2006 Examination of Econometrics Principles

2006 Examination
EC221
Principles of Econometrics
Instructions to candidates
Time allowed: 3 hours
This paper contains NINE questions. Answer ANY four. All questions will be given
equal weight (25%)
You are supplied with: Murdock & Barnes Statistical Tables (2nd =3rd =4th ed.)
Table A5 Durbin-Watson d-statistic
You may also use: Electronic calculator (as prescribed in the examination
regulations)
c LSE 2006/EC221 Page 1 of ?
127
1. (a) A sample of students from a large university is used to obtain the following re-
gression result in an attempt to explain the college grade point average (CGP Ai )
\ i = 1:39 +0:412HGP Ai + 0:15 ACTi 0:083SKi ,

CGPA N = 141; R2 = 0:234
(0:33) (0:094) (0:011) (0:026)
where HGP Ai is the high school GPA, ACTi is an achievement test score, and
SKi is the average number of lectures missed per week. The standard errors are
between brackets.
i. (2 points ) Interpret this equation. Do the parameters have the expected

signs?
Answer: Need to interpret these marginal e¤ects ceteris paribus, yes
Clearly stating what assumptions you need:
ii. (4 points ) Compute the adjusted R2 and test the signi…cance of the re-
gression.
(1 R2)=137
= 13:85;
cant regression
iii. (5 points ) Which slope coe¢ cients are signi…cantly di¤erent from zero at
the 5% level of signi…cance? What di¤erence does it make whether we test
using a one or two sided alternative?
Answer: The signi…cance of individual coe¢ cients (here the slopes), as-
suming all classical linear regression assumptions inclusive of normality of
the errors can be tested using the t-test, which under the null is distributed
as t137: The null tested H0 : i= 0 against the two sided alternative
128
HA : 6
i= 0, the 5% critical value equals 1.96, the test statistic t î =
Acc/Rej rule Acc/Rej rule

t statistic
two sided one sided
HGPA 4:383 jtj > 1:96 Reject t > 1:645 Reject
ACT 13:636 jtj > 1:96 Reject t > 1:645 Reject
SK 3:19 jtj > 1:96 Reject t < 1:645 Reject
Using a one-sided test has improved power implications, the critical value
changes, since e.g., we don’t expected skipping classes to improve college
GPA we are only concerned about too high negative values indicative of an
non-negligible e¤ect on college GPA (ceteris paribus)
iv. (4 points ) Provide the p-value associated with testing the signi…cance of
skipping classes on the college GPA using a two sided alternative. What
does the p-value tell us? (Hint: You may want to make use of the standard
normal table in light of the "large" sample size.)
Answer: The p-value (two sided) gives the lowest level of signifance at which
we want to reject the null given the null is true, i.e.,
> 3:19) = Pr(jtj > 3:19)
= 2 Pr(t137 > 3:19) ' 2 Pr(N(0; 1) > 3:19) = :0012
v. (4 points ) Find the 95% con…dence interval for HGP A ; where HGP A is
the true parameter associated with high school GPA in this model. Can you
reject the hypothesis that HGP A = 1 against a two-sided alternative at the
5% level?
Answer:
^HGPA HGPA > 1:96) = 5%

Pr(
^
SE( HGPA)
h i
^HGPA 1:96SE( ^HGPA); ^HGPA +
1:96SE( ^HGPA) [0:22776; 0:59624]
Since 1 does not lie in this 95% con…dence region we reject the hypothesis at
the 5% level of signi…cance.
129
(b) (6 points ) A four-variable regression using quarterly data from 1958 to 1976
inclusive gave an estimated equation
y^ = 2:20 + 0:104x2 3:48x3 + 0:34x4 ; ESS = 109:6; RSS = 18:48:

When the equation was re-estimated with three seasonal dummies added to the
speci…cation, the explained sum of squares rose to 114.8. Test for the presence
of seasonality, clearly stating what assumptions you need to make.
Answer: The presence of seasonality, assuming all classical linear regression as-
sumption inclusive of normality of the errors can be tested using an F-test (the
Chow test). Critically, it should be assumed that the variances are identical for
all observations, and exhibit to heteroskedasticity over the seasons! Speci…cally
we test here whether the coe¢ cients on the dummy variables are jointly signi…-
cantly di¤erent from zero: H0 : seas1 = seas2 = seas3 = 0 against the two-sided
alternative that at least one is signi…cantly di¤erent from zero. We test this us-
ing the F test = (RRSS URSS)=3 : There are 3 restrictions, and the degrees
RRSS = 18:48
URSS = T SS ESS = (109:6 + 18:48) 114:8 = 13:28
(18:48 13:28) =3
F= 13:28=69 = 9:006
Under the null the test is distributed as F3;69, so the critical value (5%) is 2.68,
yielding a rejection of the null, i.e., we …nd evidence of signi…cant seasonality.
2. Indicate whether each of the following statements is true, false, or uncertain. No

points will be awarded without justi…cation of your answer.
(a) (8 points ) “Error in variables lead to estimates of the regression coe¢ cients
that are biased towards zero.”
Answer: UNCERTAIN: (1) We discussed the setting where only 1 regressor is
measured with error and showed that under the assumption that the
measurement error is i.i.d. unrelated to anything else in the model that indeed
the regression
130
coe¢ cient on that explanatory variable is biased towards zero (full marks re-
quires formal derivation of this). (2) When more than one explanatory variable
is measured with error, or when the measurement error is related to other things
in the model, the direction of the bias is uncertain. (3) When only the depen-
dent variable is measured with error, no bias occurs, we only see an increase in
variance of our estimator.
(b) (8 points ) I want to relate distance travelled to work to income using a survey
of 10,000 London commuters. Let bm be the OLS slope coe¢ cient from regress-
ing commuter miles (y) on income in pounds (x) and let bk be the OLS slope
coe¢ cient from regressing commuter kilometers (y) on income in pennies (x).
In both cases an intercept is estimated.
\ bm = bk
[Conversion factors: 1 mile = 1.6 kilometers and 1 pound = 100 pennies]
Answer: FALSE.
(xi x )2 100 (xi x ) 100 (xi x ) 100

(c) (9 points ) Suppose that you estimate the quarterly time series regression
X
4
yt = Djt j + ut
j=1
by OLS, where Djt = 1 if the observation is in quarter j. “Since the dummy

variables are mutually orthogonal, the OLS estimator and hence the t-statistics
for 1= 0 can be obtained by a simple regression of yt on D1t alone.”Answer:
FALSE The …rst part is true by the partitioned inverse formula (need to show
result); the second part is false - you have to estimate the error variance from the
full model residuals .
131
3. In some software packages the user is asked to specify the variable to be explained and
the explanatory variables, while an intercept is added automatically. Now suppose
that you wish to compute the least squares estimates ^ in a regression of the type
y = X + " where the n k matrix X does NOT contain an “intercept column”
consisting of unit elements. De…ne
! !
y X
y = ; X = ;
y X
where the columns, consisting of unit elements only, are added by the computer
package and hte user speci…es the other data.
(a) (8 points ) Prove that the least squres estimator obtained by regressing y on
X gives the desired results.
Answer:
~ = (X The
0 regression of y on X yields the parameter estimates:
X ) 1X 0y =
! !! 0 !1 ! 0
X X X y
X X X y
! ! 0 0 0 0 ! !
0 0
X X XX n 0
= X0 X 0X X 0X =
X0 X0 X 0 2X0X
! ! ! !
0 0 0 0
y y y 0
= =
X0 X0 y X y + X0y
0
2X0y
! 1
! ! !
n 0 0 1=n 0 0
~= = 1
0 2X0X 2X0y 0 (2X0X) 2X0y
! !
0 0
= =
(X0X) 1X0y ^
So we obtain an estimate of the intercept equalling 0 and the slope parameter

estimates yield the parameter estimates we are interested in.
(b) (15 points ) Prove from …rst principles that the standard errors of the regression
p
coe¢ cients must be corrected by a factor (2n k 1)=(n k): Clearly specify
the assumptions you are making.
(Hint: In your answer you should derive the variance-covariance matrix of the
least squares estimator discussed in (a) (comparing it to the one you would get
132
from directly running a regression of the type y = X + "); discuss the estimator
this statistical package will use in the computation of its standard errors, and
discuss the correction as it relates to the estimator of the variance that should
have been used.)
2
true covariance matrix, (X0X) 1; we need to multiply the estimated covariance
matrix with (2n k 1)=(n k); or equivalently we need to perform the requested
correction on the standard errors since (assuming non-stochastic regressors for
simplicity
E (2n k 1)=(n k)s 2(2X0X) 1

= 2
(X0X) 1
(c) (2 points ) Brie‡y discuss the reason why the goodness of …t measure R2 does
not necessarily lie between 0 and 1 if our model does not contain an intercept.
P
Answer: because we no longer have "î = 0, ensuring that y^ = y
133
4. Consider the model given by
yi = + x i + "i for i = 1; :::; n;

2
where x1 ; :::; xn are …xed and "i are i.i.d N (0; ).
(a) (5 points ) Derive the maximum likelihood estimators ^ and ^ of and :

Answer:
@ 2 ^4i=1 n
(b) (7 points ) Derive the distribution of ^ : Is ^ unbiased?

Answer: ^ is (like ^) linear function in yi and is therefore normally distributed
( yi are i.i.d N( + xi; 2)).
i=1
134
So
(xi x )2
(c) (4 points ) How would you estimate the variance of ^ ?
0
Answer: We w ould replace 2
with s2 = n"^ "^
2
; since this would be an unbiased
2
yi = + ui;
where yi is the same variable as above.

(d) (2 points ) Derive the least squares estimator ^ arising from this regression.
Answer:
(e) (3 points ) Derive the distribution of ^: When is ^ an unbiased estimator for

?
Answer: ^ is a linear function in yi and is therefore normally distributed ( yi are
2
i.i.d N( + xi; )).with
It is an unbiased estimator for if x = 0 or =0
Now suppose x1 ; :::; xn are i.i.d N ( ; ! 2 ) distributed, independent of ":.

(f) (4 points ) Argue that ^ is the maximum likelihood estimator for + :
+ :
135
5. Suppose we are interested in explaining the monthly credit card expenditure of in-
dividuals (CCEi ) using data on age (AGEi ), income (IN Ci ) and a dummy variable
for homeownership (OW Ni ). The following OLS regression results are obtained
[i =
CCE 237:15 3:0818AGEi + 27:941OW Ni + 234:35IN Ci 14:977 IN Ci2
(199:35) (5:5147) (82:922) (80:366) (7:469)
2
N = 72; R = 0:244; s = 284:75
The standard errors are in parentheses.
(a) (4 points ) Discuss the problems associated with the above OLS results when
the errors exhibit heteroskedasticity. What modi…cation do you need to make
to the above results to make them suitable for inference purposes?
Answer: When the errors exhibit heteroskedasticity, OLS results no longer are
e¢ cient, they remain unbiased and consistent though. Importantly though, het-
eroskedasticity invalidates the standard errors and invalidates t and F tests. We
can correct the standard errors using White’sheteroskedastic covariance
0 1
matrix: "^21 0
B C X X X
\ 1 B0
... C
X(X0
X) 1
= ( x x 0
) 1
"^ 2
x x 0 0 1
V ar ^ 0
( ) = (X X) X @ A i i i i i( xix i)
0 "^2n
(b) (8 points ) Discuss two methods one could consider for testing for the joint
signi…cance of the two income coe¢ cients, clearly indicating what assumptions
you need to make. Are both tests suitable when you do …nd evidence of het-
eroskedasticity?
Answer: Under all the classical linear regression assumptions we can use the F
test based on comparing the restricted and unrestricted residual sum of squares,
where the restricted model leaves out both income variables when performing
OLS.
(RRSS URSS) =2
F=
F2;70 under H0
URSS=(n 5)
This test relies on the assumption of homoskedasticity and can therefore NOT be
applied in this setting. Alternatively, we use the F test based on the unrestricted
parameter estimates in combination with White’sheteroskedastic covariance ma-
trix (Wald test): Let Vînc denote the submatrix of White’scovariance matrix
associated with the income coe¢ cients
0
^
W= înc Vînc 1 inc =2 F2;70 under H0
înc2 înc2
136
More acurately (but not necessarily expected),
0
înc ^ d 2
W= V^ 1 inc
inc ! 2
înc2 înc2
This latter test is valid when evidence of heteroskedasticity is found.

(c) (8 points ) In particular, we are concerned that the errors exhibit heteroskedas-
ticity which is related to the variable income. Various tests have been suggested
to test for heteroskedasticity, e.g., White’s test, the Gold…eld-Quandt test and
the Breusch-Pagan test. Discuss brie‡y two of these tests, clearly specifying
what assumptions, if any, you need to make about the type of heteroskedastic-
ity.
Answer:
White tests the general hypothesis of the form
2 2
H0 : i = for all i
HA : Not H0
A simple operational version of this test is carried out by computing NR2 in the
regression of "bi2 on a constant and all (unique) …rst moments, second moments,
and cross-products of the original regressors. The test statistic is asymptotically
distributed as 2p where p is the number of regressors in the auxiliary regression,
excluding the intercept.
The Gold…eld-Quant presumes that the heteroskedasticity changes

monotonically with income, ranks all observation on the magnitude of income
and split the sample into two (three) parts one associated with high, and one
associated with large variances (if heteroskedasticity exist). Two independent
tors s21 =
variance "b01"b1=(n1
estima- k) and s22 = "b02"b2=(n2 k) can be obtained by
performing OLS on these two sets of data. Under the assumption of normality,
the test statistic
s21
s2 =(n2 k) Fn1 k;n2 k under H0
s22
and we reject if F > Fn1 k;n2 k; . To increase the power of the test it is sug-
gested to leave out about a third of the observations in the middle.
137
Breusch and Pagan test
2 2
H0 : i = for all i HA :
2 2 0
i = f( 0+ zi)
The test is equivalent to testing = 0, but does not require us to specify the
unknown, continuously di¤erentiable function f( ) at all. The simplest variant of
the Breusch-Pagan test can be computed using an auxilliary regression
"bi2 = 0+ zi0 1+ vi
and computing
N R2 where N is the sample size
2
The resulting test is asymptotically with degrees of freedom equal to the num-
ber of variables in zi under the null of homoskedasticity.
(d) (5 points ) The results from White’s test, Gold…eld-Quandt test, and a partic-
ular Breusch-Pagan test are reported in the next table, discuss the results and
any discrepancy you …nd.
Test statistic critical-value

W hite0 s test 14:329 21:03
Goldf ield Quandt test 15:001 1:79
Breusch P agan test 41:9203 5:99
Answer: The Gold…eld-Quant test is very speci…c concerning the way income
monotonically e¤ects and …nds strong evidence of heteroskedasticity (…nite sam-
ple test). The Breusch-Pagan test, is a bit less speci…c in that the heteroskedas-
ticy depends on an index involving the income variables but the functional form
is left indeterminate (but continuous), it also …nds strong evidence of
heteroskedasticity (asymptotic test). White’s test is least informative, it does
not …nd evidence of heteroskedasticity given the sample used, but it should be
noted, this test is also only valid when the sample size is large. The power of
White’stest is the smallest!
6. Consider the model

yt = + "t ,
138
where is the unkonwn mean of the variable y and the "i are error terms. It is
2 1=2
assumed that "1 = (1 ) 1 and "i = "i 1 + i for i = 2; :::; n; where the terms
i (with mean zero) are uncorrelated and homoskedastic and where 1< < 1:
(a) (8 points ) Show that the error terms "i are homoskedastic but that all au-
tocorrelations are non-zero. (You are not expected to provide explicit formulae
for the autocorrelations.) Describe in detail how can be estimated by the
Cochrane-Orcutt method.
2 1 2 2
Answer: Student should show V ar("i) = (1 ) " for i=2,..,n (par- tial
points awarded when relying on stationarity proof) just as V ar("1): Since
i 2 i 1
we can write "i = i+ i 1+ :: 2+ "1 i = 2; :::; n it is obvious that all "i
i 1 2
are correlated with "1 (Cov( "i; "1) = " i = 2; ::; n) but even for all
i 6= j i; j = 2; ::; n it is easy to show non-zero correlatedness everywhere since all
depend at least on "1:The Cochrane-Orcutt method proceeds as follows: Step
1: obtain an estimate of from regressing the LS residuals "î = yi y on "î 1
using i = 2; ::; n: Step 2: using this estimate, perform the OLS regression on
Step 3: using this new estimate of recompute the residuals "î = yi ^ and
return to step 2 until convergence is achieved.
(b) (6 points ) Is the estimator of (a) is unbiased. Investigate also whether it is

consistent.
Answer: As long as is unknown, this estimator is biased, but will be consistent
(c) (6 points ) Now suppose that the error terms are not generated by the above
process, but that instead "1 = 1 and "i = "i 1 + i for i = 2; ::; n: Derive the best
linear unbiased estimator for in this model.
Answer: Note the following transformation, yields a linear regression model
139
which satis…es all the Gauss-Markov conditions
(
y1 = + 1
yi yi 1 = ( )+ i
Y=Z +
where Z is a vector containing a 1 for the …rst observation only and zeros else-
where, and Y is a vector containing y1 for the …rst observation and yi for the
remaining observations. Therefore OLS on this model yields the BLUE of ;
which yields ^ = (Z0Z) 1Z0Y = y1:
(d) (3 points ) Investigate whether the estimator of (c) is unbiased. Investigate
also whether it is consistent.
Answer: The estimator is unbiased: E(y1) = E( + 1) = ; but not consistent,
while unbiased, the variance doesn’tvanish as the sample size increases.
(e) (2 points ) Try to give an intuitive explanation of the result in (d).
Answer: The observations y2; ::yn form a random walk and are therefore not
informative about the mean, and do not yield extra information (required for
consistency) about the parameter of interest.
7. Consider the regression equation
yt = x1t 1 + x2t 2 + "t (t = 1; :::; T )
"t is an i.i.d. error. We are also given two other variables w1t and w2t , and are told
that the following correlation structure is true
(x1 ; ") = 0;
(x2 ; ") = 0:3;
(w1 ; ") = 0; (w1 ; x1 ) = 0:9; (w1 ; x2 ) = 0:1;
(w2 ; ") = 0; (w2 ; x1 ) = 0:1; (w2 ; x2 ) = 0:8:
All variables are in deviations from their means.
(a) [7 marks] Show that the least squares estimates for and 1 2 are in general
inconsistent. Derive an expression for the inconsistency in b1 .
140
Answer: General inconsistency easy:
^ = (X0X) 1X0y = + (X0X) 1X0"

plim ^
" #
1
X0X X0"
= plim
T T
X0X 1 X0" X0X
= plim plim by Slutsky provided plim = MXX invertible
T T N
1 E(x1t"t)
= M XX by law of large numbers
E x2t" t)
(
1 0 0
= M XX 6
=
c 0
Consider now the expression for inconsistency in b1: From the partitioned re-
gression result
^1 = (X0 M2X1) 1X0 M2y = 1+ (X01M2X1) 1X01M2"

1 1
plim ^1 1
" #
1
1 1
(b) [2 marks] Explain two possible causes of corr(x2 ; ") 6= 0:

Answer: measurement error, endogeneity of x2; simultaneous equations
141
(c) [6 marks] De…ne two possible instrument-matrices ZI = [x1 w1 ] and ZII =
[x1 w2 ] and two possible IV estimators
eI = (Z 0 X) 1 Z 0 y and
I I
eII = (Z 0 X) 1 Z 0 y;
II II
where X = [x1 x2 ]. Is eI a consistent estimator for ? Is eII consistent? Explain

why.
Answer: Both are consistent - since the instruments are uncorrelated with the
errors.
= M zI1X =
0 0
(d) [5 marks] Can you choose between eI and eII ? What is the basis of your
choice?
(e) [5 marks] Can you o¤er a better estimator than either eI and eII ?
(f) (5 points ) Discuss the problem of identi…cation in simultaneous equation mod-

els.
142
(g) We consider the following adapted model of industry structure and performance
considered by Strickland and Weiss (1976)
Ai = 0 + 1 Mi + 2 CDi + 3 Ci + 4 GRi + 5 Di + "1i
Ci = 0 + 1 Ai + 2 M ESi + "2i
Mi = 0 + 1 Ki + 2 GRi + 3 Ci + 4 Ai + 5 M ESi + "3i ;
with endogenous variables the advertising to sales ratio (A); the concentration
level (C) ; and the price cost margin (M ); and exogenous variables: the consumer
demand to sales ratio (CD); the industry growth rate (GR); a dummy for durable
goods industry (D); the e¢ cient scale to sales ratio (M ES), and the capital
stock to sales ratio (K): The i.i.d. errors ("1i ; "2i ; "3i ) are independent from the
regressors with jointly distribution function given by N (0; ); with a general
symmetric, positive de…nite matrix of order 3.
i. (6 points ) Determine the identi…cation status of each equation.
ii. (8 points ) Discuss the estimator you would suggest we apply to estimate
the parameters of each equation separately using an appropriate Limited
143
Information Method. Justify your answer.
(h) (6 points ) Discuss the identi…cation of and in
y1i = y2i + zt + "1t

y2i = zt + "2t ;
where y1i and y2i are endogenous variables, zt is independent of ("1t ; "2t ), and
the errors ("1t ; "2t ) are i.i.d., with mean zero and arbitrary, positive de…nite
covariance matrix.
144
8. (a) (3 points ) Discuss why it is important to test for non-stationarity and discuss
the consequences of non-stationarity in regression analysis.
Answer: non-standard distribution for statistical inference, and possibility of
obtaining spurious, i.e., meaningless, regression. Important also for identifying
whether shocks have a lasting e¤ect (unit root) or not
(b) Consider the ARMA(3,2) process:
yt = 1 yt 1 + 2 yt 2 + 3 yt 3 + vt + 1 vt 1 + 2 vt 2 ;
where vt is an innovation.
i. (7 points ) Discuss the condition for this process to be covariance-stationary.
Rigour of your answer is rewarded.
ii. (5 points ) Assuming the stationarity condition is satis…ed, discuss how

can obtain consistent (not necessarily e¢ cient) estimates the parameters:
(c) Consider now the AR(2) process:
yt = 1 yt 1 + 2 yt 2 + vt ;
where vt is an innovation.
145
i. (3 points ) Write the implied AR(2) in the error correction form, namely:
yt = 0 yt 1 + 1 yt 1 + "t
and de…ne the relationship between the ’sand the ’s.
ii. (2 points )If you estimate both equations by OLS, what is the relation, if
any, between the two sets of estimated coe¢ cients? Are the two sets of OLS
residuals related?
iii. (5 points )Suppose you estimate the error-correction equation using a sam-
ple of 55 observations and obtain the following results (standard errors in
parentheses):
yt = 0:25 yt 1 + 0:50 yt 1 + "^t :
(0:167) (0:20)
Test the hypothesis that the process has at least one unit root against the
alternative that it is covariance stationary. The critical value for this Aug-
mented Dickey Fuller test is given by -1.95.
146
Summer 2008 Examination (SOLUTIONS)
EC221
Suitable for all candidates
Time allowed: 3 hours + 15 minutes reading time
This paper contains NINE questions. Answer ANY four questions. All questions will be
given equal weight (25%)
regulations)
c LSE 2008/EC221 solutions Page 1 of 21
147
1. Using information on students in a large principles of microeconomics course, the
following equation was estimated
score
[ i = 13:98 + 11:25gpai +2:57 hsgpai +0:742 acti 0:157 worki
(3:68) (0:78) (1:26) (0:122) (0:040)
+4:41 calculusi 0:728 mothcolli + 0:18 f athcolli

(0:78) (0:796) (0:766)
n = 814; R2 = 0:4194
where the dependent variable, scorei ; is the course total as a percentage of total points
possible. The explanatory variable are the grade point average at the beginning of
term (gpai ), high school performance (grade point average (hsgpai ) and ACT score
(acti )), hours of work per week (worki ), a binary variable for whether a student has
taken a calculus course (calculusi ), and binary indicators for whether mother and
father have bachelor’s degrees (mothcolli ; f athcolli ):
(a) Interpret the coe¢ cient on calculus and decide whether its estimated e¤ect seems
reasonable. [3 points]
(b) Compute the adjusted R2 and test the signi…cance of the regression. [6 points]
R
(c) Does high school performance (grade point average or ACT score) help predict
perfomance in microeconomic principles? [5 points]
148
(d) When mothcolli and f athcolli are dropped from the equation, the R2 becomes
0:4188: Is there any evidence that having a parent with a college degree helps
predict performance in microeconomics principles, having controlled for the other
explanatory variables. [5 points]
(e) If the variance of score is changing with gpa and hsgpa what can you say about
the test performed in (d); suggest any modi…cation you may wish to make. [6
points]
149
2. Let math10 denote the percentage of students at a high school receiving passing score
on a standardized math test. We are interested in estimating the e¤ect of per student
spending on math performance. A simple model is
math10i = 0 + 1 log(expendi ) + 2 log(enrolli ) + 3 povertyi + ui (2.1)
where povertyi is the percentage of students living in poverty.

You are faced with the fact that data is unavailable on a key variable: poverty: You
do have information available on a closely related variable: the percentage of students
eligible for the federally funded school lunch program, lnchprgi :
(a) In this question we want to use lnchprgi as a proxy for povertyi ; that is we will
consider running the regression
math10i = 0 + 1 log(expendi ) + 2 log(enrolli ) + 3 lnchprgi + ei ; (2.2)
where we assume that the following relationship exists
povertyi = 0 + 1 lnchprgi + vi : (2.3)
i. Brie‡y discuss why lnchprgi is a sensible proxy variable for the unobserved
variable povertyi: [2 points]
ii. Discuss the assumptions you need to make to enable consistent parameter
estimates on 1 and 2 using your estimable equation (2:2): Will your esti-
mates of 1and 2 be unbiased as well? Prove your statements. [10 points]
150
n
and 2 can be obtained as well under these conditions ( E("jX) = 0).
(b) The OLS results with and without lnchprgi as an explanatory variable are given
by (standard errors in parentheses):
\i=
math10 69:24 + 11:13 log(expendi ) + 0:022 log(enrolli ),
(26:72) (3:30) (0:615)
N = 428; R2 = 0:0297
\i=
math10 23:14 + 7:75 log(expendi ) 1:26 log(enrolli ) 0:324lnchprgi
(24:99) (3:04) (0:58) (0:036)
N = 428; R2 = 0:1893
Explain why the e¤ect of expenditures on math10i is lower in the regression

where lnchprgi is included than where it is excluded. [7 points]
bias.
(c) Test the hypothesis that we have a signi…cant positive e¤ect of expenditure at
the 5% level of signifance. [6 points]
151
3. Consider the following model for the relationship between macroeconomic consump-
tion (C); disposable income (D), and non-consumptive expenditures (Z);
Ci = + Di + "i (Consumption equation)

Di = Ci + Zi (Income equation)
Z is assumed to be exogenous in the sense that E(Zi "i ) = 0 for all i = 1; :::; n:
(a) Prove that applying OLS to the consumption equation gives an inconsistent
estimator of the parameter : Distinguish between the following two cases, one
where Z does not vary at all and another where Z has a very large variance.
What interpretation/relevance can you give for the di¤erence have? [8 points]
(b) Derive an explicit expression for the IV estimator of . Discuss what require-
ments instruments need to satisfy and relate it to your answer in (a). [7 points]
152
(c) Prove that the IV estimator is consistent. [8 points]
4. Consider the simple generalized linear regression model
y i = x i + "i ; i = 1; :::; n
2
where "i are independently distributed N (0; zi ): Concerning the explanatory vari-
able it is noted that: xi is a single nonstochastic regressor, measured in deviations
P
of its mean, x = 0; and ni=1 x2i > 0; and zi is a single nonstochastic regressor with
zi > 0 8i = 1; :::; n:
(a) Discuss the properties of the OLS estimator for for the model. Clearly speci…y
what assumptions you are using to justify all your statements. [5 points]
153
(b) Discuss a feasible GLS estimator for : What properties does this estimator
have? [5 points]
2
(c) Consider a MLE estimator for the parameters ( ; ; ). Provide the log-likelihood
function for this model and discuss how you would obtain the MLE estimates (no
detailed derivations are expected). What properties does this estimator have?
[8 points]
(d) Describe how you would use the MLE results to test for the presence of het-
eroskedasticity. [7 points]
154
5. Indicate whether each of the following statements is true, false, or uncertain. No
points will be awarded without justi…cation of your answer.
(a) Consider the regression model
yi = + x i + "i ; i = 1; :::; n
under the classical linear regression assumptions. "In the case of measurement
error in the dependent variable, the OLS estimator for is no longer BLUE".
[6 points]
(b) "In the classical linear regression model with normally distributed errors, it is
2
preferable to use the MLE estimator of the variance ^M ^0 "^=n than the OLS
LE = "
estimator of the variance s2 = "^0 "^=(n 2)". [7 points]
(c) "When testing for serial correlation, I should always make use of the Lagrange
Multiplier test, since this method allows us to estimate the model under the null
of zero autocorrelation". [6 points]
155
(d) "A con…dence interval for j can be used for testing any null hypothesis con-
cerning j : For the construction of the con…dence interval it matters whether
you want to conduct a one or two-sided test."[6 points]
156
6. Consider the following simultaneous equation system Byt + zt = t given by:
y1t = y2t 21 + z1t 11 + 1t
y2t = y1t 12 + z1t 12 + z2t 22 + z3t 32 + z4t 42 + 2t
y3t = y1t 13 + y2t 23 + z1t 13 + z5t 53 + 3t
where yt = fy1t ; y2t ; y3t g0 denotes the vector of the tth observation on the endogenous
variables and zt = fz1t ; z2t ; z3t ; z4t ; z5t g0 the vector for the non-stochastic exogenous
ones. Assume that
X
T
1
QT = T zt zt0
t=1
has full rank and converges to a …nite non-singular matrix as T ! 1 and that
0
t =f 1t ; 3t ; 3t g is i.i.d.N (0; ).
(a) Discuss in detail the problem of identi…cation in simultaneous equation models.

[7 points]
(b) Determine the identi…cation status of each equation. [6 points]
157
(c) Discuss how you would estimate the parameters of each equation separately,
using an appropriate Limited Information Method. Justify your answer. [5
points]
(d) Suppose is known to be a diagonal matrix. How does the identi…cation status
of each equation change, if at all? [7 points]
158
159
2
7. Consider the linear regression model y = X + "; where " N (0; I), X is a full
column rank T k matrix of nonstochastic regressors, and is an unknown k 1
parameter vector. We want to test the following hypothesis
H0 : c 0 = 0
HA : c0 > 0:
Standard bookwork question. Rigour rewarded!
2
(a) In deriving a test statistic for the above hypothesis, you are told that is
2
unknown. Provide an unbiased estimator of and derive the distribution of
this estimator of the variance when suitably scaled.
(b) De…ne the test statistic that you would use to test H0 : c0 = 0 versus H1 : c0 >
2
0, where c is a k 1 vector of known constants, where is unknown.
(c) Derive the distribution of the test statistic using the result derived in part a.
Justify all steps.
(d) Provide the acceptance/rejection rule for our test, how does that di¤er from the
acceptance/rejection rule of the two-sided alternative c0 =
6 0:
8. (a) Discuss why it is important to test for non-stationarity and discuss the conse-
quences of non-stationarity in regression analysis. [5 points]
(b) Using annual data on US in‡ation, we want to conduct a test for a unit root in in-
‡ation. Allowing for one lag of inf t in the augmented Dickey-Fuller regression
gives
\
inf t = 1:36 0:310 inf t 1 +0:138 inf t 1 ; R2 = 0:172; N = 47:
(0:517 (0:103) (0:126)
Test for the presence of a unit root, clealy indicating the null and alternative
hypothesis, the test statistic, and the acceptance rejection The critical value for
this Augmented Dickey Fuller test is given by -1.95. [8 points]
160
(c) Suppose the process f(xt ; yt )gTt=0 satis…es the equations
yt = xt + ut and
xt = xt 1 + vt
where ut and vt are stationary with E(ut jIt 1 ) = E(vt jIt 1 ) = 0; where It 1
contains information on x and y dated at time t 1 and earlier, 6= 0 and

j j < 1:
i. Explain why this ensures that both xt and yt are I(1): [5 points]
ii. Show that these two equations imply an error correction model of the form
yt = xt 1 + (yt 1 xt 1 ) + et :
What relations do ; and "t have with ; ; ut and vt ? Why do we call

this an error correction model. [7 points]
161
9. We are interested in the Engel curve for tobacco. The Almost Ideal Demand System
of Deaton and Muellbauer (1980) imply Engel curves of the form
wi = i + i log xi + "i ;
where wi is household i’s budget share of tobacco, xi denotes total expenditures and
the random terms "i capture mean zero unobservable di¤erences between households.
The parameters i and i depend on household characteristics, where
i = 0 + 1 agei + 2 nadulti + 3 nkids2 + 4 nkids
i = 0 + 1 agei + 2 nadulti :
The variable used are agei (the age of the head of the household, in catergories),
nadulti (number of adults in the household), nkids2i (number of children younger
than 2) and nkidsi (number of children age 2 or over). Regressions for this question
can be found below).
(a) The model has been estimated using Ordinary Least Squares twice, and the
budget share of tobacco is labelled tobacco. Test for the signi…cance of 0 . Does
it make a di¤erence which OLS regression I use, you may want to make use of
the residual based regressions reported? Brie‡y suggest how you would test for
the joint signi…cance of 0; 1 and 2. Clearly specify what assumptions you
use. [6 points]
162
(b) It is argued that OLS in fact is not a suitable estimation method for this data,
as 62% of the households in this sample have no expenditures on tobacco.
In lectures we discussed the binary choice model as an example where Max-
imum Likelihood Estimators should be considered instead of relying on OLS
(Probit/Logit). In this setting, the use of a Maximum Likelihood Estimator
has been advocated as well. The Tobit model, as this estimator is referred to,
models both the probability of observing a zero observation together with its
value when positive. The loglikelihood function (just for your information, not
used in the question itself) is given by
X
N
i + i log xi 1 wi i i log xi
log L = di log(1 ( )) + (1 di ) log( ( ));
i=0 " " "
where di takes the value 0 if wi = 0 and 1 otherwise. ( ) and ( ) are respec-

tively the pdf and cdf of a standard normal random variable.
i. Brie‡ydescribe properties that MLE estimators exhibit under standard
regularity conditions.[4 points]
ii. Discuss the Wald and LR testing principles.[6 points]

Bookwork
163
iii. As in (a) you want to test for the signi…cance of 0 and the joint signi…cance
of 0; 1 and 2. Please conduct these tests using the MLE regressions
reported. Clearly specify your test statistics, their distribution (asymptotic)
and the acceptance rejection rule. The MLE regression output contains a
row labelled SIGM A where parameter estimates (and other statistics) for
" are reported:Brie‡y discuss whether it makes a di¤erence whether you
make use of a Wald or LR test [9 points]
Following this page, the regression output for question 9 follows. The exam concludes
thereafter.
164
165
166
167
Summer 2009 Examination (SOLUTIONS)
EC221
2008/2009 syllabus only –not for resit candidates
The …rst 15 minutes is a reading period. During the reading period you cannot write in
your answer book.
This paper contains EIGHT questions. Answer ANY four questions. All questions will
be given equal weight (25%)
regulations)
c LSE 2009/EC221 Page 1 of 20
168
1. Consider production data for the year 1994 of n = 26 US …rms in the sector of primary
metal industries. For each …rm, values are given of production (Y , value added in
millions of dollars), labour (L; total payroll in millions of dollars), and capital (K;
real capital stock in millions of 1987 dollars). A log linear production function is
estimated with the following result (standard errors are in parentheses)
log Y = 0:701 + 0:756 log L + 0:242 log K + e; e0 e = 1:825544; R2 = 0:956888;

(0:415) (0:091) (0:110)
with e0 e denoting the residual sums of squares. The model is also estimated under
two alternative restrictions, the …rst with equal coe¢ cients for log L and log K and
the second with the sum of the coe¢ cients of log L and log K equal to one ("constant
returns to scale"):
log Y = 0:010 + 0:524 (log L + log K) + e1 ; e01 e1 = 2:371989; R2 = 0:943984

(0:358) (0:026)
log Y log K = 0:686 + 0:756 (log L log K) + e2 ; e02 e2 = 1:825652; R2 = 0:751397;

(0:132) (0:089)
with e01 e1 and e02 e2 denoting the residual sums of squares of these regressions, respec-
tively. In the following tests use a signi…cance level of 5%: You are required to provide
clearly the assumptions which underly the tests. (NO MENTION OF ANY AS-
SUMPTIONS REDUCE OVERALL MARK WITH 2 - only apply when
student gets 15 marks or above for question!!)
The tests rely on the GM condtions with normality of the errors. I.e., y = X +" true
2
model, "jX N (0; I) (homoskedasticity and zero autocorrelation) independence).
Not needed that X non-stochastic!
(a) 5 MARKS Test for the individual signi…cance of log L and log K in the …rst
regression and test for the joint signi…cance of these two variables.
169
(b) 4 MARKSTest the restriction of equal coe¢ cients by means of an F test based
on the residual sum of squares.
(c) 4 MARKS Rewrite the F test based on residual sum of squares in terms of the
R2 of the restricted and unrestricted models. Redo the test in (b) based on the
R2 :
(d) 3 MARKS Test the restriction of constant returns to scale using an F test
based on the RSS, as in part (b).
(e) 4 MARKS Why would you not be able to use a formulation of the F test which
compares the R2 of the restricted and unrestricted model, as was appropriate in
part (c), when conducting the F test of constant returns to scale.
170
or the part of the variation of log Y log K that can be explained. 4 MARKS
(f) 5 MARKS Discuss how you could obtain a 95% con…dence region for log L and
log K (con…dence ellipse). What additional (if any) information do you need?
Brie‡y comment on whether such a con…dence region may assist us in testing at
the 5% level of signi…cance, say, the hypothesis ( log L = 0:9; log K = 0:1).
2. Consider the partitioned regression model
Y = X1 1 + X2 2 +"
with X1 and X2 nonstochastic regressor matrices. Let ^1 and ^2 be the usual least-
squares estimators.
(a) 5 MARKS Provide the formulae for the least-squares estimators ^1 and ^2 :
Clearly de…ne any notation you may introduce. (No technical derivations re-
quested.)
171
(b) 8 MARKS With X1 and X2 stochastic regressor matrices, give a set of su¢ cient
conditions for unbiasedness of ^1 : Similarly, give a set of su¢ cient conditions re-
quired for consistency of ^1 : Explain the di¤erence between unbiasedness and
consistency.
(c) An important result for the partitioned regression model is given by Frish,
Waugh and Lovell.
Let Y^ and X
^ 1 be the residuals from auxilliary regressions of Y and X1 on X2 ;
respectively. Proof the following claims made by Frish-Waugh-Lovell:
i. 6 MARKS b1 can be obtained from regressing Y^ on X

^ 1 (a residual based
regression).
ii. 6 MARKS The residual vector "~ from the regression of Y^ on X

^ 1 are equal
172
to the residual vector "^ from the original regression Y on both X1 and X2 :
(Hint: note that you can …nd an easy transformation of "^ to yield "~; show
that this transformation leaves "^ unchanged). The residual "^ = Y X1 ^1
X2 ^2; and "~ = Y^ X^1 ^ = M2Y M2X1 ^1: (2 MARKS) We want to
show
3. (a) 6 MARKS If u is a p-dimensional vector of random variables distributed as

N (0; V ), where V is non-singular, show that u0 V 1
u is distributed as Chi-
squared with p degrees of freedom.
(b) Given the linear regression model
y = X + ";
2
where " N (0; In ) and X is a n k matrix of deterministic regressors of
rank k.
LACK OF EXPLANATIONS SHOULD BE PENALIZED!
i. 3 MARKS Show that for the OLS estimator b, b N ; 2

(X 0 X) 1
:
173
ii. 5 MARKS Suppose you want to test H0 : R = r, where R is a p k
deterministic matrix of rank p and r is a p 1 deterministic vector. Propose
a test statistic for this test and derive its distribution under H0 assuming
2
is known. You can refer to the result in part (a) of this question.
iii. 5 MARKS Given the residuals "b = y X b, show that s2 = "b0 "b= (n k) is
2
an unbiased estimator of :
iv. 5 MARKS Modify your previous test statistic for testing H0 : R = r in

2
case is unknown and derive its distribution under H0 . You could assume
that (n k) s2 = 2
is distributed as a Chi-squared with n k degrees of
freedom.
174
4. An example of MLE is the Poisson regression model. This model has been used
widely to analyze data on patents. Let yi denote the number of patents …rm i applies
for in a particular year. Its marginal distribution is given by
yi
exp( i) i
f (yi ) = ; yi = 0; 1; 2; 3; :::;
yi !
where i, the expected amount of patents …rm i applies for in a particular year, can
be expressed in terms of explanatory variables, x; and unknown parameters, ; as
follows:
i = exp(x0i ):
(a) 4 MARKS Give a general discussion of the maximum likelihood estimator

(MLE). Given standard regularity conditions, state what desirable properties
MLE exhibit.
175
(b) 6 MARKS You are given a sample of independently drawn observations (y1 ; x1 ):::; (yN ; xN ):
Provide the log-likelihood for this problem. Sketch brie‡y how we obtain the
MLE of .
Note: you will not be able to write down an explicit form for ^M LE and you are
not asked to provide rigorous mathematical derivations. [6 marks]
We have independently drawn observations, which implies that the joint density
(c) Cincera (1997) considers a sample of 181 international manufacturing …rms. For
each …rm, we have data on the annual expenditures on research and development
(R&D), the industrial sector it operates in, the country of its registered o¢ ce
and the total number of patent applications for a number of consecutive years.
The results are reported below.
i. 6 MARKS Using the Wald test, test whether R&D expenditures signif-
icantly a¤ect the number of patents a …rm applies. How does your result
compare to performing this test using the Likelihood Ratio Test? Clearly
describe the test statistics, distributions and acceptance/rejection rules. [6
marks]
176
ii. 4 MARKS You can also conduct a Lagrange Multiplier test for part
(i). Brie‡y indicate what this test involves. No mathematical derivations
expected.
iii. 5 MARKS It is argued that to improve the power of the test of signi…cance
of R&D we should use a one-sided test. Explain this statement and discuss
if this has any bearing on your preferred test (Wald, Likelihood Ratio, or
Lagrange Multiplier). What e¤ect (if any) does this have on your accep-
tance/rejection rules?
177
5. (a) Explain the meaning of the each of the following terms:
i. Structural simultaneous equations. [2 marks]
ii. Reduced-form equations. [2 marks]
(b) Explain concisely what is meant by "the identi…cation problem" in the context
of linear simultaneous equations. [4 marks]
(c) Consider the consumption function
Ct = + Yt + "t ; (1)
where Ct is aggregate consumption at t, is marginal propensity to consume

(0 < < 1) and Yt is aggregate income at t de…ned as
Yt = Ct + It + Gt : (2)
Variable It is aggregate investment at t, and variable Gt is government consump-

tion at t, and both variables are exogenous.
178
Assume that the shock "t is mean zero i.i.d across t. A sample of size n containing
Yt , Ct , It , and Gt is available.
i. Show that the OLS estimator of in (1) is inconsistent. Compute the
amount and direction of this inconsistency. [4 marks]
ii. Explain how the parameters of the reduced form can be estimated consis-
tently. [2 marks]
iii. Show how you can use estimates from (ii) to …nd consistent estimates of the
structural parameters. [4 marks]
179
(d) Consider the three-equation model
y1t = 12 y2t + 13 y3t + 10 + 11 z1t + 12 z2t u1t

y2t = 21 y1t + 20 + 21 z1t u2t
y3t = 31 y1t + 32 y2t + 30 + 32 z2t u3t ;
where
y1t ; y2t ; y3t are endogenous variables;
1; z1t ; z2t are exogenous variables:
Discuss the identi…cation of each equation. [7 marks]
180
181
6. (a) Consider the following linear regression model:
yi = + x i + "i ;
where xi is deterministic, E["i ] = 0 and X has full column rank. It is known

that the variance of "i is
2
i = exp( + xi ):
i. Suppose that i2 is known for every i = 1; : : : ; n. Explain how you can obtain
the best linear unbiased estimator of ( ; )0 in our model. [2 marks]
ii. Suppose that i2 is not known, i = 1; : : : ; n. Suggest a two-step procedure

for …nding a feasible GLS estimator of ( ; )0. [6 marks]
iii. Econometrician A claims that the estimator from (ii) is always unbiased.
Econometrician B claims that it is always biased. Econometrician C thinks
182
that usually this estimator is biased but in some situations it may be unbi-
ased. Who is right? Explain. [2 marks]
iv. Describe in detail how you would test for heteroskedasticity in our model.
[4 marks]
(b) Consider a linear regression model
y t = x t + "t ; t = 1; : : : ; T
where xt is deterministic, errors "t follow a stationary AR(1) process
"t = "t 1 + vt ;
2
vt i:i:d:(0; v ), vt independent of "t 1 ; "t 2 ; : : :
An econometrician suggests estimating estimating parameter by running the

OLS regression of M yt on M xt (without a constant term), where
M yt = yt yt 1 ; t = 2; : : : ; T
M xt = xt xt 1 ; t = 2; : : : ; T
Show that the estimator that the econometrician obtains is unbiased. [11
marks]
183
Formulate and discuss the conditions in the de…nition of a vector of instrumental
variables. [4 marks]
that is, there should be at least as many instruments as regressors.

(c) The model of interest is given by
yt = 1 xt + 2 yt 1 + "t ; t = 1; : : : ; T;
2
"t = v t + 1 vt 1 + 2 vt 2 ; vt i:i:d: (0; v );
vt is independent of any xs , vt is uncorrelated with yt 1 , yt 2 , : : :

i. Prove that regressor xt is exogenous and regressor yt 1 is endogenous. [4
marks]
c Page 17 of 20
184
ii. Suggest an instrumental variable estimator. Prove orthogonality of your
vector of instruments. Also, indicate a necessary and su¢ cient condition for
your instruments to be relevant. [4 marks]
iii. Suggest a 3-dimensional vector of instruments. Prove orthogonality and in-

dicate at least one condition su¢ cient to guarantee relevance. [6 marks]
iv. Explain how you would construct the 2SLS estimator based on the vector
of instruments from (iii). Describe the …rst stage in detail. [7 marks]
185
(d) Give the de…nition of a covariance stationary process. [2 marks]
For any s, covariance cov(yt; yt s) is …nite and does not depend on t

(e) Give the de…nition of an ARMA process with zero mean. [2 marks]
186
(L) = 1 + 1L + 2L + : : : + qL q:
(f) Consider the following seasonal process:

2
yt = yt 4 + "t ; "t i:i:d:(0; )
i. Find the values of 0 for which this process is stationary. For these
values of , …nd the autocorrelation function of the process. [5 marks]
ii. Find the value of for which this process has a unit root. Can this process
be classi…ed as an ARIMA process? If not, explain why. If yes, explain
why and indicate the values of the parameters in this ARIMA process. [5
marks]
187
(g) The true variable xt is generated by a stationary AR(1) process
2
xt = xt 1 + "t ; "t i:i:d: (0; );
but it can only be measured with an error ut . In other words, we observe variable
xt such that
xt = xt + ut ;
where ut is a white noise process independent of the process "t .
i. Obtain the process for the observed variable xt . [3 marks]
ii. Prove that the process for xt can be represented as an ARMA(1,1) process.
[8 marks]
188
Summer 2010 Examination
EC221
The …rst 15 minutes is a reading period. During the reading period you cannot write in
your answer book.
This paper contains EIGHT questions. Answer FOUR questions: TWO questions from
part A, and TWO questions from part B. All questions will be given equal weight (25%)
regulations)
189
Part A: Answer TWO questions
1. Given the linear regression model
y = X + ";
2
where " N (0; In ) and X is a n k matrix of deterministic regressors of rank k.
(a) You are interested in testing the hypothesis H0 : R = r, where R is a p k

deterministic matrix of rank p and r is a p 1 deterministic vector against
HA : R 6= r: You propose to test this by comparing the restricted and the unre-
stricted …t. Give the test statistic, it’
s distribution under the null, and provide
the acceptance rejection rule you propose we use. [4 marks]
(b) Derive the restricted OLS estimator on which the test in (a) is based. You
may want to express the restricted OLS estimator, , in terms of the unre-
stricted OLS estimator, ^: [7 marks]
190
(c) Using the result in part (b) show that the test in (a) can also be written as
1
(R ^ r)0 [ 2 R(X 0 X) 1 R] (R ^ r) / p
:
(n k) 2 s2 / (n k)
[7 marks]
(d) Use the result in part (c), or otherwise, to provide the proof of the distribution
of the test proposed in (a). [7 marks
191
2. Consider the partitioned regression
y =X +" X1 1 + X2 2 +"
where Xj is a t kj matrix of non-random regressors for j = 1; 2: Let ^1 and ^2

be the usual least-squares estimators for 1 and 2 and s2 the usual least-squares
2
estimator for :
(a) Provide the formulae for the least-squares estimators ^1 ; ^2 and s2 : Clearly
de…ne any notation you may introduce. (No technical derivations requested.) [5
marks]
(b) Assuming the Gauss-Markov assumptions are all satis…ed, discuss the following
statement “If X1 and X2 are orthogonal to each other, and we are only interested
in the parameter estimates for 1 , and precision thereof, we may simply ignore
the presence of X2:”[5 marks]
(c) Assume that E(") = X1 (i.e., the mean vector of the disturbance is a linear
combination of some of the regressors) and E [(" E")(" E")0 ] = 2
I: Stating
any additional assumptions that are needed to obtain your results, calculate
i. E( ^1 ) and E( ^2 ): Interpret your results. [5 marks]
192
ii. E(s2 ) [5 marks]
iii. plim s2 . [5 marks]
193
3. We have performed a telephone survey in order to elicit the demand for a (…ctional)
“ecologically friendly” apple. Each family was (randomly) presented with a set of
prices for regular apples (regprc) and the eco-labeled apples (ecoprc). They were asked
how many pounds of each kind of apple they would buy (ecolbs and reglbs). In addition
we obtain information about the income of the household in £ 1000s (faminc) and the
household size (hhsize).
A demand function is estimated with the following result (standard errors are in
parentheses)
\ = 1:63
ecolbs 2:90 ecoprc + 3:03 regprc + 0:0028faminc + 0:053hhsize,
(0:450) (0:589) (0:711) (0:0027) (0:064)
2
N = 660; and R = 0:0393:
(a) Test the signi…cance of the parameters individually and test the joint signi…cance
at the 5% level of signi…cance. Interpret the results economically. [5 marks]
194
(b) The average price per pound for regular apples was £ 0.88 versus £ 1.08 for eco-
logically friendly apples. The average demand for ecologically friendly apples is
1.47lbs. Please provide the own price elasiticities of demand ( P ED ) and the
cross price elasticity ( XED ) at the mean together with their associated standard
errors. [5 marks]
SE 0:711 = 0:426
ecolbs 1:47
(c) You are interested in testing whether the demand for eco-labeled apples is elastic.
You consider testing the hypothesis H0 : P ED = 1 against HA : P ED 6= 1 at
the 5% level of signi…cance.
i. Derive the 95% con…dence interval for an individual parameter in the linear
regression model, under the classical linear regression assumptions. Using
this result, provide the 95% con…dence interval for P ED . What does this
interval tell you about the hypothesis you are considering? [5 marks]
195
ii. You are told that a one-sided hypothesis H0 : P ED = 1 against HA :
P ED > 1 would be better. Discuss why this is the case and conduct the
one-sided test.[4 marks]
(d) You want to test the hypothesis H0 : ecoprc + regprc = 0 against HA : ecoprc +
regprc 6= 0: A regression of ecolbs on the di¤erence ecoprc-regprc, faminc, hhsize
and a constant gives rise to an R2 of 0:0392. Test the hypothesis at the 5%
level of signi…cance and provide its p-value. Brie‡y indicate whether (and how)
you can use the information to conduct the test against the one-sided alternative
HA : ecoprc + regprc > 0: [6 marks]
196
4. (a) Let x1 ; :::; xn be a random sample from a ( ; 2)-Weibull distribution. The Weibull
distribution is characterized by two parameters, > 0 (scale parameter) and
k > 0 (shape parameter) and by setting k = 2 it is also called a Rayleigh distri-
bution. This distribution is used e.g., in survival analysis, weather forecasting,
reliability engineering and failure analysis. Its probability density is given by
2 x x 2
f (x) = exp( ); x 0:
i. Derive the MLE estimator of . [5 marks]
p
ii. The Rayleigh distribution has the following two moments E(X) = 2
and
E(X 2 ) = 2
: Derive the asymptotic distribution of the MLE estimator of :
[5 marks]
iii. Brie‡y indicate what properties the MLE estimator ^ M LE satis…es. Is this
2
an unbiased estimator of ? [5 marks]
197
(b) MLE Inference: Consider an empirical example of MLE. We want to explain
the number of days before a felon released from prison is rearrested. For some
felons, this may never happen, or it may happen after such a long time that we
must censor the duration in order to analyze the data.
In Chung, Schmidt and Witte (1991), recidivism (the return to prison) is re-
lated to demographic characteristics (alcohol and drugs misuse, black, married,
educ (years) and age) and measures of past criminal and correctional history
(workprg (attendance in a workprogram in prison), priors (number of previ-
ous convictions), tserved (time served in months) , and felon (1=conviction for
felony, 0=conviction for misdemeanor).
With ti denoting the – potentially unobserved – log(duration) of individual i
(in months) and ci the censoring time for individual i (the maximal observable
duration), they set
ti = 0 + alc alcoholi + drugs drugsi + ::: + f elon f eloni + "i ;
The observed log(duration), ti = ci if ti > ci and ti = ti if ti < ci : "i indepen-

2
dent of the regressors ( xi ); and "i IN (0; " ).
They have a random sample of 1445 felons and estimate the parameters using
MLE (Tobit model). Below various MLE results are reported.
i. Test individually whether evidence of drug or alcohol misuse signi…cantly
a¤ects recidivism. [5 marks]
ii. Using the Likelihood Ratio Test test the joint signi…cance of past criminal
history (priors, tserved and felon). [5 marks]
198
199
Part B: Answer TWO questions
5. (a) V [ bOLS ] = (X 0 X) 1 X 0 X(X 0 X) 1 , V [ bGLS ] = (X 0 1
X) 1
.
(b) Since X=X ,
V [ bOLS ] = (X 0 X) 1 X 0 X (X 0 X) 1
= (X 0 X) 1 :
Notice that
1 1 1
X=X ) X= X ) X = X:
Therefore,
V [ bGLS ] = (X 0 X 1
) 1
= (X 0 X) 1 :
(c) i. In this model,

0 1 0 1
1 1 :::
B C B C
B 1 C B 1 ::: C
B C
X =B
B .. C;
C = B .. .. .. .. C
n 1
@ . A n n B . . . . C
@ A
1 ..
. 1
ii. 0 1
1
B C
B 1 C
X= 2
(1 + (n 1)) B
B .. C=X ;
C
@ . A
1
2
where = (1 + (n 1)).
iii. Let "ÔLS be the vector of OLS residuals. Because
V [ bOLS ] = 2
(1 + (n 1))(X 0 X) 1 ;
"^0OLS "ÔLS
then from the OLS theory it follows that is an unbiased estimator
n k
2
of (1 + (n 1)). Therefore,
0
"ÔLS "ÔLS
(n k)(1 + (n 1))
2
is an unbiased estimator of .
200
6. (a) No. If yt were covariance stationary then we would have, e.g., E[w2 ] = E[w1 ]+1.
Since E[w2 ] = E[w1 ], this implies that 1 = 0, which is false.
(b) No, it is not covariance stationary. Notice that
2
V [yt ] = t;
that is, the value of variance depends on t.

(c) i.
xt = + t + St + "t (t 12) St 12 "t 12 = 12 + "t "t 12 :
E[xt ] = 12 exists, is …nite and does not depend on t.

8
2
>
< 2 if = 0
cov(xt ; xt+ ) = 2
if 12
>
:
0 otherwise
depends only on .
Thus, fxt g is covariance stationary.
ii.
xt = ( + t)St + "t ( + (t 12))St 12 "t 12 = 12 St 12 + "t "t 12 :
E[xt ] = 12 E[St 12 ]. In general E[St ] in depends on t (if it does not, then

it means that St are identical across t and therefore there are no seasonal
e¤ects). Thus, in general, fxt g is not stationary.
wt = 12 St 12 + "t "t 12 (12 St 24 + "t 12 "t 24 ) = "t 2"t 12 + "t 24 :
E[wt ] = 0 exists, is …nite and does not depend on t.

8
> 2
if = 0
> 6
>
>
< 4 2 if 12
cov(wt ; wt+ ) =
>
>
2
if 24
>
>
: 0 otherwise
depends only on .
Thus, fwt g is covariance stationary.
201
7. (a) The estimated model is
yt = y t 1 + vt ; where
v t = "t + ut ut 1 .
Let us prove that E[yt 1 vt ] 6= 0.
E[yt 1 vt ] = E[yt 1 "t ] + E[(yt 1 + ut 1 )(ut ut 1 )] = E[u2t 1 ] 6= 0
if 6= 0.
(b) Instrument zt should satisfy the validity and the relevance conditions.
Validity: E[zt vt ] = 0. This is guaranteed if, e.g.,
E[zt "t ] = E[zt ut ] = E[zt ut 1 ] = 0: (1)
Relevance: E[zt yt 1 ] 6= 0. Assuming that (1) holds, this is satis…ed if E[zt yt 1 ] 6=

0.
Obviously, zt = 1 satis…es the conditions for validity. However, it does not satisfy
the condition for relevance: E[zt yt 1 ] = E[1 yt 1 ] = 0 because the process for
fyt 1 g is covariance stationary and, therefore, E[yt 1 ] = 0.
(c) E.g., we can use yt 2 as an instrument for one IV estimator and use yt 3 as an
instrument for another IV estimator.
These instruments are valid because
E[yt 2 vt ] = E[yt 2 "t ] + E[(yt 2 + ut 2 )(ut ut 1 )] = 0;
E[yt 3 vt ] = E[yt 3 "t ] + E[(yt 3 + ut 3 )(ut ut 1 )] = 0:
The corresponding IV estimators are

PT
bIV = P t=2 yt yt 2 ;
T
t=2 yt 1 yt 2
PT
eIV = P t=3 yt yt 3 :
T
t=3 yt 1 yt 3
202
8. (a) i.
yj = + xj + vj ; j = 1; : : : ; J;
1
P
where vj = nj i in group j "i .
2
ii. V [vj ] = nj
depends on the group size nj .
iii. All groups have the same size.
iv. OLS estimator is unbiased but ine¢ cient.
v. The e¢ cient way is to construct the GLS estimator. In this model it can be
p
done in the following way. First, multiply equation j by nj :
p p p p
nj yj = nj + nj xj + n j vj ; j = 1; : : : ; J:
Calculate the OLS estimator in this new model. This estimator is the GLS
estimator for the original model.
vi.
y1t = 12 x2t + 13 33 x3t + u1t + 13 u3t
y2t = 21 x1t +( 22 + 21 12 )x2t +( 21 13 33 + 23 33 )x3t + 21 u1t + u2t + ( 21 13 + 23 )u3t
y3t = 33 x3t + u3t :
vii. Equation 1 is identi…ed i¤ 33 6= 0. Equation 2 is not identi…ed –the rank

condition is not satis…ed. Equation 3 is identi…ed.
203
Summer 2011 Examination
EC221
SOLUTIONS
The …rst 15 minutes is a reading period. During the reading period you
cannot write in your answer book.
This paper contains EIGHT questions. Answer TWO questions from Sec-
tion A and TWO questions from Section B. All questions will be given
equal weight (25%)
Calculators ARE allowed in this examination (following examination regu-

lations)
c LSE 2011/EC221 Solutions Page 1 of 11
204
Section A
Answer TWO questions. Each question has equal weight: 25%.
1) Consider the relationship between enrollment in a pension plan and savings. The data
contains information on 9275 individuals’ eligibility for and participation in 401k
pension plans (available to many US workers) along with income and demographic
information. The variables are nettf a (net …nancial wealth), age, inc (annual family
income), f size (family size), and e401k (dummy for eligibility in a 401(k) plan).
(a) Consider the following regression result (the numbers in parentheses here and in
the rest of this question are standard errors):
\ai =0:231
nettf 0:028inci + 1:026inc2i 0:020agei + 0:035age2i +
(0:100) (0:007) (0:060) (0:005) (0:006)
0:097e401ki ; R2 = 0:2018; RSS = 3028:62; N = 9275

(0:033)
i. Test individually whether the income and age e¤ects are quadratic, imply-
ing that the marginal e¤ects of income and age on savings are nonlinear.
Clearly specify the null and alternative hypotheses, the test statistics, their
distributions under the null, and the assumptions which underlie your tests.
[4 marks]
205
ii. Find the p-value for the test H0 : e401k = 0 against H1 : e401k > 0: Do you
reject H0 at the 5% level of signi…cance? [3 marks]
(b) You want to see whether family size has an impact on the relationship between
enrollemtn in a pension plan and savings. Five family size dummy variables were
created: f size1; f size2; ::; f size5: The variable f size5 is unity for families with
…ve or more members. The following regression results were obtained
\ai = 0:182
nettf 0:094inci + 1:011inc2i 0:017agei + 0:031age2i +
(0:101) (0:008) (0:060) (0:005) (0:006)
0:096e401ki + 0:010f size2i 0:027f size3i 0:043f size4i 0:036f size5i

(0:033) (0:017) (0:018) (0:018) (0:023)
R2 = 0:2028; RSS = 3024:74; N = 9275
i. Based on comparing the adjusted R2 from these two regressions, which spec-
i…cation would you prefer? Explain why it is preferable to use the adjusted
R2 rather than the R2 itself. [4 marks]
206
ii. Conduct a formal test supporting your conclusion in (b)i. Clearly specify
the null and alternative hypothesis, the test statistic, the distribution under
the null, and the assumptions which underlie your test.[4 marks]
(c) Someone decides to run separate regressions for the model

2 2
nettf a = 0 + 1 inc + 2 inc + 3 age + 4 age + 5 e401k +u
across the …ve family size categories. In the next table some selected results from
these regressions are reported: sample size, the parameter estimate for e401k;
its standard error and the residual sum of squares.
Sample size e401k RSS

fsize1 2017 0:069 398:45
(0:022)
fsize2 2199 0:134 1162:62
(0:033)
fsize3 1829 0:080 672:50
(0:031)
fsize4 1990 0:079 496:12
(0:024)
fsize5 1240 0:112 268:86
(0:030)
Test whether there are structural di¤ erences across the …ve family size categories,
allowing for intercept di¤ erences. Clearly specify the null and alternative hypoth-
esis, the test statistic, the distribution under the null, and the assumptions which
underlie your test. [6 marks]
207
(d) Discuss the Wald test you could use to test whether the estimates on e401k
reported in (c) are signi…cantly di¤ erent from each other. You do not have to
implement this test. Clearly specify null and alternattive hypothesis, the test
statistic, and the distribution under the null. [4 marks]
2
2) Consider the linear regression model y = X + "; where " N (0; I), X is a full
column rank T k matrix of nonstochastic regressors, and is an unknown k 1
parameter vector. We want to test the following hypothesis
H0 : c 0 = 2
HA : c0 < 2:
2
(a) In deriving a test statistic for the above hypothesis, you are told that is un-
2
known. Provide an unbiased estimator of and derive the distribution of this
208
estimator of the variance when suitably scaled. [8 marks]
(b) De…ne the test statistic that you would use to test H0 : c0 = 2 versus HA :
c0 < 2, where c is a k 1 vector of known constants, where 2
is unknown. [3
marks]
SE(c0 ^)
(c) Derive the distribution of the test statistic using the result derived in part (a).
Justify all steps. [7 marks]
209
(d) Provide the acceptance/rejection rule for our test, how does that di¤er from the
acceptance/rejection rule of the two-sided alternative c0 6= 2: [3 marks]
(e) Discuss how for practical reasons when testing this hypothesis you may want
to reparameterize your model. Elaborate on the reparameterization you would
implement in this case.
Hint: you may consider the particular setting where k = 3 and c0 = 1 +2 2 + 3
where 1 is an intercept. [4 marks]
210
2
3) Consider the linear regression model y = X + ", where " N (0; IN ), X is a full
column rank N k matrix of nonstochastic regressors, and is an unknown k 1
2
parameter vector and is an unknown parameter.
(a) Demonstrate the unbiasedness of the estimators ^ = (X 0 X) 1 X 0 y and s2 =

(y X ^)0(y X ^)=(N k): [8 marks]
(b) Prove that V ar(q 0 ^) V ar(q 0 ), where is any other linear unbiased esti-
mator of and q is an arbitrary non-stochastic vector. [9 marks]
(c) Discuss the optimality of using ^ as an estimator of in the light of the result
in (b). [4 marks]
(d) Discuss the optimality of using s2 as an estimator of 2

recognizing that the
errors in our linear regression model are assumed to be normally distributed. No
elaborate derivations are expected [4 marks]
211
4) (a) Let x1 ; :::; xn be a random sample from a ( ; 2)-Gamma distribution. The Gamma
distribution is characterized by two parameters, > 0 (scale parameter) and
k > 0 (shape parameter) and by setting k = 2 it represents the sum of two in-
dependent exponentially distributed random variables. The Gamma distribution
is often used in a probability model of waiting times. Its probability density is
given by
1
f (x) = 2
x exp( x= ) 0 < x < 1; >0
i. Derive the MLE estimator of : [5 marks]
(b) The Gamma distribution under consideration has the following two moments
E(X) = 2 and E(X 2 ) = 2 2 : Derive the asymptotic distribution of the MLE
estimator of : [5 marks]
212
i. Brie‡y indicate what properties the MLE estimator ^M LE satis…es. Is this
an unbiased estimator of ? [2 marks]
(c) MLE Inference: Consider an empirical example of MLE. Ongena and Smith
(2001) investigate the duration of 383 …rm-bank relationships using Norwegian
data listed on the Oslo Stock Exhange for the years 1979 to 1995. The average
duration in the sample is 4.1 years.
Two sets of MLE estimation results are provided. Both are based on a pro-
portional hazards model (not discussed in lecture). The hazard function (t; xi )
describes the probability of a …rm-banking relationship breaking down at time t
as a function of characteristics ( xi ) and time. Speci…cally
(t; xi ) = exp(x0i ) 0 (t),
213
The …rm-speci…c characteristics (xi ) considered are:
log(sales) logarithmn of year-end sales

age at start time elapsed since the …rm’s founding date
operating income
pro…tability measured by the ratio book value of assets
Tobin’s Q indicator for management quality
book value of debt
leverage market value of equity + book value of debt
multiple relationships dummy for multiple bank relationships.
The function 0 (t) describes the duration dependence. There is positive dura-
tion dependence if the probability of leaving the …rm-bank relationship increases
(ceteris paribus) the longer their relationship is, i.e., @ 0 (t)=@t > 0.
The MLE estimation results for the slope parameters and the parameter
(describing the duration dependence) are provided in the table below.
MLE(1) MLE(2)
1
0 (t) = t ; >0 0 (t) = ; >0
Estimate Standard Error Estimate Standard Error
log(sales) -0.178 0.038 -0.218 0.053
age at start -0.00344 0.00183 -0.00352 0.00259
pro…tability 1.752 0.717 2.124 0.998
Tobin’s Q 0.238 0.141 0.268 0.195
leverage 1.933 0.444 2.281 0.628
multiple relationships 0.491 0.168 0.659 0.231
1.351 0.135 1 (…xed)
Loglikelihood -253.6265 -259.1469
i. Using the MLE(1) results (Weibull proportional hazard model), test indi-
vidually whether the …rm size, pro…tability, and leverage signi…cantly a¤ects
probability of ending a …rm-banking relationship. Clearly indicate the test
statistic, its distribution under the null, and the acceptance rejection rule [5
marks]
214
ii. I want to test the hypothesis H0 : = 1 against HA : 6= 1 (i.e., I want to
test whether there is duration dependence in the …rm-banking relationship).
Implement both a Wald and a LR test for this hypothesis using the results
provided. Clearly indicate the test statistics, their distribution under the
null, and the acceptance rejection rules. [5 marks]
ii. Provide a test for the presence of positive duration dependence. Clearly spec-
ify the null and alternative hypothesis and interpret your results. [3 marks]
215
216
Section B
Answer TWO questions. Each question has equal weight: 25%.
5) (a) Consider a linear regression model with autocorrelated errors:
yt = x0t + "t ; t = 1; : : : ; T
2
"t = "t 1 + vt ; vt i:i:d:(0; v ); E["t 1 vt ] = 0;
where regressors xt are deterministic and the process f"t g is covariance station-
ary.
i. What conditions does satisfy in this model? [1 marks]
ii. What are the unbiasedness and e¢ ciency properties of the OLS estimator
in this model? [3 marks]n
iii. Suppose is known. Describe a GLS transformation which leads to T new

equations with independently and identically distributed regression errors.
Write down the form of the transformation matrix. [6 marks]
iv. Suppose is unknown. Describe in detail a feasible GLS procedure of esti-

mating . [8 marks]
217
t=2 t 1
The second step is to estimate the transformation matrix P in the following
v. Is your feasible GLS estimator unbiased? [2 marks]
(b) Consider a linear regression model
y = X + ";
where y is an n 1 vector of dependent variables, X is an n k matrix of

(possibly endogenous) regressors, and Z is an n L matrix of instrumental
variables (with L k).
Denote
b = PZ X;
X yb = PZ y:
Show that the following three de…nitions of the two-stage least squares estimator
~2SLS are algebraically identical [5 marks]:
b
i. the OLS estimator in the regression of y on X;
b
ii. the OLS estimator in the regression of yb on X;
218
b as the matrix of
iii. the IV estimator in the regression of y on X with X
instruments.
6) (a) Consider a linear regression model
y i = x i + "i ;
where xi is a scalar random variable. Unfortunately, you do not observe xi .

Instead, you observe
xi = xi + xi 2 i ;
where "i , xi and i are independent of each other and E["i ] = E[ i ] = 0, and
all the relevant moments exist. Suppose you have a random sample f(xi ; yi )gni=1
and you regress yi on xi (that is, you run least squares without a constant term).
219
i. Write down the model being estimated. What is the error term in this model?
[3 marks]
ii. Write an expression for the OLS estimator. [2 marks]
iii. What is the probability limit of this estimator? [3 marks]
iv. Show that the estimator is inconsistent. How do you explain this inconsis-
tency? [5 marks]
v. Suppose you have an instrument zi . Write down the formula for the corre-
sponding IV estimator. [3 marks]
220
vi. Under what conditions will the instrumental variable estimator be consistent
for ? Does zi = 2 satisfy these conditions? [5 marks]
Thus, if E[xi ] 6= 0, then zi = 2 can be used as an instrument.
(b) i. Give a de…nition of an ARMA(p,q) process. [2 marks]
ii. Give a de…nition of an integrated process of order d. [2 marks]
221
7) (a) Discuss the White test for heteroskedasticity. What is a motivation for this test?
What is an idea behind this test? Give step-by-step instructions for carrying out
such a test. [12 marks]
(b) Consider the following two-equation model:
y1t = 12 y2t + 11 x1t + u1t

y2t = 21 y1t + 22 x2t + 23 x3t + u2t
0 0
The endogenous variables are (y1t ; y2t ) and the exogenous variables are (x1t ; x2t ; x3t ) .
0
The errors (u1t ; u2t ) are independently and identically distributed with mean
0
(0; 0) and a covariance matrix .
i. Derive the reduced form equations for y1t and y2t. [5 marks]
ii. Discuss the identi…cation status of each equation of the model. [8 marks]
222
8) (a) Consider the AR(2) process given by
2
yt = yt 1 0:5yt 2 + "t ; "t i:i:d:(0; ):
Is this process stationary? [5 marks]
223
(b) Consider the following in…nite-order MA process fyt g:
yt = vt + C(vt 1 + vt 2 + vt 3 + : : :);
2
where C is a …xed constant, C =
6 0, vt (0; v ).
i. Prove that this process is an integrated process of order d. Find that order
d. [7 marks]
ii. Find the autocorrelation function of the process f(1 L)dg. [5 marks]
(c) Consider the model
yi = 0 + 1 xi + 2 wi + "i ; E[xi "i ] 6= 0; E[wi "i ] = 0:
224
All the observations are independent and identically distributed.
0
You want to estimate this model by the IV method using zi = (1; z~i ; wi ) as a
vector of instruments, where an observed variable z~i is an instrument for x~i .
Can you consistently estimate 0, 1 and 2 by the IV method if
i. z~i is independent of yi, xi and wi? [3 marks]
ii. z~i = wi? [3 marks]
iii. z~i = xi . [2 marks]
225

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2006 Examination

Time allowed: 3 hours

c LSE 2006/EC221 Page 1 of ?

\ i = 1:39 +0:412HGP Ai + 0:15 ACTi 0:083SKi ,

i. (2 points ) Interpret this equation. Do the parameters have the expected

Clearly stating what assumptions you need:

c LSE 2006/EC221 Page 2 of ?

Acc/Rej rule Acc/Rej rule

> 3:19) = Pr(jtj > 3:19)

= 2 Pr(t137 > 3:19) ' 2 Pr(N(0; 1) > 3:19) = :0012

^HGPA HGPA > 1:96) = 5%

1:96SE( ^HGPA) [0:22776; 0:59624]

c LSE 2006/EC221 Page 3 of ?

y^ = 2:20 + 0:104x2 3:48x3 + 0:34x4 ; ESS = 109:6; RSS = 18:48:

2. Indicate whether each of the following statements is true, false, or uncertain. No

(xi x )2 100 (xi x ) 100 (xi x ) 100

by OLS, where Djt = 1 if the observation is in quarter j. “Since the dummy

c LSE 2006/EC221 Page 5 of ?

So we obtain an estimate of the intercept equalling 0 and the slope parameter

c LSE 2006/EC221 Page 6 of ?

E (2n k 1)=(n k)s 2(2X0X) 1

c LSE 2006/EC221 Page 7 of ?

yi = + x i + "i for i = 1; :::; n;

(a) (5 points ) Derive the maximum likelihood estimators ^ and ^ of and :

(b) (7 points ) Derive the distribution of ^ : Is ^ unbiased?

c LSE 2006/EC221 Page 8 of ?

where yi is the same variable as above.

(e) (3 points ) Derive the distribution of ^: When is ^ an unbiased estimator for

It is an unbiased estimator for if x = 0 or =0

Now suppose x1 ; :::; xn are i.i.d N ( ; ! 2 ) distributed, independent of ":.

c LSE 2006/EC221 Page 9 of ?

c LSE 2006/EC221 Page 10 of ?

This latter test is valid when evidence of heteroskedasticity is found.

White tests the general hypothesis of the form

The Gold…eld-Quant presumes that the heteroskedasticity changes

c LSE 2006/EC221 Page 11 of ?

Test statistic critical-value

6. Consider the model

c LSE 2006/EC221 Page 12 of ?

(b) (6 points ) Is the estimator of (a) is unbiased. Investigate also whether it is

c LSE 2006/EC221 Page 13 of ?

7. Consider the regression equation

yt = x1t 1 + x2t 2 + "t (t = 1; :::; T )

All variables are in deviations from their means.

c LSE 2006/EC221 Page 14 of ?

^ = (X0X) 1X0y = + (X0X) 1X0"

^1 = (X0 M2X1) 1X0 M2y = 1+ (X01M2X1) 1X01M2"

(b) [2 marks] Explain two possible causes of corr(x2 ; ") 6= 0:

c LSE 2006/EC221 Page 15 of ?

where X = [x1 x2 ]. Is eI a consistent estimator for ? Is eII consistent? Explain

(f) (5 points ) Discuss the problem of identi…cation in simultaneous equation mod-

c LSE 2006/EC221 Page 16 of ?

c LSE 2006/EC221 Page 17 of ?

(h) (6 points ) Discuss the identi…cation of and in

y1i = y2i + zt + "1t

c LSE 2006/EC221 Page 18 of ?

ii. (5 points ) Assuming the stationarity condition is satis…ed, discuss how

(c) Consider now the AR(2) process:

c LSE 2006/EC221 Page 19 of ?

and de…ne the relationship between the ’sand the ’s.

c LSE 2006/EC221 Page 20 of ?

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Time allowed: 3 hours + 15 minutes reading time