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# Regression Analysis

## Classical Normal Linear Regression Model

The Normality Assumption for Ui
Mean: E(Ui )=0
Variance: E[Ui E(Ui )]2 = E(Ui2 ) = G2
Cov: (Ui ,Ui ) : E[(Ui E / Ui )][U j E(U j )] = E(UiUj ) = 0
Ui ~ N(O,G2 )
if i j
Why Normality Assumption?
1) Ui represents the combined influence on the dependent variable of a large number of
independent variables that are not explicitly introduced in the regression model. We hope
that the influence of these omitted or neglected variables is small and at best random.
By the Central Limit theorem (CLT) of statistics, it can be shown that if there are a large
number of independent and identically distributed random variables, then, with the few
exceptions, the distribution of their sum tends to a normal distribution as a member of
such variables increases indefinitely. It is the CLT that provides a theoretical justification
for the assumption of normality of Ui .
2) Even if the number of variables is not very large or if these variables are not strictly
independent, their sum may still be normally distributed.
3) The probability distributions of OLS estimators can be easily derived because any
linear function of normally distributed variables is itself normally distributed. OLS
estimators 1 and 2 are linear functions of Ui . Therefore, if Ui are normally distributed,
so are and , which makes hypothesis testing very straightforward.
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## 4) The normal distribution is comparatively simple distribution involving only two

parameters (mean and variance). It is very well known and its properties are extensively
studied in mathematical statistics. Many phenomena seem to follow the normal
distribution.
5) Finally, if we are dealing with a small, or finite, sample size, say data of less than 100
observations, the normality assumption not only helps us to derive the exact probability
distributions of OLS estimators but also enables us to use t , F statistical tests for
regression models. If sample size is reasonably large, we may be able to relax the
normality assumption.

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