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4.

Confidence Interval
&

Hypothesis Testing

EMU, Econometrics I, M. Balclar

How reliable is this OLS estimation?

4.2

(Computing Tutorial #2: Application of Phillips Curve Theory for the Case of Hong Kong)
EMU, Econometrics I, M. Balclar

Properties of OLS estimatorstwo variable case 4.3

1
1.

Unbiased
efficient

2.

3.

2
( 1) = 1 (2)=
X ^2

2
1
n x
2
^
var(2) =
^2 =
2
2
x

2
Min. Variance var( ) =
^
1

Consistent: as n gets larger, estimator


is more accurate
EMU, Econometrics I, M. Balclar

Properties of OLS estimators (continue)

4.4

and are normally distribution


4 & 5.
1
2
6.

1 ~ N (1 , 2 )
1
~ N (2 , 2 )
2
2

( n - 2 ) 2 x 2
~ (n - 2 )
2

EMU, Econometrics I, M. Balclar

Hypothesis Testing and Confidence Interval

4.5

How reliable is the OLS estimation ?


How close is ^
1 to 1 ?
How close is ^
2 to 2 ?

f ( 2 )
Density

Estimated ^2
falls in area

true

2 -

2 +

Random interval (confidence interval)


EMU, Econometrics I, M. Balclar

Hypothesis Testing and Confidence Interval

4.6

2 - is called lower confidence bound


2 + is called upper confidence bound
the interval between ( - ) and ( + ) is
2

called random interval (confidence interval)


Pr( 2- 2 2+ ) = (1-)

0.99
0.95
0.90

where (1-) is confidence coefficient:


(0< <1)
is also called the level of significance.

0.01
0.05
0.10

EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i

4.7

By assumption:
2
(
u i ~ N O, u )

Var(u) =u2

~ N (1 , 2 )
1

E(u) = 0
2
2
xi

2
=
2
n x i

2 ~ N (2 , )

=
xi2

EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for

(cont.) 4.8

f ( 2 )
Actual estimated 2
could fall into
these regions

E( 2 )= 2

2
EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for

i (cont.)

4.9

Transform into normal


standard distribution

2 - 2
Z=
se ( 2 )
EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i

4.10

(cont.)

Use the normal distribution to make probabilistic


statements about 2 provided the true 2 is
known
2 - 2
Z =
Se ( 2 )
- )
= (
2
2

N (0 ,1 )
2

In practice this is unobserved

EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i

4.11

(cont.)

For example:
Accept
region

EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i

4.12

(cont.)

Pr (- 1 . 96 Z 1 . 96 ) = 0 . 95
2 - 2
Pr - 1 . 96
1 . 96 = 0 . 95
Se ( 2 )
95% confidence interval:

2 - 2
- 1 . 96
1 . 96
Se ( 2 )
EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i

4.13

(cont.)

2 - 1.96* se ( 2) 2 2 + 1.96 * se ( 2 )
2 1.96* se ( 2)

Assumed or test value


In practice, 2 is unknown, we have to use the
unbiased estimator
2

RSS
u

i
2
=
n- 2
Then, instead of normal standard distribution,
t-distribution is used.
EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i

4.14

(cont.)

2 - 2
t=
se ( 2)

Or some specific values


that want to compare

estimated
true
parameter
t=
standard error of estimator
t=

( 2 - 2 )

x2
SEE

Use the t to construct a confidence interval for 2


EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i

4.15

(cont.)

2 - 2
t=
se ( 2 )
where

t=

se ( 2 )=

(2 - 2)

a specified value

2
^2

x2

x2
EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i


(cont.)

4.16

Use the tc to construct a confidence interval for 2 as


c
c
*

Pr
t , n- 2 t t, n- 2 = 1 -
2

where

t
2

is the critical t value at two-tailed


, n- 2

level of significance. is level of significance

and (n-2) is degrees of freedom (in 2-variable case).


EMU, Econometrics I, M. Balclar

Constructing Confidence Interval for i

4.17

(cont.)

Therefore (assume = 0.10 /2 = 0.05 )

c
2 - 2
c

t 0 .05 , n - 2 = 0 . 90
Pr - t 0 .05 , n - 2
(
)

se

2
Pr( -tc0.025, n-2 (^2- 2)/se(^2) tc0.025, n-2 ) = 0.95
Rearranging,

c
c

Pr 2- t 0.05 , n - 2 * se (2) 2 2 + t 0.05 , n - 2 * se ( 2)

= 0 .90
EMU, Econometrics I, M. Balclar

Then 90% confidence interval for 2 is:

4.18

2 t 0.05 , n - 2 * se ( 2)
c

t 0.05 , n - 2

Check it from t-table

2 & se ( 2)

Check it from
estimated result

The 95% confidence interval interval for 2


becomes

tc
2

0.025, n-2

se( 2)

EMU, Econometrics I, M. Balclar

The t-statistic in computer (EVIEWS) output


Example: Gujarati (2003)pp.123

4.19

H0: 2= 0
H1: 2 0
0.5091 - 0

t=

0.0357

se(^2)
^
SEE=

RSS
EMU, Econometrics I, M. Balclar

4.20

Example: Gujarati (2004), p.123


Given

2 = 0.5091, n = 10, se(2) = 0.0357,

95% confidence interval is:


c

2 t

, 2 n 2

se( 2)

0 .5091 t

c
0 .025 , 8

( 0 .0357 )

0 .5091 2.306 x 0.0357


0 .5091 0 .0823
[ 0 .4268 , 0 .5914 ]

EMU, Econometrics I, M. Balclar

4.21

90% confidence interval is:


c

0 .5091 t 0.05

,8

( 0 .0357 )

EMU, Econometrics I, M. Balclar

The t-statistic in computer (EVIEWS) output


Example: tutorial #2, unemployment & inflation rate of HK

4.22

H0: 2= 0
H1: 2 0

t=

-0.395

-0

0.0332

se(^2)
^
SEE=

RSS
EMU, Econometrics I, M. Balclar

4.23

Example: tutorial #2, unemployment & inflation of HK


Given

2 = -0.395, n = 84, se(2) = 0.0332,

95% confidence interval is:

EMU, Econometrics I, M. Balclar

1. Establish hypotheses: state the null and

2.
3.
4.
5.
6.
7.
8.

alternative hypotheses.
Determine the appropriate statistical test
and sampling distribution.
Specify the Type I error rate ().
State the decision rule.
Gather sample data (estimate the model=.
Calculate the value of the test statistic.
State the statistical conclusion.
Make decision.
EMU, Econometrics I, M. Balclar

The Null and Alternative Hypotheses are


mutually exclusive. Only one of them can be
true.
The Null and Alternative Hypotheses are
collectively exhaustive. They are stated to
include all possibilities. (An abbreviated form
of the null hypothesis is often used.)
The Null Hypothesis is assumed to be true.
The burden of proof falls on the Alternative
Hypothesis.

EMU, Econometrics I, M. Balclar

A soft drink company is filling 12 oz. cans


with cola.
The company hopes that the cans are
averaging 12 ounces.

EMU, Econometrics I, M. Balclar

Rejection Region

Rejection Region

Non Rejection Region


=12 oz
Critical Value

Critical Value

EMU, Econometrics I, M. Balclar

Type I Error

Rejecting a true null hypothesis


The probability of committing a Type I error is
called , the level of significance.

Type II Error

Failing to reject a false null hypothesis


The probability of committing a Type II error is
called .

EMU, Econometrics I, M. Balclar

Null True

Null False

Fail to
reject null

Correct
Decision

Type II error
()

Reject null

Type I error
()

Correct Decision

Reduce probability of one


error and the other one goes
up holding everything else
unchanged.

EMU, Econometrics I, M. Balclar

Test-Significance Approach:
One-tailed T-test decision rule
Step 1:

H 0 : 2 2 (H 0 : 2 2 )
0
0

(
>
<
H1 : 2 H1 : 2 )
0

Step 2:

0
2 2
t =
se ( 2)

Step 3: check t-table for t

4.31

State the
hypothesis

Computed value
c
, n- 2

look for critical t value


Step 4:

compare tc and t
EMU, Econometrics I, M. Balclar

One-tailed t-test decision rule


Decision Rule
Step 5: If t > tc
If t < tc

==> reject H0
==> not reject H0

Right-tail

tc < t

(If t > -

Right-tail

left-tail

t < -tc 0

(If t < - tc ==> reject H0 )


tc

4.32

==> not reject H0 )

Left-tail
EMU, Econometrics I, M. Balclar

4.33

Two-Tailed T-test
1.

0
=

H 0 : 2
2

State the hypothesis

H1 : 2
2
0

2.

2 - 2
Compute t =
se ( 2 )

3.

Check t-table for critical t value:


EMU, Econometrics I, M. Balclar

4.34

Two-Tailed t-test (cont.)


4.
5.

Compare t and
Decision Rule:

If

t > tc or -t < - tc , then reject Ho


or | t | > | tc |
Accept
region

reject H0 region

2 - t c

2, n 2

reject H0 region

se ( 2 )

c
2 + t
2

*
, n- 2

se ( 2 )

EMU, Econometrics I, M. Balclar

4.35

One-Tailed t-test
We also could postulate that:
1.

Compute:

H 0 : 2 0 .3
H1 : 2 > 0.3

- 02
t= 2
2)
se (
- 0 .3 0 .2091
0
.
5091
=
= 5.857
t=
0 .0357
0 . 0357
EMU, Econometrics I, M. Balclar

4.36

One-Tailed t-test (cont.)


2.

Check t-table for


where
=1.860

3.

Compare t and the critical t


c
=
>
t 5 . 857 t 0.05 , 8 = 1 . 860

= 0.05

reject H 0
EMU, Econometrics I, M. Balclar

4.37

One-Tailed t-test (cont.)


H 0 : 2

0
2

0
<

H1 : 2
2

Decision rule for left-tail test

If t < - tc

, df

=> reject H0

left-tail

^*- tc se()
^
EMU, Econometrics I, M. Balclar

4.38

Two-Tailed t-test
Suppose we postulate that

H 0 : 2 = 0.3
H1 : 2 0.3

Is the observed compatible with true ?


2

(1) From Confidence-interval approach:


95% confidence-interval is [0.4268, 0.5914]
which does not contain the true 2.
The estimated 2 is not equal to 0.3
EMU, Econometrics I, M. Balclar

(2) From Significance test approach:

4.39

Compare t-value and the critical t-value:

2 - 02 0 .5091 - 0 . 3 0 .2091
=
=
= 5.857
t=
se ( 2 )
0 .0357
0 .0357
tc0.025, 8 = 2.306

==> reject H0
It means the estimated 2 is not equal to 0.3
EMU, Econometrics I, M. Balclar

Tests about

4.40

Forming the Null and Alternative


Hypotheses
Given the null and the alternative hypotheses, testing them for
statistical significance should no longer be a mystery. But how
does one formulate these hypotheses? There are no hard-andfast rules. Very often the phenomenon under study will
suggest the nature of the null and alternative hypotheses.
For example, consider the capital market line (CML) of
portfolio theory, which postulates that Ei = 1 + 2i , where E
= expected return on portfolio and = the standard deviation
of return, a measure of risk. Since return and risk are expected
to be positively relatedthe higher the risk, the higher the
returnthe natural alternative hypothesis to the null
hypothesis that 2 = 0 would be 2 > 0. That is, one would not
choose to consider values of 2 less than zero.

4.41

Forming the Null and Alternative


Hypotheses
Prior studies of the money demand functions have shown that
the incomeelasticity of demand for money (the percent change
in the demand for money for a 1 percent change in income)
has typically ranged between 0.7 and 1.3. Therefore, in a new
study of demand for money, if one postulates that the incomeelasticity coefficient 2 is 1, the alternative hypothesis could be
that 2 1, a two-sided alternative hypothesis.
Thus, theoretical expectations or prior empirical work or both
can be relied upon to formulate hypotheses. But no matter how
the hypotheses are formed, it is extremely important that the
researcher establish these hypotheses before carrying out the
empirical investigation. Otherwise, he or she will be guilty of
circular reasoning or selffulfilling prophesies.

4.42

Accepting or Rejecting

4.43

"Accept "the null hypothesis:


All we are saying is that on the basis of the
sample evidence we have no reason to reject it; We
are not saying that the null hypothesis is true
beyond any doubt.
Therefore, in accepting a Ho , we should
always be aware that another null hypothesis
may be equally compatible with the data.
So, the conclusion of a statistical test is
do not reject rather than accept.
EMU, Econometrics I, M. Balclar

4.44

p-value Approach to Testing


Convert Sample Statistic (e.g., ^2 ) to Test
Statistic (e.g., Z, t or F statistic)
Obtain the p-value from a table or computer
p-value: probability of obtaining a test statistic as
extreme or more extreme ( or ) than the
observed sample value given H0 is true
Called observed level of significance
Smallest value of that an H0 can be rejected

Compare the p-value with


If p-value , do not reject H0
If p-value < , reject H0

EMU, Econometrics I, M. Balclar

4.45

Example: Two-Tail Test


H0: 2 = 0.3
H1: 2 0.3

Test Statistic:

= 0.05, se(^2)=0.0357
n = 10, df=8
Critical Value: 2.306

Reject
.025

.025
-2.306

2.306

5.857

t=(0.5091-0.3)/0.0357
= 5.857
Decision:
Reject at = 0.05.
Conclusion:
Insufficient Evidence that
2 is equal to 0.3.
EMU, Econometrics I, M. Balclar

4.46

p-value solution
(get the p-value from my t table at the web site)

(p-value = 0.0005) < ( = 0.05)


Reject the Null.

/2= 0.025
Reject

Reject

p-value=0.0005

t
2.306 5.857
Test Statistic 5.857 is in the Reject Region
0.3

EMU, Econometrics I, M. Balclar

2-t Rule of Thumb

4.47

REGRESSION ANALYSIS AND


ANALYSIS OF VARIANCE

TSS = ESS + RSS


Consider variable F:

4.48

REGRESSION ANALYSIS AND


ANALYSIS OF VARIANCE

4.49

Therefore, if 2 is in fact zero the explanatory variable X has no linear inuence on Y


whatsoever and the entire variation in Y is explained by the random disturbances ui . If,
on the other hand, 2 is not zero, a part of the variation in Y will be ascribable to X.
Therefore, the F ratio provides a test of the null hypothesis H0: 2 = 0.

REGRESSION ANALYSIS AND


ANALYSIS OF VARIANCE

F0.05(1,8)=5.32 Reject H0

4.50