MEcon 514 Applied Econometrics 2014

Master of Economics Program for Professionals

Rabeya Khatoon

Department of Economics, University of Dhaka

19 October, 2014

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 1 / 16

 Cross-section Econometrics Multiple Regression Analysis: Inference

OLS Asymptotics

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 2 / 16

 Cross-section Econometrics OLS Asymptotics

Consistency

Under the Gauss-Markov assumptions OLS is BLUE

In those cases, we may consider estimators that are consistent,
meaning as n → ∞, the distribution of the estimator collapses to the
parameter value
For unbiasedness, we assumed a zero conditional mean
For consistency, we can have the weaker assumption of zero mean
and zero correlation: E (u) = 0 and Cov (xj , u) = 0, for j = 1, 2, . . . , k
Without this assumption, OLS will be biased and inconsistent

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 3 / 16

 Cross-section Econometrics OLS Asymptotics

Asymptotic Normality

Recall that under the CLM assumptions, the sampling distributions

are normal, so we could derive t and F distributions for testing
This exact normality was due to assuming the population error
distribution was normal
Any clearly skewed variable, like wages, savings, etc. can not be
normal, since a normal distribution is symmetric
Based on the central limit theorem, we can show that OLS estimators
are asymptotically normal
Therefore, under the CLM assumptions OLS estimator is unbiased,
efficient, consistent and asymptotically normal

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 4 / 16

 Cross-section Econometrics OLS Asymptotics

Inference Problems: Heteroscedasticity

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 5 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

Heteroscedasticity
The assumption of homoscedasticity implies that conditional on the
explanatory variables, the variance of the unobserved error, u, is
constant
If the variance of u is different for different values of the x’s, then the
errors are heteroscedastic

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 6 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

Problems

OLS is still unbiased and consistent, even if we do not assume

homoscedasticity
The standard errors of the estimates are biased if we have
heteroscedasticity
If the standard errors are biased, we can not use the usual t statistics
or F statistics for drawing inferences

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 7 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

Variance with Heteroscedasticity

For the simple bivariate regression, the OLS estimator
Pn
(xi − x̄)ui
β̂1 = β1 + Pi=1
n 2
(1)
i=1 (xi − x̄)

Variance of β̂1
 Pn  Pn 2 2
(xi − x̄)ui i=1 (xi − x̄) σi
Var (β̂1 ) = Var β1 + Pi=1
n 2
= P n 2
(2)
i=1 (xi − x̄) i=1 (xi − x̄)

A valid (consistent) estimator for this when σi2 6= σ 2 is

Pn
(xi − x̄)2 ûi2
Var (β̂1 ) = Pi=1
n 2
(3)
i=1 (xi − x̄)

For multivariate case

Pn 2
i=1 rˆij ûi
Var (β̂j ) = (4)
TSSj2
where, rˆij is the ith residual from regressing xj on all other independent
variables
Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 8 / 16
 Cross-section Econometrics Inference Problems: Heteroscedasticity

Robust standard errors

The square root of the consistent variance estimate can be used as a

standard error for inference
These are called robust standard errors
Important to remember that these robust standard errors only have
asymptotic justification
With small sample sizes t statistics formed with robust standard
errors will not have a distribution close to the t, and inferences will
not be correct
In stata robust standard errors are easily obtained using the robust
option of reg

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 9 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

Robust standard errors: stata

. reg lwage educ exper expersq

------------------------------------------------------------------------------
lwage | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
educ | .0903658 .007468 12.10 0.000 .0756948 .1050368
exper | .0410089 .0051965 7.89 0.000 .0308002 .0512175
expersq | -.0007136 .0001158 -6.16 0.000 -.000941 -.0004861
_cons | .1279975 .1059323 1.21 0.227 -.0801085 .3361034
------------------------------------------------------------------------------

. reg lwage educ exper expersq, robust

------------------------------------------------------------------------------
| Robust
lwage | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
educ | .0903658 .0077827 11.61 0.000 .0750766 .105655
exper | .0410089 .0050237 8.16 0.000 .0311398 .050878
expersq | -.0007136 .0001098 -6.50 0.000 -.0009292 -.0004979
_cons | .1279975 .1071261 1.19 0.233 -.0824537 .3384487
------------------------------------------------------------------------------

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 10 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

Testing for Heteroscedasticity

We want to test H0 : Var (u|x1 , x2 , , xk ) = σ 2 , which is equivalent to

H0 : E (u 2 |x1 , x2 , , xk ) = E (u 2 ) = σ 2
If assume the relationship between u2 and xj will be linear, can test as
a linear restriction
So, for u 2 = δ0 + δ1 x1 + · · · + δk xk + v this means testing
H0 : δ1 = δ2 = · · · = δk = 0

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 11 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

The Breusch-Pagan Test

After regressing the residuals squared on all of the x’s, can use the R 2
to form an F test
The F statistic is just the reported F statistic for overall significance
of the regression,
R 2 /k
F = ,
(1 − R 2 )/(n − k − 1)
which is distributed Fk,n−k−1

. reg lwage educ exper expersq

. estat hettest

Breusch-Pagan / Cook-Weisberg test for heteroskedasticity

Ho: Constant variance
Variables: fitted values of lwage

chi2(1) = 13.86
Prob > chi2 = 0.0002
Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 12 / 16
 Cross-section Econometrics Inference Problems: Heteroscedasticity

The White Test

The Breusch-Pagan test will detect any linear forms of

heteroskedasticity
The White test allows for nonlinearities by using squares and
crossproducts of all the x’s
Then use an F test to test whether all the xj , xj2 , and xj xh are jointly
significant
Alternatively,
Consider the fitted values from OLS, ŷ , that is a function of all the x’s
Thus, ŷ 2 will be a function of the squares and crossproducts and ŷ
and ŷ 2 can proxy for all of the xj , xj2 , and xj xh
Then regress the residuals squared on ŷ and ŷ 2 and use the R 2 to
form an F statistic

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 13 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

Weighted Least Squares

Transform the model into one that has homoscedastic errors

This can result in more efficient estimates than OLS
Suppose the heteroscedasticity can be modeled as Var (u|x) = σ 2 h(x),
where the trick is to figure out what h(x) = hi looks like
√
Then Var (ui / hi |x) = σ 2
√
So, if we divided our whole equation by hi we would have a model
where the error is homoscedastic
Idea is to minimize the weighted sum of squares (weighted by 1/hi )
WLS is great if we know what Var (ui |xi ) looks like

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 14 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

Feasible Generalized Least Squares

GLS is a weighted least squares (WLS) procedure where each squared

residual is weighted by the inverse of Var (ui |xi )
More typical is the case where we don’t know the form of the
heteroscedasticity
Estimate the model by OLS

Var (u|x) = u 2 = σ 2 exp(δ0 + δ1 x1 + · · · + δk xk )

Run the original OLS model, save the residuals, û, square them and
take the log
Regress ln(û 2 ) on all of the independent variables and get the fitted
values, ĝ
Do WLS using 1/exp(ĝ ) as the weight

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 15 / 16

 Cross-section Econometrics Inference Problems: Heteroscedasticity

WLS in stata
. vwls lwage educ exper expersq

Variance-weighted least-squares regression Number of obs = 393

Goodness-of-fit chi2(109) = 1527.36 Model chi2(3) = 2666.78
Prob > chi2 = 0.0000 Prob > chi2 = 0.0000
------------------------------------------------------------------------------
lwage | Coef. Std. Err. z P>|z| [95% Conf. Interval]
-------------+----------------------------------------------------------------
educ | .0921549 .0031406 29.34 0.000 .0859994 .0983103
exper | .0707619 .0020888 33.88 0.000 .0666679 .074856
expersq | -.0012064 .0000488 -24.70 0.000 -.0013021 -.0011106
_cons | -.121999 .043323 -2.82 0.005 -.2069106 -.0370874
------------------------------------------------------------------------------

. reg lwage educ exper expersq

------------------------------------------------------------------------------
lwage | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
educ | .0903658 .007468 12.10 0.000 .0756948 .1050368
exper | .0410089 .0051965 7.89 0.000 .0308002 .0512175
expersq | -.0007136 .0001158 -6.16 0.000 -.000941 -.0004861
_cons | .1279975 .1059323 1.21 0.227 -.0801085 .3361034
------------------------------------------------------------------------------
Rabeya Khatoon MEcon 514 Applied Econometrics 2014 19 October, 2014 16 / 16