Econometrics Notes of Book
Econometrics Notes of Book
INTRODUCTION
● Measurement of Theories.
● CAPM Model : Relation between risk and return Q^d = a - bP
● Econometrics is a unique blend of Economics, Statistics and
Mathematics
Economics Theory:
Consumption increases with income.
Statistical working:
Work on consumption (C) , Income (Y) data.
Mathematics:
If Y increase by 1 unit, C increase by C2 units.
C = C1 + C2 Y
MPC = ΔC / ΔY
MPC + MPS = 1
Econometrics:
C = C1 + C2 Y + E
E = Error (C - Ĉ)
Now here, The empirical verification of economic law has been proved.
Forecasting or If the chosen model does not refute the hypothesis or theory under
Prediction consideration, we may use it to predict the future value(s) of the
dependent, or forecast, variable Y on the basis of known or expected
future value(s) of the explanatory, or predictor, variable X.
Use of the Model An estimated model may be used for control, or policy, purposes. By
for Control or appropriate fiscal and monetary policy mix, the government can
Policy Purposes manipulate the control variable X to produce the desired level of the target
variable Y.
TYPES OF
ECONOMETRICS
THE MODERN “Regression analysis is concerned with the study of the dependence
INTERPRETATIO of one variable, the dependent variable, on one or more other
N OF variables, the explanatory variables, with a view to estimating and/or
REGRESSION predicting the (population) mean or average value of the former in
terms of the known or fixed (in repeated sampling) values of the
latter”
regression line passing through averages
DETERMINISTIC RELATIONSHIPS:
One to one relation
No error term involved
Solid reasoning and justification
Example: Scientific laws i.e Charles Law, Einstein’s law of energy.
REGRESSION Although regression analysis deals with the dependence of one variable on
VERSUS other variables, it does not necessarily imply causation. In the words of
CAUSATION Kendall and Stuart, “A statistical relationship, however strong and however
suggestive, can never establish causal connection: our ideas of causation
must come from outside statistics, ultimately from some theory or other.”5
In the crop-yield example cited previously, there is no statistical reason to
assume that rainfall does not depend on crop yield. The fact that we treat
crop yield as dependent on rainfall (among other things) is due to
nonstatistical considerations: Common sense suggests that the
relationship cannot be reversed, for we cannot control rainfall by varying
crop yield.
REGRESSION Closely related to but conceptually very much different from regression
VERSUS analysis is correlation analysis, where the primary objective is to measure
CORRELATION the strength or degree of linear association between two variables.
Date : 20th, Mar, 2023
TYPES OF DATA
Time Series Data A time series is a set of observations on the values that a variable takes at
different times. Such data may be collected at regular time intervals, such
as daily (e.g., stock prices, weather reports), weekly (e.g., money supply
figures), monthly [e.g., the unemployment rate, the Consumer Price Index
(CPI)], quarterly (e.g., GDP), annually (e.g.,government budgets),
quinquennially, that is, every 5 years (e.g., the census of manufactures), or
decennially (e.g., the census of population).
Cross-Section Cross-section data are data on one or more variables collected at the
Data same point in time, such as the census of population conducted by the
Census Bureau every 10 years (the latest being in year 2000).
Pooled Data In pooled, or combined, data are elements of both time series and
cross-section data.
This is a special type of pooled data in which the same cross-sectional unit
(say, a family or a firm) is surveyed over time. For example, the U.S.
Department of Commerce carries out a census of housing at periodic
intervals.
MEASUREMENT The variables that we will generally encounter fall into four broad
SCALES OF categories:
VARIABLES1
Ratio Scale For a variable X, taking two values, X1 and X2, the ratio X1/X2 and the
distance (X2 − X1) are meaningful quantities. Thus, it is meaningful to ask
how big is this year’s GDP compared with the previous year’s GDP.
Interval Scale An interval scale variable satisfies the last two properties of the ratio scale
variable but not the first. Thus, the distance between two time periods, say
(2000–1995) is meaningful, but not the ratio of two time periods
(2000/1995).
Ordinal Scale A variable belongs to this category only if it satisfies the third property of
the ratio scale (i.e., natural ordering). Examples are grading systems (A, B,
C grades)
Nominal Scale Variables in this category have none of the features of the ratio scale
variables. Variables such as gender (male, female) and marital status
(married, unmarried, divorced, separated) simply denote categories.
EXERCISES
1.1 Table 1.2 gives data on the Consumer Price Index (CPI) for seven
industrialized countries with 1982–1984 = 100 as the base of the index. a.
From the given data, compute the inflation rate for each country.16 b. Plot
the inflation rate for each country against time (i.e., use the horizontal axis
for time and the vertical axis for the inflation rate.) c. What broad
conclusions can you draw about the inflation experience in the seven
countries? d. Which country’s inflation rate seems to be most variable?
Can you offer any explanation?
Answer
1.2
Answer
1.3
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1.4
Answer
1.5
Answer
1.6
Answer
1.7
Answer
CHAPTER # 2 TWO-VARIABLE REGRESSION ANALYSIS: SOME BASIC
IDEAS
Conditional mean Mean at a given condition, Example: Income at a given consumption level.
Regression line passes through conditional means.
Example:
Date : 22th, Mar, 2023
population If we join these conditional mean values, we obtain what is known as the
regression line population regression line (PRL), or more generally, the population
(PRL), regression curve.5 More simply, it is the regression of Y on X.
POPULATION conditional mean E(Y | Xi) is a function of Xi, where Xi is a given value of X.
REGRESSION Symbolically,
FUNCTION (PRF)
E(Y | Xi) = f(Xi)
where f(Xi) denotes some function of the explanatory variable X. In our
example, E(Y | Xi) is a linear function of Xi. Equation (2.2.1) is known as the
conditional expectation function (CEF) or population regression
function (PRF) or population regression (PR) for short. It states merely
that the expected value of the distribution of Y given Xi is functionally
related to Xi.
Linearity in the The first and perhaps more “natural” meaning of linearity is that the
Variables conditional expectation of Y is a linear function of Xi. a regression function
such as E(Y | Xi) = β1 + β2Xi² is not a linear function because the variable
X appears with a power or index of 2
Linearity in the The second interpretation of linearity is that the conditional expectation of
Parameters Y, E(Y | Xi), is a linear function of the parameters, the β’s; it may or may not
be linear in the variable X. In this interpretation E(Y | Xi) = β1 + β2Xi² is a
linear (in the parameter) regression model.
Now consider the model E(Y | Xi) = β1 + β2²Xi . Now suppose X = 3; then
we obtain E(Y | Xi) = β1 + 3β2² , which is nonlinear in the parameter β2.
The preceding model is an example of a nonlinear (in the parameter)
regression model.
Rules for a
function to be a
Linear
Regression
Yi = E(Y | Xi) + ui
Yi = β1 + β2Xi + ui
THE Errors occur when we have either taken a smaller dataset or not accounted
SIGNIFICANCE all the important relevant variables.
OF THE
STOCHASTIC
DISTURBANCE
TERM
Vagueness of The theory, if any, determining the behavior of Y may be, and often is,
theory: incomplete.
Other variables could be incorporated.
Modified variables could be taken.
Poor proxy Using poor proxy variables when data of real variables is not available.
variables:
Principle of If our theory is not strong enough to suggest what other variables might be
parsimony: included, why introduce more variables? Let ui represent all other
variables. Of course, we should not exclude relevant and important
variables just to keep the regression model simple.
Wrong functional Sometimes ln is used in the function’s both sides without knowing the
form: data.
Answer
2.2 What is the difference between the population and sample regression
functions? Is this a distinction without difference?
Answer
2.3 What is the role of the stochastic error term ui in regression analysis? What
is the difference between the stochastic error term and the residual, uˆi
(cap) ?
Answer
2.4 Why do we need regression analysis? Why not simply use the mean value
of the regressand as its best value?
Answer
Answer
2.6 Determine whether the following models are linear in the parameters, or
the variables, or both. Which of these models are linear regression
models?
Answer
2.7
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2.8
Answer
2.9
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2.10
Answer
2.11
Answer
2.12
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2.13
Answer
2.14
Answer
2.15
Answer
2.16
Answer
CHAPTER # 3 TWO-VARIABLE REGRESSION MODEL: THE PROBLEM OF
ESTIMATION
Estimation of two Our task is to estimate the population regression function (PRF) on the
variable basis of the sample regression function (SRF) as accurately as possible.
regression model we have discussed two generally used methods of estimation:
(1) ordinary least squares (OLS)
(2) maximum likelihood (ML).
Ordinary Least The method of ordinary least squares is attributed to Carl Friedrich Gauss,
Square Method: a German mathematician.
To understand this method, we first explain the leastsquares principle.
Recall the two-variable PRF:
which shows that the uˆi (the residuals) are simply the differences between
the actual and estimated Y values.
We have to choose the SRF in such a way that the sum of the residuals
is as small as possible.
We adopt the least-squares criterion, which states that the SRF can be
fixed in such a way that
A further justification for the least-squares method lies in the fact that the
estimators obtained by it have some very desirable statistical properties,
as we shall see shortly. It is obvious that:
THE
ASSUMPTIONS
UNDERLYING
THE METHOD OF
LEAST SQUARES
Assumption : 1 Linear regression model. The regression model is linear in the parameters.
Assumption : 2 X values are fixed in repeated sampling. Values taken by the regressor X
are considered fixed in repeated samples. More technically, X is assumed
to be nonstochastic.
Assumption : 3 Zero mean value of disturbance ui. Given the value of X, the mean, or
expected, value of the random disturbance term ui is zero. Technically, the
conditional mean value of ui is zero. Symbolically, we have:
where i and j are two different observations and where cov means
covariance.
Assumption : 8 Variability in X values. The X values in a given sample must not all be the
same. Technically, var (X) must be a finite positive number.
Assumption : 10 There is no perfect multicollinearity. That is, there are no perfect linear
relationships among the explanatory variables.
PRECISION OR
STANDARD
ERRORS
OF
LEAST-SQUARES
ESTIMATES
Example:
HYPOTHETICAL
DATA ON WEEKLY
FAMILY
CONSUMPTION
EXPENDITURE Y
AND WEEKLY
FAMILY INCOME X
Monte Carlo The answer is provided by the so-called Monte Carlo experiments, which
Simulation: are essentially computer simulation, or sampling, experiments. To
introduce the basic ideas, consider our two-variable PRF:
EXERCISES
3.1
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3.2
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3.3
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3.4
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3.5
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3.6
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3.7
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3.8
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3.9
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3.10
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3.11
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3.12
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3.13
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3.14
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3.15
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3.16
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3.17
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3.18
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3.19
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3.20
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3.21
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3.22
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3.23
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3.24
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3.25
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3.26
Answer
CHAPTER # 5 TWO-VARIABLE REGRESSION: INTERVAL ESTIMATION
AND HYPOTHESIS TESTING
t-test
Null hypothesis (H₀): βˆ2 = 0
● This means the predictor variable has no significant effect on
the outcome variable.
Alternative hypothesis (H₁): βˆ2 ≠ 0
● This means the predictor variable has a significant effect on
the outcome variable.
T-statistic formula:
● t = (βˆ2 - 0) / SE(βˆ2) (where SE represents the standard error
of βˆ2)
Standard error (SE) formula:
● SE(βˆ2) = √[Σ(y - ŷ)² / (n - k - 1)] / √[Σ(x₂ - x̄₂)²] (where y
represents the observed outcome variable, ŷ represents the
predicted outcome variable, x₂ represents the values of the
predictor variable, x̄₂ represents the mean of the predictor
variable, n represents the sample size, and k represents the
number of predictors in the regression model)
Degrees of freedom (df):
● df = n - k - 1 (where n represents the sample size and k
represents the number of predictors in the regression model)
Interpretation:
● Calculate the t-statistic using the given formulas.
● Compare the t-statistic to the critical t-value corresponding to
the desired significance level and degrees of freedom.
● If the t-statistic is greater than the critical t-value (rejecting the
null hypothesis), it indicates that the predictor variable has a
significant effect on the outcome variable.
● If the t-statistic is not greater than the critical t-value (failing
to reject the null hypothesis), it suggests that the predictor
variable does not have a significant effect on the outcome
variable.
f-test
Null hypothesis (H₀): β₁ = β₂ = 0
● This means none of the predictor variables have a significant
effect on the outcome variable.
Alternative hypothesis (H₁): At least one of the β coefficients is not
equal to zero.
● This means at least one of the predictor variables has a
significant effect on the outcome variable.
F-statistic formula:
● F = [RSS / k] / [(TSS - RSS) / (n - k - 1)] (where RSS represents
the residual sum of squares, k represents the number of
predictors in the regression model, TSS represents the total
sum of squares, and n represents the sample size)
Residual sum of squares (RSS) formula:
● RSS = Σ(y - ŷ)² (where y represents the observed outcome
variable and ŷ represents the predicted outcome variable)
Total sum of squares (TSS) formula:
● TSS = Σ(y - ȳ)² (where y represents the observed outcome
variable and ȳ represents the mean of the outcome variable)
Degrees of freedom (df):
● df numerator = k
● df denominator = n - k - 1
Interpretation:
● Calculate the F-statistic using the given formulas.
● Compare the F-statistic to the critical F-value corresponding
to the desired significance level, degrees of freedom
numerator, and degrees of freedom denominator.
● If the F-statistic is greater than the critical F-value (rejecting
the null hypothesis), it indicates that at least one of the
predictor variables has a significant effect on the outcome
variable.
● If the F-statistic is not greater than the critical F-value (failing
to reject the null hypothesis), it suggests that none of the
predictor variables have a significant effect on the outcome
variable.
Overall
significance of Review the t-test results:
the model ● Examine the t-test results for each parameter (β-coefficient) in
the regression model. Determine whether each predictor
variable is individually significant (i.e., reject or fail to reject
the null hypothesis for each parameter).
Consider the F-test result:
● Analyze the F-test result, which assesses the overall
significance of the regression model.
● If the F-statistic is greater than the critical F-value at the
desired significance level, it suggests that at least one of the
predictor variables has a significant effect on the outcome
variable, indicating overall significance of the regression
model.
Interpretation:
● If the F-test indicates overall significance (step 2) and at least
one of the t-tests for the individual parameters is significant
(step 1), you can conclude that the regression model is overall
significant, and one or more predictor variables have a
significant effect on the outcome variable.
● If the F-test is significant (overall significance) but all t-tests
for the individual parameters are not significant, it suggests
that the regression model is significant as a whole, but the
specific predictors may not be individually significant. In this
case, consider the practical implications and the context of
the analysis.
Consider other factors:
● Evaluate the adjusted R-squared value to assess the
proportion of variation in the outcome variable explained by
the regression model. A higher adjusted R-squared value
indicates a better fit and strengthens the overall significance.
Jarque–Bera (JB) The Jarque-Bera (JB) test is a statistical test used to assess the normality
Test of Normality:
of a data set based on its skewness and kurtosis. Here's an explanation of
Note: The critical value depends on the desired significance level and the
to consider other diagnostic tools and the practical context of the data
analysis.
The JB test helps in assessing the normality assumption, which is
normal distribution.
Histogram of The Histogram of Residuals test is a visual method to assess the normality
Residuals assumption of the residuals in a statistical model. Here's an explanation of
the Histogram of Residuals test in a similar format:
Note: The Histogram of Residuals test is a visual method and does not
provide formal statistical measures like p-values or test statistics. It is
mainly used as a diagnostic tool to identify potential departures from
normality in the residuals. If a significant departure from normality is
observed, it may be necessary to explore alternative statistical techniques
or consider data transformations to address the violation of the normality
assumption.
Normal The Normal Probability Plot, also known as the Q-Q plot (quantile-quantile
Probability Plot plot), is a graphical method to assess the normality assumption of a data
set. Here's an explanation of the Normal Probability Plot test in a similar
format:
Note: The Normal Probability Plot is a visual method and does not provide
formal statistical measures like p-values or test statistics. It serves as a
diagnostic tool to assess departures from normality. If a significant
departure from normality is observed, it may be necessary to explore
alternative statistical techniques or consider data transformations to
address the violation of the normality assumption.
EXERCISES
5.1
Answer
5.2
Answer
5.3
Answer
5.4
Answer
5.5
Answer
5.6
Answer
5.7
Answer
5.8
Answer
5.9
Answer
5.10
Answer
5.11
Answer
5.12
Answer
5.13
Answer
5.14
Answer
5.15
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5.16
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5.17
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5.18
Answer
5.19
Answer
CHAPTER # 6 EXTENSIONS OF THE TWO-VARIABLE LINEAR
REGRESSION MODEL
REGRESSION There are occasions when the two-variable PRF assumes the following
THROUGH THE form:
ORIGIN
In this model the intercept term is absent or zero, hence the name
regression through the origin.
As an illustration, consider the Capital Asset Pricing Model (CAPM) of
modern portfolio theory, which, in its risk-premium form, may be
expressed as:
FUNCTIONAL In particular, we discuss the following regression models:
FORMS OF 1. The log-linear model
REGRESSION 2. Semilog models
MODELS 3. Reciprocal models
4. The logarithmic reciprocal model
Exponential
regression model
SEMILOG You may recall the following well-known compound interest formula from
MODELS: your introductory course in economics.
LOG–LIN AND
LIN–LOG
MODELS where r is the compound (i.e., over time) rate of growth of Y. Taking the
natural logarithm of, we can write
Linear Trend Instead of estimating model researchers sometimes estimate the following
Model model:
That is, instead of regressing the log of Y on time, they regress Y on time,
where Y is the regressand under consideration. Such a model is called a
linear trend model and the time variable t is known as the trend variable. If
the slope coefficient in is positive, there is an upward trend in Y, whereas if
it is negative, there is a downward trend in Y. For the expenditure on
services data that we considered earlier, the results of fitting the linear
trend model are as follows:
The Lin–Log Unlike the growth model just discussed, in which we were interested in
Model finding the percent growth in Y for an absolute change in X, suppose we
now want to find the absolute change in Y for a percent change in X. A
model that can accomplish this purpose can be written as:
The second step follows from the fact that a change in the log of a number
is a relative change.
Symbolically, we have
where, as usual, delta denotes a small change. Equationcan be written,
equivalently, as
6.1
Answer
6.2
Answer
6.3
Answer
6.4
Answer
6.5
Answer
6.6
Answer
6.7
Answer
6.8
Answer
6.9
Answer
6.10
Answer
6.11
Answer
6.12
Answer
6.13
Answer
6.14
Answer
6.15
Answer
6.16
Answer
6.17
Answer
6.18
Answer
6.19
Answer
CHAPTER # 7 MULTIPLE REGRESSION ANALYSIS: THE PROBLEM OF
ESTIMATION
INTERPRETATIO Given the assumptions of the classical regression model, it follows that, on
N OF MULTIPLE taking the conditional expectation of Y on both sides
REGRESSION
EQUATION
In words, this equation gives the conditional mean or expected value of Y
conditional upon the given or fixed values of X2 and X3. Therefore, as in the
two-variable case, multiple regression analysis is regression analysis
conditional upon the fixed values of the regressors, and what we obtain is
the average or mean value of Y or the mean response of Y for the given
values of the regressors.
OLS Estimators To find the OLS estimators, let us first write the sample regression function
(SRF) corresponding to the PRF
As noted in Chapter 3, the OLS procedure consists in so choosing the
values of the unknown parameters that the residual sum of squares (RSS)
is as small as possible. Symbolically,
Variances and
Standard Errors
of OLS
Estimators
Range: 0 - 1
R² AND THE
ADJUSTED R²
THE The Cobb-Douglas production function is a mathematical representation of
COBB–DOUGLAS the relationship between output and inputs in production theory. In its
PRODUCTION stochastic form, it can be expressed as:
FUNCTION
This transformation makes the model linear in the parameters β0, β2, and
β3. However, it remains nonlinear in the variables Y and X, but linear in
their logarithms. This log-log model is the multiple regression counterpart
of the two-variable log-linear model.
β2 represents the elasticity of output with respect to the labor input, while
β3 represents the elasticity of output with respect to the capital input.
The sum of β2 and β3 provides information about the returns to scale. If
the sum is 1, there are constant returns to scale. If the sum is less than 1,
there are decreasing returns to scale, and if the sum is greater than 1, there
are increasing returns to scale.
An example of the Cobb-Douglas production function is provided using
data from the agricultural sector of Taiwan for the period 1958-1972. By
applying the Ordinary Least Squares (OLS) method, the regression results
are as follows:
PARTIAL Partial correlation coefficients measure the strength and direction of the
CORRELATION linear relationship between two variables while controlling for the influence
COEFFICIENTS of one or more additional variables. In other words, they quantify the
correlation between two variables after removing the effects of other
variables.
These partial correlations can be easily obtained from the simple or zero
order, correlation coefficients as follows
The partial correlations given in Eqs. are called first order correlation
coefficients.
Thus r12.34 would be the correlation coefficient of order two, r12.345 would be
the correlation coefficient of order three, and so on.
EXERCISES
7.1
Answer
7.2
Answer
7.3
Answer
7.4
Answer
7.5
Answer
7.6
Answer
7.7
Answer
7.8
Answer
7.9
Answer
7.10
Answer
7.11
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7.12
Answer
7.13
Answer
7.14
Answer
7.15
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7.16
Answer
7.17
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7.18
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7.19
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7.20
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7.21
Answer
7.22
Answer
7.23
Answer
7.24
Answer
CHAPTER # 8 MULTIPLE REGRESSION ANALYSIS: THE PROBLEM OF
INFERENCE
Testing the
Overall
Significance of a
Multiple
Regression in
Terms of R²
Uses of F test
Overall For checking the overall significance.
Significance To test the overall significance of a sample regression using the F-test, we
assess whether the regression model as a whole is statistically significant
in explaining the dependent variable. Here's how it can be done:
Start with the unrestricted regression model, which includes all the
variables and parameters of interest: Y = β0 + β1X1 + β2X2 + ... +
βnXn + ε, where Y is the dependent variable, X1, X2, ..., Xn are the
independent variables, β0, β1, β2, ..., βn are the regression
coefficients, and ε is the error term.
Create the restricted regression model by imposing the linear
equality restriction. For example, if we want to test if the coefficients
of X1 and X2 are equal, the restricted model would be: Y = β0 + β1X1
+ β1X2 + ... + βnXn + ε.
Calculate the sum of squares error (SSE) for both the unrestricted
and restricted models.
Calculate the degrees of freedom for the error for both models. The
degrees of freedom are determined by the total number of
observations minus the number of parameters estimated in the
model.
Use the SSE and degrees of freedom to calculate the F statistic
using the formula: F = ((SSE_restricted - SSE_unrestricted) /
(df_restricted - df_unrestricted)) / (SSE_unrestricted /
df_unrestricted).
Determine the critical value of the F statistic based on the desired
significance level (e.g., α = 0.05) and the degrees of freedom.
Compare the calculated F statistic to the critical value. If the
calculated F statistic is greater than the critical value, we reject the
null hypothesis, indicating that the restricted model is statistically
different from the unrestricted model.
Alternatively, we can calculate the p-value associated with the F
statistic using the F-distribution. If the p-value is less than the
chosen significance level (e.g., p < 0.05), we reject the null
hypothesis and conclude that the restricted model is statistically
different from the unrestricted model.
Divide the dataset into two groups: the pre-break period and the
post-break period. The break point should be selected based on
theoretical considerations or prior knowledge.
Fit two separate regression models: one for the pre-break period and
one for the post-break period. Let's denote these models as Model 1
and Model 2, respectively.
Calculate the sum of squares error (SSE) for each model.
Calculate the degrees of freedom for the error for each model. The
degrees of freedom are determined by the total number of
observations minus the number of parameters estimated in the
model.
Use the SSE and degrees of freedom to calculate the F statistic
using the formula: F = ((SSE1 - SSE2) / (df1 - df2)) / (SSE2 / df2).
Determine the critical value of the F statistic based on the desired
significance level (e.g., α = 0.05) and the degrees of freedom.
Compare the calculated F statistic to the critical value. If the
calculated F statistic is greater than the critical value, we reject the
null hypothesis, indicating a significant structured break in the
relationship between the variables.
Alternatively, we can calculate the p-value associated with the F
statistic using the F-distribution. If the p-value is less than the
chosen significance level (e.g., p < 0.05), we reject the null
hypothesis and conclude that there is a significant structured break.
Sources of Linear Relationships: Multicollinearity can arise when there are strong
Multicollinearity linear relationships among the independent variables. For example, if two
variables are measuring similar aspects of the same phenomenon or if one
variable can be expressed as a linear combination of others, it can lead to
high correlation and multicollinearity.
Inverse of VIF is VIF measures the extent to which the variance of the estimated regression
tolerance (Tol) coefficient is inflated due to multicollinearity. A VIF value greater than 1
suggests the presence of multicollinearity. Generally, VIF values above 5 or
10 are considered problematic. For instance, a VIF of 8 for Variable 1
indicates that the variance of its estimated coefficient is significantly
inflated due to multicollinearity.
Klien’s Instead of formally testing all auxiliary R2 values, one may adopt Klien’s
rule of thumb rule of thumb, which suggests that multicollinearity may be a troublesome
problem only if the R2 obtained from an auxiliary regression is greater than
the overall R2, that is, that obtained from the regression of Y on all the
regressors. Of course, like all other rules of thumb, this one should be used
judiciously.
CHAPTER # 12 AUTOCORRELATION: WHAT HAPPENS IF THE ERROR
TERMS ARE CORRELATED?
Sources of Autocorrelation can arise due to various factors, such as omitted variables,
Autocorrelation: misspecified models, time-dependent trends, or the presence of
seasonality. For example, if a time series variable exhibits a consistent
increasing or decreasing trend over time, it may lead to positive
autocorrelation.
Lags: Lags refer to the number of previous time periods considered when
calculating autocorrelation. It represents the time lag between the current
observation and the past observation being compared. For example, a lag
of 1 represents the correlation between a variable's current value and its
immediately preceding value.
Run test The Run Test is a nonparametric test used to examine the presence of runs
or patterns in a sequence of binary or categorical data. It analyzes whether
the data is randomly distributed or shows systematic patterns. The test is
based on the number of runs (sequences of consecutive similar values)
observed in the data compared to the number of runs expected under the
assumption of randomness.
Define the null hypothesis (H0): The null hypothesis assumes randomness
in the data, indicating that there is no systematic pattern or trend.
Calculate the observed number of runs (Robs): Count the number of runs
(sequences of consecutive similar values) in the data sequence.
Calculate the test statistic (Z-score): The test statistic is calculated using
the formula:
The Z-score measures the deviation of the observed number of runs from
the expected number of runs, taking into account the variance of the runs.
Durbin Watson The Durbin-Watson test is a statistical test used to assess the presence of
d-test autocorrelation in the residuals of a regression model. Autocorrelation in
the residuals indicates a systematic pattern or correlation between the
error terms, which violates the assumption of independence.
Numerically, the Durbin-Watson test involves the following steps:
where ei represents the residuals at time i and ei-1 represents the residuals
at the previous time point.
Independence: The test assumes that the residuals (or error terms) in the
regression model are independent of each other. Autocorrelation in the
residuals violates this assumption and can impact the validity of the test.
The presence of autocorrelation undermines the independence
assumption and may lead to biased results.
The Durbin h The Durbin h-statistics, also known as Durbin's alternative test statistics,
statistics are alternative measures used to test for autocorrelation in the residuals of
a regression model. These statistics provide an alternative approach to
detect autocorrelation when the assumptions of the Durbin-Watson test
are not met.
Numerically, the Durbin h-statistics involve the following steps:
Calculate the residuals: Calculate the residuals (e) from the regression
model, which represent the differences between the observed values and
the predicted values.
where k represents the lag order, ei represents the residuals at time i, and
ei-k represents the residuals at a lagged time point.
Determine the critical values: The critical values for the h-statistics depend
on the significance level, the sample size, and the number of parameters in
the regression model. Critical values can be obtained from statistical tables
or software.
BG-LM The Breusch-Godfrey LM (BG-LM) test, also known as the LM test for
autocorrelation, is a statistical test used to detect the presence of
autocorrelation in the residuals of a regression model. It is an extension of
the Durbin-Watson test and can be applied to both linear and nonlinear
regression models.
Estimate the regression model: Estimate the regression model and obtain
the residuals.
Extend the model with lagged residuals: Add lagged residuals as additional
explanatory variables to the model. The number of lagged residuals to
include is determined based on the desired lag order (e.g., 1, 2, 3).
Estimate the extended model: Estimate the extended model with lagged
residuals included and obtain the residuals.
Determine the critical value: The critical value for the LM statistic depends
on the significance level and the degrees of freedom, which is equal to the
number of lagged residuals included in the extended model.
Calculate the coefficient estimate: Obtain the coefficient estimate for the
lagged residuals from the auxiliary regression model.
Correct the initial regression model: Multiply the residuals from the initial
model by the correction factor calculated in step 5.