Exercise 1:

You are using an econometric model to study the dependence of the annual salaries of
CEOs (Chief Executive Officers) of major private companies on some variables. The
sample data consist of observations for 60 private firms which include the following
variables:
SA Li : the annual salary of the CEO of firm i th, measured in thousands of dollars;

A Ri : the annual total sales revenues of firm ith, measured in millions of dollars;

M V i : the market value of firm ith, measured in millions of dollars;

E M i : the number of years the CEO has been employed with firm i th;

AG Ei : the age of the CEO of firm ith, in years.

The regression model you propose is:

2 2
lnSA Li=β 0+ β1 lnA R i+ β2 lnM V i + β 3 E M i + β 4 E M i + β 3 AGE i+ β 4 AGE i + ui

in which (ln X i) denotes the natural logarithm of X i . E M 2 and AG E2 are the squares of
corresponding variables, ui is stochastic disturbance.
Using the data, you estimate the following regression models (estimated standard
errors in parentheses below the coefficient estimates):
( 1) ^
lnSA Li=5.572+ 0.182lnA Ri +0.102 lnM V i+ 0.046 E M i−0.00122 β 4 E M 2i −0.042 AGE i+ 0.00033 AGE 2i

se(0.0412)(0.0493)(0.0142)(0.000476)(0.0412)(0.00036)
SS R=42.060 ; SS T =64.646

( 2) ^ 2
lnSA Li=4.369+0.1 646 lnA Ri +0.10 85 lnM V i+ 0.0 4512 E M i −0.00121 β 4 E M i

SS R=42.474 ; SS T =64.64 6

1. In the model (1) above, interpret the meaning of each estimated coefficients ^
β1
and ^
β 2.

Does each independent variable AR or MV affect the salaries of CEOs?

2. In the model (1), by how much the model can explain for the variation of
salaries of CEOs?
Is it correct to say that all independent variables of the model (1) simultaneously do not
explain for the variation of the salaries of CEOs?
3. In the model (1), test the hypothesis that coefficients of AR and MV are equal
given that: cov ( β^1 , β^2 ) =−0.001473
State the coefficient restrictions that are imposed on regression equation (1) in
estimating model (2) above? Conduct a test of these coefficient restrictions and state
the meaning of this test? Based on the outcome of the test, would you choose equation
(2) or equation (1)?
4. What are the implications of introducing the squared terms of EM and AGE in the
model (1)? Present the procedure to use F-test to test the hypothesis that we can drop
out two squared terms EM2 and AGE2 from model (1) (use the form of population
regression model).

Exercise 2:
In order to explain the US defense budget, you are using the data from 1962 to 1981
with the following variables (all measured in billions USD) and estimate the
corresponding model (Model 1):(Use α=0.05 for references)
Y t: Defense budget outlay for year t
X 2t : GNP for year t
X 3t : US military sales in year t
X 4t : Aerospace industry sales in year t
D 1t : Dummy variable presenting the military conflict involving more than 100,000
troops; D 1t=1 if more than 100,000 troops are involved and equal to 0 if fewer
than 100,000 troops are involved.

Dependent Variable: Y Sample: 1962 1981

Method: Least Squares Included observations: 20
Variable Coefficient Std. Error t-Statistic Prob.
C 21.40251 1.496947 14.29744 0.0000
D1 -48.21987 6.871544 -7.017328 0.0000
X2 0.013879 0.003207 4.328062 0.0008
X3 0.073146 0.203805 0.358902 0.7254
X4 1.389753 0.130197 10.67423 0.0000
 X4*D1 1.540792 0.325005 4.740818 0.0004
X2*D1 0.022406 0.005781 3.876038 0.0019
R-squared 0.996366 Mean dependent var 83.86000
Adjusted R-squared 0.994688 S.D. dependent var 28.97771
S.E. of regression 2.111972 Akaike info criterion 4.602338
Sum squared resid 57.98554 Schwarz criterion 4.950845
Log likelihood -39.02338 F-statistic 593.9815
Durbin-Watson stat 2.233771 Prob(F-statistic) 0.000000

1. Explain the meaning of each estimated coefficient and R2 in the above model.
2. Test for significance of each independent variable and test for overall
significance of the model.
3. Conduct the test of autocorrelation in the model using the information above.
State clearly the conditions to apply this test? If those conditions are not met,
name other tests you can use instead.
4. When GNP increases by 1 bil USD (other variables unchanged), what is the
confidence interval of the difference in the changing levels of defense budget
between the cases of there are more than 100,000 or fewer than 100,000 troops
involved in the military conflict?
5. For the case when there are fewer than 100,000 troops involving in the conflict
(this condition indicates that we are concerning on the coefficients of X 2 and X 4
only), if we simultaneously increase X 2 and X 4 by 1 billions USD, test the
proposition that the defense budget will increase 1.4 billions USD. What is the
confidence interval for the increase in the level of defense budget in this case?
(The covariance between two estimated coefficients of 2 variables X 2 and X 4 is
−0.00036 ).

6. Do you think that the military budget does not depend on the number of troops
involving in the conflict given that if you regress Y on X 2 , X 3 and X 4 (with
intercept), you get R2=0.971 and SS R=461.28?

7. What would happen if the model included dummies for both cases of there are
more than 100,000 and fewer than 100,000 troops involved in the military
conflict? What is this problem called? What are the consequences of this
problem?