Transforming Variables

Comparing Varables
Chapter 7
• Fig. 7.1 depicts the self-reported life
satisfaction from US citizens (2008).
• Each data point is the average value reported
by survey respondents in a two-year age
group.
• Scores range from 1 (dissatisfied) to 10
(satisfied).
• The relationship has a U shape.
Michael A. Bailey, Real Econometrics
Copyright © 2017 Oxford University Press
Fig. 7.1
 Quadratic and Polynomial Models
• Linear Versus Non-Linear Models
• When we refer to a “linear” model, we mean
linear in parameters – not linear in the
variables.
• OLS cannot handle models like the following:
2
• 𝑌𝑖 = 𝛽0 + 𝛽1 X1𝑖 + 𝜀𝑖
• 𝑌𝑖 = 𝛽0 + 𝛽1 X1𝑖 + 𝛽2 Χ2𝑖 + 𝜀𝑖

Michael A. Bailey, Real Econometrics

Copyright © 2017 Oxford University Press
• However, OLS can handle models non-linear in
the variables, like the following:
• 𝑌𝑖 = 𝛽0 + 𝛽1 X1𝑖 + 𝛽2 Χ2𝑖 2 + 𝜀𝑖
2
• 𝑌𝑖 = 𝛽0 + 𝛽1 X1𝑖 + 𝛽2 Χ2𝑖 + 𝜀𝑖

Michael A. Bailey, Real Econometrics

Copyright © 2017 Oxford University Press
Figure 7.2
• Polynomial Models
• 𝑌𝑖 = 𝛽0 + 𝛽1 X1𝑖 + 𝜀𝑖 [Linear]
• 𝐿𝑖𝑓𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑎𝑛𝑐𝑦𝑖 = 𝛽0 + 𝛽1 G𝐷𝑃𝑖 + 𝜀𝑖

• 𝑌𝑖 = 𝛽0 + 𝛽1 X1𝑖 + 𝛽2 Χ2𝑖 2 + 𝜀𝑖 [Quadratic]

• 𝐿𝑖𝑓𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑎𝑛𝑐𝑦𝑖 = 𝛽0 + 𝛽1 G𝐷𝑃𝑖 + 𝛽2 GDP𝑖 2 +
𝜀𝑖
𝜕𝑌
• = 𝛽1 + 2𝛽2 Χ1
𝜕𝑋1
Michael A. Bailey, Real Econometrics
Copyright © 2017 Oxford University Press
• Polynomial Models
2
• 𝑌𝑖 = 𝛽0 + 𝛽1 X1𝑖 + 𝛽2 Χ2𝑖 + 𝜀𝑖
• 𝐿𝑖𝑓𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑎𝑛𝑐𝑦𝑖 = 𝛽0 + 𝛽1 G𝐷𝑃𝑖 +
𝛽2 GDP𝑖 2 + 𝜀𝑖
𝜕𝑌
• = 𝛽1 + 2𝛽2 Χ1
𝜕𝑋1

Michael A. Bailey, Real Econometrics

Copyright © 2017 Oxford University Press
Figure 7.3
Figure 7.4
 Global Warming
• How should we characterize the trend of
global temperature?

• Te𝑚𝑝𝑜𝑟𝑎𝑟𝑒𝑖 = 𝛽0 +𝛽1 𝑌𝑒𝑎𝑟𝑖 + 𝜀𝑖

2
• Te𝑚𝑝𝑜𝑟𝑎𝑟𝑒𝑖 = 𝛽0 +𝛽1 𝑌𝑒𝑎𝑟𝑖 + 𝛽2 𝑌𝑒𝑎𝑟𝑖 + 𝜀𝑖

Michael A. Bailey, Real Econometrics

Copyright © 2017 Oxford University Press
Figure 7.5
Table 7.1
• How can the coefficients in the quadratic
model be interpreted?
• The predicted change from an increase in Year
by 1 in 1900 is:
• -0.166 + 2 x 0.000044 x 1900 = 0.0012 degree
• The predicted change in temperature from an
increase in Year 1 in 2000 is:
• -0.166 + 2 x 0.000044 x 2000 = 0.01 degree
Michael A. Bailey, Real Econometrics
Copyright © 2017 Oxford University Press
Figure 7.6
 Logged Variables
• Logs in Regression Models
• Wag𝑒𝑠𝑖𝑡 = 𝛽0 +𝛽1 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑖𝑡 + 𝜀𝑖𝑡
• What does 𝛽1 mean? Suppose 𝛽መ1 =1.25.

• Τhe log-linear model:

• ln(Wag𝑒𝑠𝑖𝑡 ) = 𝛽0 +𝛽1 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑖𝑡 + 𝜀𝑖𝑡
• What does 𝛽1 mean? Suppose 𝛽መ1 =0.82.

Michael A. Bailey, Real Econometrics

Copyright © 2017 Oxford University Press
 Figure 7.7
A Linear-Log Model
• The linear-log model:
• 𝑌𝑖 = 𝛽0 + 𝛽1 lnX 𝑖 + 𝜀𝑖
• What does Suppose 𝛽መ1 mean?

• ln(𝑇𝑖𝑐𝑘𝑒𝑡 𝑠𝑎𝑙𝑒𝑠𝑖𝑡 ) = 𝛽0 +𝛽1 ln(𝑃𝑟𝑖𝑐𝑒𝑖𝑡 ) + 𝜀𝑖𝑡

• We need to divide 𝛽መ1 by 100 to convert it to
units of Y.
Table 7.2