Advanced Econometrics (Fall 2017)

Final Exam Solutions

Gautam Tripathi, Andreı̈ V. Kostyrka

Problem 1
(i) Consider the short and the long models:

BLP(log price | foreign) = α0 + α1 foreign (short)

BLP(log price | foreign, quality) = β0 + β1 foreign + β2 quality (long)

Then, by a property of best linear predictors,

BLP(log price | foreign) =

  
= BLP BLP(log price | foreign, quality)  foreign =
= BLP(β0 + β1 foreign + β2 quality | foreign) =
= β0 + β1 foreign + β2 BLP(quality | foreign) = 1
Cov(quality,foreign)
We know that BLP(quality | foreign) = γ0 + γ1 foreign, where γ1 = Var(foreign)
and
γ0 = E(quality) − γ1 E(foreign). Therefore,

1 = β0 + β1 foreign + β2 (γ0 + γ1 foreign) = (β0 + β2 γ0 ) + (β1 + β2 γ1 ) foreign.
| {z } | {z }
α0 α1

We would expect α1 = β1 if and only if β2 = 0 (housing quality does not affect the price) or
γ1 = 0 (the percentage of foreign-born people in a neighbourhood does not correlate with
housing quality). Both conditions are highly implausible, so the two coefficients are expected
to differ depending on the signs of β2 and γ1 . Same goes for their estimators, α̂1 and β̂1 .
(ii) If immigrants tend to desire lower quality housing, then Cov(foreign, quality) < 0 and γ1 < 0.
Assuming the price of housing goes up with its quality (β2 > 0), the sign of β2 γ1 is negative,
so α1 < β1 .
(iii) If immigrants tend to desire better housing, then Cov(foreign, quality) > 0, γ1 > 0, β2 γ1 > 0,
and α1 > β1 .
(iv) If immigrants are not welcome (that is, people have to offer a very low price in order to sell
or rent out flats in ghettos), then β1 < 0. However, β1 does not enter the expression for the
difference of α1 and β1 (that is, β2 γ1 ), so the answer does not change.

Problem 2
(i) The instruments are valid if they are exogenous with respect to the structural model error:
E(U | exper , female, mother edu, father edu) = 0. In this example, parents’ educational
attainment must not have a direct influence on wages.
(ii) The instruments are relevant if they are capable of identifying the parameters of the struc-
def
tural model; specifically, the matrix EW̃ X̃ 0 has full column rank, where W̃ = (1, exper ,
def
female, mother edu, father edu)0 , X̃ = (1, edu, exper , female)0 . In this example, the excluded
instruments (parents’ education) must correlate with the endogenous variable (education)
given all included instruments.

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(iii) The validity condition ensures that the model is correctly specified. The relevance condition
guarantees that the model parameters are identified, i. e. uniquely defined.
(iv) Both conditions are testable. In this case, the validity condition can be tested using Hansen’s
J test since there are over-identifying restrictions (the number of excluded instruments
exceeds that of endogenous variables). The relevance condition can be tested using a matrix
rank test. In this case, since there is only one endogenous variable, the coefficients on mother’s
and father’s education in the first-stage regression must be tested for joint significance (using
Wald statistic).
(v) East wrongly included the instrument in the structural equation. West correctly estimated
the model using GMM. North correctly estimated the model using CF approach. South
wrongly omitted exogenous variables in the first-step equation of the CF approach.

Problem 3
     
def X1 0 Y1 def U1
(i) Let XD = ,Y = ,U = . Since this is a just-identified case,
0 X2 Y2 U2
!−1 !  
X
0
X def α
θ̂GMM = XD,i XD,i XD,i Y i , θ = .
β
i i

√ d
) (EXD U U 0 XD
0 −1 0 0 −1


(ii) By GMM theory, n(θ̂GMM − θ0 ) →
− N 0, (EXD XD )(EXD XD ) .
(iii) Let
def
• θ∗ = (α0 , α1 , α2 , β0 , β1 )0 be the complete parameter vector,
X1∗0
 
def def ∗ def
• X1∗ = 0
(1, X11 , X12 , 0, 0) , X2∗ = 0
(0, 0, X22 , 1, X21 ) , and XM = ,
X2∗0 2×5
def
• g(Z, θ∗ ) = XD (Y − XM ∗ ∗
θ )6×1 be the moment function,
def
• θ̃ = argminθ ĝ (θ)ĝ(θ) be the preliminary first-step estimator of θ∗ ,
0
def
• Ṽ = n1 ni=1 XD,i (Y i − XM,i∗ ∗
θ̃)0 XD,i
0
P
θ̃)(Y i − XM,i the estimator of the optimal weight
def
matrix V = Eg(Z, θ∗ )g 0 (Z, θ∗ ).
def
Sufficient condition for identification: D = E ∂θ∂
g(Z, θ∗ ) = −EXD XM ∗
is full column rank.
0 −1
(iv) The optimal two-step GMM estimator solves minθ ĝ (θ)Ṽ ĝ(θ). Since the moment function
is linear in θ, the optimal GMM estimator can be obtained in closed form and is given by
" ! !#−1 ! !
X X X X
∗ ∗0 0
θ̂GMM = XM,i XD,i Ṽ −1 ∗
XD,i XM,i ∗0
XM,i 0
XD,i Ṽ −1 XD,i Y i .
i i i i

√ ∗ d
− N 0, (D0 V −1 D)−1 .


(v) By GMM theory, n(θ̂GMM − θ0 ) →

Problem 4
(i) Period-by-period exogeneity means that

E(Uit | edu i , black i , hisp i , exper it , married it , union it , Ci ) = 0 ∀t ∈ {1, . . . , T }.

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 Strict exogeneity means that

E(Uit |edu i , black i , hisp i , Ci ,

exper i1 , . . . , exper iT ,
married i1 , . . . , married iT ,
union i1 , . . . , union iT ) = 0 ∀t ∈ {1, . . . , T }.

Since there are unobserved effects Ci in the model, in order to estimate parameters, one must
eliminate the fixed effects using Within transformation or first differencing, for which strict
exogeneity is required.
(ii) 100α1 is approximately the percentage return on one extra year of education (Ed.) in every
period (IEP) after controlling for (ACF) black or Hispanic ethnicity (BE, HE), experience
(Exp.), marital status (MS), unionisation status (US) and unobserved heterogeneity (UH).
100α2 is approximately the percentage wage gap between black and non-black non-Hispanic
employed men (the reference group) IEP ACF Ed., HE, Exp., MS, US and UH.
100α3 is approximately the percentage wage gap between Hispanic and non-black non-Hispanic
employed men IEP ACF Ed., BE, Exp., MS, US and UH.
100(α4 + 2α5 exper it ) is approximately the percentage change in wage caused by one extra year
of experience IEP ACF Ed., BE, HE, MS, US and UH. This change is not constant but rather
linearly depends on the accumulated years of experience. Therefore, 100α4 is approximately
the percentage return to experience for working men with zero years of experience, and
100 · 2α5 is approximately the change of percentage return do experience due to an extra year
α4
thereof. If α5 ≶ 0, then − 2α 5
shows the number of years of experience for which its causal
effect is maximal/minimal.
100α6 is approximately the percentage wage gap between married and non-married employed
men IEP ACF Ed., BE, HE, Exp., US and UH.
100α7 is approximately the percentage wage gap between unionised1 and non-unionised
approximately the men IEP ACF Ed., BE, HE, Exp., MS, and UH.
(iii) Since the estimation of this model required elimination of fixed effects by time-differencing or
Within transformation, all time-invariant covariates will disappear. Therefore, the marginal
effects of edu i (α1 ), black i (α2 ) and hisp i (α3 ) are not identified. More than that, since
1
Here, unionised stands for ‘members of trade unions’, not un-ionised, i. e. ‘not converted into ions by gaining or
losing electrons’.

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 exper it = exper i1 + (t − 1),

log wage it = λt + α1 edu i + α2 black i + α3 hisp i + α4 exper it + α5 exper 2it + α6 married it +

+ α7 union it + Ci + Uit
⇐⇒ Yit = λt + α4 (exper i1 + t − 1) + α5 (exper i1 + t − 1)2 + α6 married it +
+ α7 union it + C̃i + Uit
⇐⇒ Yit = λ̃t + α4 exper i1 + α5 exper 2i1 + α5 · 2exper i1 · (t − 1) + α5 (t − 1)2 + α6 married it +
+ α7 union it + C̃i + Uit
⇐⇒ Yit = λ̃ ˜ + α · 2exper · (t − 1) +α married + α union + C̃˜ + U
t 5 i1 6 it 7 it i it
| {z }
⇐⇒ Y = λ̃ ˜ + α E + α married + α union + C̃˜ + U
it t 5 it 6 it 7 it i it

We clearly see that α5 , α6 , and α7 are identified since the Within transformation or differencing
does not eliminate time-varying Eit , married it , and union it .
(iv) We rewrite (1) in order to eliminate time-varying parameters:

log wage it = λt + α1 edu i + α2 black i + α3 hisp i + α4 exper it + α5 exper 2it + α6 married it +

+ α7 union it + Ci + Uit
= δ2 I(t = 2) + . . . + δT I(t = T ) + α5 exper 2it + α6 married it +
+ α7 union it + C̃i + Uit
= Zit0 θ + C̃i + Uit ,

def
where Zit = [I(t = 2), . . . , I(t = T ), exper 2it , married it , union it ]0 , C̃i subsumes all time-
def
invariant variables, and θ = [δ2 , . . . , δT , α5 , α6 , α7 ].

Problem 5
(i) Sequential exogeneity:

E(Ui1 | Yi0 , Ci ) = 0,

..
 .
E(UiT | Yi0 , . . . , Yi,T −1 , Ci ) = 0


(ii) If Uit = γ0 Ui,t−1 + εit , then the solution is quasi-differencing, assuming εit is white noise:

Yit = ρ0 Yi,t−1 + Ci + Uit

Yi,t−1 = ρ0 Yi,t−2 + Ci + Ui,t−1
⇒ γ0 Yi,t−1 = γ0 ρ0 Yi,t−2 + γ0 Ci + γ0 Ui,t−1
⇒ Yit − γ0 Yi,t−1 = ρ0 Yi,t−1 − γ0 ρYi,t−2 + C̃i + (Uit − γ0 Ui,t−1 )
| {z }
εit , white noise

⇐⇒ Zit (γ0 ) = ρ0 Zi,t−1 (γ0 ) + C̃i + εit

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 This has been reduced to a classic dynamic panel data model with unobserved effects that
can be estimated by differencing assuming sequential exogeneity of ∆Zi,t−1 with respect to εit
in every period,
∆Zit (γ0 ) = ρ0 ∆Zi,t−1 (γ0 ) + ∆εit .
Since ∆Zi,t−1 depends on Zi,t−2 , which, in turn, depends on Yi,t−3 , at least 4 periods are
requires to estimate (ρ0 , γ0 ), and the following moment conditions can be used:
 
1
E Yi1  ∆εi4 = 0.
Yi2

(iii) Sequential exogeneity has to force zero correlation in U ’s. However, if U ’s turn out to
be serially correlated, then it means that there is longer inertia or persistence in Y ’s. (3)
would be preferred over (2) when the researcher supposes that serial correlation in U ’s arises
from omitted Yi,t−2 or higher orders (that is, true state dependence is being modelled).
Modelling autocorrelation in U is modelling spurious state dependence. In practice, more
lags of Y ’s are added until U ’s become white noise.
(iv) First, use first differencing in order to eliminate unobserved fixed effects:

∆Yit = ρ1 ∆Yi,t−1 + ρ2 ∆Yi,t−2 + ∆Vit , t = 1, 2, 3, 4.

Next, E(εi4 | Yi,−1 , Yi0 , Yi1 , Yi2 , Yi3 , Ci ) = 0, E(εi3 | Yi,−1 , Yi0 , Yi1 , Yi2 , Ci ) = 0, which implies
that E(εi4 − εi3 | Yi,−1 , Yi0 , Yi1 , Yi2 , Ci ) = E(∆εi4 | Yi,−1 , Yi0 , Yi1 , Yi2 , Ci ) = 0. Since 2 para-
meters are to be estimated, at least two moment restrictions are required, for instance,
E(Yi2 ∆εi4 ) = 0 and E(Yi1 ∆εi4 ) = 0. Extra moment restrictions can be added in order to
improve efficiency, such as E∆ε4 = 0. For example, define
 
1
g(Yi , ρ) = g(Yi , ρ1 , ρ2 ) = Yi,1  (∆Yi,4 − ρ1 ∆Yi,3 − ρ2 ∆Yi,2 )

Yi,2

The efficient two-step GMM estimator follows trivially from Eg(Yi , ρ) = 0 as

ρ̂GMM = argmin ĝ(ρ)0 Ṽ −1 ĝ(ρ),

ρ

def 1 Pn def 1 Pn
where ĝ(ρ) = n i=1 g(Yi , ρ) and Ṽ = n i=1 g(Yi , ρ̃)g 0 (Yi , ρ̃).