Population Regression Models

Econometrics II
Douglas G. Steigerwald
UC Santa Barbara

Winter 2011

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Overview
Reference: F. Hayashi Econometrics Chapter 1.1

(yt , xt1 , . . . , xtK ) := (yt , xt0 )

data

t = 1, . . . , n

yt - dependent variable
xt - regressors (covariates)

model

yt is determined by h (xt )

4 key assumptions ! Classic regression model

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Assumption 1: Linear Model

model - linear in coe cients
h (xt ) = 0 + 1 xt1 +

+ K xtK

model - approximate
yt = 0 + 1 xt1 +

+ K xtK + ut

ut - model error (latent)

ut 2 R ) yt 2 R
interpretation
k =

yt
xtk

approximate model ! k captures impact for small changes in xtk

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Examples
yt - wage (wt )

xt1 - education (st )

xt2 - experience (et )

issue 1: wt > 0 but dependent variable can take any value on R

ln (wt ) = 0 + 1 st + 2 et + ut
1 =

ln (w t )
st

w t /w t
st

1 = .02 - wages increase 2% for 1 more year of schooling (holding

experience constant)

issue 2: nonlinear function of experience

ln (wt ) = 0 + 1 st + 2 et + 3 et2 + ut
ln (w t )
e t

= 2 + 23 et
standard job: 2 > 0

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3 < 0

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Identication

yt

= 0 + 1 xt1 +
= xt0 + ut

+ K xtK + ut

goal - to learn (via estimation)

0 = ( 0 , . . . , K )
step 1 - identication: is it possible to learn from data of the type
we observe?
construct
xt yt = xt xt0 + xt ut
population value
E (xt yt ) = E (xt xt0 ) + E (xt ut ) )
1
0
= [E (xt xt )] [E (xt yt ) E (xt ut )]
xt yt and xt xt0 observed: can learn E (xt yt ) from n 1 xt yt and
E (xt xt0 ) from n 1 xt xt0
xt ut unobserved: cannot learn E (xt ut )
must assume E (xt ut ) = 0 for identication
must also assume E (xt xt0 ) invertible for identication
could use median in place of E

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Assumption 2: Strict Exogeneity

E [ut jX ] = 0

1
2

3
x10
6
7
X = 4 ... 5
n K
xn0

ensures is identied
model is the conditional mean of yt

logic
E [ut jx1 , . . . , xn ] = 0 ) E [ut jxt ] = 0 ) E [xt ut ] = 0 (LIE: detailed
next)
E [yt jX ] = xt0 + E [ut jX ] = xt0

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Law of Iterated Expectations

E (U jZ ) = EW [E (U jZ , W )]
Special case (Law of Total Expectations)
E (U ) = EZ [E (U jZ )]
1

E [ut jxt ] = Ex1 ,...,xt

1

(E [ut jx1 , . . . , xn ])

E [ut jx1 , . . . , xn ] = 0 ) E [ut jxt ] = 0

E [xt ut ] = E (E [xt ut jxt ]) = E (xt E [ut jxt ])

1

1 ,x t +1 ,...,x n

E [ut jxt ] = 0 ) E [xt ut ] = 0

Cov (xt , ut ) = E [xt ut ]

1
2

E [xt ] E [ut ]

E [ut jxt ] = 0 ) E [ut ] = 0

E [ut jxt ] = 0 ) Cov (xt , ut ) = 0

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Simple Proof of LIE

let U be discrete and take M values
let Z be discrete and take J values
E (U ) = EZ [E (U jZ )]
1
2
3
4
5
6

E (U ) = M
m =1 um P (U = um )
M
= m =1 um Jj=1 P (U = um , Z = zj )
J
= M
m =1 um j =1 P (U = um jZ = zj ) P (Z = zj )

= Jj=1 P (Z = zj ) M
m =1 um P (U = um jZ = zj )
= Jj=1 P (Z = zj ) E (U jZ = zj )
= EZ E (U jZ = zj )

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Assumption 3: Linear Independence

E (xt xt0 ) has rank K

and
X has rank K with probability 1
ensures is identied
rank X < K ) linear dependence

example: Cor xtj , xtk = 1

j = xyt not identied, (same for k )
tj
cannot vary xtj and hold xtk constant

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Assumption 4: Conditionally Spherical Error

conditionally homoskedastic
E ut2 jX = 2
conditionally uncorrelated
E (ut us jX ) = 0

notation

3
u1
7
6
u = 4 ... 5
un

= E (u u 0 )

Assumption 4 implies = 2 In

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Review

yt is determined by h (xt )
what do we assume for h (xt )?
h (xt ) = 0 + 1 xt1 +

+ K xtK

what does k capture?

k =

y t
xtk

how does the error term arise?

approximation error

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ut = yt

xt0

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what identies ?
E (xt ut ) = 0
E (xt xt0 ) has rank K

what further do we assume about the error?

E ut2 jX = 2
E (ut us jX ) = 0

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