5.

3 Varying parameters 303

5.3 Varying parameters

5.3.1 The use of dummy variables

Relaxing the assumption of fixed parameters
In the linear model y Xb e, the direct effect of a regressor xj on the
dependent variable y is given by @y=@xj bj. The assumption of xed par-
ameters (Assumption 5) means that these effects are the same for all obser-
vations. If these effects differ over the sample, then this can be modelled in
different ways. In Section 5.2.2 we discussed the addition of quadratic terms
and product terms of regressors. In other cases the sample can be split in
groups so that the parameters are constant for all observations within a
group but differ between groups. For example, the sampled population
may consist of several groups that are affected in different ways by the
regressors. This kind of parameter variation can be modelled by means of
dummy variables.

An example: Seasonal dummies

For example, suppose that the data consist of quarterly observations with a
mean level that varies over the seasons. This can be represented by the time
varying parameter model

X
k
yi ai bj xji ei , (5:8)
j2

where ai takes on four different values, according to the season of the ith
observation. This means that ai ai4 for all i, as the observations i and
(i 4) fall in the same season. Now dene four dummy variables
Dh , h 1, 2, 3, 4, where Dhi 1 if the ith observation falls in season
h and Dhi 0 if the ith observation falls in another season. These variables
are called dummies because they are articial variables that we dene
ourselves. With the help of these dummies, the model (5.8) can be ex-
pressed as

X
k
yi a1 D1i a2 D2i a3 D3i a4 D4i bj xji ei : (5:9)
j2
304 5 Diagnostic Tests and Model Adjustments

This is a linear regression model with constant parameters. That is, the
parameter variation in (5.8) is removed by including dummy variables as
additional regressors. In practice we often prefer models that include a
constant term. In this case we should delete one of the dummy variables in
(5.9) from the model. For instance, if we delete the variable D1 , then (5.9)
can be reformulated as

X
k
yi a1 g2 D2i g3 D3i g4 D4i bj xji ei , (5:10)
j2

where gs as  a1 for s 2, 3, 4. The rst quarter is called the reference

quarter in this case and the parameters gs measure the incremental effects
of the other quarters relative to the rst quarter. Clearly, the parameters gs in
(5.10) have a different interpretation from the parameters as in (5.9). For
instance, suppose we want to test whether the second quarter has a signi-
cant effect on the level of y. A t-test on a2 in (5.9) corresponds to the null
P
hypothesis that E[yi ] kj2 bj xji in the second quarter. However, a t-test on
P
g2 in (5.10) corresponds to the null hypothesis that E[yi ] a1 kj2 bj xji in
the second quarter that is, that a1  a2 . The latter hypothesis is more
interesting. If we delete another dummy variable from (5.9) for instance,
D4 instead of D1 then the dummy part in (5.10) becomes
a4 d1 D1i d2 D2i d3 D3i , where ds as  a4 for s 1, 2, 3. The interpret-
ation of the t-test on d2 differs from that of the t-test on g2 . In general, models
with dummy variables can often be formulated in different ways, and we can
choose the one with the most appealing interpretation.

The use of dummies for piece-wise linear relations

Dummy variables can also be used to model varying slope parameters. For
instance, suppose that the dependence of y on x2 is continuous and piece-wise
linear with slope b2 for x2  a and with slope b2 g2 for x > a. This can be
formulated as follows. Let D be a dummy variable with Di 0 if x2i  a and
Di 1 if x2i > a; then

X
k
yi a b2 x2i g2 (x2i  a)Di bj xji ei :
j3

This model has constant parameters and it is linear in the parameters,

provided that the break point a is known. The null hypothesis that the
marginal effect of x2 on y does not vary over the sample can be tested by a
t-test on the signicance of g2 .
 5.3 Varying parameters 305

Example 5.6: Fashion Sales

E
We consider US retail sales data of high-priced fashion apparel. The data are
taken from G.M. Allenby, L. Jen, and R.P. Leone, Economic Trends and
Being Trendy: The Inuence of Consumer Condence on Retail Fashion
Sales, Journal of Business and Economic Statistics, 14/1 (1996), 10311. XM506FAS

We may expect seasonal uctuations in sales of fashion apparel for instance,

because of sales actions around the change of seasons. We will discuss (i) the
data and the model, and (ii) estimation results and tests of seasonal effects.

(i) The data and the model

We consider quarterly data from 1986 to 1992, so that n 28, and we
investigate whether there exists a quarterly effect in the relation between
sales (Si , real sales per thousand square feet of retail space) and two explana-
tory variables, purchasing ability (Ai , real personal disposable income) and
consumer condence (Ci , an index of consumer sentiment). We dene four
quarterly dummies Dji , j 1, 2, 3, 4, where Dji 1 if the ith observation falls
in quarter j and Dji 0 if the ith observation does not fall in quarter j. The
general levels of sales and the effect of purchasing ability and consumer
condence on fashion sales may vary over the seasons. We suppose that the
standard Assumptions 17 are satised for the model

X
4 X
4 X
4
log (Si ) a1 aj Dji bj Dji log (Ai ) gj Dji log (Ci ) ei :
j2 j1 j1

The variation in the coefcients a reects the possible differences in the

average level of retail fashion sales between seasons.

(ii) Estimation results and tests on seasonal effects

Exhibit 5.10 shows the results of three estimated models. The null hypothesis
that the effects of the variables Ai and Ci on sales do not depend on the
season corresponds to the six parameter restrictions b1 b2 b3 b4 and
g1 g2 g3 g4 . The corresponding F-test of this hypothesis can be com-
puted from the results in Panels 1 and 2 of Exhibit 5.10 that is,

(0:1993  0:1437)=6
F 1:03 (P 0:440):
0:1437=(28  12)

Therefore, the null hypothesis of constant parameters for b and g is not

rejected. The corresponding restricted model has six parameters, and we
test whether fashion sales depend on the season that is, we test whether
a2 a3 a4 0 in this model. The results in Panels 2 and 3 of Exhibit
5.10 give
 5.3 Varying parameters 315

The Chow break test

In some situations there may be a clear break point in the sample and we
want to test whether the parameters have changed at this point. Let the n
observations be split in two parts, the rst part consisting of n1 observations
and the second part of the remaining n2 n  n1 observations. In order to
test the hypothesis of constant coefcients across the two subsets of data, the
model can be formulated as

y1 X1 b1 e1
(5:17)
y2 X2 b2 e2 ,

where y1 and y2 are the n1  1 and n2  1 vectors of the dependent variable

in the two subsets and X1 and X2 the n1  k and n2  k matrices of explana-
tory variables. This can also be written as
      
y1 X1 0 b1 e1
: (5:18)
y2 0 X2 b2 e2

It is assumed that the model (5.18) satises all the standard Assumptions 17,
in particular, that all the (n1 n2 ) error terms are independent and have
equal variance. The null hypothesis of constant coefcients is given by

H0 : b1 b2 : (5:19)

This can be tested against the alternative that b1 6 b2 by means of the F-test.
The number of parameters under the alternative hypothesis is 2k, and the
number of restrictions in (5.19) is k. Least squares in the unrestricted model
(5.18) gives an error sum of squares that is equal to the sum of the error sum
of squares of the two separate regressions in (5.17) (see Exercise 5.4). So the
F-test is given by

(S0  S1  S2 )=k
F , (5:20)
(S1 S2 )=(n1 n2  2k)

where S0 is the error sum of squares under the null hypothesis (obtained by
regression in y Xb e over the full sample of n n1 n2 observations)
and where S1 and S2 are obtained by the two subset regressions in (5.17).
This is called the Chow break test, and under the null hypothesis of constant
parameters it follows the F(k, n1 n2  2k) distribution. The regressions
under the alternative hypothesis require that n1  k and n2  k that is,
in both subsets the number of observations should be at least as large as the
number of parameters in the model for that subset.
316 5 Diagnostic Tests and Model Adjustments

The Chow forecast test

The model specication (5.17) allows for a break in the parameters, but
apart from this the model structure is assumed to be the same. The model
structure under the alternative can also be left unspecied. Then the null
hypothesis is that y Xb e holds for all n1 n2 observations and the
alternative is that this model only holds for the rst n1 observations and
that the last n2 observations are generated by an unknown model. This can
be expressed by the model

1 n2
nX
yi x0i b gj Dji ei , (5:21)
jn1 1

where Dj is a dummy variable with Dji 1 for i j and Dji 0 for i 6 j. So,
for every observation i > n1 , the model allows for an additional effect gj that
may differ from observation to observation. The coefcients gj represent all
factors that are excluded under the null hypothesis for instance, neglected
variables, another functional form, or another error model. The null hypoth-
esis of constant model structure corresponds to

H0 : gj 0 for all j n1 1,    , n1 n2 : (5:22)

This can be tested by the F-test, which is called the Chow forecast test. Using
the above notation, the Chow forecast test is computed as

(S0  S1 )=n2
F :
S1 =(n1  k)

This is exactly equal to the forecast test discussed in Section 3.4.3 (p. 173)
(see Exercise 5.4). This test can also be used as an alternative to the Chow
break test (5.20) if one of the subsets of data contains less than k observa-
tions.

Example 5.9: Bank Wages (continued)

E
We continue our analysis of the data on wages and education where the data
are ordered with increasing values of education (see Example 5.8). We will
discuss (i) Chow tests on parameter variations, and (ii) CUSUM and
XM5O1BWA CUSUMSQ tests.

(i) Chow tests

To test whether an additional year of education gives the same relative
increase in wages for lower and higher levels of education, we perform a
 5.3 Varying parameters 317

Chow break test and a Chow forecast test. The n 474 employees are split
into two groups, one group with at most sixteen years of education
(n1 424) and the other with seventeen years of education or more
(n2 50). Exhibit 5.14 shows the results of regressions for the whole data
set (in Panel 1) and for the two subsamples (in Panels 2 and 3). The Chow
break test (5.20) is given by

(30:852  23:403  2:941)=4

F 19:93 (P 0:000):
(23:403 2:941)=(424 50  8)

Panel 1: Dependent Variable: LOGSALARY

Method: Least Squares
Sample: 1 474
Included observations: 474
Variable Coefcient Std. Error t-Statistic Prob.
C 9.199980 0.058687 156.7634 0.0000
GENDER 0.261131 0.025511 10.23594 0.0000
MINORITY 0.132673 0.028946 4.583411 0.0000
EDUC 0.077366 0.004436 17.44229 0.0000
R-squared 0.586851 Sum squared resid 30.85177

Panel 2: Dependent Variable: LOGSALARY

Method: Least Squares
Sample: 1 424
Included observations: 424
Variable Coefcient Std. Error t-Statistic Prob.
C 9.463702 0.063095 149.9906 0.0000
GENDER 0.229931 0.023801 9.660543 0.0000
MINORITY 0.111687 0.027462 4.066947 0.0001
EDUC 0.055783 0.004875 11.44277 0.0000
R-squared 0.426202 Sum squared resid 23.40327

Panel 3: Dependent Variable: LOGSALARY

Method: Least Squares
Sample: 425 474
Included observations: 50
Variable Coefcient Std. Error t-Statistic Prob.
C 9.953242 0.743176 13.39284 0.0000
GENDER 0.830174 0.263948 3.145213 0.0029
MINORITY 0.346533 0.126096 2.748175 0.0085
EDUC 0.019132 0.041108 0.465418 0.6438
R-squared 0.302888 Sum squared resid 2.941173

Exhibit 5.14 Bank Wages (Example 5.9)

Regressions of salary on gender, minority, and education over full sample (Panel 1), over
subsample of employees with at most sixteen years of education (Panel 2), and over
subsample of employees with seventeen years of education or more (Panel 3).
318 5 Diagnostic Tests and Model Adjustments

(a) (b)
150 1.2

1.0
100
0.8

50 0.6

0.4
0
0.2
50
0.0

100 0.2
100 150 200 250 300 350 400 450 100 150 200 250 300 350 400 450

CUSUM 5% Significance CUSUM of Squares 5% Significance

Exhibit 5.15 Bank Wages (Example 5.9)

Plots of CUSUM and CUSUMSQ for wage data, ordered with increasing education. Employ-
ees with index 365 or lower have at most fteen years of education, those with index between
366 and 424 have sixteen years of education, and those with index 425 or higher have
seventeen years of education or more.

The Chow forecast test (3.58) gives

(30:852  23:403)=50
F 2:67 (P 0:000):
23:403=(424  4)

The null hypothesis of constant returns of schooling is clearly rejected.

(ii) CUSUM and CUSUMSQ tests

Exhibit 5.15 shows plots of the CUSUM and CUSUMSQ tests. This shows
that, at the end of the sample, the CUSUM deviates signicantly from zero.
After observation i 366 the recursive residuals are mostly positive, mean-
ing that predicted wages are smaller than the actual wages. This is in
agreement with the recursive slope estimate in Exhibit 5.13 (b), which
becomes larger after observation 366. The CUSUMSQ plot shows that the
squared recursive residuals in the rst part of the sample are relatively small
and that the sum of squares builds up faster after observation 366. This is a
further sign that the returns of schooling are not constant for different levels
of education.

E Exercises: T: 5.4; S: 5.19; E: 5.24, 5.31a, b, f, 5.33b, d.

5.3.4 Summary
An econometric model usually involves a number of parameters that are
all assumed to be constant over the observation sample. It is advisable to
apply tests on parameter constancy and to adjust the model if the param-
eters seem to vary over the sample.