Week 5 Class EC221

Will Matcham
W.O.Matcham@lse.ac.uk
OH: Thursday 2:303:30, 32LIF 1.30

Will Matcham (LSE)

Week 5 Class EC221

October 2014

1 / 12

Outline
Today is a demanding class...
Register
Hand back problem sets
1

Next weeks class

Material
Variance and Covariance Rules
PS3 Q4 Skipped Last Week
Multiple Linear Regression Model
Problem Set 4
Q1 Not Doing
Q2 Next Week
Q3
Q4 Tough
Q5 Tougher
Additional Class Topic
Will Matcham (LSE)

Week 5 Class EC221

October 2014

2 / 12

Content Revision
Variance Rules

Definition of variance of random variable X , and covariance of two

random variables X , Y .
Scalar variance and covariance rules:
1

V(a + X ) = V(X )

Cov (a + X , b + Y ) = cov (X , Y )

V(aX ) = a V(X ) a

Cov (aX , bY ) = a Cov (X , Y ) b

P
P P
P
P P
V( i Xi ) = i j Cov (Xi , Xj ) = i V(Xi ) + i j Cov (Xi , Xj )

i6=j
6

Cov (

Xi ,

Yj ) =

P P
i

cov (Xi , Yj )

Definition of variance of random vector X and covariance of random

vectors X, Y. What do these matrices look like?
How do above properties generalise for random vectors (at least the
first 4)?
Will Matcham (LSE)

Week 5 Class EC221

October 2014

3 / 12

Problem Set 3
Question 4

Something harder! The structure of how to approach it is

straightforward. The statistics of the steps in between are not
however.
When dealing with variances and covariances, please, try first to
work with the variance and covariance rules. Only introduce them
as expectations later on if you are stuck. Expectations are nasty to
work with!

Will Matcham (LSE)

Week 5 Class EC221

October 2014

4 / 12

Multiple Linear Regression Model

Has much changed?

Not really! Our assumptions have mostly the same intuition, we are
just using different notation.
Our assumptions:
1

A1 The model is still linear in parameters but now we have k

parameters and not 2.
A2 Perfect collinearity is about identification. Are the regressors
linearly independent so that the OLS can identify out each of the
parameters. Solving systems and dummy variable trap.
A3 Exogeneity: our errors really are ignorance. Strong: implies errors
have zero mean and no covariance between regressors and errors.
A4 Again a convenience assumption for the moment. Demand a very
simple covariance structure between our errors. Total iid data. Will
change in LT but for the moment makes OLS the best.

Switching from scalar form and matrix form. In EC221 we mainly use
matrix form. Further econometric courses require mastery of both.
Will Matcham (LSE)

Week 5 Class EC221

October 2014

5 / 12

Multiple Linear Regression Model

The formula that you simply must remember

OLS derivation follows the same intuition but everything is now a

vector or a matrix.
Thing to minimise:
S() = y 0 y 2X 0 y + 0 X 0 X
FOC:
2X 0 y + 2X 0 X = 0 = = (X 0 X )1 X 0 y
Symmetry of X 0 X really helps here.
SOC: 2X 0 X is pd so our objective function is strictly convex and we
have hit a strict global minimum at the solution.

Will Matcham (LSE)

Week 5 Class EC221

October 2014

6 / 12

Problem Set 4
Question 1

This is a slug! So much working!

Question really is to prove the point that we want to move to the
multivariate model, get into linear algebra, and forget about the
calculus derivations.
Tip is to defining terms and putting in the averages at will. You
probably didnt get what is in the solutions, but you learn with
experience the tricks to use.

Will Matcham (LSE)

Week 5 Class EC221

October 2014

7 / 12

Problem Set 4
Question 3

This is the only question that is not just doing technical work, but
requires some econometric intuition and thought.
For the second part, which requires the thought, you need to think
about what a change of units is, and how we frame a change of units
in the question we are given.
Fit of a regression is synonymous with looking at residuals.
Why is this important? Regressors are regressors, they explain the
same amount regardless of their unit. Otherwise you could hack your
regression and arbitrarily search for a matrix P to blow up the
regressors with, to obtain the best fit.
Think of regressors as information to explain the y . You cant game
the regression process by changing your unit, and fit the model better.
Only option: add (or take away) regressors, or change the model!
Will Matcham (LSE)

Week 5 Class EC221

October 2014

8 / 12

Problem Set 4
Question 4

I will present the crux of the argument and cover the details at the
end.

Do not worry if you did not get this first time. This does not mean
you are going to struggle with this course. Problem sets are a learning
process, not a mock exam.

Will Matcham (LSE)

Week 5 Class EC221

October 2014

9 / 12

Problem Set 4
Question 5

As I mentioned in week 2 class, you need to know the properties

about idempotency, and understand how they help you.

Total instinct: if A is symmetric not only is is diagonalisable but it is

orthogonally diagonalisable.

Will Matcham (LSE)

Week 5 Class EC221

October 2014

10 / 12

Additional Content
The details of Q4 and Q5

In Q4 we used that if u N (0, V ), where V is symmetric and

positive definite, then V 1/2 u N (0, I ).
How is this matrix V 1/2 defined? We want it to be such that
V 1/2 V 1/2 = V 1 .
Diagonalise V to get V = PDP 1 . Taking inverses then gives
V 1 = PD 1 P 1 . Lets try V 1/2 = PD 1/2 P 1 .
This works since
V 1/2 V 1/2 = PD 1/2 P 1 PD 1/2 P 1 = PD 1 P 1 = V 1
Still one final detail:

1/ 1 . . .

..
..
=
.
.
0
...

0
..
.

This is well defined: V being pd ensures i > 0,

i.

D 1/2

Will Matcham (LSE)

Week 5 Class EC221

1/ n

October 2014

11 / 12

Additional Content
The details of Q4 and Q5

In Q4 I defined V 1/2 u =: q N (0, I ). I then argued that each

qi N (0, 1).
From this I concluded that
n
X
0
qq=
qi2 2n
i=1

It is indeed a sum of n squared standard normal terms. What have I

missed?
This crucial exception to the rule in statistics: a joint normal having
zero covariance implies that all random variables in the vector are
independent. We did this in PS2 Q2 for the bivariate case.
This rule gives us the independence of the qi that we need:
iid

q N (0, I ) = qi N (0, 1)
Will Matcham (LSE)

Week 5 Class EC221

October 2014

12 / 12