Pgpex: Session 1 2016 Understanding Econometrics A Case of Simple Regression

PGPEX
Session 1
2016
Understanding Econometrics
A case of Simple Regression
Data types we face in Real World

Cross Section: bank wagesbankwages.csv
Time series: Stock return data
Panel data
1/28/2016
Graphical illustration of the correlation coefficient

2
1
vv
v
y
3
x
Algebraic Signs of the Quantities (yi y ) and (xi x )
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Quadrant
yi -y
xi - x
(yi y) (xi x)
Fail to capture
40
30
Y
20
10
X
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
The data:
Y
1
14
25
34
41
46
49
50
49
46
41
34
25
14
1
50
The relationship: Y=50-X^2
-10
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-5
0
X
10
Flaw in Correlation Coefficient

Y1
8.04
6.95
7.58
8.81
8.33
9.96
7.24
4.26
10.84
4.82
5.68
X1
10
8
13
9
11
14
6
4
12
7
5
Y2
9.14
8.14
8.74
8.77
9.26
8.1
6.13
3.1
9.13
7.26
4.74
X2
10
8
13
9
11
14
6
4
12
7
5
Y3
7.46
6.77
12.74
7.11
7.81
8.84
6.08
5.39
8.15
6.42
5.73
X3
10
8
13
9
11
14
6
4
12
7
5
Y4
6.58
5.76
7.71
8.84
8.47
7.04
5.25
12.5
5.56
7.91
6.89
X4
8
8
8
8
8
8
8
19
8
8
8
use http://www.ats.ucla.edu/stat/stata/examples/chp/p025b, clear

Correlation=.82
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10
12
10
Flaw in Correlation Coefficient
10
12
14
12
14
Y2
Fitted values
Fitted values
10
10
12
12
14
Y1
10
X2
X1
10
12
14
10
Y3
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Y4
Fitted values
15
20
X4
X3
Fitted values
A flowchart illustrating the dynamic iterative regression process

Start
Formulate the problem

Fit the model
No
Validate assumptions
Choose a set of variables

Choose form of model
Choose method of fitting
Specify assumptions
Use method of fitting
Residual plots
Outliers detection
Sensitivity analysis
OK?
Yes
Evaluate the fitted
model
No
Goodness of fit tests
Ok?
Yes
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Stop
Use the model for the

intended purpose
9.5
10
10.5
11
11.5
12
Bank wage
Sctatter: A starting point
10
15
20
EDUC
Correlation: 0.6967
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Simple Linear Regression

Although we could fit a line "by eye" e.g. using a
transparent ruler, this would be a subjective
approach and therefore unsatisfactory.
An objective, and therefore better, way of
determining the position of a straight line is to
use the method of least squares.
Using this method, we choose a line such that the
sum of squares of distances of all points from the
line is minimized.
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Least-squares or regression line

These distances, i.e., the distance between y
values and their corresponding estimated
values on the line are called residuals
The line which fits the best is called the
regression line or, sometimes, the leastsquares line
The line always passes through the point
defined by the mean of Y and the mean of X
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10
Steps involved
1. Statement of theory: Labour
Economics: Salary depends on
education Y = f ( X )
Step 2: Econometric Model
log( salary ) = y = 1 + 2 education + u
Step 3: data : bank wage
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11
Econometric model Building Step

Why error term is appearing?.
1. Omission of other explanatory variables
examples?
Note that there can be many x variables:
Multiple regression model
2. Measurement Error & Model Misspecification
3. Purely random
4. Linear approximation
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12
Statistical Inference(step 4)
4. Next task is to estimate the parameters of the
model so that we can say show relative increase in
salary due to one year of additional education.
To obtain a fitted line
Y = b1 + b2 X
Where y=log(salary) and X=education
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13
DERIVING LINEAR REGRESSION COEFFICIENTS: method of OLS

Y
True model : Y = 1 + 2 X + u
Fitted line : Y = b1 + b2 X
Yn = b1 + b2 X n
Yn
Y1
b1
b2
Y1 = b1 + b2 X 1
X1
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Xn
14
14
DERIVING LINEAR REGRESSION COEFFICIENTS

Y
True model : Y = 1 + 2 X + u
Fitted line : Y = b1 + b2 X
en
Yn = b1 + b2 X n
Yn
Y1
e1
b1
b2
e1 = Y1 Y1 = Y1 b1 b2 X 1
Y1 = b1 + b2 X 1
.....
en = Yn Yn = Yn b1 b2 X n
X1
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Xn
15
16
9.5
10
10.5
11
11.5
12
Bank wage Data
10
15
20
EDUC
y
1/28/2016
Fitted values
16
Actual and Fitted Model
1/28/2016
17
DERIVING LINEAR REGRESSION COEFFICIENTS
RSS = e12 + ... + en2 = (Y1 b1 b2 X 1 ) 2 + ... + (Yn b1 b2 X n ) 2

=
Y12 + b12 +
b22 X 12
2b1Y1
2b2 X 1Y1 +
2b1b2 X 1
b22 X n2
2b1Yn
2b2 X nYn +
2b1b2 X n
+ ...
+
Yn2 + b12 +
= Yi 2 + nb12 + b22 X i2 2b1 Yi 2b2 X iYi + 2b1b2 X i

RSS
= 0 2nb1 2 Yi + 2b2 X i = 0
b1
nb1 = Yi b2 X i
b1 = Y b2 X
RSS
= 0 2b2 X i2 2 X iYi + 2b1 X i = 0
b2
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18
19
b1 = y b2 x
b2
( y y )( x x )
=
(x x)
i
b2
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X Y n XY
=
X nX
i
i
2
i
19

Pgpex: Session 1 2016 Understanding Econometrics A Case of Simple Regression

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PGPEX

Data types we face in Real World

Graphical illustration of the correlation coefficient

The relationship: Y=50-X^2

Flaw in Correlation Coefficient

use http://www.ats.ucla.edu/stat/stata/examples/chp/p025b, clear

Flaw in Correlation Coefficient

A flowchart illustrating the dynamic iterative regression process

Formulate the problem

Choose a set of variables

Goodness of fit tests

Use the model for the

Simple Linear Regression

Least-squares or regression line

Step 3: data : bank wage

Econometric model Building Step

DERIVING LINEAR REGRESSION COEFFICIENTS: method of OLS

DERIVING LINEAR REGRESSION COEFFICIENTS

Bank wage Data

Actual and Fitted Model

DERIVING LINEAR REGRESSION COEFFICIENTS

RSS = e12 + ... + en2 = (Y1 b1 b2 X 1 ) 2 + ... + (Yn b1 b2 X n ) 2

= Yi 2 + nb12 + b22 X i2 2b1 Yi 2b2 X iYi + 2b1b2 X i

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