Econometrics

Econometrics
c
Michael Creel
Version 0.81, March, 2006
D EPT. OF E CONOMICS AND E CONOMIC H ISTORY, U NIVERSITAT AUTÒNOMA DE BARCELONA ,

MICHAEL . CREEL @ UAB . ES , H T T P :// P A R E T O . U A B . E S / M C R E E L
Contents
List of Figures 10
List of Tables 12
Chapter 1. About this document 13

1.1. License 13
1.2. Obtaining the materials 13
1.3. An easy way to use LYX and Octave today 14
1.4. Known Bugs 15
Chapter 2. Introduction: Economic and econometric models 16
Chapter 3. Ordinary Least Squares 18

3.1. The Linear Model 18
3.2. Estimation by least squares 19
3.3. Geometric interpretation of least squares estimation 20
3.3.1. In X,Y Space 20
3.3.2. In Observation Space 20
3.3.3. Projection Matrices 22
3.4. Influential observations and outliers 22
3.5. Goodness of fit 24
3.6. The classical linear regression model 26
3.7. Small sample statistical properties of the least squares estimator 27
3.7.1. Unbiasedness 27
3.7.2. Normality 27
3.7.3. The variance of the OLS estimator and the Gauss-Markov theorem 29
3.8. Example: The Nerlove model 31
3.8.1. Theoretical background 31
3.8.2. Cobb-Douglas functional form 32
3.8.3. The Nerlove data and OLS 33
Exercises 35
Chapter 4. Maximum likelihood estimation 36

4.1. The likelihood function 36
4.1.1. Example: Bernoulli trial 37
4.2. Consistency of MLE 38
4.3. The score function 39
4.4. Asymptotic normality of MLE 40
3
CONTENTS 4
4.6. The information matrix equality 43

4.7. The Cramér-Rao lower bound 44
Exercises 46
Chapter 5. Asymptotic properties of the least squares estimator 47

5.1. Consistency 47
5.2. Asymptotic normality 48
5.3. Asymptotic efficiency 48
Chapter 6. Restrictions and hypothesis tests 50

6.1. Exact linear restrictions 50
6.1.1. Imposition 50
6.1.2. Properties of the restricted estimator 52
6.2. Testing 53
6.2.1. t-test 53
6.2.2. F test 55
6.2.3. Wald-type tests 55
6.2.4. Score-type tests (Rao tests, Lagrange multiplier tests) 56
6.2.5. Likelihood ratio-type tests 57
6.3. The asymptotic equivalence of the LR, Wald and score tests 58
6.4. Interpretation of test statistics 61
6.5. Confidence intervals 61
6.6. Bootstrapping 61
6.7. Testing nonlinear restrictions, and the Delta Method 64
6.8. Example: the Nerlove data 66
Chapter 7. Generalized least squares 71

7.1. Effects of nonspherical disturbances on the OLS estimator 71
7.2. The GLS estimator 72
7.3. Feasible GLS 74
7.4. Heteroscedasticity 75
7.4.1. OLS with heteroscedastic consistent varcov estimation 75
7.4.2. Detection 76
7.4.3. Correction 77
7.4.4. Example: the Nerlove model (again!) 79
7.5. Autocorrelation 82
7.5.1. Causes 82
7.5.2. Effects on the OLS estimator 83
7.5.3. AR(1) 84
7.5.4. MA(1) 86
7.5.5. Asymptotically valid inferences with autocorrelation of unknown form 88
7.5.6. Testing for autocorrelation 89
7.5.7. Lagged dependent variables and autocorrelation 91
7.5.8. Examples 92
CONTENTS 5
Exercises 96
Chapter 8. Stochastic regressors 97

8.1. Case 1 98
8.2. Case 2 98
8.3. Case 3 99
8.4. When are the assumptions reasonable? 99
Exercises 101
Chapter 9. Data problems 102

9.1. Collinearity 102
9.1.1. A brief aside on dummy variables 103
9.1.2. Back to collinearity 103
9.1.3. Detection of collinearity 105
9.1.4. Dealing with collinearity 105
9.2. Measurement error 107
9.2.1. Error of measurement of the dependent variable 107
9.2.2. Error of measurement of the regressors 108
9.3. Missing observations 109
9.3.1. Missing observations on the dependent variable 109
9.3.2. The sample selection problem 111
9.3.3. Missing observations on the regressors 111
Exercises 113
Exercises 113
Exercises 113
Chapter 10. Functional form and nonnested tests 114

10.1. Flexible functional forms 114
10.1.1. The translog form 115
10.1.2. FGLS estimation of a translog model 119
10.2. Testing nonnested hypotheses 121
Chapter 11. Exogeneity and simultaneity 123

11.1. Simultaneous equations 123
11.2. Exogeneity 125
11.3. Reduced form 126
11.4. IV estimation 128
11.5. Identification by exclusion restrictions 131
11.5.1. Necessary conditions 131
11.5.2. Sufficient conditions 133
11.5.3. Example: Klein’s Model 1 136
11.6. 2SLS 138
11.7. Testing the overidentifying restrictions 139
11.8. System methods of estimation 142
11.8.1. 3SLS 143
CONTENTS 6
11.8.2. FIML 147

11.9. Example: 2SLS and Klein’s Model 1 148
Chapter 12. Introduction to the second half 150
Chapter 13. Numeric optimization methods 156

13.1. Search 156
13.2. Derivative-based methods 157
13.2.1. Introduction 157
13.2.2. Steepest descent 159
13.2.3. Newton-Raphson 159
13.3. Simulated Annealing 162
13.4. Examples 163
13.4.1. Discrete Choice: The logit model 163
13.4.2. Count Data: The Poisson model 164
13.4.3. Duration data and the Weibull model 165
13.5. Numeric optimization: pitfalls 168
13.5.1. Poor scaling of the data 168
13.5.2. Multiple optima 169
Exercises 172
Chapter 14. Asymptotic properties of extremum estimators 173

14.1. Extremum estimators 173
14.2. Consistency 173
14.3. Example: Consistency of Least Squares 177
14.4. Asymptotic Normality 177
14.5. Examples 179
14.5.1. Binary response models 179
14.5.2. Example: Linearization of a nonlinear model 182
Chapter 15. Generalized method of moments (GMM) 185

15.1. Definition 185
15.4. Choosing the weighting matrix 188
15.5. Estimation of the variance-covariance matrix 190
15.5.1. Newey-West covariance estimator 191
15.6. Estimation using conditional moments 192
15.7. Estimation using dynamic moment conditions 195
15.8. A specification test 195
15.9. Other estimators interpreted as GMM estimators 196
15.9.1. OLS with heteroscedasticity of unknown form 196
15.9.2. Weighted Least Squares 198
15.9.3. 2SLS 198
15.9.4. Nonlinear simultaneous equations 199
CONTENTS 7
15.9.5. Maximum likelihood 199

15.10. Example: The Hausman Test 201
15.11. Application: Nonlinear rational expectations 206
15.12. Empirical example: a portfolio model 208
Chapter 16. Quasi-ML 211

16.1. Consistent Estimation of Variance Components 212
16.2. Example: the MEPS Data 214
16.2.1. Infinite mixture models: the negative binomial model 214
16.2.2. Finite mixture models: the mixed negative binomial model 218
16.2.3. Information criteria 219
Exercises 221
Chapter 17. Nonlinear least squares (NLS) 222

17.1. Introduction and definition 222
17.2. Identification 223
17.5. Example: The Poisson model for count data 225
17.6. The Gauss-Newton algorithm 226
17.7. Application: Limited dependent variables and sample selection 227
17.7.1. Example: Labor Supply 228
Chapter 18. Nonparametric inference 230

18.1. Possible pitfalls of parametric inference: estimation 230
18.2. Possible pitfalls of parametric inference: hypothesis testing 233
18.3. The Fourier functional form 234
18.3.1. Sobolev norm 237
18.3.2. Compactness 237
18.3.3. The estimation space and the estimation subspace 237
18.3.4. Denseness 238
18.3.5. Uniform convergence 239
18.3.6. Identification 239
18.3.7. Review of concepts 239
18.3.8. Discussion 240
18.4. Kernel regression estimators 240
18.4.1. Estimation of the denominator 241
18.4.2. Estimation of the numerator 243
18.4.3. Discussion 243
18.4.4. Choice of the window width: Cross-validation 244
18.5. Kernel density estimation 244
18.6. Semi-nonparametric maximum likelihood 244
18.7. Examples 247
18.7.1. Kernel regression estimation 247
CONTENTS 8
18.7.2. Seminonparametric ML estimation and the MEPS data 247
Chapter 19. Simulation-based estimation 250

19.1. Motivation 250
19.1.1. Example: Multinomial and/or dynamic discrete response models 250
19.1.2. Example: Marginalization of latent variables 252
19.1.3. Estimation of models specified in terms of stochastic differential equations 252
19.2. Simulated maximum likelihood (SML) 254
19.2.1. Example: multinomial probit 254
19.2.2. Properties 255
19.3. Method of simulated moments (MSM) 256
19.3.1. Properties 256
19.3.2. Comments 257
19.4. Efficient method of moments (EMM) 258
19.4.1. Optimal weighting matrix 259
19.4.2. Asymptotic distribution 260
19.4.3. Diagnotic testing 261
19.5. Examples 261
19.5.1. Estimation of stochastic differential equations 261
19.5.2. EMM estimation of a discrete choice model 262
Chapter 20. Parallel programming for econometrics 266

20.1. Example problems 267
20.1.1. Monte Carlo 267
20.1.2. ML 267
20.1.3. GMM 268
20.1.4. Kernel regression 269
Bibliography 271
Chapter 21. Final project: econometric estimation of a RBC model 272

21.1. Data 272
21.2. An RBC Model 273
21.3. A reduced form model 274
21.4. Results (I): The score generator 275
21.5. Solving the structural model 275
Bibliography 276
Chapter 22. Introduction to Octave 277

22.1. Getting started 277
22.2. A short introduction 277
22.3. If you’re running a Linux installation... 278
Chapter 23. Notation and Review 280

23.1. Notation for differentiation of vectors and matrices 280
CONTENTS 9
23.2. Convergenge modes 281

Real-valued sequences: 281
Deterministic real-valued functions 281
Stochastic sequences 281
Stochastic functions 282
23.3. Rates of convergence and asymptotic equality 283
Exercises 285
Chapter 24. The GPL 286
Chapter 25. The attic 292

25.1. Hurdle models 292
25.1.1. Finite mixture models 296
25.2. Models for time series data 299
25.2.1. Basic concepts 300
25.2.2. ARMA models 301
Bibliography 309
Index 310
List of Figures
1.2.1 LYX 14
1.2.2 Octave 15
3.2.1 Typical data, Classical Model 19

3.3.1 Example OLS Fit 21
3.3.2 The fit in observation space 21
3.4.1 Detection of influential observations 24
3.5.1 Uncentered R2 25
3.7.1 Unbiasedness of OLS under classical assumptions 28
3.7.2 Biasedness of OLS when an assumption fails 28
3.7.3 Gauss-Markov Result: The OLS estimator 30
3.7.4 Gauss-Markov Result: The split sample estimator 31
6.5.1 Joint and Individual Confidence Regions 62

6.8.1 RTS as a function of firm size 69
7.4.1 Residuals, Nerlove model, sorted by firm size 80

7.5.1 Autocorrelation induced by misspecification 83
7.5.2 Durbin-Watson critical values 91
7.6.1 Residuals of simple Nerlove model 93
7.6.2 OLS residuals, Klein consumption equation 94
9.1.1 s(β) when there is no collinearity 103

9.1.2 s(β) when there is collinearity 104
9.3.1 Sample selection bias 112
13.1.1 The search method 157

13.2.1 Increasing directions of search 158
13.2.2 Newton-Raphson method 160
13.2.3 Using MuPAD to get analytic derivatives 162
13.4.1 Life expectancy of mongooses, Weibull model 167
13.4.2 Life expectancy of mongooses, mixed Weibull model 168
10
LIST OF FIGURES 11
13.5.1 A foggy mountain 169
15.10.1 OLS 202

15.10.2 IV 203
18.1.1 True and simple approximating functions 231

18.1.2 True and approximating elasticities 232
18.1.3 True function and more flexible approximation 233
18.1.4 True elasticity and more flexible approximation 233
18.6.1 Negative binomial raw moments 246
18.7.1 Kernel fitted OBDV usage versus AGE 248
20.1.1 Speedups from parallelization 270
21.1.1 Consumption and Investment, Levels 272

21.1.2 Consumption and Investment, Growth Rates 272
21.1.3 Consumption and Investment, Bandpass Filtered 273
22.2.1 Running an Octave program 278

List of Tables
1 Marginal Variances, Sample and Estimated (Poisson) 214

2 Marginal Variances, Sample and Estimated (NB-II) 217
3 Information Criteria, OBDV 220
1 Actual and Poisson fitted frequencies 292

2 Actual and Hurdle Poisson fitted frequencies 296
12
CHAPTER 1
About this document
This document integrates lecture notes for a one year graduate level course with com-
puter programs that illustrate and apply the methods that are studied. The immediate avail-
ability of executable (and modifiable) example programs when using the PDF 1 version of
the document is one of the advantages of the system that has been used. On the other
hand, when viewed in printed form, the document is a somewhat terse approximation to a
textbook. These notes are not intended to be a perfect substitute for a printed textbook. If
you are a student of mine, please note that last sentence carefully. There are many good
textbooks available. A few of my favorites are listed in the bibliography.
With respect to contents, the emphasis is on estimation and inference within the world
of stationary data, with a bias toward microeconometrics. The second half is somewhat
more polished than the first half, since I have taught that course more often. If you take a
moment to read the licensing information in the next section, you’ll see that you are free to
copy and modify the document. If anyone would like to contribute material that expands
the contents, it would be very welcome. Error corrections and other additions are also
welcome. As an example of a project that has made use of these notes, see these very nice
lecture slides.
1.1. License
All materials are copyrighted by Michael Creel with the date that appears above. They
are provided under the terms of the GNU General Public License, which forms Section 24
of the notes. The main thing you need to know is that you are free to modify and distribute
these materials in any way you like, as long as you do so under the terms of the GPL. In
particular, you must make available the source files, in editable form, for your modified
version of the materials.
1.2. Obtaining the materials
The materials are available on my web page, in a variety of forms including PDF
and the editable sources, at pareto.uab.es/mcreel/Econometrics/. In addition to the final
product, which you’re looking at in some form now, you can obtain the editable sources,
which will allow you to create your own version, if you like, or send error corrections
and contributions. The main document was prepared using LYX (www.lyx.org) and Oc-
tave (www.octave.org). LYX is a free2 “what you see is what you mean” word processor,
basically working as a graphical frontend to LATEX. It (with help from other applications)
1It is possible to have the program links open up in an editor, ready to run using keyboard macros. To do this with
the PDF version you need to do some setup work. See the bootable CD described below.
2”Free” is used in the sense of ”freedom”, but L X is also free of charge.
Y
13
1.3. AN EASY WAY TO USE LYX AND OCTAVE TODAY 14
F IGURE 1.2.1. LYX
can export your work in LATEX, HTML, PDF and several other forms. It will run on Linux,
Windows, and MacOS systems. Figure 1.2.1 shows LYX editing this document.
GNU Octave has been used for the example programs, which are scattered though
the document. This choice is motivated by two factors. The first is the high quality of
the Octave environment for doing applied econometrics. The fundamental tools exist and
are implemented in a way that make extending them fairly easy. The example programs
included here may convince you of this point. Secondly, Octave’s licensing philosophy
fits in with the goals of this project. Thirdly, it runs on Linux, Windows and MacOS.
Figure 1.2.2 shows an Octave program being edited by NEdit, and the result of running the
program in a shell window.
1.3. An easy way to use LYX and Octave today
The example programs are available as links to files on my web page in the PDF
version, and here. Support files needed to run these are available here. The files won’t
run properly from your browser, since there are dependencies between files - they are only
illustrative when browsing. To see how to use these files (edit and run them), you should
go to the home page of this document, since you will probably want to download the pdf
version together with all the support files and examples. Then set the base URL of the
1.4. KNOWN BUGS 15
F IGURE 1.2.2. Octave
PDF file to point to wherever the Octave files are installed. All of this may sound a bit
complicated, because it is. An easier solution is available:
The file pareto.uab.es/mcreel/Econometrics/econometrics.iso distribution of Linux is
an ISO image file that may be burnt to CDROM. It contains a bootable-from-CD Gnu/Linux
system that has all of the tools needed to edit this document, run the Octave example pro-
grams, etcetera. In particular, it will allow you to cut out small portions of the notes and
edit them, and send them to me as LYX (or TEX) files for inclusion in future versions. Think
error corrections, additions, etc.! The CD automatically detects the hardware of your com-
puter, and will not touch your hard disk unless you explicitly tell it to do so. It is based upon
the ParallelKnoppix GNU/Linux distribution. The reason why these notes are integrated
into a Linux distribution for parallel computing will be apparent if you get to Chapter 20.
1.4. Known Bugs
This section is a reminder to myself to try to fix a few things.

• The PDF version has hyperlinks to figures that jump to the wrong figure. The
numbers are correct, but the links are not. ps2pdf bugs?
CHAPTER 2
Introduction: Economic and econometric models
Economic theory tells us that the demand function for a good is something like:
x = x(p, m, z)
• x is the quantity demanded

• p is G × 1 vector of prices of the good and its substitutes and complements
• m is income
• z is a vector of other variables such as individual characteristics that affect pref-
erences
Suppose we have a sample consisting of one observation on n individuals’ demands at time
period t (this is a cross section, where i = 1, 2, ..., n indexes the individuals in the sample).
The individual demand functions are
xi = xi (pi , mi , zi )
The model is not estimable as it stands, since:

• The form of the demand function is different for all i.
• Some components of zi may not be observable to an outside modeler. For ex-
ample, people don’t eat the same lunch every day, and you can’t tell what they
will order just by looking at them. Suppose we can break zi into the observable
components wi and a single unobservable component εi .
A step toward an estimable econometric model is to suppose that the model may be written
as
xi = β1 + p0i β p + mi βm + w0i βw + εi
We have imposed a number of restrictions on the theoretical model:
• The functions xi (·) which in principle may differ for all i have been restricted to
all belong to the same parametric family.
• Of all parametric families of functions, we have restricted the model to the class
of linear in the variables functions.
• The parameters are constant across individuals.
• There is a single unobservable component, and we assume it is additive.
If we assume nothing about the error term ε, we can always write the last equation. But
in order for the β coefficients to have an economic meaning, and in order to be able to
estimate them from sample data, we need to make additional assumptions. These additional
assumptions have no theoretical basis, they are assumptions on top of those needed to
prove the existence of a demand function. The validity of any results we obtain using
this model will be contingent on these additional restrictions being at least approximately
16
2. INTRODUCTION: ECONOMIC AND ECONOMETRIC MODELS 17
correct. For this reason, specification testing will be needed, to check that the model seems
to be reasonable. Only when we are convinced that the model is at least approximately
correct should we use it for economic analysis.
When testing a hypothesis using an econometric model, three factors can cause a sta-
tistical test to reject the null hypothesis:
(1) the hypothesis is false
(2) a type I error has occured
(3) the econometric model is not correctly specified so the test does not have the
assumed distribution
We would like to ensure that the third reason is not contributing to rejections, so that rejec-
tion will be due to either the first or second reasons. Hopefully the above example makes
it clear that there are many possible sources of misspecification of econometric models. In
the next few sections we will obtain results supposing that the econometric model is en-
tirely correctly specified. Later we will examine the consequences of misspecification and
see some methods for determining if a model is correctly specified. Later on, econometric
methods that seek to minimize maintained assumptions are introduced.
CHAPTER 3
Ordinary Least Squares
3.1. The Linear Model
Consider approximating a variable y using the variables x1 , x2 , ..., xk . We can consider

a model that is a linear approximation:
Linearity: the model is a linear function of the parameter vector β0 :
y = β01 x1 + β02 x2 + ... + β0k xk + ε
or, using vector notation:

y = x 0 β0 + ε
0
The dependent variable y is a scalar random variable, x = ( x1 x2 ··· xk ) is a k-
explanatory variables, and β0 . The superscript “0” in β0
0
vector of =( β01
··· β02 β0k )
means this is the ”true value” of the unknown parameter. It will be defined more precisely
later, and usually suppressed when it’s not necessary for clarity.
Suppose that we want to use data to try to determine the best linear approximation
to y using the variables x. The data {(yt , xt )} ,t = 1, 2, ..., n are obtained by some form of
sampling1. An individual observation is
yt = xt0 β + εt
The n observations can be written in matrix form as
(3.1.1) y = Xβ + ε,
0 0
where y = y1 y2 · · · yn is n × 1 and X = x1 x2 · · · xn .
Linear models are more general than they might first appear, since one can employ
nonlinear transformations of the variables:
h i
ϕ0 (z) = ϕ1 (w) ϕ2 (w) · · · ϕ p (w) β + ε
where the φi () are known functions. Defining y = ϕ0 (z), x1 = ϕ1 (w), etc. leads to a model
in the form of equation 3.6.1. For example, the Cobb-Douglas model
β β
z = Aw2 2 w3 3 exp(ε)
can be transformed logarithmically to obtain
ln z = lnA + β2 ln w2 + β3 ln w3 + ε.
1For example, cross-sectional data may be obtained by random sampling. Time series data accumulate histori-
cally.
18
3.2. ESTIMATION BY LEAST SQUARES 19
F IGURE 3.2.1. Typical data, Classical Model

10
data
true regression line
-5
-10
-15
0 2 4 6 8 10 12 14 16 18 20
X
If we define y = ln z, β1 = ln A, etc., we can put the model in the form needed. The approx-
imation is linear in the parameters, but not necessarily linear in the variables.
3.2. Estimation by least squares
Figure 3.2.1, obtained by running TypicalData.m shows some data that follows the
linear model yt = β1 + β2 xt2 + εt . The green line is the ”true” regression line β1 + β2 xt2 ,
and the red crosses are the data points (xt2 , yt ), where εt is a random error that has mean
zero and is independent of xt2 . Exactly how the green line is defined will become clear
later. In practice, we only have the data, and we don’t know where the green line lies. We
need to gain information about the straight line that best fits the data points.
The ordinary least squares (OLS) estimator is defined as the value that minimizes the
sum of the squared errors:
β̂ = argmins(β)
where
n 2
s(β) = ∑ yt − xt0 β
t=1
= (y − Xβ)0 (y − Xβ)
= y0 y − 2y0Xβ + β0X0 Xβ
= k y − Xβ k2
This last expression makes it clear how the OLS estimator is defined: it minimizes the
Euclidean distance between y and Xβ. The fitted OLS coefficients are those that give the
3.3. GEOMETRIC INTERPRETATION OF LEAST SQUARES ESTIMATION 20
best linear approximation to y using x as basis functions, where ”best” means minimum
Euclidean distance. One could think of other estimators based upon other metrics. For
n
example, the minimum absolute distance (MAD) minimizes ∑t=1 |yt − xt0 β|. Later, we will
see that which estimator is best in terms of their statistical properties, rather than in terms
of the metrics that define them, depends upon the properties of ε, about which we have as
yet made no assumptions.
• To minimize the criterion s(β), find the derivative with respect to β and set it to
zero:
Dβ s(β) = −2X0 y + 2X0Xβ

Dβ s(β̂) = −2X0 y + 2X0Xβ̂ ≡ 0
so
β̂ = (X0 X)−1 X0 y.
• To verify that this is a minimum, check the second order sufficient condition:
D2β s(β̂) = 2X0 X
Since ρ(X) = K, this matrix is positive definite, since it’s a quadratic form in a
p.d. matrix (identity matrix of order n), so β̂ is in fact a minimizer.
• The fitted values are the vector ŷ = Xβ̂.
• The residuals are the vector ε̂ = y − Xβ̂
• Note that
y = Xβ + ε
= Xβ̂ + ε̂
• Also, the first order conditions can be written as
X0 y − X0Xβ̂ = 0

X0 y − Xβ̂ = 0
X0 ε̂ = 0
which is to say, the OLS residuals are orthogonal to X. Let’s look at this more
carefully.
3.3. Geometric interpretation of least squares estimation
3.3.1. In X,Y Space. Figure 3.3.1 shows a typical fit to data, along with the true
regression line. Note that the true line and the estimated line are different. This figure was
created by running the Octave program OlsFit.m . You can experiment with changing the
parameter values to see how this affects the fit, and to see how the fitted line will sometimes
be close to the true line, and sometimes rather far away.
3.3.2. In Observation Space. If we want to plot in observation space, we’ll need to

use only two or three observations, or we’ll encounter some limitations of the blackboard.
Let’s use two. With only two observations, we can’t have K > 1.
3.3. GEOMETRIC INTERPRETATION OF LEAST SQUARES ESTIMATION 21
F IGURE 3.3.1. Example OLS Fit

15
data points
fitted line
true line
10
-5
-10
-15
0 2 4 6 8 10 12 14 16 18 20
X
F IGURE 3.3.2. The fit in observation space
Observation 2
e = M_xY S(x)
x*beta=P_xY
Observation 1
• We can decompose y into two components: the orthogonal projection onto the
K−dimensional space spanned by X, X β̂, and the component that is the orthogo-
nal projection onto the n − K subpace that is orthogonal to the span of X, ε̂.
3.4. INFLUENTIAL OBSERVATIONS AND OUTLIERS 22
• Since β̂ is chosen to make ε̂ as short as possible, ε̂ will be orthogonal to the space

spanned by X. Since X is in this space, X 0 ε̂ = 0. Note that the f.o.c. that define
the least squares estimator imply that this is so.
3.3.3. Projection Matrices. X β̂ is the projection of y onto the span of X, or

−1 0
X β̂ = X X 0 X Xy
Therefore, the matrix that projects y onto the span of X is
PX = X(X 0 X)−1 X 0
since
X β̂ = PX y.
ε̂ is the projection of y onto the N − K dimensional space that is orthogonal to the span
of X. We have that
ε̂ = y − X β̂
= y − X(X 0X)−1 X 0 y

= In − X(X 0X)−1 X 0 y.
So the matrix that projects y onto the space orthogonal to the span of X is
MX = In − X(X 0X)−1 X 0
= In − PX .
We have
ε̂ = MX y.
Therefore
y = PX y + MX y
= X β̂ + ε̂.
These two projection matrices decompose the n dimensional vector y into two orthogonal
components - the portion that lies in the K dimensional space defined by X, and the portion
that lies in the orthogonal n − K dimensional space.
• Note that both PX and MX are symmetric and idempotent.

– A symmetric matrix A is one such that A = A0 .
– An idempotent matrix A is one such that A = AA.
– The only nonsingular idempotent matrix is the identity matrix.
3.4. Influential observations and outliers
The OLS estimator of the ith element of the vector β0 is simply

β̂i = (X 0 X)−1 X 0 i· y
= c0i y
3.4. INFLUENTIAL OBSERVATIONS AND OUTLIERS 23
This is how we define a linear estimator - it’s a linear function of the dependent vari-
able. Since it’s a linear combination of the observations on the dependent variable, where
the weights are detemined by the observations on the regressors, some observations may
have more influence than others.
To investigate this, let et be an n vector of zeros with a 1 in the tth position, i.e., it’s the
tth column of the matrix In . Define
ht = (PX )tt
= et0 PX et
so ht is the tth element on the main diagonal of PX . Note that
ht = k PX et k2
so
ht ≤k et k2 = 1
So 0 < ht < 1. Also,
TrPX = K ⇒ h = K/n.
So the average of the ht is K/n. The value ht is referred to as the leverage of the observation.
If the leverage is much higher than average, the observation has the potential to affect the
OLS fit importantly. However, an observation may also be influential due to the value of
yt , rather than the weight it is multiplied by, which only depends on the xt ’s.
To account for this, consider estimation of β without using the t th observation (des-
ignate this estimator as β̂(t) ). One can show (see Davidson and MacKinnon, pp. 32-5 for
proof) that
1
β̂ (t)
= β̂ − (X 0 X)−1 Xt0 ε̂t
1 − ht
so the change in the t th observations fitted value is

ht
xt0 β̂ − xt0 β̂(t) = ε̂t
1 − ht
While an observation may be influential if it doesn’t affect its own fitted value, it certainly
is
ht
influential if it does. A fast means of identifying influential observations is to plot 1−h t
ε̂t
(which I will refer to as the own influence of the observation) as a function of t. Figure
3.4.1 gives an example plot of data, fit, leverage and influence. The Octave program is
InfluentialObservation.m . If you re-run the program you will see that the leverage of the
last observation (an outlying value of x) is always high, and the influence is sometimes
high.
After influential observations are detected, one needs to determine why they are influ-
ential. Possible causes include:
• data entry error, which can easily be corrected once detected. Data entry errors
are very common.
• special economic factors that affect some observations. These would need to
be identified and incorporated in the model. This is the idea behind structural
change: the parameters may not be constant across all observations.
3.5. GOODNESS OF FIT 24
F IGURE 3.4.1. Detection of influential observations

14
Data points
fitted
Leverage
12 Influence
10
-2
0 0.5 1 1.5 2 2.5 3
X
• pure randomness may have caused us to sample a low-probability observation.

There exist robust estimation methods that downweight outliers.
3.5. Goodness of fit
The fitted model is

y = X β̂ + ε̂
Take the inner product:
y0 y = β̂0 X 0 X β̂ + 2β̂0X 0 ε̂ + ε̂0 ε̂

But the middle term of the RHS is zero since X 0 ε̂ = 0, so
(3.5.1) y0 y = β̂0 X 0 X β̂ + ε̂0 ε̂
The uncentered R2u is defined as

ε̂0 ε̂
R2u = 1−
y0 y
β̂0 X 0 X β̂
=
y0 y
k PX y k2
=
k y k2
= cos2 (φ),
where φ is the angle between y and the span of X .

• The uncentered R2 changes if we add a constant to y, since this changes φ (see
Figure 3.5.1, the yellow vector is a constant, since it’s on the 45 degree line in
3.5. GOODNESS OF FIT 25
observation space). Another, more common definition measures the contribution
F IGURE 3.5.1. Uncentered R2
of the variables, other than the constant term, to explaining the variation in y.
Thus it measures the ability of the model to explain the variation of y about its
unconditional sample mean.
Let ι = (1, 1, ..., 1)0 , a n -vector. So
Mι = In − ι(ι0 ι)−1 ι0
= In − ιι0 /n
Mι y just returns the vector of deviations from the mean. In terms of deviations from the
mean, equation 3.5.1 becomes
y0 Mι y = β̂0 X 0 Mι X β̂ + ε̂0 Mι ε̂
The centered R2c is defined as

ε̂0 ε̂ ESS
R2c = 1 − = 1−
y Mι y
0 T SS
n
where ESS = ε̂0 ε̂ and T SS = y0 Mι y=∑t=1 (yt − ȳ)2 .
Supposing that X contains a column of ones (i.e., there is a constant term),
X 0 ε̂ = 0 ⇒ ∑ ε̂t = 0
t
3.6. THE CLASSICAL LINEAR REGRESSION MODEL 26
so Mι ε̂ = ε̂. In this case

y0 Mι y = β̂0 X 0 Mι X β̂ + ε̂0 ε̂
So
RSS
R2c =
T SS
where RSS = β̂0 X 0 Mι X β̂
• Supposing that a column of ones is in the space spanned by X (PX ι = ι), then one
can show that 0 ≤ R2c ≤ 1.
3.6. The classical linear regression model
Up to this point the model is empty of content beyond the definition of a best linear
approximation to y and some geometrical properties. There is no economic content to the
model, and the regression parameters have no economic interpretation. For example, what
is the partial derivative of y with respect to x j ? The linear approximation is
y = β1 x1 + β2 x2 + ... + βk xk + ε
The partial derivative is

∂y ∂ε
= βj +
∂x j ∂x j
∂ε
Up to now, there’s no guarantee that ∂x j
=0. For the β to have an economic meaning, we
need to make additional assumptions. The assumptions that are appropriate to make depend
on the data under consideration. We’ll start with the classical linear regression model,
which incorporates some assumptions that are clearly not realistic for economic data. This
is to be able to explain some concepts with a minimum of confusion and notational clutter.
Later we’ll adapt the results to what we can get with more realistic assumptions.
(3.6.1) y = β01 x1 + β02 x2 + ... + β0k xk + ε
or, using vector notation:

y = x 0 β0 + ε
Nonstochastic linearly independent regressors: X is a fixed matrix of constants, it
has rank K, its number of columns, and
1
(3.6.2) lim X0 X = QX
n
where QX is a finite positive definite matrix. This is needed to be able to identify the
individual effects of the explanatory variables.
Independently and identically distributed errors:
(3.6.3) ε ∼ IID(0, σ2 In )
ε is jointly distributed IID. This implies the following two properties:

Homoscedastic errors:
(3.6.4) V (εt ) = σ20 , ∀t

3.7. SMALL SAMPLE STATISTICAL PROPERTIES OF THE LEAST SQUARES ESTIMATOR 27
Nonautocorrelated errors:
(3.6.5) E (εt εs ) = 0, ∀t 6= s
Optionally, we will sometimes assume that the errors are normally distributed.
Normally distributed errors:
(3.6.6) ε ∼ N(0, σ2 In )
3.7. Small sample statistical properties of the least squares estimator
Up to now, we have only examined numeric properties of the OLS estimator, that
always hold. Now we will examine statistical properties. The statistical properties depend
upon the assumptions we make.
3.7.1. Unbiasedness. We have β̂ = (X 0 X)−1 X 0 y. By linearity,
β̂ = (X 0 X)−1 X 0 (Xβ + ε)
= β + (X 0X)−1 X 0 ε
By 3.6.2 and 3.6.3
E(X 0 X)−1 X 0 ε = E(X 0 X)−1 X 0 ε

= (X 0 X)−1 X 0 Eε
= 0
so the OLS estimator is unbiased under the assumptions of the classical model.
Figure 3.7.1 shows the results of a small Monte Carlo experiment where the OLS
estimator was calculated for 10000 samples from the classical model with y = 1 + 2x + ε,
where n = 20, σ2ε = 9, and x is fixed across samples. We can see that the β2 appears to be
estimated without bias. The program that generates the plot is Unbiased.m , if you would
like to experiment with this.
With time series data, the OLS estimator will often be biased. Figure 3.7.2 shows the
results of a small Monte Carlo experiment where the OLS estimator was calculated for
1000 samples from the AR(1) model with yt = 0 + 0.9yt−1 + εt , where n = 20 and σ2ε = 1.
In this case, assumption 3.6.2 does not hold: the regressors are stochastic. We can see that
the bias in the estimation of β2 is about -0.2.
The program that generates the plot is Biased.m , if you would like to experiment with
this.
3.7.2. Normality. With the linearity assumption, we have β̂ = β + (X 0X)−1 X 0 ε. This

is a linear function of ε. Adding the assumption of normality (3.6.6, which implies strong
exogeneity), then

β̂ ∼ N β, (X 0 X)−1 σ20
since a linear function of a normal random vector is also normally distributed. In Figure
3.7.1 you can see that the estimator appears to be normally distributed. It in fact is normally
F IGURE 3.7.1. Unbiasedness of OLS under classical assumptions

Beta hat - Beta true
0.12
0.1
0.08
0.06
0.04
0.02
0
-3 -2 -1 0 1 2 3
F IGURE 3.7.2. Biasedness of OLS when an assumption fails

Beta hat - Beta true
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
-1.2 -1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4
distributed, since the DGP (see the Octave program) has normal errors. Even when the
data may be taken to be IID, the assumption of normality is often questionable or simply
untenable. For example, if the dependent variable is the number of automobile trips per
week, it is a count variable with a discrete distribution, and is thus not normally distributed.
Many variables in economics can take on only nonnegative values, which, strictly speaking,
rules out normality.2
3.7.3. The variance of the OLS estimator and the Gauss-Markov theorem. Now
let’s make all the classical assumptions except the assumption of normality. We have β̂ =
β + (X 0X)−1 X 0 ε and we know that E(β̂) = β. So
0
Var(β̂) = E β̂ − β β̂ − β

= E (X 0 X)−1 X 0 εε0 X(X 0 X)−1
= (X 0 X)−1 σ20
The OLS estimator is a linear estimator, which means that it is a linear function of the
dependent variable, y.

β̂ = (X 0 X)−1 X 0 y
= Cy
where C is a function of the explanatory variables only, not the dependent variable. It is
also unbiased under the present assumptions, as we proved above. One could consider
other weights W that are a function of X that define some other linear estimator. We’ll
still insist upon unbiasedness. Consider β̃ = Wy, where W = W (X) is some k × n matrix
function of X. Note that since W is a function of X, it is nonstochastic, too. If the estimator
is unbiased, then we must have W X = IK :
E (Wy) = E (W Xβ0 +W ε)
= W Xβ0
= β0
⇒
WX = IK
The variance of β̃ is
V (β̃) = WW 0 σ20 .
Define
D = W − (X 0 X)−1 X 0
so
W = D + (X 0 X)−1 X 0
Since W X = IK , DX = 0, so
0
V (β̃) = D + (X 0 X)−1 X 0 D + (X 0X)−1 X 0 σ20
−1 2
= DD0 + X 0 X σ0
So
V (β̃) ≥ V (β̂)
2Normality may be a good model nonetheless, as long as the probability of a negative value occuring is negligable
under the model. This depends upon the mean being large enough in relation to the variance.
F IGURE 3.7.3. Gauss-Markov Result: The OLS estimator

Beta 2 hat, OLS
0.1
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
0 0.5 1 1.5 2 2.5 3 3.5 4
The inequality is a shorthand means of expressing, more formally, that V ( β̃) − V (β̂) is a
positive semi-definite matrix. This is a proof of the Gauss-Markov Theorem. The OLS
estimator is the ”best linear unbiased estimator” (BLUE).
• It is worth emphasizing again that we have not used the normality assumption in
any way to prove the Gauss-Markov theorem, so it is valid if the errors are not
normally distributed, as long as the other assumptions hold.
To illustrate the Gauss-Markov result, consider the estimator that results from splitting the
sample into p equally-sized parts, estimating using each part of the data separately by OLS,
then averaging the p resulting estimators. You should be able to show that this estimator is
unbiased, but inefficient with respect to the OLS estimator. The program Efficiency.m illus-
trates this using a small Monte Carlo experiment, which compares the OLS estimator and
a 3-way split sample estimator. The data generating process follows the classical model,
with n = 21. The true parameter value is β = 2. In Figures 3.7.3 and 3.7.4 we can see that
the OLS estimator is more efficient, since the tails of its histogram are more narrow.
0 −1
We have that E(β̂) = β and Var(β̂) = X X σ20 , but we still need to estimate the
variance of ε, σ20 , in order to have an idea of the precision of the estimates of β. A com-
monly used estimator of σ20 is
c2 = 1 0
σ 0 ε̂ ε̂
n−K
This estimator is unbiased:
3.8. EXAMPLE: THE NERLOVE MODEL 31
F IGURE 3.7.4. Gauss-Markov Result: The split sample estimator

Beta 2 hat, Split Sample Estimator
0.12
0.1
0.08
0.06
0.04
0.02
0
0 0.5 1 1.5 2 2.5 3 3.5 4
c2 1 0
σ 0 = ε̂ ε̂
n−K
1 0
= ε Mε
n−K
c2 ) 1
E (σ 0 = E(Trε0 Mε)
n−K
1
= E(TrMεε0 )
n−K
1
= TrE(Mεε0 )
n−K
1
= σ2 TrM
n−K 0
1
= σ2 (n − k)
n−K 0
= σ20
where we use the fact that Tr(AB) = Tr(BA) when both products are conformable. Thus,
this estimator is also unbiased under these assumptions.
3.8. Example: The Nerlove model
3.8.1. Theoretical background. For a firm that takes input prices w and the output
level q as given, the cost minimization problem is to choose the quantities of inputs x to
solve the problem
min w0 x
x
subject to the restriction
f (x) = q.
The solution is the vector of factor demands x(w, q). The cost function is obtained by
substituting the factor demands into the criterion function:
Cw, q) = w0 x(w, q).
• Monotonicity Increasing factor prices cannot decrease cost, so

∂C(w, q)
≥0
∂w
Remember that these derivatives give the conditional factor demands (Shephard’s
Lemma).
• Homogeneity The cost function is homogeneous of degree 1 in input prices:
C(tw, q) = tC(w, q) where t is a scalar constant. This is because the factor de-
mands are homogeneous of degree zero in factor prices - they only depend upon
relative prices.
• Returns to scale The returns to scale parameter γ is defined as the inverse of the
elasticity of cost with respect to output:
−1
∂C(w, q) q
γ=
∂q C(w, q)
Constant returns to scale is the case where increasing production q implies that
cost increases in the proportion 1:1. If this is the case, then γ = 1.
3.8.2. Cobb-Douglas functional form. The Cobb-Douglas functional form is linear

in the logarithms of the regressors and the dependent variable. For a cost function, if there
are g factors, the Cobb-Douglas cost function has the form
β β
C = Aw1 1 ...wg g qβq eε
What is the elasticity of C with respect to w j ?

C ∂C w j
ew j =
∂WJ C
β β −1 β wj
= β j Aw1 1 .w j j ..wg g qβq eε β
β1
Aw1 ...wg g qβq eε
= βj
This is one of the reasons the Cobb-Douglas form is popular - the coefficients are easy
to interpret, since they are the elasticities of the dependent variable with respect to the
explanatory variable. Not that in this case,

∂C wj
eCw j =
∂WJ C
wj
= x j (w, q)
C
≡ s j (w, q)
the cost share of the jth input. So with a Cobb-Douglas cost function, β j = s j (w, q). The
cost shares are constants.
Note that after a logarithmic transformation we obtain
lnC = α + β1 ln w1 + ... + βg lnwg + βq ln q + ε
where α = ln A . So we see that the transformed model is linear in the logs of the data.
One can verify that the property of HOD1 implies that
g
∑ βg = 1
i=1
In other words, the cost shares add up to 1.

The hypothesis that the technology exhibits CRTS implies that
1
γ= =1
βq
so βq = 1. Likewise, monotonicity implies that the coefficients βi ≥ 0, i = 1, ..., g.
3.8.3. The Nerlove data and OLS. The file nerlove.data contains data on 145 electric
utility companies’ cost of production, output and input prices. The data are for the U.S.,
and were collected by M. Nerlove. The observations are by row, and the columns are
COMPANY, COST (C), OUTPUT (Q), PRICE OF LABOR (PL ), PRICE OF FUEL
(PF ) and PRICE OF CAPITAL (PK ). Note that the data are sorted by output level (the
third column).
We will estimate the Cobb-Douglas model
(3.8.1) lnC = β1 + β2 ln Q + β3 ln PL + β4 ln PF + β5 ln PK + ε
using OLS. To do this yourself, you need the data file mentioned above, as well as Nerlove.m (the estimation program)
, and the library of Octave functions mentioned in the introduction to Octave that forms sec-
tion 22 of this document.3
The results are
*********************************************************
OLS estimation results
Observations 145
R-squared 0.925955
Sigma-squared 0.153943
Results (Ordinary var-cov estimator)
estimate st.err. t-stat. p-value

3If you are running the bootable CD, you have all of this installed and ready to run.
constant -3.527 1.774 -1.987 0.049

output 0.720 0.017 41.244 0.000
labor 0.436 0.291 1.499 0.136
fuel 0.427 0.100 4.249 0.000
capital -0.220 0.339 -0.648 0.518
*********************************************************
• Do the theoretical restrictions hold?

• Does the model fit well?
• What do you think about RTS?
While we will use Octave programs as examples in this document, since following the
programming statements is a useful way of learning how theory is put into practice, you
may be interested in a more ”user-friendly” environment for doing econometrics. I heartily
recommend Gretl, the Gnu Regression, Econometrics, and Time-Series Library. This is an
easy to use program, available in English, French, and Spanish, and it comes with a lot of
data ready to use. It even has an option to save output as LATEX fragments, so that I can just
include the results into this document, no muss, no fuss. Here the results of the Nerlove
model from GRETL:
Model 2: OLS estimates using the 145 observations 1–145
Dependent variable: l_cost
Variable Coefficient Std. Error t-statistic p-value

const −3.5265 1.77437 −1.9875 0.0488
l_output 0.720394 0.0174664 41.2445 0.0000
l_labor 0.436341 0.291048 1.4992 0.1361
l_fuel 0.426517 0.100369 4.2495 0.0000
l_capita −0.219888 0.339429 −0.6478 0.5182
Mean of dependent variable 1.72466

S.D. of dependent variable 1.42172
Sum of squared residuals 21.5520
Standard error of residuals (σ̂) 0.392356
Unadjusted R2 0.925955
Adjusted R̄2 0.923840
F(4, 140) 437.686
Akaike information criterion 145.084
Schwarz Bayesian criterion 159.967
Fortunately, Gretl and my OLS program agree upon the results. Gretl is included in the
bootable CD mentioned in the introduction. I recommend using GRETL to repeat the
examples that are done using Octave.
The previous properties hold for finite sample sizes. Before considering the asymptotic
properties of the OLS estimator it is useful to review the MLE estimator, since under the
assumption of normal errors the two estimators coincide.
EXERCISES 35
Exercises
(1) Prove that the split sample estimator used to generate figure 3.7.4 is unbiased.
(2) Calculate the OLS estimates of the Nerlove model using Octave and GRETL, and
provide printouts of the results. Interpret the results.
(3) Do an analysis of whether or not there are influential observations for OLS estimation
of the Nerlove model. Discuss.
(4) Using GRETL, examine the residuals after OLS estimation and tell me whether or not
you believe that the assumption of independent identically distributed normal errors is
warranted. No need to do formal tests, just look at the plots. Print out any that you
think are relevant, and interpret them.
(5) For a random vector X ∼ N(µx , Σ), what is the distribution of AX + b, where A and b
are conformable matrices of contants?
(6) Using Octave, write a little program that verifies that Tr(AB) = Tr(BA) for A and B
4x4 matrices of random numbers. Note: there is an Octave function trace.
(7) For the model with a constant and a single regressor, yt = β1 + β2 xt + εt , which satisfies
the classical assumptions, prove that the variance of the OLS estimator declines to zero
as the sample size increases.
CHAPTER 4
Maximum likelihood estimation
The maximum likelihood estimator is important since it is asymptotically efficient,

as is shown below. For the classical linear model with normal errors, the ML and OLS
estimators of β are the same, so the following theory is presented without examples. In
the second half of the course, nonlinear models with nonnormal errors are introduced, and
examples may be found there.
4.1. The likelihood function
Suppose we
have a sampleof size n of
the random vectors
y and z. Suppose the joint
density of Y = y1 ... yn and Z = z1 . . . zn is characterized by a parameter
vector ψ0 :
fY Z (Y, Z, ψ0 ).
This is the joint density of the sample. This density can be factored as
fY Z (Y, Z, ψ0 ) = fY |Z (Y |Z, θ0 ) fZ (Z, ρ0 )
The likelihood function is just this density evaluated at other values ψ
L(Y, Z, ψ) = f (Y, Z, ψ), ψ ∈ Ψ,
where Ψ is a parameter space.

The maximum likelihood estimator of ψ0 is the value of ψ that maximizes the likeli-
hood function.
Note that if θ0 and ρ0 share no elements, then the maximizer of the conditional like-
lihood function fY |Z (Y |Z, θ) with respect to θ is the same as the maximizer of the overall
likelihood function fY Z (Y, Z, ψ) = fY |Z (Y |Z, θ) fZ (Z, ρ), for the elements of ψ that corre-
spond to θ. In this case, the variables Z are said to be exogenous for estimation of θ, and
we may more conveniently work with the conditional likelihood function fY |Z (Y |Z, θ) for
the purposes of estimating θ0 .
D EFINITION 4.1.1. The maximum likelihood estimator of θ0 = argmax fY |Z (Y |Z, θ)
• If the n observations are independent, the likelihood function can be written as

n
L(Y |Z, θ) = ∏ f (yt |zt , θ)
t=1
where the ft are possibly of different form.

• If this is not possible, we can always factor the likelihood into contributions of
observations, by using the fact that a joint density can be factored into the product
36
4.1. THE LIKELIHOOD FUNCTION 37
of a marginal and conditional (doing this iteratively)
L(Y, θ) = f (y1 |z1 , θ) f (y2 |y1 , z2 , θ) f (y3 |y1 , y2 , z3 , θ) · · · f (yn |y1, y2 , . . . yt−n , zn , θ)
To simplify notation, define
xt = {y1 , y2 , ..., yt−1 , zt }
so x1 = z1 , x2 = {y1 , z2 }, etc. - it contains exogenous and predetermined endogeous vari-

ables. Now the likelihood function can be written as
n
L(Y, θ) = ∏ f (yt |xt , θ)
t=1
The criterion function can be defined as the average log-likelihood function:

1 1 n
sn (θ) = ln L(Y, θ) = ∑ ln f (yt |xt , θ)
n n t=1
The maximum likelihood estimator may thus be defined equivalently as
θ̂ = argmaxsn (θ),
where the set maximized over is defined below. Since ln(·) is a monotonic increasing
function, ln L and L maximize at the same value of θ. Dividing by n has no effect on θ̂.
4.1.1. Example: Bernoulli trial. Suppose that we are flipping a coin that may be
biased, so that the probability of a heads may not be 0.5. Maybe we’re interested in es-
timating the probability of a heads. Let y = 1(heads) be a binary variable that indicates
whether or not a heads is observed. The outcome of a toss is a Bernoulli random variable:
y
fY (y, p0 ) = p0 (1 − p0)1−y , y ∈ {0, 1}
= 0, y ∈
/ {0, 1}
So a representative term that enters the likelihood function is
fY (y, p) = py (1 − p)1−y
and
ln fY (y, p) = y ln p + (1 − y)ln (1 − p)
The derivative of this is
∂ ln fY (y, p) y (1 − y)
= −
∂p p (1 − p)
y− p
=
p (1 − p)
Averaging this over a sample of size n gives
∂sn (p) 1 n yi − p
= ∑
∂p n i=1 p (1 − p)
Setting to zero and solving gives
p̂ = ȳ
So it’s easy to calculate the MLE of p0 in this case.
4.2. CONSISTENCY OF MLE 38
Now imagine that we had a bag full of bent coins, each bent around a sphere of a
different radius (with the head pointing to the outside of the sphere). We might suspect
that the probability of a heads could depend upon the radius. Suppose that p i ≡ p(xi , β) =
h i0
(1 + exp(−x0i β))−1 where xi = 1 ri , so that β is a 2×1 vector. Now
∂pi (β)
= pi (1 − pi) xi
∂β
so
∂ ln fY (y, β) y − pi
= pi (1 − pi) xi
∂β pi (1 − pi)
= (yi − p(xi , β)) xi
So the derivative of the average log lihelihood function is now

∂sn (β) ∑ni=1 (yi − p(xi , β)) xi
=
∂β n
This is a set of 2 nonlinear equations in the two unknown elements in β. There is no explicit
solution for the two elements that set the equations to zero. This is commonly with ML
estimators, they are often nonlinear, and finding their values often require use of numeric
methods to find solutions to the first order conditions.
4.2. Consistency of MLE
To show consistency of the MLE, we need to make explicit some assumptions.

Compact parameter space: θ ∈ Θ, an open bounded subset of ℜ K . Maximixa-
tion is over Θ, which is compact.
This implies that θ is an interior point of the parameter space Θ.
Uniform convergence:
u.a.s
sn (θ) → lim Eθ0 sn (θ) ≡ s∞ (θ, θ0 ), ∀θ ∈ Θ.
n→∞
We have suppressed Y here for simplicity. This requires that almost sure convergence
holds for all possible parameter values. For a given parameter value, an ordinary Law of
Large Numbers will usually imply almost sure convergence to the limit of the expectation.
Convergence for a single element of the parameter space, combined with the assumption
of a compact parameter space, ensures uniform convergence.
Continuity: sn (θ) is continuous in θ, θ ∈ Θ. This implies that s∞ (θ, θ0 ) is con-
tinuous in θ.
Identification: s∞ (θ, θ0 ) has a unique maximum in its first argument.
a.s.
We will use these assumptions to show that θˆn → θ0 .
First, θ̂n certainly exists, since a continuous function has a maximum on a compact set.
Second, for any θ 6= θ0

L(θ) L(θ)
E ln ≤ ln E
L(θ0 ) L(θ0 )
4.3. THE SCORE FUNCTION 39
by Jensen’s inequality ( ln (·) is a concave function).

Now, the expectation on the RHS is
Z
L(θ) L(θ)
E = L(θ0 )dy = 1,
L(θ0 ) L(θ0 )
since L(θ0 ) is the density function of the observations, and since the integral of any density
is 1. Therefore, since ln(1) = 0,

L(θ)
E ln ≤ 0,
L(θ0 )
or
E (sn (θ)) − E (sn (θ0 )) ≤ 0.
Taking limits, this is (by the assumption on uniform convergence)
s∞ (θ, θ0 ) − s∞ (θ0 , θ0 ) ≤ 0
except on a set of zero probability.

By the identification assumption there is a unique maximizer, so the inequality is strict
if θ 6= θ0 :
s∞ (θ, θ0 ) − s∞ (θ0 , θ0 ) < 0, ∀θ 6= θ0 , a.s.
Suppose that θ∗ is a limit point of θ̂n (any sequence from a compact set has at least one
limit point). Since θ̂n is a maximizer, independent of n, we must have
s∞ (θ∗ , θ0 ) − s∞ (θ0 , θ0 ) ≥ 0.
These last two inequalities imply that
θ∗ = θ0 , a.s.
Thus there is only one limit point, and it is equal to the true parameter value, with proba-
bility one. In other words,
lim θ̂ = θ0 , a.s.
n→∞
This completes the proof of strong consistency of the MLE. One can use weaker assump-
tions to prove weak consistency (convergence in probability to θ 0 ) of the MLE. This is
omitted here. Note that almost sure convergence implies convergence in probability.
4.3. The score function
Differentiability: Assume that sn (θ) is twice continuously differentiable in a

neighborhood N(θ0 ) of θ0 , at least when n is large enough.
To maximize the log-likelihood function, take derivatives:
gn (Y, θ) = Dθ sn (θ)
1 n
= ∑ Dθ ln f (yt |xx , θ)
n t=1
1 n
≡ ∑ gt (θ).
n t=1
4.4. ASYMPTOTIC NORMALITY OF MLE 40
This is the score vector (with dim K ×1). Note that the score function has Y as an argument,
which implies that it is a random function. Y (and any exogeneous variables) will often be
suppressed for clarity, but one should not forget that they are still there.
The ML estimator θ̂ sets the derivatives to zero:
1 n
gn (θ̂) = ∑ gt (θ̂) ≡ 0.
n t=1
We will show that Eθ [gt (θ)] = 0, ∀t. This is the expectation taken with respect to the
density f (θ), not necessarily f (θ0 ) .
Z
Eθ [gt (θ)] = [Dθ ln f (yt |xt , θ)] f (yt |x, θ)dyt
1
Z
= [Dθ f (yt |xt , θ)] f (yt |xt , θ)dyt
f (yt |xt , θ)
Z
= Dθ f (yt |xt , θ)dyt .
Given some regularity conditions on boundedness of Dθ f , we can switch the order of inte-
gration and differentiation, by the dominated convergence theorem. This gives
Z
Eθ [gt (θ)] = Dθ f (yt |xt , θ)dyt
= Dθ 1
= 0
where we use the fact that the integral of the density is 1.
• So Eθ (gt (θ) = 0 : the expectation of the score vector is zero.

• This hold for all t, so it implies that Eθ gn (Y, θ) = 0.
4.4. Asymptotic normality of MLE
Recall that we assume that sn (θ) is twice continuously differentiable. Take a first order
Taylor’s series expansion of g(Y, θ̂) about the true value θ0 :

0 ≡ g(θ̂) = g(θ0 ) + (Dθ0 g(θ∗ )) θ̂ − θ0
or with appropriate definitions

H(θ∗ ) θ̂ − θ0 = −g(θ0 ),
where θ∗ = λθ̂ + (1 − λ)θ0, 0 < λ < 1. Assume H(θ∗ ) is invertible (we’ll justify this in a
minute). So
√ √
n θ̂ − θ0 = −H(θ∗ )−1 ng(θ0 )
Now consider H(θ∗ ). This is
H(θ∗ ) = Dθ0 g(θ∗ )

= D2θ sn (θ∗ )
1 n 2
= ∑ Dθ ln ft (θ∗ )
n t=1
where the notation

∂2 sn (θ)
D2θ sn (θ) ≡ .
∂θ∂θ0
Given that this is an average of terms, it should usually be the case that this satisfies a
strong law of large numbers (SLLN). Regularity conditions are a set of assumptions that
guarantee that this will happen. There are different sets of assumptions that can be used to
justify appeal to different SLLN’s. For example, the D2θ ln ft (θ∗ ) must not be too strongly
dependent over time, and their variances must not become infinite. We don’t assume any
particular set here, since the appropriate assumptions will depend upon the particularities
of a given model. However, we assume that a SLLN applies.
Also, since we know that θ̂ is consistent, and since θ∗ = λθ̂ + (1 − λ)θ0 , we have that
a.s.
θ∗ → θ0 . Also, by the above differentiability assumtion, H(θ) is continuous in θ. Given
this, H(θ∗ ) converges to the limit of it’s expectation:
a.s.
H(θ∗ ) → lim E D2θ sn (θ0 ) = H∞ (θ0 ) < ∞
n→∞
This matrix converges to a finite limit.

Re-arranging orders of limits and differentiation, which is legitimate given regularity
conditions, we get
H∞ (θ0 ) = D2θ lim E (sn (θ0 ))

n→∞
2
= Dθ s∞ (θ0 , θ0 )
We’ve already seen that

s∞ (θ, θ0 ) < s∞ (θ0 , θ0 )
i.e., θ0 maximizes the limiting objective function. Since there is a unique maximizer, and
by the assumption that sn (θ) is twice continuously differentiable (which holds in the limit),
then H∞ (θ0 ) must be negative definite, and therefore of full rank. Therefore the previous
inversion is justified, asymptotically, and we have
√ a.s. √
(4.4.1) n θ̂ − θ0 → −H∞ (θ0 )−1 ng(θ0 ).
√
Now consider ng(θ0 ). This is
√ √
ngn (θ0 ) = nDθ sn (θ)
√ n
n
= ∑ Dθ ln ft (yt |xt , θ0 )
n t=1
1 n
= √ ∑ gt (θ0 )
n t=1
We’ve already seen that Eθ [gt (θ)] = 0. As such, it is reasonable to assume that a CLT
applies.
a.s.
Note that gn (θ0 ) → 0, by consistency. To avoid this collapse to a degenerate r.v. (a
√
constant vector) we need to scale by n. A generic CLT states that, for Xn a random vector
that satisfies certain conditions,
d
Xn − E(Xn ) → N(0, limV (Xn ))
The “certain conditions” that Xn must satisfy depend on the case at hand. Usually, Xn will
√
be of the form of an average, scaled by n:
n
√ ∑t=1 Xt
Xn = n
n
√
This is the case for ng(θ0 ) for example. Then the properties of Xn depend on the proper-
ties of the Xt . For example, if the Xt have finite variances and are not too strongly dependent,
then a CLT for dependent processes will apply. Supposing that a CLT applies, and noting
√
that E( ngn (θ0 ) = 0, we get
√ d
I∞ (θ0 )−1/2 ngn (θ0 ) → N [0, IK ]
where

I∞ (θ0 ) = lim Eθ0 n [gn (θ0 )] [gn (θ0 )]0
n→∞
√
= lim Vθ0 ngn (θ0 )
n→∞
This can also be written as

√ d
(4.4.2) ngn (θ0 ) → N [0, I∞ (θ0 )]
• I∞ (θ0 ) is known as the information matrix.

• Combining [4.4.1] and [4.4.2], we get
√ a
n θ̂ − θ0 ∼ N 0, H∞ (θ0 )−1 I∞ (θ0 )H∞ (θ0 )−1 .
The MLE estimator is asymptotically normally distributed.
√
D EFINITION 1 (CAN). An estimator θ̂ of a parameter θ0 is n-consistent and asymp-
totically normally distributed if
√ d
(4.4.3) n θ̂ − θ0 → N (0,V∞ )
where V∞ is a finite positive definite matrix.
√ p
There do exist, in special cases, estimators that are consistent such that n θ̂ − θ0 →
√
0. These are known as superconsistent estimators, since normally, n is the highest factor
that we can multiply by and still get convergence to a stable limiting distribution.
D EFINITION 2 (Asymptotic unbiasedness). An estimator θ̂ of a parameter θ0 is asymp-

totically unbiased if
(4.4.4) lim Eθ (θ̂) = θ.

n→∞
Estimators that are CAN are asymptotically unbiased, though not all consistent esti-
mators are asymptotically unbiased. Such cases are unusual, though. An example is
E XERCISE 4.5. Consider an estimator θ̂ with density
1 − 1n , θ̂ = θ0
f (θ̂) = 1
n, θ̂ =n
4.6. THE INFORMATION MATRIX EQUALITY 43
Show that this estimator is consistent but asymptotically biased. Also, ask yourself how
you could define, without knowledge of the true parameter value, an estimator that would
have this density.
4.6. The information matrix equality
We will show that H∞ (θ) = −I∞ (θ). Let ft (θ) be short for f (yt |xt , θ)
Z
1 = ft (θ)dy, so
Z
0 = Dθ ft (θ)dy
Z
= (Dθ ln ft (θ)) ft (θ)dy
Now differentiate again:

Z Z
0 = D2θ ln ft (θ) ft (θ)dy + [Dθ ln ft (θ)] Dθ0 ft (θ)dy
2 Z
= Eθ Dθ ln ft (θ) + [Dθ ln ft (θ)] [Dθ0 ln ft (θ)] ft (θ)dy

= Eθ D2θ ln ft (θ) + Eθ [Dθ ln ft (θ)] [Dθ0 ln ft (θ)]
(4.6.1) = Eθ [Ht (θ)] + Eθ [gt (θ)] [gt (θ)]0
1
Now sum over n and multiply by n
" #
1 n 1 n
Eθ ∑ [Ht (θ)] = −Eθ ∑ [gt (θ)] [gt (θ)] 0
n t=1 n t=1
The scores gt and gs are uncorrelated for t 6= s, since for t > s, ft (yt |y1 , ..., yt−1 , θ) has
conditioned on prior information, so what was random in s is fixed in t. (This forms the
basis for a specification test proposed by White: if the scores appear to be correlated one
may question the specification of the model). This allows us to write

Eθ [H(θ)] = −Eθ n [g(θ)] [g(θ)]0
since all cross products between different periods expect to zero. Finally take limits, we
get
(4.6.2) H∞ (θ) = −I∞ (θ).
This holds for all θ, in particular, for θ0 . Using this,

√ a.s.
n θ̂ − θ0 → N 0, H∞ (θ0 )−1 I∞ (θ0 )H∞ (θ0 )−1
simplifies to
√ a.s.
(4.6.3) n θ̂ − θ0 → N 0, I∞ (θ0 )−1
To estimate the asymptotic variance, we need estimators of H∞ (θ0 ) and I∞ (θ0 ). We can
use
n
I\
∞ (θ0 ) = n ∑ gt (θ̂)gt (θ̂)0
t=1
H\
∞ (θ0 ) = H(θ̂).
4.7. THE CRAMÉR-RAO LOWER BOUND 44
Note, one can’t use

0
I\
∞ (θ0 ) = n gn (θ̂) gn (θ̂)
to estimate the information matrix. Why not?

From this we see that there are alternative ways to estimate V∞ (θ0 ) that are all valid.
These include
−1
V\ \
∞ (θ0 ) = −H∞ (θ0 )
−1
V\
∞ (θ0 ) = I\
∞ (θ0 )
−1 −1
V\
∞ (θ0 ) = H\
∞ (θ0 ) I\ \
∞ (θ0 )H∞ (θ0 )
These are known as the inverse Hessian, outer product of the gradient (OPG) and sandwich
estimators, respectively. The sandwich form is the most robust, since it coincides with the
covariance estimator of the quasi-ML estimator.
4.7. The Cramér-Rao lower bound
T HEOREM 3. [Cramer-Rao Lower Bound] The limiting variance of a CAN estimator

of θ0 , say θ̃, minus the inverse of the information matrix is a positive semidefinite matrix.
Proof: Since the estimator is CAN, it is asymptotically unbiased, so
lim Eθ (θ̃ − θ) = 0
n→∞
Differentiate wrt θ0 :
Z
Dθ0 lim Eθ (θ̃ − θ) = lim Dθ0 f (Y, θ) θ̃ − θ dy
n→∞ n→∞
= 0 (this is a K × K matrix of zeros).
Noting that Dθ0 f (Y, θ) = f (θ)Dθ0 ln f (θ), we can write

Z Z
lim θ̃ − θ f (θ)Dθ0 ln f (θ)dy + lim f (Y, θ)Dθ0 θ̃ − θ dy = 0.
n→∞ n→∞

Now note that Dθ0 θ̃ − θ = −IK , and f (Y, θ)(−IK )dy = −IK . With this we have
R
Z
lim θ̃ − θ f (θ)Dθ0 ln f (θ)dy = IK .
n→∞
Playing with powers of n we get

Z
√ √ 1
lim n θ̃ − θ n [Dθ0 ln f (θ)] f (θ)dy = IK
|n
n→∞
{z }
Note that the bracketed part is just the transpose of the score vector, g(θ), so we can write
√ √
lim Eθ n θ̃ − θ ng(θ)0 = IK
n→∞
√
This means that the covariance of the score function with n θ̃ − θ , for θ̃ any CAN
√
estimator, is an identity matrix. Using this, suppose the variance of n θ̃ − θ tends to
V∞ (θ̃). Therefore,
" √ # " #
n θ̃ − θ V∞ (θ̃) IK
(4.7.1) V∞ √ = .
ng(θ) IK I∞ (θ)
4.7. THE CRAMÉR-RAO LOWER BOUND 45
Since this is a covariance matrix, it is positive semi-definite. Therefore, for any K -vector
α, " #" #
h i V (θ̃) I α
∞ K
α0 −α0 I∞−1 (θ) ≥ 0.
IK I∞ (θ) −I∞ (θ)−1 α
This simplifies to

α0 V∞ (θ̃) − I∞−1(θ) α ≥ 0.
Since α is arbitrary, V∞ (θ̃) − I∞−1 (θ) is positive semidefinite. This conludes the proof.
This means that I∞−1 (θ) is a lower bound for the asymptotic variance of a CAN esti-
mator.
D EFINITION 4.7.1. (Asymptotic efficiency) Given two CAN estimators of a parameter

θ0 , say θ̃ and θ̂, θ̂ is asymptotically efficient with respect to θ̃ if V∞ (θ̃) −V∞ (θ̂) is a positive
semidefinite matrix.
A direct proof of asymptotic efficiency of an estimator is infeasible, but if one can

show that the asymptotic variance is equal to the inverse of the information matrix, then the
estimator is asymptotically efficient. In particular, the MLE is asymptotically efficient with
respect to any other CAN estimator.
Summary of MLE
• Consistent
• Asymptotically normal (CAN)
• Asymptotically efficient
• Asymptotically unbiased
• This is for general MLE: we haven’t specified the distribution or the lineari-
ty/nonlinearity of the estimator
EXERCISES 46
Exercises
(1) Consider coin tossing with a single possibly biased coin. The density function for the
random variable y = 1(heads) is
y
fY (y, p0 ) = p0 (1 − p0)1−y , y ∈ {0, 1}
= 0, y ∈
/ {0, 1}
Suppose that we have a sample of size n. We know from above that the ML estimator
is pb0 = ȳ. We also know from the theory above that
√ a
n (ȳ − p0 ) ∼ N 0, H∞ (p0 )−1 I∞ (p0 )H∞ (p0 )−1
a) find the analytic expression for gt (θ) and show that Eθ [gt (θ)] = 0
b) find the analytical expressions for H∞ (p0 ) and I∞ (p0 ) for this problem
√
c) Write an Octave program that does a Monte Carlo study that shows that n (ȳ − p0 )
is approximately normally distributed when n is large. Please give me histograms that
√
show the sampling frequency of n (ȳ − p0 ) for several values of n.
(2) Consider the model yt = xt0 β + αεt where the errors follow the Cauchy (Student-t with
1 degree of freedom) density. So
1
f (εt ) = , −∞ < εt < ∞
π 1 + εt2
The Cauchy density has a shape similar to a normal density, but with much thicker tails.
Thus, extremely small and large errors occur much more frequently with this density
than would happen
if the errors
were normally distributed. Find the score function
0
gn (θ) where θ = β0 α .
(3) Consider the model classical linear regression model yt = xt0 β+εt where εt ∼ IIN(0, σ2 ).
0
Find the score function gn (θ) where θ = β0 σ .
(4) Compare the first order conditional that define the ML estimators of problems 2 and 3
and interpret the differences. Why are the first order conditions that define an efficient
estimator different in the two cases?
CHAPTER 5
Asymptotic properties of the least squares estimator
The OLS estimator under the classical assumptions is unbiased and BLUE, for all
sample sizes. Now let’s see what happens when the sample size tends to infinity.
5.1. Consistency
β̂ = (X 0 X)−1 X 0 y
= (X 0 X)−1 X 0 (Xβ + ε)
= β0 + (X 0 X)−1 X 0 ε
0 −1 0
XX Xε
= β0 +
n n
0 0 −1
Consider the last two terms. By assumption limn→∞ XnX = QX ⇒ limn→∞ XnX =
Q−1
X , since the inverse of a nonsingular matrix is a continuous function of the elements of
the matrix. Considering Xnε ,
0
X 0ε 1 n
= ∑ xt εt
n n t=1
Each xt εt has expectation zero, so

X 0ε
E =0
n
The variance of each term is
V (xt εt ) = xt xt0 σ2 .
As long as these are finite, and given a technical condition1, the Kolmogorov SLLN applies,
so
1 n a.s.
∑ xt εt → 0.
n t=1
This implies that
a.s.
β̂ → β0 .
This is the property of strong consistency: the estimator converges in almost surely to the
true value.
• The consistency proof does not use the normality assumption.
• Remember that almost sure convergence implies convergence in probability.
1For application of LLN’s and CLT’s, of which there are very many to choose from, I’m going to avoid the
technicalities. Basically, as long as terms of an average have finite variances and are not too strongly dependent,
one will be able to find a LLN or CLT to apply.
47
5.3. ASYMPTOTIC EFFICIENCY 48
5.2. Asymptotic normality
We’ve seen that the OLS estimator is normally distributed under the assumption of
normal errors. If the error distribution is unknown, we of course don’t know the distribution
of the estimator. However, we can get asymptotic results. Assuming the distribution of ε is
unknown, but the the other classical assumptions hold:
β̂ = β0 + (X 0 X)−1 X 0 ε
β̂ − β0 = (X 0 X)−1 X 0 ε
0 −1 0
√ XX Xε
n β̂ − β0 = √
n n
0 −1
• Now as before, XnX → Q−1X .
√ε ,
X 0
• Considering n
the limit of the variance is
0 0 0
Xε X εε X
lim V √ = lim E
n→∞ n n→∞ n
= σ20 QX
The mean is of course zero. To get asymptotic normality, we need to apply a

CLT. We assume one (for instance, the Lindeberg-Feller CLT) holds, so
X 0ε d
√ → N 0, σ20 QX
n
Therefore,
√
d
n β̂ − β0 → N 0, σ20 Q−1
X
• In summary, the OLS estimator is normally distributed in small and large samples
if ε is normally distributed. If ε is not normally distributed, β̂ is asymptotically
normally distributed when a CLT can be applied.
5.3. Asymptotic efficiency
The least squares objective function is
n 2
s(β) = ∑ yt − xt0 β
t=1
Supposing that ε is normally distributed, the model is
y = Xβ0 + ε,
ε ∼ N(0, σ20 In ), so
n
1 ε2
f (ε) = ∏√ 2πσ2
exp − t 2
2σ
t=1
5.3. ASYMPTOTIC EFFICIENCY 49
The joint density for y can be constructed using a change of variables. We have ε = y − Xβ,
∂ε ∂ε
so ∂y 0 = In and | ∂y0 | = 1, so
n
1 (yt − xt0 β)2
f (y) = ∏ √ exp − .
t=1 2πσ
2 2σ2
Taking logs,
√ n
(yt − xt0 β)2
ln L(β, σ) = −n ln 2π − n lnσ − ∑ .
t=1 2σ2
It’s clear that the fonc for the MLE of β0 are the same as the fonc for OLS (up to mul-
tiplication by a constant), so the estimators are the same, under the present assumptions.
Therefore, their properties are the same. In particular, under the classical assumptions with
normality, the OLS estimator β̂ is asymptotically efficient.
As we’ll see later, it will be possible to use (iterated) linear estimation methods and
still achieve asymptotic efficiency even if the assumption that Var(ε) 6= σ 2 In , as long as ε is
still normally distributed. This is not the case if ε is nonnormal. In general with nonnormal
errors it will be necessary to use nonlinear estimation methods to achieve asymptotically
efficient estimation.
CHAPTER 6
Restrictions and hypothesis tests
6.1. Exact linear restrictions
In many cases, economic theory suggests restrictions on the parameters of a model.

For example, a demand function is supposed to be homogeneous of degree zero in prices
and income. If we have a Cobb-Douglas (log-linear) model,
ln q = β0 + β1 ln p1 + β2 ln p2 + β3 ln m + ε,
then we need that
k0 lnq = β0 + β1 ln kp1 + β2 ln kp2 + β3 ln km + ε,
so
β1 ln p1 + β2 ln p2 + β3 ln m = β1 ln kp1 + β2 ln kp2 + β3 ln km
= (ln k) (β1 + β2 + β3) + β1 ln p1 + β2 ln p2 + β3 ln m.
The only way to guarantee this for arbitrary k is to set
β1 + β2 + β3 = 0,
which is a parameter restriction. In particular, this is a linear equality restriction, which is

probably the most commonly encountered case.
6.1.1. Imposition. The general formulation of linear equality restrictions is the model
y = Xβ + ε
Rβ = r
where R is a Q × K matrix, Q < K and r is a Q × 1 vector of constants.
• We assume R is of rank Q, so that there are no redundant restrictions.

• We also assume that ∃β that satisfies the restrictions: they aren’t infeasible.
Let’s consider how to estimate β subject to the restrictions Rβ = r. The most obvious ap-
proach is to set up the Lagrangean
1
min s(β) = (y − Xβ)0 (y − Xβ) + 2λ0 (Rβ − r).
β n
The Lagrange multipliers are scaled by 2, which makes things less messy. The fonc are
Dβ s(β̂, λ̂) = −2X 0 y + 2X 0X β̂R + 2R0λ̂ ≡ 0

Dλ s(β̂, λ̂) = Rβ̂R − r ≡ 0,
50
6.1. EXACT LINEAR RESTRICTIONS 51
which can be written as

" #" # " #
X 0X R0 β̂R X 0y
= .
R 0 λ̂ r
We get
" # " #−1 " #
β̂R X 0X R0 X 0y
= .
λ̂ R 0 r
For the masochists: Stepwise Inversion
Note that
" #" #
(X 0 X)−1 0 X 0 X R0
≡ AB
−R (X 0 X)−1 IQ R 0
" #
IK (X 0 X)−1 R0
=
0 −R (X 0 X)−1 R0
" #
IK (X 0 X)−1 R0
≡
0 −P
≡ C,
and
" #" #
IK (X 0 X)−1 R0 P−1 IK (X 0 X)−1 R0
≡ DC
0 −P−1 0 −P
= IK+Q ,
so
DAB = IK+Q
DA = B−1
" #" #
I (X 0 X)−1 R0 P−1 (X 0 X)−1 0
K
B−1 =
0 −P−1 −R (X 0 X)−1 IQ
" #
(X 0 X)−1 − (X 0 X)−1 R0 P−1 R (X 0 X)−1 (X 0 X)−1 R0 P−1
= ,
P−1 R (X 0 X)−1 −P−1
so (everyone should start paying attention again, and please note that we have made the
definition P = R (X 0 X)−1 R0 )
" # " #" #
β̂R (X 0 X)−1 − (X 0 X)−1 R0 P−1 R (X 0 X)−1 (X 0 X)−1 R0 P−1 X 0y
=
λ̂ P−1 R (X 0 X)−1 −P−1 r
 
β̂ − (X 0 X)−1 R0 P−1 Rβ̂ − r
=  
P−1 Rβ̂ − r
" # " #
IK − (X 0 X)−1 R0 P−1 R (X 0 X)−1 R0 P−1 r
= β̂ +
P−1 R −P−1 r
The fact that β̂R and λ̂ are linear functions of β̂ makes it easy to determine their distribu-
tions, since the distribution of β̂ is already known. Recall that for x a random vector, and
for A and b a matrix and vector of constants, respectively, Var (Ax + b) = AVar(x)A 0 .
6.1. EXACT LINEAR RESTRICTIONS 52
Though this is the obvious way to go about finding the restricted estimator, an easier
way, if the number of restrictions is small, is to impose them by substitution. Write
y = X1 β1 + X2β2 + ε
" #
h i β1
R1 R2 = r
β2
where R1 is Q × Q nonsingular. Supposing the Q restrictions are linearly independent, one
can always make R1 nonsingular by reorganizing the columns of X. Then
β1 = R−1
1 r − R 1 R 2 β2 .
−1
Substitute this into the model
1 r − X1 R1 R2 β2 + X2 β2 + ε
y = X1 R−1 −1

y − X1R−1
1 r = 1 R 2 β2 + ε
X2 − X1 R−1
or with the appropriate definitions,
yR = XR β2 + ε.
This model satisfies the classical assumptions, supposing the restriction is true. One can
estimate by OLS. The variance of β̂2 is as before
−1 2
V (β̂2 ) = XR0 XR σ0
and the estimator is

−1
V̂ (β̂2 ) = XR0 XR σ̂2
where one estimates σ20 in the normal way, using the restricted model, i.e.,
0
yR − XRβb2 yR − XRβb2
c2 =
σ 0
n − (K − Q)
To recover β̂1 , use the restriction. To find the variance of β̂1 , use the fact that it is a linear
function of β̂2 , so

−1 0
V (β̂1 ) = R−1 1 R2V (β̂2 )R2 R1
0
−1 0 −1 0 2
= R−1 0
1 R2 X2 X2 R2 R1 σ0
6.1.2. Properties of the restricted estimator. We have that

β̂R = β̂ − (X 0 X)−1 R0 P−1 Rβ̂ − r
= β̂ + (X 0 X)−1 R0 P−1 r − (X 0 X)−1 R0 P−1 R(X 0 X)−1 X 0 y

= β + (X 0X)−1 X 0 ε + (X 0 X)−1 R0 P−1 [r − Rβ] − (X 0 X)−1 R0 P−1 R(X 0 X)−1 X 0 ε
β̂R − β = (X 0 X)−1 X 0 ε
+ (X 0 X)−1 R0 P−1 [r − Rβ]
− (X 0 X)−1 R0 P−1 R(X 0 X)−1 X 0 ε
Mean squared error is

MSE(β̂R ) = E (β̂R − β)(β̂R − β)0
6.2. TESTING 53
Noting that the crosses between the second term and the other terms expect to zero, and
that the cross of the first and third has a cancellation with the square of the third, we obtain
MSE(β̂R ) = (X 0 X)−1 σ2
+ (X 0 X)−1 R0 P−1 [r − Rβ][r − Rβ]0 P−1 R(X 0 X)−1
− (X 0 X)−1 R0 P−1 R(X 0 X)−1 σ2
So, the first term is the OLS covariance. The second term is PSD, and the third term is
NSD.
• If the restriction is true, the second term is 0, so we are better off. True restrictions
improve efficiency of estimation.
• If the restriction is false, we may be better or worse off, in terms of MSE, de-
pending on the magnitudes of r − Rβ and σ2 .
6.2. Testing
In many cases, one wishes to test economic theories. If theory suggests parameter
restrictions, as in the above homogeneity example, one can test theory by testing parameter
restrictions. A number of tests are available.
6.2.1. t-test. Suppose one has the model
y = Xβ + ε
and one wishes to test the single restriction H0 :Rβ = r vs. HA :Rβ 6= r . Under H0 , with
normality of the errors,

Rβ̂ − r ∼ N 0, R(X 0 X)−1 R0 σ20
so
Rβ̂ − r Rβ̂ − r
q = p ∼ N (0, 1) .
R(X 0 X)−1 R0 σ20 σ0 R(X 0 X)−1 R0
c2 in place of
The problem is that σ20 is unknown. One could use the consistent estimator σ 0
σ20 , but the test would only be valid asymptotically in this case.
P ROPOSITION 4.
N(0, 1)
(6.2.1) q
2
∼ t(q)
χ (q)
q
as long as the N(0, 1) and the χ2 (q) are independent.
We need a few results on the χ2 distribution.
P ROPOSITION 5. If x ∼ N(µ, In ) is a vector of n independent r.v.’s., then
(6.2.2) x0 x ∼ χ2 (n, λ)
where λ = ∑i µ2i = µ0 µ is the noncentrality parameter.
When a χ2 r.v. has the noncentrality parameter equal to zero, it is referred to as a central
χ2 r.v., and it’s distribution is written as χ2 (n), suppressing the noncentrality parameter.
6.2. TESTING 54
P ROPOSITION 6. If the n dimensional random vector x ∼ N(0,V ), then x0V −1 x ∼

χ2 (n).
We’ll prove this one as an indication of how the following unproven propositions could
be proved.
Proof: Factor V −1 as P0 P (this is the Cholesky factorization, where P is defined to be
upper triangular). Then consider y = Px. We have
y ∼ N(0, PV P0 )
but
V P0 P = In
PV P0 P = P
so PV P0 = In and thus y ∼ N(0, In ). Thus y0 y ∼ χ2 (n) but
y0 y = x0 P0 Px = xV −1 x
and we get the result we wanted.

A more general proposition which implies this result is
P ROPOSITION 7. If the n dimensional random vector x ∼ N(0,V ), then
(6.2.3) x0 Bx ∼ χ2 (ρ(B))
if and only if BV is idempotent.

An immediate consequence is
P ROPOSITION 8. If the random vector (of dimension n) x ∼ N(0, I), and B is idempo-
tent with rank r, then
(6.2.4) x0 Bx ∼ χ2 (r).
Consider the random variable

ε̂0 ε̂ ε 0 MX ε
=
σ20 σ20
0
ε ε
= MX
σ0 σ0
∼ χ2 (n − K)
P ROPOSITION 9. If the random vector (of dimension n) x ∼ N(0, I), then Ax and x 0 Bx
are independent if AB = 0.
Now consider (remember that we have only one restriction in this case)
√ Rβ̂−r
σ0R(X 0 X)−1 R0 Rβ̂ − r
q 0 = p
ε̂ ε̂ σ
c0 R(X 0 X)−1 R0
(n−K)σ20
This will have the t(n−K) distribution if β̂ and ε̂0 ε̂ are independent. But β̂ = β+(X 0X)−1 X 0 ε
and
(X 0 X)−1 X 0 MX = 0,
6.2. TESTING 55
so
Rβ̂ − r Rβ̂ − r
p = ∼ t(n − K)
σ
c0 R(X 0 X)−1 R0 σ̂Rβ̂
In particular, for the commonly encountered test of significance of an individual coefficient,
for which H0 : βi = 0 vs. H0 : βi 6= 0 , the test statistic is
β̂i
∼ t(n − K)
σ̂β̂i
• Note: the t− test is strictly valid only if the errors are actually normally dis-
tributed. If one has nonnormal errors, one could use the above asymptotic result
d
to justify taking critical values from the N(0, 1) distribution, since t(n − K) →
N(0, 1) as n → ∞. In practice, a conservative procedure is to take critical values
from the t distribution if nonnormality is suspected. This will reject H0 less often
since the t distribution is fatter-tailed than is the normal.
6.2.2. F test. The F test allows testing multiple restrictions jointly.
P ROPOSITION 10. If x ∼ χ2 (r) and y ∼ χ2 (s), then

x/r
(6.2.5) ∼ F(r, s)
y/s
provided that x and y are independent.
P ROPOSITION 11. If the random vector (of dimension n) x ∼ N(0, I), then x 0 Ax and
x0 Bx are independent if AB = 0.
Using these results, and previous results on the χ2 distribution, it is simple to show that
the following statistic has the F distribution:
0 −1
Rβ̂ − r R (X 0 X)−1 R0 Rβ̂ − r
F= ∼ F(q, n − K).
qσ̂2
A numerically equivalent expression is
(ESSR − ESSU ) /q
∼ F(q, n − K).
ESSU /(n − K)
• Note: The F test is strictly valid only if the errors are truly normally distributed.
The following tests will be appropriate when one cannot assume normally dis-
tributed errors.
6.2.3. Wald-type tests. The Wald principle is based on the idea that if a restriction is
true, the unrestricted model should “approximately” satisfy the restriction. Given that the
least squares estimator is asymptotically normally distributed:
√
d
n β̂ − β0 → N 0, σ20 Q−1 X
then under H0 : Rβ0 = r, we have

√
d
n Rβ̂ − r → N 0, σ20 RQ−1
X R
0
6.2. TESTING 56
so by Proposition [6]
0
0 −1 d
n Rβ̂ − r σ20 RQ−1
X R R β̂ − r → χ2 (q)
2
X or σ0 are not observable. The test statistic we use substitutes the consis-
Note that Q−1
tent estimators. Use (X 0 X/n)−1 as the consistent estimator of Q−1 X . With this, there is a
cancellation of n0 s, and the statistic to use is
0
Rβ̂ − r c2 R(X 0 X)−1 R0 −1 Rβ̂ − r →
σ
d 2
χ (q)
0
• The Wald test is a simple way to test restrictions without having to estimate the
restricted model.
• Note that this formula is similar to one of the formulae provided for the F test.
6.2.4. Score-type tests (Rao tests, Lagrange multiplier tests). In some cases, an
unrestricted model may be nonlinear in the parameters, but the model is linear in the pa-
rameters under the null hypothesis. For example, the model
y = (Xβ)γ + ε
is nonlinear in β and γ, but is linear in β under H0 : γ = 1. Estimation of nonlinear models is

a bit more complicated, so one might prefer to have a test based upon the restricted, linear
model. The score test is useful in this situation.
• Score-type tests are based upon the general principle that the gradient vector of
the unrestricted model, evaluated at the restricted estimate, should be asymptoti-
cally normally distributed with mean zero, if the restrictions are true. The original
development was for ML estimation, but the principle is valid for a wide variety
of estimation methods.
We have seen that

−1
λ̂ = R(X 0 X)−1 R0 Rβ̂ − r

= P−1 Rβ̂ − r
so
√ ˆ √
nPλ = n Rβ̂ − r
Given that
√
d
n Rβ̂ − r → N 0, σ20 RQ−1
X R
0
under the null hypothesis, we obtain

√ ˆ d
nPλ → N 0, σ20 RQ−1
X R
0
So √ 0
0 −1 √ ˆ

d
ˆ
nPλ σ20 RQ−1 R nPλ → χ2 (q)
X
Noting that lim nP = RQ−1

X R , we obtain,
0

R(X 0 X)−1 R0 d
λ̂0 λ̂ → χ2 (q)
σ20
6.2. TESTING 57
since the powers of n cancel. To get a usable test statistic substitute a consistent estimator
of σ20 .
• This makes it clear why the test is sometimes referred to as a Lagrange multiplier
test. It may seem that one needs the actual Lagrange multipliers to calculate this.
If we impose the restrictions by substitution, these are not available. Note that
the test can be written as
0
R0 λ̂ (X 0 X)−1 R0 λ̂ d
→ χ2 (q)
σ20
However, we can use the fonc for the restricted estimator:
−X 0 y + X 0X β̂R + R0 λ̂
to get that
R0 λ̂ = X 0 (y − X β̂R)
= X 0 ε̂R
Substituting this into the above, we get

ε̂0R X(X 0 X)−1 X 0 ε̂R d 2
→ χ (q)
σ20
but this is simply
PX d
2
ε̂R → χ2 (q).
ε̂0R
σ0
To see why the test is also known as a score test, note that the fonc for restricted least
squares
−X 0 y + X 0X β̂R + R0 λ̂
give us
R0 λ̂ = X 0 y − X 0X β̂R
and the rhs is simply the gradient (score) of the unrestricted model, evaluated at the re-
stricted estimator. The scores evaluated at the unrestricted estimate are identically zero.
The logic behind the score test is that the scores evaluated at the restricted estimate should
be approximately zero, if the restriction is true. The test is also known as a Rao test, since
P. Rao first proposed it in 1948.
6.2.5. Likelihood ratio-type tests. The Wald test can be calculated using the unre-
stricted model. The score test can be calculated using only the restricted model. The like-
lihood ratio test, on the other hand, uses both the restricted and the unrestricted estimators.
The test statistic is

LR = 2 ln L(θ̂) − lnL(θ̃)
where θ̂ is the unrestricted estimate and θ̃ is the restricted estimate. To show that it is
asymptotically χ2 , take a second order Taylor’s series expansion of lnL(θ̃) about θ̂ :
n 0
ln L(θ̃) ' ln L(θ̂) + θ̃ − θ̂ H(θ̂) θ̃ − θ̂
2
6.3. THE ASYMPTOTIC EQUIVALENCE OF THE LR, WALD AND SCORE TESTS 58
(note, the first order term drops out since Dθ ln L(θ̂) ≡ 0 by the fonc and we need to multiply
the second-order term by n since H(θ) is defined in terms of n1 lnL(θ)) so
0
LR ' −n θ̃ − θ̂ H(θ̂) θ̃ − θ̂
As n → ∞, H(θ̂) → H∞ (θ0 ) = −I (θ0 ), by the information matrix equality. So

a 0
LR = n θ̃ − θ̂ I∞ (θ0 ) θ̃ − θ̂
We also have that, from [??] that

√ a
n θ̂ − θ0 = I∞ (θ0 )−1 n1/2 g(θ0 ).
An analogous result for the restricted estimator is (this is unproven here, to prove this set
up the Lagrangean for MLE subject to Rβ = r, and manipulate the first order conditions) :
√ a −1
n θ̃ − θ0 = I∞ (θ0 )−1 In − R0 RI∞ (θ0 )−1 R0 RI∞ (θ0 )−1 n1/2 g(θ0 ).
Combining the last two equations

√ a −1
n θ̃ − θ̂ = −n1/2I∞ (θ0 )−1 R0 RI∞ (θ0 )−1 R0 RI∞ (θ0 )−1 g(θ0 )
so, substituting into [??]

h i −1 h i
a
LR = n1/2 g(θ0 )0 I∞ (θ0 )−1 R0 RI∞ (θ0 )−1 R0 RI∞ (θ0 )−1 n1/2 g(θ0 )
But since
d
n1/2 g(θ0 ) → N (0, I∞ (θ0 ))
the linear function
d
RI∞ (θ0 )−1 n1/2 g(θ0 ) → N(0, RI∞ (θ0 )−1 R0 ).
We can see that LR is a quadratic form of this rv, with the inverse of its variance in the
middle, so
d
LR → χ2 (q).
6.3. The asymptotic equivalence of the LR, Wald and score tests
We have seen that the three tests all converge to χ2 random variables. In fact, they
all converge to the same χ2 rv, under the null hypothesis. We’ll show that the Wald and
LR tests are asymptotically equivalent. We have seen that the Wald test is asymptotically
equivalent to 0
a
0 −1

d
W = n Rβ̂ − r σ20 RQ−1
X R Rβ̂ − r → χ2 (q)
Using
β̂ − β0 = (X 0 X)−1 X 0 ε
and
Rβ̂ − r = R(β̂ − β0 )
we get
√ √
nR(β̂ − β0) = nR(X 0 X)−1 X 0 ε
0 −1
XX
= R n−1/2 X 0 ε
n
Substitute this into [??] to get
a 2
−1
W = n−1 ε0 XQ−1
X R σ0 RQX R
0 −1 0
RQ−1X X ε
0
a −1
= ε0 X(X 0 X)−1 R0 σ20 R(X 0 X)−1 R0 R(X 0 X)−1 X 0 ε
a ε0 A(A0 A)−1 A0 ε
=
σ20
a ε0 PR ε
=
σ20
where PR is the projection matrix formed by the matrix X(X 0 X)−1 R0 .
• Note that this matrix is idempotent and has q columns, so the projection matrix
has rank q.
Now consider the likelihood ratio statistic

a −1
LR = n1/2g(θ0 )0 I (θ0 )−1 R0 RI (θ0 )−1 R0 RI (θ0 )−1 n1/2 g(θ0 )
Under normality, we have seen that the likelihood function is

√ 1 (y − Xβ)0 (y − Xβ)
ln L(β, σ) = −n ln 2π − n lnσ − .
2 σ2
Using this,
1
g(β0 ) ≡ Dβ ln L(β, σ)
n
X 0 (y − Xβ0)
=
nσ2
Xε0
=
nσ2
Also, by the information matrix equality:
I (θ0 ) = −H∞ (θ0 )

= lim −Dβ0 g(β0 )
X 0 (y − Xβ0)
= lim −Dβ0
nσ2
X 0X
= lim
nσ2
QX
=
σ2
so
I (θ0 )−1 = σ2 Q−1
X
Substituting these last expressions into [??], we get

a −1
LR = ε0 X 0 (X 0 X)−1 R0 σ20 R(X 0 X)−1 R0 R(X 0 X)−1 X 0 ε
a ε0 PR ε
=
σ20
a
= W
This completes the proof that the Wald and LR tests are asymptotically equivalent. Simi-
larly, one can show that, under the null hypothesis,
a a a
qF = W = LM = LR
• The proof for the statistics except for LR does not depend upon normality of the
errors, as can be verified by examining the expressions for the statistics.
• The LR statistic is based upon distributional assumptions, since one can’t write
the likelihood function without them.
• However, due to the close relationship between the statistics qF and LR, suppos-
ing normality, the qF statistic can be thought of as a pseudo-LR statistic, in that
it’s like a LR statistic in that it uses the value of the objective functions of the
restricted and unrestricted models, but it doesn’t require distributional assump-
tions.
• The presentation of the score and Wald tests has been done in the context of
the linear model. This is readily generalizable to nonlinear models and/or other
estimation methods.
Though the four statistics are asymptotically equivalent, they are numerically different in
small samples. The numeric values of the tests also depend upon how σ 2 is estimated, and
we’ve already seen than there are several ways to do this. For example all of the following
are consistent for σ2 under H0
ε̂0 ε̂
n−k
ε̂0 ε̂
n
ε̂0R ε̂R
n−k+q
ε̂0R ε̂R
n
and in general the denominator call be replaced with any quantity a such that lim a/n = 1.
It can be shown, for linear regression models subject to linear restrictions, and if ε̂nε̂ is
0
ε̂0R ε̂R
used to calculate the Wald test and n is used for the score test, that
W > LR > LM.
For this reason, the Wald test will always reject if the LR test rejects, and in turn the LR
test rejects if the LM test rejects. This is a bit problematic: there is the possibility that by
careful choice of the statistic used, one can manipulate reported results to favor or disfavor
a hypothesis. A conservative/honest approach would be to report all three test statistics
6.6. BOOTSTRAPPING 61
when they are available. In the case of linear models with normal errors the F test is to be
preferred, since asymptotic approximations are not an issue.
The small sample behavior of the tests can be quite different. The true size (probability
of rejection of the null when the null is true) of the Wald test is often dramatically higher
than the nominal size associated with the asymptotic distribution. Likewise, the true size
of the score test is often smaller than the nominal size.
6.4. Interpretation of test statistics
Now that we have a menu of test statistics, we need to know how to use them.
6.5. Confidence intervals
Confidence intervals for single coefficients are generated in the normal manner. Given
the t statistic
β̂ − β
t(β) =
σ
cβ̂
a 100 (1 − α)% confidence interval for β0 is defined by the bounds of the set of β such that
t(β) does not reject H0 : β0 = β, using a α significance level:
β̂ − β
C(α) = {β : −cα/2 < < cα/2 }
σ
cβ̂
The set of such β is the interval

β̂ ± σ
cβ̂ cα/2
A confidence ellipse for two coefficients jointly would be, analogously, the set of
{β1 , β2 } such that the F (or some other test statistic) doesn’t reject at the specified criti-
cal value. This generates an ellipse, if the estimators are correlated.
• The region is an ellipse, since the CI for an individual coefficient defines a (in-
finitely long) rectangle with total prob. mass 1 − α, since the other coefficient is
marginalized (e.g., can take on any value). Since the ellipse is bounded in both
dimensions but also contains mass 1 − α, it must extend beyond the bounds of
the individual CI.
• From the pictue we can see that:
– Rejection of hypotheses individually does not imply that the joint test will
reject.
– Joint rejection does not imply individal tests will reject.
6.6. Bootstrapping
When we rely on asymptotic theory to use the normal distribution-based tests and con-
fidence intervals, we’re often at serious risk of making important errors. If the sample size
√
is small and errors are highly nonnormal, the small sample distribution of n β̂ − β0 may
be very different than its large sample distribution. Also, the distributions of test statistics
may not resemble their limiting distributions at all. A means of trying to gain information
on the small sample distribution of test statistics and estimators is the bootstrap. We’ll
consider a simple example, just to get the main idea.
F IGURE 6.5.1. Joint and Individual Confidence Regions

Suppose that
y = Xβ0 + ε
ε ∼ IID(0, σ20 )
X is nonstochastic
Given that the distribution of ε is unknown, the distribution of β̂ will be unknown in small
samples. However, since we have random sampling, we could generate artificial data. The
steps are:
(1) Draw n observations from ε̂ with replacement. Call this vector ε̃ j (it’s a n × 1).
(2) Then generate the data by ỹ j = X β̂ + ε̃ j
(3) Now take this and estimate
β̃ j = (X 0 X)−1 X 0 ỹ j .
(4) Save β̃ j
(5) Repeat steps 1-4, until we have a large number, J, of β̃ j .
With this, we can use the replications to calculate the empirical distribution of β̃ j . One way
to form a 100(1-α)% confidence interval for β0 would be to order the β̃ j from smallest to
largest, and drop the first and last Jα/2 of the replications, and use the remaining endpoints
as the limits of the CI. Note that this will not give the shortest CI if the empirical distribution
is skewed.
• Suppose one was interested in the distribution of some function of β̂, for example
a test statistic. Simple: just calculate the transformation for each j, and work with
the empirical distribution of the transformation.
• If the assumption of iid errors is too strong (for example if there is heteroscedas-
ticity or autocorrelation, see below) one can work with a bootstrap defined by
sampling from (y, x) with replacement.
• How to choose J: J should be large enough that the results don’t change with
repetition of the entire bootstrap. This is easy to check. If you find the results
change a lot, increase J and try again.
• The bootstrap is based fundamentally on the idea that the empirical distribution of
the sample data converges to the actual sampling distribution as n becomes large,
so statistics based on sampling from the empirical distribution should converge in
distribution to statistics based on sampling from the actual sampling distribution.
• In finite samples, this doesn’t hold. At a minimum, the bootstrap is a good way
to check if asymptotic theory results offer a decent approximation to the small
sample distribution.
• Bootstrapping can be used to test hypotheses. Basically, use the bootstrap to
get an approximation to the empirical distribution of the test statistic under the
alternative hypothesis, and use this to get critical values. Compare the test statis-
tic calculated using the real data, under the null, to the bootstrap critical values.
There are many variations on this theme, which we won’t go into here.
6.7. TESTING NONLINEAR RESTRICTIONS, AND THE DELTA METHOD 64
6.7. Testing nonlinear restrictions, and the Delta Method
Testing nonlinear restrictions of a linear model is not much more difficult, at least when
the model is linear. Since estimation subject to nonlinear restrictions requires nonlinear
estimation methods, which are beyond the score of this course, we’ll just consider the
Wald test for nonlinear restrictions on a linear model.
Consider the q nonlinear restrictions
r(β0 ) = 0.
where r(·) is a q-vector valued function. Write the derivative of the restriction evaluated at
β as

Dβ0 r(β)β = R(β)
We suppose that the restrictions are not redundant in a neighborhood of β 0 , so that
ρ(R(β)) = q
in a neighborhood of β0 . Take a first order Taylor’s series expansion of r(β̂) about β0 :
r(β̂) = r(β0 ) + R(β∗)(β̂ − β0 )
where β∗ is a convex combination of β̂ and β0 . Under the null hypothesis we have
r(β̂) = R(β∗ )(β̂ − β0)
Due to consistency of β̂ we can replace β∗ by β0 , asymptotically, so

√ a √
nr(β̂) = nR(β0 )(β̂ − β0)
√
We’ve already seen the distribution of n(β̂ − β0 ). Using this we get
√ d 0 2

nr(β̂) → N 0, R(β0 )Q−1 X R(β0 ) σ0 .
Considering the quadratic form

−1
nr(β̂)0 R(β0 )Q−1
X R(β0 )
0 r(β̂) d
2
→ χ2 (q)
σ0
under the null hypothesis. Substituting consistent estimators for β 0, QX and σ20 , the resulting
statistic is −1
r(β̂)0 R(β̂)(X 0 X)−1 R(β̂)0 r(β̂) d
→ χ2 (q)
σc2
under the null hypothesis.
• This is known in the literature as the Delta method, or as Klein’s approximation.

• Since this is a Wald test, it will tend to over-reject in finite samples. The score and
LR tests are also possibilities, but they require estimation methods for nonlinear
models, which aren’t in the scope of this course.
Note that this also gives a convenient way to estimate nonlinear functions and associated
asymptotic confidence intervals. If the nonlinear function r(β0 ) is not hypothesized to be
6.7. TESTING NONLINEAR RESTRICTIONS, AND THE DELTA METHOD 65
zero, we just have

√
d 0 2

n r(β̂) − r(β0 ) → N 0, R(β0 )Q−1
X R(β0 ) σ0
so an approximation to the distribution of the function of the estimator is
r(β̂) ≈ N(r(β0 ), R(β0 )(X 0 X)−1 R(β0 )0 σ20 )
For example, the vector of elasticities of a function f (x) is

∂ f (x) x
η(x) =
∂x f (x)
where means element-by-element multiplication. Suppose we estimate a linear function
y = x0 β + ε.
The elasticities of y w.r.t. x are

β
η(x) = x
x0 β
(note that this is the entire vector of elasticities). The estimated elasticities are
β̂
η
b(x) = x
x0 β̂
To calculate the estimated standard errors of all five elasticites, use
∂η(x)
R(β) =
∂β0
   
x1 0 ··· 0 β1 x21 0 ··· 0
 ..   .. 
 0 x .   0 β2 x22 . 
 2  0  
 . .. x β− . .. 
 .   . 
 . . 0   . . 0 
0 ··· 0 xk 0 ··· 0 βk x2k
= .
(x0 β)2
To get a consistent estimator just substitute in β̂. Note that the elasticity and the standard
error are functions of x. The program ExampleDeltaMethod.m shows how this can be done.
In many cases, nonlinear restrictions can also involve the data, not just the parameters.
For example, consider a model of expenditure shares. Let x(p, m) be a demand funcion,
where p is prices and m is income. An expenditure share system for G goods is
pi xi (p, m)
si (p, m) = , i = 1, 2, ..., G.
m
Now demand must be positive, and we assume that expenditures sum to income, so we
have the restrictions
0 ≤ si (p, m) ≤ 1, ∀i
G
∑ si (p, m) = 1
i=1
Suppose we postulate a linear model for the expenditure shares:
si (p, m) = βi1 + p0 βip + mβim + εi

6.8. EXAMPLE: THE NERLOVE DATA 66
It is fairly easy to write restrictions such that the shares sum to one, but the restriction that
the shares lie in the [0, 1] interval depends on both parameters and the values of p and m.
It is impossible to impose the restriction that 0 ≤ si (p, m) ≤ 1 for all possible p and m. In
such cases, one might consider whether or not a linear model is a reasonable specification.
6.8. Example: the Nerlove data
Remember that we in a previous example (section 3.8.3) that the OLS results for the
Nerlove model are
*********************************************************
Observations 145
R-squared 0.925955

constant -3.527 1.774 -1.987 0.049
output 0.720 0.017 41.244 0.000
labor 0.436 0.291 1.499 0.136
fuel 0.427 0.100 4.249 0.000
capital -0.220 0.339 -0.648 0.518
*********************************************************
Note that sK = βK < 0, and that βL + βF + βK 6= 1.

Remember that if we have constant returns to scale, then βQ = 1, and if there is homo-
geneity of degree 1 then βL + βF + βK = 1. We can test these hypotheses either separately
or jointly. NerloveRestrictions.m imposes and tests CRTS and then HOD1. From it we
obtain the results that follow:
Imposing and testing HOD1
*******************************************************
Restricted LS estimation results
Observations 145
R-squared 0.925652

constant -4.691 0.891 -5.263 0.000
output 0.721 0.018 41.040 0.000
labor 0.593 0.206 2.878 0.005
fuel 0.414 0.100 4.159 0.000
capital -0.007 0.192 -0.038 0.969
*******************************************************
Value p-value
F 0.574 0.450
Wald 0.594 0.441
LR 0.593 0.441
Score 0.592 0.442
Imposing and testing CRTS
*******************************************************
Restricted LS estimation results
Observations 145
R-squared 0.790420

constant -7.530 2.966 -2.539 0.012
output 1.000 0.000 Inf 0.000
labor 0.020 0.489 0.040 0.968
fuel 0.715 0.167 4.289 0.000
capital 0.076 0.572 0.132 0.895
*******************************************************
Value p-value
F 256.262 0.000
Wald 265.414 0.000
LR 150.863 0.000
Score 93.771 0.000
Notice that the input price coefficients in fact sum to 1 when HOD1 is imposed. HOD1
is not rejected at usual significance levels (e.g., α = 0.10). Also, R 2 does not drop much
when the restriction is imposed, compared to the unrestricted results. For CRTS, you should
note that βQ = 1, so the restriction is satisfied. Also note that the hypothesis that β Q = 1 is
rejected by the test statistics at all reasonable significance levels. Note that R 2 drops quite
a bit when imposing CRTS. If you look at the unrestricted estimation results, you can see
that a t-test for βQ = 1 also rejects, and that a confidence interval for βQ does not overlap
1.
From the point of view of neoclassical economic theory, these results are not anoma-
lous: HOD1 is an implication of the theory, but CRTS is not.
E XERCISE 12. Modify the NerloveRestrictions.m program to impose and test the re-
strictions jointly.
The Chow test. Since CRTS is rejected, let’s examine the possibilities more carefully.
Recall that the data is sorted by output (the third column). Define 5 subsamples of firms,
with the first group being the 29 firms with the lowest output levels, then the next 29 firms,
etc. The five subsamples can be indexed by j = 1, 2, ..., 5, where j = 1 for t = 1, 2, ...29,
j = 2 for t = 30, 31, ...58, etc. Define a piecewise linear model
j j j j j
(6.8.1) lnCt = β1 + β2 ln Qt + β3 ln PLt + β4 ln PFt + β5 ln PKt + εt
where j is a superscript (not a power) that inicates that the coefficients may be different
according to the subsample in which the observation falls. That is, the coefficients depend
upon j which in turn depends upon t. Note that the first column of nerlove.data indicates
this way of breaking up the sample. The new model may be written as
      1 
y1 X1 0 ··· 0 β1 ε
     2 
 y2   0 X2   β2   ε
 
      . 
 ..   ..  + . 
(6.8.2)  . = . X3    . 
      
      
   X4 0  
5
y5 0 X5 β ε5
where y1 is 29×1, X1 is 29×5, β j is the 5 × 1 vector of coefficient for the jth subsample,
and ε j is the 29 × 1 vector of errors for the jth subsample.
The Octave program Restrictions/ChowTest.m estimates the above model. It also tests
the hypothesis that the five subsamples share the same parameter vector, or in other words,
that there is coefficient stability across the five subsamples. The null to test is that the
parameter vectors for the separate groups are all the same, that is,
β1 = β 2 = β 3 = β 4 = β 5
This type of test, that parameters are constant across different sets of data, is sometimes
referred to as a Chow test.
• There are 20 restrictions. If that’s not clear to you, look at the Octave program.
• The restrictions are rejected at all conventional significance levels.
Since the restrictions are rejected, we should probably use the unrestricted model for anal-
ysis. What is the pattern of RTS as a function of the output group (small to large)? Figure
6.8.1 plots RTS. We can see that there is increasing RTS for small firms, but that RTS is
approximately constant for large firms.
F IGURE 6.8.1. RTS as a function of firm size

2.6
RTS
2.4
2.2
1.8
1.6
1.4
1.2
0.8
1 1.5 2 2.5 3 3.5 4 4.5 5
Output group
(1) Using the Chow test on the Nerlove model, we reject that there is coefficient
stability across the 5 groups. But perhaps we could restrict the input price coef-
ficients to be the same but let the constant and output coefficients vary by group
size. This new model is
j j
(6.8.3) lnCi = β1 + β2 ln Qi + β3 ln PLi + β4 ln PFi + β5 ln PKi + εi
(a) estimate this model by OLS, giving R, estimated standard errors for co-
efficients, t-statistics for tests of significance, and the associated p-values.
Interpret the results in detail.
(b) Test the restrictions implied by this model (relative to the model that lets all
coefficients vary across groups) using the F, qF, Wald, score and likelihood
ratio tests. Comment on the results.
(c) Estimate this model but imposing the HOD1 restriction, using an OLS esti-
mation program. Don’t use mc_olsr or any other restricted OLS estimation
program. Give estimated standard errors for all coefficients.
(d) Plot the estimated RTS parameters as a function of firm size. Compare the
plot to that given in the notes for the unrestricted model. Comment on the
results.
(2) For the simple Nerlove model, estimated returns to scale is RT dS = 1 . Apply
c βq
the delta method to calculate the estimated standard error for estimated RTS.
Directly test H0 : RT S = 1 versus HA : RT S 6= 1 rather than testing H0 : βQ = 1
versus HA : βQ 6= 1. Comment on the results.
(3) Perform a Monte Carlo study that generates data from the model
y = −2 + 1x2 + 1x3 + ε
where the sample size is 30, x2 and x3 are independently uniformly distributed on
[0, 1] and ε ∼ IIN(0, 1)
(a) Compare the means and standard errors of the estimated coefficients using
OLS and restricted OLS, imposing the restriction that β2 + β3 = 2.
(b) Compare the means and standard errors of the estimated coefficients using
OLS and restricted OLS, imposing the restriction that β2 + β3 = 1.
(c) Discuss the results.
CHAPTER 7
Generalized least squares
One of the assumptions we’ve made up to now is that
εt ∼ IID(0, σ2 ),
or occasionally
εt ∼ IIN(0, σ2 ).
Now we’ll investigate the consequences of nonidentically and/or dependently distributed
errors. We’ll assume fixed regressors for now, relaxing this admittedly unrealistic assump-
tion later. The model is
y = Xβ + ε
E (ε) = 0
V (ε) = Σ
where Σ is a general symmetric positive definite matrix (we’ll write β in place of β 0 to

simplify the typing of these notes).
• The case where Σ is a diagonal matrix gives uncorrelated, nonidentically dis-

tributed errors. This is known as heteroscedasticity.
• The case where Σ has the same number on the main diagonal but nonzero ele-
ments off the main diagonal gives identically (assuming higher moments are also
the same) dependently distributed errors. This is known as autocorrelation.
• The general case combines heteroscedasticity and autocorrelation. This is known
as “nonspherical” disturbances, though why this term is used, I have no idea.
Perhaps it’s because under the classical assumptions, a joint confidence region
for ε would be an n− dimensional hypersphere.
7.1. Effects of nonspherical disturbances on the OLS estimator
The least square estimator is
β̂ = (X 0 X)−1 X 0 y
= β + (X 0X)−1 X 0 ε
• We have unbiasedness, as before.

• The variance of β̂ is
h i
E (β̂ − β)(β̂ − β)0 = E (X 0 X)−1 X 0 εε0 X(X 0 X)−1
(7.1.1) = (X 0 X)−1 X 0 ΣX(X 0 X)−1

71
7.2. THE GLS ESTIMATOR 72
Due to this, any test statistic that is based upon an estimator of σ2 is invalid, since
there isn’t any σ2 , it doesn’t exist as a feature of the true d.g.p. In particular, the
formulas for the t, F, χ2 based tests given above do not lead to statistics with these
distributions.
• β̂ is still consistent, following exactly the same argument given before.
• If ε is normally distributed, then

β̂ ∼ N β, (X 0 X)−1 X 0 ΣX(X 0 X)−1
The problem is that Σ is unknown in general, so this distribution won’t be useful

for testing hypotheses.
• Without normality, and unconditional on X we still have
√ √
n β̂ − β = n(X 0 X)−1 X 0 ε
0 −1
XX
= n−1/2 X 0 ε
n
Define the limiting variance of n−1/2 X 0 ε (supposing a CLT applies) as
0 0
X εε X
lim E =Ω
n→∞ n
√
d
so we obtain n β̂ − β → N 0, Q−1 X ΩQX
−1
Summary: OLS with heteroscedasticity and/or autocorrelation is:

• unbiased in the same circumstances in which the estimator is unbiased with iid
errors
• has a different variance than before, so the previous test statistics aren’t valid
• is consistent
• is asymptotically normally distributed, but with a different limiting covariance
matrix. Previous test statistics aren’t valid in this case for this reason.
• is inefficient, as is shown below.
7.2. The GLS estimator
Suppose Σ were known. Then one could form the Cholesky decomposition
P0 P = Σ−1
Here, P is an upper triangular matrix. We have
P0 PΣ = In
so
P0 PΣP0 = P0 ,
which implies that
PΣP0 = In
Consider the model
Py = PXβ + Pε,
7.2. THE GLS ESTIMATOR 73
or, making the obvious definitions,
y∗ = X ∗ β + ε ∗ .
This variance of ε∗ = Pε is
E (Pεε0 P0 ) = PΣP0
= In
Therefore, the model
y∗ = X ∗ β + ε∗
E (ε∗ ) = 0
∗
V (ε ) = In
satisfies the classical assumptions. The GLS estimator is simply OLS applied to the trans-
formed model:
β̂GLS = (X ∗0 X ∗ )−1 X ∗0 y∗
= (X 0 P0 PX)−1 X 0 P0 Py
= (X 0 Σ−1 X)−1 X 0 Σ−1 y
The GLS estimator is unbiased in the same circumstances under which the OLS esti-
mator is unbiased. For example, assuming X is nonstochastic

E (β̂GLS ) = E (X 0 Σ−1 X)−1 X 0 Σ−1 y

= E (X 0 Σ−1 X)−1 X 0 Σ−1 (Xβ + ε
= β.
The variance of the estimator, conditional on X can be calculated using
β̂GLS = (X ∗0 X ∗ )−1 X ∗0 y∗
= (X ∗0 X ∗ )−1 X ∗0 (X ∗ β + ε∗ )
= β + (X ∗0X ∗ )−1 X ∗0 ε∗
so
0
E β̂GLS − β β̂GLS − β = E (X ∗0 X ∗ )−1 X ∗0 ε∗ ε∗0 X ∗ (X ∗0 X ∗ )−1
= (X ∗0 X ∗ )−1 X ∗0 X ∗ (X ∗0 X ∗ )−1
= (X ∗0 X ∗ )−1
= (X 0 Σ−1 X)−1
Either of these last formulas can be used.
• All the previous results regarding the desirable properties of the least squares
estimator hold, when dealing with the transformed model, since the transformed
model satisfies the classical assumptions..
7.3. FEASIBLE GLS 74
• Tests are valid, using the previous formulas, as long as we substitute X ∗ in place
of X. Furthermore, any test that involves σ2 can set it to 1. This is preferable to
re-deriving the appropriate formulas.
• The GLS estimator is more efficient than the OLS estimator. This is a conse-
quence of the Gauss-Markov theorem, since the GLS estimator is based on a
model that satisfies the classical assumptions but the OLS estimator is not. To
see this directly, not that (the following needs to be completed)
Var(β̂) −Var(β̂GLS ) = (X 0 X)−1 X 0 ΣX(X 0 X)−1 − (X 0 Σ−1 X)−1

0
= AΣA
h i
where A = (X 0 X)−1 X 0 − (X 0Σ−1 X)−1 X 0 Σ−1 . This may not seem obvious, but
0
it is true, as you can verify for yourself. Then noting that AΣA is a quadratic form
0
in a positive definite matrix, we conclude that AΣA is positive semi-definite, and
that GLS is efficient relative to OLS.
• As one can verify by calculating fonc, the GLS estimator is the solution to the
minimization problem
β̂GLS = argmin(y − Xβ)0Σ−1 (y − Xβ)
so the metric Σ−1 is used to weight the residuals.
7.3. Feasible GLS
The problem is that Σ isn’t known usually, so this estimator isn’t available.

• Consider the dimension of Σ : it’s an n×n matrix with n2 − n /2+n = n2 + n /2
unique elements.
• The number of parameters to estimate is larger than n and increases faster than
n. There’s no way to devise an estimator that satisfies a LLN without adding
restrictions.
• The feasible GLS estimator is based upon making sufficient assumptions regard-
ing the form of Σ so that a consistent estimator can be devised.
Suppose that we parameterize Σ as a function of X and θ, where θ may include β as well
as other parameters, so that
Σ = Σ(X, θ)
where θ is of fixed dimension. If we can consistently estimate θ, we can consistently
estimate Σ, as long as Σ(X, θ) is a continuous function of θ (by the Slutsky theorem). In
this case,
p
b = Σ(X, θ̂) →
Σ Σ(X, θ)
If we replace Σ in the formulas for the GLS estimator with Σ,
b we obtain the FGLS estimator.
The FGLS estimator shares the same asymptotic properties as GLS. These are
(1) Consistency
(2) Asymptotic normality
(3) Asymptotic efficiency if the errors are normally distributed. (Cramer-Rao).
(4) Test procedures are asymptotically valid.
7.4. HETEROSCEDASTICITY 75
In practice, the usual way to proceed is

(1) Define a consistent estimator of θ. This is a case-by-case proposition, depending
on the parameterization Σ(θ). We’ll see examples below.
(2) Form Σb = Σ(X, θ̂)
(3) Calculate the Cholesky factorization Pb = Chol(Σ̂−1 ).
(4) Transform the model using
P̂0 y = P̂0 Xβ + P̂0ε
(5) Estimate using OLS on the transformed model.
7.4. Heteroscedasticity
Heteroscedasticity is the case where
E (εε0 ) = Σ
is a diagonal matrix, so that the errors are uncorrelated, but have different variances. Het-
eroscedasticity is usually thought of as associated with cross sectional data, though there is
absolutely no reason why time series data cannot also be heteroscedastic. Actually, the pop-
ular ARCH (autoregressive conditionally heteroscedastic) models explicitly assume that a
time series is heteroscedastic.
Consider a supply function
qi = β1 + β pPi + βs Si + εi
where Pi is price and Si is some measure of size of the ith firm. One might suppose that
unobservable factors (e.g., talent of managers, degree of coordination between production
units, etc.) account for the error term εi . If there is more variability in these factors for large
firms than for small firms, then εi may have a higher variance when Si is high than when it
is low.
Another example, individual demand.
qi = β1 + β pPi + βm Mi + εi
where P is price and M is income. In this case, εi can reflect variations in preferences.
There are more possibilities for expression of preferences when one is rich, so it is possible
that the variance of εi could be higher when M is high.
Add example of group means.
7.4.1. OLS with heteroscedastic consistent varcov estimation. Eicker (1967) and
White (1980) showed how to modify test statistics to account for heteroscedasticity of
unknown form. The OLS estimator has asymptotic distribution
√
d
n β̂ − β → N 0, Q−1 X ΩQX
−1
as we’ve already seen. Recall that we defined

0 0
X εε X
lim E =Ω
n→∞ n
This matrix has dimension K × K and can be consistently estimated, even if we can’t esti-
mate Σ consistently. The consistent estimator, under heteroscedasticity but no autocorrela-
tion is
n
b = 1 ∑ xt xt0 ε̂t2
Ω
n t=1
One can then modify the previous test statistics to obtain tests that are valid when there is
heteroscedasticity of unknown form. For example, the Wald test for H0 : Rβ − r = 0 would
be !−1
0 −1 −1
X 0X X 0X a
n Rβ̂ − r R Ω̂ R 0
Rβ̂ − r ∼ χ2 (q)
n n
7.4.2. Detection. There exist many tests for the presence of heteroscedasticity. We’ll
discuss three methods.
Goldfeld-Quandt. The sample is divided in to three parts, with n 1 , n2 and n3 observa-
tions, where n1 + n2 + n3 = n. The model is estimated using the first and third parts of the
sample, separately, so that β̂1 and β̂3 will be independent. Then we have
0
ε̂10 ε̂1 ε1 M 1 ε1 d 2
= → χ (n1 − K)
σ 2 σ2
and
0
ε̂30 ε̂3 ε3 M 3 ε3 d 2
= → χ (n3 − K)
σ2 σ2
so
ε̂10 ε̂1 /(n1 − K) d
→ F(n1 − K, n3 − K).
ε̂30 ε̂3 /(n3 − K)
The distributional result is exact if the errors are normally distributed. This test is a two-
tailed test. Alternatively, and probably more conventionally, if one has prior ideas about the
possible magnitudes of the variances of the observations, one could order the observations
accordingly, from largest to smallest. In this case, one would use a conventional one-tailed
F-test. Draw picture.
• Ordering the observations is an important step if the test is to have any power.
• The motive for dropping the middle observations is to increase the difference
between the average variance in the subsamples, supposing that there exists het-
eroscedasticity. This can increase the power of the test. On the other hand,
dropping too many observations will substantially increase the variance of the
statistics ε̂10 ε̂1 and ε̂30 ε̂3 . A rule of thumb, based on Monte Carlo experiments is
to drop around 25% of the observations.
• If one doesn’t have any ideas about the form of the het. the test will probably
have low power since a sensible data ordering isn’t available.
White’s test. When one has little idea if there exists heteroscedasticity, and no idea of
its potential form, the White test is a possibility. The idea is that if there is homoscedasticity,
then
E (εt2 |xt ) = σ2 , ∀t
so that xt or functions of xt shouldn’t help to explain E (εt2 ). The test works as follows:
(1) Since εt isn’t available, use the consistent estimator ε̂t instead.
(2) Regress
ε̂t2 = σ2 + zt0 γ + vt
where zt is a P-vector. zt may include some or all of the variables in xt , as well
as other variables. White’s original suggestion was to use xt , plus the set of all
unique squares and cross products of variables in xt .
(3) Test the hypothesis that γ = 0. The qF statistic in this case is
P (ESSR − ESSU ) /P
qF =
ESSU / (n − P − 1)
Note that ESSR = T SSU , so dividing both numerator and denominator by this we
get
R2
qF = (n − P − 1)
1 − R2
2
Note that this is the R or the artificial regression used to test for heteroscedastic-
ity, not the R2 of the original model.
An asymptotically equivalent statistic, under the null of no heteroscedasticity (so that R 2

should tend to zero), is
a
nR2 ∼ χ2 (P).
This doesn’t require normality of the errors, though it does assume that the fourth moment
of εt is constant, under the null. Question: why is this necessary?
• The White test has the disadvantage that it may not be very powerful unless the
zt vector is chosen well, and this is hard to do without knowledge of the form of
heteroscedasticity.
• It also has the problem that specification errors other than heteroscedasticity may
lead to rejection.
• Note: the null hypothesis of this test may be interpreted as θ = 0 for the variance
model V (εt2 ) = h(α + zt0 θ), where h(·) is an arbitrary function of unknown form.
The test is more general than is may appear from the regression that is used.
Plotting the residuals. A very simple method is to simply plot the residuals (or their
squares). Draw pictures here. Like the Goldfeld-Quandt test, this will be more informative
if the observations are ordered according to the suspected form of the heteroscedasticity.
7.4.3. Correction. Correcting for heteroscedasticity requires that a parametric form

for Σ(θ) be supplied, and that a means for estimating θ consistently be determined. The es-
timation method will be specific to the for supplied for Σ(θ). We’ll consider two examples.
Before this, let’s consider the general nature of GLS when there is heteroscedasticity.
Multiplicative heteroscedasticity
Suppose the model is
yt = xt0 β + εt
δ
σt2 = E (εt2 ) = zt0 γ
but the other classical assumptions hold. In this case

δ
εt2 = zt0 γ + vt
and vt has mean zero. Nonlinear least squares could be used to estimate γ and δ consistently,
were εt observable. The solution is to substitute the squared OLS residuals ε̂t2 in place of
εt2 , since it is consistent by the Slutsky theorem. Once we have γ̂ and δ̂, we can estimate σt2
consistently using
δ̂ p
σ̂t2 = zt0 γ̂ → σt2 .
In the second step, we transform the model by dividing by the standard deviation:
yt x0 β εt
= t +
σ̂t σ̂t σ̂t
or
yt∗ = xt∗0 β + εt∗ .
Asymptotically, this model satisfies the classical assumptions.
• This model is a bit complex in that NLS is required to estimate the model of the
variance. A simpler version would be
yt = xt0 β + εt
σt2 = E (εt2 ) = σ2 ztδ
where zt is a single variable. There are still two parameters to be estimated, and
the model of the variance is still nonlinear in the parameters. However, the search
method can be used in this case to reduce the estimation problem to repeated
applications of OLS.
• First, we define an interval of reasonable values for δ, e.g., δ ∈ [0, 3].
• Partition this interval into M equally spaced values, e.g., {0, .1, .2, ..., 2.9, 3}.
• For each of these values, calculate the variable ztδm .
• The regression
ε̂t2 = σ2 ztδm + vt
is linear in the parameters, conditional on δm , so one can estimate σ2 by OLS.
• Save the pairs (σ2m , δm ), and the corresponding ESSm . Choose the pair with the
minimum ESSm as the estimate.
• Next, divide the model by the estimated standard deviations.
• Can refine. Draw picture.
• Works well when the parameter to be searched over is low dimensional, as in this
case.
Groupwise heteroscedasticity
A common case is where we have repeated observations on each of a number of eco-
nomic agents: e.g., 10 years of macroeconomic data on each of a set of countries or re-
gions, or daily observations of transactions of 200 banks. This sort of data is a pooled
cross-section time-series model. It may be reasonable to presume that the variance is con-
stant over time within the cross-sectional units, but that it differs across them (e.g., firms or
countries of different sizes...). The model is
yit = x0it β + εit

E (ε2it ) = σ2i , ∀t
where i = 1, 2, ..., G are the agents, and t = 1, 2, ..., n are the observations on each agent.
• The other classical assumptions are presumed to hold.

• In this case, the variance σ2i is specific to each agent, but constant over the n
observations for that agent.
• In this model, we assume that E (εit εis ) = 0. This is a strong assumption that we’ll
relax later.
To correct for heteroscedasticity, just estimate each σ2i using the natural estimator:
1 n 2
σ̂2i = ∑ ε̂it
n t=1
• Note that we use 1/n here since it’s possible that there are more than n regressors,
so n − K could be negative. Asymptotically the difference is unimportant.
• With each of these, transform the model as usual:
yit x0 β εit
= it +
σ̂i σ̂i σ̂i
Do this for each cross-sectional group. This transformed model satisfies the clas-
sical assumptions, asymptotically.
7.4.4. Example: the Nerlove model (again!) Let’s check the Nerlove data for evi-
dence of heteroscedasticity. In what follows, we’re going to use the model with the constant
and output coefficient varying across 5 groups, but with the input price coefficients fixed
(see Equation 6.8.3 for the rationale behind this). Figure 7.4.1, which is generated by the
Octave program GLS/NerloveResiduals.m plots the residuals. We can see pretty clearly
that the error variance is larger for small firms than for larger firms.
Now let’s try out some tests to formally check for heteroscedasticity. The Octave
program GLS/HetTests.m performs the White and Goldfeld-Quandt tests, using the above
model. The results are
Value p-value
White’s test 61.903 0.000
Value p-value
GQ test 10.886 0.000
All in all, it is very clear that the data are heteroscedastic. That means that OLS estimation
is not efficient, and tests of restrictions that ignore heteroscedasticity are not valid. The
previous tests (CRTS, HOD1 and the Chow test) were calculated assuming homoscedastic-
ity. The Octave program GLS/NerloveRestrictions-Het.m uses the Wald test to check for
F IGURE 7.4.1. Residuals, Nerlove model, sorted by firm size

Regression residuals
1.5
Residuals
0.5
-0.5
-1
-1.5
0 20 40 60 80 100 120 140 160
CRTS and HOD1, but using a heteroscedastic-consistent covariance estimator. 1 The results
are
Testing HOD1
Value p-value
Wald test 6.161 0.013
Testing CRTS
Value p-value
Wald test 20.169 0.001
We see that the previous conclusions are altered - both CRTS is and HOD1 are rejected at
the 5% level. Maybe the rejection of HOD1 is due to to Wald test’s tendency to over-reject?
From the previous plot, it seems that the variance of ε is a decreasing function of
output. Suppose that the 5 size groups have different error variances (heteroscedasticity by
groups):
Var(εi ) = σ2j ,
where j = 1 if i = 1, 2, ..., 29, etc., as before. The Octave program GLS/NerloveGLS.m
estimates the model using GLS (through a transformation of the model so that OLS can be
applied). The estimation results are
*********************************************************
1By the way, notice that GLS/NerloveResiduals.m and GLS/HetTests.m use the restricted LS estimator directly
to restrict the fully general model with all coefficients varying to the model with only the constant and the output
coefficient varying. But GLS/NerloveRestrictions-Het.m estimates the model by substituting the restrictions into
the model. The methods are equivalent, but the second is more convenient and easier to understand.

Observations 145
R-squared 0.958822
Results (Het. consistent var-cov estimator)

constant1 -1.046 1.276 -0.820 0.414
constant2 -1.977 1.364 -1.450 0.149
constant3 -3.616 1.656 -2.184 0.031
constant4 -4.052 1.462 -2.771 0.006
constant5 -5.308 1.586 -3.346 0.001
output1 0.391 0.090 4.363 0.000
output2 0.649 0.090 7.184 0.000
output3 0.897 0.134 6.688 0.000
output4 0.962 0.112 8.612 0.000
output5 1.101 0.090 12.237 0.000
labor 0.007 0.208 0.032 0.975
fuel 0.498 0.081 6.149 0.000
capital -0.460 0.253 -1.818 0.071
*********************************************************
*********************************************************
Observations 145
R-squared 0.987429
Results (Het. consistent var-cov estimator)

constant1 -1.580 0.917 -1.723 0.087
constant2 -2.497 0.988 -2.528 0.013
constant3 -4.108 1.327 -3.097 0.002
constant4 -4.494 1.180 -3.808 0.000
constant5 -5.765 1.274 -4.525 0.000
output1 0.392 0.090 4.346 0.000
output2 0.648 0.094 6.917 0.000
output3 0.892 0.138 6.474 0.000
output4 0.951 0.109 8.755 0.000
output5 1.093 0.086 12.684 0.000
7.5. AUTOCORRELATION 82
labor 0.103 0.141 0.733 0.465

fuel 0.492 0.044 11.294 0.000
capital -0.366 0.165 -2.217 0.028
*********************************************************
Testing HOD1
Value p-value
Wald test 9.312 0.002
The first panel of output are the OLS estimation results, which are used to consistently esti-
mate the σ2j . The second panel of results are the GLS estimation results. Some comments:
• The R2 measures are not comparable - the dependent variables are not the same.
The measure for the GLS results uses the transformed dependent variable. One
could calculate a comparable R2 measure, but I have not done so.
• The differences in estimated standard errors (smaller in general for GLS) can
be interpreted as evidence of improved efficiency of GLS, since the OLS stan-
dard errors are calculated using the Huber-White estimator. They would not be
comparable if the ordinary (inconsistent) estimator had been used.
• Note that the previously noted pattern in the output coefficients persists. The
nonconstant CRTS result is robust.
• The coefficient on capital is now negative and significant at the 3% level. That
seems to indicate some kind of problem with the model or the data, or economic
theory.
• Note that HOD1 is now rejected. Problem of Wald test over-rejecting? Specifi-
cation error in model?
7.5. Autocorrelation
Autocorrelation, which is the serial correlation of the error term, is a problem that
is usually associated with time series data, but also can affect cross-sectional data. For
example, a shock to oil prices will simultaneously affect all countries, so one could expect
contemporaneous correlation of macroeconomic variables across countries.
7.5.1. Causes. Autocorrelation is the existence of correlation across the error term:
E (εt εs ) 6= 0,t 6= s.
Why might this occur? Plausible explanations include

(1) Lags in adjustment to shocks. In a model such as
yt = xt0 β + εt ,
one could interpret xt0 β as the equilibrium value. Suppose xt is constant over a
number of observations. One can interpret εt as a shock that moves the system
away from equilibrium. If the time needed to return to equilibrium is long with
F IGURE 7.5.1. Autocorrelation induced by misspecification
respect to the observation frequency, one could expect εt+1 to be positive, condi-
tional on εt positive, which induces a correlation.
(2) Unobserved factors that are correlated over time. The error term is often assumed
to correspond to unobservable factors. If these factors are correlated, there will
be autocorrelation.
(3) Misspecification of the model. Suppose that the DGP is
yt = β0 + β1xt + β2 xt2 + εt
but we estimate
yt = β0 + β1xt + εt
The effects are illustrated in Figure 7.5.1.
7.5.2. Effects on the OLS estimator. The variance of the OLS estimator is the same
as in the case of heteroscedasticity - the standard formula does not apply. The correct
formula is given in equation 7.1.1. Next we discuss two GLS corrections for OLS. These
will potentially induce inconsistency when the regressors are nonstochastic (see Chapter 8)
and should either not be used in that case (which is usually the relevant case) or used with
caution. The more recommended procedure is discussed in section 7.5.5.
7.5.3. AR(1). There are many types of autocorrelation. We’ll consider two examples.
The first is the most commonly encountered case: autoregressive order 1 (AR(1) errors.
The model is
yt = xt0 β + εt
εt = ρεt−1 + ut
ut ∼ iid(0, σ2u )
E (εt us ) = 0,t < s
We assume that the model satisfies the other classical assumptions.
• We need a stationarity assumption: |ρ| < 1. Otherwise the variance of εt explodes

as t increases, so standard asymptotics will not apply.
• By recursive substitution we obtain
= ρ (ρεt−2 + ut−1 ) + ut
= ρ2 εt−2 + ρut−1 + ut
= ρ2 (ρεt−3 + ut−2 ) + ρut−1 + ut
In the limit the lagged ε drops out, since ρm → 0 as m → ∞, so we obtain

∞
εt = ∑ ρm ut−m
m=0
With this, the variance of εt is found as

∞
E (εt2 ) = σ2u ∑ ρ2m
m=0
σ2u
=
1 − ρ2
• If we had directly assumed that εt were covariance stationary, we could obtain
this using
V (εt ) = ρ2 E (εt−1
2
) + 2ρE (εt−1 ut ) + E (ut2 )
= ρ2V (εt ) + σ2u,
so
σ2u
V (εt ) =
1 − ρ2
• The variance is the 0th order autocovariance: γ0 = V (εt )
• Note that the variance does not depend on t
Likewise, the first order autocovariance γ1 is
Cov(εt , εt−1 ) = γs = E ((ρεt−1 + ut ) εt−1 )

= ρV (εt )
ρσ2u
=
1 − ρ2
• Using the same method, we find that for s < t

ρs σ2u
Cov(εt , εt−s ) = γs =
1 − ρ2
• The autocovariances don’t depend on t: the process {εt } is covariance stationary
The correlation (in general, for r.v.’s x and y) is defined as

cov(x, y)
corr(x, y) =
se(x)se(y)
but in this case, the two standard errors are the same, so the s-order autocorrelation ρ s is
ρs = ρ s
• All this means that the overall matrix Σ has the form
 
1 ρ ρ2 · · · ρn−1
 
 ρ
 1 ρ · · · ρn−2 

σu2
 ... ..
 .. 
Σ= . . 
1 − ρ2  
| {z }   .. 

this is the variance 
. ρ 
ρn−1 ··· 1
| {z }
this is the correlation matrix
So we have homoscedasticity, but elements off the main diagonal are not zero.
All of this depends only on two parameters, ρ and σ2u . If we can estimate these
consistently, we can apply FGLS.
It turns out that it’s easy to estimate these consistently. The steps are
(1) Estimate the model yt = xt0 β + εt by OLS.

(2) Take the residuals, and estimate the model
ε̂t = ρε̂t−1 + ut∗

p
Since ε̂t → εt , this regression is asymptotically equivalent to the regression
which satisfies the classical assumptions. Therefore, ρ̂ obtained by applying OLS

p
to ε̂t = ρε̂t−1 + ut∗ is consistent. Also, since ut∗ → ut , the estimator
1 n ∗ 2 p 2
σ̂2u = ∑ (ût ) → σu
n t=2
(3) With the consistent estimators σ̂2u and ρ̂, form Σ̂ = Σ(σ̂2u , ρ̂) using the previous
structure of Σ, and estimate by FGLS. Actually, one can omit the factor σ̂2u /(1 −
ρ2 ), since it cancels out in the formula
−1 0 −1
β̂FGLS = X 0 Σ̂−1 X (X Σ̂ y).
• One can iterate the process, by taking the first FGLS estimator of β, re-estimating
ρ and σ2u , etc. If one iterates to convergences it’s equivalent to MLE (supposing
normal errors).
• An asymptotically equivalent approach is to simply estimate the transformed

model
yt − ρ̂yt−1 = (xt − ρ̂xt−1 )0 β + ut∗
using n − 1 observations (since y0 and x0 aren’t available). This is the method
of Cochrane and Orcutt. Dropping the first observation is asymptotically irrele-
vant, but it can be very important in small samples. One can recuperate the first
observation by putting
q
y∗1 = y1 1 − ρ̂2
q
x∗1 = x1 1 − ρ̂2
This somewhat odd-looking result is related to the Cholesky factorization of Σ −1 .

See Davidson and MacKinnon, pg. 348-49 for more discussion. Note that the
variance of y∗1 is σ2u , asymptotically, so we see that the transformed model will
be homoscedastic (and nonautocorrelated, since the u0 s are uncorrelated with the
y0 s, in different time periods.
7.5.4. MA(1). The linear regression model with moving average order 1 errors is
yt = xt0 β + εt
εt = ut + φut−1
ut ∼ iid(0, σ2u )
E (εt us ) = 0,t < s
In this case,
h i
V (εt ) = γ0 = E (ut + φut−1 )2
= σ2u + φ2 σ2u
= σ2u (1 + φ2 )
Similarly
γ1 = E [(ut + φut−1 ) (ut−1 + φut−2 )]

= φσ2u
and
γ2 = [(ut + φut−1 ) (ut−2 + φut−3 )]

= 0
so in this case  
1 + φ2 φ 0 ··· 0
 
 φ
 1 + φ2 φ 

2
 .. .. 

Σ = σu  0 φ . . 
 .. .. 
 . . φ 
 
0 ··· φ 1 + φ2
Note that the first order autocorrelation is

φσ2u γ1
ρ1 = σ2u (1+φ2 )
=
γ0
φ
=
(1 + φ2)
• This achieves a maximum at φ = 1 and a minimum at φ = −1, and the maximal
and minimal autocorrelations are 1/2 and -1/2. Therefore, series that are more
strongly autocorrelated can’t be MA(1) processes.
Again the covariance matrix has a simple structure that depends on only two parameters.
The problem in this case is that one can’t estimate φ using OLS on
ε̂t = ut + φut−1
because the ut are unobservable and they can’t be estimated consistently. However, there is
a simple way to estimate the parameters.
• Since the model is homoscedastic, we can estimate
V (εt ) = σ2ε = σ2u (1 + φ2 )
using the typical estimator:

1 n 2
c2 = σ2\
σ ε u (1 + φ 2) =
∑ ε̂t
n t=1
• By the Slutsky theorem, we can interpret this as defining an (unidentified) esti-
mator of both σ2u and φ, e.g., use this as
1 n
σ u φ2 ) = ∑ ε̂t2
c2 (1 + b
n t=1
However, this isn’t sufficient to define consistent estimators of the parameters,
since it’s unidentified.
• To solve this problem, estimate the covariance of εt and εt−1 using
n
d2 = 1
d t , εt−1 ) = φσ
Cov(ε u ∑
n t=2
ε̂t ε̂t−1
This is a consistent estimator, following a LLN (and given that the epsilon hats
are consistent for the epsilons). As above, this can be interpreted as defining an
unidentified estimator:
1 n
c2 =
φ̂σ u ∑ ε̂t ε̂t−1
n t=2
• Now solve these two equations to obtain identified (and therefore consistent)
estimators of both φ and σ2u . Define the consistent estimator
c2 )
Σ̂ = Σ(φ̂, σ u
following the form we’ve seen above, and transform the model using the Cholesky
decomposition. The transformed model satisfies the classical assumptions asymp-
totically.
7.5.5. Asymptotically valid inferences with autocorrelation of unknown form. See

Hamilton Ch. 10, pp. 261-2 and 280-84.
When the form of autocorrelation is unknown, one may decide to use the OLS estima-
tor, without correction. We’ve seen that this estimator has the limiting distribution
√
d
n β̂ − β → N 0, Q−1 X ΩQX
−1
where, as before, Ω is
X 0 εε0 X
Ω = lim E
n→∞ n
We need a consistent estimate of Ω. Define mt = xt εt (recall that xt is defined as a K × 1
vector). Note that
 
ε1
h i
 ε2


Xε0
= x1 x2 ··· xn 
 .. 

 . 
εn
n
= ∑ xt εt
t=1
n
= ∑ mt
t=1
so that " ! !#
n n
1
Ω = lim E
n→∞ n
∑ mt ∑ mt0
t=1 t=1
We assume that mt is covariance stationary (so that the covariance between mt and mt−s
does not depend on t).
Define the v − th autocovariance of mt as
Γv = E (mt mt−v
0
).
0 ) = Γ0 . (show this with an example). In general, we expect that:
Note that E (mt mt+v v
• mt will be autocorrelated, since εt is potentially autocorrelated:
Γv = E (mt mt−v
0
) 6= 0
Note that this autocovariance does not depend on t, due to covariance stationarity.
• contemporaneously correlated ( E (mit m jt ) 6= 0 ), since the regressors in xt will
in general be correlated (more on this later).
• and heteroscedastic (E (m2it ) = σ2i , which depends upon i ), again since the re-
gressors will have different variances.
While one could estimate Ω parametrically, we in general have little information upon
which to base a parametric specification. Recent research has focused on consistent non-
parametric estimators of Ω.
Now define " ! !#
n n
1
Ωn = E
n ∑ mt ∑ mt0
t=1 t=1
We have (show that the following is true, by expanding sum and shifting rows to left)
n−1 n−2 1
Ωn = Γ 0 + Γ1 + Γ01 + Γ2 + Γ02 · · · + Γn−1 + Γ0n−1
n n n
The natural, consistent estimator of Γv is
1 n
Γbv = ∑ m̂t m̂t−v
n t=v+1
0
.
where
m̂t = xt ε̂t
(note: one could put 1/(n−v) instead of 1/n here). So, a natural, but inconsistent, estimator
of Ωn would be
n−2 1d
Ω̂n c0 + n − 1 Γ
= Γ c1 + c
Γ01 + c2 + c
Γ Γ02 + · · · + Γn−1 + Γd
0
n−1
n n n
n−1
c0 + ∑ n − v Γbv + Γb0v .
= Γ
v=1 n
This estimator is inconsistent in general, since the number of parameters to estimate is more
than the number of observations, and increases more rapidly than n, so information does
not build up as n → ∞.
On the other hand, supposing that Γv tends to zero sufficiently rapidly as v tends to ∞,
a modified estimator
q(n)
c0 + ∑ Γbv + Γb0v ,
Ω̂n = Γ
v=1
p
where q(n) → ∞ as n → ∞ will be consistent, provided q(n) grows sufficiently slowly.
• The assumption that autocorrelations die off is reasonable in many cases. For
example, the AR(1) model with |ρ| < 1 has autocorrelations that die off.
• The term n−v
n can be dropped because it tends to one for v < q(n), given that q(n)
increases slowly relative to n.
• A disadvantage of this estimator is that is may not be positive definite. This could
cause one to calculate a negative χ2 statistic, for example!
• Newey and West proposed and estimator (Econometrica, 1987) that solves the
problem of possible nonpositive definiteness of the above estimator. Their esti-
mator is
q(n)
v
Ω̂n = Γ0 + ∑ 1 −
c Γbv + Γb0v .
v=1 q+1
This estimator is p.d. by construction. The condition for consistency is that
n−1/4 q(n) → 0. Note that this is a very slow rate of growth for q. This estimator
is nonparametric - we’ve placed no parametric restrictions on the form of Ω. It is
an example of a kernel estimator.
p
cX = 1 X 0 X to
Finally, since Ωn has Ω as its limit, Ω̂n → Ω. We can now use Ω̂n and Q n
consistently estimate the limiting distribution of the OLS estimator under heteroscedasticity
and autocorrelation of unknown form. With this, asymptotically valid tests are constructed
in the usual way.
7.5.6. Testing for autocorrelation. Durbin-Watson test

The Durbin-Watson test statistic is

n 2
∑t=2 (ε̂t − ε̂t−1 )
DW = n
∑t=1 ε̂t2
n

∑t=2 ε̂t2 − 2ε̂t ε̂t−1 + ε̂t−1
2
= n
∑t=1 ε̂t2
• The null hypothesis is that the first order autocorrelation of the errors is zero: H0 :
ρ1 = 0. The alternative is of course HA : ρ1 6= 0. Note that the alternative is not
that the errors are AR(1), since many general patterns of autocorrelation will have
the first order autocorrelation different than zero. For this reason the test is useful
for detecting autocorrelation in general. For the same reason, one shouldn’t just
assume that an AR(1) model is appropriate when the DW test rejects the null.
• Under the null, the middle term tends to zero, and the other two tend to one, so
p
DW → 2.
• Supposing that we had an AR(1) error process with ρ = 1. In this case the middle
p
term tends to −2, so DW → 0
• Supposing that we had an AR(1) error process with ρ = −1. In this case the
p
middle term tends to 2, so DW → 4
• These are the extremes: DW always lies between 0 and 4.
• The distribution of the test statistic depends on the matrix of regressors, X, so
tables can’t give exact critical values. The give upper and lower bounds, which
correspond to the extremes that are possible. See Figure 7.5.2. There are means
of determining exact critical values conditional on X.
• Note that DW can be used to test for nonlinearity (add discussion).
• The DW test is based upon the assumption that the matrix X is fixed in repeated
samples. This is often unreasonable in the context of economic time series, which
is precisely the context where the test would have application. It is possible to
relate the DW test to other test statistics which are valid without strict exogeneity.
Breusch-Godfrey test
This test uses an auxiliary regression, as does the White test for heteroscedasticity. The
regression is
ε̂t = xt0 δ + γ1 ε̂t−1 + γ2 ε̂t−2 + · · · + γP ε̂t−P + vt
and the test statistic is the nR2 statistic, just as in the White test. There are P restrictions,
so the test statistic is asymptotically distributed as a χ2 (P).
• The intuition is that the lagged errors shouldn’t contribute to explaining the cur-
rent error if there is no autocorrelation.
• xt is included as a regressor to account for the fact that the ε̂t are not independent
even if the εt are. This is a technicality that we won’t go into here.
• This test is valid even if the regressors are stochastic and contain lagged depen-
dent variables, so it is considerably more useful than the DW test for typical time
series data.
F IGURE 7.5.2. Durbin-Watson critical values
• The alternative is not that the model is an AR(P), following the argument above.
The alternative is simply that some or all of the first P autocorrelations are differ-
ent from zero. This is compatible with many specific forms of autocorrelation.
7.5.7. Lagged dependent variables and autocorrelation. We’ve seen that the OLS
estimator is consistent under autocorrelation, as long as plim Xnε = 0. This will be the case
0
when E (X 0 ε) = 0, following a LLN. An important exception is the case where X contains

lagged y0 s and the errors are autocorrelated. A simple example is the case of a single lag of
the dependent variable with AR(1) errors. The model is
yt = xt0 β + yt−1γ + εt
Now we can write

0
E (yt−1 εt ) = E (xt−1 β + yt−2γ + εt−1 )(ρεt−1 + ut )
6= 0
2 ) which is clearly nonzero. In this case E (X 0 ε) 6= 0, and
since one of the terms is E (ρεt−1
therefore plim Xnε 6= 0. Since
0
X 0ε
plimβ̂ = β + plim
n
the OLS estimator is inconsistent in this case. One needs to estimate by instrumental vari-
ables (IV), which we’ll get to later.
7.5.8. Examples.
Nerlove model, yet again. The Nerlove model uses cross-sectional data, so one may
not think of performing tests for autocorrelation. However, specification error can induce
autocorrelated errors. Consider the simple Nerlove model
lnC = β1 + β2 ln Q + β3 ln PL + β4 ln PF + β5 ln PK + ε
and the extended Nerlove model

j j
lnC = β1 + β2 ln Q + β3 ln PL + β4 ln PF + β5 ln PK + ε.
We have seen evidence that the extended model is preferred. So if it is in fact the proper
model, the simple model is misspecified. Let’s check if this misspecification might induce
autocorrelated errors.
The Octave program GLS/NerloveAR.m estimates the simple Nerlove model, and
plots the residuals as a function of ln Q, and it calculates a Breusch-Godfrey test statis-
tic. The residual plot is in Figure 7.6.1 , and the test results are:
Value p-value
Breusch-Godfrey test 34.930 0.000
Clearly, there is a problem of autocorrelated residuals.
E XERCISE 7.6. Repeat the autocorrelation tests using the extended Nerlove model
(Equation ??) to see the problem is solved.
Klein model. Klein’s Model I is a simple macroeconometric model. One of the equa-
tions in the model explains consumption (C) as a function of profits (P), both current and
lagged, as well as the sum of wages in the private sector (W p ) and wages in the government
sector (W g ). Have a look at the README file for this data set. This gives the variable
names and other information.
Consider the model
p g
Ct = α0 + α1 Pt + α2 Pt−1 + α3 (Wt +Wt ) + ε1t
The Octave program GLS/Klein.m estimates this model by OLS, plots the residuals, and
performs the Breusch-Godfrey test, using 1 lag of the residuals. The estimation and test
results are:
*********************************************************
Observations 21
R-squared 0.981008

F IGURE 7.6.1. Residuals of simple Nerlove model

2
Residuals
Quadratic fit to Residuals
1.5
0.5
-0.5
-1
0 1 2 3 4 5 6 7 8 9 10

Constant 16.237 1.303 12.464 0.000
Profits 0.193 0.091 2.115 0.049
Lagged Profits 0.090 0.091 0.992 0.335
Wages 0.796 0.040 19.933 0.000
*********************************************************
Value p-value
and the residual plot is in Figure 7.6.2. The test does not reject the null of nonautocorre-
latetd errors, but we should remember that we have only 21 observations, so power is likely
to be fairly low. The residual plot leads me to suspect that there may be autocorrelation -
there are some significant runs below and above the x-axis. Your opinion may differ.
Since it seems that there may be autocorrelation, lets’s try an AR(1) correction. The
Octave program GLS/KleinAR1.m estimates the Klein consumption equation assuming
that the errors follow the AR(1) pattern. The results, with the Breusch-Godfrey test for
remaining autocorrelation are:
*********************************************************
Observations 21
F IGURE 7.6.2. OLS residuals, Klein consumption equation

Regression residuals
2
Residuals
1.5
0.5
-0.5
-1
-1.5
-2
-2.5
0 5 10 15 20 25
R-squared 0.967090

Constant 16.992 1.492 11.388 0.000
Profits 0.215 0.096 2.232 0.039
Lagged Profits 0.076 0.094 0.806 0.431
Wages 0.774 0.048 16.234 0.000
*********************************************************
Value p-value
• The test is farther away from the rejection region than before, and the residual
plot is a bit more favorable for the hypothesis of nonautocorrelated residuals,
IMHO. For this reason, it seems that the AR(1) correction might have improved
the estimation.
• Nevertheless, there has not been much of an effect on the estimated coefficients
nor on their estimated standard errors. This is probably because the estimated
AR(1) coefficient is not very large (around 0.2)
• The existence or not of autocorrelation in this model will be important later, in

the section on simultaneous equations.
EXERCISES 96
Exercises
(1) Comparing the variances of the OLS and GLS estimators, I claimed that the following
holds:
0
Var(β̂) −Var(β̂GLS ) = AΣA
Verify that this is true.

(2) Show that the GLS estimator can be defined as
β̂GLS = argmin(y − Xβ)0Σ−1 (y − Xβ)
(3) The limiting distribution of the OLS estimator with heteroscedasticity of unknown
form is
√
d
n β̂ − β → N 0, Q−1
X ΩQX ,
−1
where
X 0 εε0 X
lim E =Ω
n→∞ n
Explain why
n
b = 1 ∑ xt x0 ε̂2
Ω
n t=1 t t
is a consistent estimator of this matrix.
(4) Define the v − th autocovariance of a covariance stationary process mt , where E(mt =
0) as
Γv = E (mt mt−v
0
).
0 ) = Γ0 .
Show that E (mt mt+v v
(5) For the Nerlove model
j j
assume that V (εt |xt ) = σ2j , j = 1, 2, ..., 5. That is, the variance depends upon which of
the 5 firm size groups the observation belongs to.
a) Apply White’s test using the OLS residuals, to test for homoscedasticity
b) Calculate the FGLS estimator and interpret the estimation results.
c) Test the transformed model to check whether it appears to satisfy homoscedasticity.
CHAPTER 8
Stochastic regressors
Up to now we have treated the regressors as fixed, which is clearly unrealistic. Now we
will assume they are random. There are several ways to think of the problem. First, if we
are interested in an analysis conditional on the explanatory variables, then it is irrelevant if
they are stochastic or not, since conditional on the values of they regressors take on, they
are nonstochastic, which is the case already considered.
• In cross-sectional analysis it is usually reasonable to make the analysis condi-

tional on the regressors.
• In dynamic models, where yt may depend on yt−1 , a conditional analysis is not
sufficiently general, since we may want to predict into the future many periods
out, so we need to consider the behavior of β̂ and the relevant test statistics un-
conditional on X.
The model we’ll deal will involve a combination of the following assumptions
yt = xt0 β0 + εt ,
or in matrix form,
y = Xβ0 + ε,
0
where y is n × 1, X = x1 x2 · · · xn , where xt is K × 1, and β0 and ε are con-
formable.
Stochastic, linearly independent regressors
X has rank K with probability 1
X is stochastic

limn→∞ Pr 1n X 0 X = QX = 1, where QX is a finite positive definite matrix.
Central limit theorem
d
n−1/2 X 0 ε → N(0, QX σ20 )
Normality (Optional): ε|X ∼ N(0, σ2 In ): ε is normally distributed
Strongly exogenous regressors:
(8.0.1) E (εt |X) = 0, ∀t
Weakly exogenous regressors:
(8.0.2) E(εt |xt ) = 0, ∀t
In both cases, xt0 β is the conditional mean of yt given xt : E(yt |xt ) = xt0 β
97
8.2. CASE 2 98
8.1. Case 1
Normality of ε, strongly exogenous regressors

In this case,
β̂ = β0 + (X 0 X)−1 X 0 ε
E (β̂|X) = β0 + (X 0 X)−1 X 0 E (ε|X)

= β0
and since this holds for all X, E(β̂) = β, unconditional on X. Likewise,

β̂|X ∼ N β, (X 0 X)−1 σ20
• If the density of X is dµ(X), the marginal density of β̂ is obtained by multiplying

the conditional density by dµ(X) and integrating over X. Doing this leads to a
nonnormal density for β̂, in small samples.
• However, conditional on X, the usual test statistics have the t, F and χ 2 distribu-
tions. Importantly, these distributions don’t depend on X, so when marginalizing
to obtain the unconditional distribution, nothing changes. The tests are valid in
small samples.
• Summary: When X is stochastic but strongly exogenous and ε is normally dis-
tributed:
(1) β̂ is unbiased
(2) β̂ is nonnormally distributed
(3) The usual test statistics have the same distribution as with nonstochastic X.
(4) The Gauss-Markov theorem still holds, since it holds conditionally on X,
and this is true for all X.
(5) Asymptotic properties are treated in the next section.
8.2. Case 2
ε nonnormally distributed, strongly exogenous regressors

The unbiasedness of β̂ carries through as before. However, the argument regarding test
statistics doesn’t hold, due to nonnormality of ε. Still, we have
β̂ = β0 + (X 0 X)−1 X 0 ε
0 −1 0
XX Xε
= β0 +
n n
Now −1
X 0X p
→ Q−1
X
n
by assumption, and
X 0 ε n−1/2 X 0 ε p
= √ →0
n n
since the numerator converges to a N(0, QX σ2 ) r.v. and the denominator still goes to infin-
ity. We have unbiasedness and the variance disappearing, so, the estimator is consistent:
p
β̂ → β0 .
8.4. WHEN ARE THE ASSUMPTIONS REASONABLE? 99
Considering the asymptotic distribution

√ √ X 0 X −1 X 0 ε
n β̂ − β0 = n
n n
0 −1
XX
= n−1/2X 0 ε
n
so
√
d 2
X σ0 )
n β̂ − β0 → N(0, Q−1
directly following the assumptions. Asymptotic normality of the estimator still holds. Since
the asymptotic results on all test statistics only require this, all the previous asymptotic
results on test statistics are also valid in this case.
• Summary: Under strongly exogenous regressors, with ε normal or nonnormal, β̂
has the properties:
(1) Unbiasedness
(2) Consistency
(3) Gauss-Markov theorem holds, since it holds in the previous case and doesn’t
depend on normality.
(4) Asymptotic normality
(5) Tests are asymptotically valid
(6) Tests are not valid in small samples if the error is normally distributed
8.3. Case 3
Weakly exogenous regressors

An important class of models are dynamic models, where lagged dependent variables
have an impact on the current value. A simple version of these models that captures the
important points is
p
yt = zt0 α + ∑ γs yt−s + εt
s=1
= xt β + εt
0
where now xt contains lagged dependent variables. Clearly, even with E(εt |xt ) = 0, X and
ε are not uncorrelated, so one can’t show unbiasedness. For example,
E (εt−1 xt ) 6= 0
since xt contains yt−1 (which is a function of εt−1 ) as an element.

• This fact implies that all of the small sample properties such as unbiasedness,
Gauss-Markov theorem, and small sample validity of test statistics do not hold
in this case. Recall Figure 3.7.2. This is a case of weakly exogenous regressors,
and we see that the OLS estimator is biased in this case.
• Nevertheless, under the above assumptions, all asymptotic properties continue to
hold, using the same arguments as before.
8.4. When are the assumptions reasonable?
The two assumptions we’ve added are

8.4. WHEN ARE THE ASSUMPTIONS REASONABLE? 100
1 0

(1) limn→∞ Pr nX X = QX = 1, a QX finite positive definite matrix.
d
(2) n−1/2 X 0 ε → N(0, QX σ20 )
The most complicated case is that of dynamic models, since the other cases can be treated as
nested in this case. There exist a number of central limit theorems for dependent processes,
many of which are fairly technical. We won’t enter into details (see Hamilton, Chapter 7
if you’re interested). A main requirement for use of standard asymptotics for a dependent
sequence
1 n
{st } = { ∑ zt }
n t=1
to converge in probability to a finite limit is that zt be stationary, in some sense.
• Strong stationarity requires that the joint distribution of the set
{zt , zt+s , zt−q , ...}
not depend on t.
• Covariance (weak) stationarity requires that the first and second moments of this
set not depend on t.
• An example of a sequence that doesn’t satisfy this is an AR(1) process with a unit
root (a random walk):
xt = xt−1 + εt
εt ∼ IIN(0, σ2 )
One can show that the variance of xt depends upon t in this case.
Stationarity prevents the process from trending off to plus or minus infinity, and prevents
cyclical behavior which would allow correlations between far removed zt znd zs to be high.
Draw a picture here.
• In summary, the assumptions are reasonable when the stochastic conditioning
variables have variances that are finite, and are not too strongly dependent. The
AR(1) model with unit root is an example of a case where the dependence is too
strong for standard asymptotics to apply.
• The econometrics of nonstationary processes has been an active area of research
in the last two decades. The standard asymptotics don’t apply in this case. This
isn’t in the scope of this course.
EXERCISES 101
Exercises
(1) Show that for two random variables A and B, if E(A|B) = 0, then E (A f (B)) = 0. How
is this used in the Gauss-Markov theorem?
(2) If it possible for an AR(1) model for time series data, e.g., yt = 0 + 0.9yt−1 + εt satisfy
weak exogeneity? Strong exogeneity? Discuss.
CHAPTER 9
Data problems
In this section well consider problems associated with the regressor matrix: collinear-
ity, missing observation and measurement error.
9.1. Collinearity
Collinearity is the existence of linear relationships amongst the regressors. We can

always write
λ1 x 1 + λ 2 x 2 + · · · + λ K x K + v = 0
th
where xi is the i column of the regressor matrix X, and v is an n × 1 vector. In the
case that there exists collinearity, the variation in v is relatively small, so that there is an
approximately exact linear relation between the regressors.
• “relative” and “approximate” are imprecise, so it’s difficult to define when collinearilty
exists.
In the extreme, if there are exact linear relationships (every element of v equal) then ρ(X) <
K, so ρ(X 0 X) < K, so X 0 X is not invertible and the OLS estimator is not uniquely defined.
For example, if the model is
yt = β1 + β2 x2t + β3x3t + εt
x2t = α1 + α2 x3t
then we can write
yt = β1 + β2 (α1 + α2 x3t ) + β3x3t + εt

= β1 + β2α1 + β2α2 x3t + β3x3t + εt
= (β1 + β2α1 ) + (β2 α2 + β3) x3t
= γ1 + γ2 x3t + εt
• The γ0 s can be consistently estimated, but since the γ0 s define two equations in
three β0 s, the β0 s can’t be consistently estimated (there are multiple values of β
that solve the fonc). The β0 s are unidentified in the case of perfect collinearity.
• Perfect collinearity is unusual, except in the case of an error in construction of
the regressor matrix, such as including the same regressor twice.
Another case where perfect collinearity may be encountered is with models with dummy
variables, if one is not careful. Consider a model of rental price (y i ) of an apartment. This
could depend factors such as size, quality etc., collected in x i , as well as on the location of
the apartment. Let Bi = 1 if the ith apartment is in Barcelona, Bi = 0 otherwise. Similarly,
102
9.1. COLLINEARITY 103
F IGURE 9.1.1. s(β) when there is no collinearity
60
55
50
45
40
6 35
30
25
4 20
15
-2
-4
-6
-6 -4 -2 0 2 4 6
define Gi , Ti and Li for Girona, Tarragona and Lleida. One could use a model such as
yi = β1 + β2 Bi + β3 Gi + β4 Ti + β5 Li + x0i γ + εi
In this model, Bi + Gi + Ti + Li = 1, ∀i, so there is an exact relationship between these

variables and the column of ones corresponding to the constant. One must either drop the
constant, or one of the qualitative variables.
9.1.1. A brief aside on dummy variables. Introduce a brief discussion of dummy

variables here.
9.1.2. Back to collinearity. The more common case, if one doesn’t make mistakes
such as these, is the existence of inexact linear relationships, i.e., correlations between the
regressors that are less than one in absolute value, but not zero. The basic problem is
that when two (or more) variables move together, it is difficult to determine their separate
influences. This is reflected in imprecise estimates, i.e., estimates with high variances. With
economic data, collinearity is commonly encountered, and is often a severe problem.
When there is collinearity, the minimizing point of the objective function that defines
the OLS estimator (s(β), the sum of squared errors) is relatively poorly defined. This is
seen in Figures 9.1.1 and 9.1.2.
To see the effect of collinearity on variances, partition the regressor matrix as
h i
X= x W
where x is the first column of X (note: we can interchange the columns of X isf we like, so
there’s no loss of generality in considering the first column). Now, the variance of β̂, under
F IGURE 9.1.2. s(β) when there is collinearity
100
90
80
70
60
6 50
40
30
4 20
-2
-4
-6
-6 -4 -2 0 2 4 6
the classical assumptions, is

−1
V (β̂) = X 0 X σ2
Using the partition, " #
x0 x x 0W
X 0X =
W 0 x W 0W
and following a rule for partitioned inversion,
−1 −1
X 0 X 1,1 = x0 x − x0W (W 0W )−1W 0 x
0
−1
= x0 In −W (W 0W ) 1W 0 x
−1
= ESSx|W
where by ESSx|W we mean the error sum of squares obtained from the regression
x = W λ + v.
Since
R2 = 1 − ESS/TSS,
we have
ESS = T SS(1 − R2)
so the variance of the coefficient corresponding to x is
σ2
V (β̂x ) =
T SSx(1 − R2x|W )
We see three factors influence the variance of this coefficient. It will be high if
(1) σ2 is large
(2) There is little variation in x. Draw a picture here.
(3) There is a strong linear relationship between x and the other regressors, so that
W can explain the movement in x well. In this case, R2x|W will be close to 1. As
R2x|W → 1,V (β̂x ) → ∞.
The last of these cases is collinearity.
Intuitively, when there are strong linear relations between the regressors, it is difficult
to determine the separate influence of the regressors on the dependent variable. This can
be seen by comparing the OLS objective function in the case of no correlation between
regressors with the objective function with correlation between the regressors. See the
figures nocollin.ps (no correlation) and collin.ps (correlation), available on the web site.
9.1.3. Detection of collinearity. The best way is simply to regress each explanatory
variable in turn on the remaining regressors. If any of these auxiliary regressions has a
high R2 , there is a problem of collinearity. Furthermore, this procedure identifies which
parameters are affected.
• Sometimes, we’re only interested in certain parameters. Collinearity isn’t a prob-
lem if it doesn’t affect what we’re interested in estimating.
An alternative is to examine the matrix of correlations between the regressors. High corre-
lations are sufficient but not necessary for severe collinearity.
Also indicative of collinearity is that the model fits well (high R2 ), but none of the
variables is significantly different from zero (e.g., their separate influences aren’t well de-
termined).
In summary, the artificial regressions are the best approach if one wants to be careful.
9.1.4. Dealing with collinearity. More information

Collinearity is a problem of an uninformative sample. The first question is: is all the
available information being used? Is more data available? Are there coefficient restrictions
that have been neglected? Picture illustrating how a restriction can solve problem of perfect
collinearity.
Stochastic restrictions and ridge regression
Supposing that there is no more data or neglected restrictions, one possibility is to
change perspectives, to Bayesian econometrics. One can express prior beliefs regarding the
coefficients using stochastic restrictions. A stochastic linear restriction would be something
of the form
Rβ = r + v
where R and r are as in the case of exact linear restrictions, but v is a random vector. For
example, the model could be
y = Xβ + ε
Rβ = r + v
! ! !
ε 0 σ2ε In 0n×q
∼ N ,
v 0 0q×n σ2v Iq
This sort of model isn’t in line with the classical interpretation of parameters as constants:
according to this interpretation the left hand side of Rβ = r + v is constant but the right is
random. This model does fit the Bayesian perspective: we combine information coming
from the model and the data, summarized in
y = Xβ + ε
ε ∼ N(0, σ2ε In )
with prior beliefs regarding the distribution of the parameter, summarized in
Rβ ∼ N(r, σ2v Iq )
Since the sample is random it is reasonable to suppose that E (εv0 ) = 0, which is the last
piece of information in the specification. How can you estimate using this model? The
solution is to treat the restrictions as artificial data. Write
" # " # " #
y X ε
= β+
r R v
This model is heteroscedastic, since σ2ε 6= σ2v . Define the prior precision k = σε /σv . This
expresses the degree of belief in the restriction relative to the variability of the data. Sup-
posing that we specify k, then the model
" # " # " #
y X ε
= β+
kr kR kv
is homoscedastic and can be estimated by OLS. Note that this estimator is biased. It is
consistent, however, given that k is a fixed constant, even if the restriction is false (this
is in contrast to the case of false exact restrictions). To see this, note that there are Q
restrictions, where Q is the number of rows of R. As n → ∞, these Q artificial observations
have no weight in the objective function, so the estimator has the same limiting objective
function as the OLS estimator, and is therefore consistent.
To motivate the use of stochastic restrictions, consider the expectation of the squared
length of β̂:

−1 0 0 −1 0
E (β̂0 β̂) = E β + X 0X Xε β + X 0X Xε

= β0 β + E ε0 X(X 0 X)−1 (X 0 X)−1 X 0 ε
−1 2
= β0 β + Tr X 0 X σ
K
= β0 β + σ2 ∑ λi (the trace is the sum of eigenvalues)
i=1
> β β + λmax(X 0 X −1 ) σ2 (the eigenvalues are all positive, sinceX 0 X is p.d.

0
so
σ2
E (β̂0 β̂) > β0 β +
λmin(X 0 X)
where λmin(X 0 X) is the minimum eigenvalue of X 0 X (which is the inverse of the maximum
eigenvalue of (X 0 X)−1 ). As collinearity becomes worse and worse, X 0 X becomes more
9.2. MEASUREMENT ERROR 107
nearly singular, so λmin(X 0 X) tends to zero (recall that the determinant is the product of the
eigenvalues) and E (β̂0 β̂) tends to infinite. On the other hand, β0 β is finite.
Now considering the restriction IK β = 0 + v. With this restriction the model becomes
" # " # " #
y X ε
= β+
0 kIK kv
and the estimator is
" #!−1 " #
h i X h i y
β̂ridge = X0 kIK X0 IK
kIK 0
−1
= X 0 X + k2 IK X 0y
This is the ordinary ridge regression estimator. The ridge regression estimator can be seen
to add k2 IK , which is nonsingular, to X 0 X, which is more and more nearly singular as
collinearity becomes worse and worse. As k → ∞, the restrictions tend to β = 0, that is, the
coefficients are shrunken toward zero. Also, the estimator tends to
−1 −1 X 0y
β̂ridge = X 0 X + k2 IK X 0 y → k2 IK X 0y = →0
k2
so β̂0ridge β̂ridge → 0. This is clearly a false restriction in the limit, if our original model is at
al sensible.
There should be some amount of shrinkage that is in fact a true restriction. The prob-
lem is to determine the k such that the restriction is correct. The interest in ridge regression
centers on the fact that it can be shown that there exists a k such that MSE( β̂ridge ) < β̂OLS .
The problem is that this k depends on β and σ2 , which are unknown.
The ridge trace method plots β̂0ridge β̂ridge as a function of k, and chooses the value of k
that “artistically” seems appropriate (e.g., where the effect of increasing k dies off). Draw
picture here. This means of choosing k is obviously subjective. This is not a problem from
the Bayesian perspective: the choice of k reflects prior beliefs about the length of β.
In summary, the ridge estimator offers some hope, but it is impossible to guarantee
that it will outperform the OLS estimator. Collinearity is a fact of life in econometrics, and
there is no clear solution to the problem.
9.2. Measurement error
Measurement error is exactly what it says, either the dependent variable or the re-
gressors are measured with error. Thinking about the way economic data are reported,
measurement error is probably quite prevalent. For example, estimates of growth of GDP,
inflation, etc. are commonly revised several times. Why should the last revision necessarily
be correct?
9.2.1. Error of measurement of the dependent variable. Measurement errors in the

dependent variable and the regressors have important differences. First consider error in
9.2. MEASUREMENT ERROR 108
measurement of the dependent variable. The data generating process is presumed to be
y∗ = Xβ + ε
y = y∗ + v
vt ∼ iid(0, σ2v )
where y∗ is the unobservable true dependent variable, and y is what is observed. We assume
that ε and v are independent and that y∗ = Xβ + ε satisfies the classical assumptions. Given
this, we have
y + v = Xβ + ε
so
y = Xβ + ε − v
= Xβ + ω
ωt ∼ iid(0, σ2ε + σ2v )
• As long as v is uncorrelated with X, this model satisfies the classical assumptions

and can be estimated by OLS. This type of measurement error isn’t a problem,
then.
9.2.2. Error of measurement of the regressors. The situation isn’t so good in this
case. The DGP is
yt = xt∗0 β + εt
xt = xt∗ + vt
vt ∼ iid(0, Σv )
where Σv is a K × K matrix. Now X ∗ contains the true, unobserved regressors, and X is

what is observed. Again assume that v is independent of ε, and that the model y = X ∗ β + ε
satisfies the classical assumptions. Now we have
yt = (xt − vt )0 β + εt
= xt0 β − vt0 β + εt
= xt0 β + ωt
The problem is that now there is a correlation between xt and ωt , since

E (xt ωt ) = E (xt∗ + vt ) −vt0 β + εt
= −Σv β
where

Σv = E vt vt0 .
Because of this correlation, the OLS estimator is biased and inconsistent, just as in the
case of autocorrelated errors with lagged dependent variables. In matrix notation, write the
estimated model as
y = Xβ + ω
9.3. MISSING OBSERVATIONS 109
We have that −1

X 0X X 0y
β̂ =
n n
and
−1
X 0X (X ∗0 +V 0 ) (X ∗ +V )
plim = plim
n n
= (QX ∗ + Σv )−1
since X ∗ and V are independent, and

V 0V 1 n
plim
n
= lim E ∑ vt vt0
n t=1
= Σv
Likewise,

X 0y (X ∗0 +V 0 ) (X ∗ β + ε)
plim = plim
n n
= QX ∗ β
so
plimβ̂ = (QX ∗ + Σv )−1 QX ∗ β
So we see that the least squares estimator is inconsistent when the regressors are measured
with error.
• A potential solution to this problem is the instrumental variables (IV) estimator,

which we’ll discuss shortly.
9.3. Missing observations
Missing observations occur quite frequently: time series data may not be gathered in
a certain year, or respondents to a survey may not answer all questions. We’ll consider
two cases: missing observations on the dependent variable and missing observations on the
regressors.
9.3.1. Missing observations on the dependent variable. In this case, we have
y = Xβ + ε
or " # " # " #

y1 X1 ε1
= β+
y2 X2 ε2
where y2 is not observed. Otherwise, we assume the classical assumptions hold.
• A clear alternative is to simply estimate using the compete observations
y1 = X1 β + ε1
Since these observations satisfy the classical assumptions, one could estimate by
OLS.
• The question remains whether or not one could somehow replace the unobserved
y2 by a predictor, and improve over OLS in some sense. Let ŷ2 be the predictor
of y2 . Now
(" #0 " #)−1 " #0 " #

X1 X1 X1 y1
β̂ =
X2 X2 X2 ŷ2
0 −1
= X1 X1 + X20 X2 X10 y1 + X20 ŷ2
Recall that the OLS fonc are

X 0 X β̂ = X 0 y
so if we regressed using only the first (complete) observations, we would have
X10 X1 β̂1 = X10 y1.
Likewise, an OLS regression using only the second (filled in) observations would give
X20 X2 β̂2 = X20 ŷ2 .
Substituting these into the equation for the overall combined estimator gives
−1 h 0 i
β̂ = X10 X1 + X20 X2 X1 X1 β̂1 + X20 X2 β̂2
−1 0 −1 0
= X10 X1 + X20 X2 X1 X1 β̂1 + X10 X1 + X20 X2 X2 X2 β̂2
≡ Aβ̂1 + (IK − A)β̂2
where
−1 0
A ≡ X10 X1 + X20 X2 X1 X1
and we use
0 −1 0 −1 0
X1 X1 + X20 X2 X2 X2 = X10 X1 + X20 X2 X1 X1 + X20 X2 − X10 X1
−1 0
= IK − X10 X1 + X20 X2 X1 X1
= IK − A.
Now,
E (β̂) = Aβ + (IK − A)E β̂2

and this will be unbiased only if E β̂2 = β.
• The conclusion is the this filled in observations alone would need to define an
unbiased estimator. This will be the case only if
ŷ2 = X2 β + ε̂2
where ε̂2 has mean zero. Clearly, it is difficult to satisfy this condition without
knowledge of β.
• Note that putting ŷ2 = ȳ1 does not satisfy the condition and therefore leads to a
biased estimator.
E XERCISE 13. Formally prove this last statement.

• One possibility that has been suggested (see Greene, page 275) is to estimate β
using a first round estimation using only the complete observations
β̂1 = (X10 X1 )−1 X10 y1
then use this estimate, β̂1 ,to predict y2 :
ŷ2 = X2 β̂1
= X2 (X10 X1 )−1 X10 y1
Now, the overall estimate is a weighted average of β̂1 and β̂2 , just as above, but
we have
β̂2 = (X20 X2 )−1 X20 ŷ2

= (X20 X2 )−1 X20 X2 β̂1
= β̂1
This shows that this suggestion is completely empty of content: the final estima-
tor is the same as the OLS estimator using only the complete observations.
9.3.2. The sample selection problem. In the above discussion we assumed that the
missing observations are random. The sample selection problem is a case where the missing
observations are not random. Consider the model
yt∗ = xt0 β + εt
which is assumed to satisfy the classical assumptions. However, yt∗ is not always observed.
What is observed is yt defined as
yt = yt∗ if yt∗ ≥ 0
Or, in other words, yt∗ is missing when it is less than zero.

The difference in this case is that the missing values are not random: they are correlated
with the xt . Consider the case
y∗ = x + ε
with V (ε) = 25, but using only the observations for which y∗ > 0 to estimate. Figure 9.3.1
illustrates the bias. The Octave program is sampsel.m
9.3.3. Missing observations on the regressors. Again the model is

" # " # " #
y1 X1 ε1
= β+
y2 X2 ε2
but we assume now that each row of X2 has an unobserved component(s). Again, one could
just estimate using the complete observations, but it may seem frustrating to have to drop
observations simply because of a single missing variable. In general, if the unobserved
X2 is replaced by some prediction, X2∗ , then we are in the case of errors of observation.
As before, this means that the OLS estimator is biased when X2∗ is used instead of X2 .
Consistency is salvaged, however, as long as the number of missing observations doesn’t
increase with n.
F IGURE 9.3.1. Sample selection bias

25
Data
True Line
Fitted Line
20
15
10
-5
-10
0 2 4 6 8 10
• Including observations that have missing values replaced by ad hoc values can be
interpreted as introducing false stochastic restrictions. In general, this introduces
bias. It is difficult to determine whether MSE increases or decreases. Monte
Carlo studies suggest that it is dangerous to simply substitute the mean, for ex-
ample.
• In the case that there is only one regressor other than the constant, subtitution of
x̄ for the missing xt does not lead to bias. This is a special case that doesn’t hold
for K > 2.
E XERCISE 14. Prove this last statement.
• In summary, if one is strongly concerned with bias, it is best to drop observations

that have missing components. There is potential for reduction of MSE through
filling in missing elements with intelligent guesses, but this could also increase
MSE.
EXERCISES 113
Exercises
(1) Consider the Nerlove model
j j
When this model is estimated by OLS, some coefficients are not significant. This may
be due to collinearity.
Exercises
(a) Calculate the correlation matrix of the regressors.
(b) Perform artificial regressions to see if collinearity is a problem.
(c) Apply the ridge regression estimator.
Exercises
(i) Plot the ridge trace diagram
(ii) Check what happens as k goes to zero, and as k becomes very large.
CHAPTER 10
Functional form and nonnested tests
Though theory often suggests which conditioning variables should be included, and
suggests the signs of certain derivatives, it is usually silent regarding the functional form of
the relationship between the dependent variable and the regressors. For example, consider-
ing a cost function, one could have a Cobb-Douglas model
β β
c = Aw1 1 w2 2 qβq eε
This model, after taking logarithms, gives
ln c = β0 + β1 ln w1 + β2 ln w2 + βq lnq + ε
where β0 = ln A. Theory suggests that A > 0, β1 > 0, β2 > 0, β3 > 0. This model isn’t com-
patible with a fixed cost of production since c = 0 when q = 0. Homogeneity of degree one
in input prices suggests that β1 + β2 = 1, while constant returns to scale implies βq = 1.
While this model may be reasonable in some cases, an alternative
√ √ √ √
c = β 0 + β 1 w1 + β 2 w2 + β q q + ε
√
may be just as plausible. Note that x and ln(x) look quite alike, for certain values of the
regressors, and up to a linear transformation, so it may be difficult to choose between these
models.
The basic point is that many functional forms are compatible with the linear-in-parameters
model, since this model can incorporate a wide variety of nonlinear transformations of the
dependent variable and the regressors. For example, suppose that g(·) is a real valued func-
tion and that x(·) is a K− vector-valued function. The following model is linear in the
parameters but nonlinear in the variables:
xt = x(zt )
yt = xt0 β + εt
There may be P fundamental conditioning variables zt , but there may be K regressors,

where K may be smaller than, equal to or larger than P. For example, xt could include
squares and cross products of the conditioning variables in zt .
10.1. Flexible functional forms
Given that the functional form of the relationship between the dependent variable and
the regressors is in general unknown, one might wonder if there exist parametric mod-
els that can closely approximate a wide variety of functional relationships. A “Diewert-
Flexible” functional form is defined as one such that the function, the vector of first deriva-
tives and the matrix of second derivatives can take on an arbitrary value at a single data
114
10.1. FLEXIBLE FUNCTIONAL FORMS 115
point. Flexibility in this sense clearly requires that there be at least

K = 1 + P + P2 − P /2 + P
free parameters: one for each independent effect that we wish to model.
Suppose that the model is
y = g(x) + ε
A second-order Taylor’s series expansion (with remainder term) of the function g(x) about
the point x = 0 is
x0 D2x g(0)x
g(x) = g(0) + x0 Dx g(0) + +R
2
Use the approximation, which simply drops the remainder term, as an approximation to
g(x) :
x0 D2x g(0)x
g(x) ' gK (x) = g(0) + x0Dx g(0) +
2
As x → 0, the approximation becomes more and more exact, in the sense that g K (x) → g(x),
Dx gK (x) → Dx g(x) and D2x gK (x) → D2x g(x). For x = 0, the approximation is exact, up to the
second order. The idea behind many flexible functional forms is to note that g(0), D x g(0)
and D2x g(0) are all constants. If we treat them as parameters, the approximation will have
exactly enough free parameters to approximate the function g(x), which is of unknown
form, exactly, up to second order, at the point x = 0. The model is
gK (x) = α + x0 β + 1/2x0Γx
so the regression model to fit is
y = α + x0 β + 1/2x0Γx + ε
• While the regression model has enough free parameters to be Diewert-flexible,

the question remains: is plimα̂ = g(0)? Is plimβ̂ = Dx g(0)? Is plimΓ̂ = D2x g(0)?
• The answer is no, in general. The reason is that if we treat the true values of the
parameters as these derivatives, then ε is forced to play the part of the remainder
term, which is a function of x, so that x and ε are correlated in this case. As
before, the estimator is biased in this case.
• A simpler example would be to consider a first-order T.S. approximation to a
quadratic function. Draw picture.
• The conclusion is that “flexible functional forms” aren’t really flexible in a use-
ful statistical sense, in that neither the function itself nor its derivatives are con-
sistently estimated, unless the function belongs to the parametric family of the
specified functional form. In order to lead to consistent inferences, the regression
model must be correctly specified.
10.1.1. The translog form. In spite of the fact that FFF’s aren’t really flexible for the
purposes of econometric estimation and inference, they are useful, and they are certainly
subject to less bias due to misspecification of the functional form than are many popular
forms, such as the Cobb-Douglas or the simple linear in the variables model. The translog
model is probably the most widely used FFF. This model is as above, except that the vari-
ables are subjected to a logarithmic tranformation. Also, the expansion point is usually
taken to be the sample mean of the data, after the logarithmic transformation. The model
is defined by
y = ln(c)

z
x = ln
z̄
= ln(z) − ln(z̄)
y = α + x0 β + 1/2x0Γx + ε
In this presentation, the t subscript that distinguishes observations is suppressed for sim-
plicity. Note that
∂y
= β + Γx
∂x
∂ ln(c)
= (the other part of x is constant)
∂ ln(z)
∂c z
=
∂z c
which is the elasticity of c with respect to z. This is a convenient feature of the translog
model. Note that at the means of the conditioning variables, z̄, x = 0, so

∂y
=β
∂x z=z̄
so the β are the first-order elasticities, at the means of the data.
To illustrate, consider that y is cost of production:
y = c(w, q)
where w is a vector of input prices and q is output. We could add other variables by
extending q in the obvious manner, but this is supressed for simplicity. By Shephard’s
lemma, the conditional factor demands are
∂c(w, q)
x=
∂w
and the cost shares of the factors are therefore
wx ∂c(w, q) w
s= =
c ∂w c
which is simply the vector of elasticities of cost with respect to input prices. If the cost
function is modeled using a translog function, we have
" #" #
h i Γ
11 Γ12 x
ln(c) = α + x β + z δ + 1/2 x z
0 0 0
Γ12 Γ22
0 z
= α + x0 β + z0 δ + 1/2x0Γ11 x + x0 Γ12 z + 1/2z2γ22
where x = ln(w/w̄) (element-by-element division) and z = ln(q/q̄), and

" #
γ11 γ12
Γ11 =
γ12 γ22
" #
γ13
Γ12 =
γ23
Γ22 = γ33 .
Note that symmetry of the second derivatives has been imposed.

Then the share equations are just
" #
h i x
s = β + Γ11 Γ12
z
Therefore, the share equations and the cost equation have parameters in common. By
pooling the equations together and imposing the (true) restriction that the parameters of the
equations be the same, we can gain efficiency.
To illustrate in more detail, consider the case of two inputs, so
" #
x1
x= .
x2
In this case the translog model of the logarithmic cost function is
γ11 2 γ22 2 γ33 2
lnc = α + β1x1 + β2 x2 + δz + x + x + z + γ12x1 x2 + γ13 x1 z + γ23x2 z
2 1 2 2 2
The two cost shares of the inputs are the derivatives of ln c with respect to x 1 and x2 :
s1 = β1 + γ11 x1 + γ12 x2 + γ13 z

s2 = β2 + γ12 x1 + γ22 x2 + γ13 z
Note that the share equations and the cost equation have parameters in common. One
can do a pooled estimation of the three equations at once, imposing that the parameters
are the same. In this way we’re using more observations and therefore more information,
which will lead to imporved efficiency. Note that this does assume that the cost equation
is correctly specified (i.e., not an approximation), since otherwise the derivatives would
not be the true derivatives of the log cost function, and would then be misspecified for the
shares. To pool the equations, write the model in matrix form (adding in error terms)
 
α
 
 β1 
 
 β 
 2 
    δ  


x21 x22 2  
ln c 1 x 1 x2 z 2 z
x1 x2 x1 z x 2 z   ε1
   2 2   γ11   
 s1  =   0 1 0 0 x 1 0 0 x2 z 0    +  ε2 
 γ22 
s2 0 0 1 0 0 x 2 0 x1 0 z   ε3
 γ 
 33 
 
 γ12 
 
 γ 
 13 
γ23
This is one observation on the three equations. With the appropriate notation, a single
observation can be written as
yt = Xt θ + εt
The overall model would stack n observations on the three equations for a total of 3n
observations:      
y1 X1 ε1
     
 y2   X2   ε2 
 . = .. θ+ .. 
 .     
 .   .   . 
yn Xn εn
Next we need to consider the errors. For observation t the errors can be placed in a vector
 
ε1t
 
εt =  ε2t 
ε3t
First consider the covariance matrix of this vector: the shares are certainly correlated
since they must sum to one. (In fact, with 2 shares the variances are equal and the covari-
ance is -1 times the variance. General notation is used to allow easy extension to the case
of more than 2 inputs). Also, it’s likely that the shares and the cost equation have differ-
ent variances. Supposing that the model is covariance stationary, the variance of εt won0 t
depend upon t:
 
σ11 σ12 σ13
 
Varεt = Σ0 =  · σ22 σ23 
· · σ33
Note that this matrix is singular, since the shares sum to 1. Assuming that there is no au-
tocorrelation, the overall covariance matrix has the seemingly unrelated regressions (SUR)
structure.
 
ε1
 
 ε2 
Var  . 

 = Σ
 .. 
εn
 
Σ0 0 ··· 0
 . . .. 
 0 Σ0 . . 
 
=  . 
 . .. 
 . . 0 
0 ··· 0 Σ0
= In ⊗ Σ0
where the symbol ⊗ indicates the Kronecker product. The Kronecker product of two ma-
trices A and B is  
a11 B a12 B · · · a1q B
 . .. 

 a21 B . . . 

A⊗B =  .. .
 
 . 
a pqB · · · a pq B
10.1.2. FGLS estimation of a translog model. So, this model has heteroscedasticity
and autocorrelation, so OLS won’t be efficient. The next question is: how do we estimate
efficiently using FGLS? FGLS is based upon inverting the estimated error covariance Σ̂. So
we need to estimate Σ.
An asymptotically efficient procedure is (supposing normality of the errors)
(1) Estimate each equation by OLS

(2) Estimate Σ0 using
1 n
Σ̂0 = ∑ ε̂t ε̂t0
n t=1
(3) Next we need to account for the singularity of Σ0 . It can be shown that Σ̂0 will
be singular when the shares sum to one, so FGLS won’t work. The solution is to
drop one of the share equations, for example the second. The model becomes
 
α
 
 β1 
 
 β 
 2 
 
 δ 
" # " #   " #
x2 x2 2  
ln c 1 x1 x2 z 21 22 z2 x1 x2 x1 z x2 z  γ11  ε1
=  +
s1 0 1 0 0 x 1 0 0 x2 z 0  γ22  ε2
 
 γ 
 33 
 
 γ12 
 
 γ 
 13 
γ23
or in matrix notation for the observation:
yt∗ = Xt∗ θ + εt∗
and in stacked notation for all observations we have the 2n observations:

 ∗   ∗   ∗ 
y1 X1 ε1
 ∗   ∗   ∗ 
 y2   X2   ε 
 .  =  . θ+ . 2 
 .   .   . 
 .   .   . 
y∗n Xn∗ ε∗n
or, finally in matrix notation for all observations:
y∗ = X ∗ θ + ε ∗
Considering the error covariance, we can define

" #
ε1
Σ0 = Var
∗
ε2
Σ∗ = In ⊗ Σ∗0
Define Σ̂∗0 as the leading 2 × 2 block of Σ̂0 , and form
Σ̂∗ = In ⊗ Σ̂∗0 .
This is a consistent estimator, following the consistency of OLS and applying a

LLN.
(4) Next compute the Cholesky factorization
−1
P̂0 = Chol Σ̂∗0
(I am assuming this is defined as an upper triangular matrix, which is consis-

tent with the way Octave does it) and the Cholesky factorization of the overall
covariance matrix of the 2 equation model, which can be calculated as
P̂ = Chol Σ̂∗ = In ⊗ P̂0
(5) Finally the FGLS estimator can be calculated by applying OLS to the transformed
model
ˆ0
P̂0 y∗ = P̂0 X ∗ θ + ˆPε∗
or by directly using the GLS formula
−1 ∗ −1 ∗0 ∗ −1 ∗
θ̂FGLS = X ∗0 Σ̂∗0 X X Σ̂0 y
It is equivalent to transform each observation individually:
P̂00 y∗y = P̂00 Xt∗ θ + P̂00 ε∗
and then apply OLS. This is probably the simplest approach.
A few last comments.
(1) We have assumed no autocorrelation across time. This is clearly restrictive. It is

relatively simple to relax this, but we won’t go into it here.
(2) Also, we have only imposed symmetry of the second derivatives. Another re-
striction that the model should satisfy is that the estimated shares should sum to
1. This can be accomplished by imposing
β1 + β 2 = 1
3
∑ γi j = 0, j = 1, 2, 3.
i=1
These are linear parameter restrictions, so they are easy to impose and will im-
prove efficiency if they are true.
(3) The estimation procedure outlined above can be iterated. That is, estimate θ̂FGLS
as above, then re-estimate Σ∗0 using errors calculated as
ε̂ = y − X θ̂FGLS
These might be expected to lead to a better estimate than the estimator based
on θ̂OLS , since FGLS is asymptotically more efficient. Then re-estimate θ us-
ing the new estimated error covariance. It can be shown that if this is repeated
until the estimates don’t change (i.e., iterated to convergence) then the result-
ing estimator is the MLE. At any rate, the asymptotic properties of the iterated
and uniterated estimators are the same, since both are based upon a consistent
estimator of the error covariance.
10.2. TESTING NONNESTED HYPOTHESES 121
10.2. Testing nonnested hypotheses
Given that the choice of functional form isn’t perfectly clear, in that many possibilities
exist, how can one choose between forms? When one form is a parametric restriction of
another, the previously studied tests such as Wald, LR, score or qF are all possibilities. For
example, the Cobb-Douglas model is a parametric restriction of the translog: The translog
is
yt = α + xt0 β + 1/2xt0 Γxt + ε
where the variables are in logarithms, while the Cobb-Douglas is
yt = α + xt0 β + ε
so a test of the Cobb-Douglas versus the translog is simply a test that Γ = 0.

The situation is more complicated when we want to test non-nested hypotheses. If the
two functional forms are linear in the parameters, and use the same transformation of the
dependent variable, then they may be written as
M1 : y = Xβ + ε
εt ∼ iid(0, σ2ε )
M2 : y = Zγ + η
η ∼ iid(0, σ2η )
We wish to test hypotheses of the form: H0 : Mi is correctly specified versus HA : Mi is

misspecified, for i = 1, 2.
• One could account for non-iid errors, but we’ll suppress this for simplicity.
• There are a number of ways to proceed. We’ll consider the J test, proposed by
Davidson and MacKinnon, Econometrica (1981). The idea is to artificially nest
the two models, e.g.,
y = (1 − α)Xβ + α(Zγ) + ω
If the first model is correctly specified, then the true value of α is zero. On the
other hand, if the second model is correctly specified then α = 1.
– The problem is that this model is not identified in general. For example, if
the models share some regressors, as in
M1 : yt = β1 + β2x2t + β3 x3t + εt
M2 : yt = γ1 + γ2 x2t + γ3 x4t + ηt
then the composite model is
yt = (1 − α)β1 + (1 − α)β2x2t + (1 − α)β3x3t + αγ1 + αγ2 x2t + αγ3 x4t + ωt
Combining terms we get
yt = ((1 − α)β1 + αγ1 ) + ((1 − α)β2 + αγ2 ) x2t + (1 − α)β3x3t + αγ3 x4t + ωt
= δ1 + δ2 x2t + δ3 x3t + δ4 x4t + ωt
10.2. TESTING NONNESTED HYPOTHESES 122
The four δ0 s are consistently estimable, but α is not, since we have four equations in 7
unknowns, so one can’t test the hypothesis that α = 0.
The idea of the J test is to substitute γ̂ in place of γ. This is a consistent estimator
supposing that the second model is correctly specified. It will tend to a finite probability
limit even if the second model is misspecified. Then estimate the model
y = (1 − α)Xβ + α(Zγ̂) + ω
= Xθ + αŷ + ω
where ŷ = Z(Z 0 Z)−1 Z 0 y = PZ y. In this model, α is consistently estimable, and one can
p
show that, under the hypothesis that the first model is correct, α → 0 and that the ordinary
t -statistic for α = 0 is asymptotically normal:
α̂ a
t= ∼ N(0, 1)
σ̂α̂
p
• If the second model is correctly specified, then t → ∞, since α̂ tends in probability
to 1, while it’s estimated standard error tends to zero. Thus the test will always re-
ject the false null model, asymptotically, since the statistic will eventually exceed
any critical value with probability one.
• We can reverse the roles of the models, testing the second against the first.
• It may be the case that neither model is correctly specified. In this case, the test
will still reject the null hypothesis, asymptotically, if we use critical values from
the N(0, 1) distribution, since as long as α̂ tends to something different from zero,
p
|t| → ∞. Of course, when we switch the roles of the models the other will also be
rejected asymptotically.
• In summary, there are 4 possible outcomes when we test two models, each against
the other. Both may be rejected, neither may be rejected, or one of the two may
be rejected.
• There are other tests available for non-nested models. The J− test is simple to
apply when both models are linear in the parameters. The P-test is similar, but
easier to apply when M1 is nonlinear.
• The above presentation assumes that the same transformation of the dependent
variable is used by both models. MacKinnon, White and Davidson, Journal of
Econometrics, (1983) shows how to deal with the case of different transforma-
tions.
• Monte-Carlo evidence shows that these tests often over-reject a correctly speci-
fied model. Can use bootstrap critical values to get better-performing tests.
CHAPTER 11
Exogeneity and simultaneity
Several times we’ve encountered cases where correlation between regressors and the
error term lead to biasedness and inconsistency of the OLS estimator. Cases include au-
tocorrelation with lagged dependent variables and measurement error in the regressors.
Another important case is that of simultaneous equations. The cause is different, but the
effect is the same.
11.1. Simultaneous equations
Up until now our model is

y = Xβ + ε
where, for purposes of estimation we can treat X as fixed. This means that when estimating
β we condition on X. When analyzing dynamic models, we’re not interested in conditioning
on X, as we saw in the section on stochastic regressors. Nevertheless, the OLS estimator
obtained by treating X as fixed continues to have desirable asymptotic properties even in
that case.
Simultaneous equations is a different prospect. An example of a simultaneous equation
system is a simple supply-demand system:
Demand: qt = α1 + α2 pt + α3 yt + ε1t
Supply: qt = β1 + β2 pt + ε2t
" # ! " #
ε1t h i σ11 σ12
E ε1t ε2t =
ε2t · σ22
≡ Σ, ∀t
The presumption is that qt and pt are jointly determined at the same time by the intersection
of these equations. We’ll assume that yt is determined by some unrelated process. It’s easy
to see that we have correlation between regressors and errors. Solving for pt :
α1 + α2 pt + α3 yt + ε1t = β1 + β2 pt + ε2t
β2 pt − α2 pt = α1 − β1 + α3 yt + ε1t − ε2t
α1 − β 1 α3 yt ε1t − ε2t
pt = + +
β2 − α 2 β2 − α 2 β2 − α 2
Now consider whether pt is uncorrelated with ε1t :

α1 − β 1 α3 yt ε1t − ε2t
E (pt ε1t ) = E + + ε1t
β2 − α 2 β2 − α 2 β2 − α 2
σ11 − σ12
=
β2 − α 2
123
11.1. SIMULTANEOUS EQUATIONS 124
Because of this correlation, OLS estimation of the demand equation will be biased and
inconsistent. The same applies to the supply equation, for the same reason.
In this model, qt and pt are the endogenous varibles (endogs), that are determined
within the system. yt is an exogenous variable (exogs). These concepts are a bit tricky,
and we’ll return to it in a minute. First, some notation. Suppose we group together current
endogs in the vector Yt . If there are G endogs, Yt is G × 1. Group current and lagged exogs,
as well as lagged endogs in the vector Xt , which is K ×1. Stack the errors of the G equations
into the error vector Et . The model, with additional assumtions, can be written as
Yt0 Γ = Xt0 B + Et0

Et ∼ N(0, Σ), ∀t
E (Et Es0 ) = 0,t 6= s
We can stack all n observations and write the model as
Y Γ = XB + E
E (X 0 E) = 0(K×G)
vec(E) ∼ N(0, Ψ)
where      
Y10 X10 E10
   0   
 Y20   X   E20 
Y = .. ,X =  . 2 ,E =  .. 
   .   
 .   .   . 
Yn0 Xn0 En0
Y is n × G, X is n × K, and E is n × G.
• This system is complete, in that there are as many equations as endogs.

• There is a normality assumption. This isn’t necessary, but allows us to consider
the relationship between least squares and ML estimators.
• Since there is no autocorrelation of the Et ’s, and since the columns of E are
individually homoscedastic, then
 
σ11 In σ12 In ··· σ1G In
 .. 
 σ22 In . 
 
Ψ =  .. 
 .. 
 . . 
· σGG In
= In ⊗ Σ
• X may contain lagged endogenous and exogenous variables. These variables are
predetermined.
• We need to define what is meant by “endogenous” and “exogenous” when clas-
sifying the current period variables.
11.2. EXOGENEITY 125
11.2. Exogeneity
The model defines a data generating process. The model involves two sets of variables,
Yt and Xt , as well as a parameter vector
h i0
θ = vec(Γ)0 vec(B)0 vec∗ (Σ)0

• In general, without additional restrictions, θ is a G2 + GK + G2 − G /2 + G di-
mensional vector. This is the parameter vector that were interested in estimating.
• In principle, there exists a joint density function for Yt and Xt , which depends on
a parameter vector φ. Write this density as
ft (Yt , Xt |φ, It )
where It is the information set in period t. This includes lagged Yt0 s and lagged
Xt ’s of course. This can be factored into the density of Yt conditional on Xt times
the marginal density of Xt :
ft (Yt , Xt |φ, It ) = ft (Yt |Xt , φ, It ) ft (Xt |φ, It )
This is a general factorization, but is may very well be the case that not all param-
eters in φ affect both factors. So use φ1 to indicate elements of φ that enter into
the conditional density and write φ2 for parameters that enter into the marginal.
In general, φ1 and φ2 may share elements, of course. We have
ft (Yt , Xt |φ, It ) = ft (Yt |Xt , φ1 , It ) ft (Xt |φ2 , It )
• Recall that the model is

Et ∼ N(0, Σ), ∀t
E (Et Es0 ) = 0,t 6= s
Normality and lack of correlation over time imply that the observations are independent of
one another, so we can write the log-likelihood function as the sum of likelihood contribu-
tions of each observation:
n
ln L(Y |θ, It ) = ∑ ln ft (Yt , Xt |φ, It )
t=1
n
= ∑ ln( ft (Yt |Xt , φ1 , It ) ft (Xt |φ2 , It ))
t=1
n n
= ∑ ln ft (Yt |Xt , φ1 , It ) + ∑ ln ft (Xt |φ2 , It ) =
t=1 t=1
D EFINITION 15 (Weak Exogeneity). Xt is weakly exogeneous for θ (the original pa-

rameter vector) if there is a mapping from φ to θ that is invariant to φ2 . More formally, for
an arbitrary (φ1 , φ2 ), θ(φ) = θ(φ1 ).
This implies that φ1 and φ2 cannot share elements if Xt is weakly exogenous, since
φ1 would change as φ2 changes, which prevents consideration of arbitrary combinations of
(φ1 , φ2 ).
11.3. REDUCED FORM 126
Supposing that Xt is weakly exogenous, then the MLE of φ1 using the joint density is
the same as the MLE using only the conditional density
n
ln L(Y |X, θ, It ) = ∑ ln ft (Yt |Xt , φ1 , It )
t=1
since the conditional likelihood doesn’t depend on φ2 . In other words, the joint and condi-
tional log-likelihoods maximize at the same value of φ1 .
• With weak exogeneity, knowledge of the DGP of Xt is irrelevant for inference
on φ1 , and knowledge of φ1 is sufficient to recover the parameter of interest, θ.
Since the DGP of Xt is irrelevant, we can treat Xt as fixed in inference.
• By the invariance property of MLE, the MLE of θ is θ(φ̂1 ),and this mapping is
assumed to exist in the definition of weak exogeneity.
• Of course, we’ll need to figure out just what this mapping is to recover θ̂ from
φ̂1 . This is the famous identification problem.
• With lack of weak exogeneity, the joint and conditional likelihood functions max-
imize in different places. For this reason, we can’t treat Xt as fixed in inference.
The joint MLE is valid, but the conditional MLE is not.
• In resume, we require the variables in Xt to be weakly exogenous if we are to be
able to treat them as fixed in estimation. Lagged Yt satisfy the definition, since
they are in the conditioning information set, e.g., Yt−1 ∈ It . Lagged Yt aren’t
exogenous in the normal usage of the word, since their values are determined
within the model, just earlier on. Weakly exogenous variables include exogenous
(in the normal sense) variables as well as all predetermined variables.
11.3. Reduced form
Recall that the model is

V (Et ) = Σ
This is the model in structural form.
D EFINITION 16 (Structural form). An equation is in structural form when more than

one current period endogenous variable is included.
The solution for the current period endogs is easy to find. It is
Yt0 = Xt0 BΓ−1 + Et0 Γ−1

= Xt0 Π +Vt0 =
Now only one current period endog appears in each equation. This is the reduced form.
D EFINITION 17 (Reduced form). An equation is in reduced form if only one current

period endog is included.
An example is our supply/demand system. The reduced form for quantity is obtained
by solving the supply equation for price and substituting into demand:
11.3. REDUCED FORM 127

qt − β1 − ε2t
qt = α1 + α2 + α3 yt + ε1t
β2
β2 qt − α2 qt = β2 α1 − α2 (β1 + ε2t ) + β2α3 yt + β2ε1t
β2 α1 − α2 β1 β2 α3 yt β2 ε1t − α2 ε2t
qt = + +
β2 − α 2 β2 − α 2 β2 − α 2
= π11 + π21yt +V1t
Similarly, the rf for price is
β1 + β2 pt + ε2t = α1 + α2 pt + α3 yt + ε1t
β2 pt − α2 pt = α1 − β1 + α3 yt + ε1t − ε2t
α1 − β 1 α3 yt ε1t − ε2t
pt = + +
β2 − α 2 β2 − α 2 β2 − α 2
= π12 + π22yt +V2t
The interesting thing about the rf is that the equations individually satisfy the classical as-
sumptions, since yt is uncorrelated with ε1t and ε2t by assumption, and therefore E (yt Vit ) =
0, i=1,2, ∀t. The errors of the rf are
" # " β ε −α ε #
2 1t 2 2t
V1t β2 −α2
= ε1t −ε
V2t β2 −α2
2t
The variance of V1t is

β2 ε1t − α2 ε2t β2 ε1t − α2 ε2t
V (V1t ) = E
β2 − α 2 β2 − α 2
β22 σ11 − 2β2α2 σ12 + α2 σ22
=
(β2 − α2 )2
• This is constant over time, so the first rf equation is homoscedastic.
• Likewise, since the εt are independent over time, so are the Vt .
The variance of the second rf error is

ε1t − ε2t ε1t − ε2t
V (V2t ) = E
β2 − α 2 β2 − α 2
σ11 − 2σ12 + σ22
=
(β2 − α2 )2
and the contemporaneous covariance of the errors across equations is

β2 ε1t − α2 ε2t ε1t − ε2t
E (V1t V2t ) = E
β2 − α 2 β2 − α 2
β2 σ11 − (β2 + α2 ) σ12 + σ22
=
(β2 − α2 )2
• In summary the rf equations individually satisfy the classical assumptions, under
the assumtions we’ve made, but they are contemporaneously correlated.
The general form of the rf is
Yt0 = Xt0 BΓ−1 + Et0 Γ−1

= Xt0 Π +Vt0
11.4. IV ESTIMATION 128
so we have that
0 0
Vt = Γ−1 Et ∼ N 0, Γ−1 ΣΓ−1 , ∀t
and that the Vt are timewise independent (note that this wouldn’t be the case if the Et were
autocorrelated).
11.4. IV estimation
The IV estimator may appear a bit unusual at first, but it will grow on you over time.
The simultaneous equations model is
Y Γ = XB + E
Considering the first equation (this is without loss of generality, since we can always reorder
the equations) we can partition the Y matrix as
h i
Y = y Y1 Y2
• y is the first column

• Y1 are the other endogenous variables that enter the first equation
• Y2 are endogs that are excluded from this equation
Similarly, partition X as h i
X= X1 X2
• X1 are the included exogs, and X2 are the excluded exogs.
Finally, partition the error matrix as

h i
E= ε E12
Assume that Γ has ones on the main diagonal. These are normalization restrictions that
simply scale the remaining coefficients on each equation, and which scale the variances of
the error terms.
Given this scaling and our partitioning, the coefficient matrices can be written as
 
1 Γ12
 
Γ =  −γ1 Γ22 
0 Γ32
" #
β1 B12
B =
0 B22
With this, the first equation can be written as
y = Y1 γ1 + X1 β1 + ε
= Zδ + ε
The problem, as we’ve seen is that Z is correlated with ε, since Y1 is formed of endogs.
Now, let’s consider the general problem of a linear regression model with correlation
between regressors and the error term:
y = Xβ + ε
ε ∼ iid(0, In σ2 )
E (X 0 ε) 6= 0.
The present case of a structural equation from a system of equations fits into this notation,
but so do other problems, such as measurement error or lagged dependent variables with
autocorrelated errors. Consider some matrix W which is formed of variables uncorrelated
with ε. This matrix defines a projection matrix
PW = W (W 0W )−1W 0
so that anything that is projected onto the space spanned by W will be uncorrelated with ε,
by the definition of W. Transforming the model with this projection matrix we get
PW y = PW Xβ + PW ε
or
y∗ = X ∗ β + ε ∗
Now we have that ε∗ and X ∗ are uncorrelated, since this is simply
E (X ∗0 ε∗ ) = E (X 0 PW0 PW ε)
= E (X 0 PW ε)
and
PW X = W (W 0W )−1W 0 X
is the fitted value from a regression of X on W. This is a linear combination of the columns
of W, so it must be uncorrelated with ε. This implies that applying OLS to the model
y∗ = X ∗ β + ε ∗
will lead to a consistent estimator, given a few more assumptions. This is the generalized
instrumental variables estimator. W is known as the matrix of instruments. The estimator
is
β̂IV = (X 0 PW X)−1 X 0 PW y
from which we obtain
β̂IV = (X 0 PW X)−1 X 0 PW (Xβ + ε)

= β + (X 0PW X)−1 X 0 PW ε
so
β̂IV − β = (X 0 PW X)−1 X 0 PW ε
−1
= X 0W (W 0W )−1W 0 X X 0W (W 0W )−1W 0 ε
Now we can introduce factors of n to get

0 ! !−1 0 0 −1 0
XW W 0W −1 W 0X XW WW Wε
β̂IV − β =
n n n n n n
Assuming that each of the terms with a n in the denominator satisfies a LLN, so that
W 0W p
• n → QWW , a finite pd matrix
X 0W p
• n → QXW , a finite matrix with rank K (= cols(X) )
W 0ε p
• n →0
then the plim of the rhs is zero. This last term has plim 0 since we assume that W and ε are
uncorrelated, e.g.,
E (Wt0 εt ) = 0,
Given these assumtions the IV estimator is consistent
p
β̂IV → β.
√
Furthermore, scaling by n, we have
−1 !−1 −1
√ X 0W W 0W W 0X X 0W W 0W W 0ε
n β̂IV − β = √
n n n n n n
Assuming that the far right term satifies a CLT, so that
d
√ε →
W 0
• n
N(0, QWW σ2 )
then we get
√
d
n β̂IV − β → N 0, (QXW QWW
−1
Q0XW )−1 σ2
The estimators for QXW and QWW are the obvious ones. An estimator for σ2 is
d 1 0
σ2IV = y − X β̂IV y − X β̂IV .
n
This estimator is consistent following the proof of consistency of the OLS estimator of σ 2 ,
when the classical assumptions hold.
The formula used to estimate the variance of β̂IV is
−1 −1 d
V̂ (β̂IV ) = X 0W W 0W W 0X σ2IV
The IV estimator is
(1) Consistent
(2) Asymptotically normally distributed
(3) Biased in general, since even though E (X 0 PW ε) = 0, E (X 0 PW X)−1 X 0 PW ε may
not be zero, since (X 0 PW X)−1 and X 0 PW ε are not independent.
An important point is that the asymptotic distribution of β̂IV depends upon QXW and QWW ,
and these depend upon the choice of W. The choice of instruments influences the efficiency
of the estimator.
• When we have two sets of instruments, W1 and W2 such that W1 ⊂ W2 , then the
IV estimator using W2 is at least as efficiently asymptotically as the estimator that
used W1 . More instruments leads to more asymptotically efficient estimation, in
general.
11.5. IDENTIFICATION BY EXCLUSION RESTRICTIONS 131
• There are special cases where there is no gain (simultaneous equations is an ex-
ample of this, as we’ll see).
• The penalty for indiscriminant use of instruments is that the small sample bias of
the IV estimator rises as the number of instruments increases. The reason for this
is that PW X becomes closer and closer to X itself as the number of instruments
increases.
• IV estimation can clearly be used in the case of simultaneous equations. The only
issue is which instruments to use.
11.5. Identification by exclusion restrictions
The identification problem in simultaneous equations is in fact of the same nature as

the identification problem in any estimation setting: does the limiting objective function
have the proper curvature so that there is a unique global minimum or maximum at the true
parameter value? In the context of IV estimation, this is the case if the limiting covariance
of the IV estimator is positive definite and plim 1n W 0 ε = 0. This matrix is
V∞ (β̂IV ) = (QXW QWW

−1
Q0XW )−1 σ2
• The necessary and sufficient condition for identification is simply that this matrix
be positive definite, and that the instruments be (asymptotically) uncorrelated
with ε.
• For this matrix to be positive definite, we need that the conditions noted above
hold: QWW must be positive definite and QXW must be of full rank ( K ).
• These identification conditions are not that intuitive nor is it very obvious how to
check them.
11.5.1. Necessary conditions. If we use IV estimation for a single equation of the

system, the equation can be written as
y = Zδ + ε
where h i
Z= Y1 X1
Notation:
• Let K be the total numer of weakly exogenous variables.
• Let K ∗ = cols(X1 ) be the number of included exogs, and let K ∗∗ = K − K ∗ be the
number of excluded exogs (in this equation).
• Let G∗ = cols(Y1 ) + 1 be the total number of included endogs, and let G∗∗ =
G − G∗ be the number of excluded endogs.
Using this notation, consider the selection of instruments.
• Now the X1 are weakly exogenous and can serve as their own instruments.
• It turns out that X exhausts the set of possible instruments, in that if the variables
in X don’t lead to an identified model then no other instruments will identify the
model either. Assuming this is true (we’ll prove it in a moment), then a necessary
condition for identification is that cols(X2 ) ≥ cols(Y1 ) since if not then at least
one instrument must be used twice, so W will not have full column rank:
ρ(W ) < K ∗ + G∗ − 1 ⇒ ρ(QZW ) < K ∗ + G∗ − 1
This is the order condition for identification in a set of simultaneous equations.

When the only identifying information is exclusion restrictions on the variables
that enter an equation, then the number of excluded exogs must be greater than
or equal to the number of included endogs, minus 1 (the normalized lhs endog),
e.g.,
K ∗∗ ≥ G∗ − 1
• To show that this is in fact a necessary condition consider some arbitrary set of
instruments W. A necessary condition for identification is that

1
ρ plim W 0 Z = K ∗ + G∗ − 1
n
where h i
Z= Y1 X1
Recall that we’ve partitioned the model
Y Γ = XB + E
as h i
Y= y Y1 Y2
h i
X = X1 X2
Given the reduced form
Y = XΠ +V
we can write the reduced form using the same partition
" #
h i h i π h i
11 Π12 Π13
y Y1 Y2 = X1 X2 + v V1 V2
π21 Π22 Π23
so we have
Y1 = X1 Π12 + X2 Π22 +V1
so
1 0 1 h i
W Z = W 0 X1 Π12 + X2 Π22 +V1 X1
n n
Because the W ’s are uncorrelated with the V1 ’s, by assumption, the cross between W and
V1 converges in probability to zero, so
1 1 h i
plim W 0 Z = plim W 0 X1 Π12 + X2Π22 X1
n n
Since the far rhs term is formed only of linear combinations of columns of X, the rank of
this matrix can never be greater than K, regardless of the choice of instruments. If Z has
more than K columns, then it is not of full column rank. When Z has more than K columns
we have
G∗ − 1 + K ∗ > K
or noting that K ∗∗ = K − K ∗,
G∗ − 1 > K ∗∗
In this case, the limiting matrix is not of full column rank, and the identification condition
fails.
11.5.2. Sufficient conditions. Identification essentially requires that the structural pa-
rameters be recoverable from the data. This won’t be the case, in general, unless the struc-
tural model is subject to some restrictions. We’ve already identified necessary conditions.
Turning to sufficient conditions (again, we’re only considering identification through zero
restricitions on the parameters, for the moment).
The model is
Yt0 Γ = Xt0 B + Et
V (Et ) = Σ
This leads to the reduced form
Yt0 = Xt0 BΓ−1 + Et Γ−1

= Xt0 Π +Vt
0
V (Vt ) = Γ−1 ΣΓ−1
= Ω
The reduced form parameters are consistently estimable, but none of them are known a
priori, and there are no restrictions on their values. The problem is that more than one
structural form has the same reduced form, so knowledge of the reduced form parameters
alone isn’t enough to determine the structural parameters. To see this, consider the model
Yt0 ΓF = Xt0 BF + Et F
V (Et F) = F 0 ΣF
where F is some arbirary nonsingular G × G matrix. The rf of this new model is
Yt0 = Xt0 BF (ΓF)−1 + Et F (ΓF)−1

= Xt0 BFF −1 Γ−1 + Et FF −1 Γ−1
= Xt0 BΓ−1 + Et Γ−1
= Xt0 Π +Vt
Likewise, the covariance of the rf of the transformed model is
V (Et F (ΓF)−1 ) = V (Et Γ−1 )

= Ω
Since the two structural forms lead to the same rf, and the rf is all that is directly estimable,
the models are said to be observationally equivalent. What we need for identification are
restrictions on Γ and B such that the only admissible F is an identity matrix (if all of the
equations are to be identified). Take the coefficient matrices as partitioned before:
 
1 Γ12
" #  
 −γ1 Γ22 
Γ  
=
 0 Γ32 

B  
 β1 B12 
0 B22
The coefficients of the first equation of the transformed model are simply these coefficients
multiplied by the first column of F. This gives
 
1 Γ12
" #" #   −γ1

Γ22  " #
Γ f11   f11
=  0 Γ32 
 F
B F2   2
 β1 B12 
0 B22
For identification of the first equation we need that there be enough restrictions so that the
only admissible " #
f11
F2
be the leading column of an identity matrix, so that
   
1 Γ12 1
  #  
 −γ1 Γ22  "  −γ1 
  f11  
 0 
Γ32  = 0 
  
  F2  
 β1 B12   β1 
0 B22 0
Note that the third and fifth rows are
" # " #
Γ32 0
F2 =
B22 0
Supposing that the leading matrix is of full column rank, e.g.,
" #! " #!
Γ32 Γ32
ρ = cols = G−1
B22 B22
then the only way this can hold, without additional restrictions on the model’s parameters,
is if F2 is a vector of zeros. Given that F2 is a vector of zeros, then the first equation
" #
h i f
11
1 Γ12 = 1 ⇒ f11 = 1
F2
Therefore, as long as " #!
Γ32
ρ = G−1
B22
then " # " #
f11 1
=
F2 0G−1
The first equation is identified in this case, so the condition is sufficient for identification.
It is also necessary, since the condition implies that this submatrix must have at least G − 1
rows. Since this matrix has
G∗∗ + K ∗∗ = G − G∗ + K ∗∗
rows, we obtain
G − G∗ + K ∗∗ ≥ G − 1
or
K ∗∗ ≥ G∗ − 1
which is the previously derived necessary condition.
The above result is fairly intuitive (draw picture here). The necessary condition ensures
that there are enough variables not in the equation of interest to potentially move the other
equations, so as to trace out the equation of interest. The sufficient condition ensures that
those other equations in fact do move around as the variables change their values. Some
points:
• When an equation has K ∗∗ = G∗ − 1, is is exactly identified, in that omission of
an identifiying restriction is not possible without loosing consistency.
• When K ∗∗ > G∗ − 1, the equation is overidentified, since one could drop a re-
striction and still retain consistency. Overidentifying restrictions are therefore
testable. When an equation is overidentified we have more instruments than are
strictly necessary for consistent estimation. Since estimation by IV with more
instruments is more efficient asymptotically, one should employ overidentifying
restrictions if one is confident that they’re true.
• We can repeat this partition for each equation in the system, to see which equa-
tions are identified and which aren’t.
• These results are valid assuming that the only identifying information comes
from knowing which variables appear in which equations, e.g., by exclusion
restrictions, and through the use of a normalization. There are other sorts of
identifying information that can be used. These include
(1) Cross equation restrictions
(2) Additional restrictions on parameters within equations (as in the Klein model
discussed below)
(3) Restrictions on the covariance matrix of the errors
(4) Nonlinearities in variables
• When these sorts of information are available, the above conditions aren’t neces-
sary for identification, though they are of course still sufficient.
To give an example of how other information can be used, consider the model
Y Γ = XB + E
where Γ is an upper triangular matrix with 1’s on the main diagonal. This is a triangular
system of equations. In this case, the first equation is
y1 = XB·1 + E·1
Since only exogs appear on the rhs, this equation is identified.

The second equation is
y2 = −γ21 y1 + XB·2 + E·2

This equation has K ∗∗ = 0 excluded exogs, and G∗ = 2 included endogs, so it fails the order
(necessary) condition for identification.
• However, suppose that we have the restriction Σ21 = 0, so that the first and second
structural errors are uncorrelated. In this case

E (y1t ε2t ) = E (Xt0 B·1 + ε1t )ε2t = 0
so there’s no problem of simultaneity. If the entire Σ matrix is diagonal, then

following the same logic, all of the equations are identified. This is known as a
fully recursive model.
11.5.3. Example: Klein’s Model 1. To give an example of determining identification

status, consider the following macro model (this is the widely known Klein’s Model 1)
p g
Consumption: Ct = α0 + α1 Pt + α2 Pt−1 + α3 (Wt +Wt ) + ε1t
Investment: It = β0 + β1 Pt + β2Pt−1 + β3 Kt−1 + ε2t
p
Private Wages: Wt = γ0 + γ1 Xt + γ2 Xt−1 + γ3 At + ε3t
Output: Xt = Ct + It + Gt
Profits: Pt = Xt − Tt −Wt p
Capital Stock: Kt = Kt−1 + It
     
ε1t 0 σ11 σ12 σ13
     
 ε2t  ∼ IID  0  ,  σ22 σ23 
ε3t 0 σ33
g
The other variables are the government wage bill, Wt , taxes, Tt , government nonwage
spending, Gt ,and a time trend, At . The endogenous variables are the lhs variables,
h i
Yt0 = Ct It Wt p Xt Pt Kt
and the predetermined variables are all others:

h i
Xt0 = 1 Wtg Gt Tt At Pt−1 Kt−1 Xt−1 .
The model assumes that the errors of the equations are contemporaneously correlated, by
nonautocorrelated. The model written as Y Γ = XB + E gives
 
1 0 0 −1 0 0
 
 0 1 0 −1 0 −1 
 
 −α 0 1 0 1 0 
 3 
Γ= 
 0 0 −γ 1 1 −1 0 
 
 −α −β 0 0 1 0 
 1 1 
0 0 0 0 0 1
 
α0 β0 γ0 0 0 0
 

 α3 0 0 0 0 0 

 0 0 0 1 0 0 
 
 
 0 0 0 0 −1 0 
B=



 0 0 γ3 0 0 0 
 

 α2 β2 0 0 0 0 

 0 β3 0 0 0 1 
 
0 0 γ2 0 0 0
To check this identification of the consumption equation, we need to extract Γ 32 and B22 ,
the submatrices of coefficients of endogs and exogs that don’t appear in this equation.
These are the rows that have zeros in the first column, and we need to drop the first column.
We get  
1 0 −1 0 −1
 
 0 −γ1 1 −1 0 
 
 0 0 0 0 1 
" # 



Γ32  0 0 1 0 0 
=



B22  0 0 0 −1 0 
 

 0 γ3 0 0 0 

 β3 0 0 0 1 
 
0 γ2 0 0 0
We need to find a set of 5 rows of this matrix gives a full-rank 5×5 matrix. For example,
selecting rows 3,4,5,6, and 7 we obtain the matrix
 
0 0 0 0 1
 
 0 0 1 0 0 
 
A=  0 0 0 −1 0 

 
 0 γ3 0 0 0 
β3 0 0 0 1
This matrix is of full rank, so the sufficient condition for identification is met. Counting
included endogs, G∗ = 3, and counting excluded exogs, K ∗∗ = 5, so
K ∗∗ − L = G∗ − 1
5−L = 3−1
L =3
• The equation is over-identified by three restrictions, according to the counting

rules, which are correct when the only identifying information are the exclusion
restrictions. However, there is additional information in this case. Both Wt p and
g
Wt enter the consumption equation, and their coefficients are restricted to be the
same. For this reason the consumption equation is in fact overidentified by four
restrictions.
11.6. 2SLS 138
11.6. 2SLS
When we have no information regarding cross-equation restrictions or the structure of

the error covariance matrix, one can estimate the parameters of a single equation of the
system without regard to the other equations.
• This isn’t always efficient, as we’ll see, but it has the advantage that misspecifi-
cations in other equations will not affect the consistency of the estimator of the
parameters of the equation of interest.
• Also, estimation of the equation won’t be affected by identification problems in
other equations.
The 2SLS estimator is very simple: in the first stage, each column of Y1 is regressed on all
the weakly exogenous variables in the system, e.g., the entire X matrix. The fitted values
are
Ŷ1 = X(X 0 X)−1 X 0Y1

= PX Y1
= X Π̂1
Since these fitted values are the projection of Y1 on the space spanned by X, and since any
vector in this space is uncorrelated with ε by assumption, Ŷ1 is uncorrelated with ε. Since Ŷ1
is simply the reduced-form prediction, it is correlated with Y1 , The only other requirement
is that the instruments be linearly independent. This should be the case when the order
condition is satisfied, since there are more columns in X2 than in Y1 in this case.
The second stage substitutes Ŷ1 in place of Y1 , and estimates by OLS. This original
model is
y = Y1 γ1 + X1 β1 + ε
= Zδ + ε
and the second stage model is

y = Yˆ1 γ1 + X1 β1 + ε.
Since X1 is in the space spanned by X, PX X1 = X1 , so we can write the second stage model
as
y = PX Y1 γ1 + PX X1 β1 + ε
≡ PX Zδ + ε
The OLS estimator applied to this model is
δ̂ = (Z 0 PX Z)−1 Z 0 PX y
which is exactly what we get if we estimate using IV, with the reduced form predictions of
the endogs used as instruments. Note that if we define
Ẑ = PX Z
h i
= Ŷ1 X1
11.7. TESTING THE OVERIDENTIFYING RESTRICTIONS 139
so that Ẑ are the instruments for Z, then we can write
δ̂ = (Ẑ 0 Z)−1 Ẑ 0 y
• Important note: OLS on the transformed model can be used to calculate the 2SLS
estimate of δ, since we see that it’s equivalent to IV using a particular set of
instruments. However the OLS covariance formula is not valid. We need to
apply the IV covariance formula already seen above.
Actually, there is also a simplification of the general IV variance formula. Define
Ẑ = PX Z
h i
= Ŷ X
The IV covariance estimator would ordinarily be

−1 0 0 −1 2
V̂ (δ̂) = Z 0 Ẑ Ẑ Ẑ Ẑ Z σ̂IV
However, looking at the last term in brackets

" #
h i0 h i Y10 (PX )Y1 Y10 (PX )X1
Ẑ 0 Z = Ŷ1 X1 Y1 X1 =
X10 Y1 X10 X1
but since PX is idempotent and since PX X = X, we can write
" #
h i0 h i Y10 PX PX Y1 Y10 PX X1
Ŷ1 X1 Y1 X1 =
X10 PX Y1 X10 X1
h i0 h i
= Ŷ1 X1 Ŷ1 X1
= Ẑ 0 Ẑ
Therefore, the second and last term in the variance formula cancel, so the 2SLS varcov
estimator simplifies to
−1 2
V̂ (δ̂) = Z 0 Ẑ σ̂IV
which, following some algebra similar to the above, can also be written as
−1 2
V̂ (δ̂) = Ẑ 0 Ẑ σ̂IV
Finally, recall that though this is presented in terms of the first equation, it is general since
any equation can be placed first.
Properties of 2SLS:
(1) Consistent
(2) Asymptotically normal
(3) Biased when the mean esists (the existence of moments is a technical issue we
won’t go into here).
(4) Asymptotically inefficient, except in special circumstances (more on this later).
11.7. Testing the overidentifying restrictions
The selection of which variables are endogs and which are exogs is part of the specifi-
cation of the model. As such, there is room for error here: one might erroneously classify
a variable as exog when it is in fact correlated with the error term. A general test for the
specification on the model can be formulated as follows:
The IV estimator can be calculated by applying OLS to the transformed model, so the
IV objective function at the minimized value is
0
s(β̂IV ) = y − X β̂IV PW y − X β̂IV ,
but
ε̂IV = y − X β̂IV
= y − X(X 0PW X)−1 X 0 PW y

= I − X(X 0PW X)−1 X 0 PW y

= I − X(X 0PW X)−1 X 0 PW (Xβ + ε)
= A (Xβ + ε)
where
A ≡ I − X(X 0PW X)−1 X 0 PW
so

s(β̂IV ) = ε0 + β0 X 0 A0 PW A (Xβ + ε)
Moreover, A0 PW A is idempotent, as can be verified by multiplication:

A0 PW A = I − PW X(X 0 PW X)−1 X 0 PW I − X(X 0PW X)−1 X 0 PW

= PW − PW X(X 0 PW X)−1 X 0 PW PW − PW X(X 0 PW X)−1 X 0 PW

= I − PW X(X 0 PW X)−1 X 0 PW .
Furthermore, A is orthogonal to X

AX = I − X(X 0PW X)−1 X 0 PW X
= X −X
= 0
so
s(β̂IV ) = ε0 A0 PW Aε
Supposing the ε are normally distributed, with variance σ2 , then the random variable
s(β̂IV ) ε0 A0 PW Aε
=
σ2 σ2
is a quadratic form of a N(0, 1) random variable with an idempotent matrix in the middle,
so
s(β̂IV )
∼ χ2 (ρ(A0 PW A))
σ2
This isn’t available, since we need to estimate σ2 . Substituting a consistent estimator,
s(β̂IV ) a 2
∼ χ (ρ(A0 PW A))
c2
σ
• Even if the ε aren’t normally distributed, the asymptotic result still holds. The
last thing we need to determine is the rank of the idempotent matrix. We have

A0 PW A = PW − PW X(X 0 PW X)−1 X 0 PW
so

ρ(A0 PW A) = Tr PW − PW X(X 0 PW X)−1 X 0 PW
= TrPW − TrX 0 PW PW X(X 0 PW X)−1
= TrW (W 0W )−1W 0 − KX
= TrW 0W (W 0W )−1 − KX
= KW − KX
where KW is the number of columns of W and KX is the number of columns

of X. The degrees of freedom of the test is simply the number of overidentifying
restrictions: the number of instruments we have beyond the number that is strictly
necessary for consistent estimation.
• This test is an overall specification test: the joint null hypothesis is that the model
is correctly specified and that the W form valid instruments (e.g., that the vari-
ables classified as exogs really are uncorrelated with ε. Rejection can mean that
either the model y = Zδ + ε is misspecified, or that there is correlation between
X and ε.
• This is a particular case of the GMM criterion test, which is covered in the second
half of the course. See Section 15.8.
• Note that since
ε̂IV = Aε
and
s(β̂IV ) = ε0 A0 PW Aε
we can write

s(β̂IV ) ε̂0W (W 0W )−1W 0 W (W 0W )−1W 0 ε̂
=
c2
σ ε̂0 ε̂/n
= n(RSSε̂IV |W /T SSε̂IV )
= nR2u
where R2u is the uncentered R2 from a regression of the IV residuals on all of the
instruments W . This is a convenient way to calculate the test statistic.
On an aside, consider IV estimation of a just-identified model, using the standard notation
y = Xβ + ε
and W is the matrix of instruments. If we have exact identification then cols(W ) = cols(X),
0
so W X is a square matrix. The transformed model is
PW y = PW Xβ + PW ε
11.8. SYSTEM METHODS OF ESTIMATION 142
and the fonc are

X 0 PW (y − X β̂IV ) = 0
The IV estimator is
−1
β̂IV = X 0 PW X X 0 PW y
Considering the inverse here
−1 −1
X 0 PW X = X 0W (W 0W )−1W 0 X
−1
= (W 0 X)−1 X 0W (W 0W )−1
−1
= (W 0 X)−1 (W 0W ) X 0W
Now multiplying this by X 0 PW y, we obtain

−1
β̂IV = (W 0 X)−1 (W 0W ) X 0W X 0 PW y
−1
= (W 0 X)−1 (W 0W ) X 0W X 0W (W 0W )−1W 0 y
= (W 0 X)−1W 0 y
The objective function for the generalized IV estimator is

0
s(β̂IV ) = y − X β̂IV PW y − X β̂IV

= y0 PW y − X β̂IV − β̂0IV X 0 PW y − X β̂IV

= y0 PW y − X β̂IV − β̂0IV X 0 PW y + β̂0IV X 0 PW X β̂IV

= y0 PW y − X β̂IV − β̂0IV X 0 PW y + X 0PW X β̂IV

= y0 PW y − X β̂IV
by the fonc for generalized IV. However, when we’re in the just indentified case, this is

s(β̂IV ) = y0 PW y − X(W 0 X)−1W 0 y

= y0 PW I − X(W 0 X)−1W 0 y

= y0 W (W 0W )−1W 0 −W (W 0W )−1W 0 X(W 0 X)−1W 0 y
= 0
The value of the objective function of the IV estimator is zero in the just identified case.
This makes sense, since we’ve already shown that the objective function after dividing by
σ2 is asymptotically χ2 with degrees of freedom equal to the number of overidentifying
restrictions. In the present case, there are no overidentifying restrictions, so we have a
χ2 (0) rv, which has mean 0 and variance 0, e.g., it’s simply 0. This means we’re not able
to test the identifying restrictions in the case of exact identification.
11.8. System methods of estimation
2SLS is a single equation method of estimation, as noted above. The advantage of a

single equation method is that it’s unaffected by the other equations of the system, so they
don’t need to be specified (except for defining what are the exogs, so 2SLS can use the
complete set of instruments). The disadvantage of 2SLS is that it’s inefficient, in general.
• Recall that overidentification improves efficiency of estimation, since an overi-

dentified equation can use more instruments than are necessary for consistent
estimation.
• Secondly, the assumption is that
Y Γ = XB + E
E (X 0 E) = 0(K×G)
vec(E) ∼ N(0, Ψ)
• Since there is no autocorrelation of the Et ’s, and since the columns of E are
individually homoscedastic, then
 
σ11 In σ12 In ··· σ1G In
 .. 
 σ22 In . 
 
Ψ =  .. 
 .. 
 . . 
· σGG In
= Σ ⊗ In
This means that the structural equations are heteroscedastic and correlated with
one another
• In general, ignoring this will lead to inefficient estimation, following the sec-
tion on GLS. When equations are correlated with one another estimation should
account for the correlation in order to obtain efficiency.
• Also, since the equations are correlated, information about one equation is im-
plicitly information about all equations. Therefore, overidentification restrictions
in any equation improve efficiency for all equations, even the just identified equa-
tions.
• Single equation methods can’t use these types of information, and are therefore
inefficient (in general).
11.8.1. 3SLS. Note: It is easier and more practical to treat the 3SLS estimator as a
generalized method of moments estimator (see Chapter 15). I no longer teach the following
section, but it is retained for its possible historical interest. Another alternative is to use
FIML (Subsection 11.8.2), if you are willing to make distributional assumptions on the
errors. This is computationally feasible with modern computers.
Following our above notation, each structural equation can be written as
yi = Yi γ1 + Xi β1 + εi
= Zi δi + ε i
Grouping the G equations together we get

      
y1 Z1 0 ··· 0 δ1 ε1
   ..    

 y2   0 Z 2 . 
 δ2   ε2 
 . =  .. + .. 
 .   .. ..    
 .   . . 0  .   . 
yG 0 ··· 0 ZG δG εG
or
y = Zδ + ε
where we already have that
E (εε0 ) = Ψ
= Σ ⊗ In
The 3SLS estimator is just 2SLS combined with a GLS correction that takes advantage of
the structure of Ψ. Define Ẑ as
 
X(X 0 X)−1 X 0 Z1 0 ··· 0
 .. 
 0 X(X 0 X)−1 X 0 Z2 . 
 
Ẑ =  . 
 . .. 
 . . 0 
0 ··· 0 X(X 0 X)−1 X 0 ZG
 
Ŷ1 X1 0 ··· 0
 .. 
 0 Ŷ2 X2 . 
 
=  . 
 . .. 
 . . 0 
0 ··· 0 ŶG XG
These instruments are simply the unrestricted rf predicitions of the endogs, combined
with the exogs. The distinction is that if the model is overidentified, then
Π = BΓ−1
may be subject to some zero restrictions, depending on the restrictions on Γ and B, and Π̂
does not impose these restrictions. Also, note that Π̂ is calculated using OLS equation by
equation. More on this later.
The 2SLS estimator would be
δ̂ = (Ẑ 0 Z)−1 Ẑ 0 y
as can be verified by simple multiplication, and noting that the inverse of a block-diagonal
matrix is just the matrix with the inverses of the blocks on the main diagonal. This IV
estimator still ignores the covariance information. The natural extension is to add the GLS
transformation, putting the inverse of the error covariance into the formula, which gives the
3SLS estimator
−1
δ̂3SLS = Ẑ 0 (Σ ⊗ In)−1 Z Ẑ 0 (Σ ⊗ In)−1 y
−1 0 −1
= Ẑ 0 Σ−1 ⊗ In Z Ẑ Σ ⊗ In y
This estimator requires knowledge of Σ. The solution is to define a feasible estimator using
a consistent estimator of Σ. The obvious solution is to use an estimator based on the 2SLS
residuals:
ε̂i = yi − Zi δ̂i,2SLS
(IMPORTANT NOTE: this is calculated using Zi , not Ẑi ). Then the element i, j of Σ is
estimated by
ε̂0i ε̂ j
σ̂i j =
n
Substitute Σ̂ into the formula above to get the feasible 3SLS estimator.
Analogously to what we did in the case of 2SLS, the asymptotic distribution of the
3SLS estimator can be shown to be
  ! 
√  Ẑ 0 (Σ ⊗ I )−1 Ẑ −1 
a n
n δ̂3SLS − δ ∼ N 0, lim E 
n→∞  n 
A formula for estimating the variance of the 3SLS estimator in finite samples (cancelling
out the powers of n) is −1
V̂ δ̂3SLS = Ẑ 0 Σ̂−1 ⊗ In Ẑ
• This is analogous to the 2SLS formula in equation (??), combined with the GLS
correction.
• In the case that all equations are just identified, 3SLS is numerically equivalent to
2SLS. Proving this is easiest if we use a GMM interpretation of 2SLS and 3SLS.
GMM is presented in the next econometrics course. For now, take it on faith.
The 3SLS estimator is based upon the rf parameter estimator Π̂, calculated equation by
equation using OLS:
Π̂ = (X 0 X)−1 X 0Y
which is simply h i
Π̂ = (X 0 X)−1 X 0 y1 y2 ··· yG
that is, OLS equation by equation using all the exogs in the estimation of each column of
Π.
It may seem odd that we use OLS on the reduced form, since the rf equations are
correlated:
Yt0 = Xt0 BΓ−1 + Et0 Γ−1

= Xt0 Π +Vt0
and
0 0
Vt = Γ−1 Et ∼ N 0, Γ−1 ΣΓ−1 , ∀t
Let this var-cov matrix be indicated by
0
Ξ = Γ−1 ΣΓ−1
OLS equation by equation to get the rf is equivalent to

      
y1 X 0 ··· 0 π1 v1
   ..     
 y2    0 X . 
 π2   v2 
 . =   .. + .. 
 .   .. ..    
 .   . . 0  .   . 
yG 0 ··· 0 X πG vG
where yi is the n × 1 vector of observations of the ith endog, X is the entire n × K matrix of
exogs, πi is the ith column of Π, and vi is the ith column of V. Use the notation
y = Xπ + v
to indicate the pooled model. Following this notation, the error covariance matrix is
V (v) = Ξ ⊗ In
• This is a special case of a type of model known as a set of seemingly unrelated

equations (SUR) since the parameter vector of each equation is different. The
equations are contemporanously correlated, however. The general case would
have a different Xi for each equation.
• Note that each equation of the system individually satisfies the classical assump-
tions.
• However, pooled estimation using the GLS correction is more efficient, since
equation-by-equation estimation is equivalent to pooled estimation, since X is
block diagonal, but ignoring the covariance information.
• The model is estimated by GLS, where Ξ is estimated using the OLS residuals
from equation-by-equation estimation, which are consistent.
• In the special case that all the Xi are the same, which is true in the present case of
estimation of the rf parameters, SUR ≡OLS. To show this note that in this case
X = In ⊗ X. Using the rules
(1) (A ⊗ B)−1 = (A−1 ⊗ B−1 )
(2) (A ⊗ B)0 = (A0 ⊗ B0 ) and
(3) (A ⊗ B)(C ⊗ D) = (AC ⊗ BD), we get
−1
π̂SUR = (In ⊗ X)0 (Ξ ⊗ In)−1 (In ⊗ X) (In ⊗ X)0 (Ξ ⊗ In)−1 y
−1 −1
= Ξ−1 ⊗ X 0 (In ⊗ X) Ξ ⊗ X0 y

= Ξ ⊗ (X 0X)−1 Ξ−1 ⊗ X 0 y

= IG ⊗ (X 0 X)−1 X 0 y
 
π̂1
 
 π̂2 
=  . 


 .. 
π̂G
• So the unrestricted rf coefficients can be estimated efficiently (assuming normal-
ity) by OLS, even if the equations are correlated.
• We have ignored any potential zeros in the matrix Π, which if they exist could
potentially increase the efficiency of estimation of the rf.
• Another example where SUR≡OLS is in estimation of vector autoregressions.
See two sections ahead.
11.8.2. FIML. Full information maximum likelihood is an alternative estimation method.

FIML will be asymptotically efficient, since ML estimators based on a given information
set are asymptotically efficient w.r.t. all other estimators that use the same information set,
and in the case of the full-information ML estimator we use the entire information set. The
2SLS and 3SLS estimators don’t require distributional assumptions, while FIML of course
does. Our model is, recall

Et ∼ N(0, Σ), ∀t
E (Et Es0 ) = 0,t 6= s
The joint normality of Et means that the density for Et is the multivariate normal, which is

−1/2 1
(2π)−g/2 det Σ−1 exp − Et0 Σ−1 Et
2
The transformation from Et to Yt requires the Jacobian
dEt
| det | = | det Γ|
dYt0
so the density for Yt is

−1/2 1 0
(2π)−G/2 | det Γ| detΣ−1 exp − Yt0 Γ − Xt0B Σ−1 Yt0 Γ − Xt0B
2
Given the assumption of independence over time, the joint log-likelihood function is
nG n 1 n 0
ln L(B, Γ, Σ) = − ln(2π)+n ln(| det Γ|)− ln det Σ−1 − ∑ Yt0 Γ − Xt0B Σ−1 Yt0 Γ − Xt0B
2 2 2 t=1
• This is a nonlinear in the parameters objective function. Maximixation of this
can be done using iterative numeric methods. We’ll see how to do this in the next
section.
• It turns out that the asymptotic distribution of 3SLS and FIML are the same,
assuming normality of the errors.
• One can calculate the FIML estimator by iterating the 3SLS estimator, thus avoid-
ing the use of a nonlinear optimizer. The steps are
(1) Calculate Γ̂3SLS and B̂3SLS as normal.
(2) Calculate Π̂ = B̂3SLS Γ̂−1
3SLS . This is new, we didn’t estimate Π in this way
before. This estimator may have some zeros in it. When Greene says iter-
ated 3SLS doesn’t lead to FIML, he means this for a procedure that doesn’t
update Π̂, but only updates Σ̂ and B̂ and Γ̂. If you update Π̂ you do converge
to FIML.
(3) Calculate the instruments Ŷ = X Π̂ and calculate Σ̂ using Γ̂ and B̂ to get the
estimated errors, applying the usual estimator.
11.9. EXAMPLE: 2SLS AND KLEIN’S MODEL 1 148
(4) Apply 3SLS using these new instruments and the estimate of Σ.
(5) Repeat steps 2-4 until there is no change in the parameters.
• FIML is fully efficient, since it’s an ML estimator that uses all information. This
implies that 3SLS is fully efficient when the errors are normally distributed.
Also, if each equation is just identified and the errors are normal, then 2SLS
will be fully efficient, since in this case 2SLS≡3SLS.
• When the errors aren’t normally distributed, the likelihood function is of course
different than what’s written above.
11.9. Example: 2SLS and Klein’s Model 1
The Octave program Simeq/Klein.m performs 2SLS estimation for the 3 equations of
Klein’s model 1, assuming nonautocorrelated errors, so that lagged endogenous variables
can be used as instruments. The results are:
CONSUMPTION EQUATION
*******************************************************
2SLS estimation results
Observations 21
R-squared 0.976711

Constant 16.555 1.321 12.534 0.000
Profits 0.017 0.118 0.147 0.885
Lagged Profits 0.216 0.107 2.016 0.060
Wages 0.810 0.040 20.129 0.000
*******************************************************
INVESTMENT EQUATION
*******************************************************
Observations 21
R-squared 0.884884

Constant 20.278 7.543 2.688 0.016
Profits 0.150 0.173 0.867 0.398
Lagged Profits 0.616 0.163 3.784 0.001
Lagged Capital -0.158 0.036 -4.368 0.000
*******************************************************
11.9. EXAMPLE: 2SLS AND KLEIN’S MODEL 1 149
WAGES EQUATION
*******************************************************
Observations 21
R-squared 0.987414

Constant 1.500 1.148 1.307 0.209
Output 0.439 0.036 12.316 0.000
Lagged Output 0.147 0.039 3.777 0.002
Trend 0.130 0.029 4.475 0.000
*******************************************************
The above results are not valid (specifically, they are inconsistent) if the errors are
autocorrelated, since lagged endogenous variables will not be valid instruments in that
case. You might consider eliminating the lagged endogenous variables as instruments,
and re-estimating by 2SLS, to obtain consistent parameter estimates in this more complex
case. Standard errors will still be estimated inconsistently, unless use a Newey-West type
covariance estimator. Food for thought...
CHAPTER 12
Introduction to the second half
We’ll begin with study of extremum estimators in general. Let Zn be the available data,
based on a sample of size n.
D EFINITION 12.0.1. [Extremum estimator] An extremum estimator θ̂ is the optimiz-

ing element of an objective function sn (Zn , θ) over a set Θ.
We’ll usually write the objective function suppressing the dependence on Z n .

Example: Least squares, linear model
Let the d.g.p. be yt = xt0 θ0 + εt , t = 1, 2, ..., n, θ0 ∈ Θ. Stacking observations vertically,
0
yn = Xn θ0 + εn , where Xn = x1 x2 · · · xn . The least squares estimator is defined
as
θ̂ ≡ argmin sn (θ) = (1/n)[yn − Xn θ]0 [yn − Xn θ]
Θ
We readily find that θ̂ = (X0 X)−1 X0 y.
Example: Maximum likelihood
Suppose that the continuous random variable yt ∼ IIN(θ0 , 1). The maximum likeli-
hood estimator is defined as
!
n
(yt − θ)2
θ̂ ≡ argmax Ln (θ) = ∏ (2π)−1/2
exp −
Θ t=1 2
Because the logarithmic function is strictly increasing on (0, ∞), maximization of the av-
erage logarithm of the likelihood function is achieved at the same θ̂ as for the likelihood
function:
n
(yt − θ)2
θ̂ ≡ argmax sn (θ) = (1/n)ln Ln (θ) = −1/2 ln2π − (1/n) ∑
Θ t=1 2
Solution of the f.o.c. leads to the familiar result that θ̂ = ȳ.
• MLE estimators are asymptotically efficient (Cramér-Rao lower bound, The-

orem3), supposing the strong distributional assumptions upon which they are
based are true.
• One can investigate the properties of an “ML” estimator supposing that the distri-
butional assumptions are incorrect. This gives a quasi-ML estimator, which we’ll
study later.
• The strong distributional assumptions of MLE may be questionable in many
cases. It is possible to estimate using weaker distributional assumptions based
only on some of the moments of a random variable(s).
Example: Method of moments

150
12. INTRODUCTION TO THE SECOND HALF 151
Suppose we draw a random sample of yt from the χ2 (θ0 ) distribution. Here, θ0 is

the parameter of interest. The first moment (expectation), µ1 , of a random variable will in
general be a function of the parameters of the distribution, i.e., µ 1 (θ0 ) .
• µ1 = µ1 (θ0 ) is a moment-parameter equation.

• In this example, the relationship is the identity function µ1 (θ0 ) = θ0 , though in
general the relationship may be more complicated. The sample first moment is
n
µb1 = ∑ yt /n.
t=1
• Define
m1 (θ) = µ1 (θ) − µb1
• The method of moments principle is to choose the estimator of the parameter
to set the estimate of the population moment equal to the sample moment, i.e.,
m1 (θ̂) ≡ 0. Then the moment-parameter equation is inverted to solve for the
parameter estimate.
In this case,
n
m1 (θ̂) = θ̂ − ∑ yt /n = 0.
t=1
n p
Since ∑t=1 yt /n → θ0 by the LLN, the estimator is consistent.
More on the method of moments
Continuing with the above example, the variance of a χ2 (θ0 ) r.v. is
2
V (yt ) = E yt − θ0 = 2θ0 .
• Define
n 2
∑t=1 (yt − ȳ)
m2 (θ) = 2θ −
n
• The MM estimator would set
n 2
∑t=1 (yt − ȳ)
m2 (θ̂) = 2θ̂ − ≡ 0.
n
Again, by the LLN, the sample variance is consistent for the true variance, that
is,
n 2
∑t=1 (yt − ȳ) p
→ 2θ0 .
n
So,
n 2
∑t=1 (yt − ȳ)
θ̂ = ,
2n
which is obtained by inverting the moment-parameter equation, is consistent.
Example: Generalized method of moments (GMM)

The previous two examples give two estimators of θ0 which are both consistent. With
a given sample, the estimators will be different in general.
• With two moment-parameter equations and only one parameter, we have overi-
dentification, which means that we have more information than is strictly neces-
sary for consistent estimation of the parameter.
• The GMM combines information from the two moment-parameter equations to

form a new estimator which will be more efficient, in general (proof of this be-
low).
From the first example, define m1t (θ) = θ − yt . We already have that m1 (θ) is the sample
average of m1t (θ), i.e.,
n
m1 (θ) = 1/n ∑ m1t (θ)
t=1
n
= θ − ∑ yt /n.
t=1

Clearly, when evaluated at the true parameter value θ0 , both E m1t (θ0 ) = 0 and E m1 (θ0 ) =
0.
From the second example we define additional moment conditions
m2t (θ) = 2θ − (yt − ȳ)2
and
n 2
∑t=1 (yt − ȳ)
m2 (θ) = 2θ − .
n
a.s.
Again, it is clear from the LLN that m2 (θ0 ) → 0. The MM estimator would chose θ̂ to set
either m1 (θ̂) = 0 or m2 (θ̂) = 0. In general, no single value of θ will solve the two equations
simultaneously.
• The GMM estimator is based on defining a measure of distance d(m(θ)), where

m(θ) = (m1 (θ), m2 (θ))0 , and choosing
θ̂ = argmin sn (θ) = d (m(θ)) .

Θ
An example would be to choose d(m) = m0 Am, where A is a positive definite matrix. While
it’s clear that the MM gives consistent estimates if there is a one-to-one relationship be-
tween parameters and moments, it’s not immediately obvious that the GMM estimator is
consistent. (We’ll see later that it is.)
These examples show that these widely used estimators may all be interpreted as the
solution of an optimization problem. For this reason, the study of extremum estimators is
useful for its generality. We will see that the general results extend smoothly to the more
specialized results available for specific estimators. After studying extremum estimators
in general, we will study the GMM estimator, then QML and NLS. The reason we study
GMM first is that LS, IV, NLS, MLE, QML and other well-known parametric estimators
may all be interpreted as special cases of the GMM estimator, so the general results on
GMM can simplify and unify the treatment of these other estimators. Nevertheless, there
are some special results on QML and NLS, and both are important in empirical research,
which makes focus on them useful.
One of the focal points of the course will be nonlinear models. This is not to suggest
that linear models aren’t useful. Linear models are more general than they might first
appear, since one can employ nonlinear transformations of the variables:
h i
ϕ0 (yt ) = ϕ1 (xt ) ϕ2 (xt ) · · · ϕ p (xt ) θ0 + εt
For example,
ln yt = α + βx1t + γx21t + δx1t x2t + εt
fits this form.
• The important point is that the model is linear in the parameters but not neces-
sarily linear in the variables.
In spite of this generality, situations often arise which simply can not be convincingly
represented by linear in the parameters models. Also, theory that applies to nonlinear
models also applies to linear models, so one may as well start off with the general case.
Example: Expenditure shares
Roy’s Identity states that the quantity demanded of the ith of G goods is
−∂v(p, y)/∂pi
xi = .
∂v(p, y)/∂y
An expenditure share is
si ≡ pi xi /y,
so necessarily si ∈ [0, 1], and ∑G
i=1 si = 1. No linear in the parameters model for xi or si
with a parameter space that is defined independent of the data can guarantee that either of
these conditions holds. These constraints will often be violated by estimated linear models,
which calls into question their appropriateness in cases of this sort.
Example: Binary limited dependent variable
The referendum contingent valuation (CV) method of infering the social value of a
project provides a simple example. This example is a special case of more general discrete
choice (or binary response) models. Individuals are asked if they would pay an amount A
for provision of a project. Indirect utility in the base case (no project) is v 0 (m, z)+ε0 , where
m is income and z is a vector of other variables such as prices, personal characteristics, etc.
After provision, utility is v1 (m, z) + ε1 . The random terms εi , i = 1, 2, reflect variations of
preferences in the population. With this, an individual agrees 1 to pay A if
ε0 − ε 1 v1 (m − A, z) − v0(m, z)
| {z } < | {z }
ε ∆v(w, A)
Define ε = ε0 − ε1 , let w collect m and z, and let ∆v(w, A) = v1 (m − A, z) − v0(m, z). Define
y = 1 if the consumer agrees to pay A for the change, y = 0 otherwise. The probability of
agreement is
(12.0.1) Pr(y = 1) = Fε [∆v(w, A)] .
1We assume here that responses are truthful, that is there is no strategic behavior and that individuals are able to
order their preferences in this hypothetical situation.
To simplify notation, define p(w, A) ≡ Fε [∆v(w, A)] . To make the example specific, sup-
pose that
v1 (m, z) = α − βm
0
v (m, z) = −βm
and ε0 and ε1 are i.i.d. extreme value random variables. That is, utility depends only on
income, preferences in both states are homothetic, and a specific distributional assumption
is made on the distribution of preferences in the population. With these assumptions (the
details are unimportant here, see articles by D. McFadden if you’re interested) it can be
shown that
p(A, θ) = Λ (α + βA),
where Λ(z) is the logistic distribution function
Λ(z) = (1 + exp(−z))−1 .
This is the simple logit model: the choice probability is the logit function of a linear in
parameters function.
Now, y is either 0 or 1, and the expected value of y is Λ (α + βA) . Thus, we can write
y = Λ (α + βA) + η
E (η) = 0.
One could estimate this by (nonlinear) least squares

1
α̂,β̂ = argmin ∑ (y − Λ (α + βA))2
n t
The main point is that it is impossible that Λ (α + βA) can be written as a linear in the
parameters model, in the sense that, for arbitrary A, there are no θ, ϕ(A) such that
Λ (α + βA) = ϕ(A)0 θ, ∀A
where ϕ(A) is a p-vector valued function of A and θ is a p dimensional parameter. This

is because for any θ, we can always find a A such that ϕ(A)0 θ will be negative or greater
than 1, which is illogical, since it is the expectation of a 0/1 binary random variable. Since
this sort of problem occurs often in empirical work, it is useful to study NLS and other
nonlinear models.
After discussing these estimation methods for parametric models we’ll briefly intro-
duce nonparametric estimation methods. These methods allow one, for example, to esti-
mate f (xt ) consistently when we are not willing to assume that a model of the form
yt = f (xt ) + εt
can be restricted to a parametric form
yt = f (xt , θ) + εt
Pr(εt < z) = Fε (z|φ, xt )
θ ∈ Θ, φ ∈ Φ
where f (·) and perhaps Fε (z|φ, xt ) are of known functional form. This is important since
economic theory gives us general information about functions and the signs of their deriva-
tives, but not about their specific form.
Then we’ll look at simulation-based methods in econometrics. These methods allow
us to substitute computer power for mental power. Since computer power is becoming
relatively cheap compared to mental effort, any econometrician who lives by the principles
of economic theory should be interested in these techniques.
Finally, we’ll look at how econometric computations can be done in parallel on a clus-
ter of computers. This allows us to harness more computational power to work with more
complex models that can be dealt with using a desktop computer.
CHAPTER 13
Numeric optimization methods
Readings: Hamilton, ch. 5, section 7 (pp. 133-139)∗; Gourieroux and Monfort, Vol.
1, ch. 13, pp. 443-60∗; Goffe, et. al. (1994).
If we’re going to be applying extremum estimators, we’ll need to know how to find
an extremum. This section gives a very brief introduction to what is a large literature
on numeric optimization methods. We’ll consider a few well-known techniques, and one
fairly new technique that may allow one to solve difficult problems. The main objective
is to become familiar with the issues, and to learn how to use the BFGS algorithm at the
practical level.
The general problem we consider is how to find the maximizing element θ̂ (a K -vector)
of a function s(θ). This function may not be continuous, and it may not be differentiable.
Even if it is twice continuously differentiable, it may not be globally concave, so local
maxima, minima and saddlepoints may all exist. Supposing s(θ) were a quadratic function
of θ, e.g.,
1
s(θ) = a + b0θ + θ0Cθ,
2
the first order conditions would be linear:
Dθ s(θ) = b +Cθ
so the maximizing (minimizing) element would be θ̂ = −C−1 b. This is the sort of problem
we have with linear models estimated by OLS. It’s also the case for feasible GLS, since
conditional on the estimate of the varcov matrix, we have a quadratic objective function in
the remaining parameters.
More general problems will not have linear f.o.c., and we will not be able to solve for
the maximizer analytically. This is when we need a numeric optimization method.
13.1. Search
The idea is to create a grid over the parameter space and evaluate the function at each
point on the grid. Select the best point. Then refine the grid in the neighborhood of the
best point, and continue until the accuracy is ”good enough”. See Figure 13.1.1. One has
to be careful that the grid is fine enough in relationship to the irregularity of the function to
ensure that sharp peaks are not missed entirely.
To check q values in each dimension of a K dimensional parameter space, we need
to check qK points. For example, if q = 100 and K = 10, there would be 100 10 points
to check. If 1000 points can be checked in a second, it would take 3. 171 × 10 9 years to
perform the calculations, which is approximately the age of the earth. The search method
156
13.2. DERIVATIVE-BASED METHODS 157
F IGURE 13.1.1. The search method
is a very reasonable choice if K is small, but it quickly becomes infeasible if K is moderate

or large.
13.2. Derivative-based methods
13.2.1. Introduction. Derivative-based methods are defined by

(1) the method for choosing the initial value, θ1
(2) the iteration method for choosing θk+1 given θk (based upon derivatives)
(3) the stopping criterion.
The iteration method can be broken into two problems: choosing the stepsize a k (a scalar)
and choosing the direction of movement, d k , which is of the same dimension of θ, so that
θ(k+1) = θ(k) + ak d k .
A locally increasing direction of search d is a direction such that

∂s(θ + ad)
∃a : >0
∂a
for a positive but small. That is, if we go in direction d, we will improve on the objective
function, at least if we don’t go too far in that direction.
F IGURE 13.2.1. Increasing directions of search
• As long as the gradient at θ is not zero there exist increasing directions, and
they can all be represented as Qk g(θk ) where Qk is a symmetric pd matrix and
g (θ) = Dθ s(θ) is the gradient at θ. To see this, take a T.S. expansion around
a0 = 0
s(θ + ad) = s(θ + 0d) + (a − 0)g(θ + 0d)0d + o(1)

= s(θ) + ag(θ)0 d + o(1)
For small enough a the o(1) term can be ignored. If d is to be an increasing

direction, we need g(θ)0 d > 0. Defining d = Qg(θ), where Q is positive definite,
we guarantee that
g(θ)0 d = g(θ)0 Qg(θ) > 0
unless g(θ) = 0. Every increasing direction can be represented in this way (p.d.
matrices are those such that the angle between g and Qg(θ) is less that 90 de-
grees). See Figure 13.2.1.
• With this, the iteration rule becomes
θ(k+1) = θ(k) + ak Qk g(θk )

and we keep going until the gradient becomes zero, so that there is no increasing direction.
The problem is how to choose a and Q.
• Conditional on Q, choosing a is fairly straightforward. A simple line search is
an attractive possibility, since a is a scalar.
• The remaining problem is how to choose Q.
• Note also that this gives no guarantees to find a global maximum.
13.2.2. Steepest descent. Steepest descent (ascent if we’re maximizing) just sets Q
to and identity matrix, since the gradient provides the direction of maximum rate of change
of the objective function.
• Advantages: fast - doesn’t require anything more than first derivatives.
• Disadvantages: This doesn’t always work too well however (draw picture of ba-
nana function).
13.2.3. Newton-Raphson. The Newton-Raphson method uses information about the

slope and curvature of the objective function to determine which direction and how far to
move from an initial point. Supposing we’re trying to maximize s n (θ). Take a second order
Taylor’s series approximation of sn (θ) about θk (an initial guess).
0
sn (θ) ≈ sn (θk ) + g(θk )0 θ − θk + 1/2 θ − θk H(θk ) θ − θk
To attempt to maximize sn (θ), we can maximize the portion of the right-hand side that
depends on θ, i.e., we can maximize
0
s̃(θ) = g(θk )0 θ + 1/2 θ − θk H(θk ) θ − θk
with respect to θ. This is a much easier problem, since it is a quadratic function in θ, so it

has linear first order conditions. These are

Dθ s̃(θ) = g(θk ) + H(θk ) θ − θk
So the solution for the next round estimate is
θk+1 = θk − H(θk )−1 g(θk )
This is illustrated in Figure 13.2.2.

However, it’s good to include a stepsize, since the approximation to s n (θ) may be bad
far away from the maximizer θ̂, so the actual iteration formula is
θk+1 = θk − ak H(θk )−1 g(θk )
• A potential problem is that the Hessian may not be negative definite when we’re
far from the maximizing point. So −H(θk )−1 may not be positive definite, and
−H(θk )−1 g(θk ) may not define an increasing direction of search. This can hap-
pen when the objective function has flat regions, in which case the Hessian matrix
is very ill-conditioned (e.g., is nearly singular), or when we’re in the vicinity of
a local minimum, H(θk ) is positive definite, and our direction is a decreasing di-
rection of search. Matrix inverses by computers are subject to large errors when
the matrix is ill-conditioned. Also, we certainly don’t want to go in the direction
F IGURE 13.2.2. Newton-Raphson method
of a minimum when we’re maximizing. To solve this problem, Quasi-Newton

methods simply add a positive definite component to H(θ) to ensure that the re-
sulting matrix is positive definite, e.g., Q = −H(θ) + bI, where b is chosen large
enough so that Q is well-conditioned and positive definite. This has the benefit
that improvement in the objective function is guaranteed.
• Another variation of quasi-Newton methods is to approximate the Hessian by
using successive gradient evaluations. This avoids actual calculation of the Hes-
sian, which is an order of magnitude (in the dimension of the parameter vector)
more costly than calculation of the gradient. They can be done to ensure that the
approximation is p.d. DFP and BFGS are two well-known examples.
Stopping criteria
The last thing we need is to decide when to stop. A digital computer is subject to
limited machine precision and round-off errors. For these reasons, it is unreasonable to
hope that a program can exactly find the point that maximizes a function. We need to
define acceptable tolerances. Some stopping criteria are:
• Negligable change in parameters:
|θkj − θk−1
j | < ε1 , ∀ j
• Negligable relative change:

θkj − θk−1
j
| | < ε2 , ∀ j
θk−1
j
• Negligable change of function:
|s(θk ) − s(θk−1 )| < ε3
• Gradient negligibly different from zero:
|g j (θk )| < ε4 , ∀ j
• Or, even better, check all of these.

• Also, if we’re maximizing, it’s good to check that the last round (real, not ap-
proximate) Hessian is negative definite.
Starting values
The Newton-Raphson and related algorithms work well if the objective function is
concave (when maximizing), but not so well if there are convex regions and local minima
or multiple local maxima. The algorithm may converge to a local minimum or to a local
maximum that is not optimal. The algorithm may also have difficulties converging at all.
• The usual way to “ensure” that a global maximum has been found is to use many
different starting values, and choose the solution that returns the highest objective
function value. THIS IS IMPORTANT in practice. More on this later.
Calculating derivatives
The Newton-Raphson algorithm requires first and second derivatives. It is often dif-
ficult to calculate derivatives (especially the Hessian) analytically if the function s n (·) is
complicated. Possible solutions are to calculate derivatives numerically, or to use programs
such as MuPAD or Mathematica to calculate analytic derivatives. For example, Figure
13.2.3 shows MuPAD1 calculating a derivative that I didn’t know off the top of my head,
and one that I did know.
• Numeric derivatives are less accurate than analytic derivatives, and are usually
more costly to evaluate. Both factors usually cause optimization programs to be
less successful when numeric derivatives are used.
• One advantage of numeric derivatives is that you don’t have to worry about hav-
ing made an error in calculating the analytic derivative. When programming an-
alytic derivatives it’s a good idea to check that they are correct by using numeric
derivatives. This is a lesson I learned the hard way when writing my thesis.
• Numeric second derivatives are much more accurate if the data are scaled so that
the elements of the gradient are of the same order of magnitude. Example: if the
model is yt = h(αxt +βzt )+εt , and estimation is by NLS, suppose that Dα sn (·) =
1000 and Dβ sn (·) = 0.001. One could define α∗ = α/1000; xt∗ = 1000xt ;β∗ =
1000β; zt∗ = zt /1000. In this case, the gradients Dα∗ sn (·) and Dβ sn (·) will both be
1.
1MuPAD is not a freely distributable program, so it’s not on the CD. You can download it from
http://www.mupad.de/download.shtml
13.3. SIMULATED ANNEALING 162
F IGURE 13.2.3. Using MuPAD to get analytic derivatives
In general, estimation programs always work better if data is scaled in this

way, since roundoff errors are less likely to become important. This is important
in practice.
• There are algorithms (such as BFGS and DFP) that use the sequential gradient
evaluations to build up an approximation to the Hessian. The iterations are faster
for this reason since the actual Hessian isn’t calculated, but more iterations usu-
ally are required for convergence.
• Switching between algorithms during iterations is sometimes useful.
13.3. Simulated Annealing
Simulated annealing is an algorithm which can find an optimum in the presence of non-
concavities, discontinuities and multiple local minima/maxima. Basically, the algorithm
randomly selects evaluation points, accepts all points that yield an increase in the objective
function, but also accepts some points that decrease the objective function. This allows the
algorithm to escape from local minima. As more and more points are tried, periodically
the algorithm focuses on the best point so far, and reduces the range over which random
points are generated. Also, the probability that a negative move is accepted reduces. The
algorithm relies on many evaluations, as in the search method, but focuses in on promising
13.4. EXAMPLES 163
areas, which reduces function evaluations with respect to the search method. It does not
require derivatives to be evaluated. I have a program to do this if you’re interested.
13.4. Examples
This section gives a few examples of how some nonlinear models may be estimated
using maximum likelihood.
13.4.1. Discrete Choice: The logit model. In this section we will consider maximum
likelihood estimation of the logit model for binary 0/1 dependent variables. We will use the
BFGS algotithm to find the MLE.
We saw an example of a binary choice model in equation 12.0.1. A more general
representation is
y∗ = g(x) − ε
y = 1(y∗ > 0)
Pr(y = 1) = Fε [g(x)]
≡ p(x, θ)
The log-likelihood function is
1 n
sn (θ) = ∑ (yi ln p(xi , θ) + (1 − yi) ln [1 − p(xi, θ)])
n i=1
For the logit model (see the contingent valuation example above), the probability has
the specific form
1
p(x, θ) =
1 + exp(−x0θ)
You should download and examine LogitDGP.m , which generates data according to
the logit model, logit.m , which calculates the loglikelihood, and EstimateLogit.m , which
sets things up and calls the estimation routine, which uses the BFGS algorithm.
Here are some estimation results with n = 100, and the true θ = (0, 1) 0 .
***********************************************
Trial of MLE estimation of Logit model
MLE Estimation Results

BFGS convergence: Normal convergence
Average Log-L: 0.607063

Observations: 100
estimate st. err t-stat p-value

constant 0.5400 0.2229 2.4224 0.0154
slope 0.7566 0.2374 3.1863 0.0014
Information Criteria
CAIC : 132.6230
13.4. EXAMPLES 164
BIC : 130.6230
AIC : 125.4127
***********************************************
The estimation program is calling mle_results(), which in turn calls a number of

other routines. These functions are part of the octave-forge repository.
13.4.2. Count Data: The Poisson model. Demand for health care is usually thought
of a a derived demand: health care is an input to a home production function that produces
health, and health is an argument of the utility function. Grossman (1972), for example,
models health as a capital stock that is subject to depreciation (e.g., the effects of ageing).
Health care visits restore the stock. Under the home production framework, individuals de-
cide when to make health care visits to maintain their health stock, or to deal with negative
shocks to the stock in the form of accidents or illnesses. As such, individual demand will
be a function of the parameters of the individuals’ utility functions.
The MEPS health data file , meps1996.data, contains 4564 observations on six mea-
sures of health care usage. The data is from the 1996 Medical Expenditure Panel Sur-
vey (MEPS). You can get more information at http://www.meps.ahrq.gov/. The six
measures of use are are office-based visits (OBDV), outpatient visits (OPV), inpatient vis-
its (IPV), emergency room visits (ERV), dental visits (VDV), and number of prescription
drugs taken (PRESCR). These form columns 1 - 6 of meps1996.data. The conditioning
variables are public insurance (PUBLIC), private insurance (PRIV), sex (SEX), age (AGE),
years of education (EDUC), and income (INCOME). These form columns 7 - 12 of the file,
in the order given here. PRIV and PUBLIC are 0/1 binary variables, where a 1 indicates
that the person has access to public or private insurance coverage. SEX is also 0/1, where
1 indicates that the person is female. This data will be used in examples fairly extensively
in what follows.
The program ExploreMEPS.m shows how the data may be read in, and gives some
descriptive information about variables, which follows:
All of the measures of use are count data, which means that they take on the values
0, 1, 2, .... It might be reasonable to try to use this information by specifying the density as
a count data density. One of the simplest count data densities is the Poisson density, which
is
exp(−λ)λy
fY (y) = .
y!
The Poisson average log-likelihood function is
1 n
sn (θ) = ∑ (−λi + yi ln λi − lnyi !)
n i=1
We will parameterize the model as
λi = exp(x0i β)
xi = [1 PUBLIC PRIV SEX AGE EDUC INC]0 .
13.4. EXAMPLES 165
This ensures that the mean is positive, as is required for the Poisson model. Note that for
this parameterization
∂λ/∂β j
βj =
λ
so
β j x j = ηλx j ,
the elasticity of the conditional mean of y with respect to the jth conditioning variable.
The program EstimatePoisson.m estimates a Poisson model using the full data set. The
results of the estimation, using OBDV as the dependent variable are here:
MPITB extensions found
OBDV
******************************************************
Poisson model, MEPS 1996 full data set

Average Log-L: -3.671090

Observations: 4564

constant -0.791 0.149 -5.290 0.000
pub. ins. 0.848 0.076 11.093 0.000
priv. ins. 0.294 0.071 4.137 0.000
sex 0.487 0.055 8.797 0.000
age 0.024 0.002 11.471 0.000
edu 0.029 0.010 3.061 0.002
inc -0.000 0.000 -0.978 0.328
CAIC : 33575.6881 Avg. CAIC: 7.3566
BIC : 33568.6881 Avg. BIC: 7.3551
AIC : 33523.7064 Avg. AIC: 7.3452
******************************************************
13.4.3. Duration data and the Weibull model. In some cases the dependent variable
may be the time that passes between the occurence of two events. For example, it may be
the duration of a strike, or the time needed to find a job once one is unemployed. Such
variables take on values on the positive real line, and are referred to as duration data.
13.4. EXAMPLES 166
A spell is the period of time between the occurence of initial event and the concluding
event. For example, the initial event could be the loss of a job, and the final event is the
finding of a new job. The spell is the period of unemployment.
Let t0 be the time the initial event occurs, and t1 be the time the concluding event
occurs. For simplicity, assume that time is measured in years. The random variable D
is the duration of the spell, D = t1 − t0 . Define the density function of D, f D (t), with
distribution function FD (t) = Pr(D < t).
Several questions may be of interest. For example, one might wish to know the ex-
pected time one has to wait to find a job given that one has already waited s years. The
probability that a spell lasts s years is
Pr(D > s) = 1 − Pr(D ≤ s) = 1 − FD(s).
The density of D conditional on the spell already having lasted s years is
fD (t)
fD (t|D > s) = .
1 − FD(s)
The expectanced additional time required for the spell to end given that is has already lasted
s years is the expectation of D with respect to this density, minus s.
Z ∞
fD (z)
E = E (D|D > s) − s = z dz − s
t 1 − FD(s)
To estimate this function, one needs to specify the density f D (t) as a parametric density,
then estimate by maximum likelihood. There are a number of possibilities including the
exponential density, the lognormal, etc. A reasonably flexible model that is a generalization
of the exponential density is the Weibull density
γ
fD (t|θ) = e−(λt) λγ(λt)γ−1 .
According to this model, E (D) = λ−γ . The log-likelihood is just the product of the log
densities.
To illustrate application of this model, 402 observations on the lifespan of mongooses
in Serengeti National Park (Tanzania) were used to fit a Weibull model. The ”spell” in this
case is the lifetime of an individual mongoose. The parameter estimates and standard errors
are λ̂ = 0.559 (0.034) and γ̂ = 0.867 (0.033) and the log-likelihood value is -659.3. Figure
13.4.1 presents fitted life expectancy (expected additional years of life) as a function of age,
with 95% confidence bands. The plot is accompanied by a nonparametric Kaplan-Meier
estimate of life-expectancy. This nonparametric estimator simply averages all spell lengths
greater than age, and then subtracts age. This is consistent by the LLN.
In the figure one can see that the model doesn’t fit the data well, in that it predicts
life expectancy quite differently than does the nonparametric model. For ages 4-6, the
nonparametric estimate is outside the confidence interval that results from the parametric
model, which casts doubt upon the parametric model. Mongooses that are between 2-6
years old seem to have a lower life expectancy than is predicted by the Weibull model,
whereas young mongooses that survive beyond infancy have a higher life expectancy, up
to a bit beyond 2 years. Due to the dramatic change in the death rate as a function of t, one
13.4. EXAMPLES 167
F IGURE 13.4.1. Life expectancy of mongooses, Weibull model
might specify f D (t) as a mixture of two Weibull densities,

γ1
γ2

fD (t|θ) = δ e−(λ1t) λ1 γ1 (λ1t)γ1 −1 + (1 − δ) e−(λ2t) λ2 γ2 (λ2t)γ2 −1 .
The parameters γi and λi , i = 1, 2 are the parameters of the two Weibull densities, and δ is
the parameter that mixes the two.
With the same data, θ can be estimated using the mixed model. The results are a
log-likelihood = -623.17. Note that a standard likelihood ratio test cannot be used to chose
between the two models, since under the null that δ = 1 (single density), the two parameters
λ2 and γ2 are not identified. It is possible to take this into account, but this topic is out
of the scope of this course. Nevertheless, the improvement in the likelihood function is
considerable. The parameter estimates are
Parameter Estimate St. Error
λ1 0.233 0.016
γ1 1.722 0.166
λ2 1.731 0.101
γ2 1.522 0.096
δ 0.428 0.035
13.5. NUMERIC OPTIMIZATION: PITFALLS 168
F IGURE 13.4.2. Life expectancy of mongooses, mixed Weibull model
Note that the mixture parameter is highly significant. This model leads to the fit in Figure
13.4.2. Note that the parametric and nonparametric fits are quite close to one another, up to
around 6 years. The disagreement after this point is not too important, since less than 5%
of mongooses live more than 6 years, which implies that the Kaplan-Meier nonparametric
estimate has a high variance (since it’s an average of a small number of observations).
Mixture models are often an effective way to model complex responses, though they
can suffer from overparameterization. Alternatives will be discussed later.
13.5. Numeric optimization: pitfalls
In this section we’ll examine two common problems that can be encountered when
doing numeric optimization of nonlinear models, and some solutions.
13.5.1. Poor scaling of the data. When the data is scaled so that the magnitudes of
the first and second derivatives are of different orders, problems can easily result. If we
uncomment the appropriate line in EstimatePoisson.m, the data will not be scaled, and the
estimation program will have difficulty converging (it seems to take an infinite amount of
time). With unscaled data, the elements of the score vector have very different magnitudes
at the initial value of θ (all zeros). To see this run CheckScore.m. With unscaled data,
F IGURE 13.5.1. A foggy mountain
one element of the gradient is very large, and the maximum and minimum elements are
5 orders of magnitude apart. This causes convergence problems due to serious numerical
inaccuracy when doing inversions to calculate the BFGS direction of search. With scaled
data, none of the elements of the gradient are very large, and the maximum difference in
orders of magnitude is 3. Convergence is quick.
13.5.2. Multiple optima. Multiple optima (one global, others local) can complicate
life, since we have limited means of determining if there is a higher maximum the the one
we’re at. Think of climbing a mountain in an unknown range, in a very foggy place (Figure
13.5.1). You can go up until there’s nowhere else to go up, but since you’re in the fog you
don’t know if the true summit is across the gap that’s at your feet. Do you claim victory
and go home, or do you trudge down the gap and explore the other side?
The best way to avoid stopping at a local maximum is to use many starting values, for
example on a grid, or randomly generated. Or perhaps one might have priors about possible
values for the parameters (e.g., from previous studies of similar data).
Let’s try to find the true minimizer of minus 1 times the foggy mountain function (since
the algoritms are set up to minimize). From the picture, you can see it’s close to (0, 0), but
let’s pretend there is fog, and that we don’t know that. The program FoggyMountain.m
shows that poor start values can lead to problems. It uses SA, which finds the true global
minimum, and it shows that BFGS using a battery of random start values can also find the
global minimum help. The output of one run is here:
======================================================
BFGSMIN final results
Used numeric gradient
------------------------------------------------------
STRONG CONVERGENCE
Function conv 1 Param conv 1 Gradient conv 1
------------------------------------------------------
Objective function value -0.0130329
Stepsize 0.102833
43 iterations
------------------------------------------------------
param gradient change

15.9999 -0.0000 0.0000
-28.8119 0.0000 0.0000
The result with poor start values
ans =
16.000 -28.812
================================================
SAMIN final results
NORMAL CONVERGENCE
Func. tol. 1.000000e-10 Param. tol. 1.000000e-03

Obj. fn. value -0.100023
parameter search width

0.037419 0.000018
-0.000000 0.000051
================================================
Now try a battery of random start values and
a short BFGS on each, then iterate to convergence
The result using 20 randoms start values
ans =
3.7417e-02 2.7628e-07
The true maximizer is near (0.037,0)
In that run, the single BFGS run with bad start values converged to a point far from the true
minimizer, which simulated annealing and BFGS using a battery of random start values
both found the true maximizaer. battery of random start values managed to find the global
max. The moral of the story is be cautious and don’t publish your results too quickly.
EXERCISES 172
Exercises
(1) In octave, type ”help bfgsmin_example”, to find out the location of the file. Edit the
file to examine it and learn how to call bfgsmin. Run it, and examine the output.
(2) In octave, type ”help samin_example”, to find out the location of the file. Edit the
file to examine it and learn how to call samin. Run it, and examine the output.
(3) Using logit.m and EstimateLogit.m as templates, write a function to calculate the probit
loglikelihood, and a script to estimate a probit model. Run it using data that actually
follows a logit model (you can generate it in the same way that is done in the logit
example).
(4) Study mle_results.m to see what it does. Examine the functions that mle_results.m
calls, and in turn the functions that those functions call. Write a complete description
of how the whole chain works.
(5) Look at the Poisson estimation results for the OBDV measure of health care use and
give an economic interpretation. Estimate Poisson models for the other 5 measures of
health care usage.
CHAPTER 14
Asymptotic properties of extremum estimators
Readings: Gourieroux and Monfort (1995), Vol. 2, Ch. 24∗ ; Amemiya, Ch. 4 section
4.1∗ ; Davidson and MacKinnon, pp. 591-96; Gallant, Ch. 3; Newey and McFadden (1994),
“Large Sample Estimation and Hypothesis Testing,” in Handbook of Econometrics, Vol. 4,
Ch. 36.
14.1. Extremum estimators
In Definition 12.0.1 we defined an extremum estimator θ̂ as the optimizing element of

an objective function sn (θ) over a set Θ. Let the objective function sn (Zn , θ) depend upon a
h i0
n × p random matrix Zn = z1 z2 · · · zn where the zt are p-vectors and p is finite.
E XAMPLE 18. Given the model yi = x0i θ + εi , with n observations, define zi = (yi , x0i )0 .
The OLS estimator minimizes
n 2
sn (Zn , θ) = 1/n ∑ yi − x0i θ
i=1
= 1/n k Y − Xθ k2
where Y and X are defined similarly to Z.
14.2. Consistency
The following theorem is patterned on a proof in Gallant (1987) (the article, ref. later),
which we’ll see in its original form later in the course. It is interesting to compare the
following proof with Amemiya’s Theorem 4.1.1, which is done in terms of convergence in
probability.
T HEOREM 19. [Consistency of e.e.] Suppose that θ̂n is obtained by maximizing sn (θ)
over Θ.
Assume
(1) Compactness: The parameter space Θ is an open bounded subset of Euclidean
space ℜK . So the closure of Θ, Θ, is compact.
(2) Uniform Convergence: There is a nonstochastic function s∞ (θ) that is continuous
in θ on Θ such that
lim sup |sn (θ) − s∞ (θ)| = 0, a.s.

n→∞
θ∈Θ
(3) Identification: s∞ (·) has a unique global maximum at θ0 ∈ Θ, i.e., s∞ (θ0 ) >
s∞ (θ), ∀θ 6= θ0 , θ ∈ Θ
a.s.
Then θ̂n → θ0 .
173
14.2. CONSISTENCY 174
Proof: Select a ω ∈ Ω and hold it fixed. Then {sn (ω, θ)} is a fixed sequence of
functions. Suppose that ω is such that sn (θ) converges uniformly to s∞ (θ). This happens
with probability one by assumption (b). The sequence {θ̂n } lies in the compact set Θ, by
assumption (1) and the fact that maximixation is over Θ. Since every sequence from a
compact set has at least one limit point (Davidson, Thm. 2.12), say that θ̂ is a limit point
of {θ̂n }. There is a subsequence {θ̂nm } ({nm } is simply a sequence of increasing integers)
with limm→∞ θ̂nm = θ̂. By uniform convergence and continuity
lim snm (θ̂nm ) = s∞ (θ̂).

m→∞

To see this, first of all, select an element θ̂t from the sequence θ̂nm . Then uniform con-
vergence implies
lim snm (θ̂t ) = s∞ (θ̂t ).
m→∞
Continuity of s∞ (·) implies that
lim s∞ (θ̂t ) = s∞ (θ̂)

t→∞

since the limit as t → ∞ of θ̂t is θ̂. So the above claim is true.
Next, by maximization
snm (θ̂nm ) ≥ snm (θ0 )
which holds in the limit, so
lim snm (θ̂nm ) ≥ lim snm (θ0 ).

m→∞ m→∞
However,
lim snm (θ̂nm ) = s∞ (θ̂),
m→∞
as seen above, and
lim snm (θ0 ) = s∞ (θ0 )
m→∞
by uniform convergence, so
s∞ (θ̂) ≥ s∞ (θ0 ).
But by assumption (3), there is a unique global maximum of s∞ (θ) at θ0 , so we must have
s∞ (θ̂) = s∞ (θ0 ), and θ̂ = θ0 . Finally, all of the above limits hold almost surely, since so far
we have held ω fixed, but now we need to consider all ω ∈ Ω. Therefore { θ̂n } has only one
limit point, θ0 , except on a set C ⊂ Ω with P(C) = 0.
Discussion of the proof:
• This proof relies on the identification assumption of a unique global maximum at

θ0 . An equivalent way to state this is
(2) Identification: Any point θ in Θ with s∞ (θ) ≥ s∞ (θ0 ) must be such that k θ − θ0 k=
0, which matches the way we will write the assumption in the section on nonparametric
inference.
• We assume that θ̂n is in fact a global maximum of sn (θ) . It is not required to be

unique for n finite, though the identification assumption requires that the limiting
objective function have a unique maximizing argument. The previous section on
numeric optimization methods showed that actually finding the global maximum
of sn (θ) may be a non-trivial problem.
• See Amemiya’s Example 4.1.4 for a case where discontinuity leads to breakdown
of consistency.
• The assumption that θ0 is in the interior of Θ (part of the identification assump-
tion) has not been used to prove consistency, so we could directly assume that
θ0 is simply an element of a compact set Θ. The reason that we assume it’s in
the interior here is that this is necessary for subsequent proof of asymptotic nor-
mality, and I’d like to maintain a minimal set of simple assumptions, for clarity.
Parameters on the boundary of the parameter set cause theoretical difficulties that
we will not deal with in this course. Just note that conventional hypothesis testing
methods do not apply in this case.
• Note that sn (θ) is not required to be continuous, though s∞ (θ) is.
• The following figures illustrate why uniform convergence is important. In the
second figure, if the function is not converging around the lower of the two max-
ima, there is no guarantee that the maximizer will be in the neighborhood of the
global maximizer.
With uniform convergence, the maximum of the sample

objective function eventually must be in the neighborhood
of the maximum of the limiting objective function
With pointwise convergence, the sample objective function

may have its maximum far away from that of the limiting
objective function
We need a uniform strong law of large numbers in order to verify assumption (2) of
Theorem 19. The following theorem is from Davidson, pg. 337.
T HEOREM 20. [Uniform Strong LLN] Let {Gn (θ)} be a sequence of stochastic real-
valued functions on a totally-bounded metric space (Θ, ρ). Then
a.s.
sup |Gn (θ)| → 0
θ∈Θ
if and only if
a.s.
(a) Gn (θ) → 0 for each θ ∈ Θ0 , where Θ0 is a dense subset of Θ and
(b) {Gn (θ)} is strongly stochastically equicontinuous..
• The metric space we are interested in now is simply Θ ⊂ ℜK , using the Euclidean
norm.
• The pointwise almost sure convergence needed for assuption (a) comes from one
of the usual SLLN’s.
• Stronger assumptions that imply those of the theorem are:
– the parameter space is compact (this has already been assumed)
– the objective function is continuous and bounded with probability one on
the entire parameter space
– a standard SLLN can be shown to apply to some point in the parameter space
• These are reasonable conditions in many cases, and henceforth when dealing with
specific estimators we’ll simply assume that pointwise almost sure convergence
can be extended to uniform almost sure convergence in this way.
• The more general theorem is useful in the case that the limiting objective function
can be continuous in θ even if sn (θ) is discontinuous. This can happen because
discontinuities may be smoothed out as we take expectations over the data. In
14.4. ASYMPTOTIC NORMALITY 177
the section on simlation-based estimation we will se a case of a discontinuous

objective function.
14.3. Example: Consistency of Least Squares
We suppose that data is generated by random sampling of (y, w), where yt = α0 + β0 wt

+εt . (wt , εt ) has the common distribution function µw µε (w and ε are independent) with
support W × E . Suppose that the variances σ2w and σ2ε are finite. Let θ0 = (α0 , β0 )0 ∈ Θ,
for which Θ is compact. Let xt = (1, wt )0 , so we can write yt = xt0 θ0 + εt . The sample
objective function for a sample size n is
n 2 n 2
sn (θ) = 1/n ∑ yt − xt0 θ = 1/n ∑ xt0 θ0 + εt − xt0 θ
t=1 i=1
n 2 n n
= 1/n ∑ xt0 θ0 − θ + 2/n ∑ xt0 θ0 − θ εt + 1/n ∑ εt2
t=1 t=1 t=1
• Considering the last term, by the SLLN,

n Z Z
a.s.
1/n ∑ εt2 → ε2 dµW dµE = σ2ε .
t=1 W E
• Considering the second term, since E(ε) = 0 and w and ε are independent, the
SLLN implies that it converges to zero.
• Finally, for the first term, for a given θ, we assume that a SLLN applies so that
n 2 a.s. Z 2
(14.3.1) 1/n ∑ xt0 θ0 − θ → x0 θ 0 − θ dµW
t=1 W
2 Z 2 Z
= α0 − α + 2 α0 − α β0 − β wdµW + β0 − β w2 dµW
W W
2 2
= α0 − α + 2 α0 − α β0 − β E(w) + β0 − β E w2
Finally, the objective function is clearly continuous, and the parameter space is assumed to
be compact, so the convergence is also uniform. Thus,
2 2
s∞ (θ) = α0 − α + 2 α0 − α β0 − β E(w) + β0 − β E w2 + σ2ε
A minimizer of this is clearly α = α0 , β = β0 .
E XERCISE 21. Show that in order for the above solution to be unique it is necessary
that E(w2 ) 6= 0. Discuss the relationship between this condition and the problem of colin-
earity of regressors.
This example shows that Theorem 19 can be used to prove strong consistency of the
OLS estimator. There are easier ways to show this, of course - this is only an example of
application of the theorem.
14.4. Asymptotic Normality
A consistent estimator is oftentimes not very useful unless we know how fast it is
likely to be converging to the true value, and the probability that it is far away from the true
value. Establishment of asymptotic normality with a known scaling factor solves these two
problems. The following theorem is similar to Amemiya’s Theorem 4.1.3 (pg. 111).
T HEOREM 22. [Asymptotic normality of e.e.] In addition to the assumptions of Theo-

rem 19, assume
(a) Jn (θ) ≡ D2θ sn (θ) exists and is continuous in an open, convex neighborhood of θ 0 .
a.s.
(b) {Jn (θn )} → J∞ (θ0 ), a finite negative definite matrix, for any sequence {θn } that
converges almost surely to θ0 .
√ d √
(c) nDθ sn (θ0 ) → N 0, I∞ (θ0 ) , where I∞ (θ0 ) = limn→∞ Var nDθ sn (θ0 )
√ d
Then n θ̂ − θ0 → N 0, J∞ (θ0 )−1 I∞ (θ0 )J∞ (θ0 )−1
Proof: By Taylor expansion:

Dθ sn (θ̂n ) = Dθ sn (θ0 ) + D2θsn (θ∗ ) θ̂ − θ0
where θ∗ = λθ̂ + (1 − λ)θ0, 0 ≤ λ ≤ 1.
• Note that θ̂ will be in the neighborhood where D2θ sn (θ) exists with probability
one as n becomes large, by consistency.
• Now the l.h.s. of this equation is zero, at least asymptotically, since θ̂n is a
maximizer and the f.o.c. must hold exactly since the limiting objective function
is strictly concave in a neighborhood of θ0 .
a.s.
• Also, since θ∗ is between θ̂n and θ0 , and since θ̂n → θ0 , assumption (b) gives
a.s.
D2θ sn (θ∗ ) → J∞ (θ0 )
So

0 = Dθ sn (θ0 ) + J∞ (θ0 ) + o p(1) θ̂ − θ0
And
√ √
0= nDθ sn (θ0 ) + J∞ (θ0 ) + o p(1) n θ̂ − θ0
Now J∞ (θ0 ) is a finite negative definite matrix, so the o p (1) term is asymptotically irrele-
vant next to J∞ (θ0 ), so we can write
a √ √
0 = nDθ sn (θ0 ) + J∞ (θ0 ) n θ̂ − θ0
√ a √
n θ̂ − θ0 = −J∞ (θ0 )−1 nDθ sn (θ0 )
Because of assumption (c), and the formula for the variance of a linear combination of
r.v.’s,
√ d
n θ̂ − θ0 → N 0, J∞ (θ0 )−1 I∞ (θ0 )J∞ (θ0 )−1
• Assumption (b) is not implied by the Slutsky theorem. The Slutsky theorem says
a.s.
that g(xn ) → g(x) if xn → x and g(·) is continuous at x. However, the function
g(·) can’t depend on n to use this theorem. In our case Jn (θn ) is a function of n.
A theorem which applies (Amemiya, Ch. 4) is
T HEOREM 23. If gn (θ) converges uniformly almost surely to a nonstochastic func-

a.s.
tion g∞ (θ) uniformly on an open neighborhood of θ0 , then gn (θ̂) → g∞ (θ0 ) if g∞ (θ0 ) is
a.s.
continuous at θ0 and θ̂ → θ0 .
• To apply this to the second derivatives, sufficient conditions would be that the
second derivatives be strongly stochastically equicontinuous on a neighborhood
14.5. EXAMPLES 179
of θ0 , and that an ordinary LLN applies to the derivatives when evaluated at

θ ∈ N(θ0 ).
• Stronger conditions that imply this are as above: continuous and bounded second
derivatives in a neighborhood of θ0 .
• Skip this in lecture. A note on the order of these matrices: Supposing that s n (θ)
is representable as an average of n terms, which is the case for all estimators we
consider, D2θ sn (θ) is also an average of n matrices, the elements of which are not
centered (they do not have zero expectation). Supposing a SLLN applies, the
almost sure limit of D2θ sn (θ0 ), J∞ (θ0 ) = O(1), as we saw in Example 51. On the
√ d
other hand, assumption (c): nDθ sn (θ0 ) → N 0, I∞ (θ0 ) means that
√
nDθ sn (θ0 ) = O p ()
√
where we use the result of Example 49. If we were to omit the n, we’d have
1
Dθ sn (θ0 ) = n− 2 O p (1)
1
= O p n− 2
where we use the fact that O p (nr )O p (nq ) = O p (nr+q ). The sequence Dθ sn (θ0 ) is
√
centered, so we need to scale by n to avoid convergence to zero.
14.5. Examples
14.5.1. Binary response models. Binary response models arise in a variety of con-
texts. We’ve already seen a logit model. Another simple example is a probit threshold-
crossing model. Assume that
y∗ = x0 β − ε
y = 1(y∗ > 0)
ε ∼ N(0, 1)
Here, y∗ is an unobserved (latent) continuous variable, and y is a binary variable that indi-
cates whether y∗ is negative or positive. Then Pr(y = 1) = Pr(ε < xβ) = Φ(xβ), where
ε2
Z xβ
Φ(•) = (2π)−1/2 exp(− )dε
−∞ 2
is the standard normal distribution function.
In general, a binary response model will require that the choice probability be parame-
terized in some form. For a vector of explanatory variables x, the response probability will
be parameterized in some manner
Pr(y = 1|x) = p(x, θ)
If p(x, θ) = Λ(x0 θ), we have a logit model. If p(x, θ) = Φ(x0 θ), where Φ(·) is the standard
normal distribution function, then we have a probit model.
Regardless of the parameterization, we are dealing with a Bernoulli density,
fYi (yi |xi ) = p(xi , θ)yi (1 − p(x, θ))1−yi

14.5. EXAMPLES 180
so as long as the observations are independent, the maximum likelihood (ML) estimator, θ̂,
is the maximizer of
1 n
sn (θ) = ∑ (yi ln p(xi , θ) + (1 − yi) ln [1 − p(xi, θ)])
n i=1
1 n
(14.5.1) ≡ ∑ s(yi , xi , θ).
n i=1
Following the above theoretical results, θ̂ tends in probability to the θ0 that maximizes the
uniform almost sure limit of sn (θ). Noting that E yi = p(xi , θ0 ), and following a SLLN for
i.i.d. processes, sn (θ) converges almost surely to the expectation of a representative term
s(y, x, θ). First one can take the expectation conditional on x to get

Ey|x {y ln p(x, θ) + (1 − y) ln[1 − p(x, θ)]} = p(x, θ0 ) ln p(x, θ)+ 1 − p(x, θ0) ln [1 − p(x, θ)].
Next taking expectation over x we get the limiting objective function

Z
(14.5.2) s∞ (θ) = p(x, θ0 ) ln p(x, θ) + 1 − p(x, θ0) ln [1 − p(x, θ)] µ(x)dx,
X
where µ(x) is the (joint - the integral is understood to be multiple, and X is the support of
x) density function of the explanatory variables x. This is clearly continuous in θ, as long
as p(x, θ) is continuous, and if the parameter space is compact we therefore have uniform
almost sure convergence. Note that p(x, θ) is continous for the logit and probit models, for
example. The maximizing element of s∞ (θ), θ∗ , solves the first order conditions
Z
p(x, θ0 ) ∂ 1 − p(x, θ0 ) ∂
p(x, θ ∗
) − p(x, θ ∗
) µ(x)dx = 0
X p(x, θ∗ ) ∂θ 1 − p(x, θ∗ ) ∂θ
This is clearly solved by θ∗ = θ0 . Provided the solution is unique, θ̂ is consistent. Question:
what’s needed to ensure that the solution is unique?
The asymptotic normality theorem tells us that
√ d
n θ̂ − θ0 → N 0, J∞ (θ0 )−1 I∞ (θ0 )J∞ (θ0 )−1 .
√
In the case of i.i.d. observations I∞ (θ0 ) = limn→∞ Var nDθ sn (θ0 ) is simply the expectation
of a typical element of the outer product of the gradient.
• There’s no need to subtract the mean, since it’s zero, following the f.o.c. in the
consistency proof above and the fact that observations are i.i.d.
• The terms in n also drop out by the same argument:
√ √ 1
lim Var nDθ sn (θ0 ) = lim Var nDθ ∑ s(θ0 )
n→∞ n→∞ n t
1
= lim Var √ Dθ ∑ s(θ0 )
n→∞ n t
1
= lim Var ∑ Dθ s(θ0 )
n→∞n t
= lim VarDθ s(θ0 )

n→∞
= VarDθ s(θ0 )
14.5. EXAMPLES 181
So we get
0 ∂ 0 ∂ 0
I∞ (θ ) = E s(y, x, θ ) 0 s(y, x, θ ) .
∂θ ∂θ
Likewise,
∂2
J∞ (θ0 ) = E s(y, x, θ0 ).
∂θ∂θ0
Expectations are jointly over y and x, or equivalently, first over y conditional on x, then over
x. From above, a typical element of the objective function is

s(y, x, θ0 ) = y ln p(x, θ0 ) + (1 − y) ln 1 − p(x, θ0) .
Now suppose that we are dealing with a correctly specified logit model:
−1
p(x, θ) = 1 + exp(−x0 θ) .
We can simplify the above results in this case. We have that
∂ −2
p(x, θ) = 1 + exp(−x0 θ) exp(−x0 θ)x
∂θ
−1 exp(−x0 θ)
= 1 + exp(−x0 θ) x
1 + exp(−x0 θ)
= p(x, θ) (1 − p(x, θ))x

= p(x, θ) − p(x, θ)2 x.
So
∂
(14.5.3) s(y, x, θ0 ) = y − p(x, θ0 ) x
∂θ
∂2
s(θ0 ) = − p(x, θ0 ) − p(x, θ0 )2 xx0 .
∂θ∂θ0
Taking expectations over y then x gives
Z
(14.5.4) I∞ (θ0 ) = EY y2 − 2p(x, θ0 )p(x, θ0 ) + p(x, θ0 )2 xx0 µ(x)dx
Z
(14.5.5) = p(x, θ0 ) − p(x, θ0 )2 xx0 µ(x)dx.
where we use the fact that EY (y) = EY (y2 ) = p(x, θ0 ). Likewise,

Z
(14.5.6) J∞ (θ0 ) = − p(x, θ0 ) − p(x, θ0 )2 xx0 µ(x)dx.
Note that we arrive at the expected result: the information matrix equality holds (that is,
J∞ (θ0 ) = −I∞ (θ0 )). With this,
√ d
n θ̂ − θ0 → N 0, J∞ (θ0 )−1 I∞ (θ0 )J∞ (θ0 )−1
simplifies to
√ d
n θ̂ − θ0 → N 0, −J∞ (θ0 )−1
which can also be expressed as
√ d
n θ̂ − θ0 → N 0, I∞ (θ0 )−1 .
On a final note, the logit and standard normal CDF’s are very similar - the logit distri-
bution is a bit more fat-tailed. While coefficients will vary slightly between the two models,
14.5. EXAMPLES 182
functions of interest such as estimated probabilities p(x, θ̂) will be virtually identical for the
two models.
14.5.2. Example: Linearization of a nonlinear model. Ref. Gourieroux and Mon-

fort, section 8.3.4. White, Intn’l Econ. Rev. 1980 is an earlier reference.
Suppose we have a nonlinear model
yi = h(xi , θ0 ) + εi
where
εi ∼ iid(0, σ2 )
The nonlinear least squares estimator solves
1 n
θ̂n = argmin ∑ (yi − h(xi, θ))2
n i=1
We’ll study this more later, but for now it is clear that the foc for minimization will require
solving a set of nonlinear equations. A common approach to the problem seeks to avoid
this difficulty by linearizing the model. A first order Taylor’s series expansion about the
point x0 with remainder gives
∂h(x0 , θ0 )
yi = h(x0 , θ0 ) + (xi − x0 )0 + νi
∂x
where νi encompasses both εi and the Taylor’s series remainder. Note that νi is no longer a
classical error - its mean is not zero. We should expect problems.
Define
∂h(x0 , θ0 )
α∗ = h(x0 , θ0 ) − x00
∂x
∂h(x0 , θ0 )
β∗ =
∂x
Given this, one might try to estimate α∗ and β∗ by applying OLS to
yi = α + βxi + νi
• Question, will α̂ and β̂ be consistent for α∗ and β∗ ?

• The answer is no, as one can see by interpreting α̂ and β̂ as extremum estimators.
Let γ = (α, β0 )0 .
1 n
γ̂ = argminsn (γ) = ∑ (yi − α − βxi)2
n i=1
The objective function converges to its expectation
u.a.s.
sn (γ) → s∞ (γ) = EX EY |X (y − α − βx)2
and γ̂ converges a.s. to the γ0 that minimizes s∞ (γ):
γ0 = argmin EX EY |X (y − α − βx)2
Noting that
2 2
EX EY |X y − α − x0β = EX EY |X h(x, θ0 ) + ε − α − βx
2
= σ2 + EX h(x, θ0 ) − α − βx
14.5. EXAMPLES 183
since cross products involving ε drop out. α0 and β0 correspond to the hyperplane that is
closest to the true regression function h(x, θ0 ) according to the mean squared error crite-
rion. This depends on both the shape of h(·) and the density function of the conditioning
variables.
Inconsistency of the linear approximation, even at

the approximation point
x
h(x,θ)
x
Tangent line x
β
α x x
x x
x Fitted line
x_0
• It is clear that the tangent line does not minimize MSE, since, for example, if
h(x, θ0 ) is concave, all errors between the tangent line and the true function are
negative.
• Note that the true underlying parameter θ0 is not estimated consistently, either
(it may be of a different dimension than the dimension of the parameter of the
approximating model, which is 2 in this example).
• Second order and higher-order approximations suffer from exactly the same prob-
lem, though to a less severe degree, of course. For this reason, translog, Gener-
alized Leontiev and other “flexible functional forms” based upon second-order
approximations in general suffer from bias and inconsistency. The bias may not
be too important for analysis of conditional means, but it can be very important
for analyzing first and second derivatives. In production and consumer analysis,
first and second derivatives (e.g., elasticities of substitution) are often of interest,
so in this case, one should be cautious of unthinking application of models that
impose stong restrictions on second derivatives.
• This sort of linearization about a long run equilibrium is a common practice in
dynamic macroeconomic models. It is justified for the purposes of theoretical
analysis of a model given the model’s parameters, but it is not justifiable for the
estimation of the parameters of the model using data. The section on simulation-
based methods offers a means of obtaining consistent estimators of the param-
eters of dynamic macro models that are too complex for standard methods of
analysis.
14.5. EXAMPLES 184
Chapter Exercises
(1) Suppose that xi ∼ uniform(0,1), and yi = 1 − x2i + εi , where εi is iid(0,σ2 ). Sup-
pose we estimate the misspecified model yi = α + βxi + ηi by OLS. Find the
numeric values of α0 and β0 that are the probability limits of α̂ and β̂
(2) Verify your results using Octave by generating data that follows the above model,
and calculating the OLS estimator. When the sample size is very large the esti-
mator should be very close to the analytical results you obtained in question 1.
(3) Use the asymptotic normality theorem to find the asymptotic distribution of the
ML estimator of β0 for the model y = xβ0 + ε, where ε ∼ N(0, 1) and is in-
∂2
dependent of x. This means finding ∂β∂β 0 ∂sn (β) , and I (β0 ). The
0 sn (β), J (β ), ∂β
expressions may involve the unspecified density of x.
−1
(4) Assume a d.g.p. follows the logit model: Pr(y = 1|x) = 1 + exp(−β0x) .
(a) Assume that x ∼ uniform(-a,a). Find the asymptotic distribution of the ML
estimator of β0 (this is a scalar parameter).
(b) Now assume that x ∼ uniform(-2a,2a). Again find the asymptotic distribu-
tion of the ML estimator of β0 .
(c) Comment on the results
CHAPTER 15
Generalized method of moments (GMM)
Readings: Hamilton Ch. 14∗ ; Davidson and MacKinnon, Ch. 17 (see pg. 587 for refs.
to applications); Newey and McFadden (1994), “Large Sample Estimation and Hypothesis
Testing,” in Handbook of Econometrics, Vol. 4, Ch. 36.
15.1. Definition
We’ve already seen one example of GMM in the introduction, based upon the χ 2 distri-
bution. Consider the following example based upon the t-distribution. The density function
of a t-distributed r.v. Yt is

0 Γ θ0 + 1 /2 −(θ0 +1)/2
fYt (yt , θ ) = 1/2
1 + yt2 /θ0
(πθ0 ) Γ (θ0 /2)
Given an iid sample of size n, one could estimate θ0 by maximizing the log-likelihood
function
n
θ̂ ≡ argmax ln Ln (θ) =
Θ
∑ ln fYt (yt , θ)
t=1
• This approach is attractive since ML estimators are asymptotically efficient. This
is because the ML estimator uses all of the available information (e.g., the dis-
tribution is fully specified up to a parameter). Recalling that a distribution is
completely characterized by its moments, the ML estimator is interpretable as a
GMM estimator that uses all of the moments. The method of moments estimator
uses only K moments to estimate a K− dimensional parameter. Since informa-
tion is discarded, in general, by the MM estimator, efficiency is lost relative to
the ML estimator.
• Continuing with the example, a t-distributed r.v. with density fYt (yt , θ0 ) has mean

zero and variance V (yt ) = θ0 / θ0 − 2 (for θ0 > 2).
• Using the notation introduced previously, define a moment condition m 1t (θ) =
n n
θ/ (θ − 2) − yt2 and m1 (θ) = 1/n ∑t=1 m1t (θ) = θ/ (θ − 2) − 1/n ∑t=1 yt2 . As be-

fore, when evaluated at the true parameter value θ0 , both Eθ0 m1t (θ0 ) = 0 and

Eθ0 m1 (θ0 ) = 0.
• Choosing θ̂ to set m1 (θ̂) ≡ 0 yields a MM estimator:
2
(15.1.1) θ̂ = n
1−
∑i y2i
This estimator is based on only one moment of the distribution - it uses less information
than the ML estimator, so it is intuitively clear that the MM estimator will be inefficient
relative to the ML estimator.
185
15.1. DEFINITION 186
• An alternative MM estimator could be based upon the fourth moment of the t-

distribution. The fourth moment of a t-distributed r.v. is
2
4 3 θ0
µ4 ≡ E(yt ) = 0 ,
(θ − 2)(θ0 − 4)
provided θ0 > 4. We can define a second moment condition
3 (θ)2 1 n
m2 (θ) = − ∑ yt4
(θ − 2)(θ − 4) n t=1
• A second, different MM estimator chooses θ̂ to set m2 (θ̂) ≡ 0. If you solve this

you’ll see that the estimate is different from that in equation 15.1.1.
This estimator isn’t efficient either, since it uses only one moment. A GMM estimator
would use the two moment conditions together to estimate the single parameter. The GMM
estimator is overidentified, which leads to an estimator which is efficient relative to the just
identified MM estimators (more on efficiency later).
• As before, set mn (θ) = (m1 (θ), m2 (θ))0 . The n subscript is used to indicate the
sample size. Note that m(θ0 ) = O p (n−1/2 ), since it is an average of centered
random variables, whereas m(θ) = O p (1), θ 6= θ0 , where expectations are taken
using the true distribution with parameter θ0 . This is the fundamental reason that
GMM is consistent.
• A GMM estimator requires defining a measure of distance, d (m(θ)). A popular
choice (for reasons noted below) is to set d (m(θ)) = m0Wn m, and we minimize
sn (θ) = m(θ)0Wn m(θ). We assume Wn converges to a finite positive definite ma-
trix.
• In general, assume we have g moment conditions, so m(θ) is a g -vector and W
is a g × g matrix.
For the purposes of this course, the following definition of the GMM estimator is suffi-
ciently general:
D EFINITION 24. The GMM estimator of the K -dimensional parameter vector θ 0 ,

θ̂ ≡ argminΘ sn (θ) ≡ mn (θ)0Wn mn (θ), where mn (θ) = 1n ∑t=1
n
mt (θ) is a g-vector, g ≥ K,
with Eθ m(θ) = 0, and Wn converges almost surely to a finite g × g symmetric positive
definite matrix W∞ .
What’s the reason for using GMM if MLE is asymptotically efficient?

• Robustness: GMM is based upon a limited set of moment conditions. For con-
sistency, only these moment conditions need to be correctly specified, whereas
MLE in effect requires correct specification of every conceivable moment condi-
tion. GMM is robust with respect to distributional misspecification. The price for
robustness is loss of efficiency with respect to the MLE estimator. Keep in mind
that the true distribution is not known so if we erroneously specify a distribution
and estimate by MLE, the estimator will be inconsistent in general (not always).
– Feasibility: in some cases the MLE estimator is not available, because we
are not able to deduce the likelihood function. More on this in the section
on simulation-based estimation. The GMM estimator may still be feasible

even though MLE is not possible.
15.2. Consistency
We simply assume that the assumptions of Theorem 19 hold, so the GMM estimator
is strongly consistent. The only assumption that warrants additional comments is that of
identification. In Theorem 19, the third assumption reads: (c) Identification: s∞ (·) has a
unique global maximum at θ0 , i.e., s∞ (θ0 ) > s∞ (θ), ∀θ 6= θ0 . Taking the case of a quadratic
objective function sn (θ) = mn (θ)0Wn mn (θ), first consider mn (θ).
a.s.
• Applying a uniform law of large numbers, we get mn (θ) → m∞ (θ).
• Since Eθ0 mn (θ0 ) = 0 by assumption, m∞ (θ0 ) = 0.
• Since s∞ (θ0 ) = m∞ (θ0 )0W∞ m∞ (θ0 ) = 0, in order for asymptotic identification,
we need that m∞ (θ) 6= 0 for θ 6= θ0 , for at least some element of the vector. This
a.s.
and the assumption that Wn → W∞ , a finite positive g × g definite g × g matrix
guarantee that θ0 is asymptotically identified.
• Note that asymptotic identification does not rule out the possibility of lack of
identification for a given data set - there may be multiple minimizing solutions in
finite samples.
We also simply assume that the conditions of Theorem 22 hold, so we will have as-
ymptotic normality. However, we do need to find the structure of the asymptotic variance-
covariance matrix of the estimator. From Theorem 22, we have
√ d
n θ̂ − θ0 → N 0, J∞ (θ0 )−1 I∞ (θ0 )J∞ (θ0 )−1
∂2 √ ∂
where J∞ (θ0 ) is the almost sure limit of ∂θ∂θ 0 0
0 sn (θ) and I∞ (θ ) = limn→∞ Var n ∂θ sn (θ ).
We need to determine the form of these matrices given the objective function s n (θ) =
mn (θ)0Wn mn (θ).
Now using the product rule from the introduction,

∂ ∂ 0
sn (θ) = 2 mn (θ) Wn mn (θ)
∂θ ∂θ
Define the K × g matrix
∂ 0
Dn (θ) ≡ m (θ) ,
∂θ n
so:
∂
(15.3.1) s(θ) = 2D(θ)W m (θ) .
∂θ
(Note that sn (θ), Dn (θ), Wn and mn (θ) all depend on the sample size n, but it is omitted to
unclutter the notation).
To take second derivatives, let Di be the i− th row of D(θ). Using the product rule,
∂2 ∂
s(θ) = 2Di (θ)Wn m (θ)
∂θ0 ∂θi ∂θ0

0 0 ∂ 0
= 2DiW D + 2m W D
∂θ0 i
15.4. CHOOSING THE WEIGHTING MATRIX 188
When evaluating the term

0 ∂
2m(θ) W D(θ)0i
∂θ0
∂
at θ0 , assume that ∂θ0 D(θ)i
0 satisfies a LLN, so that it converges almost surely to a finite
limit. In this case, we have

∂ 0 0 a.s.
2m(θ0 )0W D(θ ) i → 0,
∂θ0
a.s.
since m(θ0 ) = o p (1), W → W∞ .
Stacking these results over the K rows of D, we get
∂2
lim sn (θ0 ) = J∞ (θ0 ) = 2D∞W∞ D0∞ , a.s.,
∂θ∂θ0
where we define lim D = D∞ , a.s., and limW = W∞ , a.s. (we assume a LLN holds).
With regard to I∞ (θ0 ), following equation 15.3.1, and noting that the scores have mean
zero at θ0 (since E m(θ0 ) = 0 by assumption), we have
√ ∂
I∞ (θ0 ) = lim Var n sn (θ0 )
n→∞ ∂θ
= lim E 4nDnWn m(θ0 )m(θ)0Wn D0n
n→∞
√ √
= lim E 4DnWn nm(θ0 ) nm(θ)0 Wn D0n
n→∞
Now, given that m(θ0 )

is an average of centered (mean-zero) quantities, it is reasonable to
√
expect a CLT to apply, after multiplication by n. Assuming this,
√ d
nm(θ0 ) → N(0, Ω∞ ),
where

Ω∞ = lim E nm(θ0 )m(θ0 )0 .
n→∞
Using this, and the last equation, we get
I∞ (θ0 ) = 4D∞W∞ Ω∞W∞ D0∞
Using these results, the asymptotic normality theorem gives us

√ d h −1 −1 i
n θ̂ − θ0 → N 0, D∞W∞ D0∞ D∞W∞ Ω∞W∞ D0∞ D∞W∞ D0∞ ,
the asymptotic distribution of the GMM estimator for arbitrary weighting matrix Wn . Note
that for J∞ to be positive definite, D∞ must have full row rank, ρ(D∞ ) = k.
15.4. Choosing the weighting matrix
W is a weighting matrix, which determines the relative importance of violations of the

individual moment conditions. For example, if we are much more sure of the first moment
condition, which is based upon the variance, than of the second, which is based upon the
fourth moment, we could set " #
a 0
W=
0 b
with a much larger than b. In this case, errors in the second moment condition have less
weight in the objective function.
15.4. CHOOSING THE WEIGHTING MATRIX 189
• Since moments are not independent, in general, we should expect that there be a
correlation between the moment conditions, so it may not be desirable to set the
off-diagonal elements to 0. W may be a random, data dependent matrix.
• We have already seen that the choice of W will influence the asymptotic distri-
bution of the GMM estimator. Since the GMM estimator is already inefficient
w.r.t. MLE, we might like to choose the W matrix to make the GMM estimator
efficient within the class of GMM estimators defined by mn (θ).
• To provide a little intuition, consider the linear model y = x0 β + ε, where ε ∼
N(0, Ω). That is, he have heteroscedasticity and autocorrelation.
• Let P be the Cholesky factorization of Ω−1 , e.g, P0 P = Ω−1 .
• Then the model Py = PXβ+Pε satisfies the classical assumptions of homoscedas-
ticity and nonautocorrelation, since V (Pε) = PV (ε)P0 = PΩP0 = P(P0 P)−1 P0 =
PP−1 (P0 )−1 P0 = In . (Note: we use (AB)−1 = B−1 A−1 for A, B both nonsingular).
This means that the transformed model is efficient.
• The OLS estimator of the model Py = PXβ+Pε minimizes the objective function
(y − Xβ)0 Ω−1 (y − Xβ). Interpreting (y − Xβ) = ε(β) as moment conditions (note
that they do have zero expectation when evaluated at β0 ), the optimal weighting
matrix is seen to be the inverse of the covariance matrix of the moment condi-
tions. This result carries over to GMM estimation. (Note: this presentation of
GLS is not a GMM estimator, because the number of moment conditions here is
equal to the sample size, n. Later we’ll see that GLS can be put into the GMM
framework defined above).
T HEOREM 25. If θ̂ is a GMM estimator that minimizes mn (θ)0Wn mn (θ), the asymp-
a.s
totic variance of θ̂ will be minimized by choosing Wn so that Wn → W∞ = Ω−1
∞ , where

Ω∞ = limn→∞ E nm(θ0 )m(θ0 )0 .
Proof: For W∞ = Ω−1 ∞ , the asymptotic variance

−1 −1
D∞W∞ D0∞ D∞W∞ Ω∞W∞ D0∞ D∞W∞ D0∞

0 −1 . Now, for any choice such that W 6= Ω−1 , consider the dif-
simplifies to D∞ Ω−1∞ D∞ ∞ ∞
ference of the inverses of the variances when W = Ω−1 versus when W is some arbitrary
positive definite matrix:

0 −1

D∞ Ω−1
∞ D∞ − D∞W∞ D∞ D∞W∞ Ω∞W∞ D∞
0 0
D∞W∞ D0∞
h i
0 −1
= D ∞ Ω∞
−1/2
I − Ω1/2
∞ W∞ D 0
∞ D ∞ W∞ Ω ∞ W∞ D ∞ D ∞ W∞ Ω 1/2
∞ Ω∞
−1/2 0
D∞
as can be verified by multiplication. The term in brackets is idempotent, which is also easy
to check by multiplication, and is therefore positive semidefinite. A quadratic form in a
positive semidefinite matrix is also positive semidefinite. The difference of the inverses of
the variances is positive semidefinite, which implies that the difference of the variances is
negative semidefinite, which proves the theorem.
The result
√ d h i
0 −1
(15.4.1) n θ̂ − θ0 → N 0, D∞ Ω−1
∞ D∞
15.5. ESTIMATION OF THE VARIANCE-COVARIANCE MATRIX 190
allows us to treat −1 !

0D∞ Ω−1
∞ D∞
0
θ̂ ≈ N θ , ,
n
where the ≈ means ”approximately distributed as.” To operationalize this we need estima-
tors of D∞ and Ω∞ .
∂ 0

c∞ is simply
• The obvious estimator of D ∂θ mn θ̂ , which is consistent by the con-
∂ 0
sistency of θ̂, assuming that ∂θ mn is continuous in θ. Stochastic equicontinuity
∂ 0
results can give us this result even if ∂θ mn is not continuous. We now turn to
estimation of Ω∞ .
15.5. Estimation of the variance-covariance matrix
(See Hamilton Ch. 10, pp. 261-2 and 280-84)∗.

In the case that we wish to use the optimal weighting matrix, we need an estimate
√
of Ω∞ , the limiting variance-covariance matrix of nmn (θ0 ). While one could estimate
Ω∞ parametrically, we in general have little information upon which to base a parametric
specification. In general, we expect that:
0
• mt will be autocorrelated (Γts = E (mt mt−s ) 6= 0). Note that this autocovariance
will not depend on t if the moment conditions are covariance stationary.
• contemporaneously correlated, since the individual moment conditions will not
in general be independent of one another (E (mit m jt ) 6= 0).
• and have different variances (E (m2it ) = σ2it ).
Since we need to estimate so many components if we are to take the parametric approach,
it is unlikely that we would arrive at a correct parametric specification. For this reason,
research has focused on consistent nonparametric estimators of Ω ∞ .
Henceforth we assume that mt is covariance stationary (the covariance between mt and
mt−s does not depend on t). Define the v − th autocovariance of the moment conditions
Γv = E (mt mt−s
0 0
). Note that E (mt mt+s ) = Γ0v . Recall that mt and m are functions of θ, so
for now assume that we have some consistent estimator of θ0 , so that m̂t = mt (θ̂). Now
" ! !#
n n
Ωn = E nm(θ )m(θ ) = E n 1/n ∑ mt
0 0 0
1/n ∑ mt0
t=1 t=1
" ! !#
n n
= E 1/n ∑ mt ∑ mt0
t=1 t=1
n−1 n−2 1
= Γ0 + Γ1 + Γ01 + Γ2 + Γ02 · · · + Γn−1 + Γ0n−1
n n n
A natural, consistent estimator of Γv is
n
Γbv = 1/n ∑ 0
m̂t m̂t−v .
t=v+1
15.5. ESTIMATION OF THE VARIANCE-COVARIANCE MATRIX 191
(you might use n − v in the denominator instead). So, a natural, but inconsistent, estimator
of Ω∞ would be
n−2
Ω̂ = Γ c0 + n − 1 Γ c1 + cΓ01 + c2 + c
Γ Γ02 + · · · + Γd d
n−1 + Γn−1
0
n n
n−1
n − v
= Γ c0 + ∑ Γbv + Γb0v .
v=1 n
This estimator is inconsistent in general, since the number of parameters to estimate is more
than the number of observations, and increases more rapidly than n, so information does
not build up as n → ∞.
On the other hand, supposing that Γv tends to zero sufficiently rapidly as v tends to ∞,
a modified estimator
q(n)
c0 + ∑ Γbv + Γb0v ,
Ω̂ = Γ
v=1
p
where q(n) → ∞ as n → ∞ will be consistent, provided q(n) grows sufficiently slowly.
n−v
The term n can be dropped because q(n) must be o p (n). This allows information to
accumulate at a rate that satisfies a LLN. A disadvantage of this estimator is that it may not
be positive definite. This could cause one to calculate a negative χ 2 statistic, for example!
• Note: the formula for Ω̂ requires an estimate of m(θ0 ), which in turn requires
an estimate of θ, which is based upon an estimate of Ω! The solution to this cir-
cularity is to set the weighting matrix W arbitrarily (for example to an identity
matrix), obtain a first consistent but inefficient estimate of θ0 , then use this esti-
mate to form Ω̂, then re-estimate θ0 . The process can be iterated until neither Ω̂
nor θ̂ change appreciably between iterations.
15.5.1. Newey-West covariance estimator. The Newey-West estimator (Economet-

rica, 1987) solves the problem of possible nonpositive definiteness of the above estimator.
Their estimator is
q(n)
c0 + ∑ 1 − v
Ω̂ = Γ Γbv + Γb0v .
v=1 q+1
This estimator is p.d. by construction. The condition for consistency is that n −1/4q → 0.
Note that this is a very slow rate of growth for q. This estimator is nonparametric - we’ve
placed no parametric restrictions on the form of Ω. It is an example of a kernel estimator.
In a more recent paper, Newey and West (Review of Economic Studies, 1994) use
pre-whitening before applying the kernel estimator. The idea is to fit a VAR model to the
moment conditions. It is expected that the residuals of the VAR model will be more nearly
white noise, so that the Newey-West covariance estimator might perform better with short
lag lengths..
The VAR model is
m̂t = Θ1 m̂t−1 + · · · + Θ pm̂t−p + ut
This is estimated, giving the residuals ût . Then the Newey-West covariance estimator is
applied to these pre-whitened residuals, and the covariance Ω is estimated combining the
fitted VAR
c1 m̂t−1 + · · · + Θ
ĉt = Θ
m cpm̂t−p
15.6. ESTIMATION USING CONDITIONAL MOMENTS 192
with the kernel estimate of the covariance of the ut . See Newey-West for details.
• I have a program that does this if you’re interested.
15.6. Estimation using conditional moments
So far, the moment conditions have been presented as unconditional expectations. One
common way of defining unconditional moment conditions is based upon conditional mo-
ment conditions.
Suppose that a random variable Y has zero expectation conditional on the random
variable X Z
EY |X Y = Y f (Y |X)dY = 0
Then the unconditional expectation of the product of Y and a function g(X) of X is also
zero. The unconditional expectation is
Z Z
E Y g(X) = Y g(X) f (Y, X)dY dX.
X Y
This can be factored into a conditional expectation and an expectation w.r.t. the marginal
density of X :
Z Z
E Y g(X) = Y g(X) f (Y |X)dY f (X)dX.
X Y
Since g(X) doesn’t depend on Y it can be pulled out of the integral
Z Z
E Y g(X) = Y f (Y |X)dY g(X) f (X)dX.
X Y
But the term in parentheses on the rhs is zero by assumption, so
E Y g(X) = 0
as claimed.
This is important econometrically, since models often imply restrictions on conditional
moments. Suppose a model tells us that the function K(yt , xt ) has expectation, conditional
on the information set It , equal to k(xt , θ),
Eθ K(yt , xt )|It = k(xt , θ).
• For example, in the context of the classical linear model yt = xt0 β + εt , we can set
K(yt , xt ) = yt so that k(xt , θ) = xt0 β.
With this, the function

ht (θ) = K(yt , xt ) − k(xt , θ)
has conditional expectation equal to zero
Eθ ht (θ)|It = 0.
This is a scalar moment condition, which isn’t sufficient to identify a K -dimensional pa-
rameter θ (K > 1). However, the above result allows us to form various unconditional
expectations
mt (θ) = Z(wt )ht (θ)
where Z(wt ) is a g × 1-vector valued function of wt and wt is a set of variables drawn

from the information set It . The Z(wt ) are instrumental variables. We now have g moment
conditions, so as long as g > K the necessary condition for identification holds.
One can form the n × g matrix
 
Z1 (w1 ) Z2 (w1 ) · · · Zg (w1 )
 
 Z1 (w2 ) Z2 (w2 ) Zg (w2 ) 
Zn =  .  .. 

 .. . 
Z1 (wn ) Z2 (wn ) · · · Zg (wn )
 
Z10
 
 Z20 
=  
 
 
Zn0
With this we can form the g moment conditions
 
h1 (θ)
 
1 0 h2 (θ) 
mn (θ) = Z  .. 
n n
 .


hn (θ)
1 0
= Z hn (θ)
n n
1 n
= ∑ Zt ht (θ)
n t=1
1 n
= ∑ mt (θ)
n t=1
where Z(t,·) is the t th row of Zn . This fits the previous treatment. An interesting question
that arises is how one should choose the instrumental variables Z(wt ) to achieve maximum
efficiency.
∂ 0
Note that with this choice of moment conditions, we have that Dn ≡ ∂θ m (θ) (a K × g
matrix) is
∂ 1 0 0
Dn (θ) = Zn hn (θ)
∂θ n

1 ∂ 0
= hn (θ) Zn
n ∂θ
which we can define to be
1
Dn (θ) = Hn Zn .
n
where Hn is a K × n matrix that has the derivatives of the individual moment conditions as
its columns. Likewise, define the var-cov. of the moment conditions

Ωn = E nmn (θ0 )mn (θ0 )0

1
= E Zn0 hn (θ0 )hn (θ0 )0 Zn
n

1
= Zn0 E hn (θ0 )hn (θ0 )0 Zn
n
Φn
≡ Zn0 Zn
n
where we have defined Φn = Varhn (θ0 ). Note that the dimension of this matrix is growing
with the sample size, so it is not consistently estimable without additional assumptions.
The asymptotic normality theorem above says that the GMM estimator using the opti-
mal weighting matrix is distributed as
√ d
n θ̂ − θ0 → N(0,V∞ )
where
−1 !−1
Hn Zn Zn0 Φn Zn Zn0 Hn0
(15.6.1) V∞ = lim .
n→∞ n n n
Using an argument similar to that used to prove that Ω−1

∞ is the efficient weighting matrix,
we can show that putting
Zn = Φ−1 0
n Hn
causes the above var-cov matrix to simplify to

0 −1
Hn Φ−1
n Hn
(15.6.2) V∞ = lim .
n→∞ n
and furthermore, this matrix is smaller that the limiting var-cov for any other choice of
instrumental variables. (To prove this, examine the difference of the inverses of the var-cov
matrices with the optimal intruments and with non-optimal instruments. As above, you can
show that the difference is positive semi-definite).
• Note that both Hn , which we should write more properly as Hn (θ0 ), since it de-
pends on θ0 , and Φ must be consistently estimated to apply this.
• Usually, estimation of Hn is straightforward - one just uses
b = ∂ h0n θ̃ ,

H
∂θ
where θ̃ is some initial consistent estimator based on non-optimal instruments.
• Estimation of Φn may not be possible. It is an n × n matrix, so it has more
unique elements than n, the sample size, so without restrictions on the parameters
it can’t be estimated consistently. Basically, you need to provide a parametric
specification of the covariances of the ht (θ) in order to be able to use optimal
instruments. A solution is to approximate this matrix parametrically to define
the instruments. Note that the simplified var-cov matrix in equation 15.6.2 will
not apply if approximately optimal instruments are used - it will be necessary
15.8. A SPECIFICATION TEST 195
Z0 Φ Z
to use an estimator based upon equation 15.6.1, where the term n nn n must be
estimated consistently apart, for example by the Newey-West procedure.
15.7. Estimation using dynamic moment conditions
Note that dynamic moment conditions simplify the var-cov matrix, but are often harder
to formulate. The will be added in future editions. For now, the Hansen application below
is enough.
15.8. A specification test
The first order conditions for minimization, using the an estimate of the optimal weight-
ing matrix, are
∂ ∂ 0 −1
s(θ̂) = 2 mn θ̂ Ω̂ mn θ̂ ≡ 0
∂θ ∂θ
or
D(θ̂)Ω̂−1 mn (θ̂) ≡ 0
Consider a Taylor expansion of m(θ̂):

(15.8.1) m(θ̂) = mn (θ0 ) + D0n(θ0 ) θ̂ − θ0 + o p(1).
Multiplying by D(θ̂)Ω̂−1 we obtain

D(θ̂)Ω̂−1 m(θ̂) = D(θ̂)Ω̂−1 mn (θ0 ) + D(θ̂)Ω̂−1 D(θ0 )0 θ̂ − θ0 + o p(1)
The lhs is zero, and since θ̂ tends to θ0 and Ω̂ tends to Ω∞ , we can write
0 a 0

D∞ Ω−1 ∞ mn (θ ) = −D∞ Ω∞ D∞ θ̂ − θ
−1 0
or
√ a √
0 −1
n θ̂ − θ0 = − n D∞ Ω−1
∞ D∞ D∞ Ω−1 0
∞ mn (θ )
With this, and taking into account the original expansion (equation 15.8.1), we get
√ a √ √
0 −1
nm(θ̂) = nmn (θ0 ) − nD0∞ D∞ Ω−1 ∞ D∞ D∞ Ω−1 0
∞ mn (θ ).
This last can be written as

√
a √ −1 0 −1
nm(θ̂) = n Ω1/2 ∞ − D ∞ D∞ Ω∞ D∞
0
D∞ Ω∞
−1/2
Ω∞
−1/2
mn (θ0 )
Or
√ −1/2
a √ 0 −1
nΩ∞ m(θ̂) = n Ig − Ω∞ D∞ D∞ Ω−1
−1/2 0
∞ D ∞ D Ω
∞ ∞
−1/2
Ω∞
−1/2
mn (θ0 )
Now
√ −1/2 d
nΩ∞ mn (θ0 ) → N(0, Ig )
and one can easily verify that

0 −1
P = Ig − Ω∞ D∞ D∞ Ω−1
−1/2 0
∞ D∞ D∞ Ω∞
−1/2
15.9. OTHER ESTIMATORS INTERPRETED AS GMM ESTIMATORS 196
is idempotent of rank g − K, (recall that the rank of an idempotent matrix is equal to its
trace) so
√ 0 √
d 2
nΩ∞ −1/2
m(θ̂) −1/2
nΩ∞ m(θ̂) = nm(θ̂)0 Ω−1∞ m(θ̂) → χ (g − K)
Since Ω̂ converges to Ω∞ , we also have

d
nm(θ̂)0 Ω̂−1 m(θ̂) → χ2 (g − K)
or
d
n · sn (θ̂) → χ2 (g − K)
supposing the model is correctly specified. This is a convenient test since we just multiply
the optimized value of the objective function by n, and compare with a χ 2 (g − K) critical
value. The test is a general test of whether or not the moments used to estimate are correctly
specified.
• This won’t work when the estimator is just identified. The f.o.c. are
Dθ sn (θ) = DΩ̂−1 m(θ̂) ≡ 0.
But with exact identification, both D and Ω̂ are square and invertible (at least
asymptotically, assuming that asymptotic normality hold), so
m(θ̂) ≡ 0.
So the moment conditions are zero regardless of the weighting matrix used. As
such, we might as well use an identity matrix and save trouble. Also s n (θ̂) = 0,
so the test breaks down.
• A note: this sort of test often over-rejects in finite samples. One should be cau-
tious in rejecting a model when this test rejects.
15.9. Other estimators interpreted as GMM estimators
15.9.1. OLS with heteroscedasticity of unknown form.
E XAMPLE 26. White’s heteroscedastic consistent varcov estimator for OLS.
Suppose y = Xβ0 + ε, where ε ∼ N(0, Σ), Σ a diagonal matrix.
• The typical approach is to parameterize Σ = Σ(σ), where σ is a finite dimensional

parameter vector, and to estimate β and σ jointly (feasible GLS). This will work
well if the parameterization of Σ is correct.
• If we’re not confident about parameterizing Σ, we can still estimate β consistently
by OLS. However, the typical covariance estimator V (β̂) = (X0 X)−1 σ̂2 will be
biased and inconsistent, and will lead to invalid inferences.
By exogeneity of the regressors xt (a K × 1 column vector) we have E(xt εt ) = 0,which

suggests the moment condition

mt (β) = xt yt − xt0 β .
In this case, we have exact identification ( K parameters and K moment conditions). We

have
m(β) = 1/n ∑ mt = 1/n ∑ xt yt − 1/n ∑ xt xt0 β.
t t t
For any choice of W, m(β) will be identically zero at the minimum, due to exact iden-
tification. That is, since the number of moment conditions is identical to the number of
parameters, the foc imply that m(β̂) ≡ 0 regardless of W. There is no need to use the “opti-
mal” weighting matrix in this case, an identity matrix works just as well for the purpose of
estimation. Therefore
−1
β̂ = ∑ xt xt 0
∑ xt yt = (X0 X)−1X0 y,
t t
which is the usual OLS estimator. −1

The GMM estimator of the asymptotic varcov matrix is Dc∞ Ω c∞ 0
b −1 D . Recall that
∂ 0

D∞ is simply ∂θ m θ̂ . In this case
c
c∞ = −1/n ∑ xt xt0 = −X0 X/n.

D
t
Recall that a possible estimator of Ω is

n−1
c0 + ∑ Γbv + Γb0v .
Ω̂ = Γ
v=1
This is in general inconsistent, but in the present case of nonautocorrelation, it simplifies to

c0
Ω̂ = Γ
which has a constant number of elements to estimate, so information will accumulate, and
consistency obtains. In the present case
!
n
b = Γ
Ω c0 = 1/n ∑ m̂t m̂t0
t=1
" #
n 2
= 1/n ∑ xt xt0 yt − xt0 β̂
t=1
" #
n
= 1/n ∑ xt xt0 ε̂t2
t=1
X0 ÊX
=
n
where Ê is an n × n diagonal matrix with ε̂t2 in the position t,t.
Therefore, the GMM varcov. estimator, which is consistent, is
( !
−1 )−1
√ X0 X X0 ÊX X0 X
V̂ n β̂ − β = − −
n n n
0 −1 0 0 −1
XX X ÊX XX
=
n n n
This is the varcov estimator that White (1980) arrived at in an influential article. This
estimator is consistent under heteroscedasticity of an unknown form. If there is autocorre-
lation, the Newey-West estimator can be used to estimate Ω - the rest is the same.
15.9.2. Weighted Least Squares. Consider the previous example of a linear model
with heteroscedasticity of unknown form:
y = Xβ0 + ε
ε ∼ N(0, Σ)
where Σ is a diagonal matrix.

Now, suppose that the form of Σ is known, so that Σ(θ0 ) is a correct parametric speci-
fication (which may also depend upon X). In this case, the GLS estimator is
−1 0 −1
β̃ = X0 Σ−1 X X Σ y)
This estimator can be interpreted as the solution to the K moment conditions

xt yt xt xt0
m(β̃) = 1/n ∑ − 1/n ∑ β̃ ≡ 0.
t σt (θ0 ) t σt (θ )
0
That is, the GLS estimator in this case has an obvious representation as a GMM estimator.
With autocorrelation, the representation exists but it is a little more complicated. Neverthe-
less, the idea is the same. There are a few points:
• The (feasible) GLS estimator is known to be asymptotically efficient in the class

of linear asymptotically unbiased estimators (Gauss-Markov).
• This means that it is more efficient than the above example of OLS with White’s
heteroscedastic consistent covariance, which is an alternative GMM estimator.
• This means that the choice of the moment conditions is important to achieve
efficiency.
15.9.3. 2SLS. Consider the linear model
yt = zt0 β + εt ,
or
y = Zβ + ε
using the usual construction, where β is K × 1 and εt is i.i.d. Suppose that this equation
is one of a system of simultaneous equations, so that zt contains both endogenous and
exogenous variables. Suppose that xt is the vector of all exogenous and predetermined
variables that are uncorrelated with εt (suppose that xt is r × 1).
• Define Ẑ as the vector of predictions of Z when regressed upon X, e.g., Ẑ =

X (X0 X)−1 X0 Z
−1 0
Ẑ = X X0 X XZ
• Since Ẑ is a linear combination of the exogenous variables x, ẑt must be un-
correlated with ε. This suggests the K-dimensional moment condition mt (β) =
ẑt (yt − zt0 β) and so

m(β) = 1/n ∑ ẑt yt − zt0 β .
t
• Since we have K parameters and K moment conditions, the GMM estimator will
set m identically equal to zero, regardless of W, so we have
−1
−1
β̂ = ∑ ẑt zt0
∑ (ẑt yt ) = Ẑ0 Z Ẑ0 y
t t
This is the standard formula for 2SLS. We use the exogenous variables and the reduced
form predictions of the endogenous variables as instruments, and apply IV estimation. See
Hamilton pp. 420-21 for the varcov formula (which is the standard formula for 2SLS), and
for how to deal with εt heterogeneous and dependent (basically, just use the Newey-West or
some other consistent estimator of Ω, and apply the usual formula). Note that εt dependent
causes lagged endogenous variables to loose their status as legitimate instruments.
15.9.4. Nonlinear simultaneous equations. GMM provides a convenient way to es-

timate nonlinear systems of simultaneous equations. We have a system of equations of the
form
y1t = f1 (zt , θ01 ) + ε1t

y2t = f2 (zt , θ02 ) + ε2t
..
.
yGt = fG (zt , θ0G ) + εGt ,
or in compact notation
yt = f (zt , θ0 ) + εt ,
where f (·) is a G -vector valued function, and θ0 = (θ00 00 00 0
1 , θ2 , · · · , θG ) .
We need to find an Ai × 1 vector of instruments xit , for each equation, that are un-
correlated with εit . Typical instruments would be low order monomials in the exogenous

variables in zt , with their lagged values. Then we can define the ∑G i=1 Ai ×1 orthogonality
conditions  
(y1t − f1 (zt , θ1 )) x1t
 
 (y2t − f2 (zt , θ2 )) x2t 

mt (θ) =  .. .

 . 
(yGt − fG (zt , θG )) xGt
• A note on identification: selection of instruments that ensure identification is a
non-trivial problem.
• A note on efficiency: the selected set of instruments has important effects on the
efficiency of estimation. Unfortunately there is little theory offering guidance on
what is the optimal set. More on this later.
15.9.5. Maximum likelihood. In the introduction we argued that ML will in general

be more efficient than GMM since ML implicitly uses all of the moments of the distribution
while GMM uses a limited number of moments. Actually, a distribution with P parameters
can be uniquely characterized by P moment conditions. However, some sets of P moment
conditions may contain more information than others, since the moment conditions could
be highly correlated. A GMM estimator that chose an optimal set of P moment conditions
would be fully efficient. Here we’ll see that the optimal moment conditions are simply the
scores of the ML estimator.
Let yt be a G -vector of variables, and let Yt = (y01 , y02 , ..., yt0 )0 . Then at time t, Yt−1 has
been observed (refer to it as the information set, since we assume the conditioning variables
have been selected to take advantage of all useful information). The likelihood function is
the joint density of the sample:
L (θ) = f (y1 , y2 , ..., yn , θ)
which can be factored as
L (θ) = f (yn |Yn−1 , θ) · f (Yn−1 , θ)
and we can repeat this to get
L (θ) = f (yn |Yn−1 , θ) · f (yn−1 |Yn−2 , θ) · ... · f (y1 ).
The log-likelihood function is therefore

n
ln L (θ) = ∑ ln f (yt |Yt−1 , θ).
t=1
Define
mt (Yt , θ) ≡ Dθ ln f (yt |Yt−1 , θ)
as the score of the t th
observation. It can be shown that, under the regularity conditions,
that the scores have conditional mean zero when evaluated at θ 0 (see notes to Introduction
to Econometrics):
E {mt (Yt , θ0 )|Yt−1 } = 0
so one could interpret these as moment conditions to use to define a just-identified GMM
estimator ( if there are K parameters there are K score equations). The GMM estimator sets
n n
1/n ∑ mt (Yt , θ̂) = 1/n ∑ Dθ ln f (yt |Yt−1 , θ̂) = 0,
t=1 t=1
which are precisely the first order conditions of MLE. Therefore, MLE can be interpreted
−1
as a GMM estimator. The GMM varcov formula is V∞ = D∞ Ω−1 D0∞ .
Consistent estimates of variance components are as follows
• D∞
n
c∞ = ∂ m(Yt , θ̂) = 1/n ∑ D2θ ln f (yt |Yt−1 , θ̂)
D
∂θ0 t=1
• Ω
It is important to note that mt and mt−s , s > 0 are both conditionally and un-
conditionally uncorrelated. Conditional uncorrelation follows from the fact that
mt−s is a function of Yt−s , which is in the information set at time t. Unconditional
uncorrelation follows from the fact that conditional uncorrelation hold regardless
of the realization of Yt−1 , so marginalizing with respect to Yt−1 preserves uncor-
relation (see the section on ML estimation, above). The fact that the scores are
serially uncorrelated implies that Ω can be estimated by the estimator of the 0th
15.10. EXAMPLE: THE HAUSMAN TEST 201
autocovariance of the moment conditions:

n n
b = 1/n ∑ mt (Yt , θ̂)mt (Yt , θ̂)0 = 1/n ∑ Dθ ln f (yt |Yt−1 , θ̂) Dθ ln f (yt |Yt−1 , θ̂) 0
Ω
t=1 t=1
Recall from study of ML estimation that the information matrix equality (equation ??)
states that
n 0 o
E Dθ ln f (yt |Yt−1 , θ0 ) Dθ ln f (yt |Yt−1 , θ0 ) = −E D2θ ln f (yt |Yt−1 , θ0 ) .
This result implies the well known (and already seeen) result that we can estimate V∞ in
any of three ways:
• The sandwich version:
 n −1

 ∑t=1 D2θ ln f (yt |Yt−1 , θ̂) × 

 n 0 o−1 
c
V∞=n ∑ n
D θ ln f (yt |Yt−1 , θ̂) D θ ln f (y t |Yt−1 , θ̂) ×
 t=1 

 n 2


∑t=1 Dθ ln f (yt |Yt−1 , θ̂)
• or the inverse of the negative of the Hessian (since the middle and last term can-
cel, except for a minus sign):
" #−1
n
V∞ = −1/n ∑ Dθ ln f (yt |Yt−1 , θ̂)
c 2
,
t=1
• or the inverse of the outer product of the gradient (since the middle and last cancel
except for a minus sign, and the first term converges to minus the inverse of the
middle term, which is still inside the overall inverse)
( )−1
n 0
c
V∞ = 1/n ∑ Dθ ln f (yt |Yt−1 , θ̂) Dθ ln f (yt |Yt−1 , θ̂) .
t=1
This simplification is a special result for the MLE estimator - it doesn’t apply to GMM
estimators in general.
Asymptotically, if the model is correctly specified, all of these forms converge to the
same limit. In small samples they will differ. In particular, there is evidence that the outer
product of the gradient formula does not perform very well in small samples (see Davidson
and MacKinnon, pg. 477). White’s Information matrix test (Econometrica, 1982) is based
upon comparing the two ways to estimate the information matrix: outer product of gradient
or negative of the Hessian. If they differ by too much, this is evidence of misspecification
of the model.
15.10. Example: The Hausman Test
This section discusses the Hausman test, which was originally presented in Hausman,
J.A. (1978), Specification tests in econometrics, Econometrica, 46, 1251-71.
Consider the simple linear regression model yt = xt0 β + εt . We assume that the func-
tional form and the choice of regressors is correct, but that the some of the regressors may
be correlated with the error term, which as you know will produce inconsistency of β̂. For
example, this will be a problem if
• if some regressors are endogeneous
• some regressors are measured with error
F IGURE 15.10.1. OLS

OLS estimates
0.14
line 1
0.12
0.1
0.08
0.06
0.04
0.02
0
2.26 2.28 2.3 2.32 2.34 2.36 2.38 2.4
• lagged values of the dependent variable are used as regressors and εt is autocor-
related.
To illustrate, the Octave program biased.m performs a Monte Carlo experiment where er-
rors are correlated with regressors, and estimation is by OLS and IV. Figure 15.10.1 shows
that the OLS estimator is quite biased, while Figure 15.10.2 shows that the IV estimator
is on average much closer to the true value. If you play with the program, increasing the
sample size, you can see evidence that the OLS estimator is asymptotically biased, while
the IV estimator is consistent.
We have seen that inconsistent and the consistent estimators converge to different prob-
ability limits. This is the idea behind the Hausman test - a pair of consistent estimators
converge to the same probability limit, while if one is consistent and the other is not they
converge to different limits. If we accept that one is consistent (e.g., the IV estimator), but
we are doubting if the other is consistent (e.g., the OLS estimator), we might try to check
if the difference between the estimators is significantly different from zero.
• If we’re doubting about the consistency of OLS (or QML, etc.), why should we
be interested in testing - why not just use the IV estimator? Because the OLS
estimator is more efficient when the regressors are exogenous and the other clas-
sical assumptions (including normality of the errors) hold. When we have a more
efficient estimator that relies on stronger assumptions (such as exogeneity) than
the IV estimator, we might prefer to use it, unless we have evidence that the
assumptions are false.
F IGURE 15.10.2. IV
IV estimates
0.16
line 1
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
1.85 1.9 1.95 2 2.05 2.1 2.15
So, let’s consider the covariance between the MLE estimator θ̂ (or any other fully efficient
estimator) and some other CAN estimator, say θ̃. Now, let’s recall some results from MLE.
Equation 4.4.1 is:
√ a.s. √
n θ̂ − θ0 → −H∞ (θ0 )−1 ng(θ0 ).
Equation 4.6.2 is
H∞ (θ) = −I∞ (θ).
Combining these two equations, we get
√ a.s. √
n θ̂ − θ0 → I∞ (θ0 )−1 ng(θ0 ).
Also, equation 4.7.1 tells us that the asymptotic covariance between any CAN estima-
tor and the MLE score vector is
" √ # " #
n θ̃ − θ V∞ (θ̃) IK
V∞ √ = .
ng(θ) IK I∞ (θ)
Now, consider
" #" √ # " √ #
IK 0K n θ̃ − θ a.s. n θ̃ − θ
√ → √ .
0K I∞ (θ)−1 ng(θ) n θ̂ − θ
The asymptotic covariance of this is

" √ # " #" #" #
n θ̃ − θ IK 0K V∞ (θ̃) IK IK 0K
V∞ √ =
n θ̂ − θ 0K I∞ (θ)−1 IK I∞ (θ) 0K I∞ (θ)−1
" #
V∞ (θ̃) I∞ (θ)−1
= ,
I∞ (θ)−1 I∞ (θ)−1
which, for clarity in what follows, we might write as
" √ # " #
n θ̃ − θ V∞ (θ̃) I∞ (θ)−1
V∞ √ = .
n θ̂ − θ I∞ (θ)−1 V∞ (θ̂)
So, the asymptotic covariance between the MLE and any other CAN estimator is equal to
the MLE asymptotic variance (the inverse of the information matrix).
Now, suppose we with to test whether the the two estimators are in fact both converging
to θ0 , versus the alternative hypothesis that the ”MLE” estimator is not in fact consistent
(the consistency of θ̃ is a maintained hypothesis). Under the null hypothesis that they are,
we have " √ #
h i n θ̃ − θ0 √
IK −IK √ = n θ̃ − θ̂ ,
n θ̂ − θ0
will be asymptotically normally distributed as
√ d
n θ̃ − θ̂ → N 0,V∞ (θ̃) −V∞(θ̂) .
So,
0 −1 d
n θ̃ − θ̂ V∞ (θ̃) −V∞(θ̂) θ̃ − θ̂ → χ2 (ρ),
where ρ is the rank of the difference of the asymptotic variances. A statistic that has the
same asymptotic distribution is
0 −1 d
θ̃ − θ̂ V̂ (θ̃) − V̂(θ̂) θ̃ − θ̂ → χ2 (ρ).
This is the Hausman test statistic, in its original form. The reason that this test has power
under the alternative hypothesis is that in that case the ”MLE” estimator will not be con-
sistent, and will converge to θA , say, where θA 6= θ0 . Then the mean of the asymptotic
√
distribution of vector n θ̃ − θ̂ will be θ0 − θA , a non-zero vector, so the test statistic will
eventually reject, regardless of how small a significance level is used.
• Note: if the test is based on a sub-vector of the entire parameter vector of the
MLE, it is possible that the inconsistency of the MLE will not show up in the
portion of the vector that has been used. If this is the case, the test may not
have power to detect the inconsistency. This may occur, for example, when the
consistent but inefficient estimator is not identified for all the parameters of the
model.
Some things to note:
• The rank, ρ, of the difference of the asymptotic variances is often less than the
dimension of the matrices, and it may be difficult to determine what the true rank
is. If the true rank is lower than what is taken to be true, the test will be biased
against rejection of the null hypothesis. The contrary holds if we underestimate

the rank.
• A solution to this problem is to use a rank 1 test, by comparing only a single
coefficient. For example, if a variable is suspected of possibly being endogenous,
that variable’s coefficients may be compared.
• This simple formula only holds when the estimator that is being tested for consis-
tency is fully efficient under the null hypothesis. This means that it must be a ML
estimator or a fully efficient estimator that has the same asymptotic distribution
as the ML estimator. This is quite restrictive since modern estimators such as
GMM and QML are not in general fully efficient.
Following up on this last point, let’s think of two not necessarily efficient estimators, θ̂1
and θ̂2 , where one is assumed to be consistent, but the other may not be. We assume
for expositional simplicity that both θ̂1 and θ̂2 belong to the same parameter space, and
that they can be expressed as generalized method of moments (GMM) estimators. The
estimators are defined (suppressing the dependence upon data) by
θ̂i = arg min mi (θi )0 Wi mi (θi )

θi ∈Θ
where mi (θi ) is a gi × 1 vector of moment conditions, and Wi is a gi × gi positive definite

weighting matrix, i = 1, 2. Consider the omnibus GMM estimator
(15.10.1) " #" #
h i W1 0(g1 ×g2 ) m1 (θ1 )
θ̂1 , θ̂2 = arg min m1 (θ1 ) m2 (θ2 )
0 0 .
Θ×Θ 0(g2 ×g1 ) W2 m2 (θ2 )
Suppose that the asymptotic covariance of the omnibus moment vector is
( " #)
√ m1 (θ1 )
(15.10.2) Σ = lim Var n
n→∞ m2 (θ2 )
!
Σ1 Σ12
≡ .
· Σ2
The standard Hausman test is equivalent to a Wald test of the equality of θ 1 and θ2 (or
subvectors of the two) applied to the omnibus GMM estimator, but with the covariance of
the moment conditions estimated as
!
c1
Σ 0(g1 ×g2 )
b=
Σ .
0(g2 ×g1 ) c
Σ2
While this is clearly an inconsistent estimator in general, the omitted Σ12 term cancels out
of the test statistic when one of the estimators is asymptotically efficient, as we have seen
above, and thus it need not be estimated.
The general solution when neither of the estimators is efficient is clear: the entire Σ
matrix must be estimated consistently, since the Σ12 term will not cancel out. Methods
for consistently estimating the asymptotic covariance of a vector of moment conditions
are well-known, e.g., the Newey-West estimator discussed previously. The Hausman test
using a proper estimator of the overall covariance matrix will now have an asymptotic χ 2
distribution when neither estimator is efficient. However, the test suffers from a loss of
15.11. APPLICATION: NONLINEAR RATIONAL EXPECTATIONS 206
power due to the fact that the omnibus GMM estimator of equation 15.10.1 is defined using
an inefficient weight matrix. A new test can be defined by using an alternative omnibus
GMM estimator
" #
h i −1 m1 (θ1 )
(15.10.3) θ̂1 , θ̂2 = arg min m1 (θ1 )0 m2 (θ2 )0 e
Σ ,
Θ×Θ m2 (θ2 )
e is a consistent estimator of the overall covariance matrix Σ of equation 15.10.2.
where Σ
By standard arguments, this is a more efficient estimator than that defined by equation
15.10.1, so the Wald test using this alternative is more powerful. See my article in Applied
Economics, 2004, for more details, including simulation results.
15.11. Application: Nonlinear rational expectations
Readings: Hansen and Singleton, 1982∗; Tauchen, 1986

Though GMM estimation has many applications, application to rational expectations
models is elegant, since theory directly suggests the moment conditions. Hansen and Sin-
gleton’s 1982 paper is also a classic worth studying in itself. Though I strongly recommend
reading the paper, I’ll use a simplified model with similar notation to Hamilton’s.
We assume a representative consumer maximizes expected discounted utility over an
infinite horizon. Utility is temporally additive, and the expected utility hypothesis holds.
∞
The future consumption stream is the stochastic sequence {ct }t=0 . The objective function
at time t is the discounted expected utility
∞
(15.11.1) ∑ βsE (u(ct+s )|It ) .
s=0
• The parameter β is between 0 and 1, and reflects discounting.

• It is the information set at time t, and includes the all realizations of random
variables indexed t and earlier.
• The choice variable is ct - current consumption, which is constained to be less
than or equal to current wealth wt .
• Suppose the consumer can invest in a risky asset. A dollar invested in the asset
yields a gross return
pt+1 + dt+1
(1 + rt+1) =
pt
where pt is the price and dt is the dividend in period t. The price of ct is normal-
ized to 1.
• Current wealth wt = (1 + rt )it−1 , where it−1 is investment in period t − 1. So the
problem is to allocate current wealth between current consumption and invest-
ment to finance future consumption: wt = ct + it .
• Future net rates of return rt+s , s > 0 are not known in period t: the asset is risky.
A partial set of necessary conditions for utility maximization have the form:

(15.11.2) u0 (ct ) = βE (1 + rt+1 ) u0 (ct+1 )|It .
To see that the condition is necessary, suppose that the lhs < rhs. Then by reducing current
consumption marginally would cause equation 15.11.1 to drop by u0 (ct ), since there is no
15.11. APPLICATION: NONLINEAR RATIONAL EXPECTATIONS 207
discounting of the current period. At the same time, the marginal reduction in consumption
finances investment, which has gross return (1 + rt+1 ) , which could finance consumption in
period t +1. This increase in consumption would cause the objective function to increase by
βE {(1 + rt+1) u0 (ct+1 )|It } . Therefore, unless the condition holds, the expected discounted
utility function is not maximized.
• To use this we need to choose the functional form of utility. A constant relative
risk aversion form is
1−γ
−1 ct
u(ct ) =
1−γ
where γ is the coefficient of relative risk aversion. With this form,
−γ
u0 (ct ) = ct
so the foc are n o

−γ −γ
ct = βE (1 + rt+1 ) ct+1 |It
While it is true that n o
−γ −γ
E ct − β (1 + rt+1 ) ct+1 |It = 0
so that we could use this to define moment conditions, it is unlikely that ct is stationary,
even though it is in real terms, and our theory requires stationarity. To solve this, divide
−γ
though by ct ( −γ )!
ct+1
E 1-β (1 + rt+1 ) |It = 0
ct
(note that ct can be passed though the conditional expectation since ct is chosen based only
upon information available in time t).
Now ( −γ )
ct+1
1-β (1 + rt+1 )
ct
is analogous to ht (θ) defined above: it’s a scalar moment condition. To get a vector of mo-
ment conditions we need some instruments. Suppose that zt is a vector of variables drawn
from the information set It . We can use the necessary conditions to form the expressions
−γ
c
1 − β (1 + rt+1 ) t+1ct zt ≡ mt (θ)
• θ represents β and γ.
• Therefore, the above expression may be interpreted as a moment condition which
can be used for GMM estimation of the parameters θ0 .
Note that at time t, mt−s has been observed, and is therefore an element of the information
set. By rational expectations, the autocovariances of the moment conditions other than Γ 0
should be zero. The optimal weighting matrix is therefore the inverse of the variance of the
moment conditions:

Ω∞ = lim E nm(θ0 )m(θ0 )0
15.12. EMPIRICAL EXAMPLE: A PORTFOLIO MODEL 208
which can be consistently estimated by

n
Ω̂ = 1/n ∑ mt (θ̂)mt (θ̂)0
t=1
As before, this estimate depends on an initial consistent estimate of θ, which can be ob-
tained by setting the weighting matrix W arbitrarily (to an identity matrix, for example).
After obtaining θ̂, we then minimize
s(θ) = m(θ)0 Ω̂−1 m(θ).
This process can be iterated, e.g., use the new estimate to re-estimate Ω, use this to estimate
θ0 , and repeat until the estimates don’t change.
• In principle, we could use a very large number of moment conditions in estima-
tion, since any current or lagged variable could be used in xt . Since use of more
moment conditions will lead to a more (asymptotically) efficient estimator, one
might be tempted to use many instrumental variables. We will do a computer lab
that will show that this may not be a good idea with finite samples. This issue has
been studied using Monte Carlos (Tauchen, JBES, 1986). The reason for poor
performance when using many instruments is that the estimate of Ω becomes
very imprecise.
• Empirical papers that use this approach often have serious problems in obtain-
ing precise estimates of the parameters. Note that we are basing everything on
a single parial first order condition. Probably this f.o.c. is simply not informa-
tive enough. Simulation-based estimation methods (discussed below) are one
means of trying to use more informative moment conditions to estimate this sort
of model.
15.12. Empirical example: a portfolio model
The Octave program portfolio.m performs GMM estimation of a portfolio model, us-
ing the data file tauchen.data. The columns of this data file are c, p, and d in that order.
There are 95 observations (source: Tauchen, JBES, 1986). As instruments we use lags of
c and r, as well as a constant. For a single lag the estimation results are
******************************************************
Example of GMM estimation of rational expectations model
GMM Estimation Results

Objective function value: 0.000014

Observations: 94
Value df p-value
X^2 test 0.001 1.000 0.971

beta 0.915 0.009 97.271 0.000
gamma 0.569 0.319 1.783 0.075
******************************************************
For two lags the estimation results are

******************************************************
Example of GMM estimation of rational expectations model


Observations: 93
Value df p-value
X^2 test 3.523 3.000 0.318

beta 0.857 0.024 35.636 0.000
gamma -2.351 0.315 -7.462 0.000
******************************************************
Pretty clearly, the results are sensitive to the choice of instruments. Maybe there is
some problem here: poor instruments, or possibly a conditional moment that is not very
informative.
Exercises
(1) Show how to cast the generalized IV estimator presented in section 11.4 as a
GMM estimator. Identify what are the moment conditions, mt (θ), what is the
form of the the matrix Dn , what is the efficient weight matrix, and show that the
covariance matrix formula given previously corresponds to the GMM covariance
matrix formula.
(2) Using Octave, generate data from the logit dgp . Recall that E(yt |xt ) = p(xt , θ) =
[1 + exp(−xt 0θ)]−1 . Consider the moment condtions (exactly identified) mt (θ) =
[yt − p(xt , θ)]xt
(a) Estimate by GMM, using these moments.
(b) Estimate by MLE.
(c) The two estimators should coincide. Prove analytically that the estimators
coicide.
(3) Verify the missing steps needed to show that n · m(θ̂)0 Ω̂−1 m(θ̂) has a χ2 (g − K)
distribution. That is, show that the monster matrix is idempotent and has trace
equal to g − K.
(4) For the portfolio example, experiment with the program using lags of 3 and 4
periods to define instruments
(a) Iterate the estimation of θ = (β, γ) and Ω to convergence.
(b) Comment on the results. Are the results sensitive to the set of instruments
used? (Look at Ω̂ as well as θ̂. Are these good instruments? Are the instru-
ments highly correlated with one another?
CHAPTER 16
Quasi-ML
Quasi-ML is the estimator one obtains when a misspecified probability model is used
to calculate an ”ML” estimator.
Given a sample of size n of arandom vector y and a vector of conditioning
variables x,
suppose the joint density of Y = y1 . . . yn conditional on X = x1 . . . xn is
a member of the parametric family pY (Y|X, ρ), ρ ∈ Ξ. The true joint density is associated
with the vector ρ0 :
pY (Y|X, ρ0 ).
As long as the marginal density of X doesn’t depend on ρ0 , this conditional density fully
characterizes the random characteristics of samples: i.e., it fully describes the probabilisti-
cally important features of the d.g.p. The likelihood function is just this density evaluated
at other values ρ
L(Y|X, ρ) = pY (Y|X, ρ), ρ ∈ Ξ.

• Let Yt−1 = y1 . . . yt−1 , Y0 = 0, and let Xt = x1 . . . xt The like-
lihood function, taking into account possible dependence of observations, can be
written as
n
L(Y|X, ρ) = ∏ pt (yt |Yt−1 , Xt , ρ)
t=1
n
≡ ∏ pt (ρ)
t=1
• The average log-likelihood function is:

1 1 n
sn (ρ) = lnL(Y|X, ρ) = ∑ ln pt (ρ)
n n t=1
• Suppose that we do not have knowledge of the family of densities pt (ρ). Mistak-
enly, we may assume that the conditional density of yt is a member of the family
ft (yt |Yt−1 , Xt , θ), θ ∈ Θ, where there is no θ0 such that ft (yt |Yt−1 , Xt , θ0 ) =
pt (yt |Yt−1 , Xt , ρ0 ), ∀t (this is what we mean by “misspecified”).
• This setup allows for heterogeneous time series data, with dynamic misspecifica-
tion.
211
16.1. CONSISTENT ESTIMATION OF VARIANCE COMPONENTS 212
The QML estimator is the argument that maximizes the misspecified average log likeli-
hood, which we refer to as the quasi-log likelihood function. This objective function is
1 n
sn (θ) = ∑ ln ft (yt |Yt−1 , Xt , θ0 )
n t=1
1 n
≡ ∑ ln ft (θ)
n t=1
and the QML is
θ̂n = argmax sn (θ)
Θ
A SLLN for dependent sequences applies (we assume), so that
a.s. 1 n
sn (θ) → lim E
n→∞
∑ ln ft (θ) ≡ s∞ (θ)
n t=1
We assume that this can be strengthened to uniform convergence, a.s., following the previ-
ous arguments. The “pseudo-true” value of θ is the value that maximizes s̄(θ):
θ0 = argmax s∞ (θ)
Θ
Given assumptions so that theorem 19 is applicable, we obtain
lim θ̂n = θ0 , a.s.

n→∞
• Applying the asymptotic normality theorem,

√ d
n θ̂ − θ0 → N 0, J∞ (θ0 )−1 I∞ (θ0 )J∞ (θ0 )−1
where
J∞ (θ0 ) = lim E D2θ sn (θ0 )
n→∞
and
√
I∞ (θ0 ) = lim Var nDθ sn (θ0 ).
n→∞
• Note that asymptotic normality only requires that the additional assumptions re-
garding J and I hold in a neighborhood of θ0 for J and at θ0 , for I , not through-
out Θ. In this sense, asymptotic normality is a local property.
16.1. Consistent Estimation of Variance Components
Consistent estimation of J∞ (θ0 ) is straightforward. Assumption (b) of Theorem 22

implies that
1 n 2 a.s. 1 n
Jn (θ̂n ) = ∑
n t=1
Dθ ln ft (θ̂n ) → lim E ∑ D2θ ln ft (θ0 ) = J∞ (θ0 ).
n→∞ n
t=1
That is, just calculate the Hessian using the estimate θ̂n in place of θ0 .
Consistent estimation of I∞ (θ0 ) is more difficult, and may be impossible.
• Notation: Let gt ≡ Dθ ft (θ0 )

16.1. CONSISTENT ESTIMATION OF VARIANCE COMPONENTS 213
We need to estimate
√
I∞ (θ0 ) = lim Var nDθ sn (θ0 )
n→∞
√ 1 n
= lim Var n ∑ Dθ ln ft (θ0 )
n→∞ n t=1
n
1
= lim Var ∑ gt
n→∞ n
t=1
( ! !0 )
n n
1
= lim E
n→∞ n
∑ (gt − E gt ) ∑ (gt − E gt )
t=1 t=1
This is going to contain a term

1 n
lim
n→∞ n
∑ (E gt ) (E gt )0
t=1
which will not tend to zero, in general. This term is not consistently estimable in general,
since it requires calculating an expectation using the true density under the d.g.p., which is
unknown.
• There are important cases where I∞ (θ0 ) is consistently estimable. For example,
suppose that the data come from a random sample (i.e., they are iid). This would
be the case with cross sectional data, for example. (Note: under i.i.d. sampling,
the joint distribution of (yt , xt ) is identical. This does not imply that the condi-
tional density f (yt |xt ) is identical).
• With random sampling, the limiting objective function is simply
s∞ (θ0 ) = EX E0 ln f (y|x, θ0 )
where E0 means expectation of y|x and EX means expectation respect to the

marginal density of x.
• By the requirement that the limiting objective function be maximized at θ 0 we
have
Dθ EX E0 ln f (y|x, θ0 ) = Dθ s∞ (θ0 ) = 0
• The dominated convergence theorem allows switching the order of expectation
and differentiation, so
Dθ EX E0 ln f (y|x, θ0 ) = EX E0 Dθ ln f (y|x, θ0 ) = 0
The CLT implies that

1 n d
√ ∑ Dθ ln f (y|x, θ0 ) → N(0, I∞ (θ0 )).
n t=1
That is, it’s not necessary to subtract the individual means, since they are zero.
Given this, and due to independent observations, a consistent estimator is
1 n
I = ∑ Dθ ln ft (θ̂)Dθ0 ln ft (θ̂)
b
n t=1
This is an important case where consistent estimation of the covariance matrix is possible.
Other cases exist, even for dynamically misspecified time series models.
16.2. EXAMPLE: THE MEPS DATA 214
16.2. Example: the MEPS Data
To check the plausibility of the Poisson model for the MEPS data, we can compare
the sample unconditional variance with the estimated unconditional variance according to
∑n λ̂
the Poisson model: Vd(y) = t=1 t . Using the program PoissonVariance.m, for OBDV and
n
ERV, we get We see that even after conditioning, the overdispersion is not captured in either
TABLE 1. Marginal Variances, Sample and Estimated (Poisson)
OBDV ERV
Sample 38.09 0.151
Estimated 3.28 0.086
case. There is huge problem with OBDV, and a significant problem with ERV. In both cases
the Poisson model does not appear to be plausible. You can check this for the other use
measures if you like.
16.2.1. Infinite mixture models: the negative binomial model. Reference: Cameron
and Trivedi (1998) Regression analysis of count data, chapter 4.
The two measures seem to exhibit extra-Poisson variation. To capture unobserved
heterogeneity, a possibility is the random parameters approach. Consider the possibility
that the constant term in a Poisson model were random:
exp(−θ)θy
fY (y|x, ε) =
y!
θ = exp(x0β + ε)
= exp(x0β) exp(ε)
= λν
where λ = exp(x0β) and ν = exp(ε). Now ν captures the randomness in the constant. The
problem is that we don’t observe ν, so we will need to marginalize it to get a usable density
exp[−θ]θy
Z ∞
fY (y|x) = fv (z)dz
−∞ y!
This density can be used directly, perhaps using numerical integration to evaluate the like-
lihood function. In some cases, though, the integral will have an analytic solution. For
example, if ν follows a certain one parameter gamma density, then
ψ y
Γ(y + ψ) ψ λ
(16.2.1) fY (y|x, φ) =
Γ(y + 1)Γ(ψ) ψ + λ ψ+λ
where φ = (λ, ψ). ψ appears since it is the parameter of the gamma density.
• For this density, E(y|x) = λ, which we have parameterized λ = exp(x 0 β)
• The variance depends upon how ψ is parameterized.
– If ψ = λ/α, where α > 0, then V (y|x) = λ + αλ. Note that λ is a function of
x, so that the variance is too. This is referred to as the NB-I model.
– If ψ = 1/α, where α > 0, then V (y|x) = λ + αλ2 . This is referred to as the
NB-II model.
So both forms of the NB model allow for overdispersion, with the NB-II model allowing
for a more radical form.
Testing reduction of a NB model to a Poisson model cannot be done by testing α = 0
using standard Wald or LR procedures. The critical values need to be adjusted to account
for the fact that α = 0 is on the boundary of the parameter space. Without getting into
details, suppose that the data were in fact Poisson, so there is equidispersion and the true
α = 0. Then about half the time the sample data will be underdispersed, and about half
the time overdispersed. When the data is underdispersed, the MLE of α will be α̂ = 0.
Thus, under the null, there will be a probability spike in the asymptotic distribution of
p √
n(α̂ − α) = nα̂ at 0, so standard testing methods will not be valid.
This program will do estimation using the NB model. Note how modelargs is used to
select a NB-I or NB-II density. Here are NB-I estimation results for OBDV:
OBDV
======================================================
Used analytic gradient
------------------------------------------------------
STRONG CONVERGENCE
------------------------------------------------------
Objective function value 2.18573
Stepsize 0.0007
17 iterations
------------------------------------------------------

1.0965 0.0000 -0.0000
0.2551 -0.0000 0.0000
0.2024 -0.0000 0.0000
0.2289 0.0000 -0.0000
0.1969 0.0000 -0.0000
0.0769 0.0000 -0.0000
0.0000 -0.0000 0.0000
1.7146 -0.0000 0.0000
******************************************************
Negative Binomial model, MEPS 1996 full data set


Observations: 4564

constant -0.523 0.104 -5.005 0.000
pub. ins. 0.765 0.054 14.198 0.000
priv. ins. 0.451 0.049 9.196 0.000
sex 0.458 0.034 13.512 0.000
age 0.016 0.001 11.869 0.000
edu 0.027 0.007 3.979 0.000
inc 0.000 0.000 0.000 1.000
alpha 5.555 0.296 18.752 0.000
CAIC : 20026.7513 Avg. CAIC: 4.3880
BIC : 20018.7513 Avg. BIC: 4.3862
AIC : 19967.3437 Avg. AIC: 4.3750
******************************************************
Note that the parameter values of the last BFGS iteration are different that those re-
ported in the final results. This reflects two things - first, the data were scaled before doing
the BFGS minimization, but the mle_results script takes this into account and reports
the results using the original scaling. But also, the parameterization α = exp(α ∗ ) is used
to enforce the restriction that α > 0. The unrestricted parameter α∗ = logα is used to
define the log-likelihood function, since the BFGS minimization algorithm does not do
contrained minimization. To get the standard error and t-statistic of the estimate of α, we
need to use the delta method. This is done inside mle_results, making use of the function
parameterize.m .
Likewise, here are NB-II results:
OBDV
======================================================
------------------------------------------------------
STRONG CONVERGENCE
------------------------------------------------------
Stepsize 0.0104394
13 iterations
------------------------------------------------------

1.0375 0.0000 -0.0000
0.3673 -0.0000 0.0000
0.2136 0.0000 -0.0000
0.2816 0.0000 -0.0000

0.3027 0.0000 0.0000
0.0843 -0.0000 0.0000
-0.0048 0.0000 -0.0000
0.4780 -0.0000 0.0000
******************************************************
Negative Binomial model, MEPS 1996 full data set


Observations: 4564

constant -1.068 0.161 -6.622 0.000
pub. ins. 1.101 0.095 11.611 0.000
priv. ins. 0.476 0.081 5.880 0.000
sex 0.564 0.050 11.166 0.000
age 0.025 0.002 12.240 0.000
edu 0.029 0.009 3.106 0.002
inc -0.000 0.000 -0.176 0.861
alpha 1.613 0.055 29.099 0.000
CAIC : 20019.7439 Avg. CAIC: 4.3864
BIC : 20011.7439 Avg. BIC: 4.3847
AIC : 19960.3362 Avg. AIC: 4.3734
******************************************************
• For the OBDV usage measurel, the NB-II model does a slightly better job than the
NB-I model, in terms of the average log-likelihood and the information criteria
(more on this last in a moment).
• Note that both versions of the NB model fit much better than does the Poisson
model (see 13.4.2).
• The estimated α is highly significant.
To check the plausibility of the NB-II model, we can compare the sample unconditional
variance with the estimated unconditional variance according to the NB-II model: Vd
(y) =
n λ̂ +α̂ λ̂ 2
∑t=1 t ( t )
n . For OBDV and ERV (estimation results not reported), we get For OBDV,
TABLE 2. Marginal Variances, Sample and Estimated (NB-II)
OBDV ERV
Sample 38.09 0.151
Estimated 30.58 0.182
the overdispersion problem is significantly better than in the Poisson case, but there is still
some that is not captured. For ERV, the negative binomial model seems to capture the
overdispersion adequately.
16.2.2. Finite mixture models: the mixed negative binomial model. The finite
mixture approach to fitting health care demand was introduced by Deb and Trivedi (1997).
The mixture approach has the intuitive appeal of allowing for subgroups of the population
with different health status. If individuals are classified as healthy or unhealthy then two
subgroups are defined. A finer classification scheme would lead to more subgroups. Many
studies have incorporated objective and/or subjective indicators of health status in an ef-
fort to capture this heterogeneity. The available objective measures, such as limitations on
activity, are not necessarily very informative about a person’s overall health status. Sub-
jective, self-reported measures may suffer from the same problem, and may also not be
exogenous
Finite mixture models are conceptually simple. The density is
p−1
∑ πi fY (y, φi ) + π p fYp (y, φ p ),
(i)
fY (y, φ1 , ..., φ p , π1 , ..., π p−1 ) =
i=1
p−1 p
where πi > 0, i = 1, 2, ..., p, π p = 1 − ∑i=1 πi ,
and ∑i=1 πi = 1. Identification requires
that the πi are ordered in some way, for example, π1 ≥ π2 ≥ · · · ≥ π p and φi 6= φ j , i 6= j.
This is simple to accomplish post-estimation by rearrangement and possible elimination of
redundant component densities.
• The properties of the mixture density follow in a straightforward way from those
of the components. In particular, the moment generating function is the same
mixture of the moment generating functions of the component densities, so, for
p
example, E(Y |x) = ∑i=1 πi µi (x), where µi (x) is the mean of the ith component
density.
• Mixture densities may suffer from overparameterization, since the total number
of parameters grows rapidly with the number of component densities. It is possi-
ble to constrained parameters across the mixtures.
• Testing for the number of component densities is a tricky issue. For example,
testing for p = 1 (a single component, which is to say, no mixture) versus p = 2
(a mixture of two components) involves the restriction π1 = 1, which is on the
boundary of the parameter space. Not that when π1 = 1, the parameters of the
second component can take on any value without affecting the density. Usual
methods such as the likelihood ratio test are not applicable when parameters are
on the boundary under the null hypothesis. Information criteria means of choos-
ing the model (see below) are valid.
The following results are for a mixture of 2 NB-II models, for the OBDV data, which you
can replicate using this program .
OBDV
******************************************************
Mixed Negative Binomial model, MEPS 1996 full data set


Observations: 4564

constant 0.127 0.512 0.247 0.805
pub. ins. 0.861 0.174 4.962 0.000
priv. ins. 0.146 0.193 0.755 0.450
sex 0.346 0.115 3.017 0.003
age 0.024 0.004 6.117 0.000
edu 0.025 0.016 1.590 0.112
inc -0.000 0.000 -0.214 0.831
alpha 1.351 0.168 8.061 0.000
constant 0.525 0.196 2.678 0.007
pub. ins. 0.422 0.048 8.752 0.000
priv. ins. 0.377 0.087 4.349 0.000
sex 0.400 0.059 6.773 0.000
age 0.296 0.036 8.178 0.000
edu 0.111 0.042 2.634 0.008
inc 0.014 0.051 0.274 0.784
alpha 1.034 0.187 5.518 0.000
Mix 0.257 0.162 1.582 0.114
CAIC : 19920.3807 Avg. CAIC: 4.3647
BIC : 19903.3807 Avg. BIC: 4.3610
AIC : 19794.1395 Avg. AIC: 4.3370
******************************************************
It is worth noting that the mixture parameter is not significantly different from zero,
but also not that the coefficients of public insurance and age, for example, differ quite a bit
between the two latent classes.
16.2.3. Information criteria. As seen above, a Poisson model can’t be tested (using
standard methods) as a restriction of a negative binomial model. But it seems, based upon
the values of the likelihood functions and the fact that the NB model fits the variance much
better, that the NB model is more appropriate. How can we determine which of a set of
competing models is the best?
The information criteria approach is one possibility. Information criteria are functions
of the log-likelihood, with a penalty for the number of parameters used. Three popular
information criteria are the Akaike (AIC), Bayes (BIC) and consistent Akaike (CAIC). The
formulae are
CAIC = −2 lnL(θ̂) + k(lnn + 1)

BIC = −2 lnL(θ̂) + k lnn
AIC = −2 lnL(θ̂) + 2k
It can be shown that the CAIC and BIC will select the correctly specified model from a
group of models, asymptotically. This doesn’t mean, of course, that the correct model
is necesarily in the group. The AIC is not consistent, and will asymptotically favor an
over-parameterized model over the correctly specified model. Here are information crite-
ria values for the models we’ve seen, for OBDV. Pretty clearly, the NB models are better
TABLE 3. Information Criteria, OBDV
Model AIC BIC CAIC

Poisson 7.345 7.355 7.357
NB-I 4.375 4.386 4.388
NB-II 4.373 4.385 4.386
MNB-II 4.337 4.361 4.365
than the Poisson. The one additional parameter gives a very significant improvement in
the likelihood function value. Between the NB-I and NB-II models, the NB-II is slightly
favored. But one should remember that information criteria values are statistics, with vari-
ances. With another sample, it may well be that the NB-I model would be favored, since the
differences are so small. The MNB-II model is favored over the others, by all 3 information
criteria.
Why is all of this in the chapter on QML? Let’s suppose that the correct model for
OBDV is in fact the NB-II model. It turns out in this case that the Poisson model will
give consistent estimates of the slope parameters (if a model is a member of the linear-
exponential family and the conditional mean is correctly specified, then the parameters of
the conditional mean will be consistently estimated). So the Poisson estimator would be
a QML estimator that is consistent for some parameters of the true model. The ordinary
OPG or inverse Hessinan ”ML” covariance estimators are however biased and inconsis-
tent, since the information matrix equality does not hold for QML estimators. But for
i.i.d. data (which is the case for the MEPS data) the QML asymptotic covariance can be
consistently estimated, as discussed above, using the sandwich form for the ML estimator.
mle_results in fact reports sandwich results, so the Poisson estimation results would be
reliable for inference even if the true model is the NB-I or NB-II. Not that they are in fact
similar to the results for the NB models.
However, if we assume that the correct model is the MNB-II model, as is favored by
the information criteria, then both the Poisson and NB-x models will have misspecified
mean functions, so the parameters that influence the means would be estimated with bias
and inconsistently.
EXERCISES 221
Exercises
Exercises
(1) Considering the MEPS data (the description is in Section 13.4.2), for the OBDV (y)
measure, let η be a latent index of health status that has expectation equal to unity. 1 We
suspect that η and PRIV may be correlated, but we assume that η is uncorrelated with
the other regressors. We assume that
E(y|PUB, PRIV, AGE, EDUC, INC, η)

= exp(β1 + β2PUB + β3PRIV + β4 AGE + β5EDUC + β6 INC)η.
We use the Poisson QML estimator of the model
y ∼ Poisson(λ)
(16.2.2) λ = exp(β1 + β2 PUB + β3PRIV +
β4 AGE + β5 EDUC + β6 INC).
Since much previous evidence indicates that health care services usage is overdis-
persed2, this is almost certainly not an ML estimator, and thus is not efficient. However,
when η and PRIV are uncorrelated, this estimator is consistent for the β i parameters,
since the conditional mean is correctly specified in that case. When η and PRIV are
correlated, Mullahy’s (1997) NLIV estimator that uses the residual function
y
ε = − 1,
λ
where λ is defined in equation 16.2.2, with appropriate instruments, is consistent. As
instruments we use all the exogenous regressors, as well as the cross products of PUB
with the variables in Z = {AGE, EDUC, INC}. That is, the full set of instruments is
W = {1 PUB Z PUB × Z }.
(a) Calculate the Poisson QML estimates.

(b) Calculate the generalized IV estimates (do it using a GMM formulation - see the
portfolio example for hints how to do this).
(c) Calculate the Hausman test statistic to test the exogeneity of PRIV.
(d) comment on the results
1A restriction of this sort is necessary for identification.

2Overdispersion exists when the conditional variance is greater than the conditional mean. If this is the case, the
Poisson specification is not correct.
CHAPTER 17
Nonlinear least squares (NLS)
Readings: Davidson and MacKinnon, Ch. 2∗ and 5∗ ; Gallant, Ch. 1
17.1. Introduction and definition
Nonlinear least squares (NLS) is a means of estimating the parameter of the model
yt = f (xt , θ0 ) + εt .
• In general, εt will be heteroscedastic and autocorrelated, and possibly nonnor-

mally distributed. However, dealing with this is exactly as in the case of linear
models, so we’ll just treat the iid case here,
εt ∼ iid(0, σ2 )
If we stack the observations vertically, defining
y = (y1 , y2 , ..., yn )0
f = ( f (x1 , θ), f (x1 , θ), ..., f (x1 , θ))0

and
ε = (ε1 , ε2 , ..., εn )0
we can write the n observations as
y = f(θ) + ε
Using this notation, the NLS estimator can be defined as

1 1
θ̂ ≡ argmin sn (θ) = [y − f(θ)]0 [y − f(θ)] = k y − f(θ) k2
Θ n n
• The estimator minimizes the weighted sum of squared errors, which is the same
as minimizing the Euclidean distance between y and f(θ).
The objective function can be written as
1 0
sn (θ) = y y − 2y0f(θ) + f(θ)0 f(θ) ,
n
which gives the first order conditions

∂ ∂
− f(θ̂)0 y + f(θ̂)0 f(θ̂) ≡ 0.
∂θ ∂θ
Define the n × K matrix
(17.1.1) F(θ̂) ≡ Dθ0 f(θ̂).

222
17.2. IDENTIFICATION 223
In shorthand, use F̂ in place of F(θ̂). Using this, the first order conditions can be written as
−F̂0 y + F̂0f(θ̂) ≡ 0,
or

(17.1.2) F̂0 y − f(θ̂) ≡ 0.
This bears a good deal of similarity to the f.o.c. for the linear model - the derivative of the
prediction is orthogonal to the prediction error. If f(θ) = Xθ, then F̂ is simply X, so the
f.o.c. (with spherical errors) simplify to
X0 y − X0Xβ = 0,
the usual 0LS f.o.c.

We can interpret this geometrically: INSERT drawings of geometrical depiction of
OLS and NLS (see Davidson and MacKinnon, pgs. 8,13 and 46).
• Note that the nonlinearity of the manifold leads to potential multiple local max-
ima, minima and saddlepoints: the objective function sn (θ) is not necessarily
well-behaved and may be difficult to minimize.
17.2. Identification
As before, identification can be considered conditional on the sample, and asymptot-

ically. The condition for asymptotic identification is that sn (θ) tend to a limiting function
s∞ (θ) such that s∞ (θ0 ) < s∞ (θ), ∀θ 6= θ0 . This will be the case if s∞ (θ0 ) is strictly convex
at θ0 , which requires that D2θ s∞ (θ0 ) be positive definite. Consider the objective function:
1 n
sn (θ) = ∑ [yt − f (xt , θ)]2
n t=1
1 n 2
= ∑
n t=1
f (xt , θ0 ) + εt − ft (xt , θ)
1 n 2 1 n
= ∑
n t=1
ft (θ0 ) − ft (θ) + ∑ (εt )2
n t=1
2 n
− ∑
n t=1
ft (θ0 ) − ft (θ) εt
• As in example 14.3, which illustrated the consistency of extremum estimators

using OLS, we conclude that the second term will converge to a constant which
does not depend upon θ.
• A LLN can be applied to the third term to conclude that it converges pointwise
to 0, as long as f(θ) and ε are uncorrelated.
• Next, pointwise convergence needs to be stregnthened to uniform almost sure
convergence. There are a number of possible assumptions one could use. Here,
we’ll just assume it holds.
• Turning to the first term, we’ll assume a pointwise law of large numbers applies,
so
1 n 2 a.s. Z 2
(17.2.1) ∑
n t=1
f t (θ 0
) − f t (θ) → f (z, θ0 ) − f (z, θ) dµ(z),
where µ(x) is the distribution function of x. In many cases, f (x, θ) will be bounded
and continuous, for all θ ∈ Θ, so strengthening to uniform almost sure conver-
gence is immediate. For example if f (x, θ) = [1 + exp(−xθ)]−1 , f : ℜK → (0, 1) ,
a bounded range, and the function is continuous in θ.
Given these results, it is clear that a minimizer is θ0 . When considering identification (as-
ymptotic), the question is whether or not there may be some other minimizer. A local
condition for identification is that
∂2 ∂2
Z 2
s ∞ (θ) = f (x, θ0 ) − f (x, θ) dµ(x)
∂θ∂θ0 ∂θ∂θ0
be positive definite at θ0 . Evaluating this derivative, we obtain (after a little work)

∂2
Z 2 Z 0
0
f (x, θ ) − f (x, θ) dµ(x) = 2 Dθ f (z, θ0 )0 Dθ0 f (z, θ0 ) dµ(z)
∂θ∂θ0 0
θ
the expectation of the outer product of the gradient of the regression function evaluated at
θ0 . (Note: the uniform boundedness we have already assumed allows passing the derivative
through the integral, by the dominated convergence theorem.) This matrix will be positive
definite (wp1) as long as the gradient vector is of full rank (wp1). The tangent space to the
regression manifold must span a K -dimensional space if we are to consistently estimate
a K -dimensional parameter vector. This is analogous to the requirement that there be no
perfect colinearity in a linear model. This is a necessary condition for identification. Note
that the LLN implies that the above expectation is equal to
F0 F
J∞ (θ0 ) = 2 lim E
n
17.3. Consistency
We simply assume that the conditions of Theorem 19 hold, so the estimator is consis-
tent. Given that the strong stochastic equicontinuity conditions hold, as discussed above,
and given the above identification conditions an a compact estimation space (the closure of
the parameter space Θ), the consistency proof’s assumptions are satisfied.
As in the case of GMM, we also simply assume that the conditions for asymptotic nor-
mality as in Theorem 22 hold. The only remaining problem is to determine the form of the
asymptotic variance-covariance matrix. Recall that the result of the asymptotic normality
theorem is
√ d
n θ̂ − θ0 → N 0, J∞ (θ0 )−1 I∞ (θ0 )J∞ (θ0 )−1 ,
∂2
where J∞ (θ0 ) is the almost sure limit of ∂θ∂θ0 sn (θ) evaluated at θ0 , and
√
I∞ (θ0 ) = limVar nDθ sn (θ0 )
The objective function is

1 n
sn (θ) = ∑ [yt − f (xt , θ)]2
n t=1
17.5. EXAMPLE: THE POISSON MODEL FOR COUNT DATA 225
So
2 n
Dθ sn (θ) = − ∑ [yt − f (xt , θ)] Dθ f (xt , θ).
n t=1
Evaluating at θ0 ,
2 n
Dθ sn (θ0 ) = − ∑ εt Dθ f (xt , θ0 ).
n t=1
Note that the expectation of this is zero, since εt and xt are assumed to be uncorrelated.
So to calculate the variance, we can simply calculate the second moment about zero. Also
note that
n
∂ 0
∑ εt Dθ f (xt , θ0 ) = ∂θ f(θ0 ) ε
t=1
= F0 ε
With this we obtain

√
I∞ (θ0 ) = limVar nDθ sn (θ0 )
4
= lim nE 2 F0 εε’ F
n
F0 F
= 4σ2 lim E
n
We’ve already seen that
F0 F
J∞ (θ0 ) = 2 lim E,
n
where the expectation is with respect to the joint density of x and ε. Combining these
expressions for J∞ (θ0 ) and I∞ (θ0 ), and the result of the asymptotic normality theorem, we
get !
−1
√ 0
d F0 F 2
n θ̂ − θ → N 0, lim E σ .
n
We can consistently estimate the variance covariance matrix using
0 −1
F̂ F̂
(17.4.1) σ̂2 ,
n
where F̂ is defined as in equation 17.1.1 and
0
2 y − f(θ̂) y − f(θ̂)
σ̂ = ,
n
the obvious estimator. Note the close correspondence to the results for the linear model.
17.5. Example: The Poisson model for count data
Suppose that yt conditional on xt is independently distributed Poisson. A Poisson

random variable is a count data variable, which means it can take the values {0,1,2,...}.
This sort of model has been used to study visits to doctors per year, number of patents
registered by businesses per year, etc.
The Poisson density is
y
exp(−λt )λt t
f (yt ) = , yt ∈ {0, 1, 2, ...}.
yt !
17.6. THE GAUSS-NEWTON ALGORITHM 226
The mean of yt is λt , as is the variance. Note that λt must be positive. Suppose that the true
mean is
λt0 = exp(xt0 β0 ),
which enforces the positivity of λt . Suppose we estimate β0 by nonlinear least squares:
1 n 2
β̂ = argminsn (β) = ∑ yt − exp(xt0 β)
T t=1
We can write
1 n 2
sn (β) = ∑ exp(xt0 β0 + εt − exp(xt0 β)
T t=1
1 n 2 1 n 1 n
= ∑
T t=1
exp(xt0 β0 − exp(xt0 β) + ∑ εt2 + 2 ∑ εt exp(xt0 β0 − exp(xt0 β)
T t=1 T t=1
The last term has expectation zero since the assumption that E (yt |xt ) = exp(xt0 β0 ) implies
that E (εt |xt ) = 0, which in turn implies that functions of xt are uncorrelated with εt . Ap-
plying a strong LLN, and noting that the objective function is continuous on a compact
parameter space, we get
2
s∞ (β) = Ex exp(x0 β0 − exp(x0 β) + Ex exp(x0 β0 )
where the last term comes from the fact that the conditional variance of ε is the same as
the variance of y. This function is clearly minimized at β = β0 , so the NLS estimator is
consistent as long as identification holds.
√
E XERCISE 27. Determine the limiting distribution of n β̂ − β0 . This means find-

∂2
ing the the specific forms of ∂β∂β 0 ∂sn (β) , and I (β0 ). Again, use a CLT as
0 sn (β), J (β ), ∂β
needed, no need to verify that it can be applied.
17.6. The Gauss-Newton algorithm
Readings: Davidson and MacKinnon, Chapter 6, pgs. 201-207 ∗.

The Gauss-Newton optimization technique is specifically designed for nonlinear least
squares. The idea is to linearize the nonlinear model, rather than the objective function.
The model is
y = f(θ0 ) + ε.
At some θ in the parameter space, not equal to θ0 , we have
y = f(θ) + ν
where ν is a combination of the fundamental error term ε and the error due to evaluating
the regression function at θ rather than the true value θ0 . Take a first order Taylor’s series
approximation around a point θ1 :

y = f(θ1 ) + Dθ0 f θ1 θ − θ1 + ν + approximation error.
Define z ≡ y − f(θ1) and b ≡ (θ − θ1 ). Then the last equation can be written as
z = F(θ1 )b + ω,
17.7. APPLICATION: LIMITED DEPENDENT VARIABLES AND SAMPLE SELECTION 227
where, as above, F(θ1 ) ≡ Dθ0 f(θ1 ) is the n × K matrix of derivatives of the regression
function, evaluated at θ1 , and ω is ν plus approximation error from the truncated Taylor’s
series.
• Note that F is known, given θ1 .

• Note that one could estimate b simply by performing OLS on the above equation.
• Given b̂, we calculate a new round estimate of θ0 as θ2 = b̂ + θ1 . With this, take a
new Taylor’s series expansion around θ2 and repeat the process. Stop when b̂ = 0
(to within a specified tolerance).
To see why this might work, consider the above approximation, but evaluated at the NLS
estimator:

y = f(θ̂) + F(θ̂) θ − θ̂ + ω
The OLS estimate of b ≡ θ − θ̂ is
−1 0
b̂ = F̂0 F̂ F̂ y − f(θ̂) .
This must be zero, since

F̂0 θ̂ y − f(θ̂) ≡ 0
by definition of the NLS estimator (these are the normal equations as in equation 17.1.2,
Since b̂ ≡ 0 when we evaluate at θ̂, updating would stop.
• The Gauss-Newton method doesn’t require second derivatives, as does the Newton-
Raphson method, so it’s faster.
• The varcov estimator, as in equation 17.4.1 is simple to calculate, since we have
F̂ as a by-product of the estimation process (i.e., it’s just the last round “regressor
matrix”). In fact, a normal OLS program will give the NLS varcov estimator
directly, since it’s just the OLS varcov estimator from the last iteration.
• The method can suffer from convergence problems since F(θ) 0 F(θ), may be very
nearly singular, even with an asymptotically identified model, especially if θ is
very far from θ̂. Consider the example
y = β1 + β2 xt β3 + εt
When evaluated at β2 ≈ 0, β3 has virtually no effect on the NLS objective func-

tion, so F will have rank that is “essentially” 2, rather than 3. In this case, F 0 F
will be nearly singular, so (F0 F)−1 will be subject to large roundoff errors.
17.7. Application: Limited dependent variables and sample selection
Readings: Davidson and MacKinnon, Ch. 15∗ (a quick reading is sufficient), J. Heck-
man, “Sample Selection Bias as a Specification Error”, Econometrica, 1979 (This is a
classic article, not required for reading, and which is a bit out-dated. Nevertheless it’s a
good place to start if you encounter sample selection problems in your research).
Sample selection is a common problem in applied research. The problem occurs when
observations used in estimation are sampled non-randomly, according to some selection
scheme.
17.7.1. Example: Labor Supply. Labor supply of a person is a positive number of

hours per unit time supposing the offer wage is higher than the reservation wage, which is
the wage at which the person prefers not to work. The model (very simple, with t subscripts
suppressed):
• Characteristics of individual: x
• Latent labor supply: s∗ = x0 β + ω
• Offer wage: wo = z0 γ + ν
• Reservation wage: wr = q0 δ + η
Write the wage differential as

w∗ = z 0 γ + ν − q0 δ + η
≡ r0 θ + ε
We have the set of equations
s∗ = x0 β + ω
w∗ = r0 θ + ε.
Assume that " # " # " #!

ω 0 σ2 ρσ
∼N , .
ε 0 ρσ 1
We assume that the offer wage and the reservation wage, as well as the latent variable s ∗
are unobservable. What is observed is
w = 1 [w∗ > 0]
s = ws∗ .
In other words, we observe whether or not a person is working. If the person is working,
we observe labor supply, which is equal to latent labor supply, s ∗ . Otherwise, s = 0 6= s∗ .
Note that we are using a simplifying assumption that individuals can freely choose their
weekly hours of work.
Suppose we estimated the model
s∗ = x0 β + residual
using only observations for which s > 0. The problem is that these observations are those
for which w∗ > 0, or equivalently, −ε < r0 θ and

E ω| − ε < r0 θ 6= 0,
since ε and ω are dependent. Furthermore, this expectation will in general depend on x
since elements of x can enter in r. Because of these two facts, least squares estimation is
biased and inconsistent.
Consider more carefully E [ω| − ε < r0 θ] . Given the joint normality of ω and ε, we can
write (see for example Spanos Statistical Foundations of Econometric Modelling, pg. 122)
ω = ρσε + η,
where η has mean zero and is independent of ε. With this we can write
s∗ = x0 β + ρσε + η.
If we condition this equation on −ε < r0 θ we get
s = x0 β + ρσE (ε| − ε < r0 θ) + η
which may be written as
s = x0 β + ρσE (ε|ε > −r0 θ) + η
• A useful result is that for
z ∼ N(0, 1)
φ(z∗ )
E(z|z > z∗ ) = ,
Φ(−z∗ )
where φ (·) and Φ (·) are the standard normal density and distribution function,
respectively. The quantity on the RHS above is known as the inverse Mill’s ratio:
φ(z∗ )
IMR(z∗ ) =
Φ(−z∗ )
With this we can write (making use of the fact that the standard normal density
is symmetric about zero, so that φ(−a) = φ(a)):
φ (r0 θ)
(17.7.1) s = x0 β + ρσ +η
Φ (r0 θ)
" #
h i β
φ (r0 θ )
(17.7.2) ≡ x0 Φ(r0 θ)
+ η.
ζ
where ζ = ρσ. The error term η has conditional mean zero, and is uncorrelated with the
regressors x0 φΦ(r
(r0 θ) . At this point, we can estimate the equation by NLS.
0 θ)
• Heckman showed how one can estimate this in a two step procedure where first
θ is estimated, then equation 17.7.2 is estimated by least squares using the esti-
mated value of θ to form the regressors. This is inefficient and estimation of the
covariance is a tricky issue. It is probably easier (and more efficient) just to do
MLE.
• The model presented above depends strongly on joint normality. There exist
many alternative models which weaken the maintained assumptions. It is pos-
sible to estimate consistently without distributional assumptions. See Ahn and
Powell, Journal of Econometrics, 1994.
CHAPTER 18
Nonparametric inference
18.1. Possible pitfalls of parametric inference: estimation
Readings: H. White (1980) “Using Least Squares to Approximate Unknown Regres-

sion Functions,” International Economic Review, pp. 149-70.
In this section we consider a simple example, which illustrates both why nonparametric
methods may in some cases be preferred to parametric methods.
We suppose that data is generated by random sampling of (y, x), where y = f (x) +ε, x
is uniformly distributed on (0, 2π), and ε is a classical error. Suppose that
3x x 2
f (x) = 1 + −
2π 2π
The problem of interest is to estimate the elasticity of f (x) with respect to x, throughout
the range of x.
In general, the functional form of f (x) is unknown. One idea is to take a Taylor’s
series approximation to f (x) about some point x0 . Flexible functional forms such as the
transcendental logarithmic (usually know as the translog) can be interpreted as second order
Taylor’s series approximations. We’ll work with a first order approximation, for simplicity.
Approximating about x0 :
h(x) = f (x0 ) + Dx f (x0 ) (x − x0)
If the approximation point is x0 = 0, we can write
h(x) = a + bx
The coefficient a is the value of the function at x = 0, and the slope is the value of the
derivative at x = 0. These are of course not known. One might try estimation by ordinary
least squares. The objective function is
n
s(a, b) = 1/n ∑ (yt − h(xt ))2 .
t=1
The limiting objective function, following the argument we used to get equations 14.3.1
and 17.2.1 is Z 2π
s∞ (a, b) = ( f (x) − h(x))2 dx.
0
The theorem regarding the consistency of extremum estimators (Theorem 19) tells us that
â and b̂ will converge almost surely to the values that minimize the limiting objective
function. Solving the first order conditions1 reveals that s∞ (a, b) obtains its minimum
1The following results were obtained using the command maxima -b fff.mac You can get the source file at
http://pareto.uab.es/mcreel/Econometrics/Include/Nonparametric/fff.mac.
230
18.1. POSSIBLE PITFALLS OF PARAMETRIC INFERENCE: ESTIMATION 231
F IGURE 18.1.1. True and simple approximating functions

3.5
Fun1
x/%PI+7/6
2.5
1.5
1
0 1 2 3 4 5 6 7

at a0 = 67 , b0 = π1 . The estimated approximating function ĥ(x) therefore tends almost
surely to
h∞ (x) = 7/6 + x/π

In Figure 18.1.1 we see the true function and the limit of the approximation to see the
asymptotic bias as a function of x.
(The approximating model is the straight line, the true model has curvature.) Note that
the approximating model is in general inconsistent, even at the approximation point. This
shows that “flexible functional forms” based upon Taylor’s series approximations do not in
general lead to consistent estimation of functions.
The approximating model seems to fit the true model fairly well, asymptotically. How-
ever, we are interested in the elasticity of the function. Recall that an elasticity is the mar-
ginal function divided by the average function:
ε(x) = xφ0 (x)/φ(x)
Good approximation of the elasticity over the range of x will require a good approximation
of both f (x) and f 0 (x) over the range of x. The approximating elasticity is
η(x) = xh0 (x)/h(x)
In Figure 18.1.2 we see the true elasticity and the elasticity obtained from the limiting
approximating model.
The true elasticity is the line that has negative slope for large x. Visually we see that
the elasticity is not approximated so well. Root mean squared error in the approximation
of the elasticity is
Z 2π
1/2
2
(ε(x) − η(x)) dx = . 31546
0
18.1. POSSIBLE PITFALLS OF PARAMETRIC INFERENCE: ESTIMATION 232
F IGURE 18.1.2. True and approximating elasticities

0.7
Fun1
x/(%PI*(x/%PI+7/6))
0.6
0.5
0.4
0.3
0.2
0.1
0
0 1 2 3 4 5 6 7
Now suppose we use the leading terms of a trigonometric series as the approximating
model. The reason for using a trigonometric series as an approximating model is motivated
by the asymptotic properties of the Fourier flexible functional form (Gallant, 1981, 1982),
which we will study in more detail below. Normally with this type of model the number
of basis functions is an increasing function of the sample size. Here we hold the set of
basis function fixed. We will consider the asymptotic behavior of a fixed model, which we
interpret as an approximation to the estimator’s behavior in finite samples. Consider the set
of basis functions:
h i
Z(x) = 1 x cos(x) sin(x) cos(2x) sin(2x) .
The approximating model is
gK (x) = Z(x)α.
Maintaining these basis functions as the sample size increases, we find that the limiting
objective function is minimized at

7 1 1 1
a1 = , a2 = , a3 = − 2 , a4 = 0, a5 = − 2 , a6 = 0 .
6 π π 4π
Substituting these values into gK (x) we obtain the almost sure limit of the approximation

1 1
(18.1.1) g∞ (x) = 7/6 + x/π + (cos x) − 2 + (sin x) 0 + (cos 2x) − 2 + (sin 2x) 0
π 4π
In Figure 18.1.3 we have the approximation and the true function: Clearly the truncated
trigonometric series model offers a better approximation, asymptotically, than does the
linear model. In Figure 18.1.4 we have the more flexible approximation’s elasticity and
that of the true function: On average, the fit is better, though there is some implausible
18.2. POSSIBLE PITFALLS OF PARAMETRIC INFERENCE: HYPOTHESIS TESTING 233
F IGURE 18.1.3. True function and more flexible approximation

3.5
Fun1
Fun2
2.5
1.5
1
0 1 2 3 4 5 6 7
F IGURE 18.1.4. True elasticity and more flexible approximation

0.7
Fun1
Fun2
0.6
0.5
0.4
0.3
0.2
0.1
0
0 1 2 3 4 5 6 7
wavyness in the estimate. Root mean squared error in the approximation of the elasticity is
Z 2π !1/2
g0∞ (x)x 2
ε(x) − dx = . 16213,
0 g∞ (x)
about half that of the RMSE when the first order approximation is used. If the trigonometric
series contained infinite terms, this error measure would be driven to zero, as we shall see.
18.2. Possible pitfalls of parametric inference: hypothesis testing
What do we mean by the term “nonparametric inference”? Simply, this means infer-
ences that are possible without restricting the functions of interest to belong to a parametric
family.
18.3. THE FOURIER FUNCTIONAL FORM 234
• Consider means of testing for the hypothesis that consumers maximize utility. A
consequence of utility maximization is that the Slutsky matrix D2p h(p,U), where
h(p,U) are the a set of compensated demand functions, must be negative semi-
definite. One approach to testing for utility maximization would estimate a set of
normal demand functions x(p, m).
• Estimation of these functions by normal parametric methods requires specifica-
tion of the functional form of demand, for example
x(p, m) = x(p, m, θ0 ) + ε, θ0 ∈ Θ0 ,
where x(p, m, θ0 ) is a function of known form and Θ0 is a finite dimensional

parameter.
• After estimation, we could use x̂ = x(p, m, θ̂) to calculate (by solving the inte-
b 2p h(p,U). If we can statistically reject
grability problem, which is non-trivial) D
that the matrix is negative semi-definite, we might conclude that consumers don’t
maximize utility.
• The problem with this is that the reason for rejection of the theoretical proposition
may be that our choice of functional form is incorrect. In the introductory section
we saw that functional form misspecification leads to inconsistent estimation of
the function and its derivatives.
• Testing using parametric models always means we are testing a compound hy-
pothesis. The hypothesis that is tested is 1) the economic proposition we wish to
test, and 2) the model is correctly specified. Failure of either 1) or 2) can lead to
rejection. This is known as the “model-induced augmenting hypothesis.”
• Varian’s WARP allows one to test for utility maximization without specifying the
form of the demand functions. The only assumptions used in the test are those
directly implied by theory, so rejection of the hypothesis calls into question the
theory.
• Nonparametric inference allows direct testing of economic propositions, without
the “model-induced augmenting hypothesis”.
18.3. The Fourier functional form
Readings: Gallant, 1987, “Identification and consistency in semi-nonparametric re-

gression,” in Advances in Econometrics, Fifth World Congress, V. 1, Truman Bewley, ed.,
Cambridge.
• Suppose we have a multivariate model
y = f (x) + ε,
where f (x) is of unknown form and x is a P−dimensional vector. For simplicity,

assume that ε is a classical error. Let us take the estimation of the vector of
elasticities with typical element
xi ∂ f (x)
ξ xi = ,
f (x) ∂xi f (x)
at an arbitrary point xi .
The Fourier form, following Gallant (1982), but with a somewhat different parameteriza-
tion, may be written as
A J
(18.3.1) gK (x | θK ) = α + x0β + 1/2x0Cx + ∑∑ u jα cos( jk0α x) − v jα sin( jk0α x) .
α=1 j=1
where the K-dimensional parameter vector
(18.3.2) θK = {α, β0 , vec∗ (C)0 , u11 , v11 , . . . , uJA , vJA }0 .
• We assume that the conditioning variables x have each been transformed to lie in
an interval that is shorter than 2π. This is required to avoid periodic behavior of
the approximation, which is desirable since economic functions aren’t periodic.
For example, subtract sample means, divide by the maxima of the conditioning
variables, and multiply by 2π − eps, where eps is some positive number less than
2π in value.
• The kα are ”elementary multi-indices” which are simply P− vectors formed of
integers (negative, positive and zero). The kα , α = 1, 2, ..., A are required to be
linearly independent, and we follow the convention that the first non-zero element
be positive. For example
h i0
0 1 −1 0 1
is a potential multi-index to be used, but

h i0
0 −1 −1 0 1
is not since its first nonzero element is negative. Nor is

h i0
0 2 −2 0 2
a multi-index we would use, since it is a scalar multiple of the original multi-

index.
• We parameterize the matrix C differently than does Gallant because it simplifies
things in practice. The cost of this is that we are no longer able to test a quadratic
specification using nested testing.
The vector of first partial derivatives is
A J
(18.3.3) Dx gK (x | θK ) = β + Cx + ∑∑ −u jα sin( jk0α x) − v jα cos( jk0α x) jkα
α=1 j=1
and the matrix of second partial derivatives is
A J
(18.3.4) D2x gK (x|θK ) = C + ∑∑ −u jα cos( jk0α x) + v jα sin( jk0α x) j2 kα k0α
α=1 j=1
To define a compact notation for partial derivatives, let λ be an N-dimensional multi-

index with no negative elements. Define | λ |∗ as the sum of the elements of λ. If we
have N arguments x of the (arbitrary) function h(x), use Dλ h(x) to indicate a certain partial
derivative: ∗
λ ∂|λ|
D h(x) ≡ h(x)
∂xλ1 1 ∂xλ2 2 · · · ∂xλNN
When λ is the zero vector, Dλ h(x) ≡ h(x). Taking this definition and the last few equations
into account, we see that it is possible to define (1 × K) vector Z λ (x) so that
(18.3.5) Dλ gK (x|θK ) = zλ (x)0 θK .
• Both the approximating model and the derivatives of the approximating model
are linear in the parameters.
• For the approximating model to the function (not derivatives), write g K (x|θK ) =
z0 θK for simplicity.
The following theorem can be used to prove the consistency of the Fourier form.
T HEOREM 28. [Gallant and Nychka, 1987] Suppose that ĥn is obtained by maximizing
a sample objective function sn (h) over HKn where HK is a subset of some function space
H on which is defined a norm k h k. Consider the following conditions:
(a) Compactness: The closure of H with respect to k h k is compact in the relative
topology defined by k h k.
(b) Denseness: ∪K HK , K = 1, 2, 3, ... is a dense subset of the closure of H with respect
to k h k and HK ⊂ HK+1 .
(c) Uniform convergence: There is a point h∗ in H and there is a function s∞ (h, h∗ )
that is continuous in h with respect to k h k such that
lim sup | sn (h) − s∞(h, h∗ ) |= 0

n→∞
H
almost surely.
(d) Identification: Any point h in the closure of H with s∞ (h, h∗ ) ≥ s∞ (h∗ , h∗ ) must
have k h − h∗ k= 0.
Under these conditions limn→∞ k h∗ − ĥn k= 0 almost surely, provided that limn→∞ Kn =
∞ almost surely.
The modification of the original statement of the theorem that has been made is to set
the parameter space Θ in Gallant and Nychka’s (1987) Theorem 0 to a single point and to
state the theorem in terms of maximization rather than minimization.
This theorem is very similar in form to Theorem 19. The main differences are:
(1) A generic norm k h k is used in place of the Euclidean norm. This norm may
be stronger than the Euclidean norm, so that convergence with respect to k h k
implies convergence w.r.t the Euclidean norm. Typically we will want to make
sure that the norm is strong enough to imply convergence of all functions of
interest.
(2) The “estimation space” H is a function space. It plays the role of the parameter
space Θ in our discussion of parametric estimators. There is no restriction to a
parametric family, only a restriction to a space of functions that satisfy certain
conditions. This formulation is much less restrictive than the restriction to a
parametric family.
(3) There is a denseness assumption that was not present in the other theorem.
We will not prove this theorem (the proof is quite similar to the proof of theorem [19], see
Gallant, 1987) but we will discuss its assumptions, in relation to the Fourier form as the
approximating model.
18.3.1. Sobolev norm. Since all of the assumptions involve the norm k h k , we need
to make explicit what norm we wish to use. We need a norm that guarantees that the
errors in approximation of the functions we are interested in are accounted for. Since we
are interested in first-order elasticities in the present case, we need close approximation
of both the function f (x) and its first derivative f 0 (x), throughout the range of x. Let X
be an open set that contains all values of x that we’re interested in. The Sobolev norm is
appropriate in this case. It is defined, making use of our notation for partial derivatives, as:

k h km,X = max sup Dλ h(x)
∗
|λ |≤m X
To see whether or not the function f (x) is well approximated by an approximating model
gK (x | θK ), we would evaluate
k f (x) − gK (x | θK ) km,X .
We see that this norm takes into account errors in approximating the function and partial
derivatives up to order m. If we want to estimate first order elasticities, as is the case in this
example, the relevant m would be m = 1. Furthermore, since we examine the sup over X ,
convergence w.r.t. the Sobolev means uniform convergence, so that we obtain consistent
estimates for all values of x.
18.3.2. Compactness. Verifying compactness with respect to this norm is quite tech-
nical and unenlightening. It is proven by Elbadawi, Gallant and Souza, Econometrica,
1983. The basic requirement is that if we need consistency w.r.t. k h k m,X , then the func-
tions of interest must belong to a Sobolev space which takes into account derivatives of
order m + 1. A Sobolev space is the set of functions
Wm,X (D) = {h(x) :k h(x) km,X < D},
where D is a finite constant. In plain words, the functions must have bounded partial
derivatives of one order higher than the derivatives we seek to estimate.
18.3.3. The estimation space and the estimation subspace. Since in our case we’re
interested in consistent estimation of first-order elasticities, we’ll define the estimation
space as follows:
D EFINITION 29. [Estimation space] The estimation space H = W2,X (D). The esti-
mation space is an open set, and we presume that h∗ ∈ H .
So we are assuming that the function to be estimated has bounded second derivatives
throughout X .
With seminonparametric estimators, we don’t actually optimize over the estimation
space. Rather, we optimize over a subspace, HKn , defined as:
D EFINITION 30. [Estimation subspace] The estimation subspace HK is defined as
HK = {gK (x|θK ) : gK (x|θK ) ∈ W2,Z (D), θK ∈ ℜK },
where gK (x, θK ) is the Fourier form approximation as defined in Equation 18.3.1.
18.3.4. Denseness. The important point here is that HK is a space of functions that
is indexed by a finite dimensional parameter (θK has K elements, as in equation 18.3.2).
With n observations, n > K, this parameter is estimable. Note that the true function h ∗ is
not necessarily an element of HK , so optimization over HK may not lead to a consistent
estimator. In order for optimization over HK to be equivalent to optimization over H , at
least asymptotically, we need that:
(1) The dimension of the parameter vector, dim θKn → ∞ as n → ∞. This is achieved
by making A and J in equation 18.3.1 increasing functions of n, the sample size.
It is clear that K will have to grow more slowly than n. The second requirement
is:
(2) We need that the HK be dense subsets of H .
The estimation subspace HK , defined above, is a subset of the closure of the estimation
space, H . A set of subsets Aa of a set A is “dense” if the closure of the countable union
of the subsets is equal to the closure of A :
∪∞
a=1 Aa = A
Use a picture here. The rest of the discussion of denseness is provided just for completeness:
there’s no need to study it in detail. To show that HK is a dense subset of H with respect
to k h k1,X , it is useful to apply Theorem 1 of Gallant (1982), who in turn cites Edmunds
and Moscatelli (1977). We reproduce the theorem as presented by Gallant, with minor
notational changes, for convenience of reference:
T HEOREM 31. [Edmunds and Moscatelli, 1977] Let the real-valued function h ∗ (x)
be continuously differentiable up to order m on an open set containing the closure of X .
Then it is possible to choose a triangular array of coefficients θ1 , θ2 , . . . θK , . . . , such that
for every q with 0 ≤ q < m, and every ε > 0, k h∗ (x) − hK (x|θK ) kq,X = o(K −m+q+ε ) as
K → ∞.
In the present application, q = 1, and m = 2. By definition of the estimation space, the

elements of H are once continuously differentiable on X , which is open and contains the
closure of X , so the theorem is applicable. Closely following Gallant and Nychka (1987),
∪∞ HK is the countable union of the HK . The implication of Theorem 31 is that there is a
sequence of {hK } from ∪∞ HK such that
lim k h∗ − hK k1,X = 0,
K→∞
for all h∗ ∈ H . Therefore,

H ⊂ ∪ ∞ HK .
However,
∪ ∞ HK ⊂ H ,
so
∪ ∞ HK ⊂ H .
Therefore
H = ∪ ∞ HK ,
so ∪∞ HK is a dense subset of H , with respect to the norm k h k1,X .
18.3.5. Uniform convergence. We now turn to the limiting objective function. We

estimate by OLS. The sample objective function stated in terms of maximization is
1 n
sn (θK ) = − ∑ (yt − gK (xt | θK ))2
n t=1
With random sampling, as in the case of Equations 14.3.1 and 17.2.1, the limiting objective
function is
Z
(18.3.6) s∞ (g, f ) = − ( f (x) − g(x))2 dµx − σ2ε .
X
where the true function f (x) takes the place of the generic function h ∗ in the presentation
of the theorem. Both g(x) and f (x) are elements of ∪∞ HK .
The pointwise convergence of the objective function needs to be strengthened to uni-
form convergence. We will simply assume that this holds, since the way to verify this
depends upon the specific application. We also have continuity of the objective function in
g, with respect to the norm k h k1,X since

lim s∞ g 1 , f ) − s ∞ g 0 , f )
kg1 −g0 k1,X →0
Z h 2 2 i
= lim g1 (x) − f (x) − g0 (x) − f (x) dµx.
kg1 −g0 k1,X →0 X
By the dominated convergence theorem (which applies since the finite bound D used to
define W2,Z (D) is dominated by an integrable function), the limit and the integral can be
interchanged, so by inspection, the limit is zero.
18.3.6. Identification. The identification condition requires that for any point (g, f )
in H × H , s∞ (g, f ) ≥ s∞ ( f , f ) ⇒ k g − f k1,X = 0. This condition is clearly satisfied given
that g and f are once continuously differentiable (by the assumption that defines the esti-
mation space).
18.3.7. Review of concepts. For the example of estimation of first-order elasticities,

the relevant concepts are:
• Estimation space H = W2,X (D): the function space in the closure of which the
true function must lie.
• Consistency norm k h k1,X . The closure of H is compact with respect to this
norm.
• Estimation subspace HK . The estimation subspace is the subset of H that is rep-
resentable by a Fourier form with parameter θK . These are dense subsets of H .
• Sample objective function sn (θK ), the negative of the sum of squares. By stan-
dard arguments this converges uniformly to the
18.4. KERNEL REGRESSION ESTIMATORS 240
• Limiting objective function s∞ ( g, f ), which is continuous in g and has a global

maximum in its first argument, over the closure of the infinite union of the esti-
mation subpaces, at g = f .
• As a result of this, first order elasticities
xi ∂ f (x)
f (x) ∂xi f (x)
are consistently estimated for all x ∈ X .
18.3.8. Discussion. Consistency requires that the number of parameters used in the
expansion increase with the sample size, tending to infinity. If parameters are added at a
high rate, the bias tends relatively rapidly to zero. A basic problem is that a high rate of
inclusion of additional parameters causes the variance to tend more slowly to zero. The
issue of how to chose the rate at which parameters are added and which to add first is
fairly complex. A problem is that the allowable rates for asymptotic normality to obtain
(Andrews 1991; Gallant and Souza, 1991) are very strict. Supposing we stick to these rates,
our approximating model is:
gK (x|θK ) = z0 θK .
• Define ZK as the n × K matrix of regressors obtained by stacking observations.
The LS estimator is
+
θ̂K = Z0K ZK Z0K y,
where (·)+ is the Moore-Penrose generalized inverse.
– This is used since Z0K ZK may be singular, as would be the case for K(n)
large enough when some dummy variables are included.
• . The prediction, z0 θ̂K , of the unknown function f (x) is asymptotically normally
distributed:
√ d
n z0 θ̂K − f (x) → N(0, AV ),
where " + #
0 ZK ZK
0
2
AV = lim E z zσ̂ .
n→∞ n
Formally, this is exactly the same as if we were dealing with a parametric linear
model. I emphasize, though, that this is only valid if K grows very slowly as
n grows. If we can’t stick to acceptable rates, we should probably use some
other method of approximating the small sample distribution. Bootstrapping is a
possibility. We’ll discuss this in the section on simulation.
18.4. Kernel regression estimators
Readings: Bierens, 1987, “Kernel estimators of regression functions,” in Advances in

Econometrics, Fifth World Congress, V. 1, Truman Bewley, ed., Cambridge.
An alternative method to the semi-nonparametric method is a fully nonparametric
method of estimation. Kernel regression estimation is an example (others are splines, near-
est neighbor, etc.). We’ll consider the Nadaraya-Watson kernel regression estimator in a
simple case.
• Suppose we have an iid sample from the joint density f (x, y), where x is k -
dimensional. The model is
yt = g(xt ) + εt ,
where
E(εt |xt ) = 0.
• The conditional expectation of y given x is g(x). By definition of the conditional
expectation, we have
f (x, y)
Z
g(x) = y dy
h(x)
1
Z
= y f (x, y)dy,
h(x)
where h(x) is the marginal density of x :
Z
h(x) = f (x, y)dy.
• This suggests that we could estimate g(x) by estimating h(x) and y f (x, y)dy.
R
18.4.1. Estimation of the denominator. A kernel estimator for h(x) has the form
1 n K [(x − xt ) /γn ]
ĥ(x) = ∑
n t=1 γkn
,
where n is the sample size and k is the dimension of x.
• The function K(·) (the kernel) is absolutely integrable:

Z
|K(x)|dx < ∞,
and K(·) integrates to 1 :

Z
K(x)dx = 1.
In this respect, K(·) is like a density function, but we do not necessarily restrict
K(·) to be nonnegative.
• The window width parameter, γn is a sequence of positive numbers that satisfies
lim γn = 0
n→∞
lim nγkn = ∞
n→∞
So, the window width must tend to zero, but not too quickly.
• To show pointwise consistency of ĥ(x) for h(x), first consider the expectation
of the estimator (since the estimator is an average of iid terms we only need to
consider the expectation of a representative term):
Z
E ĥ(x) = γ−k n K [(x − z)/γn ] h(z)dz.
Change variables as z∗ = (x − z)/γn, so z = x − γn z∗ and | dzdz∗0 | = γkn , we obtain

Z
∗ k ∗
E ĥ(x) = γ−k
n K (z ) h(x − γn z )γn dz
∗
Z
= K (z∗ ) h(x − γnz∗ )dz∗ .
Now, asymptotically,
Z
lim E ĥ(x) = lim K (z∗ ) h(x − γnz∗ )dz∗
n→∞ n→∞
Z
= lim K (z∗ ) h(x − γnz∗ )dz∗
n→∞
Z
= K (z∗ ) h(x)dz∗
Z
= h(x) K (z∗ ) dz∗
= h(x),
since γn → 0 and K (z∗ ) dz∗ = 1 by assumption. (Note: that we can pass the
R
limit through the integral is a result of the dominated convergence theorem.. For
this to hold we need that h(·) be dominated by an absolutely integrable function.
• Next, considering the variance of ĥ(x), we have, due to the iid assumption
n
k 1 K [(x − xt ) /γn ]

nγnV ĥ(x) = nγn 2 ∑ V
k
n t=1 γkn
1 n
= γ−k
n ∑ V {K [(x − xt ) /γn ]}
n t=1
• By the representative term argument, this is

nγknV ĥ(x) = γ−k
n V {K [(x − z)/γn ]}
• Also, since V (x) = E(x2 ) − E(x)2 we have

n o
2 2
nγknV ĥ(x) = γ−k n E (K [(x − z) /γn ]) − γ−k
n {E (K [(x − z)/γn ])}
Z Z 2
2 k
= γ−k
n K [(x − z)/γ n ] h(z)dz − γ n γ −k
n K [(x − z)/γ n ] h(z)dz
Z h i2
2 k b
= γ−k
n K [(x − z)/γ n ] h(z)dz − γ n E h(x)
The second term converges to zero:

h i2
γkn E bh(x) → 0,
by the previous result regarding the expectation and the fact that γ n → 0. There-
fore,
Z
2
lim nγknV ĥ(x) = lim γ−k n K [(x − z)/γn ] h(z)dz.
n→∞ n→∞
Using exactly the same change of variables as before, this can be shown to be
Z
lim nγknV ĥ(x) = h(x) [K(z∗ )]2 dz∗ .
n→∞
Since both [K(z∗ )]2 dz∗ and h(x) are bounded, this is bounded, and since nγkn →
R
∞ by assumption, we have that

V ĥ(x) → 0.
• Since the bias and the variance both go to zero, we have pointwise consistency
(convergence in quadratic mean implies convergence in probability).
18.4.2. Estimation of the numerator. To estimate y f (x, y)dy, we need an estima-

R
tor of f (x, y). The estimator has the same form as the estimator for h(x), only with one
dimension more:
1 n K∗ [(y − yt ) /γn , (x − xt ) /γn ]
fˆ(x, y) = ∑
n t=1 γk+1
n
The kernel K∗ (·) is required to have mean zero:
Z
yK∗ (y, x) dy = 0
and to marginalize to the previous kernel for h(x) :

Z
K∗ (y, x) dy = K(x).
With this kernel, we have

1 n K [(x − xt ) /γn ]
Z
y fˆ(y, x)dy = ∑ yt
n t=1 γkn
by marginalization of the kernel, so we obtain
1
Z
ĝ(x) = y fˆ(y, x)dy
ĥ(x)
1 n K[(x−xt )/γn ]
n ∑t=1 yt γkn
=
1 n K[(x−xt )/γn ]
n ∑t=1 γkn
n
∑t=1 yt K [(x − xt ) /γn ]
= n .
∑t=1 K [(x − xt ) /γn ]
This is the Nadaraya-Watson kernel regression estimator.
18.4.3. Discussion.
• The kernel regression estimator for g(xt ) is a weighted average of the y j , j =
1, 2, ..., n, where higher weights are associated with points that are closer to xt .
The weights sum to 1.
• The window width parameter γn imposes smoothness. The estimator is increas-
ingly flat as γn → ∞, since in this case each weight tends to 1/n.
• A large window width reduces the variance (strong imposition of flatness), but
increases the bias.
• A small window width reduces the bias, but makes very little use of informa-
tion except points that are in a small neighborhood of xt . Since relatively little
information is used, the variance is large when the window width is small.
• The standard normal density is a popular choice for K(.) and K∗ (y, x), though
there are possibly better alternatives.
18.6. SEMI-NONPARAMETRIC MAXIMUM LIKELIHOOD 244
18.4.4. Choice of the window width: Cross-validation. The selection of an appro-

priate window width is important. One popular method is cross validation. This consists
of splitting the sample into two parts (e.g., 50%-50%). The first part is the “in sample”
data, which is used for estimation, and the second part is the “out of sample” data, used for
evaluation of the fit though RMSE or some other criterion. The steps are:
(1) Split the data. The out of sample data is yout and xout .
(2) Choose a window width γ.
(3) With the in sample data, fit ŷtout corresponding to each xtout . This fitted value is a
function of the in sample data, as well as the evaluation point xtout , but it does not
involve ytout .
(4) Repeat for all out of sample points.
(5) Calculate RMSE(γ)
(6) Go to step 2, or to the next step if enough window widths have been tried.
(7) Select the γ that minimizes RMSE(γ) (Verify that a minimum has been found, for
example by plotting RMSE as a function of γ).
(8) Re-estimate using the best γ and all of the data.
This same principle can be used to choose A and J in a Fourier form model.
18.5. Kernel density estimation
The previous discussion suggests that a kernel density estimator may easily be con-
structed. We have already seen how joint densities may be estimated. If were interested
in a conditional density, for example of y conditional on x, then the kernel estimate of the
conditional density is simply
fˆ(x, y)
fby|x =
ĥ(x)
1 n K∗ [(y−yt )/γn ,(x−xt )/γn ]
n ∑t=1 γnk+1
= K[(x−x
1 n t )/γn ]
n ∑t=1 γkn
n
1 ∑t=1 K∗ [(y − yt ) /γn , (x − xt ) /γn ]
= n
γn ∑t=1 K [(x − xt ) /γn ]
where we obtain the expressions for the joint and marginal densities from the section on
kernel regression.
18.6. Semi-nonparametric maximum likelihood
Readings: Gallant and Nychka, Econometrica, 1987. For a Fortran program to do this
and a useful discussion in the user’s guide, see
this link . See also Cameron and Johansson, Journal of Applied Econometrics, V. 12,
1997.
MLE is the estimation method of choice when we are confident about specifying the
density. Is is possible to obtain the benefits of MLE when we’re not so confident about the
specification? In part, yes.
Suppose we’re interested in the density of y conditional on x (both may be vectors).
Suppose that the density f (y|x, φ) is a reasonable starting approximation to the true density.
This density can be reshaped by multiplying it by a squared polynomial. The new density
is
h2p (y|γ) f (y|x, φ)
g p (y|x, φ, γ) =
η p (x, φ, γ)
where
p
h p (y|γ) = ∑ γk yk
k=0
and η p (x, φ, γ) is a normalizing factor to make the density integrate (sum) to one. Because
h2p (y|γ)/η p (x, φ, γ) is a homogenous function of θ it is necessary to impose a normalization:
γ0 is set to 1. The normalization factor η p (φ, γ) is calculated (following Cameron and
Johansson) using
∞
E(Y r ) = ∑ yr fY (y|φ, γ)
y=0
∞
[h p (y|γ)]2
= ∑ yr η p (φ, γ)
fY (y|φ)
y=0
∞ p p
= ∑ ∑ ∑ yr fY (y|φ)γk γl yk yl /η p(φ, γ)
y=0 k=0 l=0
( )
p p ∞
= ∑ ∑ γk γl ∑ y r+k+l
fY (y|φ) /η p (φ, γ)
k=0 l=0 y=0
p p
= ∑ ∑ γk γl mk+l+r /η p (φ, γ).
k=0 l=0
By setting r = 0 we get that the normalizing factor is

18.6.1
p p
(18.6.1) η p (φ, γ) = ∑ ∑ γk γl mk+l
k=0 l=0
Recall that γ0 is set to 1 to achieve identification. The mr in equation 18.6.1 are the raw mo-
ments of the baseline density. Gallant and Nychka (1987) give conditions under which such
a density may be treated as correctly specified, asymptotically. Basically, the order of the
polynomial must increase as the sample size increases. However, there are technicalities.
Similarly to Cameron and Johannson (1997), we may develop a negative binomial
polynomial (NBP) density for count data. The negative binomial baseline density may be
written (see equation as
ψ y
Γ(y + ψ) ψ λ
fY (y|φ) =
Γ(y + 1)Γ(ψ) ψ + λ ψ+λ
where φ = {λ, ψ}, λ > 0 and ψ > 0. The usual means of incorporating conditioning vari-
ables x is the parameterization λ = ex β . When ψ = λ/α we have the negative binomial-I
0
model (NB-I). When ψ = 1/α we have the negative binomial-II (NP-II) model. For the
NB-I density, V (Y ) = λ + αλ. In the case of the NB-II model, we have V (Y ) = λ + αλ 2 .
For both forms, E(Y ) = λ.
The reshaped density, with normalization to sum to one, is
ψ y
[h p (y|γ)]2 Γ(y + ψ) ψ λ
(18.6.2) fY (y|φ, γ) = .
η p (φ, γ) Γ(y + 1)Γ(ψ) ψ + λ ψ+λ
F IGURE 18.6.1. Negative binomial raw moments
To get the normalization factor, we need the moment generating function:

−ψ
(18.6.3) MY (t) = ψψ λ − et λ + ψ .
To illustrate, Figure 18.6.1 shows calculation of the first four raw moments of the NB den-
sity, calculated using MuPAD, which is a Computer Algebra System that (use to be?) free
for personal use. These are the moments you would need to use a second order polynomial
(p = 2). MuPAD will output these results in the form of C code, which is relatively easy to
edit to write the likelihood function for the model. This has been done in NegBinSNP.cc,
which is a C++ version of this model that can be compiled to use with octave using the
mkoctfile command. Note the impressive length of the expressions when the degree of
the expansion is 4 or 5! This is an example of a model that would be difficult to formulate
without the help of a program like MuPAD.
It is possible that there is conditional heterogeneity such that the appropriate reshaping
should be more local. This can be accomodated by allowing the γ k parameters to depend
upon the conditioning variables, for example using polynomials.
Gallant and Nychka, Econometrica, 1987 prove that this sort of density can approxi-
mate a wide variety of densities arbitrarily well as the degree of the polynomial increases
with the sample size. This approach is not without its drawbacks: the sample objective
function can have an extremely large number of local maxima that can lead to numeric
difficulties. If someone could figure out how to do in a way such that the sample objec-
tive function was nice and smooth, they would probably get the paper published in a good
journal. Any ideas?
18.7. EXAMPLES 247
Here’s a plot of true and the limiting SNP approximations (with the order of the poly-
nomial fixed) to four different count data densities, which variously exhibit over and un-
derdispersion, as well as excess zeros. The baseline model is a negative binomial density.
Case 1 Case 2
.5
.4 .1
.3
.2 .05
.1
0 5 10 15 20 0 5 10 15 20 25
Case 3 Case 4
.25 .2
.2 .15
.15
.1
.1
.05
.05
1 2 3 4 5 6 7 2.5 5 7.5 10 12.5 15
18.7. Examples
We’ll use the MEPS OBDV data to illustrate kernel regression and semi-nonparametric
maximum likelihood.
18.7.1. Kernel regression estimation. Let’s try a kernel regression fit for the OBDV
data. The program OBDVkernel.m loads the MEPS OBDV data, scans over a range of
window widths and calculates leave-one-out CV scores, and plots the fitted OBDV usage
versus AGE, using the best window width. The plot is in Figure 18.7.1. Note that us-
age increases with age, just as we’ve seen with the parametric models. Once could use
bootstrapping to generate a confidence interval to the fit.
18.7.2. Seminonparametric ML estimation and the MEPS data. Now let’s esti-
mate a seminonparametric density for the OBDV data. We’ll reshape a negative binomial
density, as discussed above. The program EstimateNBSNP.m loads the MEPS OBDV data
and estimates the model, using a NB-I baseline density and a 2nd order polynomial expan-
sion. The output is:
18.7. EXAMPLES 248
F IGURE 18.7.1. Kernel fitted OBDV usage versus AGE

Kernel fit, OBDV visits versus AGE
5
4.5
3.5
2.5
2
15 20 25 30 35 40 45 50 55 60 65
OBDV
======================================================
Used numeric gradient
------------------------------------------------------
STRONG CONVERGENCE
------------------------------------------------------
Stepsize 0.0065
24 iterations
------------------------------------------------------

1.3826 0.0000 -0.0000
0.2317 -0.0000 0.0000
0.1839 0.0000 0.0000
0.2214 0.0000 -0.0000
0.1898 0.0000 -0.0000
0.0722 0.0000 -0.0000
-0.0002 0.0000 -0.0000
1.7853 -0.0000 -0.0000
-0.4358 0.0000 -0.0000
0.1129 0.0000 0.0000
18.7. EXAMPLES 249
******************************************************
NegBin SNP model, MEPS full data set


Observations: 4564

constant -0.147 0.126 -1.173 0.241
pub. ins. 0.695 0.050 13.936 0.000
priv. ins. 0.409 0.046 8.833 0.000
sex 0.443 0.034 13.148 0.000
age 0.016 0.001 11.880 0.000
edu 0.025 0.006 3.903 0.000
inc -0.000 0.000 -0.011 0.991
gam1 1.785 0.141 12.629 0.000
gam2 -0.436 0.029 -14.786 0.000
lnalpha 0.113 0.027 4.166 0.000
CAIC : 19907.6244 Avg. CAIC: 4.3619
BIC : 19897.6244 Avg. BIC: 4.3597
AIC : 19833.3649 Avg. AIC: 4.3456
******************************************************
Note that the CAIC and BIC are lower for this model than for the models presented in
Table 3. This model fits well, still being parsimonious. You can play around trying other
use measures, using a NP-II baseline density, and using other orders of expansions. Density
functions formed in this way may have MANY local maxima, so you need to be careful
before accepting the results of a casual run. To guard against having converged to a local
maximum, one can try using multiple starting values, or one could try simulated annealing
as an optimization method. If you uncomment the relevant lines in the program, you can
use SA to do the minimization. This will take a lot of time, compared to the default BFGS
minimization. The chapter on parallel computations might be interesting to read before
trying this.
CHAPTER 19
Simulation-based estimation
Readings: In addition to the book mentioned previously, articles include Gallant and
Tauchen (1996), “Which Moments to Match?”, ECONOMETRIC THEORY, Vol. 12, 1996,
pages 657-681;ă Gourieroux, Monfort and Renault (1993), “Indirect Inference,” J. Apl.
Econometrics; Pakes and Pollard (1989) Econometrica; McFadden (1989) Econometrica.
19.1. Motivation
Simulation methods are of interest when the DGP is fully characterized by a parameter
vector, but the likelihood function is not calculable. If it were available, we would simply
estimate by MLE, which is asymptotically fully efficient.
19.1.1. Example: Multinomial and/or dynamic discrete response models. Let y ∗i

be a latent random vector of dimension m. Suppose that
y∗i = Xi β + εi
where Xi is m × K. Suppose that
(19.1.1) εi ∼ N(0, Ω)
Henceforth drop the i subscript when it is not needed for clarity.

• y∗ is not observed. Rather, we observe a many-to-one mapping
y = τ(y∗ )
This mapping is such that each element of y is either zero or one (in some cases
only one element will be one).
• Define
Ai = A(yi ) = {y∗ |yi = τ(y∗ )}
Suppose random sampling of (yi , Xi ). In this case the elements of yi may not be
independent of one another (and clearly are not if Ω is not diagonal). However,
yi is independent of y j , i 6= j.
• Let θ = (β0 , (vec∗ Ω)0 )0 be the vector of parameters of the model. The contribution
of the ith observation to the likelihood function is
Z
pi (θ) = n(y∗i − Xi β, Ω)dy∗i
Ai
where
−1/2 −ε0 Ω−1 ε
n(ε, Ω) = (2π) −M/2
|Ω| exp
2
250
19.1. MOTIVATION 251
is the multivariate normal density of an M -dimensional random vector. The log-

likelihood function is
1 n
ln L (θ) = ∑ ln pi (θ)
n i=1
and the MLE θ̂ solves the score equations

1 n 1 n Dθ pi (θ̂)
∑
n i=1
gi (θ̂) = ∑
n i=1 pi (θ̂)
≡ 0.
• The problem is that evaluation of Li (θ) and its derivative w.r.t. θ by standard
methods of numeric integration such as quadrature is computationally infeasi-
ble when m (the dimension of y) is higher than 3 or 4 (as long as there are no
restrictions on Ω).
• The mapping τ(y∗ ) has not been made specific so far. This setup is quite general:
for different choices of τ(y∗ ) it nests the case of dynamic binary discrete choice
models as well as the case of multinomial discrete choice (the choice of one out
of a finite set of alternatives).
– Multinomial discrete choice is illustrated by a (very simple) job search model.
We have cross sectional data on individuals’ matching to a set of m jobs that
are available (one of which is unemployment). The utility of alternative j is
u j = Xjβ + ε j
Utilities of jobs, stacked in the vector ui are not observed. Rather, we ob-
serve the vector formed of elements
y j = 1 [u j > uk , ∀k ∈ m, k 6= j]
Only one of these elements is different than zero.

– Dynamic discrete choice is illustrated by repeated choices over time between
two alternatives. Let alternative j have utility
u jt = W jt β − ε jt ,
j ∈ {1, 2}
t ∈ {1, 2, ..., m}
Then
y∗ = u2 − u1
= (W2 −W1 )β + ε2 − ε1
≡ Xβ + ε
Now the mapping is (element-by-element)
y = 1 [y∗ > 0] ,
that is yit = 1 if individual i chooses the second alternative in period t, zero

otherwise.
19.1.2. Example: Marginalization of latent variables. Economic data often presents

substantial heterogeneity that may be difficult to model. A possibility is to introduce latent
random variables. This can cause the problem that there may be no known closed form
for the distribution of observable variables after marginalizing out the unobservable latent
variables. For example, count data (that takes values 0, 1, 2, 3, ...) is often modeled using
the Poisson distribution
exp(−λ)λi
Pr(y = i) =
i!
The mean and variance of the Poisson distribution are both equal to λ :
E (y) = V (y) = λ.
Often, one parameterizes the conditional mean as
λi = exp(Xi β).
This ensures that the mean is positive (as it must be). Estimation by ML is straightforward.
Often, count data exhibits “overdispersion” which simply means that
V (y) > E (y).
If this is the case, a solution is to use the negative binomial distribution rather than the
Poisson. An alternative is to introduce a latent variable that reflects heterogeneity into the
specification:
λi = exp(Xi β + ηi )
where ηi has some specified density with support S (this density may depend on additional
parameters). Let dµ(ηi ) be the density of ηi . In some cases, the marginal density of y
exp[− exp(Xi β + ηi)] [exp(Xi β + ηi )]yi
Z
Pr(y = yi ) = dµ(ηi )
S yi !
will have a closed-form solution (one can derive the negative binomial distribution in the
way if η has an exponential distribution), but often this will not be possible. In this case,
simulation is a means of calculating Pr(y = i), which is then used to do ML estimation.
This would be an example of the Simulated Maximum Likelihood (SML) estimation.
• In this case, since there is only one latent variable, quadrature is probably a bet-
ter choice. However, a more flexible model with heterogeneity would allow all
parameters (not just the constant) to vary. For example
exp[− exp(Xi βi )] [exp(Xi βi )]yi
Z
Pr(y = yi ) = dµ(βi )
S yi !
entails a K = dimβi -dimensional integral, which will not be evaluable by quad-
rature when K gets large.
19.1.3. Estimation of models specified in terms of stochastic differential equa-

tions. It is often convenient to formulate models in terms of continuous time using dif-
ferential equations. A realistic model should account for exogenous shocks to the system,
which can be done by assuming a random component. This leads to a model that is ex-
pressed as a system of stochastic differential equations. Consider the process
dyt = g(θ, yt )dt + h(θ, yt )dWt
which is assumed to be stationary. {Wt } is a standard Brownian motion (Weiner process),

such that Z T
W (T ) = dWt ∼ N(0, T )
0
Brownian motion is a continuous-time stochastic process such that
• W (0) = 0
• [W (s) −W (t)] ∼ N(0, s − t)
• [W (s) −W (t)] and [W ( j) −W (k)] are independent for s > t > j > k. That is,
non-overlapping segments are independent.
One can think of Brownian motion the accumulation of independent normally distributed
shocks with infinitesimal variance.
• The function g(θ, yt ) is the deterministic part.

• h(θ, yt ) determines the variance of the shocks.
To estimate a model of this sort, we typically have data that are assumed to be observations
of yt in discrete points y1 , y2 , ...yT . That is, though yt is a continuous process it is observed
in discrete time.
To perform inference on θ, direct ML or GMM estimation is not usually feasible,
because one cannot, in general, deduce the transition density f (yt |yt−1 , θ). This density is
necessary to evaluate the likelihood function or to evaluate moment conditions (which are
based upon expectations with respect to this density).
• A typical solution is to “discretize” the model, by which we mean to find a dis-

crete time approximation to the model. The discretized version of the model is
yt − yt−1 = g(φ, yt−1 ) + h(φ, yt−1 )εt

εt ∼ N(0, 1)
The discretization induces a new parameter, φ (that is, the φ0 which defines
the best approximation of the discretization to the actual (unknown) discrete
time version of the model is not equal to θ0 which is the true parameter value).
This is an approximation, and as such “ML” estimation of φ (which is actually
quasi-maximum likelihood, QML) based upon this equation is in general biased
and inconsistent for the original parameter, θ. Nevertheless, the approximation
shouldn’t be too bad, which will be useful, as we will see.
• The important point about these three examples is that computational difficulties
prevent direct application of ML, GMM, etc. Nevertheless the model is fully
specified in probabilistic terms up to a parameter vector. This means that the
model is simulable, conditional on the parameter vector.
19.2. SIMULATED MAXIMUM LIKELIHOOD (SML) 254
19.2. Simulated maximum likelihood (SML)
For simplicity, consider cross-sectional data. An ML estimator solves

1 n
θ̂ML = argmaxsn (θ) = ∑ ln p(yt |Xt , θ)
n t=1
where p(yt |Xt , θ) is the density function of the t th observation. When p(yt |Xt , θ) does not
have a known closed form, θ̂ML is an infeasible estimator. However, it may be possible to
define a random function such that
Eν f (ν, yt , Xt , θ) = p(yt |Xt , θ)
where the density of ν is known. If this is the case, the simulator

H
1
p̃ (yt , Xt , θ) =
H ∑ f (νts , yt , Xt , θ)
s=1
is unbiased for p(yt |Xt , θ).
• The SML simply substitutes p̃ (yt , Xt , θ) in place of p(yt |Xt , θ) in the log-likelihood
function, that is
1 n
θ̂SML = argmaxsn (θ) = ∑ ln p̃ (yt , Xt , θ)
n i=1
19.2.1. Example: multinomial probit. Recall that the utility of alternative j is
u j = Xjβ + ε j
and the vector y is formed of elements
y j = 1 [u j > uk , k ∈ m, k 6= j]
The problem is that Pr(y j = 1|θ) can’t be calculated when m is larger than 4 or 5. However,
it is easy to simulate this probability.
• Draw ε̃i from the distribution N(0, Ω)

• Calculate ũi = Xi β + ε̃i (where Xi is the matrix formed by stacking the Xi j )
• Define ỹi j = 1 [ui j > uik , ∀k ∈ m, k 6= j]
• Repeat this H times and define
∑Hh=1 ỹi jh
πi j =
e
H
• Define π
ei as the m-vector formed of the π πi is between 0 and
ei j . Each element of e
1, and the elements sum to one.
• Now p̃ (yi , Xi , θ) = y0i e
πi
• The SML multinomial probit log-likelihood function is
1 n 0
ln L (β, Ω) = ∑ yi ln p̃ (yi , Xi , θ)
n i=1
This is to be maximized w.r.t. β and Ω.
Notes:
19.2. SIMULATED MAXIMUM LIKELIHOOD (SML) 255
• The H draws of ε̃i are draw only once and are used repeatedly during the iterations
used to find β̂ and Ω̂. The draws are different for each i. If the ε̃i are re-drawn at
every iteration the estimator will not converge.
• The log-likelihood function with this simulator is a discontinuous function of β
and Ω. This does not cause problems from a theoretical point of view since it
can be shown that ln L (β, Ω) is stochastically equicontinuous. However, it does
cause problems if one attempts to use a gradient-based optimization method such
as Newton-Raphson.
• It may be the case, particularly if few simulations, H, are used, that some ele-
πi are zero. If the corresponding element of yi is equal to 1, there will
ments of e
be a log(0) problem.
• Solutions to discontinuity:
– 1) use an estimation method that doesn’t require a continuous and differen-
tiable objective function, for example, simulated annealing. This is compu-
tationally costly.
– 2) Smooth the simulated probabilities so that they are continuous functions
of the parameters. For example, apply a kernel transformation such as

m m
ỹi j = Φ A × ui j − max uik + .5 × 1 ui j = max uik
k=1 k=1
where A is a large positive number. This approximates a step function such

that ỹi j is very close to zero if ui j is not the maximum, and ui j = 1 if it is the
maximum. This makes ỹi j a continuous function of β and Ω, so that p̃i j and
therefore ln L (β, Ω) will be continuous and differentiable. Consistency re-
p
quires that A(n) → ∞, so that the approximation to a step function becomes
arbitrarily close as the sample size increases. There are alternative meth-
ods (e.g., Gibbs sampling) that may work better, but this is too technical to
discuss here.
• To solve to log(0) problem, one possibility is to search the web for the slog func-
tion. Also, increase H if this is a serious problem.
19.2.2. Properties. The properties of the SML estimator depend on how H is set. The
following is taken from Lee (1995) “Asymptotic Bias in Simulated Maximum Likelihood
Estimation of Discrete Choice Models,” Econometric Theory, 11, pp. 437-83.
T HEOREM 32. [Lee] 1) if limn→∞ n1/2/H = 0, then

√ d
n θ̂SML − θ0 → N(0, I −1 (θ0 ))
2) if limn→∞ n1/2 /H = λ, λ a finite constant, then

√ d
n θ̂SML − θ0 → N(B, I −1 (θ0 ))
where B is a finite vector of constants.
• This means that the SML estimator is asymptotically biased if H doesn’t grow
faster than n1/2 .
19.3. METHOD OF SIMULATED MOMENTS (MSM) 256
• The varcov is the typical inverse of the information matrix, so that as long as H
grows fast enough the estimator is consistent and fully asymptotically efficient.
19.3. Method of simulated moments (MSM)
Suppose we have a DGP(y|x, θ) which is simulable given θ, but is such that the density
of y is not calculable.
Once could, in principle, base a GMM estimator upon the moment conditions
mt (θ) = [K(yt , xt ) − k(xt , θ)] zt
where Z
k(xt , θ) = K(yt , xt )p(y|xt , θ)dy,
zt is a vector of instruments in the information set and p(y|xt , θ) is the density of y condi-
tional on xt . The problem is that this density is not available.
• However k(xt , θ) is readily simulated using
1 H
k (xt , θ) = ∑ K(e
e yth , xt )
H h=1
a.s.
• By the law of large numbers, e
k (xt , θ) → k (xt , θ) , as H → ∞, which provides
a clear intuitive basis for the estimator, though in fact we obtain consistency
even for H finite, since a law of large numbers is also operating across the n
observations of real data, so errors introduced by simulation cancel themselves
out.
• This allows us to form the moment conditions
h i
(19.3.1) ft (θ) = K(yt , xt ) − e
m k (xt , θ) zt
where zt is drawn from the information set. As before, form

1 n
m(θ)
e = ∑m
n i=1
ft (θ)
" #
1 n 1 H
(19.3.2) = ∑ K(yt , xt ) − H ∑ k(eyth , xt ) zt
n i=1 h=1
with which we form the GMM criterion and estimate as usual. Note that the
yth , xt ) appears linearly within the sums.
unbiased simulator k(e
19.3.1. Properties. Suppose that the optimal weighting matrix is used. McFadden
(ref. above) and Pakes and Pollard (refs. above) show that the asymptotic distribution of
the MSM estimator is very similar to that of the infeasible GMM estimator. In particular,
assuming that the optimal weighting matrix is used, and for H finite,

√
0 d 1
−1 0 −1
(19.3.3) n θ̂MSM − θ → N 0, 1 + D∞ Ω D∞
H
−1
where D∞ Ω−1 D0∞ is the asymptotic variance of the infeasible GMM estimator.
• That is, the asymptotic variance is inflated by a factor 1 + 1/H. For this reason
the MSM estimator is not fully asymptotically efficient relative to the infeasible
19.3. METHOD OF SIMULATED MOMENTS (MSM) 257
GMM estimator, for H finite, but the efficiency loss is small and controllable, by
setting H reasonably large.
• The estimator is asymptotically unbiased even for H = 1. This is an advantage
relative to SML.
• If one doesn’t use the optimal weighting matrix, the asymptotic varcov is just the
ordinary GMM varcov, inflated by 1 + 1/H.
• The above presentation is in terms of a specific moment condition based upon the
conditional mean. Simulated GMM can be applied to moment conditions of any
form.
19.3.2. Comments. Why is SML inconsistent if H is finite, while MSM is? The
reason is that SML is based upon an average of logarithms of an unbiased simulator (the
densities of the observations). To use the multinomial probit model as an example, the
log-likelihood function is
1 n 0
ln L (β, Ω) = ∑ yi ln pi (β, Ω)
n i=1
The SML version is
1 n 0
ln L (β, Ω) = ∑ yi ln p̃i (β, Ω)
n i=1
The problem is that
E ln( p̃i (β, Ω)) 6= ln(E p̃i (β, Ω))
in spite of the fact that
E p̃i (β, Ω) = pi (β, Ω)
due to the fact that ln(·) is a nonlinear transformation. The only way for the two to be equal
(in the limit) is if H tends to infinite so that p̃ (·) tends to p (·).
The reason that MSM does not suffer from this problem is that in this case the unbiased
simulator appears linearly within every sum of terms, and it appears within a sum over n
(see equation [19.3.2]). Therefore the SLLN applies to cancel out simulation errors, from
which we get consistency. That is, using simple notation for the random sampling case, the
moment conditions
" #
1 n 1 H
(19.3.4) m̃(θ) = ∑ K(yt , xt ) − H ∑ k(eyth , xt ) zt
n i=1 h=1
" #
1 n 1 H
(19.3.5) = ∑ k(xt , θ ) + εt − H ∑ [k(xt , θ) + ε̃ht ] zt
n i=1
0
h=1
converge almost surely to

Z
m̃∞ (θ) = k(x, θ0 ) − k(x, θ) z(x)dµ(x).
(note: zt is assume to be made up of functions of xt ). The objective function converges to
s∞ (θ) = m̃∞ (θ)0 Ω−1

∞ m̃∞ (θ)
which obviously has a minimum at θ0 , henceforth consistency.

19.4. EFFICIENT METHOD OF MOMENTS (EMM) 258
• If you look at equation 19.3.5 a bit, you will see why the variance inflation factor
is (1 + H1 ).
19.4. Efficient method of moments (EMM)
The choice of which moments upon which to base a GMM estimator can have very
pronounced effects upon the efficiency of the estimator.
• A poor choice of moment conditions may lead to very inefficient estimators, and
can even cause identification problems (as we’ve seen with the GMM problem
set).
• The drawback of the above approach MSM is that the moment conditions used
in estimation are selected arbitrarily. The asymptotic efficiency of the estimator
may be low.
• The asymptotically optimal choice of moments would be the score vector of the
likelihood function,
mt (θ) = Dθ ln pt (θ | It )
As before, this choice is unavailable.

The efficient method of moments (EMM) (see Gallant and Tauchen (1996), “Which Mo-
ments to Match?”, ECONOMETRIC THEORY, Vol. 12, 1996, pages 657-681) seeks to
provide moment conditions that closely mimic the score vector. If the approximation is
very good, the resulting estimator will be very nearly fully efficient.
The DGP is characterized by random sampling from the density
p(yt |xt , θ0 ) ≡ pt (θ0 )
We can define an auxiliary model, called the “score generator”, which simply provides
a (misspecified) parametric density
f (y|xt , λ) ≡ ft (λ)
• This density is known up to a parameter λ. We assume that this density function

is calculable. Therefore quasi-ML estimation is possible. Specifically,
1 n
λ̂ = argmax sn (λ) =
Λ
∑ ln ft (λ).
n t=1
• After determining λ̂ we can calculate the score functions Dλ ln f (yt |xt , λ̂).
• The important point is that even if the density is misspecified, there is a pseudo-
true λ0 for which the true expectation, taken with respect to the true but unknown
density of y, p(y|xt , θ0 ), and then marginalized over x is zero:
Z Z
∃λ0 : EX EY |X Dλ ln f (y|x, λ0 ) = Dλ ln f (y|x, λ0 )p(y|x, θ0 )dydµ(x) = 0
X Y |X
p
• We have seen in the section on QML that λ̂ → λ0 ; this suggests using the moment
conditions
1 n
Z
(19.4.1) mn (θ, λ̂) = ∑
n t=1
Dλ ln ft (λ̂)pt (θ)dy
• These moment conditions are not calculable, since pt (θ) is not available, but they
are simulable using
1 n 1 H
fn (θ, λ̂) =
m ∑H
n t=1 ∑ Dλ ln f (eyth |xt , λ̂)
h=1
where ỹth is a draw from DGP(θ), holding xt fixed. By the LLN and the fact that
λ̂ converges to λ0 ,
e∞ (θ0 , λ0 ) = 0.
m
This is not the case for other values of θ, assuming that λ0 is identified.
• The advantage of this procedure is that if f (yt |xt , λ) closely approximates p(y|xt , θ),
e n (θ, λ̂) will closely approximate the optimal moment conditions which
then m
characterize maximum likelihood estimation, which is fully efficient.
• If one has prior information that a certain density approximates the data well, it
would be a good choice for f (·).
• If one has no density in mind, there exist good ways of approximating unknown
distributions parametrically: Philips’ ERA’s (Econometrica, 1983) and Gallant
and Nychka’s (Econometrica, 1987) SNP density estimator which we saw before.
Since the SNP density is consistent, the efficiency of the indirect estimator is the
same as the infeasible ML estimator.
19.4.1. Optimal weighting matrix. I will present the theory for H finite, and possibly
small. This is done because it is sometimes impractical to estimate with H very large.
Gallant and Tauchen give the theory for the case of H so large that it may be treated as
infinite (the difference being irrelevant given the numerical precision of a computer). The
theory for the case of H infinite follows directly from the results presented here.
The moment condition m(θ, e λ̂) depends on the pseudo-ML estimate λ̂. We can apply
Theorem 22 to conclude that
√
d
(19.4.2) n λ̂ − λ0 → N 0, J (λ0 )−1 I (λ0 )J (λ0 )−1
If the density f (yt |xt , λ̂) were in fact the true density p(y|xt , θ), then λ̂ would be the maxi-
mum likelihood estimator, and J (λ0 )−1 I (λ0 ) would be an identity matrix, due to the infor-
mation matrix equality. However, in the present case we assume that f (yt |xt , λ̂) is only an
approximation to p(y|xt , θ), sothere is no cancellation.

∂ 2
Recall that J (λ0 ) ≡ p lim ∂λ∂λ 0
0 sn (λ ) . Comparing the definition of sn (λ) with the
definition of the moment condition in Equation 19.4.1, we see that
J (λ0 ) = Dλ0 m(θ0 , λ0 ).
As in Theorem 22,
∂sn (λ) ∂sn (λ)
I (λ0 ) = lim E n .
n→∞ ∂λ λ0 ∂λ0 λ0
In this case, this is simply the asymptotic variance covariance matrix of the moment con-
√
ditions, Ω. Now take a first order Taylor’s series approximation to nmn (θ0 , λ̂) about λ0
:
√ √ √
nm̃n (θ0 , λ̂) = nm̃n (θ0 , λ0 ) + nDλ0 m̃(θ0 , λ0 ) λ̂ − λ0 + o p(1)
√
First consider nm̃n (θ0 , λ0 ). It is straightforward but somewhat tedious to show that
the asymptotic variance of this term is H1 I∞ (λ0 ).
√ a.s.
Next consider the second term nDλ0 m̃(θ0 , λ0 ) λ̂ − λ0 . Note that Dλ0 m̃n (θ0 , λ0 ) →
J (λ0 ), so we have
√ √
nDλ0 m̃(θ0 , λ0 ) λ̂ − λ0 = nJ (λ0 ) λ̂ − λ0 , a.s.
But noting equation 19.4.2

√
a
nJ (λ0 ) λ̂ − λ0 ∼ N 0, I (λ0 )
Now, combining the results for the first and second terms,

√ a 1
nm̃n (θ0 , λ̂) ∼ N 0, 1 + I (λ0 )
H
Suppose that I[
(λ0 ) is a consistent estimator of the asymptotic variance-covariance matrix
of the moment conditions. This may be complicated if the score generator is a poor ap-
proximator, since the individual score contributions may not have mean zero in this case
(see the section on QML) . Even if this is the case, the individuals means can be calculated
by simulation, so it is always possible to consistently estimate I (λ0 ) when the model is
simulable. On the other hand, if the score generator is taken to be correctly specified, the
ordinary estimator of the information matrix is consistent. Combining this with the result
on the efficient GMM weighting matrix in Theorem 25, we see that defining θ̂ as
−1
1 [
θ̂ = argmin mn (θ, λ̂)0 1 + I (λ0 ) mn (θ, λ̂)
Θ H
is the GMM estimator with the efficient choice of weighting matrix.
• If one has used the Gallant-Nychka ML estimator as the auxiliary model, the
appropriate weighting matrix is simply the information matrix of the auxiliary
model, since the scores are uncorrelated. (e.g., it really is ML estimation asymp-
totically, since the score generator can approximate the unknown density arbi-
trarily well).
19.4.2. Asymptotic distribution. Since we use the optimal weighting matrix, the as-
ymptotic distribution is as in Equation 15.4.1, so we have (using the result in Equation
19.4.2): 
−1 !−1 
√ 0
d 1
n θ̂ − θ → N 0, D∞ 1+ I (λ0 ) D0∞ ,
H
where

D∞ = lim E Dθ m0n (θ0 , λ0 ) .
n→∞
This can be consistently estimated using
D̂ = Dθ m0n (θ̂, λ̂)

19.5. EXAMPLES 261
19.4.3. Diagnotic testing. The fact that

√ 0 a 1 0
nmn (θ , λ̂) ∼ N 0, 1 + I (λ )
H
implies that

−1
1 a
nmn (θ̂, λ̂)0 I (λ̂)
1+ mn (θ̂, λ̂) ∼ χ2 (q)
H
where q is dim(λ) − dim(θ), since without dim(θ) moment conditions the model is not
identified, so testing is impossible. One test of the model is simply based on this statistic: if
it exceeds the χ2 (q) critical point, something may be wrong (the small sample performance
of this sort of test would be a topic worth investigating).
• Information about what is wrong can be gotten from the pseudo-t-statistics:

1/2 !−1
1 √
diag 1 + I (λ̂) nmn (θ̂, λ̂)
H
can be used to test which moments are not well modeled. Since these moments
are related to parameters of the score generator, which are usually related to cer-
tain features of the model, this information can be used to revise the model. These
√ √
aren’t actually distributed as N(0, 1), since nmn (θ0 , λ̂) and nmn (θ̂, λ̂) have
√
different distributions (that of nmn (θ̂, λ̂) is somewhat more complicated). It
can be shown that the pseudo-t statistics are biased toward nonrejection. See
Gourieroux et. al. or Gallant and Long, 1995, for more details.
19.5. Examples
19.5.1. Estimation of stochastic differential equations. It is often convenient to for-

mulate theoretical models in terms of differential equations, and when the observation fre-
quency is high (e.g., weekly, daily, hourly or real-time) it may be more natural to adopt this
framework for econometric models of time series.
The most common approach to estimation of stochastic differential equations is to
“discretize” the model, as above, and estimate using the discretized version. However, since
the discretization is only an approximation to the true discrete-time version of the model
(which is not calculable), the resulting estimator is in general biased and inconsistent.
An alternative is to use indirect inference: The discretized model is used as the score
generator. That is, one estimates by QML to obtain the scores of the discretized approxi-
mation:
yt − yt−1 = g(φ, yt−1 ) + h(φ, yt−1 )εt

εt ∼ N(0, 1)
Indicate these scores by mn (θ, φ̂). Then the system of stochastic differential equations
dyt = g(θ, yt )dt + h(θ, yt )dWt

19.5. EXAMPLES 262
is simulated over θ, and the scores are calculated and averaged over the simulations
N
1
m̃n (θ, φ̂) =
N ∑ min (θ, φ̂)
i=1
θ̂ is chosen to set the simulated scores to zero
m̃n (θ̂, φ̂) ≡ 0
(since θ and φ are of the same dimension).

This method requires simulating the stochastic differential equation. There are many
ways of doing this. Basically, they involve doing very fine discretizations:
yt+τ = yt + g(θ, yt ) + h(θ, yt )ηt

ηt ∼ N(0, τ)
By setting τ very small, the sequence of ηt approximates a Brownian motion fairly well.
This is only one method of using indirect inference for estimation of differential equa-
tions. There are others (see Gallant and Long, 1995 and Gourieroux et. al.). Use of a series
approximation to the transitional density as in Gallant and Long is an interesting possi-
bility since the score generator may have a higher dimensional parameter than the model,
which allows for diagnostic testing. In the method described above the score generator’s
parameter φ is of the same dimension as is θ, so diagnostic testing is not possible.
19.5.2. EMM estimation of a discrete choice model. In this section consider EMM
estimation. There is a sophisticated package by Gallant and Tauchen for this, but here we’ll
look at some simple, but hopefully didactic code. The file probitdgp.m generates data that
follows the probit model. The file emm_moments.m defines EMM moment conditions,
where the DGP and score generator can be passed as arguments. Thus, it is a general
purpose moment condition for EMM estimation. This file is interesting enough to war-
rant some discussion. A listing appears in Listing 19.1. Line 3 defines the DGP, and the
arguments needed to evaluate it are defined in line 4. The score generator is defined in
line 5, and its arguments are defined in line 6. The QML estimate of the parameter of the
score generator is read in line 7. Note in line 10 how the random draws needed to simulate
data are passed with the data, and are thus fixed during estimation, to avoid ”chattering”.
The simulated data is generated in line 16, and the derivative of the score generator using
the simulated data is calculated in line 18. In line 20 we average the scores of the score
generator, which are the moment conditions that the function returns.
1 function scores = emm_moments(theta, data, momentargs)

2 k = momentargs{1};
3 dgp = momentargs{2}; # the data generating process (DGP)
4 dgpargs = momentargs{3}; # its arguments (cell array)
5 sg = momentargs{4}; # the score generator (SG)
6 sgargs = momentargs{5}; # SG arguments (cell array)
7 phi = momentargs{6}; # QML estimate of SG parameter
8 y = data(:,1);
9 x = data(:,2:k+1);
19.5. EXAMPLES 263
10 rand_draws = data(:,k+2:columns(data)); # passed with data to ensure fixed

across iterations
11 n = rows(y);
12 scores = zeros(n,rows(phi)); # container for moment contributions
13 reps = columns(rand_draws); # how many simulations?
14 for i = 1:reps
15 e = rand_draws(:,i);
16 y = feval(dgp, theta, x, e, dgpargs); # simulated data
17 sgdata = [y x]; # simulated data for SG
18 scores = scores + numgradient(sg, {phi, sgdata, sgargs}); # gradient of SG
19 endfor
20 scores = scores / reps; # average over number of simulations
21 endfunction
L ISTING 19.1
The file emm_example.m performs EMM estimation of the probit model, using a logit
model as the score generator. The results we obtain are
Score generator results:

=====================================================
------------------------------------------------------
STRONG CONVERGENCE
------------------------------------------------------
Stepsize 0.0279
15 iterations
------------------------------------------------------

1.8979 0.0000 0.0000
1.6648 -0.0000 0.0000
1.9125 -0.0000 0.0000
1.8875 -0.0000 0.0000
1.7433 -0.0000 0.0000
======================================================
Model results:
******************************************************
EMM example


Observations: 1000
19.5. EXAMPLES 264
Exactly identified, no spec. test

p1 1.069 0.022 47.618 0.000
p2 0.935 0.022 42.240 0.000
p3 1.085 0.022 49.630 0.000
p4 1.080 0.022 49.047 0.000
p5 0.978 0.023 41.643 0.000
******************************************************
It might be interesting to compare the standard errors with those obtained from ML
estimation, to check efficiency of the EMM estimator. One could even do a Monte Carlo
study.
19.5. EXAMPLES 265
Exercises
(1) Do SML estimation of the probit model.
(2) Do a little Monte Carlo study to compare ML, SML and EMM estimation of
the probit model. Investigate how the number of simulations affect the two
simulation-based estimators.
CHAPTER 20
Parallel programming for econometrics
The following borrows heavily from Creel (2005).

Parallel computing can offer an important reduction in the time to complete compu-
tations. This is well-known, but it bears emphasis since it is the main reason that parallel
computing may be attractive to users. To illustrate, the Intel Pentium IV (Willamette)
processor, running at 1.5GHz, was introduced in November of 2000. The Pentium IV
(Northwood-HT) processor, running at 3.06GHz, was introduced in November of 2002. An
approximate doubling of the performance of a commodity CPU took place in two years.
Extrapolating this admittedly rough snapshot of the evolution of the performance of com-
modity processors, one would need to wait more than 6.6 years and then purchase a new
computer to obtain a 10-fold improvement in computational performance. The examples in
this chapter show that a 10-fold improvement in performance can be achieved immediately,
using distributed parallel computing on available computers.
Recent (this is written in 2005) developments that may make parallel computing at-
tractive to a broader spectrum of researchers who do computations. The first is the fact that
setting up a cluster of computers for distributed parallel computing is not difficult. If you
are using the ParallelKnoppix bootable CD that accompanies these notes, you could create
a cluster in less that 10 minutes, given a few easily satisfied conditions. See the Tutorial,
on the Desktop if you’re running the bootable CD, or available at the preceeding link. The
second development is the existence of extensions to some of the high-level matrix pro-
gramming (HLMP) languages1 that allow the incorporation of parallelism into programs
written in these languages.
Following are examples of parallel implementations of several mainstream problems
in econometrics. A focus of the examples is on the possibility of hiding parallelization
from end users of programs. If programs that run in parallel have an interface that is
nearly identical to the interface of equivalent serial versions, end users will find it easy to
take advantage of parallel computing’s performance. We continue to use Octave, taking
advantage of the MPI Toolbox (MPITB) for Octave, by by Fernández Baldomero et al.
(2004). There are also parallel packages for Ox, R, and Python which may be of interest
to econometricians, but as of this writing, the following examples are the most accessible
introduction to parallel programming for econometricians.
1By ”high-level matrix programming language” I mean languages such as MATLAB (TM the Mathworks, Inc.),
Ox (TM OxMetrics Technologies, Ltd.), and GNU Octave (www.octave.org), for example.
266
20.1. EXAMPLE PROBLEMS 267
20.1. Example problems
This section introduces example problems from econometrics, and shows how they
can be parallelized in a natural way.
20.1.1. Monte Carlo. A Monte Carlo study involves repeating a random experiment
many times under identical conditions. Several authors have noted that Monte Carlo stud-
ies are obvious candidates for parallelization (Doornik et al. 2002; Bruche, 2003) since
blocks of replications can be done independently on different computers. To illustrate the
parallelization of a Monte Carlo study, we use same trace test example as do Doornik, et.
al. (2002). tracetest.m is a function that calculates the trace test statistic for the lack of
cointegration of integrated time series. This function is illustrative of the format that we
adopt for Monte Carlo simulation of a function: it receives a single argument of cell type,
and it returns a row vector that holds the results of one random simulation. The single ar-
gument in this case is a cell array that holds the length of the series in its first position, and
the number of series in the second position. It generates a random result though a process
that is internal to the function, and it reports some output in a row vector (in this case the
result is a scalar).
mc_example1.m is an Octave script that executes a Monte Carlo study of the trace
test by repeatedly evaluating the tracetest.m function. The main thing to notice about
this script is that lines 7 and 10 call the function montecarlo.m. When called with 3
arguments, as in line 7, montecarlo.m executes serially on the computer it is called from.
In line 10, there is a fourth argument. When called with four arguments, the last argument
is the number of slave hosts to use. We see that running the Monte Carlo study on one or
more processors is transparent to the user - he or she must only indicate the number of slave
computers to be used.
20.1.2. ML. For a sample {(yt , xt )}n of n observations of a set of dependent and ex-
planatory variables, the maximum likelihood estimator of the parameter θ can be defined
as
θ̂ = argmaxsn (θ)
where
1 n
sn (θ) = ∑ ln f (yt |xt , θ)
n t=1
Here, yt may be a vector of random variables, and the model may be dynamic since xt may
contain lags of yt . As Swann (2002) points out, this can be broken into sums over blocks
of observations, for example two blocks:
( ! !)
n1 n
1
sn (θ) =
n ∑ ln f (yt |xt , θ) + ∑ ln f (yt |xt , θ)
t=1 t=n1 +1
Analogously, we can define up to n blocks. Again following Swann, parallelization can be

done by calculating each block on separate computers.
mle_example1.m is an Octave script that calculates the maximum likelihood estimator
of the parameter vector of a model that assumes that the dependent variable is distributed
as a Poisson random variable, conditional on some explanatory variables. In lines 1-3 the
data is read, the name of the density function is provided in the variable model, and the
initial value of the parameter vector is set. In line 5, the function mle_estimate performs
ordinary serial calculation of the ML estimator, while in line 7 the same function is called
with 6 arguments. The fourth and fifth arguments are empty placeholders where options to
mle_estimate may be set, while the sixth argument is the number of slave computers to
use for parallel execution, 1 in this case. A person who runs the program sees no parallel
programming code - the parallelization is transparent to the end user, beyond having to
select the number of slave computers. When executed, this script prints out the estimates
theta_s and theta_p, which are identical.
It is worth noting that a different likelihood function may be used by making the model
variable point to a different function. The likelihood function itself is an ordinary Octave
function that is not parallelized. The mle_estimate function is a generic function that
can call any likelihood function that has the appropriate input/output syntax for evaluation
either serially or in parallel. Users need only learn how to write the likelihood function
using the Octave language.
20.1.3. GMM. For a sample as above, the GMM estimator of the parameter θ can be
defined as
θ̂ ≡ argmin sn (θ)
Θ
where
sn (θ) = mn (θ)0Wn mn (θ)
and
1 n
mn (θ) = ∑ mt (yt |xt , θ)
n t=1
Since mn (θ) is an average, it can obviously be computed blockwise, using for example 2
blocks:
( ! !)
n1 n
1
(20.1.1) mn (θ) =
n ∑ mt (yt |xt , θ) + ∑ mt (yt |xt , θ)
t=1 t=n1 +1
Likewise, we may define up to n blocks, each of which could potentially be computed on a

different machine.
gmm_example1.m is a script that illustrates how GMM estimation may be done seri-
ally or in parallel. When this is run, theta_s and theta_p are identical up to the tolerance
for convergence of the minimization routine. The point to notice here is that an end user
can perform the estimation in parallel in virtually the same way as it is done serially. Again,
gmm_estimate, used in lines 8 and 10, is a generic function that will estimate any model
specified by the moments variable - a different model can be estimated by changing the
value of the moments variable. The function that moments points to is an ordinary Oc-
tave function that uses no parallel programming, so users can write their models using the
simple and intuitive HLMP syntax of Octave. Whether estimation is done in parallel or
serially depends only the seventh argument to gmm_estimate - when it is missing or zero,
estimation is by default done serially with one processor. When it is positive, it specifies
the number of slave nodes to use.
20.1.4. Kernel regression. The Nadaraya-Watson kernel regression estimator of a

function g(x) at a point x is
n
∑t=1 yt K [(x − xt ) /γn ]
ĝ(x) = n
∑t=1 K [(x − xt ) /γn ]
n
≡ ∑ wt yy
t=1
We see that the weight depends upon every data point in the sample. To calculate the fit at
every point in a sample of size n, on the order of n2 k calculations must be done, where k
is the dimension of the vector of explanatory variables, x. Racine (2002) demonstrates that
MPI parallelization can be used to speed up calculation of the kernel regression estimator
by calculating the fits for portions of the sample on different computers. We follow this im-
plementation here. kernel_example1.m is a script for serial and parallel kernel regression.
Serial execution is obtained by setting the number of slaves equal to zero, in line 15. In line
17, a single slave is specified, so execution is in parallel on the master and slave nodes.
The example programs show that parallelization may be mostly hidden from end users.
Users can benefit from parallelization without having to write or understand parallel code.
The speedups one can obtain are highly dependent upon the specific problem at hand, as
well as the size of the cluster, the efficiency of the network, etc. Some examples of speedups
are presented in Creel (2005). Figure 20.1.1 reproduces speedups for some econometric
problems on a cluster of 12 desktop computers. The speedup for k nodes is the time to
finish the problem on a single node divided by the time to finish the problem on k nodes.
Note that you can get 10X speedups, as claimed in the introduction. It’s pretty obvious that
much greater speedups could be obtained using a larger cluster, for the ”embarrassingly
parallel” problems.
F IGURE 20.1.1. Speedups from parallelization

11
10 MONTECARLO
BOOTSTRAP
MLE
9 GMM
KERNEL
1
2 4 6 8 10 12
nodes
Bibliography
[1] Bruche, M. (2003) A note on embarassingly parallel computation using OpenMosix and Ox, working paper,
Financial Markets Group, London School of Economics.
[2] Creel, M. (2005) User-friendly parallel computations with econometric examples, Computational Econom-
ics, V. 26, pp. 107-128.
[3] Doornik, J.A., D.F. Hendry and N. Shephard (2002) Computationally-intensive econometrics using a dis-
tributed matrix-programming language, Philosophical Transactions of the Royal Society of London, Series
A, 360, 1245-1266.
[4] Fernández Baldomero, J. (2004) LAM/MPI parallel computing under GNU Octave,
atc.ugr.es/javier-bin/mpitb.
[5] Racine, Jeff (2002) Parallel distributed kernel estimation, Computational Statistics & Data Analysis, 40,
293-302.
[6] Swann, C.A. (2002) Maximum likelihood estimation using parallel computing: an introduction to MPI,
Computational Economics, 19, 145-178.
271
CHAPTER 21
Final project: econometric estimation of a RBC model
THIS IS NOT FINISHED - IGNORE IT FOR NOW

In this last chapter we’ll go through a worked example that combines a number of the
topics we’ve seen. We’ll do simulated method of moments estimation of a real business
cycle model, similar to what Valderrama (2002) does.
21.1. Data
We’ll develop a model for private consumption and real gross private investment. The
data are obtained from the US Bureau of Economic Analysis (BEA) National Income and
Product Accounts (NIPA), Table 11.1.5, Lines 2 and 6 (you can download quarterly data
from 1947-I to the present). The data we use are in the file rbc_data.m. This data is real
(constant dollars).
The program plots.m will make a few plots, including Figures 21.1.1 though 21.1.3.
First looking at the plot for levels, we can see that real consumption and investment are
clearly nonstationary (surprise, surprise). There appears to be somewhat of a structural
change in the mid-1970’s.
Looking at growth rates, the series for consumption has an extended period of high growth
in the 1970’s, becoming more moderate in the 90’s. The volatility of growth of consumption
F IGURE 21.1.1. Consumption and Investment, Levels
Include/RBC/levels.eps not found!
F IGURE 21.1.2. Consumption and Investment, Growth Rates
Include/RBC/growth.eps not found!
272
21.2. AN RBC MODEL 273
F IGURE 21.1.3. Consumption and Investment, Bandpass Filtered
Include/RBC/filtered.eps not found!
has declined somewhat, over time. Looking at investment, there are some notable periods of
high volatility in the mid-1970’s and early 1980’s, for example. Since 1990 or so, volatility
seems to have declined.
Economic models for growth often imply that there is no long term growth (!) - the data
that the models generate is stationary and ergodic. Or, the data that the models generate
needs to be passed through the inverse of a filter. We’ll follow this, and generate stationary
business cycle data by applying the bandpass filter of Christiano and Fitzgerald (1999). The
filtered data is in Figure 21.1.3. We’ll try to specify an economic model that can generate
similar data. To get data that look like the levels for consumption and investment, we’d
need to apply the inverse of the bandpass filter.
21.2. An RBC Model
Consider a very simple stochastic growth model (the same used by Maliar and Maliar
(2003), with minor notational difference):
∞ E0 ∑∞ βt U(ct )
max{ct ,kt }t=0 t=0
α
ct + kt = (1 − δ)kt−1 + φt kt−1
logφt = ρ logφt−1 + εt
εt ∼ IIN(0, σ2ε )
Assume that the utility function is

1−γ
ct −1
U(ct ) =
1−γ
• β is the discount rate
• δ is the depreciation rate of capital
• α is the elasticity of output with respect to capital
• φ is a technology shock that is positive. φt is observed in period t.
• γ is the coefficient of relative risk aversion. When γ = 1, the utility function is
logarithmic.
• gross investment, it , is the change in the capital stock:
it = kt − (1 − δ)kt−1
• we assume that the initial condition (k0 , θ0 ) is given.

21.3. A REDUCED FORM MODEL 274

2 0
We would like to estimate the parameters θ = β, γ, δ, α, ρ, σε using the data that we have
on consumption and investment. This problem is very similar to the GMM estimation of the
portfolio model discussed in Sections 15.11 and 15.12. Once can derive the Euler condition
in the same way we did there, and use it to define a GMM estimator. That approach was not
very successful, recall. Now we’ll try to use some more informative moment conditions to
see if we get better results.
21.3. A reduced form model
Macroeconomic time series data are often modeled using vector autoregressions. A
vector autogression is just the vector version of an autoregressive model. Let yt be a G-
vector of jointly dependent variables. A VAR(p) model is
yt = c + A1yt−1 + A2yt−2 + ... + A pyt−p + vt
where c is a G-vector of parameters, and A j , j=1,2,...,p, are G × G matrices of parameters.

Let vt = Rt ηt , where ηt ∼ IIN(0, I2 ), and Rt is upper triangular. So V (vt |yt−1 , ...yt−p ) =
0
Rt Rt . You can think of a VAR model as the reduced form of a dynamic linear simultaneous
equations model where all of the variables are treated as endogenous. Clearly, if all of the
variables are endogenous, one would need some form of additional information to identify
a structural model. But we already have a structural model, and we’re only going to use
the VAR to help us estimate the parameters. A well-fitting reduced form model will be
adequate for the purpose.
We’re seen that our data seems to have episodes where the variance of growth rates
and filtered data is non-constant. This brings us to the general area of stochastic volatility.
Without going into details, we’ll just consider the exponential GARCH model of Nelson
(1991) as presented in Hamilton (1994, pg. 668-669).
Define ht = vec∗ (Rt ), the vector of elements in the upper triangle of Rt (in our case
this is a 3 × 1 vector). We assume that the elements follow
n p o
logh jt = κ j + P( j,.) |vt−1 | − 2/π + ℵ( j,.) vt−1 + G( j,.) loght−1
The variance of the VAR error depends upon its own past, as well as upon the past realiza-
tions of the shocks.
• This is an EGARCH(1,1) specification. The obvious generalization is the EGARCH(r, m)
specification, with longer lags (r for lags of v, m for lags of h).
• The advantage of the EGARCH formulation is that the variance is assuredly pos-
itive without parameter restrictions
• The matrix P has dimension 3 × 2.
• The matrix G has dimension 3 × 3.
• The matrix ℵ (reminder to self: this is an ”aleph”) has dimension 2 × 2.
• The parameter matrix ℵ allows for leverage, so that positive and negative shocks
can have asymmetric effects upon volatility.
• We will probably want to restrict these parameter matrices in some way. For
instance, G could plausibly be diagonal.
21.5. SOLVING THE STRUCTURAL MODEL 275
With the above specification, we have
ηt ∼ IIN (0, I2 )
ηt = Rt−1 vt
and we know how to calculate Rt and vt , given the data and the parameters. Thus, it is
straighforward to do estimation by maximum likelihood. This will be the score generator.
21.4. Results (I): The score generator
21.5. Solving the structural model
The first order condition for the structural model is

ct = βEt ct+1 1 − δ + αφt+1ktα−1
−γ −γ
or
n h io −1
γ
ct = βEt ct+1 1 − δ + αφt+1ktα−1
−γ
The problem is that we cannot solve for ct since we do not know the solution for the
expectation in the previous equation.
The parameterized expectations algorithm (PEA: den Haan and Marcet, 1990), is a
means of solving the problem. The expectations term is replaced by a parametric function.
As long as the parametric function is a flexible enough function of variables that have been
realized in period t, there exist parameter values that make the approximation as close to
the true expectation as is desired. We will write the approximation
h i
Et ct+1 1 − δ + αφt+1ktα−1 ' exp(ρ0 + ρ1 log φt + ρ2 logkt−1 )
−γ
For given values of the parameters of this approximating function, we can solve for ct , and
then for kt using the restriction that
α
ct + kt = (1 − δ)kt−1 + φt kt−1
This allows us to generate a series {(ct , kt )}. Then the expectations approximation is up-
dated by fitting

ct+1 1 − δ + αφt+1ktα−1 = exp(ρ0 + ρ1 log φt + ρ2 log kt−1 ) + ηt
−γ
by nonlinear least squares. The 2 step procedure of generating data and updating the param-
eters of the approximation to expectations is iterated until the parameters no longer change.
When this is the case, the expectations function is the best fit to the generated data. As long
it is a rich enough parametric model to encompass the true expectations function, it can be
made to be equal to the true expectations function by using a long enough simulation.
0
Thus, given the parameters of the structural model, θ = β, γ, δ, α, ρ, σ2ε , we can
generate data {(ct , kt )} using the PEA. From this we can get the series {(ct , it )} using
it = kt − (1 − δ)kt−1 . This can be used to do EMM estimation using the scores of the re-
duced form model to define moments, using the simulated data from the structural model.
Bibliography
[1] Creel. M (2005) A Note on Parallelizing the Parameterized Expectations Algorithm.

[2] den Haan, W. and Marcet, A. (1990) Solving the stochastic growth model by parameterized expectations,
Journal of Business and Economics Statistics, 8, 31-34.
[3] Hamilton, J. (1994) Time Series Analysis, Princeton Univ. Press
[4] Maliar, L. and Maliar, S. (2003) Matlab code for Solving a Neoclassical Growh Model with a Parametrized Expectations Algorithm and Moving Bo
[5] Nelson, D. (1991) Conditional heteroscedasticity is asset returns: a new approach, Econometrica, 59, 347-
70.
[6] Valderrama, D. (2002) Statistical nonlinearities in the business cycle: a challenge for
the canonical RBC model, Economic Research, Federal Reserve Bank of San Francisco.
http://ideas.repec.org/p/fip/fedfap/2002-13.html
276
CHAPTER 22
Introduction to Octave
Why is Octave being used here, since it’s not that well-known by econometricians?
Well, because it is a high quality environment that is easily extensible, uses well-tested and
high performance numerical libraries, it is licensed under the GNU GPL, so you can get it
for free and modify it if you like, and it runs on both GNU/Linux, Mac OSX and Windows
systems. It’s also quite easy to learn.
22.1. Getting started
Get the bootable CD, as was described in Section 1.3. Then burn the image, and boot
your computer with it. This will give you this same PDF file, but with all of the example
programs ready to run. The editor is configure with a macro to execute the programs using
Octave, which is of course installed. From this point, I assume you are running the CD (or
sitting in the computer room across the hall from my office), or that you have configured
your computer to be able to run the *.m files mentioned below.
22.2. A short introduction
The objective of this introduction is to learn just the basics of Octave. There are other
ways to use Octave, which I encourage you to explore. These are just some rudiments.
After this, you can look at the example programs scattered throughout the document (and
edit them, and run them) to learn more about how Octave can be used to do econometrics.
Students of mine: your problem sets will include exercises that can be done by modifying
the example programs in relatively minor ways. So study the examples!
Octave can be used interactively, or it can be used to run programs that are written using
a text editor. We’ll use this second method, preparing programs with NEdit, and calling Oc-
tave from within the editor. The program first.m gets us started. To run this, open it up with
NEdit (by finding the correct file inside the /home/knoppix/Desktop/Econometrics
folder and clicking on the icon) and then type CTRL-ALT-o, or use the Octave item in
the Shell menu (see Figure 22.2.1).
Note that the output is not formatted in a pleasing way. That’s because printf()
doesn’t automatically start a new line. Edit first.m so that the 8th line reads ”printf(”hello
world\n”);” and re-run the program.
We need to know how to load and save data. The program second.m shows how. Once
you have run this, you will find the file ”x” in the directory Econometrics/Include/OctaveIntro/
You might have a look at it with NEdit to see Octave’s default format for saving data. Basi-
cally, if you have data in an ASCII text file, named for example ”myfile.data”, formed of
277
22.3. IF YOU’RE RUNNING A LINUX INSTALLATION... 278
F IGURE 22.2.1. Running an Octave program
numbers separated by spaces, just use the command ”load myfile.data”. After having
done so, the matrix ”myfile” (without extension) will contain the data.
Please have a look at CommonOperations.m for examples of how to do some basic
things in Octave. Now that we’re done with the basics, have a look at the Octave programs
that are included as examples. If you are looking at the browsable PDF version of this
document, then you should be able to click on links to open them. If not, the example
programs are available here and the support files needed to run these are available here.
Those pages will allow you to examine individual files, out of context. To actually use
these files (edit and run them), you should go to the home page of this document, since
you will probably want to download the pdf version together with all the support files and
examples. Or get the bootable CD.
There are some other resources for doing econometrics with Octave. You might like to
check the article Econometrics with Octave and the Econometrics Toolbox , which is for
Matlab, but much of which could be easily used with Octave.
22.3. If you’re running a Linux installation...
Then to get the same behavior as found on the CD, you need to:
• Get the collection of support programs and the examples, from the document
home page.
22.3. IF YOU’RE RUNNING A LINUX INSTALLATION... 279
• Put them somewhere, and tell Octave how to find them, e.g., by putting a link to
the MyOctaveFiles directory in /usr/local/share/octave/site-m
• Make sure nedit is installed and configured to run Octave and use syntax high-
lighting. Copy the file /home/econometrics/.nedit from the CD to do this.
Or, get the file NeditConfiguration and save it in your $HOME directory with the
name ”.nedit”. Not to put too fine a point on it, please note that there is a period
in that name.
• Associate *.m files with NEdit so that they open up in the editor when you click
on them. That should do it.
CHAPTER 23
Notation and Review
• All vectors will be column vectors, unless they have a transpose symbol (or I for-
get to apply this rule - your help catching typos and er0rors is much appreciated).
For example, if xt is a p × 1 vector, xt0 is a 1 × p vector. When I refer to a p-vector,
I mean a column vector.
23.1. Notation for differentiation of vectors and matrices
[3, Chapter 1]
∂s(θ)
Let s(·) : ℜ p → ℜ be a real valued function of the p-vector θ. Then ∂θ is organized
as a p-vector,  
∂s(θ)
∂θ1
 ∂s(θ) 
∂s(θ) 
 ∂θ2


= .. 
∂θ  . 
 
∂s(θ)
∂θ p
2
Following this convention, ∂s(θ) ∂ s(θ)
∂θ0 is a 1 × p vector, and ∂θ∂θ0 is a p × p matrix. Also,

∂2 s(θ) ∂ ∂s(θ) ∂ ∂s(θ)
= = 0 .
∂θ∂θ0 ∂θ ∂θ0 ∂θ ∂θ
∂a0 x
E XERCISE 33. For a and x both p-vectors, show that ∂x = a.
Let f (θ):ℜ p → ℜn be a n-vector valued function of the p-vector θ. Let f (θ)0 be the
0
∂
1 × n valued transpose of f . Then ∂θ f (θ)0 = ∂θ∂ 0 f (θ).
• Product rule: Let f (θ):ℜ p → ℜn and h(θ):ℜ p → ℜn be n-vector valued func-
tions of the p-vector θ. Then

∂ 0 0 ∂ 0 ∂
h(θ) f (θ) = h f + f h
∂θ0 ∂θ0 ∂θ0
has dimension 1 × p. Applying the transposition rule we get

∂ ∂ 0 ∂ 0
h(θ)0 f (θ) = f h+ h f
∂θ ∂θ ∂θ
which has dimension p × 1.
∂x0 Ax
E XERCISE 34. For A a p × p matrix and x a p × 1 vector, show that ∂x = A + A0 .
• Chain rule: Let f (·):ℜ p → ℜn a n-vector valued function of a p-vector argu-

ment, and let g():ℜr → ℜ p be a p-vector valued function of an r-vector valued
argument ρ. Then

∂ ∂ ∂
f [g (ρ)] = 0 f (θ) g(ρ)
∂ρ 0 ∂θ θ=g(ρ) ∂ρ
0
280
23.2. CONVERGENGE MODES 281
has dimension n × r.
∂ exp(x0 β)
E XERCISE 35. For x and β both p × 1 vectors, show that ∂β = exp(x0 β)x.
23.2. Convergenge modes
Readings: [1, Chapter 4];[4, Chapter 4].

We will consider several modes of convergence. The first three modes discussed are
simply for background. The stochastic modes are those which will be used later in the
course.
D EFINITION 36. A sequence is a mapping from the natural numbers {1, 2, ...} =
{n}∞
n=1 = {n} to some other set, so that the set is ordered according to the natural numbers
associated with its elements.
Real-valued sequences:
D EFINITION 37. [Convergence] A real-valued sequence of vectors {a n } converges to

the vector a if for any ε > 0 there exists an integer Nε such that for all n > Nε , k an − a k< ε
. a is the limit of an , written an → a.
Deterministic real-valued functions. Consider a sequence of functions { f n (ω)} where
fn : Ω → T ⊆ ℜ.
Ω may be an arbitrary set.
D EFINITION 38. [Pointwise convergence] A sequence of functions { f n (ω)} converges

pointwise on Ω to the function f (ω) if for all ε > 0 and ω ∈ Ω there exists an integer Nεω
such that
| fn (ω) − f (ω)| < ε, ∀n > Nεω .
It’s important to note that Nεω depends upon ω, so that converge may be much more
rapid for certain ω than for others. Uniform convergence requires a similar rate of conver-
gence throughout Ω.
D EFINITION 39. [Uniform convergence] A sequence of functions { f n (ω)} converges

uniformly on Ω to the function f (ω) if for any ε > 0 there exists an integer N such that
sup | fn (ω) − f (ω)| < ε, ∀n > N.

ω∈Ω
(insert a diagram here showing the envelope around f (ω) in which f n (ω) must lie)
Stochastic sequences. In econometrics, we typically deal with stochastic sequences.

Given a probability space (Ω, F , P) , recall that a random variable maps the sample space to
the real line, i.e., X(ω) : Ω → ℜ. A sequence of random variables {Xn (ω)} is a collection
of such mappings, i.e., each Xn (ω) is a random variable with respect to the probability
space (Ω, F , P) . For example, given the model Y = Xβ0 + ε, the OLS estimator β̂n =
(X 0 X)−1 X 0Y, where n is the sample size, can be used to form a sequence of random vectors
{β̂n }. A number of modes of convergence are in use when dealing with sequences of
random variables. Several such modes of convergence should already be familiar:
23.2. CONVERGENGE MODES 282
D EFINITION 40. [Convergence in probability] Let Xn (ω) be a sequence of random

variables, and let X(ω) be a random variable. Let An = {ω : |Xn (ω) − X(ω)| > ε}. Then
{Xn (ω)} converges in probability to X(ω) if
lim P (An ) = 0, ∀ε > 0.

n→∞
p
Convergence in probability is written as Xn → X, or plim Xn = X.
D EFINITION 41. [Almost sure convergence] Let Xn (ω) be a sequence of random vari-
ables, and let X(ω) be a random variable. Let A = {ω : limn→∞ Xn (ω) = X(ω)}. Then
{Xn (ω)} converges almost surely to X(ω) if
P (A ) = 1.
In other words, Xn (ω) → X(ω) (ordinary convergence of the two functions) except on a
a.s.
set C = Ω − A such that P(C) = 0. Almost sure convergence is written as Xn → X, or
Xn → X, a.s. One can show that
a.s. p
Xn → X ⇒ Xn → X.
D EFINITION 42. [Convergence in distribution] Let the r.v. Xn have distribution func-
tion Fn and the r.v. Xn have distribution function F. If Fn → F at every continuity point of
F, then Xn converges in distribution to X.
d
Convergence in distribution is written as Xn → X. It can be shown that convergence in
probability implies convergence in distribution.
Stochastic functions. Simple laws of large numbers (LLN’s) allow us to directly con-
a.s.
clude that β̂n → β0 in the OLS example, since
0 −1 0
XX Xε
β̂n = β0 + ,
n n
a.s.
and Xnε → 0 by a SLLN. Note that this term is not a function of the parameter β. This easy
0
proof is a result of the linearity of the model, which allows us to express the estimator in a
way that separates parameters from random functions. In general, this is not possible. We
often deal with the more complicated situation where the stochastic sequence depends on
parameters in a manner that is not reducible to a simple sequence of random variables. In
this case, we have a sequence of random functions that depend on θ: {Xn (ω, θ)}, where
each Xn (ω, θ) is a random variable with respect to a probability space (Ω, F , P) and the
parameter θ belongs to a parameter space θ ∈ Θ.
D EFINITION 43. [Uniform almost sure convergence] {Xn (ω, θ)} converges uniformly
almost surely in Θ to X(ω, θ) if
lim sup |Xn (ω, θ) − X(ω, θ)| = 0, (a.s.)

n→∞ θ∈Θ
Implicit is the assumption that all Xn (ω, θ) and X(ω, θ) are random variables w.r.t.
u.a.s.
(Ω, F , P) for all θ ∈ Θ. We’ll indicate uniform almost sure convergence by → and uni-
u.p.
form convergence in probability by → .
23.3. RATES OF CONVERGENCE AND ASYMPTOTIC EQUALITY 283
• An equivalent definition, based on the fact that “almost sure” means “with prob-
ability one” is

Pr lim sup |Xn (ω, θ) − X(ω, θ)| = 0 = 1
n→∞ θ∈Θ
This has a form similar to that of the definition of a.s. convergence - the essential
difference is the addition of the sup.
23.3. Rates of convergence and asymptotic equality
It’s often useful to have notation for the relative magnitudes of quantities. Quantities
that are small relative to others can often be ignored, which simplifies analysis.
D EFINITION 44. [Little-o] Let f (n) and g(n) be two real-valued functions. The nota-
f (n)
tion f (n) = o(g(n)) means limn→∞ g(n) = 0.
D EFINITION 45. [Big-O] Let f (n) and g(n) be two real-valued functions.
The nota-
f (n)
tion f (n) = O(g(n)) means there exists some N such that for n > N, g(n) < K, where K
is a finite constant.
f (n)
This definition doesn’t require that g(n) have a limit (it may fluctuate boundedly).
If { fn } and {gn } are sequences of random variables analogous definitions are
f (n) p
D EFINITION 46. The notation f (n) = o p (g(n)) means g(n) → 0.

E XAMPLE 47. The least squares estimator θ̂ = (X 0 X)−1 X 0Y = (X 0 X)−1 X 0 Xθ0 + ε =
0 −1 X 0 ε
θ0 + (X 0 X)−1 X 0 ε. Since plim (X X)1 = 0, we can write (X 0 X)−1 X 0 ε = o p (1) and θ̂ =
θ0 + o p (1). Asymptotically, the term o p (1) is negligible. This is just a way of indicating
that the LS estimator is consistent.
D EFINITION 48. The notation f (n) = O p (g(n)) means there exists some Nε such that
for ε > 0 and all n > Nε ,
f (n)
P < Kε > 1 − ε,
g(n)
where Kε is a finite constant.
E XAMPLE 49. If Xn ∼ N(0, 1) then Xn = O p (1), since, given ε, there is always some
Kε such that P (|Xn | < Kε ) > 1 − ε.
Useful rules:
• O p (n p )O p (nq ) = O p (n p+q )
• o p (n p )o p (nq ) = o p (n p+q )
E XAMPLE 50. Consider a random sample of iid r.v.’s with mean 0 and variance σ 2 .
The estimator of the mean θ̂ = 1/n ∑ni=1 xi is asymptotically normally distributed, e.g.,
A
n1/2 θ̂ ∼ N(0, σ2 ). So n1/2θ̂ = O p (1), so θ̂ = O p (n−1/2 ). Before we had θ̂ = o p (1), now we
have have the stronger result that relates the rate of convergence to the sample size.
E XAMPLE 51. Now consider a random sample of iid r.v.’s with mean µ and variance
σ2 .The estimator of the mean θ̂ = 1/n ∑ni=1 xi is asymptotically normally distributed, e.g.,
A
n1/2 θ̂ − µ ∼ N(0, σ2 ). So n1/2 θ̂ − µ = O p (1), so θ̂ − µ = O p (n−1/2 ), so θ̂ = O p (1).
23.3. RATES OF CONVERGENCE AND ASYMPTOTIC EQUALITY 284
These two examples show that averages of centered (mean zero) quantities typically
have plim 0, while averages of uncentered quantities have finite nonzero plims. Note that
the definition of O p does not mean that f (n) and g(n) are of the same order. Asymptotic
equality ensures that this is the case.
D EFINITION 52. Two sequences of random variables { f n } and {gn } are asymptoti-
a
cally equal (written f n = gn ) if
f (n)
plim =1
g(n)
Finally, analogous almost sure versions of o p and O p are defined in the obvious way.
EXERCISES 285
Exercises
(1) For a and x both p × 1 vectors, show that Dx a0 x = a.
(2) For A a p × p matrix and x a p × 1 vector, show that D2x x0 Ax = A + A0.
(3) For x and β both p × 1 vectors, show that Dβ expx0 β = exp(x0 β)x.
(4) For x and β both p × 1 vectors, find the analytic expression for D 2β expx0 β.
(5) Write an Octave program that verifies each of the previous results by taking numeric
derivatives. For a hint, type help numgradient and help numhessian inside octave.
CHAPTER 24
The GPL
This document and the associated examples and materials are copyright Michael Creel,
under the terms of the GNU General Public License. This license follows:
GNU GENERAL PUBLIC LICENSE Version 2, June 1991
Copyright (C) 1989, 1991 Free Software Foundation, Inc. 59 Temple Place, Suite
330, Boston, MA 02111-1307 USA Everyone is permitted to copy and distribute verbatim
copies of this license document, but changing it is not allowed.
Preamble
The licenses for most software are designed to take away your freedom to share and
change it. By contrast, the GNU General Public License is intended to guarantee your
freedom to share and change free software–to make sure the software is free for all its users.
This General Public License applies to most of the Free Software Foundation’s software
and to any other program whose authors commit to using it. (Some other Free Software
Foundation software is covered by the GNU Library General Public License instead.) You
can apply it to your programs, too.
When we speak of free software, we are referring to freedom, not price. Our General
Public Licenses are designed to make sure that you have the freedom to distribute copies
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can get it if you want it, that you can change the software or use pieces of it in new free
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To protect your rights, we need to make restrictions that forbid anyone to deny you
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For example, if you distribute copies of such a program, whether gratis or for a fee,
you must give the recipients all the rights that you have. You must make sure that they,
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We protect your rights with two steps: (1) copyright the software, and (2) offer you this
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24. THE GPL 291
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CHAPTER 25
The attic
This holds material that is not really ready to be incorporated into the main body, but
that I don’t want to lose. Basically, ignore it, unless you’d like to help get it ready for
inclusion.
25.1. Hurdle models
Returning to the Poisson model, lets look at actual and fitted count probabilities. Ac-
tual relative frequencies are f (y = j) = ∑i 1(yi = j)/n and fitted frequencies are fˆ(y =
j) = ∑ni=1 fY ( j|xi , θ̂)/n We see that for the OBDV measure, there are many more actual
TABLE 1. Actual and Poisson fitted frequencies
Count OBDV ERV

Count Actual Fitted Actual Fitted
0 0.32 0.06 0.86 0.83
1 0.18 0.15 0.10 0.14
2 0.11 0.19 0.02 0.02
3 0.10 0.18 0.004 0.002
4 0.052 0.15 0.002 0.0002
5 0.032 0.10 0 2.4e-5
zeros than predicted. For ERV, there are somewhat more actual zeros than fitted, but the
difference is not too important.
Why might OBDV not fit the zeros well? What if people made the decision to contact
the doctor for a first visit, they are sick, then the doctor decides on whether or not follow-up
visits are needed. This is a principal/agent type situation, where the total number of visits
depends upon the decision of both the patient and the doctor. Since different parameters
may govern the two decision-makers choices, we might expect that different parameters
govern the probability of zeros versus the other counts. Let λ p be the parameters of the
patient’s demand for visits, and let λd be the paramter of the doctor’s “demand” for visits.
The patient will initiate visits according to a discrete choice model, for example, a logit
model:
Pr(Y = 0) = fY (0, λ p ) = 1 − 1/ [1 + exp(−λ p)]

Pr(Y > 0) = 1/ [1 + exp(−λ p)] ,
The above probabilities are used to estimate the binary 0/1 hurdle process. Then, for the ob-
servations where visits are positive, a truncated Poisson density is estimated. This density
292
25.1. HURDLE MODELS 293
is
fY (y, λd )
fY (y, λd |y > 0) =
Pr(y > 0)
fY (y, λd )
=
1 − exp(−λd )
since according to the Poisson model with the doctor’s paramaters,
exp(−λd )λ0d
Pr(y = 0) = .
0!
Since the hurdle and truncated components of the overall density for Y share no parameters,
they may be estimated separately, which is computationally more efficient than estimating
the overall model. (Recall that the BFGS algorithm, for example, will have to invert the
approximated Hessian. The computational overhead is of order K 2 where K is the number
of parameters to be estimated) . The expectation of Y is
E(Y |x) = Pr(Y > 0|x)E(Y |Y > 0, x)

1 λd
=
1 + exp(−λ p ) 1 − exp(−λd )
Here are hurdle Poisson estimation results for OBDV, obtained from this estimation program
**************************************************************************
MEPS data, OBDV
logit results
Strong convergence
Observations = 500
Function value -0.58939
t-Stats
params t(OPG) t(Sand.) t(Hess)
constant -1.5502 -2.5709 -2.5269 -2.5560
pub_ins 1.0519 3.0520 3.0027 3.0384
priv_ins 0.45867 1.7289 1.6924 1.7166
sex 0.63570 3.0873 3.1677 3.1366
age 0.018614 2.1547 2.1969 2.1807
educ 0.039606 1.0467 0.98710 1.0222
inc 0.077446 1.7655 2.1672 1.9601
Consistent Akaike
639.89
Schwartz
632.89
Hannan-Quinn
614.96
Akaike
603.39
**************************************************************************
The results for the truncated part:

**************************************************************************
MEPS data, OBDV
tpoisson results
Strong convergence
Observations = 500
t-Stats
constant 0.54254 7.4291 1.1747 3.2323
pub_ins 0.31001 6.5708 1.7573 3.7183
priv_ins 0.014382 0.29433 0.10438 0.18112
sex 0.19075 10.293 1.1890 3.6942
age 0.016683 16.148 3.5262 7.9814
educ 0.016286 4.2144 0.56547 1.6353
inc -0.0079016 -2.3186 -0.35309 -0.96078
Consistent Akaike
2754.7
Schwartz
2747.7
Hannan-Quinn
2729.8
Akaike
2718.2
**************************************************************************
Fitted and actual probabilites (NB-II fits are provided as well) are:
TABLE 2. Actual and Hurdle Poisson fitted frequencies
Count OBDV ERV

Count Actual Fitted HP Fitted NB-II Actual Fitted HP Fitted NB-II
0 0.32 0.32 0.34 0.86 0.86 0.86
1 0.18 0.035 0.16 0.10 0.10 0.10
2 0.11 0.071 0.11 0.02 0.02 0.02
3 0.10 0.10 0.08 0.004 0.006 0.006
4 0.052 0.11 0.06 0.002 0.002 0.002
5 0.032 0.10 0.05 0 0.0005 0.001
For the Hurdle Poisson models, the ERV fit is very accurate. The OBDV fit is not so
good. Zeros are exact, but 1’s and 2’s are underestimated, and higher counts are overes-
timated. For the NB-II fits, performance is at least as good as the hurdle Poisson model,
and one should recall that many fewer parameters are used. Hurdle version of the negative
binomial model are also widely used.
25.1.1. Finite mixture models. The following are results for a mixture of 2 negative
binomial (NB-I) models, for the OBDV data, which you can replicate using this estimation program
**************************************************************************
MEPS data, OBDV
mixnegbin results
Strong convergence
Observations = 500
t-Stats
constant 0.64852 1.3851 1.3226 1.4358
pub_ins -0.062139 -0.23188 -0.13802 -0.18729
priv_ins 0.093396 0.46948 0.33046 0.40854
sex 0.39785 2.6121 2.2148 2.4882
age 0.015969 2.5173 2.5475 2.7151
educ -0.049175 -1.8013 -1.7061 -1.8036
inc 0.015880 0.58386 0.76782 0.73281
ln_alpha 0.69961 2.3456 2.0396 2.4029
constant -3.6130 -1.6126 -1.7365 -1.8411
pub_ins 2.3456 1.7527 3.7677 2.6519
priv_ins 0.77431 0.73854 1.1366 0.97338
sex 0.34886 0.80035 0.74016 0.81892
age 0.021425 1.1354 1.3032 1.3387
educ 0.22461 2.0922 1.7826 2.1470
inc 0.019227 0.20453 0.40854 0.36313
ln_alpha 2.8419 6.2497 6.8702 7.6182
logit_inv_mix 0.85186 1.7096 1.4827 1.7883
Consistent Akaike
2353.8
Schwartz
2336.8
Hannan-Quinn
2293.3
Akaike
2265.2
**************************************************************************
Delta method for mix parameter st. err.
mix se_mix
0.70096 0.12043
• The 95% confidence interval for the mix parameter is perilously close to 1, which
suggests that there may really be only one component density, rather than a mix-
ture. Again, this is not the way to test this - it is merely suggestive.
• Education is interesting. For the subpopulation that is “healthy”, i.e., that makes
relatively few visits, education seems to have a positive effect on visits. For the
“unhealthy” group, education has a negative effect on visits. The other results are
more mixed. A larger sample could help clarify things.
The following are results for a 2 component constrained mixture negative binomial model
where all the slope parameters in λ j = exβ j are the same across the two components. The
constants and the overdispersion parameters α j are allowed to differ for the two compo-
nents.
25.2. MODELS FOR TIME SERIES DATA 299
**************************************************************************
MEPS data, OBDV
cmixnegbin results
Strong convergence
Observations = 500
t-Stats
constant -0.34153 -0.94203 -0.91456 -0.97943
pub_ins 0.45320 2.6206 2.5088 2.7067
priv_ins 0.20663 1.4258 1.3105 1.3895
sex 0.37714 3.1948 3.4929 3.5319
age 0.015822 3.1212 3.7806 3.7042
educ 0.011784 0.65887 0.50362 0.58331
inc 0.014088 0.69088 0.96831 0.83408
ln_alpha 1.1798 4.6140 7.2462 6.4293
const_2 1.2621 0.47525 2.5219 1.5060
lnalpha_2 2.7769 1.5539 6.4918 4.2243
logit_inv_mix 2.4888 0.60073 3.7224 1.9693
Consistent Akaike
2323.5
Schwartz
2312.5
Hannan-Quinn
2284.3
Akaike
2266.1
**************************************************************************
Delta method for mix parameter st. err.
mix se_mix
0.92335 0.047318
• Now the mixture parameter is even closer to 1.
• The slope parameter estimates are pretty close to what we got with the NB-I
model.
25.2. Models for time series data
This section can be ignored in its present form. Just left in to form a basis for comple-
tion (by someone else ?!) at some point.
Hamilton, Time Series Analysis is a good reference for this section. This is very in-
complete and contributions would be very welcome.
Up to now we’ve considered the behavior of the dependent variable yt as a function of

other variables xt . These variables can of course contain lagged dependent variables, e.g.,
xt = (wt , yt−1 , ..., yt− j ). Pure time series methods consider the behavior of yt as a function
only of its own lagged values, unconditional on other observable variables. One can think
of this as modeling the behavior of yt after marginalizing out all other variables. While it’s
not immediately clear why a model that has other explanatory variables should marginalize
to a linear in the parameters time series model, most time series work is done with linear
models, though nonlinear time series is also a large and growing field. We’ll stick with
linear time series models.
25.2.1. Basic concepts.
D EFINITION 53 (Stochastic process). A stochastic process is a sequence of random

variables, indexed by time:
∞
(25.2.1) {Yt }t=−∞
D EFINITION 54 (Time series). A time series is one observation of a stochastic process,

over a specific interval:
n
(25.2.2) {yt }t=1
So a time series is a sample of size n from a stochastic process. It’s important to keep
in mind that conceptually, one could draw another sample, and that the values would be
different.
D EFINITION 55 (Autocovariance). The jth autocovariance of a stochastic process is
(25.2.3) γ jt = E (yt − µt )(yt− j − µt− j )
where µt = E (yt ) .
D EFINITION 56 (Covariance (weak) stationarity). A stochastic process is covariance

stationary if it has time constant mean and autocovariances of all orders:
µt = µ, ∀t
γ jt = γ j , ∀t
As we’ve seen, this implies that γ j = γ− j : the autocovariances depend only one the
interval between observations, but not the time of the observations.
D EFINITION 57 (Strong stationarity). A stochastic process is strongly stationary if the

joint distribution of an arbitrary collection of the {Yt } doesn’t depend on t.
Since moments are determined by the distribution, strong stationarity⇒weak station-

arity.
What is the mean of Yt ? The time series is one sample from the stochastic process. One
could think of M repeated samples from the stoch. proc., e.g., {ytm } By a LLN, we would
expect that
1 M p
lim
M→∞ M
∑ ytm → E (Yt )
m=1
The problem is, we have only one sample to work with, since we can’t go back in time and
collect another. How can E (Yt ) be estimated then? It turns out that ergodicity is the needed
property.
D EFINITION 58 (Ergodicity). A stationary stochastic process is ergodic (for the mean)

if the time average converges to the mean
1 n p
(25.2.4) ∑
n t=1
yt → µ
A sufficient condition for ergodicity is that the autocovariances be absolutely summa-

ble:
∞
∑ |γ j | < ∞
j=0
This implies that the autocovariances die off, so that the yt are not so strongly dependent
that they don’t satisfy a LLN.
D EFINITION 59 (Autocorrelation). The jth autocorrelation, ρ j is just the jth autoco-

variance divided by the variance:
γj
(25.2.5) ρj =
γ0
D EFINITION 60 (White noise). White noise is just the time series literature term for a
classical error. εt is white noise if i) E (εt ) = 0, ∀t, ii) V (εt ) = σ2 , ∀t, and iii) εt and εs are
independent, t 6= s. Gaussian white noise just adds a normality assumption.
25.2.2. ARMA models. With these concepts, we can discuss ARMA models. These
are closely related to the AR and MA error processes that we’ve already discussed. The
main difference is that the lhs variable is observed directly now.
MA(q) processes. A qth order moving average (MA) process is
yt = µ + εt + θ1 εt−1 + θ2 εt−2 + · · · + θq εt−q
where εt is white noise. The variance is
γ0 = E (yt − µ)2
= E (εt + θ1 εt−1 + θ2 εt−2 + · · · + θq εt−q )2

= σ2 1 + θ21 + θ22 + · · · + θ2q
Similarly, the autocovariances are
γj = θ j + θ j+1θ1 + θ j+2 θ2 + · · · + θq θq− j , j ≤ q

= 0, j > q
Therefore an MA(q) process is necessarily covariance stationary and ergodic, as long as σ 2

and all of the θ j are finite.
AR(p) processes. An AR(p) process can be represented as
yt = c + φ1 yt−1 + φ2 yt−2 + · · · + φ p yt−p + εt

The dynamic behavior of an AR(p) process can be studied by writing this pth order differ-
ence equation as a vector first order difference equation:
 
    φ1 φ2 · · · φp    
yt c   1 0
 yt−1
 εt
    0 0    
 yt−1   0  ..   yt−2   0 
 .  =  .  0 1 0 . 0     
 .   .    ..  +  .. 
 .   .  . .. .. ..   .   . 
 .. . . . 0··· 
yt−p+1 0   yt−p 0
0 ··· 0 1 0
or
Yt = C + FYt−1 + Et
With this, we can recursively work forward in time:
Yt+1 = C + FYt + Et+1

= C + F (C + FYt−1 + Et ) + Et+1
= C + FC + F 2Yt−1 + FEt + Et+1
and
Yt+2 = C + FYt+1 + Et+2

= C + F C + FC + F 2Yt−1 + FEt + Et+1 + Et+2
= C + FC + F 2C + F 3Yt−1 + F 2 Et + FEt+1 + Et+2
or in general
Yt+ j = C + FC + · · · + F jC + F j+1Yt−1 + F j Et + F j−1 Et+1 + · · · + FEt+ j−1 + Et+ j
Consider the impact of a shock in period t on yt+ j . This is simply

∂Yt+ j j
= F(1,1)
∂Et0 (1,1)
If the system is to be stationary, then as we move forward in time this impact must die off.
Otherwise a shock causes a permanent change in the mean of yt . Therefore, stationarity
requires that
j
lim F =0
j→∞ (1,1)
• Save this result, we’ll need it in a minute.
Consider the eigenvalues of the matrix F. These are the for λ such that
|F − λIP| = 0
The determinant here can be expressed as a polynomial. for example, for p = 1, the matrix
F is simply
F = φ1
so
|φ1 − λ| = 0
can be written as
φ1 − λ = 0
When p = 2, the matrix F is " #

φ1 φ2
F=
1 0
so " #
φ1 − λ φ 2
F − λIP =
1 −λ
and
|F − λIP| = λ2 − λφ1 − φ2
So the eigenvalues are the roots of the polynomial
λ2 − λφ1 − φ2
which can be found using the quadratic equation. This generalizes. For a pth order AR
process, the eigenvalues are the roots of
λ p − λ p−1φ1 − λ p−2φ2 − · · · − λφ p−1 − φ p = 0
Supposing that all of the roots of this polynomial are distinct, then the matrix F can be
factored as
F = T ΛT −1
where T is the matrix which has as its columns the eigenvectors of F, and Λ is a diagonal
matrix with the eigenvalues on the main diagonal. Using this decomposition, we can write

F j = T ΛT −1 T ΛT −1 · · · T ΛT −1
where T ΛT −1 is repeated j times. This gives
F j = T Λ j T −1
and  
j
λ1 0 0
 j 
 0 λ2 
j
Λ =
 ..


 . 
j
0 λp
Supposing that the λi i = 1, 2, ..., p are all real valued, it is clear that
j
lim F =0
j→∞ (1,1)
requires that
|λi | < 1, i = 1, 2, ..., p
e.g., the eigenvalues must be less than one in absolute value.
• It may be the case that some eigenvalues are complex-valued. The previous result
generalizes to the requirement that the eigenvalues be less than one in modulus,
where the modulus of a complex number a + bi is
p
mod(a + bi) = a2 + b2
This leads to the famous statement that “stationarity requires the roots of the
determinantal polynomial to lie inside the complex unit circle.” draw picture
here.
• When there are roots on the unit circle (unit roots) or outside the unit circle, we
leave the world of stationary processes.
j
• Dynamic multipliers: ∂yt+ j /∂εt = F(1,1) is a dynamic multiplier or an impulse-
response function. Real eigenvalues lead to steady movements, whereas comlpex
eigenvalue lead to ocillatory behavior. Of course, when there are multiple eigen-
values the overall effect can be a mixture. pictures
Invertibility of AR process
To begin with, define the lag operator L
Lyt = yt−1
The lag operator is defined to behave just as an algebraic quantity, e.g.,
L2 yt = L(Lyt )
= Lyt−1
= yt−2
or
(1 − L)(1 + L)yt = 1 − Lyt + Lyt − L2 yt

= 1 − yt−2
A mean-zero AR(p) process can be written as
yt − φ1 yt−1 − φ2 yt−2 − · · · − φ p yt−p = εt
or
yt (1 − φ1 L − φ2 L2 − · · · − φ p L p ) = εt
Factor this polynomial as
1 − φ1L − φ2 L2 − · · · − φ p L p = (1 − λ1L)(1 − λ2L) · · · (1 − λ pL)
For the moment, just assume that the λi are coefficients to be determined. Since L is defined
to operate as an algebraic quantitiy, determination of the λi is the same as determination of
the λi such that the following two expressions are the same for all z :
1 − φ1z − φ2 z2 − · · · − φ p z p = (1 − λ1z)(1 − λ2z) · · · (1 − λ pz)
Multiply both sides by z−p
z−p − φ1 z1−p − φ2 z2−p − · · · φ p−1 z−1 − φ p = (z−1 − λ1 )(z−1 − λ2 ) · · · (z−1 − λ p)
and now define λ = z−1 so we get
λ p − φ1 λ p−1 − φ2 λ p−2 − · · · − φ p−1 λ − φ p = (λ − λ1)(λ − λ2) · · · (λ − λ p)

The LHS is precisely the determinantal polynomial that gives the eigenvalues of F. There-
fore, the λi that are the coefficients of the factorization are simply the eigenvalues of the
matrix F.
Now consider a different stationary process
(1 − φL)yt = εt
• Stationarity, as above, implies that |φ| < 1.
Multiply both sides by 1 + φL + φ2L2 + ... + φ j L j to get

1 + φL + φ2L2 + ... + φ j L j (1 − φL)yt = 1 + φL + φ2L2 + ... + φ j L j εt
or, multiplying the polynomials on th LHS, we get

1 + φL + φ2L2 + ... + φ j L j − φL − φ2 L2 − ... − φ j L j − φ j+1 L j+1 yt

== 1 + φL + φ2L2 + ... + φ j L j εt
and with cancellations we have

1 − φ j+1L j+1 yt = 1 + φL + φ2L2 + ... + φ j L j εt
so

yt = φ j+1 L j+1 yt + 1 + φL + φ2L2 + ... + φ j L j εt
Now as j → ∞, φ j+1 L j+1 yt → 0, since |φ| < 1, so

= 1 + φL + φ2L2 + ... + φ j L j εt
yt ∼
and the approximation becomes better and better as j increases. However, we started with
(1 − φL)yt = εt
Substituting this into the above equation we have

= 1 + φL + φ2L2 + ... + φ j L j (1 − φL)yt
yt ∼
so

1 + φL + φ2L2 + ... + φ j L j (1 − φL) ∼
=1
and the approximation becomes arbitrarily good as j increases arbitrarily. Therefore, for
|φ| < 1, define
∞
(1 − φL)−1 = ∑ φ jL j
j=0
Recall that our mean zero AR(p) process
yt (1 − φ1 L − φ2 L2 − · · · − φ p L p ) = εt
can be written using the factorization
yt (1 − λ1L)(1 − λ2 L) · · · (1 − λ pL) = εt
where the λ are the eigenvalues of F, and given stationarity, all the |λ i | < 1. Therefore, we
can invert each first order polynomial on the LHS to get
! ! !
∞ ∞ ∞
∑ λ1 L j ∑ λ2 L j · · · ∑ λ pj L j
j j
yt = εt
j=0 j=0 j=0
The RHS is a product of infinite-order polynomials in L, which can be represented as
yt = (1 + ψ1L + ψ2 L2 + · · · )εt
where the ψi are real-valued and absolutely summable.
• The ψi are formed of products of powers of the λi , which are in turn functions of
the φi .
• The ψi are real-valued because any complex-valued λi always occur in conju-
gate pairs. This means that if a + bi is an eigenvalue of F, then so is a − bi. In
multiplication
(a + bi)(a − bi) = a2 − abi + abi − b2i2

= a2 + b2
which is real-valued.
• This shows that an AR(p) process is representable as an infinite-order MA(q)
process.
• Recall before that by recursive substitution, an AR(p) process can be written as
Yt+ j = C + FC + · · · + F jC + F j+1Yt−1 + F j Et + F j−1 Et+1 + · · · + FEt+ j−1 + Et+ j
If the process is mean zero, then everything with a C drops out. Take this and lag
it by j periods to get
Yt = F j+1Yt− j−1 + F j Et− j + F j−1 Et− j+1 + · · · + FEt−1 + Et
As j → ∞, the lagged Y on the RHS drops out. The Et−s are vectors of zeros
except for their first element, so we see that the first equation here, in the limit, is
just
∞
yt = ∑ F j 1,1 εt− j
j=0
which makes explicit the relationship between the ψi and the φi (and the λi as
well, recalling the previous factorization of F j ).
Moments of AR(p) process. The AR(p) process is
yt = c + φ1 yt−1 + φ2 yt−2 + · · · + φ p yt−p + εt
Assuming stationarity, E (yt ) = µ, ∀t, so
µ = c + φ1µ + φ2µ + ... + φ pµ
so
c
µ=
1 − φ1 − φ2 − ... − φ p
and
c = µ − φ1µ − ... − φ pµ
so
yt − µ = µ − φ1µ − ... − φ pµ + φ1yt−1 + φ2 yt−2 + · · · + φ p yt−p + εt − µ

= φ1 (yt−1 − µ) + φ2(yt−2 − µ) + ... + φ p(yt−p − µ) + εt
With this, the second moments are easy to find: The variance is
γ0 = φ1 γ1 + φ2 γ2 + ... + φ pγ p + σ2
The autocovariances of orders j ≥ 1 follow the rule
γj = E [(yt − µ)(yt− j − µ))]

= E [(φ1 (yt−1 − µ) + φ2(yt−2 − µ) + ... + φ p(yt−p − µ) + εt ) (yt− j − µ)]
= φ1 γ j−1 + φ2 γ j−2 + ... + φ pγ j−p
Using the fact that γ− j = γ j , one can take the p + 1 equations for j = 0, 1, ..., p, which have
p + 1 unknowns (σ2 , γ0 , γ1 , ..., γ p ) and solve for the unknowns. With these, the γ j for j > p
can be solved for recursively.
Invertibility of MA(q) process. An MA(q) can be written as
yt − µ = (1 + θ1L + ... + θqLq )εt
As before, the polynomial on the RHS can be factored as
(1 + θ1L + ... + θqLq ) = (1 − η1L)(1 − η2 L)...(1 − ηq L)
and each of the (1 − ηi L) can be inverted as long as |ηi | < 1. If this is the case, then we can
write
(1 + θ1L + ... + θqLq )−1 (yt − µ) = εt
where
(1 + θ1L + ... + θqLq )−1
will be an infinite-order polynomial in L, so we get
∞
∑ −δ j L j (yt− j − µ) = εt
j=0
with δ0 = −1, or
(yt − µ) − δ1(yt−1 − µ) − δ2(yt−2 − µ) + ... = εt
or
yt = c + δ1yt−1 + δ2 yt−2 + ... + εt
where
c = µ + δ1µ + δ2µ + ...
So we see that an MA(q) has an infinite AR representation, as long as the |η i | < 1, i =
1, 2, ..., q.
• It turns out that one can always manipulate the parameters of an MA(q) process
to find an invertible representation. For example, the two MA(1) processes
yt − µ = (1 − θL)εt
and
yt∗ − µ = (1 − θ−1L)εt∗
have exactly the same moments if
σ2ε∗ = σ2ε θ2
For example, we’ve seen that
γ0 = σ2 (1 + θ2 ).
Given the above relationships amongst the parameters,
γ∗0 = σ2ε θ2 (1 + θ−2) = σ2 (1 + θ2)
so the variances are the same. It turns out that all the autocovariances will be the
same, as is easily checked. This means that the two MA processes are observa-
tionally equivalent. As before, it’s impossible to distinguish between observa-
tionally equivalent processes on the basis of data.
• For a given MA(q) process, it’s always possible to manipulate the parameters to
find an invertible representation (which is unique).
• It’s important to find an invertible representation, since it’s the only representa-
tion that allows one to represent εt as a function of past y0 s. The other represen-
tations express
• Why is invertibility important? The most important reason is that it provides a
justification for the use of parsimonious models. Since an AR(1) process has an
MA(∞) representation, one can reverse the argument and note that at least some
MA(∞) processes have an AR(1) representation. At the time of estimation, it’s a
lot easier to estimate the single AR(1) coefficient rather than the infinite number
of coefficients associated with the MA representation.
• This is the reason that ARMA models are popular. Combining low-order AR
and MA models can usually offer a satisfactory representation of univariate time
series data with a reasonable number of parameters.
• Stationarity and invertibility of ARMA models is similar to what we’ve seen - we
won’t go into the details. Likewise, calculating moments is similar.
E XERCISE 61. Calculate the autocovariances of an ARMA(1,1) model: (1 + φL)yt =

c + (1 + θL)εt
Bibliography
[1] Davidson, R. and J.G. MacKinnon (1993) Estimation and Inference in Econometrics, Oxford Univ. Press.
[2] Davidson, R. and J.G. MacKinnon (2004) Econometric Theory and Methods, Oxford Univ. Press.
[3] Gallant, A.R. (1985) Nonlinear Statistical Models, Wiley.
[4] Gallant, A.R. (1997) An Introduction to Econometric Theory, Princeton Univ. Press.
[5] Hamilton, J. (1994) Time Series Analysis, Princeton Univ. Press
[6] Hayashi, F. (2000) Econometrics, Princeton Univ. Press.
[7] Wooldridge (2003), Introductory Econometrics, Thomson. (undergraduate level, for supplementary use
only).
309
Index
asymptotic equality, 284
Chain rule, 280

Cobb-Douglas model, 18
convergence, almost sure, 282
convergence, in distribution, 282
convergence, in probability, 282
Convergence, ordinary, 281
convergence, pointwise, 281
convergence, uniform, 281
convergence, uniform almost sure, 282
cross section, 16
estimator, linear, 23, 29

estimator, OLS, 19
extremum estimator, 150
leverage, 23
likelihood function, 36
matrix, idempotent, 22
matrix, projection, 22
matrix, symmetric, 22
observations, influential, 22
outliers, 22
own influence, 23
parameter space, 36
Product rule, 280
R- squared, uncentered, 24
R-squared, centered, 25
310

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Econometrics

Version 0.81, March, 2006

D EPT. OF E CONOMICS AND E CONOMIC H ISTORY, U NIVERSITAT AUTÒNOMA DE BARCELONA ,

Chapter 1. About this document 13

Chapter 2. Introduction: Economic and econometric models 16

Chapter 3. Ordinary Least Squares 18

Chapter 4. Maximum likelihood estimation 36

4.6. The information matrix equality 43

Chapter 5. Asymptotic properties of the least squares estimator 47

Chapter 6. Restrictions and hypothesis tests 50

Chapter 7. Generalized least squares 71

Chapter 8. Stochastic regressors 97

Chapter 9. Data problems 102

Chapter 10. Functional form and nonnested tests 114

Chapter 11. Exogeneity and simultaneity 123

11.8.2. FIML 147

Chapter 12. Introduction to the second half 150

Chapter 13. Numeric optimization methods 156

Chapter 14. Asymptotic properties of extremum estimators 173

Chapter 15. Generalized method of moments (GMM) 185

15.9.5. Maximum likelihood 199

Chapter 16. Quasi-ML 211

Chapter 17. Nonlinear least squares (NLS) 222

Chapter 18. Nonparametric inference 230

18.7.2. Seminonparametric ML estimation and the MEPS data 247

Chapter 19. Simulation-based estimation 250

Chapter 20. Parallel programming for econometrics 266

Chapter 21. Final project: econometric estimation of a RBC model 272

Chapter 22. Introduction to Octave 277

Chapter 23. Notation and Review 280

23.2. Convergenge modes 281

Chapter 24. The GPL 286

Chapter 25. The attic 292

3.2.1 Typical data, Classical Model 19

6.5.1 Joint and Individual Confidence Regions 62

7.4.1 Residuals, Nerlove model, sorted by firm size 80

9.1.1 s(β) when there is no collinearity 103

13.1.1 The search method 157

13.5.1 A foggy mountain 169

15.10.1 OLS 202

18.1.1 True and simple approximating functions 231

20.1.1 Speedups from parallelization 270

21.1.1 Consumption and Investment, Levels 272

22.2.1 Running an Octave program 278

1 Marginal Variances, Sample and Estimated (Poisson) 214

1 Actual and Poisson fitted frequencies 292

About this document

1.2. Obtaining the materials

F IGURE 1.2.1. LYX

1.3. An easy way to use LYX and Octave today

F IGURE 1.2.2. Octave

1.4. Known Bugs

This section is a reminder to myself to try to fix a few things.

Introduction: Economic and econometric models

• x is the quantity demanded

The model is not estimable as it stands, since: