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    Statistical Methods in Econometrics Ramu Ramanathan

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    am STATISTICAL METHODS IN ECONOMETRICS Ramu Ramanathan Academic Press, inc. Spidey Tokyo Toronto Tomy family— Vimala, Sadhana, Pradeep, and Sridhar Academic Press Raplé Manuscript Reproduction ‘This book sprinted on acid-free paper. © Copyright © 1993 by ACADEMIC PRESS, INC. AID RightsReserved, [opr of this publication may be reproduced or transmitted in any form or by any meas, electronic oF mechanical, including photocopy, recording, or any information storage and retrieval sytem, without penmission in writing from the publisher. ‘Academic Press, Inc. 1250 Sixth Avenue, San Diego, California 92101-4311 United Kingdom Eaton published by ‘Academic Press Limited 24-28 Oval Road, Londow NWI 7DX ‘Ramanathan, Ramu, date ‘Statistical methods in econometrics / Ramu Ramanathan pom Includes bibliographical references and indexes. ISBN: 0-12-576830-3 1. Bconomics-Suastical methods, 2, Econometics. 1. Tie, 1HBI37R36 1993 ‘i 3307.015195-de20 PRINTED INTHE UNITED STATES OF AMERICA, 2% 95 95 7 QW 9ETESE371 92-83101 cP CONTENTS Preface ix PARTI PROBABILITY THEORY — 1, Introduction 3 - Basic Probability 7 2.1 Sample Space, Sample Points, and Events 7 2.2 Some Results from Set Theory 9 2.3 Probability: Definitions and Concepts 15 Exercises 24 3. Random Variables and Distributions 27 8.1 Distribution Funetion 28 8.2 . Discrete Distributions 31 8.3. Continuous Distributions 35 3.4. ‘Transformations of Random Variables 38 3.5 Characteristics of Distributions 40 3.6 “Generating Functions 52 Exercises 57 4. Some Special Distributions 61 41 Discrete Distributions 61 42 Continuous Distributions 66 4.3: ~ Extensions of Distributions ° 72 Exercises 74 iv CONTENTS 5. Multivariate Distributions 79 5.1 Bivariate Distributions 79 5.2 Conditional Expectation 88 5.3 Conditional Variance 88 5.4 The Bivariate Normal Distribution 90 5.5 Bivariate Transformations 92 5.6 ‘The Convolution Formula 96 5.7 Mixture Distributions 99 5.8 Bivariate Characteristic Funetions 101, 5.9 Multivariate Density Funetions 104 5.10. The Multivariate Normal Distribution 105 5.1 The Chi-square Distribution 111 6.12 Distributions of Quadratic Forms 113 5.13, Multinomial Distributions 116 Exercises 117 PARTIL STATISTICALINFERENCE 123 6. Sampling Theory 125 6.1 independent, Dependent, and Random Samples 126 62 Sample Statistic 127 6.3 Sampling Distributions 129 64 Monte Carlo Simulations of Data 187 Exercises 138 7. Asymptotic Distribution Theory 141 TA. Differeit Types of Convergence 141 712. Relationships among Modes of Convergence 145 7.3 The Weak Law of Large Numbers 150 ‘TA. . The Strong Law ofLarge Numbers 154 15 16 CONTENTS v ‘The Central Limit Theorem 155 ‘Multivariate Central Limit Theorem 158 Exercises 159 Estimation 163 81 82 83 84 85 86 87 88 89 8.10 aan 8.12 8.13 ‘Small Sample Criteria for Estimators 164 Large Sample Properties of Estimators 169 The Likelihood Function 172 ‘The Principle of Maximum Likelihood 177 Lower Bounds for Variances of Estimators 179 < The Exponential Family of Distributions 182 ‘Small Sample Properties of Maximum Likelihood Estimators 184 Asymptotic Properties of Maximum Likelihood Estimators 185 ‘Joint Estimation of Several Parameters 185 Information Matrix and Generalized Cramer-Rao Inequality 187 Existence, Uniqueness, and Consistency of ‘Maximum Likelihood Estimators 192 Asymptotic Normality of Maximum . 195 Likelihood Estimators ‘Numerical Procedure for Obtaining Maximum Likelihood Estimators 197 Exercises 198 ‘Tests of Hypotheses 205 91 9.2 93 94 9.5 9.6 Basic Concepts in Hypothesis Testing 205 ‘The Neyman-Pearson Fundamental Lemma 209 Monotone Likelihood Ratio 218 Applications to the Normal Distribution 215 Unbiased Tests 216 ‘UMPU Tests for Multiparameter Exponential Families 219 CONTENTS 9.7 Generalized Likelihood Ratio Tests 221 9.8 LR Tests on the Mean and $.D. ofa Normal Distribution 222 9.9 Testing the Equality of Means of ‘Two Normal Populations 225 9,10 ‘Testing the Equality of Variances of ‘Two Normal Populations 227 9.11 The Wald, Likelihood Ratio, and Lagrange Multiplier Tests 228 9.12 ‘Test of Goodness of Fit 286 9.13 Confidence Intervals 240 Exercises 244 PARTI ECONOMETRICS 249 10. Multiple Regression 251 i 10.1 102 103 10.4 10.5 10.6 10.7 108 Assumptions of the Model 253 Procedures for Estimating the Parameters 257 Procision of the Estimates 262 ‘The Goodness of Fit 263 Tests of Hypotheses 267 ‘Model Selection Criteria 280 Nonnormality of Errors 282 Introduction to Bayesian Estimation 286 Exercises | 287 Funetional Forms and Dummy Variables 294 m4 2 13 uw 15 Dummy (or Binary) Independent Variables 294 Alternative Functional Forms 304 Nonlinearities in Parameters’ 309 Specification Errors 313, Multicollinearity 316 Exercises 324 CONTENTS vii 12, Nonspherical Disturbances 330 12.1 General Aitken Estimation 330 122 Heteroscedasticity 338 12,8 Autocorrelation 338 Exercises 950 APPENDICES A Matrix Algebra 353 B Statistical Tables 363 References 390 Copyright Acknowledgments 396 Author Index 397 Subject Index 399 PREFACE ‘This book is designed to fill the gap between two types of texts that are currently being used in econometries courses. Books that cater to a wide audience are skimpy on multivariate and multiparam- eter analyses because they involve a knowledge of linear algebra, Books that deal with multivariate analysis, on the other hand, assume a considerable knowledge of basic probability and statistics. Econometrics makes extensive.use.of: matrix algebra, but a typical graduate student has not been taught statistics with the linear alge- bra prerequisite. This book is appropriate for a beginning course on mathematical statisties and econometrics in which the foundations of probability and statistical theory are developed with a view to applying them to econometric methodology. Because econometrics generally deals with the study of several unknown parameters, this book places greater emphasis than is common on the estimation and hypothesis testing involving several parameters. Accordingly, the multivariate normal and distribution of quadratic ‘forms are’emphasized more, The Lagrange multiplier tests, which have gained popularity in recent years, are discussed here in considerable detail along with the tradi- tional likelihood ratio and Wald tests, Characteristic: functions and their properties are exploited more fully than in most books. Also, asymptotic distribution theory, which is typically given only cursory ‘treatment in other books, is discussed in detail. ‘The book assumes a working knowledge of advanced calculus (including integral calculus), basie probability and statistics, and Iinear algebra, Important properties from matrix algebra are, how- ever, summarized in Appendix A, but no proofs are presented. ‘The book is organized in three parts. Part I consists of an intro- uctory chapter followed by several chapters that provide the founda- tions of probability theory. Part II deals with the theory of sampling, the specific implications of having a large sample, the principles behind the methods of estimating unknown parameters and studying their properties, and testing hypotheses on parameters. Part III cov- rs basic econometrics in which topics in probability and statistics are brought together to address issues that are special to economics. At the beginning of each part, there is a brief description of the material in the chapters for that part. In addition to the usual exercises at the x PREFACE end of each chapter, there are numerous "Practice Problems” scat- tered throughout the book. These are usually short and pertain to the section in which the problems are given. Solving all the problems and exercises in each chapter will be extremely useful in understand- * ing the material. ‘As the emphasis on this book is more on theory and methodol- ogy (especially on probability and statistics), the number of empirical applications and associated data are somewhat limited. Interested readers and instructors are referred to my econometries book Intro- ductory Econometrics with Applications, Second Edition (1992), pub- Yished by Harcourt Brace Jovanovich, for numerous applications and data tables. A diskette containing all the data sets in that book, along with an easy to use econometrics program, can be purchased (MS-DOS version only) by sending a check payable to Ramu Ramanathan on a U.S, bank in the amount of $35 for U.S. and Cana- dian destinations and $50 for other countries. 4; 1 would like to acknowledge several people who have helped improve the book. My colleagues Richard Carson, Robert Engle, Clive Granger, Glenn Sueyochi, and Hal White have read parts of the ‘manuscript (Glenn read all of the manuscript) and made many useful suggestions. Present and former graduate students Bruno Broseta, Francis Lim, Chien-Fu Lin, Joao Issler, Sheila Najberg, Pu Shen, Farshid Vahid-Araghi, and Jeff Wooldridge also made comments on earlier drafts. Professors Tae Jun Seo (Southern Methodist Univer- sity), David Brownstone (University of California, Irvine), and Glenn Sueyoshi (University of California, San Diego) served as detailed reviewers for the manuscript. Their input has been immensely valu- able in improving the book. Finally, I am indebted to my colleague John Conlisk for his "theorem list’ on linear algebra which was of great help in writing the appendix on matrices. I would also like to thank my UNIX guru, Michael O'Hagan, for all the help in setting up the chapter files so that a “camera ready" version of the manuscript could be printed. The department of economies word processing specialists, Paula Lindsay and Meredee O'Brien, prepared the bibliography and the Appendix tables with expert diligence. Paula and Meredee have been invaluable in incor- porating all the manuscript editor's corrections and helping me prepare the final manuscript. I am also indebted to the editor, Rick Roehrich, for his constant support and encouragement and to Bill LaDue who was in charge of the production. Finally, I acknowledge with thanks help from my daughter Sadhana who painstakingly proofread the manuscript audaiso compiled the indioes.As‘ that remain, I alone take responsibility for them. I would, very much appreciate readers’ comments on the book as well as their pointing out typographical and other errors. Parti” PROBABILITY THEORY This part consists of five chapters. The introductory chapter provides an overview of probability theory, mathematical statistics, and their. applications to econometrics. . Chapter 2 presents the definitions of probability and related concepts and develops cer- tain basic results. Random variables and probability distributions associated with them. are discussed in Chapter 3. Several measures that characterize sta- tistical distributions of single random variables are also. discussed here. Chapter 4 presents a number ‘of special probability distributions used in statistics. The concepts“developed in the first four chapters are extended in considerable detail in Chapter 5 to bivariate and multivariate random variables and dis- tributions. lie alae: INTRODUCTION ‘The discipline of econometrics uses statistical techniques to develop and apply tools for (1) estimating economic relationships, (2) testing hypotheses involving economic behavior, and (8) forecasting the behavior of economic variables. Econometric theorists focus their attention on-developing the. analytical tools, examining assumptions behind certain methods, and studying the consequenees of applying ‘them to inappropriate situations. Applied econometrics deals mainly with the application of the methods in a specific context, This distine- tion, however, is arbitrary. A specific applied problem might demand that new techniques be developed to address the issues that arise. In this chapter, we give a brief overview of what econometric methodology is all about and we introduce a number of basic con- cepts, all of which are defined and analyzed more formally in later chapters. An econometrician typically formulates a theoretical model, that is, a framework for analyzing economie-behavior using some underlying logical structure. The model might arise out of formal economic theory, other studies, past. experience, intitition about actual behavior that the model is expected to portray, and so on: A well-specified model would be a reasonable approximation to the actual process that generates the observed data. This process (known as the data generating process or DGP) would involve the interac- tions of behavior among numerous economic agents, ‘The econometric model might be formulated as a single equa- tion model, such as a cost or production fanetion of a firm, or a simultaneous equation model comprising a system of equations that characterizes the interdependence among variables (for example, a complete macro economic model). A single equation model gen- erally has the form ¥ = FQ, Xp... Xu) where Y is a variable of primary interest, referred to as the 3 4 Chapter 1 Introduction dependent variable (also as regressand or endogenous vari- able), X;’s are variables that have causal effects on the dependent variable (and are referred to as the independent variables or regressors or exogenous variables), and u is an unobserved vari- - able (referred to as a random variable or stochastic variable) that captures uncertainties in the formulation. The X’s may also be random variables but are generally taken to be observable along with Y. As an example, ¥ could be the earnings of an employee in a firm, X; might be the employee's age, Xz the number of years of education, Xz the number of years of work experience, and so on. If we draw a sample of workers and measure the attributes described above, not all of them will have exactly the same relationship between ¥ and the Xs, An estimated relation will instead be a "statistical average." To allow for this fact, an econometric model will be formulated with an additional variable (denoted by u in the above equation) that cap- ‘tures the uncertainty in the relationship. A particularly simple form of an econometric model is given hy the following equation in which alf'the variables appear linearly. Y= BX +k + + PIX tu where the js are unknown parameters to be estimated from the data, The independent variables denoted by X; in the above equation might also be past values of the dependent and independent vari- ables. ‘To illustrate, suppose ¥; is the consumption expenditure of a family, evaluated at-time f, Families typically maintain their past standard of living, but adjust it if their financial position changes. ta bbe the family's income at time ¢. If income fell from time .éfiod ¢1 to time period ¢, we would expect consumption expenditure tobe adjusted downward to accommodate the reduction in income. The following econometric model captures the underlying behavior specified here. Ye = Bi +B2¥e-1 +Ba(X, ~ Xia) + Ue ‘We would expect 3 to be positive because of the assumption that consumers try to maintain their standard of living. By is also likely to be positive because an increase in income would induce addi- tional consumption. The random error term u; is included to capture the uncertainty in the postulated behavioral equation. A simultaneous equation model is typically of the form Fi, Ya, «++ Yo, Xt) Xay +++ Xi May Way +++ ata) = 0 where the Y's are the endogenous variables, X's are the exogenous Introduction 5 variables, and the ws are unobsorved stochastic variables. The sub- script i represents the index of an equation (@=1,2,...,G@). To ‘iMustrate, consider the following macro econometrie model. 0 +04Cp4 +02¥F + uy Ty = Bo + Bite +Bara +BoYF + ux n= ro+nYe +1 + 1Mis + Uy YP =¥-% Y= Ce +h+G where Y is net national product, C is consumption, I is not invest ment, G is government expenditure, Tis taxes, M is money supply, and ¥ is disposable income, all measured at the time period ¢. All of these variables are measired in real terms. ‘The other variable in the system is the corporate bond rate (7). ‘The endogenous variables in the system are C, I, r, Y%, and ¥, which are jointly determined within the system. 7, G, and Mf are given exogenously. The variables M;-1, Ju, and ¥#, are known as predetermined variables because at time ¢ their valués are known. The variables uy) up, and ug represent ‘unobservable error. terms that capture the uncertainty in the rela- tionships. Based on data on all the observable variables, the eeonometrician would be interested in estimating the unknown parameters (a's, p's, 7's, and the parameters that represent the sta- tistical properties of the random variables uy, w2, and ws). ‘The fourth equation is an accounting identity and the last equa- tion is an equilibritim condition equating aggregate demand to the net national product, ‘These two equations do not. contain any unknown parameters. In order to estimate the econometric model specified by an investigator, data on the observable variables (that is, the exogenous and endogenous variables) must be obtained. Such data might be time series, if the analyst is interested in modeling the behavior of economic variables (such as the unemployment and inflation rates) over time, or cross section, if the focus is on economic behavior of a number of units (individuals, firms, states, countries, and so on) at a given point in time. Some studies might require panel data which are time series data for a cross section of economic units. ‘An investigator might find that the type of data available does not match the theoretical specification exactly. For example, a great deal of economic theory deals with the interest rate, but there is no such thing as a single interest rate, When one studies investment 6 Chapter 1 Introduction behavior, the appropriate rate might be the prime rate, the corporate ‘bond rate, or another rate that applies to borrowers. If, on the other hand, the focus is on the demand for housing, the home mortgage rate ‘would be appropriate. Other problems that might arise in obtaining * the data are changes in definitions, new products requiring the meas- urement of new variables, changes in prices and other market situa- tions, and so forth. Thus a considerable amount of care should be exercised in obtaining data and in being aware of their limitations. Once a model has been formulated and the data gathered, the next step in an empirical study is to estimate the unknown parame- ters of the model and to subject the model to a variety of diagnostic tests to make sure that one obtains robust conclusions, that is, con clusions that are not sensitive to model specification. 'To achieve this goa); an investigator may have to reformulate the models and perhaps use alternative techniques to estimate them. Methods of hypothesis testing would be useful not only at this diagnostic testing stage but also to test the validity of a body of theory. © Unlike the natural sciences whoro-a researcher can usually con- duct a controlled experiment ina laboratory, economics most fre- quently deals with nonexperimental data generated by a complicated Process involving the interactions of the behavior of numerous economic and political agents. This imposes a great deal of uncor- tainty in the models and methods used by econometricians. In partic- ular, estimated relations are not precise, hypothesis testing can lead to the error of rejecting a true hypothesis or that of accepting a false ‘hypothesis, and forecasts of variables often turn out to be far from their actual ‘values. ‘This uncertainty makes statistical methodology very important in econometrics.

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