Pen & Paper

a) !" = !" + ! + !" (1) with !" = !,!!! + !" and (! |) = ! !"

If he error term is serially correlated over time, then standard statistical

inference as normally applied to regressions is invalid because standard errors are
estimated with bias. To avoid this problem, the residuals must be modeled. If the
process generating the residuals is found to be a stationary first-order autoregressive
structure, !" = ! ,!!! + !" , < 1, with the errors {!" } being white noise, then
the CochraneOrcutt procedure can be used to transform the model by taking a quasidifference:
!" !,!!! = ! 1 + !" !,!!! + !" (2)

We can then rewrite equation (1) in this way !" = ! 1 + !" + !"
The term is typically unknown, and along with we may wish to estimate it.
If is not known, then it is estimated by first regressing the untransformed model and
obtaining the residuals !" , and regressing !" on !,!!! , leading to an estimate of and
making the transformed regression (2) feasible. The resulting estimator for is given
by:

!! !

!,!!!
!!! !!!

!" !,!!!
!!! !!!

Solving this problem we can then start the within transformation to estimate the fixed
effects estimator:

First, we calculate the sample average of !" across periods and we denote it as
!
! = ! !!!! !"

So, ! = ! 1 + ! + !

Second from the transformed regression:

!" ! = ! 1 + !" + !" ! 1 + ! + !
!" ! = !" ! + !" !
!" = !" + !"

Now we stack by observation for t=1, , T giving the giant regression.

! = ! + !

The within-group FE estimator is pooled OLS on the transformed regression
! (stacked by observation).

!" = ()!!
!

!" =

(! ! )
!!!

!!

! !
!!!

b) We have, !" = + !" + ! + !"

Assumption: ! and !" are uncorrelated with !" .

Hence, the model can be rewritten as:

!" = !" + !" , Where !" = ! + !"

!" Is treated as an error term consisting in two components: an individual specific

component that does not vary overtime, and a reminder component that is assumed to
be uncorrelated overtime.

 !" = ! + !" = (! + !,!!! + !" )

!" = !! + !!

We need to find !! . And as we already know !" is an AR (1), hence:

! !

!! = !!!! (1)

With the estimation of as in question a) we can now calculate !" :

!" =

!!

!
+
1 !

Now we need to find the covariance between the unobserved terms within periods.
!" = ! + !"
!,!!! = ! + !,!!!
!,!!! = ! + !,!!! () Since ! do not change overtime.

The covariance can be calculated by:

(!" , !,!!! ) = (! + !" , ! + !,!!! )
(!" , !,!!! ) = (! + !,!!! + !" , ! + !,!!! )
(!" , !,!!! ) = !! + !!
(!" , !,!!! ) = !! +

!
1 !

In the same way,

(!" , !,!!! ) = (! + ! , ! + !,!!! )
(!" , !,!!! ) = (! + !,!!! + !" , ! + !,!!! )
(!" , !,!!! ) = (! + !,!!! + !,!!! + !" , ! + !,!!! )
(!" , !,!!! ) = !! + ! !!
!
(!" , !,!!! ) = !! + !
1 !
Iterating forward we have:
! !

(!" , !,!!! ) = !! + ! !!!!

With j = 1,2 T

Hence,
! !

(!" , !,!!! ) = !! + ! !!!!

With j = 1,2 T

Now we can show that the variance covariance matrix will be:
!
+

1 !

!
!
!
! +
1 !
!!

! =

!
+
1 !

!
!
! +
1 !

!!

TxT matrix
Using the GLS estimator we can estimate our Random Effects estimator.
!"# = ( ! !! )!! ! !!

DATA 1
a)

i) ii)

First of all we perform an estimation of the regression using lvio as dependent

variable, which is the logarithm of violent crime rate against shall.
In this case we find a coefficient of -.443 (with a significant level of 99%), which
suggests us that the shall-issue laws reduce the violent crime rate by 44%. Table 1.
We find this value surprisingly high from an economic point of view. To our
knowledge we think that is odd a law like this, which allows you to carry a weapon, to
have such an impact on reducing the violent crime rate.
Nevertheless, looking at our R we can deduct that this model is still too simple and
with a really low explanatory power (R = 0.0866), which let us conclude that we are
probably over-valuating the effect of the variable shall on our model.
For this reason we add new control variables to eliminate this overvaluation.
From the second regression (Table 2) we can conclude that adding the control
variables results in a small drop in the estimated coefficient (now the coefficient for
shall is -.368 with the same significance level of 99% as before), still too small to
have a reasonable interpretation from an economic point of view (the decrease of the
violent crime rate by 36% after the enactment of the shall law seems a too large
effect).
Even if this result do not seem logic from an economic point of view, we have to
highlight that, adding control variables, our model achieves a higher explanatory
power (R = 0.5643), as we can see also from the likelihood ratio test (really high
value = 990.02).
Consequentially, we can deduct that we have a problem of omitted variables in our
regressions (e.g.: the quality of security forces, the level of poverty, etc.).
b) Now we analyze the changes if we add fixed state effects in our regression. The
results are presented on Table 3.
We can notice that this model is more credible than the other one studied at point a)
ii).
Indeed, we can see that applying the FE (fixed-effects) estimator using the within
transformation our coefficient falls deeply from -0.3687 to -.046, which is a more
credible value from an economic point of view, even if our explanatory power is not
so high anymore (R within= 0.218).
Our regression model with fixed effects is more credible because applying this
method we are controlling for heterogeneity that is fixed in time because each state is
different from the other and the different states are not all included in our control
variables.

For this reason our model with fixed-effects is more credible: it is more specific, it
highlights the mismatching between the different states and it confirms our previous
theory that in a) ii) there was important omitted variable bias.
Moreover, the estimate of the effect of shall issue laws on the violent crime rate is no
longer statistically different from 0.
c) Now we analyze how our results change when we add fixed state effects and fixed
time effects: this means that we are considering every variable fixed in time in each
different state (Results presented on Table 4).
In this way we have the possibility to see how is changed the rate of violent crime
after the introduction of the shall-issue law, keeping fixed the time variables of
each state.
From an economic point of view this approach is the most useful and realistic because
it helps us to not over-evaluate our values extrapolating them from the historic
connection [for example we could have years of crisis, war, civil war, political
changing () which could generate an increase in the violent crime rate].
We can notice that adding fixed effects on years our coefficient falls further to .0279935 (not significantly different from 0) and there is also an increase in the value
of R from the previous regression with just fixed effects on states [in point (b) R was
= 21.8%; with fixed effects also on years R = 0.4180]. The higher value of R is to
interpret as a more significant statistic explanation of our model.
As consequence we can see that the coefficient is not significant anymore and the
violent crime rate is less affected by the introduction of the shall law.
d) In this point we are going to study how our model changes adding random state
effects and fixed time effects (Results presented on Table 5). Its easy to notice that
our results are not so different from what we obtained at the previous point (we still
have insignificant coefficients): even if in the OLS regression the coefficient were
significant applying the Breusch-Pagan test for all three regressions we have to reject
H0 in all cases. The rejection of the null hypothesis deletes the possibility to do the
Pooled OLS.
For this reason we decided to do the Haussmann test, which evaluates the consistency
of an estimator when compared to an alternative, less efficient, estimator, which is
already known to be consistent, and it helps us to evaluate if a statistical model
corresponds to the data.
We did the Haussmann test between the random state effect and the fixed-effect
models and we arrived at the conclusion that we cannot reject H0 (this means that we
can take in account the most efficient estimator because there isnt a huge difference
between the FE and the RE).
Then we arrived at the conclusion that the RE is not consistent and, consequentially,
we have to use the FE estimator as we did in the previous point [see point (c)].

In all three cases (violent crime rates, robbery rates and murder rates), we reject the
Haussmann test, which means we cannot use the random effect estimators, as they are
not consistent. Therefore, one has to apply the fixed effect estimators as seen in part
(c).
On a economically point of view, there is little evidence that the individual
heterogeneity is randomly distributed between different states, which could make
sense as we assume that the state specific intercepts are not independent from the
explanatory variables.
e) Now we are going to use the fixed effect and time effect model to test lagged
effects of shall-issue laws and to evaluate how change the response between the short
and long run (Results presented on Table 6).
Its easy to notice that all our shall dummy variables and all the shall-lagged dummy
variables are in the reality non significant. The only difference in the trend of our
three variables is in the robbery rate, which becomes negative after the addition of the
lagged variable (its equal to -0.040).
Then, we analyzed the Arellano-Bond dynamic panel-data estimation.
This test is in relation to two-step robust estimation and it is useful to study the
autocorrelation.
From this test we arrive at the conclusion that the lagged variable estimates for the
robbery rate and the violence rate are both positive and with a really high value,
instead the murder rate is not so affected from the rate of murders calculated for the
previous year (lvio= 0.599; lrob = 0.441; lmur = 0.029).
The short-term effect is characterized by the sum of all b coefficients. b is a
scalar of all the independent explanatory variables and in our analysis it assumes a
value of -0.061 for lvio, of 0.011 for lrob and of 0.25 for lmur (p-value lmur= 0.08).
On the other hand, the long-run effect is the sum of all the b coefficients divided by
(1-a), where a represents a scalar for the coefficient of the lagged dependent
variable.
The values that we obtained for the long-run are: 0.153 for lvio, 0.019 for lrob and
0.257 for lmur and similarly to the short-run only the lmur is significant and as before
with a p-value around 0.08.

f) Using the robbery rate instead of the violent crime rate.

We can notice that our results are not very different from what we obtained using the
violent crime rate in point a) and b).
Indeed, in the OLS model the regression coefficients of the shall-issue law on the log
of robbery rates (lrob) is equal to -0.773 (we can interpret it as a decreasing of the
robbery rates of 77% after the introduction of this law) with a very low R = 0.12 ;

adding control variables in the OLS model our values are lower but not so
significantly: the coefficient is equal to -0.529 ( it is still to high to have a logic
economic interpretation) , even if R gives an higher explanatory power to our model
(R = 0.60 ).
In the fixed-effects model in which is kept constant the states, we can see that the
coefficient of robbery rates falls deeply showing that the enactment of the shall law
generates only a decreasing of the 0.8% in the robbery rate, although our R has a
really low value = 0.04 (its in any case a plausible value taking in account the
restrictions generated by the fixed effect).
When we fix also the years, our results are pretty different from what we obtained
studying the violent crime rate: the robbery rate has a positive coefficient = 0.027,
which we can interpret as an increase of 2.7% of the robbery rate after the
introduction of the shall law (R= 0.24, not so statistically significant).
Addressing the murder crime rate;
We can see when we perform OLS on lmur as dependent variable and shall as
explanatory (Table 1) a highly significant negative impact of shall on the murder
crime rate. In states with a shall law in motion we can see that the murder rates
decrease by 47%. By the same justification given for the violent crime rates on
question a) this value seems to high. For the second part of question a) adding the
control variables does not really change the outcome on an economic sense. The value
it is still high.
On question b) applying fixed state effects makes the value of the coefficient for shall
drop massively. Now the effect of shall law on murder rates is only -4.6% (Table 3).
With the fixed effects estimator the effect of the law in the murder rate seems to be
more credible.
Regarding question c) when applying fixed state and time effects the shall dummy
variables has a negative value for the murder rate. But in any case this value is not
significant as one can see in Table 4.
For question d) when using random state effects, combined with fixed time effects we
get negative effects on murder rates but the coefficients have no significance (Table
5).

g) When we use in first place pooled OLS, it seems that the effect of shall law
variable is enormous when we address the problem of crime reduction. While using
other methods and analyzing if they work better the influence and the significance of
the shall variable on crime statistics takes a noose dive. From a political point of view
it seems demagogic to introduce such a law to reduce crime because the effect of such
option may be exaggerated and lightly interpreted.

Table 1.
Variables
shall
_cons
R2
N

OLS
lvio
lrob
-0.443***
-0.773***
(0.048)
(0.069)
6.135***
4.873***
(0.019)
(0.028)
0.087
0.121
1,173
1,173
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.10

lmur
-0.473***
(0.049)
1.898***
(0.022)
0.083
1,173

Table 2.
Variables
shall
Incarc_rate
density
avginc
pop
pb1064
pw1064
pm1029
_cons
R2
N

OLS w/ control variables

lvio
lrob
-0.368***
-0.529***
(0.035)
(0.051)
0.002***
0.001***
(0.000)
(0.000)
0.027*
0.091***
(0.014)
(0.015)
0.001
0.041***
(0.007)
(0.009)
0.043***
0.078***
(0.003)
(0.005)
0.081***
0.102***
(0.020)
(0.027)
0.031***
0.028**
(0.010)
(0.014)
0.009
0.027*
(0.012)
(0.015)
2.982***
0.904
(0.609)
(0.889)
0.564
0.596
1,173
1,173
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.10

lmur
-0.313***
(0.036)
0.002***
(0.000)
0.040***
(0.012)
-0.077***
(0.009)
0.042***
(0.004)
0.131***
(0.019)
0.047***
(0.009)
0.066***
(0.014)
-2.486***
(0.615)
0.606
1,173

Table 3.
Variables
shall
Incarc_rate
density
avginc
pop
pb1064
pw1064
pm1029
_cons
R2
N

Fixed Effects
lvio
lrob
-0.046
-0.008
(0.042)
(0.055)
-0.000
-0.000
(0.000)
(0.000)
-0.172
-0.186
(0.138)
(0.166)
-0.009
-0.018
(0.013)
(0.022)
0.012
0.016
(0.014)
(0.028)
0.104***
0.112**
(0.033)
(0.051)
0.041***
0.027
(0.013)
(0.016)
-0.050**
0.027
(0.021)
(0.016)
3.866***
2.446**
(0.770)
(1.013)
0.218
0.037
1,173
1,173
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.10

lmur
-0.061
(0.037)
-0.000
(0.000)
-0.671*
(0.396)
0.024
(0.016)
-0.026
(0.020)
0.031
(0.078)
0.010
(0.013)
0.039*
(0.022)
0.460
(0.843)
0.153
1,173

Table 4.
Variables
shall
Incarc_rate
density
avginc
pop
pb1064
pw1064
pm1029
_Iyear_78

_Iyear_99
_cons
R2
N

Fixed effects and fixed state effects

lvio
lrob
-0.028
0.027
(0.041)
(0.052)
0.000
0.000
(0.000)
(0.000)
0.001
-0.045
(0.016)
(0.198)
-0.005
0.014
(0.015)
(0.025)
0.012
0.000
(0.014)
(0.026)
0.029
0.014
(0.050)
(0.084)
0.009
-0.013
(0.024)
(0.033)
0.073
0.105
(0.052)
(0.073)
0.059***
0.033
(0.016)
(0.022)

0.433
0.189
(0.286)
(0.385)
3.766***
3.279*
(1.152)
(1.677)
0.418
0.236
1,173
1,173
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.10

lmur
-0.015
(0.038)
-0.000
(0.000)
-0.544*
(0.319)
0.057***
(0.017)
-0.032
(0.021)
0.022
(0.076)
-0.000
(0.020)
0.069
(0.042)
-0.001
(0.032)

-0.255
(0.242)
0.188
(1.057)
0.291
1,173

Table 5.
Variables
shall
Incarc_rate
density
avginc
pop
pb1064
pw1064
pm1029
_Iyear_78

_Iyear_99
_cons
N

Fixed time and random effects estimation

lvio
lrob
-0.034
0.019
(0.041)
(0.052)
0.000**
0.000
(0.000)
(0.000)
0.070
0.105*
(0.049)
(0.061)
0.009
0.029
(0.016)
(0.025)
0.016
0.034
(0.012)
(0.023)
0.079
0.083
(0.050)
(0.065)
0.028
0.015
(0.023)
(0.031)
0.041
0.053
(0.047)
(0.066)
0.047***
0.014
(0.016)
(0.022)

0.139
-0.238
(0.254)
(0.326)
2.683**
1.719
(1.187)
(1.625)
1,173
1,173
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.10

lmur
-0.030
(0.041)
0.001**
(0.000)
-0.022
(0.076)
0.056***
(0.017)
0.003
(0.010)
0.105**
(0.053)
0.028
(0.019)
0.021
(0.037)
-0.014
(0.031)

-0.749***
(0.206)
-1.589
(1.015)
1,173

Table 6.
Variables
lvio(-1)
lrob(-1)

Arellano-Bond linear dynamic panel-data estimation

lvio
lrob
0.599***
(0.020)
0.441***
(0.023)

lmur(-1)
shall
Incarc_rate
density
avginc
pop
pb1064
pw1064
pm1029
_cons
N

-0.026*
0.026
(0.014)
(0.021)
-0.000***
-0.000***
(0.000)
(0.000)
0.038
0.036
(0.065)
(0.094)
-0.005
-0.039***
(0.004)
(0.006)
-0.005
0.030**
(0.008)
(0.012)
-0.027
-0.026
(0.017)
(0.023)
0.025***
0.040***
(0.003)
(0.004)
-0.061***
-0.055***
(0.005)
(0.006)
2.196***
1.601***
(0.247)
(0.340)
1,071
1,071
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.10

lmur

0.029
(0.030)
-0.061*
(0.034)
-0.000*
(0.000)
0.381**
(0.166)
0.001
(0.012)
-0.014
(0.023)
-0.071
(0.045)
0.026***
(0.009)
-0.012
(0.012)
0.704
(0.657)
1,071

DATA 2
a) OLS
When using POLS we get the estimator:

Hence, plugging in the model for !" :

It is easy to see that the estimator is biased since the term on the right does not have
zero expectation due to the correlation between the individual effect, , which is part
of , and the explanatory variable, !,!!! .
The Fixed Effect estimator (within transformation):

It is easy to see that it is also biased.!,!!! !,!! is correlated with the error term
!" ! because the averages include all time values of both variables.
The First Differences estimator: `

Being !,!!! !,!!! correlate with !" !,!!! this estimator is also biased. To solve
this kind of problems is useful to use instrumental variables with GMM method.
b) We estimated the parameters from the model by three different methods (pooled
OLS, fixed effects and first difference) the results are presented on Table 1. We can
see from the table that we can achieve significant coefficients on all the variables with
all three methods. As we know, Pooled OLS is consistent and asymptotic normal only
if it and it are not correlated, but it is not efficient. Indeed, we can notice from our
table that we cannot use the OLS standard error estimates because there is clustering
(autocorrelation). Consequentially, these are biased and not useful for testing
hypothesis.

In our table the first coulmn shows the Pooled OLS, the second the Fixed Effect, the
third the First Difference Estimators, and the fourth is the GMM.
We can see that for lagged employment (L.n) the highest coefficient is found using
the POLS method (0.936) and it decreases if we use the FE (0.538) or FD method
(0.185). Logically, it means that more employment today is probably caused by more
employment yesterday.
Estimates indicate that there are differences and that the OLS estimator attributes
more of the difference in wages to employment level while FE and FD are less
optimistic in that respect.
We can interpret the different results that we obtain using one procedure or the others
as a sign that the assumptions justifying Pooled OLS are perhaps not valid (the
estimates are biased).
On the other hand, if we look at the wage, our results differ less (POLS= -0.459; FE=
-0.524; FD= -0.510) and if we look at the lag it is possible to notice that its relevance
decreases from POLS to FD.
This result is logic: if I have an higher current product wage, this will reduce my
current labor demand. On the other hand my current employment is positively
affected by the previous wages.
Studying the capitalwe should higlight that the effect is the opposite: its value is
smaller using the POLS (0.058), while it increases with FE (0.298) and it reaches its
higher value with the FD method (0.360).
We can see the same increase, even if it is not so significant in this case, when we
study the industry output: POLS= 0.328; FE= 0.354; FD= 0.360. Indeed labor and
industry output are complements: if I increase the labor, I will increase
consequentially also the industry output.
We obtain more unexpected results for labor and capital. These two values are
substitutes, which means that I would expect a negative value for the capital
coefficient, instead my result is positive. If we lag the capital we find a negative
coefficient between the variables: this means that the capital of yesterday impacts
negatively on the labor of today, as we could expect
c) As we know the general GMM approach does not impose that uit is i.i.d. over
individuals and time and the optimal weighting matrix is thus estimated without
imposing these restrictions. However, the absence of autocorrelation is needed to
guarantee the validity of moment conditions, which means that weve to impose the
absence of autocorrelation in uit, combined with a homoskedasticity assumption.
Consequentially, when we want to estimate the model with GMM method we cannot
assume homoskedasticity.
The empirical implementation of the first-difference GMM estimator quite often
suffers from poor small sample properties, mostly attributable to the large number of,

potentially weak, instruments. When instruments are weak, they provide only very
little information about the parameters of interest, which leads to poor small sampke
properties of the GMM estimator. Another problem arises when the number of
instruments (moment conditions) is too large relatively the sample size.
This means that GMM estimator has misspecification tests and tend to be misleading.
This may be particularly the case for the two-step estimator, which relies upon the
estimation of a potentially high dimensional optimal weighting matrix. This means
that the twostep approach could be not sufficient to solve this problem (standard
errors can be biased downwards), but we probably need to apply the robust option to
correct it.
As shown by Roodsman, reducing and collapsing instruments help sto reduce the bias
in first-difference and system GMM estimators and to increase the the ability of the
overidentifying restrictions tests to detect misspecification.
From our table we can see that in the GMM column that there is an overestimation of
the lagged employment coefficient if we use OLS or FE (GMM= 0.388; FE=0.538 ;
OLS= 0.936) and, even if FD coefficienti s not overestimated it is biased downward.
In any case the Arellano and Bond test tells us that there isnt autocorrelation (H0: noautocorrelation, its not rejected, p-value=0.083) , which means that the GMM
estimatori s consistent.
We wont reject the null hypothesis in the Arellano and Bond test in the second-order
(correlation=0), instead in first-order-differences our errors will be correlated (our pvalue=0.454 for the first-order-p-value rejects the H0).
d) The main difference between short and long-run is that the long-run effect shows
also the fact that wages affect past value of employment, which, consequentially, has
effects on the current level of employment.
Indeed, as we know, the short-run effect of wages is given by the sum of the
coefficients: 1+2 = 0.262, which is significant at the 2% level.
We can explain this value as the impact that the wages have on employment. It seems
clear that this negative value means that this impact happens immediatly.

On the other hand, the long-run effect is: because, as we said above, the total longrun effect the impact of wages on past values of employment.
This negative values that characterized the long-run effect tells us that there is a
negative impact on labor demand caused by real product wages, which is higher than
in the short run.

Table 1

LD.Ln employment

POLS
0.185***
(0.030)

FE
0.538***
(0.028)

L.Ln wage

-0.459***
(0.048)
0.373***
(0.048)

-0.524***
(0.051)
0.236***
(0.050)

LD.Ln wage

Ln industry output

0.058***
(0.006)
0.328***
(0.046)

0.298***
(0.023)
0.354***
(0.049)

D.Ln industry
output

R-squared
N

0.272***
(0.054)
0.608***
(0.081)
0.360***
(0.025)
0.555***
(0.066)

D.Ln capital

Constant

-0.450***
(0.120)
0.189*
(0.088)
-0.510***
(0.045)
0.134**
(0.046)

D.Ln wage

Ln capital

GMM
0.388***
(0.106)

0.185***
(0.030)

LD.Ln employment
Ln wage

FD

-1.196***
(0.219)
0.992
891

-0.143
(0.297)
0.716
891
* p<0.05, ** p<0.01, *** p<0.001

-1.251*
(0.534)
0.490
751

751