REGRESSION

WITH SINGLE REGRESSOR

Simple linear regression
Stock and Watson (Chapter 5)

HYPOTHESIS TESTING:STEP 1
Specify null hypothesis and alternative hypothesis
H0: the null hypothesis
H1: the alternative Hypothesis

Choose one of the three

HYPOTHESIS TESTING:STEP 2

Choose level of significance (denoted by

the Greek letter alpha). For example,
alpha=5% the most common.

The level of significance is the probability

of type I error (i.e. of rejecting the null
hypothesis when the null hypothesis is, in
fact, correct)

HYPOTHESIS TESTING:STEP 3

Compute the test statistic on a hypothesis about 1

t=
Where 1,0 is the value of 1 hypothesized under the
null. Since under null hypothesis 1 = 0, then 1,0 = 0
(like California Test Score example)
When

t is called the t-ratio which is reported

directly in the GRETL output.

HYPOTHESIS TESTING: STEP 4

Construct the t-statistic
t=
Reject at 5% significance level if |t| > 1.96
The p-value is p = Pr[|t| > |tact|] = probability in tails of normal
outside |tact|; you reject at the 5% significance level if the pvalue is < 5%.
This procedure relies on the large-n approximation that is
normally distributed; typically n = 50 is large enough for the
approximation to be excellent.

HYPOTHESIS TESTING: STEP 4

Hypothesis testing using p-values
Decision rules:

HYPOTHESIS TESTING
EXAMPLE (CALIFORNIA DATA)
R2 = 0.05
SER = 18.6
(9.46) (0.48)
Regression software reports the standard errors:
SE() = 0.48 and SE( ) = 9.46

t-statistic testing 1,0 = 0 is:

The 1% 2-sided significance level is 2.58, so we reject the null at
the 1% significance level.
The p-value based on the large-n standard normal approximation
to the t-statistic is 0.00001 (

BINARY/DUMMY
VARIABLES
Binary/dummy variables take only two
possible values (0 or 1)
Binary/dummy variables are used in simple
linear regression to test the difference
between two means

BINARY VARIABLE:
EXAMPLE
Suppose there are two groups (60 men and
40 women). Are their mean earnings
significantly different?
Solutions
Method 1: Test for the difference between
two means using the t test
Method 2: Specify a simple linear
regression with binary variable

SOLUTION:METHOD 1
Test for the differences between the two means using the t test
Men
Women
Number of observations
Sample Mean
Sample standard deviation
: =
: (assume a two-sided test)
t

Ys Yl
ss2
ns

sl2
nl

Ys Yl

SE(Ys Yl )

Reject if |t| > 1.96 ; otherwise fail to reject

SOLUTION: METHOD 2