This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

279 0020 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences, the Diploma in Economics and Access Route for Students in the External Programme

Elements of Econometrics Thursday, 28th May 2009 : 2.30pm to 5.30pm

Candidates should answer FOUR of the following EIGHT questions: QUESTION 1 of Section A (40 marks) and THREE questions from Section B (20 marks each). Candidates are strongly advised to divide their time accordingly. Extracts from statistical tables are given after the final question on this paper Graph paper is provided at the end of this question paper. If used, it must be detached and fastened securely inside the answer book. A calculator may be used when answering questions on this paper and it must comply in all respects with the specification given with your Admission Notice. The make and type of machine must be clearly stated on the front cover of the answer book.

University of London 2009 UL09/0177

D02

PLEASE TURN OVER Page 1 of 18

SECTION A Answer all eight parts of question 1 (5 marks each). 1. (a) Consider a two equation model: y t = z t + u 1t y t = 1 z t + 2 x t + u 2 t ; t = 1, 2, , T

where y t and z t are endogenous variables, x t is an exogenous variable, u 1t and u 2 t are serially uncorrelated disturbances with zero means, variances
2 1 and 2 and covariance 12 for all t. 2

Write down the reduced form corresponding to y and z. Suggest a method of estimation of the reduced form parameters, which will give unbiased and consistent estimators. (b) (c) What is meant by a stationary time series? Under what conditions is the series generated by Xt=Xt-1+ut stationary? Explain your answer. Let X and Y be two random variables. Show that: var(aX + bY) = a2var(X) + b2 var(Y) + 2ab cov(X,Y) where a and b are known constants. Explain how this result changes if X and Y are independent. (d) What is meant by a common factor test in the context of a linear model with an autocorrelated error? How would you perform a common factor test and what hypothesis would you be testing? Explain the concepts of Type I error and Type II error in hypothesis testing. What do you understand by the power of a test? A simple random sample of size N, X1 , X 2 , , X N , is drawn from a population with mean and variance 2 . Consider the following estimators of .

(e) (f)

i.
ii. iii.

X
i =1 n i =1

N2

X (N 1)
i

X
i =1

Evaluate each estimator in terms of bias, efficiency and consistency. (question continues on next page)
UL09/0177
D02

Page 2 of 18

(g)

Suppose in a regression equation the dependent variable only takes values 0 and 1 and a researcher uses the ordinary least squares to estimate it. What problems he might face? Describe briefly a method of estimation which overcomes this problem. Let the probability density function of a population X be: f(x) = p x (1 p) 1 x ; x = 0, 1

(h)

where p is the probability of success. Let X1 ,X 2 ,,X n be a simple random sample from X. Obtain the maximum likelihood estimator of p.
SECTION B

Answer three questions from this section (20 marks each). 2. (a) Explain why distributed lag models are of importance in specifying economic relationships. Show that the infinite distributed lag model:
Yt = + j X t j + t
j=0

(b)

can be written in terms of Xt and a single lag Yt-1. What estimation problems may occur in this model? (c) Consider a model:

Yt = 1 + 2 X e+1 + u t ; t = 1, 2, , T t where X e+1 is the expected value of the explanatory variable X at time t+1 and t
E(u t ) = 0; E(u 2 ) = 2 and E(u s u t ) = 0 if s t for all s, t = 1, 2, , T. It is given that: t X e+1 X e = (X t X e ) , 0 1 . t t t X e is the expected value of the explanatory variable X at time t. t i. ii. Explain in detail how this model can be estimated. Derive the short run and long run effect of X on Y.

UL09/0177
D02

Page 3 of 18

3.

Let the regression equation be: Yt = 1 + 2 X t + u t where u t = u t 1 + t and

E ( t ) = 0 E ( s t ) = 2 =0 if s = t if s t

; t = 1, 2 , T

; t = 1,2, , T

(a)

Explain what are the consequences on ordinary least squares estimators of 1 and 2 for this model specification. Explain in detail how would you test the null hypothesis = 0 ? Specify all the assumptions needed for this test. Discuss in detail a method of estimation which gives best linear unbiased estimates of 1 and 2 .

(b) (c)

4.

(a)

Explain what is a trend stationary series and what is a difference stationary series. What is an important difference between the two types of stationarity? Let the model be: Yt = Yt 1 + u t where
E(u t ) = 0; E(u 2 ) = 2 and E(u s u t ) = 0 if s t for all s, t = 1, 2, , T. u 0 = 0. t

(b)

; t = 1, 2, , T

Explain how would you test the H 0 :| |= 1. (c) Consider an ADL(1, 1) model: Yt = 1 + 2 Yt 1 + 3X t + 4 X t 1 + u t where both Yt and X t are I(1). Express the ADL(1, 1) model in an error correction form and interpret the coefficients of the error correction model. Discuss advantages of the error correction form.

UL09/0177
D02

Page 4 of 18

5.

Regressing profits (Pt) on sales (St) for UK manufacturing corporations using quarterly data for the period 1990-1995 produces the following results: Pt = 7201.4 + 0.139 St Qlt + 0.218 St Q2t + 0.189 St Q3t + 0.0385 St + et (6.3) (2.3) (4.3) (3.7) where figures in brackets are estimated t values, et is the estimated error term and Qlt, Q2t, Q3t and Q4t are defined as: Qlt = 1 in the 1st quarter: 0 otherwise. Q2t = 1 in the 2nd quarter: 0 otherwise. Q3t = 1 in the 3rd quarter: 0 otherwise. Q4t = 1 in the 4th quarter: 0 otherwise. (a) (b) (c) What roles do the variables Qlt, Q2t, Q3t and Q4t play in the regression equation? Interpret the estimated equation. An econometrician suggests that instead of including St Qit in the model you should just have used Qit alone, i = 1, 2,3. What difference would this have made? Is it a sensible suggestion? What would be the effect of including Qlt, Q2t and Q3t as well as St Q1t , St Q 2t and St Q3t , in the regression?

(d)

6.

Write brief essays on any three of the following: (a) (b) (c) (d) (e) Spurious regression. Cointegration. Instrumental variable estimation. Chow test for structural break. Measurement error in the explanatory variables.

UL09/0177
D02

Page 5 of 18

7.

An econometric investigation into the demand for bus travel uses data from 40 cities in the UK. The variables are: BUSi = bus travel in city i measured in thousands of passenger hours per year INCi = average income per capita in city i measured in per person per year POPi = population of city i, measured in thousands of persons DENi = population density in city i, measured in persons per square mile FAREi = bus fare in city i, measured in s FUELi = average petrol price in city i measured in pence per litre. Ordinary Least Squares using log(BUSi) as the dependent variable gives the following results: MODEL 1 Coefficient Standard Error 39.15 9.33 -4.85 1.033 0.8768 0.167 1.074 0.235 0.4282 0.389 -1.767 2.459 0.656 MODEL 2 Coefficient Standard Error 39.29 9.27 -4.74 1.018 0.8555 0.163 0.9607 0.203 0.641

Variable Constant log(INCi) log(POPi) log(DENi) log(FAREi) log(FUELi) R2

where log indicates that the variable is logged. (a) Interpret the above results and, on the basis of these results, say which model you prefer and why. Explain what is meant by heteroskedasticity and why it might be a problem in fitting a model to this data set. Explain carefully how you would test the above models for heteroskedastcity. If heteroskedasticity were shown to be present what would be the effect on your answer to (a)?

(b)

(c) (d)

UL09/0177
D02

Page 6 of 18

8.

(a)

Show that specification error resulting from an omitted variable leads to biased parameter estimates under ordinary least squares and evaluate the expected size and direction of the bias. There are six missing values (denoted by xx) in the given Stata output: i. ii. iii. iv. v. Model SS Model df R-squared avetemp t value harvrain 95% Conf. Interval.

(b)

Give the formulae for them and obtain their values based on the given output:
Source | SS df MS Number of obs = 27 -------------+-----------------------------F( 3, 23) = 21.90 Model | xxxxxxxxxx xx 2.58519261 Prob > F = 0.0000 Residual | 2.71468685 23 .118029863 R-squared = xxxxxx -------------+-----------------------------Adj R-squared = 0.7069 Total | 10.4702647 26 .402702488 Root MSE = .34355 -----------------------------------------------------------------------------lnprice | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------wintrain | .001282 .0005765 2.22 0.036 .0000894 .0024747 avetemp | .7123178 .1087674 xxxx 0.000 .4873154 .9373202 harvrain | -.0036242 .0009646 -3.76 0.001 xxxxxxxxx xxxxxxxxx _cons | -13.44433 1.969396 -6.83 0.000 -17.51834 -9.370326 ------------------------------------------------------------------------------

where the explanatory variables are: wintrain: avetemp: harvrain: the level of winter rain (October - March) in millimetres average temperature in the growing season (April-September) level of harvest rain (August-September) in millimetres

and the dependent variable (lnprice) is the price of mature red wine from the Bordeaux region of France at harvest time. The data relate to wines of different vintages (ages) in 1987. (c) Interpret the regression results in (b).

(question continues on next page)

UL09/0177
D02

Page 7 of 18

(d)

If the age of the wine is included in the equation the estimates become:

Source | SS df MS -------------+-----------------------------Model | 8.66443586 4 2.16610897 Residual | 1.80582883 22 .082083129 -------------+-----------------------------Total | 10.4702647 26 .402702488

Number of obs F( 4, 22) Prob > F R-squared Adj R-squared Root MSE

= = = = = =

27 26.39 0.0000 0.8275 0.7962 .2865

-----------------------------------------------------------------------------lnprice | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------wintrain | .0011668 .000482 2.42 0.024 .0001671 .0021665 avetemp | .6163926 .0951755 6.48 0.000 .4190107 .8137745 harvrain | -.0038606 .0008075 -4.78 0.000 -.0055353 -.0021858 age | .0238474 .0071667 3.33 0.003 .0089846 .0387103 _cons | -12.31227 1.677212 -7.34 0.000 -15.79059 -8.833945 ------------------------------------------------------------------------------

i. ii.

What is the interpretation of the coefficient of variable age? If the true model is given by the specification in (d) do you think that the model in (b) should show evidence of specification error? Does it? Carefully explain your observations.

UL09/0177
D02

Page 8 of 18