Methods in Applied

Econometrics

REGRESSION ANALYSIS
Estimate the population regression function (PRF) on the basis of the
sample regression function (SRF) as accurately as possible
The two-variable PRF:
Yi = 1 + 2Xi + ui
The PRF is not directly observable. We estimate it from the SRF:
Yi = 1 + 2Xi + ui = i + ui
Here i is the estimated (conditional mean) value of Yi

ORDINARY LEAST SQUARES (OLS)

2

Choose the SRF in such a way that the sum of squares of the residuals, 2 = (Yi i) is as small as
possible.
Differentiating 2 partially with respect to 1and 2, we obtain

Setting these equations to zero, after algebraic simplification and manipulation,

Solving these two equations

BINARY RESPONSE REGRESSION MODELS

There are three approaches to developing a probability model for a
binary response variable:
1. The linear probability model (LPM)
2. The logit model
3. The probit model
All the conclusions will be valid if the sample is reasonably large.
Therefore, in small samples, the estimated results should be
interpreted carefully

LPM
The linear probability model (LPM) parameters are estimated based
on OLS method
Run the OLS regression and obtain i= estimate of the true E(Yi | Xi).
Then obtain i=i (1 i), the estimate of wi.
Use the estimated wi to transform the data as shown in equation
below and estimate the transformed equation by OLS (i.e., weighted
least squares).

LOGIT
For each sample X, compute the probability of occurance as i=ni/Ni
where Ni is the sample space and ni is the number of occurrences.
For each Xi , obtain the logit as i= i /(1-i)
Then obtain i= Ni i /(1 i), the estimate of wi
Use the estimated wi to transform the data as shown in equation
below and estimate the transformed equation by OLS (i.e., weighted
least squares).

PROBIT
The estimating model that emerges from the normal CDF (cumulative
distribution function) is popularly known as the probit model,
although sometimes it is also known as the normit model.
We express the utility index Ii as a function of explanatory variables Xi
as Ii = 1 + 2Xi and the CDF for Ii is

Now the data regression is done as

REGRESSION DISCONTINUITY DESIGN

The Parametric/Global Strategy
Y i = +0Ti + f (ri ) + i
where
= the average value of the outcome for those in the treatment group
after controlling for the rating variable;
Y i = the outcome measure for observation i;
Ti = 1 if observation i is assigned to the treatment group and 0 otherwise;
ri = the rating variable for observation i, centered at the cut-point
i = a random error term for observation i, which is assumed to be
independently and identically distributed.
The coefficient, 0 for treatment assignment represents the marginal
impact of the program at the cut-point

REGRESSION DISCONTINUITY DESIGN

The function f (ri ) represents the relationship between the rating
variable and the outcome.
A variety of functional forms can be tested to determine which fits
the data best, so that bias will be minimized.

DIFFERENCE IN DIFFERENCE MODEL

Basic two-way fixed effects model
Cross section and time fixed effects

Use time series of untreated group to establish what would have

occurred in the absence of the intervention
Key concept: can control for the fact that the intervention is more
likely in some types of states

10

DIFFERENCE IN DIFFERENCE MODEL

Three different representations
Tabular
Graphical
Regression equation

11

DIFFERENCE IN DIFFERENCE MODEL

Before
Change

After
Change

Group 1
(Treat)

Yt1

Yt2

Yt
= Yt2-Yt1

Group 2
(Control)

Yc1

Yc2

Yc
=Yc2-Yc1

Difference

Difference

Y
Yt Yc
12

Treatment effect=
(Yt2-Yt1) (Yc2-Yc1)
Yc1

Yt1

Yc2

Yt2

control
treatment
t1

t2

time
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DIFFERENCE IN DIFFERENCE MODEL

Three key variables
Tit =1 if obs i belongs in the state that will eventually be treated
Ait =1 in the periods when treatment occurs
TitAit -- interaction term, treatment states after the intervention

Yit = 0 + 1Tit + 2Ait + 3TitAit + it

14

Yit = 0 + 1Tit + 2Ait + 3TitAit + it

Before
Change

After
Change

Group 1
(Treat)

0 + 1

0+ 1+ 2+ 3 Yt
= 2 + 3

Group 2
(Control)

0 + 2

Difference

Difference

Yc
= 2
Y = 3

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INSTRUMENTAL VARIABLE APPROACH

Consider treatment assignment (dummy variable) X and outcome Y
Regress Y on X
Yi = 0 + 1Xi + i
The estimate of 1 is just the difference between the mean Y for X = 1 (the treatment group) and the
mean Y for X = 0 (the control group)

Y1 0 1 1
Y0 0 0
Thus the OLS estimate is

Y1 Y0= 1 + 1 0

INSTRUMENTAL VARIABLE APPROACH

If the treatment is randomly assigned, then X is uncorrelated with (X is exogenous)
If X is uncorrelated with if and only if 1 0
But if 1 0 , then the mean difference is
Y1 Y0 = 1 + 1 0 = 1

This implies that standard methods (OLS) give an unbiased estimate of 1, which is the
average treatment effect
That is, the treatment-control mean difference is an unbiased estimate of 1,

GENERALISED METHOD OF MOMENTS

Why use GMM?
Nonlinear estimation
Structural estimation
Robust estimation

Models estimated using GMM

Many.
Rational expectations models
Euler Equations

Non-Gaussian distributed models

GENERALISED METHOD OF MOMENTS

Simple moment conditions

Population

Sample

E[ ] 0

cov[ X , ] 0

1
T

1
T

'
t t

GENERALISED METHOD OF MOMENTS

OLS as a MM estimator

y X , so that y X
Moment conditions:
T

E[ ] 0 T1 ( yt X t ) 0
t 1

E[ X ' ] 0 X ' ( y X ) 0
MM estimator

X ' y X ' X 0 X ' X X ' y