econometricians when estimating models:
1. Run as few different specifications as possible while
still attempting to avoid the major econometric problems
• The only exception is sensitivity analysis, described in
Section 6.4
2. Report honestly the number and type of different
specifications estimated so that readers of the
researchh can evaluate
l t h how muchh weight
i ht tto give
i tto your
results
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Writing Your Research Report
• Most good research reports have a number of elements in

common:
– A brief introduction that defines the dependent variable and states
the goals of the research
– A short
h t review
i off relevant
l t previous
i literature
lit t and
d research
h
– An explanation of the specification of the equation (model):
• Independent
I d d t variables
i bl
• functional forms
• expected signs of (or other hypotheses about) the slope coefficients
– A description of the data:
• ge
generated
e a ed variables
a ab es
• data sources
• data irregularities (if any)
© 2011 Pearson Addison-Wesley. All rights reserved. 1-٣١٣
Writing Your Research Report
(cont.)
• A presentation of each estimated specification, using our standard
documentation format
– If you estimate
i more than
h one specification,
ifi i b
be sure to explain
l i which
hi h one iis
best (and why!)
• A careful analysis of the regression results:
– discussion of any econometric problems encountered
– complete documentation of all:
• equations estimated
• tests run
• A short summary/conclusion that includes any policy
recommendations
d ti or suggestions
ti f further
for f th research h
• A bibliography
• pp
An appendix that includes all data,, all regression
g runs,, and all relevant
computer output
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Table 11.2a
Regression User’s Checklist
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Table 11.2b
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Table 11.2c
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Table 11.2d
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Table 11.3a
Regression User’s Guide
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Table 11.3b
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Table 11.3c
© 2011 Pearson Addison-Wesley. All rights reserved. 1-٣٢١

• Choosing a research topic

• Data collection
• Missing data
• Surveys
• Panel data
• The 10 Commandments of Applied Econometrics
• What to Check If You Get An Unexpected
p Sign
g
• A Dozen Practical Tips Worth Reiterating
• The Ethical Econometrician
• Writing your research report
• A Regression User’s Checklist
• A Regression User’s
User s Guide
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Chapter 12
Time-Series
Time Series Models
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Dynamic Models:
Distributed Lag Models
• An (ad hoc) distributed lag model explains the current value of Y as a
function of current and past values of X, thus “distributing” the impact of
X over a number of time periods
• For example, we might be interested in the impact of a change in the
money supply
l (X) on GDP (Y) and d model
d l thi
this as:
Yt = α0 + β0Xt + β1Xt–1 + β2Xt–2 + ... + βpXt–p + εt (12.2)
• Potential issues from estimating Equation 12.2 with OLS:
1. The various lagged values of X are likely to be severely
multicollinear,
lti lli making
ki coefficient
ffi i t estimates
ti t imprecise
i i
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Dynamic Models:
Distributed Lag Models (cont.)
2. In large part because of this multicollinearity, there is no
guarantee that the estimated coefficients will follow the smoothly
declining pattern that economic theory would suggest
Instead,, it’s quite

q typical
yp to g
get something
g like:
3. The degrees of freedom tend to decrease, sometimes

substantially, since we have to:
a estimate a coefficient for each lagged X
a. X, thus increasing K and lowering
the degrees of freedom (N – K – 1)
b. decrease the sample size by one for each lagged X, thus lowering the
number of observations, N, and therefore the degrees of freedom (unless
data for lagged Xs outside the sample are available)
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What Is a Dynamic Model?
• The simplest dynamic model is:

Yt = α 0 + β0 X t + λYt−1 + ut (12.3)
• Note that Y is on the left-hand side as Yt, and on the
right-hand side as Yt–1
– It’s this difference in time period that makes the equation
dynamic
• Note that there is an important connection between a

dynamic model such as the Equation 12.3 and a
distributed lag model such as Equation 12.2
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What Is a Dynamic Model?
(cont.)
Yt = α0 + β0Xt + β1Xt–1 + β2Xt–2 + ... + βpXt–p + εt (12 2)

(12.2)
where: β1 = λβ0 (12.8)
β2 = λ2β0
β3 = λ3β0
.
.
βp = λPβ0
• As long
g as λ is between 0 and 1, these coefficients will indeed smoothly
y
decline, as shown in Figure 12.1
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Figure 12.1 Geometric Weighting Schemes
for Various Dynamic Models
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Serial Correlation and
Dynamic Models
• The consequences of serial correlation depend crucially on the type of model in
question:
1. Ad hoc distributed lag models:
– serial correlation has the effects outlined in Section 9.2:
• causes no bias in the OLS coefficients themselves
• causes OLS to no longer be the minimum variance unbiased estimator
• causes the standard errors to be biased
2 Dynamic
2. D i models:
d l
– Now serial correlation causes bias in the coefficients produced by OLS
• Compounding all this this is the fact that the consequences, detection, and
remedies for serial correlation that we discussed in Chapter 9 are all either
incorrect or need to be modified in the presence of a lagged dependent
variable
• We will now discuss the issues of testing and correcting for serial correlation
in dynamic models in a bit more detail
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Testing for Serial Correlation
in Dynamic Models
• Using the Lagrange Multiplier to test for serial correlation for a

typical dynamic model involves three steps:
1. Obtain the residuals of the estimated equation:
e t = Yt − Yöt = Yt − αö0 − βö0 X1t − λYt−1
2. Use these residuals as the dependent variable in an auxiliary
regression that includes as independent variables all those on
the right-hand side of the original equation as well as the lagged
residuals:
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Testing for Serial Correlation
in Dynamic Models (cont.)
3. Estimate Equation 12.18 using OLS and then test the null hypothesis
that a3 = 0 with the following
g test statistic:
LM = N*R2 (12.19)
where: N = the sample
p size
R2 is the unadjusted coefficient of determination
both of the auxiliary equation, Equation 12.18
For large samples, LM has a chi-square distribution with degrees
of freedom equal to the number of restrictions in the null hypothesis (in
this case, one).
If LM is greater than the critical chi-square value from Statistical
Table B-8, then we reject the null hypothesis that a3 = 0 and conclude
that
h there
h is
i indeed
i d d serial
i l correlation
l i i the
in h original
i i l equation
i
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Correcting for Serial Correlation
in Dynamic Models
• There are essentially three strategies for attempting to rid a dynamic

model of serial correlation:
• improving the specification:
– Only relevant if the serial correlation is impure
• instrumental variables:
– substituting an “instrument” (a variable that is highly correlated with YM but
is uncorrelated with ut) for
f Yt: in the original equation effectively
ff eliminates
the correlation between Ytl and ut
– Problem: good instruments are hard to come by (also see Section 14.3)
• modified GLS:
– Technique similar to the GLS procedure outlined in Section 9.4
– Potential issues: sample must be large and the standard
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Granger Causality
• Granger causality, or precedence, is a circumstance in which

one time series variable consistentlyy and p
predictably
y changes
g
before another variable
• A word of caution: even if one variable precedes (“Granger
causes”) another, this does not mean that the first variable
“causes” the other to change
• There are several tests for Granger causality
• They all involve distributed lag models in one form or another,
however
• We’ll discuss an expanded version of a test originally
developed
p by y Granger
g
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Granger Causality (cont
(cont.))
• Granger suggested that to see if A Granger-caused Y, we should

run:
Yt = β0 + β1Yt–1 + ... + βpYt–p + α1At–1 + ... + αpAt–p + εt (12.20)
and test the null hypothesis that the coefficients of the lagged As
(the αs) jointly equal zero
• If we can reject
j t this
thi nullll h
hypothesis
th i using
i ththe F-test,
F t t then
th we
have evidence that A Granger-causes Y
• N
Note
t that
th t if p = 1,
1 Equation
E ti 12.20
12 20 is
i similar
i il tto th
the dynamic
d i
model, Equation 12.3
• A
Applications
li ti off thi
this ttestt involve
i l running
i two
t G
Granger tests,
t t one
in each direction
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Granger Causality (cont
(cont.))
• That is, run Equation 12.20 and also run:

At = β0 + β1At–1 + ... + βpAt–p + α1Yt–1 + ... + αpYt–p + εt
(12.21)
testing for Granger causality in both directions by testing
the null hypothesis
yp that the coefficients of the lagged
gg Ys
(again, the αs) jointly equal zero
• If the F
F-test
test is significant for Equation 12.20 but not
for Equation 12.21, then we can conclude that
A Granger-causes Y
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Spurious Correlation and
Nonstationarity
• Independent variables can appear to be more significant than they actually are
if they have the same underlying trend as the dependent variable
• Example: In a country with rampant inflation almost any nominal variable will
appear to be highly correlated with all other nominal variables
• Why?
y
– Nominal variables are unadjusted for inflation, so every nominal variable will have
a powerful inflationary component
• Such a p
Suc problem
ob e is
saan e
example
a peo of spu
spurious
ous correlation:
co e at o
– a strong relationship between two or more variables that is not caused by a real
underlying causal relationship
– If y
you run a regression
g in which the dependent
p variable and one or more independent
p
variables are spuriously correlated, the result is a spurious regression, and the
t-scores and overall fit of such spurious regressions are likely to be overstated and
untrustworthy
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Stationary and Nonstationary
Time Series
• a time-series variable, Xt, is stationary if:

1 the
1. th mean off Xt is
i constant
t t over time,
ti
2. the variance of Xt is constant over time, and
3. the simple correlation coefficient between Xt and
Xt–k depends on the length of the lag (k) but on no
other variable ((for all k))
• If one or more of these properties is not met, then Xt is nonstationary
• If a series is nonstationary
nonstationary, that problem is often referred to as
nonstationarity
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Time Series (cont.)
• To get a better understanding of these issues, consider the case where Yt is

generated by
g y an equation that includes only
y past values of itself ((an
autoregressive equation):
Yt = γYt–1 + vt (12.22)
where vt is a classical error term
• Can you see that if | γ | < 1, then the expected value of Yt will eventually
approachh 0 (and
( d th
therefore
f be
b stationary)
t ti ) as th
the sample
l size
i gets t bi
bigger and
d
bigger? (Remember, since vt is a classical error term, its expected value = 0)
• Similarly,
y, can you
y see that if | γ | > 1,, then the expected
p value of Yt will
continuously increase, making Yt nonstationary?
• This is nonstationarity due to a trend, but it still can cause spurious
regression results
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Time Series (cont.)
• Most importantly, what about if |γ| = 1? In this case:

Yt = Yt–1 + vt (12.23)
• This is a random walk: the expected value of Yt does not
converge on any value, meaning that it is nonstationary
• This circumstance, where γ = 1 in Equation 12.23 (or similar
equations),
ti ) is
i called
ll d a unit
it roott
• If a variable has a unit root, then Equation 12.23 holds, and
th variable
the i bl follows
f ll a random
d walk
lk and
d iis nonstationary
t ti
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The Dickey–Fuller Test
• From the previous discussion of stationarity and unit

roots it makes sense to estimate Equation 12.22:
roots, 12 22:
Yt = γYt–1 + vt (12.22)
and then determine if |γ| < 1 to see if Y is stationary
• This is almost exactly
y how the Dickey-Fuller
y test works:
1. Subtract Yt–1 from both sides of Equation 12.22,
yielding:
(Yt – Yt–1) = (γ – 1)Yt–1 + vt (12.26)
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The Dickey–Fuller Test (cont.)
(cont )
If we define ⊗Yt = Yt – Yt–1 then we have the simplest

form of the Dickey
Dickey–Fuller
Fuller test:
⊗Yt = β1Yt–1 + vt (12.27)
where β1 = γ – 1
• Note: alternative Dickey-Fuller
y tests additionally
y include
a constant and/or a constant and a trend term
2. Set up the test hypotheses:
H0: β1 = 0 (unit root)
HA: β1 < 0 (stationary)
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The Dickey–Fuller Test (cont.)
(cont )
3. Set up the decision rule:

If is statistically significantly less than 0, then we can
reject the null hypothesis of nonstationarity
If is not statistically significantly less than 0, then
we cannot reject the null hypothesis of
nonstationarity
• Note that the standard t-table does not apply to Dickey–
Fuller tests
• For the case of no constant and no trend (Equation 12.27) the
large-sample
g p values for tc are listed in Table 12.1
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Table 12.1 Large-Sample Critical
Values for the Dickey–Fuller Test
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Cointegration
• If the Dickey–Fuller test reveals nonstationarity, what should we do?

• The traditional approach has been to take first differences
(⊗Y = Yt – Yt–1 and ⊗X = Xt – Xt–1) and use them in place of
Yt and Xt in the regressions
• Issue: the first-differencing basically ”throws away information”
about the possible equilibrium relationships between the variables
• Alternatively, one might want to test whether the time-series are
cointegrated, which means that even though individual variables
might
g be nonstationary,y it’s p
possible for linear combinations of
nonstationary variables to be stationary
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Cointegration (cont.)
(cont )
• To see how this works, consider Equation 12.24:

(
(12.24)
)
• Assume that both Yt and Xt have a unit root
• Solving Equation 12.24 for ut, we get:
(12.30)
• In Equation 12.24, u t is a function of two nonstationary variables, so u t might
be expected also to be nonstationary
• Cointegration refers to the case where this is not the case:
• Yt and Xt are both non
non-stationary,
stationary, yet a linear combination of them, as given
by Equation 12.24, is stationary
– This could happen if economic theory supports Equation 12.24 as an equilibrium
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Cointegration (cont.)
(cont )
• We thus see that if Xt and Yt are cointegrated then OLS estimation

of the coefficients in Equation 12.24 can avoid spurious results
• To determine if Xt and Yt are cointegrated, we begin with OLS
estimation of Equation 12.24 and calculate the OLS residuals:
(12.31)
• Next,, perform
p a Dickey-Fuller
y test on the residuals
– Remember to use the critical values from the Dickey-Fuller Table!
• If we are able to reject
j the null hypothesis
yp of a unit root in the
residuals, we can conclude that Xt and Yt are cointegrated and our
OLS estimates are not spurious
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A Standard Sequence of Steps for Dealing
with Nonstationary Time Series
1. Specify the model (lags vs. no lags, etc)

2 Test all variables for nonstationarity (technically unit roots) using the
2.
appropriate version of the Dickey–Fuller test
3. If the variables don’t have unit roots, estimate the equation in its original
units (Y and X)
4. If the variables have unit roots, test the residuals of the equation for
cointegration using the Dickey
Dickey–Fuller
Fuller test
5. If the variables have unit roots but are not cointegrated, then change the
functional form of the model to first differences (∆X and ∆Y) and
estimate
ti t the
th equation
ti
6. If the variables have unit roots and also are cointegrated, then estimate
the equation in its original
g units
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• Dynamic model
• Ad hoc distributed lag model
• Lagrange Multiplier Serial Correlation test
• Granger causality
• Nonstationary series
• Dickey
Dickey–Fuller
Fuller test
• Unit root
• Random walk
• Cointegration
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Chapter 13
Dummy Dependent Variable

Techniques
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The Linear Probability Model
• The linear probability model is simply running OLS for a

regression,
g , where the dependent
p variable is a dummy
y ((i.e.
binary) variable:
(
(13.1)
)
where Di is a dummy variable, and the Xs, βs, and ε are typical
independent
p variables, regression
g coefficients, and an error term,
respectively
• The term linear probability model comes from the fact that the
right side of the equation is linear while the expected value of
the left side measures the probability that Di = 1
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Problems with the Linear
Probability Model
1. R2 is not an accurate measure of overall fit:
– Di can equal
q only
y 1 or 0,, but must move in a continuous fashion from one
extreme to the other (as also illustrated in Figure 13.1)
– Hence, is likely to be quite different from Di for some range of Xi
– Th
Thus, R2 is
i lik
likely
l tto b
be much
h lower
l than
th 1 even if the
th model
d l actually
t ll d does an
exceptional job of explaining the choices
R p involved
2
– As an alternative, one can instead use , a measure based on the

percentage
t off the
th observations
b ti i th
in the sample
l th
thatt a particular
ti l estimated
ti t d
equation explains correctly
– To use this approach, consider a > .5 to predict that Di = 1 and a < .5
to predict that Di = 0 and then simply compare these predictions with the
actual Di
2. is not bounded by 0 and 1:
– The alternative binomial logit model, presented in Section 13.2, will address this
issue
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Figure 13.1
A Linear Probability Model
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The Binomial Logit Model
• The binomial logit is an estimation technique for equations with dummy

dependent variables that avoids the unboundedness problem of the
linear probability model
• It does so by using a variant of the cumulative logistic function:
(13.7)
• Logits cannot be estimated using OLS but are instead estimated by

maximum likelihood (ML), an iterative estimation technique that is
especially
p y useful for equations
q that are nonlinear in the coefficients
• Again, for the logit model is bounded by 1 and 0
• This is illustrated byy Figure
g 13.2
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Figure 13.2 Is Bounded by 0
and 1 in a Binomial Logit Model
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Interpreting Estimated
Logit Coefficients
• The signs of the coefficients in the logit model have the
same meaning as in the linear probability (i.e.
(i e OLS) model
• The interpretation of the magnitude of the coefficients
differs though
differs, though, the dependent variable has changed
dramatically.
• That the “marginal effects” are not constant can be seen
from Figure 13.2: the slope (i.e. the change in probability)
of the graph of the logit changes as moves from 0 to 1!
• We’ll consider three ways for helping to interpret logit
coeffcients meaningfully:
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Interpreting Estimated Logit
Coefficients (cont.)
1. Change an average observation:
– Create an “average” observation by plugging the means of all the independent variables
i t the
into th estimated
ti t d logit
l it equation
ti and d th
then calculating
l l ti an ““average””
– Then increase the independent variable of interest by one unit and recalculate the
– The difference between the two s then g
gives the marginal
g effect
2. Use a partial derivative:
– Taking a derivative of the logit yields the result that the change in the expected value of
caused by a one unit increase in holding constant the other independent variables in the
equation equals
– To use this formula, simply plug in your estimates of and Di
– From this
this, again
again, the marginal impact of X does indeed depend on the value of
3. Use a rough estimate of 0.25:
– Plugging
gg g in into the p previous equation,
q we g get the ((more handy!)
y ) result that multiplying
py ga
logit coefficient by 0.25 (or dividing by 4) yields an equivalent linear probability model
coefficient
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Other Dummy Dependent
Variable Techniques
• The Binomial Probit Model:

– Similar to the logit model this an estimation techniq
technique
e for eq
equations
ations with
ith
dummy dependent variables that avoids the unboundedness problem
of the linear probability model
– However, rather than the logistic function, this model uses a variant of the
cumulative normal distribution
• The Multinomial Logit Model:
– Sometimes there are more than two qualitative choices available
– The sequential binary model estimates such choices as a series of
binary decisions
– If the choice is made simultaneously, however, this is not appropriate
– The multinomial logit is developed specifically for the case with more
than two qualitative choices and the choice is made simultaneously1-٣٥٧
© 2011 Pearson Addison-Wesley. All rights reserved.
• Linear probability model

2
• R p
• Binomial logit model

• The interpretation of an estimated logit coefficient
• Binomial probit model
• Sequential binary model
• Multinomial logit model
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Chapter 14
Simultaneous Equations
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The Nature of Simultaneous
Equations Systems
• In a typical econometric equation:
Yt = β0 + β1X1t + β2X2t + εt (14 1)
(14.1)
a simultaneous system is one in which Y has an effect on at least
one of the Xs in addition to the effect that the Xs have on Y
• Jargon here involves feedback effects, dual causality as well as X
and Y being jointly determined
Such systems are usually modeled by distinguishing between variables
that are simultaneously determined (the Ys, called endogenous
variables) and those that are not (the Xs
Xs, called exogenous variables):
Y1t = α0 + α1Y2t + α2X1t + α3X2t + ε1t (14.2)
Y2t = β0 + β1Y1t + β2X3t + β3X2t + ε2t (14 3)
(14.3)
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Equations Systems (cont.)
• Equations 14.2 and 14.3 are examples of structural

equations
• Structural equations characterize the underlying
economic theory behind each endogenous variable by
expressing it in terms of both endogenous and
exogenous variables
• For example, Equations 14.2 and 14.3 could be a
demand and a supply equation,
equation respectively
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• The term predetermined variable includes all

exogenous variables and lagged endogenous variables
– “Predetermined” implies that exogenous and lagged endogenous
variables are determined outside the system
y of specified
p
equations or prior to the current period
• The main pproblem with simultaneous systems

y is that
they violate Classical Assumption III (the error term
and each explanatory variable should be uncorrelated)
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Reduced-Form Equations
• An alternative way of expressing a simultaneous equations

system is through the use of reduced
reduced-form
form equations
• Reduced-form equations express a particular
endogenous variable solely in terms of an error term and all
the predetermined (exogenous plus lagged endogenous)
variables in the simultaneous system
y
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(cont.)
• The reduced-form equations for the structural

Equations 14.2
14 2 and 14.3
14 3 would thus be:
Y1t = 0 + 1X1t + 2X2t + 3X3t + v1t (14.6)
Y2t = 4+ π5X1t + 6X2t + 7X3t + v2t (14.7)
where the vs are stochastic error terms and the πs are
called reduced-form coefficients
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(cont.)
There are at least three reasons for using reduced-form equations:
1 Since the reduced
1. reduced-form
form equations have no inherent simultaneity,
simultaneity they
do not violate Classical Assumption III
– Therefore, they can be estimated with OLS without encountering the
problems discussed in this chapter
2. The interpretation of the reduced-form coefficients as impact
multipliers means that they have economic meaning and useful
applications of their own
3 Reduced-form
3. Reduced form equations play a crucial role in Two
Two-Stage
Stage Least
Squares, the estimation technique most frequently used for
simultaneous equations (discussed in Section 14.3)
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The Bias of Ordinary Least
Squares (OLS)
• Simultaneity bias refers to the fact that in a simultaneous system,
the expected values of the OLS-estimated structural coefficients are
not equal to the true βs, that is:
(14.10)
• The reason for this is that the two error terms of Equation 14.11
and 14.12 are correlated with the endogenous variables when
they appear as explanatory variables
• As an example of how the application of OLS to simultaneous
equations
q estimation causes bias, a Monte Carlo experiment
p was
conducted for a supply and demand model
• As Figure 14.2 illustrates, the sampling distributions differed greatly
f
from the
th “true”
“t ” distributions
di t ib ti defined
d fi d in
i th
the M
Monte
t C Carlo
l experiment
i t
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Figure 14.2 Sampling Distributions Showing
Simultaneity Bias of OLS Estimates
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What Is Two-Stage Least
Squares?
• Two-Stage Least Squares (2SLS) helps mitigate

simultaneity bias in simultaneous equation systems
• 2SLS requires a variable that is:
1. a good proxy for the endogenous variable
2. uncorrelated with the error term
• Such a variable is called an instrumental variable
• 2SLS essentially
ti ll consist
i t off the
th following
f ll i ttwo steps:
t
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Squares?
• STAGE ONE:
– R
Run OLS on theth reduced-form
d df equations
ti f each
for h off the
th
endogenous variables that appear as explanatory variables in the
structural equations in the system
– That is, estimate (using OLS):
(14.18)
(14.19)
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Squares? (cont.)
• STAGE TWO:
– S
Substitute
b tit t the
th Ys
Y from
f the
th reduced
d d form
f for
f the
th Ys
Y that
th t appear on
the right side (only) of the structural equations, and then estimate
these revised structural equations with OLS
– That is, estimate (using OLS):
(14.20)
(14.21)
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The Properties of Two-Stage
Least Squares
1. 2SLS estimates are still biased in small samples
– But consistent in large samples (get closer to true βs as N increases)
2. Bias in 2SLS for small samples typically is of the opposite sign of
the bias in OLS
3. If the fit of the reduced-form equation is poor, then 2SLS will not rid
the equation of bias even in a large sample
4. 2SLS estimates have increased variances and standard errors
relative to OLS
• Note that Two-Stage Least Squares cannot be applied to an
equation unless that equation is identified, however
• We therefore now turn to the issue of identification
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What Is the Identification
Problem?
• Identification is a precondition for the application of 2SLS to equations
in simultaneous systems
• A structural equation is identified only when enough of the system’s
predetermined variables are omitted from the equation in question to
allow
ll that
th t equation
ti to
t be
b distinguished
di ti i h d ffrom allll th
the others
th iin th
the system
t
– Note that one equation in a simultaneous system might be identified and
another might
g not
• Most simultaneous systems are fairly complicated, so econometricians
need a general method by which to determine whether equations are
id ifi d
identified
• The method typically used is the order condition of identification, to
which we now turn
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The Order Condition of
Identification
• Is a systematic method of determining whether a particular

equation in a simultaneous system has the potential to be
identified
• If an equation can meet the order condition,
condition then it is
almost always identified
• We thus say that the order condition is a necessary but not
sufficient condition of identification
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The Order Condition of
Identification (cont.)
• THE ORDER CONDITION:

– A necessary condition
diti ffor an equation
ti tto be
b id
identified
tifi d iis th
thatt
the number of predetermined (exogenous plus lagged
endogenous)
e doge ous) variables
a ab es in the
e sys
system
e be g greater
eate tthan
a o or
equal to the number of slope coefficients in the equation of
interest
• Or, in equation form, a structural equation meets the order
condition if:
# predetermined variables ≥ # slope coefficients
(in the simultaneous system) (in the equation)
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Figure 14.1 Supply and Demand
Simultaneous Equations
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Figure 14.3
A Shifting Supply Curve
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Figure 14.4
When Both Curves Shift
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Table 14.1a
Data for a Small Macromodel
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Table 14.1b
Data for a Small Macromodel
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• Endogenous variable
• Predetermined variable
• Structural equation
• Reduced-form equation
• Simultaneity
y bias
• Two-Stage Least Squares
• Identification
• Order condition for identification
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Chapter 15
Forecasting
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What Is Forecasting?
• In general, forecasting is the act of predicting the future

• In econometrics
econometrics, forecasting is the estimation of the expected value of
a dependent variable for observations that are not part of the same
data set
• In most forecasts, the values being predicted are for time periods in
the future, but cross-sectional predictions of values for countries or
people not in the sample are also common
• To simplify terminology, the words prediction and forecast will be used
interchangeably
g y in this chapter
p
– Some authors limit the use of the word forecast to out-of-sample prediction
for a time series
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What Is Forecasting? (cont.)
(cont )
• Econometric forecasting generally uses a single linear

equation to predict or forecast
• Our use of such an equation to make a forecast can be
summarized into two steps:
1. Specify and estimate an equation that has as its
dependent variable the item that we wish to forecast:
(15.2)
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What Is Forecasting? (cont.)
(cont )
2. Obtain values for each of the independent

variables for the observations for which we
want a forecast and substitute them into our
forecasting equation:
(
(15.3)
)
• Figure 15.1
15 1 illustrates two examples
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Figure 15.1a
Forecasting Examples
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Figure 15.1b
Forecasting Examples
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More Complex
Forecasting Problems
• The forecasts generated in the previous section are quite simple,
however, and most actual forecasting involves one or more
additional questions—for example:
1. Unknown Xs: It is unrealistic to expect to know the
values
l ffor th
the iindependent
d d t variables
i bl outside
t id th
the sample
l
• What happens when we don’t know the values of the
independent variables for the forecast period?
2. Serial Correlation: If there is serial correlation involved,
the forecasting
g equation
q may y be estimated with GLS
• How should predictions be adjusted when forecasting equations
are estimated with GLS?
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More Complex Forecasting
Problems (cont.)
3. Confidence Intervals: All the previous forecasts were
single values, but such single values are almost never
exactly right, so maybe it would be more helpful if we
forecasted a confidence interval instead
• How
H can we d
develop
l ththese confidence
fid iintervals?
t l ?
4. Simultaneous Equations Models: As we saw in
Chapter 14,
14 many economic and business equations are
part of simultaneous models
• How can we use an independent
p variable to forecast a
dependent variable when we know that a change in value of the
dependent variable will change, in turn, the value of the
independent variable that we used to make the forecast?
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Conditional Forecasting (Unknown X
Values for the Forecast Period)
• Unconditional forecast: all values of the independent

variables
i bl are kknown with
i h certainty
i
– This is rare in practice
• Conditional forecast: actual values of one or more of

the independent variables are not known
– This is the more common type of forecast
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Conditional Forecasting (Unknown X
Values for the Forecast Period) (cont.)
• The careful selection of independent variables can

sometimes
i h
help
l avoid
id the
h needd ffor conditional
di i l
forecasting
• This opportunity can arise when the dependent variable
can be expressed as a function of leading indicators:
– A leading indicator is an independent variable the movements
of which anticipate movements in the dependent variable
– Th
The best
b t known
k leading
l di indicator,
i di t the
th Index
I d off Leading
L di
Economic Indicators, is produced each month
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Forecasting with Serially
Correlated Error Terms
• Recall from Chapter 9 that when serial correlation is severe, one

remedyy is to run Generalized Least Squares
q (GLS)
( ) as noted in
Equation 9.18:
(
(9.18)
)
• If Equation 9.18 is estimated, the dependent variable will be:
(15 7)
(15.7)
• Thus, if a GLS equation is used for forecasting, it will produce
predictions of Y*
Y T + 1 rather than of YT+1
• Such predictions thus will be of the wrong variable!
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Forecasting with Serially
Correlated Error Terms (cont.)
• If forecasts are to be made with a GLS equation, Equation 9.18

should first be solved for YT before forecasting
g is attempted:
p
(15.8)
• Next
Next, substitute T+1 for t (to forecast time period T+1) and insert
estimates for the coefficients, ρs and Xs into the equation to get:
(15 9)
(15.9)
• Equation 15.9 thus should be used for forecasting when an
equation has been estimated with GLS to correct for serial
correlation
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Forecasting Confidence
Intervals
• The techniques we use to test hypotheses can also be
adapted to create forecasting confidence intervals
• Given a point forecast, all we need to generate a
confidence interval around that forecast are tc, the critical
t-value (for the desired level of confidence), and SF, the
estimated standard error of the forecast:
(15.11)
• Th
The critical t l , tc, can be
iti l t-value b ffoundd iin St
Statistical
ti ti l TTable
bl
B-1 (for a two-tailed test with T-K-1 degrees of freedom)
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Forecasting Confidence
Intervals (cont.)
• Lastly, the standard error of the forecast, SF, for an equation with just
one independent variable, equals the square root of the forecast error
variance:
(15.13)
where:
s2 = the estimated variance of the error term
T = the number of observations in the sample
XTT+11 = the forecasted value of the single
g independent
p variable
X = the arithmetic mean of the observed Xs in the sample
• Figure 15.2 illustrates an example of a forecast confidence interval
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Figure 15.2
A Confidence Interval for
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Forecasting with Simultaneous
Equations Systems
• How should forecasting be done in the context of a

simultaneous model?
• There are two approaches to answering this question,
depending on whether there are lagged endogenous
variables on the right-hand side of any of the equations in
the system:
y
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Forecasting with Simultaneous
1. No lagged endogenous variables in the system:

• the reduced-form
reduced form equation for the particular endogenous variable can
be used for forecasting because it represents the simultaneous solution
of the system for the endogenous variable being forecasted
2. Lagged endogenous variables in the system:

• then the approach must be altered to take into account the dynamic
interaction caused by the lagged endogenous variables
• For simple models, this sometimes can be done by substituting
for the lagged endogenous variables where they appear in the
reduced-form equations
• If such a manipulation is difficult, however, then a technique called
simulation analysis can be used
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ARIMA Models
• ARIMA is a highly refined curve-fitting device that uses current and

past values of the dependent variable to produce often accurate
short-term forecasts of that variable
– Examples of such forecasts are stock market price predictions created by
brokerage analysts (called “chartists”
chartists or “technicians”)
technicians ) based entirely on
past patterns of movement of the stock prices
• If ARIMA models thus essentially ignores economic theory (by
ignoring “traditional” explanatory variables), why use them?
• The use of ARIMA is appropriate when:
– little or nothing is known about the dependent variable being forecasted,
– the independent variables known to be important cannot be forecasted
effectively
– all that is needed is a one or two-period forecast
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ARIMA Models (cont.)
(cont )
• The ARIMA approach combines two different

specifications (called processes) into one equation:
1. An autoregressive process (AR):
• expresses a dependent variable as a function of past values of the
dependent variable
• This is similar to the serial correlation error term function of
Chapter 9 and to the dynamic model of Chapter 12
2. a moving average process (MA):
• expresses a dependent variable as a function of past values of the
error term
• Such a function is a moving average of past error term observations
that can be added to the mean of Y to obtain a moving average of past
values of Y
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(cont )
• To create an ARIMA model, we begin with an econometric equation

with no independent variables:
• and then add to it both the autoregressive

g and moving-average
g g
processes:
(15.17)
where the θs and the φφs are the coefficients of the autoregressive
g and
moving-average processes, respectively, and p and q are the number
of past values used of Y and ε, respectively
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(cont )
• Before this equation can be applied to a time series, however, it

must be ensured that the time series is stationary,
y, as defined in
Section 12.4
p , a non-stationary
• For example, y series can often be converted
into a stationary one by taking the first difference:
(
(15.18)
)
• If the first differences do not produce a stationary series, then
first differences of this first-differenced series can be taken—i.e.
a second-difference transformation:
(15.19)
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(cont )
• If a forecast of Y* or Y** is made, then it must be converted back into

Y terms
• For example, if d = 1 (where d is the number of differences taken to
make Y stationary), then:
(15.20)
• This conversion process is similar to integration in mathematics, so
the “I”
“ ” in ARIMA stands ffor “integrated”
“
• ARIMA thus stands for Auto-Regressive Integrated Moving Average
– An ARIMA model with p, d, and q specified is usually denoted as ARIMA
(p,d,q) with the specific integers chosen inserted for p, d, and q
– If the
eooriginal
g a seseries
es is
s stat
stationary
o a yaand
d d therefore
e e o e equa
equals
s 0, thiss iss
sometimes shortened to ARMA
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• Unconditional forecast
• Conditional forecast
• Leading indicator
• Confidence interval (of forecast)
• Autoregressive process
• Moving-average process
• ARIMA(p,d,q)
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Chapter 16
Experimental and Panel Data
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Random Assignment
Experiments
• When medical researchers want to examine the effect of a new drug, they
use an experimental design called an random assignment experiment
• In such experiments, two groups are chosen randomly:
1. Treatment group: receives the treatment (a specific medicine, say)
2. Control group: receives a harmless, ineffective placebo
• The resulting equation is:
OUTCOMEi = β0 + β1TREATMENTi + εi (16.1)
where:
OUTCOMEi = a measure of the desired outcome in the ith individual
TREATMENTi = a dummy variable equal to 1 for individuals in the
t t
treatment
t group and
d 0 for
f individuals
i di id l iin th
the control
t l group
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Random Assignment
Experiments (cont.)
• But random assignment can’t always control for all possible
other factors—though g sometimes we may y be able to identify
y some
of these factors and add them to our equation
• Let’s say that the treatment is job training:
– Suppose that random assignment, by chance, results in one group having more
males and being slightly older than the other group
– If gender and age matter in determining earnings
earnings, then we can control for the
different composition of the two groups by including gender and age in our
regression equation:
OUTCOMEi = β0 + β1TREATMENTi + β2X1i + β3X2i + εi (16.2)

where: X1 = dummy variable for the individual’s gender
X2 = the individual’s age
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Random Assignment
Experiments (cont.)
• Unfortunately, random assignment experiments are not common in
economics because they are subject to problems that typically do not
plague medical experiments—e.g.:
1. Non-Random Samples:
• Most subjects in economic experiments are volunteers, and samples of
volunteers often aren’t random and therefore may not be representative of the
overall population
• As a result, our conclusions may not apply to everyone
2. Unobservable Heterogeneity:
• In Equation 16.2, we added observable factors to the equation to avoid omitted
variable bias, but not all omitted factors in economics are observable
• This “unobservable omitted variable” problem is called unobserved
heterogeneity
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Random Assignment
Experiments (cont.)
3. The Hawthorne Effect:
• Human subjects typically know that they’re
they re being studied
studied, and they
usually know whether they’re in the treatment group or the control group
• The fact that human subjects know that they’re being observed
sometimes
ti can change
h th
their
i bbehavior,
h i and d thi
this change
h iin b
behavior
h i could
ld
clearly change the results of the experiment
4. Impossible Experiments:
• It’s often impossible (or unethical) to run a random assignment
experiment in economics
• Think about how difficult it would be to use a random assignment
experiment to study the impact of marriage on earnings!
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Natural Experiments
• Natural experiments (or quasi-experiments) are similar

to random assignment experiments,
experiments except:
– observations fall into treatment and control groups
“naturally”
naturally (because of an exogenous event) instead of
being randomly assigned by the researcher
– By “exogenous
exogenous event”
event is meant that the natural event
must not be under the control of either of the two groups
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Natural Experiments (cont
(cont.))
• The appropriate regression equation for such a natural experiment is:

⊗OUTCOMEi = β0 + β1TREATMENTi + β2X1i + β3X2i + εi (16.3)
(16 3)
where:
⊗OUTCOMEi is defined as the outcome after the treatment minus the

outcome before the treatment for the ith observation
β1 is called the difference
difference-in-differences
in differences estimator
estimator, and it measures
the difference between the change in the treatment group and the
change in the control group, holding constant X1 and X2
• Figure 16.1 illustrates an example of a natural experiment
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Figure 16.1 Treatment and
Control Groups for Los Angeles
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What Are Panel Data?
• Panel (or longitudinal) data combine time-series and cross-

sectional data such that observations on the same variables from the
same cross sectional
ti l sample
l are followed
f ll d over two
t or more
different time periods
• Why use panel data? At least three reasons—using panel data:
1. certainly will increase sample sizes!
2 can help provide insights into analytical questions that can
2. can’tt be
answered by using time-series or cross-sectional data alone:
• Allows determining whether the same people are unemployed year
after year or whether different individuals are unemployed in different
years
3. often allow researchers to avoid omitted variable problems that
otherwise would cause bias in cross-sectional studies
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What Are Panel Data? (cont.)
(cont )
• There are four different kinds of variables that we encounter when

we use panel data:
1. Variables that can differ between individuals but don’t change
over time:
• e.g., gender, ethnicity, and race
2. Variables that change over time but are the same for all
individuals in a given time period:
• e.g., the retail price index and the national unemployment rate
3 Variables that vary both over time and between individuals:

3.
• e.g., income and marital status
4 Trend variables that vary in predictable ways:

4.
• e.g., an individual’s age
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The Fixed Effects Model
• There are several alternative panel data estimation procedures

• Most researchers use the fixed effects model
model, which allows each
cross-sectional unit to have a different intercept:
Yit = β0 + β1Xit + β2D2i + ... + βNDNi + vit ((16.4))
where:
D2 = intercept dummy equal to 1 for the second cross-sectional
cross sectional entity
and 0 otherwise
DN = intercept
p dummy
y equal
q to 1 for the Nth cross-sectional entity
y
and 0 otherwise
• Note that Y, X, and v have two subscripts!
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(cont.)
• One major advantage of the fixed effects model is that it avoids bias
due to omitted variables that don’t change over time
– e.g., race or gender
– Such time-invariant omitted variables often are referred to as unobserved
heterogeneity or a fixed effect
• To understand how this works, consider what Equation 16.4 would look
like with only two years worth of data:
Yit = β0 + β1Xit + β2D2i + vit (16.5)
• Let’s decompose the error term
term, vit, into two
t o components,
components a classical
error term (εit) and the unobserved impact of the time-invariant
omitted variables (ai):
vit = εit + ai (16.6)
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(cont.)
• If we substitute Equation 16.6 into Equation 16.5, we get:
Yit = β0 + β1Xit + β2D2i + εit + ai (16.7)
• Next, average Equation 16.7 over time for each observation i, thus
producing:
Yi = β0 + β1Xi + β2D2i + εi + ai (16.8)
where the bar over a variable indicates the mean of that variable
across time
• Note that ai, β2D2i, and β0 don’t have bars over them because they’re
constant over time
i
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(cont.)
• If we now subtract Equation 16.8 from Equation 16.7, we get:
• Note that ai, β2, D2i, and β0 are subtracted out because they’re in both
equations
q
• We’ve therefore shown that estimating panel data with the fixed effects
model does indeed drop the ai out of the equation
• Hence, the fixed effects model will not experience bias due to time-
invariant omitted variables!
• Example: The death penalty and the murder rate:
– Figures 16.2 and 16.3 illustrates the importance of the fixed-effects model:
the unlikely (positive) result from the cross-section model is reversed by
the fixed effects model!
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Figure 16.2 In a Single-Year
Cross-Sectional Model
Model, the Murder Rate
Appears to Increase with Executions
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Figure 16.3
In a Panel Data Model
Model, the Murder
Rate Decreases with Executions
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The Random Effects Model
• Recall that the fixed effects model is based on the assumption

that each cross-sectional unit has its own interceptp
• The random effects model instead is based on the assumption
that the intercept
p for each cross-sectional unit is drawn from
a distribution (that is centered around a mean intercept)
• Thus each intercept p is a random draw from an “interceptp
distribution” and therefore is independent of the error term for
any particular observation
– Hence the term random effects model
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The Random Effects Model
(cont.)
• Advantages of the random effects model:
1 more degrees of freedom than a fixed effects model
1.
• This is because rather than estimating an intercept for virtually every cross-
sectional unit, all we need to do is to estimate the parameters that describe the
distribution of the intercepts
intercepts.
2. Can now also estimate time-invariant explanatory variables

((like race or gender).
g )
• Disadvantages of the random effects model:
1 Most importantly,
1. importantly the random effects estimator requires us to
assume that ai is uncorrelated with the independent variables,
the Xs, if we’re going to avoid omitted variable bias
• This may be an overly strong assumption in many cases
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Choosing Between Fixed
and Random Effects
• One key is the nature of the relationship between ai and the Xs:
– If they’re likely to be correlated, then it makes sense to use the fixed
effects model
– If not, then it makes sense to use the random effects model
• Can also use the Hausman test to examine whether there is
correlation between ai and X
• Essentially, this procedure tests to see whether the regression
Essentially
coefficients under the fixed effects and random effects models are
statistically different from each other
– If they are different, then the fixed effects model is preferred
– If the they are not different, then the random effects model is preferred
(or estimates of both the fixed fi ed effects and random effects models are
provided)
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Table 16.1a
16 1a
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Table 16.1b
16 1b
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Table 16.1c
16 1c
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Table 16.1d
16 1d
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Table 16.1e
16 1e
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• Treatment group
• Control group
g p
• Differences estimator
• Difference in differences
• Unobserved heterogeneity
• The Hawthorne effect
• Panel data
• The fixed effects model
• The random effects model
• Hausman test
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Chapter 17
Statistical Principles
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Probability
• A random variable X is a variable whose numerical value is

determined by chance, the outcome of a random phenomenon
– A discrete random variable has a countable number of possible values,
such as 0, 1, and 2
– A continuous random variable, such as time and distance, can take on any
value in an interval
• A probability distribution P[Xi] for a discrete random variable X
assigns probabilities to the possible values X1, X2, and so on
• For example,
p when a fair six-sided die is rolled, there are six equally
q y
likely outcomes, each with a 1/6 probability of occurring
• Figure 17.1 shows this probability distribution
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Figure 17.1 Probability
Distribution for a Six-Sided Die
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Mean, Variance, and
Standard Deviation
• The expected value (or mean) of a discrete random variable X is a
weighted average of all possible values of X, using the probability of
each X value as weights:
µ = E[X] = ∑ XiP[Xi ] (17.1)
i
• the variance of a discrete random variable X is a weighted average,
for all possible values of X, of the squared difference between X and
its expected value
value, using the probability of each X value as weights:
σ 2 = E[(X − µ)2 ] = ∑ (Xi − µ)2 P[Xi ] (17.2)
i
• The
Th standard
t d d deviation
d i ti σ is the square roott off the
i th th variance
i
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Continuous Random
Variables
• Our examples to this point have involved discrete random variables,
for which we can count the number of possible outcomes:
– The coin can be heads or tails; the die can be 1, 2, 3, 4, 5, or 6
• For continuous random variables, however, the outcome can be any
value in a given interval
– For example, Figure 17.2 shows a spinner for randomly selecting a point on
a circle
• A continuous probability density curve shows the probability that the
outcome is in a specified
p interval as the corresponding
p g area under the
curve
– This is illustrated for the case of the spinner in Figure 17.3
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Figure 17.2
Pick a Number, Any Number
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Figure 17.3 A Continuous Probability
Distribution for the Spinner
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Standardized Variables
• To standardize a random variable X, we subtract its mean and then divide

by its standard deviation :
X−µ
Z= (17.3)
σ
• No matter what the initial units of X, the standardized random variable Z has
a mean of 0 and a standard deviation of 1
• The standardized variable Z measures how many standard deviations X is
above or below its mean:
– If X is equal to its mean, Z is equal to 0
– If X is one standard deviation above its mean, Z is equal to 1
– If X is two standard deviations below its mean, Z is equal to –2
• Figures 17.4 and 17.5 illustrates this for the case of dice and fair coin flips,
respectively
ti l
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Figure 17.4a Probability Distribution for
Six-Sided Dice, Using Standardized Z
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Figure 17.4b Probability Distribution for
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Figure 17.4c Probability Distribution for
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Figure 17.5a Probability Distribution for
Fair Coin Flips, Using Standardized Z
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Figure 17.5b Probability Distribution for
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Figure 17.5c Probability Distribution for
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The Normal Distribution
• The density curve for the normal distribution is graphed in

Figure 17.6
• The probability that the value of Z will be in a specified interval is given
by the corresponding area under this curve
• These areas can be determined by consulting statistical software or a
table, such as Table B-7 in Appendix B
• Many things follow the normal distribution (at least approximately):
– the weights of humans, dogs, and tomatoes
– The lengths of thumbs,
thumbs widths of shoulders,
shoulders and breadths of skulls
– Scores on IQ, SAT, and GRE tests
– The number of kernels on ears of corn
corn, ridges on scallop shells
shells, hairs on
cats, and leaves on trees
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Figure 17.6
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(cont.)
• The central limit theorem is a very strong result for

empirical analysis that builds on the normal
distribution
• The central limit theorem states that:
– if Z is a standardized sum of N independent, identically distributed
(discrete or continuous) random variables with a finite, nonzero
standard deviation, then the probability distribution of Z
approaches the normal distribution as N increases
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Sampling
• First, let’s define some key terms:

• Population: the entire group of items that interests us
• Sample: the part of this population that we actually
observe
• Statistical inference involves using
g the sample
p to draw
conclusions about the characteristics of the population
from which the sample came
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Selection Bias
• Any sample that differs systematically from the population that it is

intended to represent is called a biased sample
• One of the most common causes of biased samples is selection bias,
which occurs when the selection of the sample systematically
l d or underrepresents
excludes d t certain
t i groups
– Selection bias often happens when we use a convenience sample
consisting
g of data that are readily
y available
• Self-selection bias can occur when we examine data for a group of
people who have chosen to be in that group
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Survivor and
Nonresponse Bias
• A retrospective study looks at past data for a contemporaneously
selected sample
– for example, an examination of the lifetime medical records of 65-year-olds
• A prospective study, in contrast, selects a sample and then tracks the
members over time
• By its very design, retrospective studies suffer from survivor bias: we
necessarily
il exclude
l d members
b off the
th pastt population
l ti who
h are no longer
l
around!
• Nonresponse bias: The systematic refusal of some groups to
participate in an experiment or to respond to a poll
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The Power of Random
Selection
• In a simple random sample of size N from a given population:
– each member of the population is equally likely to be included in the sample
– every possible sample of size N from this population has an equal chance of
being selected
• How do we actually make random selections?
• We would like a procedure that is equivalent to the following:
– put the name of each member of the population on its own slip of paper
– drop these slips into a box
– mix thoroughly
– pick members out randomly
• In practice, random sampling is usually done through some sort of
numerical identification combined with a computerized random selection
of numbers
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Estimation
• First, some terminology:

• Parameter: a characteristic of the population whose value is
unknown, but can be estimated
• Estimator: a sample
p statistic that will be used to estimate the value of
the population parameter
• Estimate: the specific value of the estimator that is obtained in one
particular sample
• Sampling variation: the notion that because samples are chosen
randomly the sample average will vary from sample to sample
randomly, sample,
sometimes being larger than the population mean and sometimes lower
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Sampling Distributions
• The sampling distribution of a statistic is the probability distribution

or density curve that describes the population of all possible values
of this statistic
– For example, it can be shown mathematically that if the individual
observations are drawn from a normal distribution
distribution, then the sampling
distribution for the sample mean is also normal
– Even if the population does not have a normal distribution, the sampling
distribution of the sample mean will approach a normal distribution as the
sample size increases
• It can be shown mathematically that the sampling distribution for the
sample mean has the following mean and standard deviation:
Mean of X = µ
(17.5)
d i ti off X = µ / N
St d d deviation
Standard
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The Mean of the Sampling
Distribution
• A sample statistic is an unbiased estimator of a

population parameter if the mean of the sampling
distribution of this statistic is equal to the value of the
population parameter
• Because the mean of the sampling distribution of X is µ,
X is an unbiased estimator of µ
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The Standard Deviation of the
Sampling Distribution
• One way of gauging the accuracy of an estimator is with

its standard deviation:
– If an estimator has a large standard deviation, there is a
substantial p
probability
y that an estimate will be far from its mean
– If an estimator has a small standard deviation, there is a high
probability that an estimate will be close to its mean
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The t-Distribution
• When the mean of a sample from a normal distribution is

standardized by subtracting the mean of its sampling distribution and
dividing by the standard deviation of its sampling distribution, the
resulting Z variable
has a normal distribution

• W.S. Gosset determined (in 1908) the sampling distribution of the
variable that is created when the mean of a sample from a normal
distribution is standardized byy subtracting
g and dividing
g by
y its
standard error (≡ the standard deviation of an estimator):
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The t-Distribution (cont.)
(cont )
• The exact distribution of t depends on the sample

size,
– as the sample size increases, we are increasingly confident of the
accuracy of the estimated standard deviation
• Table B-1 at the end of the textbook shows some

probabilities for various t-distributions that are identified
by the number of degrees of freedom:
degrees
g of freedom = # observations - # estimated
parameters
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Confidence Intervals
• A confidence interval measures the reliability of a given statistic

such as X
• The general procedure for determining a confidence interval for a
population mean can be summarized as:
1. Calculate the sample average X
2. Calculate the standard error of X by dividing the sample standard
deviation s by the square root of the sample size N
3. Select a confidence level (such as 95 percent) and look in
Table B-1 with N-1 degrees of freedom to determine the t-value
that
h corresponds d to this
hi probability
b bili
4. A confidence interval for the population mean is then given by:
X ±t*s/ N
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Sampling from Finite
Populations
• Notably, a confidence interval does not depend on the size of the
population
• This may first seem surprising: if we are trying to estimate a
characteristic of a large population, then wouldn’t we also need a
l
large sample?
l ?
• The reason why the size of the population doesn’t matter is that the
chances that the luck of the draw will yield a sample whose mean
differs substantially from the population mean depends on the size of
the sample and the chances of selecting items that are far from the
population mean
– That is, not on how many items there are in the population
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• Random variable • Selection, survivor,

and nonresponse bias
• Probability distribution
• Sampling distribution
• Expected Value
• Population mean
• Mean
• Sample mean
• Variance
• Population standard
• Standard deviation d i ti
deviation
• Standardized • Sample standard deviation
random variable
• Degrees
D off ffreedom
d
• Population
• Confidence interval
• Sample
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Econometrics and Quantitative

Using Econometrics: A Practical Guide

Instructor: Dr. Samir Safi

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Copyright © 2011 Pearson Addison-Wesley. Slides by Niels-Hugo Blunch

• Econometrics literally means “economic

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• Three major uses of econometrics:

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• Consider the general and purely theoretical

• Econometrics allows this g general and purelyy

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• Economic theory can give us the direction of a

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• Formally, regression analysis is a statistical

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• Return to the example from before:

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• The simplest example is:

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• Application of linear regression techniques requires that the

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• Is (1.3) a complete description of origins of variation in Y?

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• Two components in (1.7):

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• Aggregate consumption as a function of aggregate income may

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• Include reference to the number of

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• The general case: multivariate regression

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• Let wages (WAGE) depend on:

• Substituting into equation (1.11) yields:

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• Subscript “i” for data on individuals (so called

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• The regression equation considered so far is the “true”—but

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• For each sample we get a different set of estimated

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• This can also be seen from the fact that

• Note difference with the error term, εi, given as

• This all comes together in Figure 1.3

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• Houses are not homogenous products, like corn or

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• Is this fair / too much /too little?

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• Note that the interpretation of the intercept term

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• How to use the estimated regression line / estimated

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• Regression analysis • Slope coefficient

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Ordinary Least Squares