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Adequacy of Lagrange Multiplier Test

Article  in  European Economics Letters · December 2014

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 European Economics Letters Volume 3 Number 2 (2014) pages 32-35

Contents lists available at www.eelet.org.uk/ShowPage.aspx?ID=7

European Economics Letters

Semi Annual Online Journal
ISSN 2323-5233, ISSN-L 2323-5233
Journal homepage: www.eelet.org.uk

Adequacy of Lagrange Multiplier Test

Mei-Yu Lee a‫٭‬
a
Department of Applied Finance, Yuanpei University, HsinChu, Taiwan
‫ ٭‬Corresponding information; Email: mylee@gm.ypu.edu.tw

ARTICLE INFO ABSTRACT

Article history:
Received 8 May 2014 This paper examines the distribution of the Lagrange multiplier test, LM test, and focuses on
Accepted 30 September 2014 what factors affect the distribution of the LM test estimator. It is worth noting that due to Chi-
Available online December 2014 square distribution properties, the degree of freedom depends not only on the lagged-number
of autocorrelation, but also on the number of independent variables whatever the sample
JEL classification: sizes, that is, degree of freedom is the lagged-number of autocorrelation plus the number of
C15 independent variables. The result also indicates that the LM test estimator is not necessary to
C32 become Chi-square distribution because the different effect of the sample size and the number
C53 of independent variables, nevertheless, the law of large number, sample size is larger than
C63 1000, leads the LM test estimator toward to Chi-square distribution.
Keywords:
Lagrange multiplier test
degree of freedom
serial correlation © 2014 EELET.ORG.UK Copyright All rights reserved.
autocorrelation

1. Introduction
Lagrange Multiplier test, LM test, is first introduced by Silvey (1959) and is applied in serial correlation analysis (Breusch, 1978;
Breusch and Godfrey, 1981). LM test is built on a multivariate regression model with lagged auto-correlated errors, and an
auxiliary regression of residuals and independent variables. Depending on the equation of SST = SSR + SSE, they provided the
LM test estimator that follows Chi-square distribution with degree of freedom as the lagged-number of autocorrelation. Thus, the
LM test model is the Durbin-Watson model and follows Chi-square distribution of df = 1 when lagged-number of autocorrelation
is 1.
LM test still has the same restriction of Durbin-Watson test. The restriction is that the residuals are affected by the values of
independent variables and linear requirement of the residuals, even though Breusch and Godfrey (1981) has considered that an
auxiliary regression can be solved the problems of Durbin-Watson test for serial correlation analysis. In fact, LM test has number
analysis concept because of the existence of auxiliary regression. Simply speaking, if the concept is divided into two groups
which have fore-and-back relationship, then we cannot distinguish that each group concept is rebuilt. Thus, the degree of freedom
of auxiliary regression in the LM test model might not be the lagged-number of autocorrelation, but need to plus the number of
independent variables.
Another main reason is that time series data originally are based on Bayesian concept, but are viewed as random variables in
researches. This is due to the autoregressive model becomes simplified as OLS when the null hypothesis is zero autocorrelation
coefficient. On the contrary, nonzero autocorrelation coefficient of alternative hypothesis causes non-linear restrictions in the
regression model. The independent variables are affected by the first-order or higher-order restrictions that cannot be grabbed by
the linear method, and are difficult to show the non-linear pattern. Thus, the problem is what the restrictions of independent
variables are and how the restriction of independent variables can be grabbed by linear regression model (Lee, 2014). If data have

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 European Economics Letters Volume 3 Number 2 (2014) pages 32-35

timing factors and non-linear properties, then linear regression model cannot detect regularity. That is why a serial correlation
model is viewed as a restricted model, or a non-linear restricted dynamic model. Because of above difficulty, the autocorrelation
tests are from approximation method to build the test tables.
As to the above difficulty, we try to use computer simulation to investigate what the distributions of the LM test estimator are
under different sample size, the number of independent variables, and the lagged-number of autocorrelation. We contribute not
only revise the true degree of freedom in LM test, but also provide the condition of law of large number, sample size is larger
than 1000, guarantees the LM test estimator converges to Chi-square distribution whatever the number of independent variables
and lagged-number of autocorrelation are. The paper is structured as follows. Section 2 describes the model setting and
simulation method then section 3 shows results. Section 4 concludes.

2. Model and simulation method

Consider a linear regression model with dependent variable, Yt , k independent variables, X 1, t ,..., X k , t , and error term, ε t ,
where t = 1, 2, …, T,
Yt = β 0 + β 1 × X 1,t + .... + β k × X k ,t + ε t , t = 1,..., T , (1)
Error term has lagged-number autocorrelation as
ε t +lag = ρ1 × ε t + ... + ρ lag × ε t +lag −1 + µ t +lag (2)
where t = 1, 2, …, T – lag, lag ≥ 1, ρi is the autocorrelation coefficient of error and ρ i < 1 , i = 1, 2, …, lag and
iid
µ1,..., µ T ~ N ( 0, σ 2 ) . The residuals, ε̂ t , are derived from (1) and satisfied with the conditions of ∑ε̂t = 0 and ∑ X tεˆt = 0 , and the
degree of freedom, T – k – 1. Then the auxiliary regression is
εˆ t + lag = γ 0 + γ 1 × X t + lag ,1 + ..... + γ k × X t + lag , k + γ k + 1 × εˆ t + ... + γ k + lag × εˆ t − lag + 1 + δ t + lag , (3)
where t = 1, 2, …, T – 1, and residuals of auxiliary regression have to be satisfied with

( )
f δˆ2 , δˆ3,...,, δˆT = ∫∫ .... ∫∫ f (ε̂1, ε̂2 ,...,, ε̂ T ) J ,
which is satisfied with ∑δˆt = 0, ∑δˆt × X1t = 0,...., ∑δˆt × X kt = 0 . LM test that is alike Durbin-Watson test is only used in
hypotheses,
H 0 : ρ1 = ρ 2 = ....ρ lag = 0, H 1 : against H 0 ,
Because of SST = SSR( X 1 ,..., X k , εˆ ) + SSE ( X 1 ,..., X k , εˆ ) , LM test is calculated as

(T − lag) × R 2 T
→∞
2
→ χ k+lag , df = k + lag (4)
The degree of freedom in (4) is different from Breusch and Godfrey (1981), because auxiliary regression becomes a new
regression and independent variables of (1) are also random variables in (3) by following the regression concept. Thus, LM test is
not necessary to become Chi-square distribution, but in the law of large number, LM test follows Chi-square distribution.
Therefore, a Chi-square test table cannot indicate the effect of the number of independent variables, the values of independent
variables and autocorrelation coefficients of errors on LM test. That is why we use computer simulation to examine the
distribution of the LM test estimator.
The computer simulation environment is on a personal computer by random number method. We follow the model setting steps
to do distribution transformation and each time runs the model setting steps repeated 32768*2*1024 = 216 times to calculate 216
values of LM test as a data set. This data set can plot frequency table and calculate the moments of the LM test estimator.
Therefore, this data set is approximated to the population of LM test value.1

3. Main results

The paper gives examples of five states for operating computer simulation. The parameters of LM test are summarized in Table
1. There are five states with different parameter values and only one parameter value can be changed as shown in the second
column. State 1 to State 5 are used to examine that (1) E(LM) is not equal to the definition of Breusch and Godfrey (1981), and
(2) LM test is adopted in the law of large number and becomes Chi-square distribution.
Due to the methodology of LM test, its estimator is a Chi-square distribution and should has the property of E(LM) = 0.5
Var(LM). State 1 and State 2 in Table 2 confirm E(LM) ≈ 6 + lag, not E(LM) = lag. This means that E(LM) equals surely to 6 +
lag, that is true means of Chi-square distribution, whatever the sample size is. State 1 and State 2 also shows that the large
samples can eliminate the effect of lag and k on the LM test estimator because State 2 has significant Var(LM) ≈ 2E(LM) rather
than State 1. Comparing with State 1, State 2 shows that the LM test estimator is suitable in large sample cases, T ≥ 1000, and
becomes a stable Chi-square distribution. Here, we can summarize the results from State 1 and State 2 as follows.

1
The simulation software of LM test is provided by C.C.C. Ltd. (http://goo.gl/okMfsY). The first-order autoregressive model is the same between LM test and
Durbin-Watson test. The only difference is about their model setting, therefore, the software has been online at the website: http://goo.gl/FyiwlJ. It needs to work on
Windows 7 and java environment.

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 European Economics Letters Volume 3 Number 2 (2014) pages 32-35

Table 1 - The state table of computer simulation

State Parameter vriable Fixed parameters Null hypothesis
1 lag T = 57, k = 6 H 0 : ρ1 = ρ 2 = ρ 3 = ... = ρ lag = 0
2 lag T = 1000, k = 6 H 0 : ρ1 = ρ 2 = ρ 3 = ... = ρ lag = 0
3 T lag = 1, k = 6 H0 : ρ = 0
4 T lag = 1, k = 1 H0 : ρ = 0
5 T lag = 1, k = 9 H0 : ρ = 0

Result 1:
(1) T ≥ 1000 guarantees the LM test estimator is Chi-square distribution by Var(LM) = 2E(LM) .
(2) E(LM) = k + lag, not E(LM) = lag.

Table 2 - The coefficients of each state

State parameter Average Variance Skewed coef. Kurtosis coef.
lag T k df* E(LM) Var(LM)
1 57 6 993 7.09403 12.06862 0.80624 3.74638
1 2 57 6 993 8.26272 13.96507 0.71816 3.54497
3 57 6 993 8.82353 14.05604 0.66586 3.45019
1 1000 6 993 7.00305 13.88735 1.05499 4.65518
2 2 1000 6 993 8.00661 15.86874 0.98507 4.43937
3 1000 6 993 9.00099 17.80960 0.92711 4.27194
1 10 6 3 7.85839 1.14413 -0.94035 3.04939
1 15 6 8 8.46167 6.84595 -0.35519 2.46157
3 1 27 6 10 7.19942 9.86636 0.49358 2.94445
1 307 6 300 7.02197 13.67032 1.02150 4.51609
1 1000 6 993 7.00305 13.88735 1.05499 4.65518
1 10 1 8 2.11715 2.57639 0.85878 3.17664
1 11 1 9 2.05619 2.61399 0.95820 3.46180
4 1 22 1 20 2.03178 3.37178 1.47098 5.52956
1 102 1 100 2.00360 3.85667 1.88459 8.12279
1 502 1 500 2.00244 3.98219 1.97826 8.82353
1 20 9 10 11.10320 7.51599 -0.22095 2.67934
1 30 9 20 10.10844 12.26468 0.30482 2.78971
5
1 210 9 200 9.98926 18.82727 0.81738 3.93607
1 1010 9 1000 9.99939 19.76977 0.87888 4.14421
*The degree of freedom in state 3, 4 and 5 means the degree of freedom of linear regression model

State 3, State 4 and State 5 indicate that how the LM test estimator is affected by the change of the number of independent
variables and sample sizes in given lag = 1 and zero autocorrelation coefficient. The distributions of the LM test estimator are
skewed from left-skewed to right-skewed when the sample sizes become larger whatever the number of independent variables is.
Second, the larger number of independent variables need more samples to strength the distributions of the LM test estimator
toward to Chi-square distribution. This implies that two opposite factors, the sample size and the number of independent
variables, have impact on the distributions of LM test. Therefore, the result 2 is shown as follows.

Result 2: When other factors are unchanged,

(1) The larger the k is, the slower the distribution of LM test estimator converges to Chi-square distribution.
(2) The larger samples decrease the effect of larger k and pull LM test estimator back to Chi-square distribution.

4. Conclusion

This paper follows the model setting of Breusch and Godfrey (1981) to investigate if the LM test estimator is Chi-square
distribution depending on the validation of Var(LM) = 2E(LM). The paper operates computer simulation and finds that the
degree of freedom of LM test is based not only on the lagged-number of autocorrelation, but also on the number of independent
variables, that is, k + lag, not lag only. According to the change of sample size, the larger samples are, the more right-skewed the
LM test estimator is. The effect of sample size guarantees the results of Breusch and Godfrey, that is, the LM test estimator
becomes Chi-square distribution when samples are larger than 1000. However, if the larger number of independent variables
increases, we have to add more samples to pull the LM test estimator back to Chi-square distribution.

Acknowledgement: I thank Kuan-Sen Wang for software support. It goes without saying that all remaining errors are mine.

References
Breusch, T. and Godfrey, L.G. 1981. A Review of Recent Work on Testing for Autocorrelation in Dynamic Simultaneous
Models, in D.A. Currie, R. Nobay and D. Peel (eds.), Macroeconomic Analysis, Essays in Macroeconomics and Economics,
Croom Helm, London: 63–100.

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 European Economics Letters Volume 3 Number 2 (2014) pages 32-35

Breusch, T.S. 1978. Testing for autocorrelation in dynamic linear models. Australian Economic Papers, 17(31), 334–355.
Lee, M.Y. 2014. Computer Simulates the Effect of Internal Restriction on Residuals in Linear Regression Model with First-order
Autoregressive Procedures, Journal of Statistical and Econometric Methods, 3(3), 1–22.
Silvey, S.D. 1959. The Lagrange multiplier test, Annals of Mathematical statistics, 30(2), 389–407.

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