STRATHMORE INSTITUTE OF MATHEMATICAL SCIENCES

BBS Actuarial Science, Financial Economics, Financial Engineering

END OF SEMESTER EXAMINATION
BSE 2103: INTRODUCTORY ECONOMETRICS

DATE: Monday, 25th July 2022 Time: 2 hours

Instructions
1. This examination consists of FIVE questions.
2. Answer Question ONE (COMPULSORY) and any other TWO questions.

(𝑅 2 𝑢𝑟 − 𝑅 2 𝑟 )/𝑄
F-Statistic:
(1− 𝑅 2 𝑢𝑟 )/ 𝑛−𝑘−1

Question One (30 Marks)

Assuming that you are interested in analysing the relationship between the salary earned by newly
recruited lawyers and their college GPA, the number of books in the library, cost of studying a
law degree and the entry class size such that:

𝑠𝑎𝑙𝑎𝑟𝑦 = 𝛽0 + 𝛽1 𝐺𝑃𝐴 + 𝛽2 𝑙𝑖𝑏𝑣𝑜𝑙 + 𝛽3 𝑙𝑐𝑜𝑠𝑡 + 𝛽4 𝑐𝑙𝑠𝑖𝑧𝑒 + 𝛽5 𝑐𝑙𝑠𝑖𝑧𝑒 ∗ 𝑙𝑖𝑏𝑣𝑜𝑙 + 𝑢

Where:
salary Salary of lawyers in dollars
GPA College GPA
libvol Number of law books in the college library
lcost Natural log of cost of a law degree
clsize Class size
𝑐𝑙𝑠𝑖𝑧𝑒 ∗ 𝑙𝑖𝑏𝑣𝑜𝑙 clsize x libvol

Using a random sample of 133 newly employed lawyers, you estimate the following regression
using the OLS estimation technique,
̂ =𝛽
𝑠𝑎𝑙𝑎𝑟𝑦 ̂0 + 𝛽
̂1 𝐺𝑃𝐴 + 𝛽
̂2 𝑙𝑖𝑏𝑣𝑜𝑙 + 𝛽
̂3 𝑙𝑐𝑜𝑠𝑡 + ̂
𝛽4 𝑐𝑙𝑠𝑖𝑧𝑒 + ̂
𝛽5 𝑐𝑙𝑠𝑖𝑧𝑒 ∗ 𝑙𝑖𝑏𝑣𝑜𝑙

Table 1 on page 6 displays the STATA output for the above regression. Use the STATA output
to answer the questions on the following page.

Page 1 of 11
 a) Carefully interpret the coefficient on lcost. Moreover, does lcost have the expected sign?
Explain. [4 marks]
b) Your friend Valarie strongly believes that class size has no effect on the salary earned and
therefore, it should be dropped from the regression. Assuming that class size is a relevant
variable, and the correlation between all the explanatory variables is substantial, would
̂3 capture the unbiased effect of lcost on salary? Discuss.
𝛽 [4 marks]

c) State the null hypothesis that the number of law books in the library has no effect on
salary, against the alternative that the number of law books in the library has an effect on
salary. With aid of a t-test, would you reject the hypothesis at the 1% level of significance?
Show all your workings and clearly state your conclusion. After stating the technical
conclusion of your hypothesis test, be sure to state in plain language what this test result
allows you to conclude. [6 marks]
d) (i) State the result of the differentiation of salary with respect to class size. [1 mark]
(ii) Given that the initial number of law books in the library (libvol) is 200, what is the
predicted change in salary given a decrease in class size of 10? [3 marks]
e) What would be the predicted change in salary if i) college GPA increases by one more
point and ii) the cost of a law degree increases by 3% holding other variables constant?
[3 marks]
f) Using the results from Table 2 on page 6
i) With relevant calculations (using Breusch Pagan test), determine whether the
regression suffers from the problem of heteroscedasticity. [3 marks]
ii) Clearly discuss any three consequences of heteroskedasticity. [6 marks]

Question 2 through Question 5 are drawn from the study by Appel and Loyle (2012) whose aim
was to assess the role of Post Conflict Justice (PCJ) on net Foreign Direct Investment (FDI)
inflows in states that have experienced conflicts in the past. Post-conflict justice is defined as any
process initiated within five years following an armed conflict that attempts to address
wrongdoings, which took place during the conflict. FDI is an investment to acquire a lasting
interest in a firm operating in an economy other than that of the investor. The results of the study
indicate that post-conflict states that implement restorative justice processes in the post-conflict
period receive higher levels of FDI than those countries that do not.

Page 2 of 11
Using the definition of variables in Table 3 page 7 and OLS results in Table 4 on page 8
answer Questions 2 through 5.
Question Two (15 Marks)
Note: Use Regression 2 in Table 4 to answer the following questions.
a) Interpret the coefficient on Economic growth. In addition, explain whether this is the
expected sign of the coefficient. [3 marks]
b) State the null hypothesis that economic growth has no effect on FDI, against the
alternative that economic growth has a positive effect on FDI. [1 mark]
c) Perform the hypothesis test in part (b) above. Make sure to state the formula for the
relevant statistic, the values you plug into the formula, the value you derive for your
statistic, the significance level of your test, your critical value and your conclusion. After
stating the technical conclusion of your hypothesis test, be sure to state in plain language
what this test result allows you to conclude. [5 marks]
d) Is the effect of economic growth on FDI economically significant? Briefly discuss.
[2 marks]
e) Identify one variable that might belong in Regression 2 but is not included here. State
everything that would have to be true about an omitted variable for its omission to produce
either an upward or downward bias in the estimate of the effect of economic growth on
FDI. [4 marks]

Question Three (15 marks)

a) In Regression 2, interpret the coefficient on Labor force. [2 marks]
b) Suppose the authors have omitted an important variable in Regression 2 and used OLS
to estimate the regression. Can the OLS estimator still “consistently” estimate the effect
of PCJ on net FDI inflows in post-conflict states? Clearly discuss. (Use the formula
developed in class in your discussion and define all notation clearly). [4 marks]
c) Compare the economic significance of the estimate of Labor force effect on FDI in
Regression 1 and Regression 2. Clearly discuss how you arrived at your conclusion. Be
sure to state which effect is economically larger or smaller. [3 marks]
d) Perform the hypothesis test to examine whether all independent variables in Regression
2 are jointly significant in explaining our dependent variable net FDI inflows at the 5%
level of significance.

Page 3 of 11
 Make sure to state the null and alternative hypothesis, the formula for the relevant statistic,
the values you plug into the formula, the value you derive for your statistic, your critical
values and your conclusion. After stating the technical conclusion of your hypothesis test,
be sure to state in plain language what this test result allows you to conclude about the
significance of these variables. [6 marks]

Question Four (15 marks)

Note: Use Regression 2 in Table 4 to answer the following questions.
a) Suppose the researchers wanted to find out whether: the effect of economic growth on net
FDI inflows differs across countries depending on the Labor force.
i) State the new variable that will have to be included in Regression 2. [2 marks]
ii) State the null and alternative hypothesis that best addresses the question, does the
effect of economic growth on net FDI inflows differ across countries depending on
the Labor force? [3 marks]
b) Suppose you find a sample correlation of 0.95 between economic growth and economic
development and a VIF> 10 for both variables.
i) As a result, what econometric problem does this regression appear to have?
Explain. [2 marks]
ii) Clearly discuss any two consequences of the econometric problem identified in
part b(i) above. [4 marks]
c) Regression 2 contains the variable Economic size. However, the researchers decide to
include ‘Economic size squared’ i.e. (economic size 2) in the regression and the coefficient
on (Economic size 2) turns out to be negative. Draw the estimated relationship between
the dependent variable net FDI inflows and economic size. [2 marks)]
d) Suppose the variable economic size 2 has a large partial effect on FDI. Discuss the Gauss
Markov assumption that is likely to be violated if economic size2 is omitted from
Regression 2. [2 marks]

Page 4 of 11
Question Five (15 marks)
Note: Use Regression 3 in Table 4 to answer the following questions.
a) In terms of the parameters using Regression 3, state the null hypothesis that a 1-point
increase in democracy is offset by a 1 percentage point increase in political constraints.
[2 marks]
b) Explain why it would not be possible to test the null hypothesis in 5 (a) above from the
reported results in Regression 3. [2 marks]
c) Rewrite the regression equation in terms of 𝛽0 , 𝜃1 , 𝛽2 𝑎𝑛𝑑 𝛽3 that will allow you test the
hypothesis in 5 (a) above. [6 marks]
d) Define the term ‘causality’. In addition, do you think the effect of democracy on net FDI
inflows is causally significant? Explain your answer. [3 marks]
e) What econometric problems (if any) out of irrelevant variables and omitted variables
appear to exist in Regression 3? [2 marks]

Page 5 of 11
Table 1: OLS Regression STATA output

. reg salary GPA libvol lcost clsize clsizelibvol

Source SS df MS Number of obs = 133

F(5, 127) = 66.80
Model 1.4715e+10 5 2.9431e+09 Prob > F = 0.0000
Residual 5.5952e+09 127 44056990.8 R-squared = 0.7245
Adj R-squared = 0.7137
Total 2.0311e+10 132 153868852 Root MSE = 6637.5

salary Coefficient Std. err. t P>|t| [95% conf. interval]

GPA 32720.84 3906.554 8.38 0.000 24990.48 40451.21

libvol 32.7234 8.695685 3.76 0.000 15.51621 49.93059
lcost 6715.419 1697.443 3.96 0.000 3356.486 10074.35
clsize 21.89479 9.170316 2.39 0.018 3.748386 40.04119
clsizelibvol -.036856 .0181711 -2.03 0.045 -.0728133 -.0008987
_cons -145158.5 18598.23 -7.80 0.000 -181961 -108355.9

salary Salary of lawyers in dollars

GPA College GPA
libvol Number of law books in the college library
lcost Natural log of cost of a law degree
clsize Class size
clsize*libvol clsize x libvol

Table 2: Regression 2 from STATA output

. predict res, residuals
(23 missing values generated)

. gen residuals_squared= res* res

(23 missing values generated)

. reg residuals_squared GPA libvol lcost clsize clsizelibvol

Source SS df MS Number of obs = 133

F(5, 127) = 2.92
Model 4.6790e+16 5 9.3579e+15 Prob > F = 0.0158
Residual 4.0728e+17 127 3.2069e+15 R-squared = 0.1030
Adj R-squared = 0.0677
Total 4.5407e+17 132 3.4399e+15 Root MSE = 5.7e+07

residuals_~d Coefficient Std. err. t P>|t| [95% conf. interval]

GPA 6.31e+07 3.33e+07 1.89 0.061 -2866991 1.29e+08

libvol 24721.2 74189.13 0.33 0.740 -122085.7 171528.1
lcost 5100982 1.45e+07 0.35 0.725 -2.36e+07 3.38e+07
clsize 137645.7 78238.55 1.76 0.081 -17174.27 292465.7
clsizelibvol -73.23926 155.0305 -0.47 0.637 -380.0166 233.5381
_cons -2.50e+08 1.59e+08 -1.58 0.118 -5.64e+08 6.40e+07

Page 6 of 11
Table 3: Description of variables from the paper Appel and Loyle (2012) on the effect of
Post-conflict justice on net FDI inflows in post-conflict states
Variable Measurement
FDI is an investment to acquire a lasting interest (10% or more
Net Foreign Direct Investment voting stock) in a firm operating in an economy other than that of
(FDI) inflows the investor. Net FDI inflows are measured as total FDI inflows
minus total FDI outflows in millions of US dollars.
Any process initiated within 5 years following an armed conflict
that attempts to address wrongdoings, which took place during the
Post-conflict justice
conflict. The episode receives a 1 if a state implemented at least one
Post Conflict Justice process within five years; and 0 otherwise.
Measured as Gross Domestic Product (GDP) as a percentage of the
Economic development
total population.
Measured as Gross Domestic Product (GDP). GDP is the market
Economic size value of all final goods and services produced within a country in a
given period of time.
Economic growth Measured as the growth (in percentage points) of GDP per capita.
KAOPEN Index Measurement of a country's degree of capital account openness.
Measured as the ratio of the exchange rate in a given year (relative
Exchange rate
to the US dollar) to its mean value over the previous two years.
Measured as the number of people that could be economically
Labour force active (ages 15–64) as a percentage of the total population. This
variable is measured in percentage points.
Life expectancy (Female) average female life expectancy.
Measures the degree of domestic political constraints, which are
factors that may interfere with the decision-making process in
Political constraints
government. This is a variable that ranges from 0% to 86%. Higher
numbers indicate greater stability.
Democratic states are viewed as more secure and stable compared
Democracy to non-democratic states. This variable ranges from -10 (no
democracy) to 10 (fully democratic).
Continuous variable that measures the amount of pre-conflict GDP
Damage
lost by the end of the conflict.
Duration Measured as the total number of days of the conflict episode.
Dummy variable that is coded 1 if the disputants ended the conflict
Peace agreement
with an agreement, and 0 otherwise.
Dummy variable that equals 1 if one side emerged as the clear
Victory
winner in the conflict, and 0 otherwise.
Dummy variable that equals 1 if it is a Cold War period, and 0
Cold War
otherwise.

Page 7 of 11
Table 4: The Effect of Post Conflict Justice on net FDI inflows in post conflict states

Dependent Variable: Net FDI inflows

Independent Variables Regression 1 Regression 2 Regression 3

Post-conflict justice 1532.6 1960.3 1654.7

(629.4) (703.0) (722.9)
Economic development -0.0576 - 0.111
(0.134) (0.133)
Economic size 1.05e-08 1.10e-08
(1.67e-09) (1.74e-09)
Economic growth 0.724 37.40
(21.30) (23.24)
KAOPEN Index 132.6 198.8
(208.0) (201.6)
Exchange rate -49.22 -42.52
(13.56) (13.89)
Labor force 14.72 9.844
(25.45) (25.53)
Life expectancy (Female) 17.39 3.475
(30.29) (32.99)
Political constraints 2558.0 4389.1
(1459.6) (1366.3)
Democracy -90.17 -99.64
(56.31) (61.24)
Damage 28.38
(10.24)
Duration 0.811
(35.54)
Peace agreement -1215.1
(793.8)
Victory -33.97
(650.7)
Cold War 81.53
(654.1)
Constant -2011.6 -1278.3 -632.6
(2677.9) (2852.3) (459.2)
n (Number of 95 95 95
Observations)
R2 0.424 0.514 0.156
Adjusted R2 0.370 0.422 0.128
Standard errors are reported in (parentheses).

Reference:
Appel, B. J., & Loyle, C. E. (2012). The economic benefits of justice: Post-conflict justice and
foreign direct investment. Journal of Peace Research, 49(5), 685–699.

Page 8 of 11
Table 5 - Critical Values for the t-distribution

Page 9 of 11
Table 6 – 5% Critical Values for the F-distribution

DF1- Numerator degrees of freedom

DF2-Denominator degrees of freedom

Page 10 of 11
Table 7 - Critical Values of the Chi-Square Distribution

Page 11 of 11