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Quantitative Techniques

Topic 6
Muticollinearity

Reading: GJ (Ch. 10);

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Summary

The Nature of Muticollinearity


OLS Estimation
Consequences of Multicollinearity
Detection of Multicollinearity
Remedial Measures

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Multicollinearity
The Nature of Multicollinearity
- Perfect Multicollearity
- Near-perfect Multicollinearity

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Multicollinearity
The OLS Estimation
- Perfect Multicollearity
a) The regression coefficients are
indeterminate

b) Standard errors are infinite

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Multicollinearity
The OLS Estimation
- Less Than Perfect Multicollearity
a) The regression coefficients are
determinate

b) Standard errors are large

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Multicollinearity
The Sources of Multicollinearity
- The Data Collection Method Employed
(sampling over a limited range of values)
- Constraints on the Model or Population
Being Sampled
- Model Specification
- An Over-identified Model (model has more
explanatory variables than observation) 6
Multicollinearity
Consequences of Multicollinearity
- BLUE Estimators, OLS estimators
have large variances making precise
estimation difficult.
- Wider confidence intervals
- Statistically insignificant parameters.
- BUT High R2
- Estimators and standard errors
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sensitive to small changes
Multicollinearity
Detection of Multicollinearity
- High R2 BUT few significant t-ratios
- High pair-wise correlation among
regressors
- Auxilliary regressions
- Tolerance and VIF (variance-
inflating factor)

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Multicollinearity
Remedial Measures
- Do Nothing
- Rules-of-Thumb Procedures
- A priori information
- Combining cross-section and time series data
- Dropping a variable(s) and specification bias
- Transformation of variables
- Additional or new data
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