Advanced Econometrics: Week 1

Advanced Econometrics
Week 1
Institute of Economic Studies

Faculty of Social Sciences
Charles University in Prague
Fall 2015
1 / 28
Outline of Today’s talk
General remarks about the organisation of the course

→ new syllabus.
2 / 28

→ new syllabus.
Why study econometrics?
2 / 28

→ new syllabus.
Why study econometrics?
A very short visit to Least Squares algebra.
2 / 28
Starting New Course
Econometrics I (Bc.) → Econometrics II (Bc.) →
Advanced Econometrics (MA.)
Syllabi of all core courses revised largely now.
3 / 28
Starting New Course
The course basically covers chapters from 2 books
Greene, W.H. Econometric Analysis, 7th edition, Prentice Hall,
2012
Wooldridge, J. Econometric Analysis of Cross-Section and Panel
Data, Boston: MIT Press, 2010, 2nd edition
3 / 28
Starting New Course
2012
While no book is perfect, it is good to know where to

consult some topics (details on complimentary books in
syllabus).
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Starting New Course
2012

syllabus).
Chapters (pages) and book which covers the lecture
material best will be recommended each lecture.
3 / 28
Starting New Course
2012

syllabus).
Chapters (pages) and book which covers the lecture
material best will be recommended each lecture.
Please note older versions of books can be used as well
(just use different pages).
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Starting New Course: Feedback
We will appreciate any type of feedback

Feedback from students is crucial for improvement of the
course.
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course.
During the lectures and seminars - complain, ask.
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course.
During consultations - make an appointment via email.
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course.
Questions at lectures - use my service, use your time spent
on the lecture wisely.
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course.
There is no “trivial” question! All questions are crucial and
the most trivial are always the most crucial.
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course.
There is no “trivial” question! All questions are crucial and
the most trivial are always the most crucial.
Short discussion groups during the lectures and seminars.
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Syllabus - Further Changes
Hal Varian, chief economist at Google
“I keep saying the sexy job in the next ten years will be
statisticians.”
We have huge supply of data but short supply of

statisticians (you need to develop computational skills!)
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statisticians.”

For this, we need to develop skills to manipulate the data,
implement new methods, etc.
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statisticians.”

Software: R Studio
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statisticians.”

Software: R Studio
It is good to master different software, R is a business
industry standard.
5 / 28
statisticians.”

Software: R Studio
industry standard.
Any software has its advantages and disadvantages.
Seminars will be oriented to help students master
computations.
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statisticians.”

Software: R Studio
industry standard.
Any software has its advantages and disadvantages.
Seminars will be oriented to help students master
computations.
R is installed on the Lab 016 computers, but you can
install on your computers as R is free.
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Requirements - Further Changes
Grading
Assignments: 0 - 15%
Midterm Exam: 0 - 20%
Final Exam: 0 - 50% (to pass the Final, more than 60%)
Empirical Paper: 15%
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Grading
80% - 100% Grade 1

70% - 79% Grade 2
60% - 69% Grade 3
0% - 59% Fail
6 / 28
Grading
80% - 100% Grade 1

70% - 79% Grade 2
60% - 69% Grade 3
0% - 59% Fail
Assignments
3 home assignments shorter ones
1 empirical project cca. 8p. details posted later
Work in group of 3 students.
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Why (not) to Visit Lectures and Seminars?
Mark Twain
“College is a place where a professor’s lecture notes go straight
to the students lecture notes, without passing through the
brains of either.”
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In fact, we can learn much more than by reading.
8 / 28
Simply because most of the people are lazy to read the
1000 pages textbooks on their own?
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Surely not! The answer is more complicated: how much do
we learn by reading (concentration is decreasing rapidly
after few pages), listening, discussing (when our brain needs
to be much more active) and explaining to someone else?
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Lecture and seminar provides you with great opportunity
of thinking about the problem!
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Prepare (go through the outline of the chapter before the
lecture), discuss with your colleagues, ask!
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Prepare (go through the outline of the chapter before the
lecture), discuss with your colleagues, ask!
By simple listening to lectures, you will remember roughly
20% of material after 3 weeks (only 10% from reading a
book). By discussion, up to 70%, the rest is short term
memory.
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Why Study Econometrics?
Many people think Econometrics is not the most exciting

of subjects.
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of subjects.
People are interested in the results of analysis but not
means of obtaining them.
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of subjects.
But its purpose is to increase understudying of quantitative
relationships in economics (e.g. to provide correct policy
analysis and advice).
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of subjects.
But its purpose is to increase understudying of quantitative
relationships in economics (e.g. to provide correct policy
analysis and advice).
Quantification based on invalid statistical inference is
dangerous.
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What is Econometrics?
Discuss with your neighbour

“What is Econometrics?”
1
Ragnar Frisch
10 / 28

Economic statistics ∩ economic theory ∩ mathematics1 .
1
Ragnar Frisch
10 / 28


Everything is in fact:
1
Ragnar Frisch
10 / 28


Model.
Information.
Risk.
1
Ragnar Frisch
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Model.
Information.
Risk.
Most of the models we will be dealing with are parametric.
1
Ragnar Frisch
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Model.
Information.
Risk.
The question is how to estimate them, which means
uncertainty (risk).
1
Ragnar Frisch
10 / 28


Model.
Information.
Risk.
The question is how to estimate them, which means
uncertainty (risk).
We need to minimize this risk.
1
Ragnar Frisch
10 / 28
Experimental data are rare in economics ⇒ we need to

work with observational data to make inference.
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Econometrics is a tool for quantifying economic relations.
Otherwise we cannot apply economic theory to real world
data.
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data.
We can use the data to test a theory or estimate a
relationship.
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data.
We can use the data to test a theory or estimate a
relationship.
Thus, econometrics is a powerful tool each economist
should master.
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Model building:
Role of the assumptions.
Parametrizing the model:
Nonparametric and Semiparametric analysis vs.
Parametric analysis.
Sharpness of inferences.
Trends:
Small structural models vs. large scale models.
Robust methods (e.g. GMM).
Role of software and computational power – simulation
based inference.
Unit roots, cointegration, macroeconometrics.
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Plan of the Course
Main Objective
Help students understand the core modern techniques,
problems, and apply them correctly in empirical research.
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Plan of the Course
Main Objective
Modern Estimation frameworks in Econometrics (From

OLS to MLE, GMM, empirical likelihoods and
simulation-based inference).
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Plan of the Course
Main Objective

Useful applications – Quantile Regressions.
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Plan of the Course
Main Objective

Endogeneity, GLS and non-iid errors.
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Plan of the Course
Main Objective

Advanced Panel Data.
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Plan of the Course
Main Objective

Advanced Panel Data.
Discrete Choice models.
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A Short Visit to Least Squares Algebra
Classical linear regression model (CLRM)
yi = β1 xi1 + β2 xi2 + . . . + βK xiK + ei = xi 0 .β + ei (1)
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Classical linear regression model (CLRM)
yi = β1 xi1 + β2 xi2 + . . . + βK xiK + ei = xi 0 .β + ei (1)
The goal is to estimate unknown parameters

β 0 = (β1 , β2 , . . . , βK ). The more information we have, the
smaller the variance of the estimator we obtain.
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y = X . β + e
(n×1) (n×K) (K×1) (n×1)
       
y1 1 x12 x13 . . . x1K β1 e1
 y2   1 x22   β2   e2 
= . +
       
 .. .. .. .. .. .. 
 .   . . .   .   . 
yn 1 xn2 . . . xnK βK en
Note the inclusion of constant in X.
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Hence we choose such an estimator b of β, which minimizes the
sum of squared residuals (note residuals are estimated
disturbances e):
0 = (y − Xb)0 (y − Xb)
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disturbances e):
0 = (y − Xb)0 (y − Xb)
While FOC’s are X0 = 0, we can write
X0 = X0 (y − Xb) = X0 y − X0 Xb = 0,
16 / 28
disturbances e):
0 = (y − Xb)0 (y − Xb)
X0 = X0 (y − Xb) = X0 y − X0 Xb = 0,
and premultiplying by (X0 X)−1 ,
(X0 X)−1 X0 y − (X0 X)−1 X0 X b = 0,

| {z }
I
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disturbances e):
0 = (y − Xb)0 (y − Xb)
X0 = X0 (y − Xb) = X0 y − X0 Xb = 0,
and premultiplying by (X0 X)−1 ,
(X0 X)−1 X0 y − (X0 X)−1 X0 X b = 0,

| {z }
I
we obtain an OLS estimator:
b = (X0 X)−1 X0 y
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Assuming it exists (full column rank – no linear dependencies,
moments existence – positive definite X0 X),
b = (X0 X)−1 X0 y
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b = (X0 X)−1 X0 y
Note the analogy of
β = (V ar(x))−1 (Cov(x, y))
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b = (X0 X)−1 X0 y
Note the analogy of
β = (V ar(x))−1 (Cov(x, y))
to −1
1 0 1 0
b= XX Xy
n n
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b = (X0 X)−1 X0 y
Note the analogy of
β = (V ar(x))−1 (Cov(x, y))
to −1
1 0 1 0
b= XX Xy
n n
n
!−1 n
!
1X 0 1X
b= xi x i xi yi
n n
i=1 i=1
Is there something desirable about least squares?

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So does b minimize 0 ?
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 Pn 2
Pn Pn 
n
Pn i=1 xi1 Pi=1 xi1 xi2
n 2
... i=1 xi1 xiK
i=1 xi1 xi2 i=1 xi2
X  
xi x0i =
 
.. .. .. 
Pn . Pn . Pn .
 
i=1
2
i=1 xi1 xiK i=1 xi2 xiK ... i=1 xiK
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 Pn 2
Pn Pn 
n
Pn i=1 xi1 Pi=1 xi1 xi2
n 2
... i=1 xi1 xiK
i=1 xi1 xi2 i=1 xi2
X  
xi x0i =
 
.. .. .. 
Pn . Pn . Pn .
 
i=1
2
i=1 xi1 xiK i=1 xi2 xiK ... i=1 xiK
2 0
δ
As δbδb 0
0 = 2X X is sufficient condition for the solution to
minimize the sum of squares,

2 ni=1 x2i > 0 needs to be positive in case we would have
P
single b
Matrix counterpart is a positive definite matrix (for any a
it holds that a0 X0 Xa > 0)
Hence 2X0 X needs to be PD matrix.
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A Short Visit to Least Squares Algebra:
Projection
The vector of residuals can be further rewritten:
= y − Xb = y − X(X0 X)−1 X0 y = (I − X(X0 X)−1 X0 )y = My
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Projection
M is an n × n matrix and is fundamental to a regression

analysis, it is symmetric (M = M0 ) and idempotent
(M = M2 ).
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Projection

(M = M2 ).
M produces the vector of LS residuals (it premultiplies y)
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Projection

(M = M2 ).
We call M = (I − X(X0 X)−1 X0 ) a “residual maker”.
19 / 28
Projection

(M = M2 ).
Note fundamental result: MX = 0, hence
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Projection

(M = M2 ).
Note fundamental result: MX = 0, hence
ŷ = y − = (I − M)y = X(X0 X)−1 X0 y = Py,
where P is a projection matrix.
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A Short Visit to Least Squares Algebra: Example
Let’s consider the following data (note a constant term in X):

 
2.6
 5.3 
 
y=  2.9 

 3.8 
4.2
 
1 1.3

 1 4.2 

X=
 1 3.5 

 1 2.7 
1 5.1
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Let’s consider the following data (note a constant term in X):

 
2.6
 5.3 
 
y=  2.9 

 3.8 
4.2
 
1 1.3

 1 4.2 

X=
 1 3.5 

 1 2.7 
1 5.1
Can you compute b = (X0 X)−1 X0 y by hand?
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  −1
1 1.3
  1 4.2 
0 −1
 1 1 1 1 1  
(X X) =  
 1.3 4.2 3.5 2.7 5.1  1 3.5 

  1 2.7 
1 5.1
−1
5 16.8 1.5389 −0.3985
= =
16.8 64.88 −0.3985 0.1186
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  −1
1 1.3
  1 4.2 
0 −1
 1 1 1 1 1  
(X X) =  
 1.3 4.2 3.5 2.7 5.1  1 3.5 

  1 2.7 
1 5.1
−1
5 16.8 1.5389 −0.3985
= =
16.8 64.88 −0.3985 0.1186
 
2.6
 5.3 
0 1 1 1 1 1   18.8
Xy =  2.9 =
1.3 4.2 3.5 2.7 5.1   67.47
 3.8 
4.2
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1.5389 −0.3985 18.8
b = (X0 X)−1 X0 y =
−0.3985 0.1186 67.47

2.045
=
0.51
22 / 28

1.5389 −0.3985 18.8
b = (X0 X)−1 X0 y =
−0.3985 0.1186 67.47

2.045
=
0.51
Hence residuals can be obtained as:

   
2.6 1.3
 5.3   4.2 
    2.045
=  2.9  −  3.5
  
 3.8  
 0.51
2.7 
4.2 5.1
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Hence
 the model
 best
 describing
 the data:
2.6 1.3
 5.3   4.2 
   
y =  2.9 , X = 
 
 3.5 

 3.8   2.7 
4.2 5.1
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Hence the model
 best
 describing
 the data:
2.6 1.3
 5.3   4.2 
   
y =  2.9 , X = 
 
 3.5 

 3.8   2.7 
4.2 5.1
is y = 2.045 + 0.51X +
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Hence the model
 best
 describing
 the data:
2.6 1.3
 5.3   4.2 
   
y =  2.9 , X = 
 
 3.5 

 3.8   2.7 
4.2 5.1
is y = 2.045 + 0.51X +

“But how good is this estimate? Is it really the best model?”
23 / 28
Hence the model
 best
 describing
 the data:
2.6 1.3
 5.3   4.2 
   
y =  2.9 , X = 
 
 3.5 

 3.8   2.7 
4.2 5.1
is y = 2.045 + 0.51X +

What about the sample size?
23 / 28
Hence the model
 best
 describing
 the data:
2.6 1.3
 5.3   4.2 
   
y =  2.9 , X = 
 
 3.5 

 3.8   2.7 
4.2 5.1
is y = 2.045 + 0.51X +


What about and all the assumptions?
23 / 28
Hence the model
 best
 describing
 the data:
2.6 1.3
 5.3   4.2 
   
y =  2.9 , X = 
 
 3.5 

 3.8   2.7 
4.2 5.1
is y = 2.045 + 0.51X +


Is 0.51 significantly different from 0?
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Hence the model
 best
 describing
 the data:
2.6 1.3
 5.3   4.2 
   
y =  2.9 , X = 
 
 3.5 

 3.8   2.7 
4.2 5.1
is y = 2.045 + 0.51X +


Is 0.51 significantly different from 0?
We need to proceed to inference before making conclusions!
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Finite Sample Properties
Further assumptions:
Estimates and estimators.
Properties of an estimator – the sampling distribution.
“Finite sample” versus “large sample” or “asymptotic”
properties.
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Assumptions:
1 Linearity: yi = x0i β + i .
2 Full rank: The n × K sample data matrix X has full
column rank (no linear dependencies in data).
3 Exogeneity: E[i |x0i ] = 0, there is no correlation between
the disturbances and independent variables.
4 Homoscedasticity and no autocorrelation: Each i
has the same finite variance, σ 2 and is uncorrelated with
every other disturbance j .
5 Normal distribution: The disturbances are normally
distributed.
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Finite sample properties of b = (X0 X)−1 X0 y
Unbiased E(b) = β
(holds for any sample size!!!)
26 / 28
Unbiased E(b) = β
Variance V ar(b|X) = σ 2 (X0 X)−1
26 / 28
Unbiased E(b) = β
Efficiency: Gauss - Markov Theorem with all implications:
V ar(β̂|X) ≥ V ar(b|X), where β̂ is any other linear
unbiased estimator of β
26 / 28
Unbiased E(b) = β
Distribution under normality: b|X ∼ N (β, σ 2 (X0 X)−1 )
26 / 28
Unbiased E(b) = β
Distribution under normality: b|X ∼ N (β, σ 2 (X0 X)−1 )
Hence, results for testing null hypothesis H0 : βk = β̄k
against alternative H0 : βk 6= β̄k
bk − β̄k
tk = p ∼ N (0, 1)
σ [(X0 X)−1 )]kk
2
Note that [(X0 X)−1 )]kk is k-th row k-th column element of (X0 X)−1
26 / 28
Large Sample Properties
Does finite sample properties hold as well in large samples?
27 / 28

Asymptotic properties:
27 / 28

Probability Limit and Consistency: plimn→∞ b = β
27 / 28

Asymptotic Variance σ 2 Σ−1
xx
27 / 28

xx
√ d
Asymptotic Distribution: n(b − β) → N (0, σ 2 Σ−1
xx )
27 / 28

xx
√ d
xx )
Note, that in “a large sample”, we have:

√
0 −1
d
n(b − β) → N 0, s2 XnX
27 / 28

xx
√ d
xx )
Note, that in “a large sample”, we have:

√
0 −1
d
n(b − β) → N 0, s2 XnX
as we know we can consistently estimate Σ−1 0

xx by (1/nX X)
−1
and σ 2 by s2 :
1
s2 = (y − Xb)0 .(y − Xb)
n−K
27 / 28
Thank You For Your Attention!
Reading for the next weeks

For the next 2 lectures, read:
Ch. 12 (Estimation Frameworks), pp. 432 - 454
Ch. 14 (MLE) 509 - 548
Reading for revision

Those not familiar with OLS and matrix algebra, I highly
recommend to revise Ch. 2-5 in Green (or corresponding parts
in other recommended books, see syllabus)
Please note that the new editions of the books will be available
soon at the Library together with online access. Until then,
please use the resources I have provided you with.
28 / 28

Advanced Econometrics: Week 1

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Advanced Econometrics

Institute of Economic Studies

General remarks about the organisation of the course

General remarks about the organisation of the course

General remarks about the organisation of the course

While no book is perfect, it is good to know where to

While no book is perfect, it is good to know where to

While no book is perfect, it is good to know where to

We will appreciate any type of feedback

We will appreciate any type of feedback

We will appreciate any type of feedback

We will appreciate any type of feedback

We will appreciate any type of feedback

We will appreciate any type of feedback

We have huge supply of data but short supply of

We have huge supply of data but short supply of

We have huge supply of data but short supply of

We have huge supply of data but short supply of

We have huge supply of data but short supply of

We have huge supply of data but short supply of

80% - 100% Grade 1

80% - 100% Grade 1

Many people think Econometrics is not the most exciting

Many people think Econometrics is not the most exciting

Many people think Econometrics is not the most exciting

Many people think Econometrics is not the most exciting

Discuss with your neighbour

Discuss with your neighbour

Economic statistics ∩ economic theory ∩ mathematics1 .

Discuss with your neighbour

Economic statistics ∩ economic theory ∩ mathematics1 .

Discuss with your neighbour

Economic statistics ∩ economic theory ∩ mathematics1 .

Discuss with your neighbour

Economic statistics ∩ economic theory ∩ mathematics1 .

Discuss with your neighbour

Economic statistics ∩ economic theory ∩ mathematics1 .

Discuss with your neighbour

Economic statistics ∩ economic theory ∩ mathematics1 .

Experimental data are rare in economics ⇒ we need to

Experimental data are rare in economics ⇒ we need to

Experimental data are rare in economics ⇒ we need to

Experimental data are rare in economics ⇒ we need to

Modern Estimation frameworks in Econometrics (From

Modern Estimation frameworks in Econometrics (From

Modern Estimation frameworks in Econometrics (From

Modern Estimation frameworks in Econometrics (From

Modern Estimation frameworks in Econometrics (From

Classical linear regression model (CLRM)

yi = β1 xi1 + β2 xi2 + . . . + βK xiK + ei = xi 0 .β + ei (1)

Classical linear regression model (CLRM)

yi = β1 xi1 + β2 xi2 + . . . + βK xiK + ei = xi 0 .β + ei (1)

The goal is to estimate unknown parameters

Note the inclusion of constant in X.

While FOC’s are X0  = 0, we can write

While FOC’s are X0  = 0, we can write

and premultiplying by (X0 X)−1 ,

(X0 X)−1 X0 y − (X0 X)−1 X0 X b = 0,

While FOC’s are X0  = 0, we can write

and premultiplying by (X0 X)−1 ,

(X0 X)−1 X0 y − (X0 X)−1 X0 X b = 0,

we obtain an OLS estimator:

While FOC’s are X0 = 0, we can write

While FOC’s are X0 = 0, we can write

While FOC’s are X0 = 0, we can write

= y − Xb = y − X(X0 X)−1 X0 y = (I − X(X0 X)−1 X0 )y = My

= y − Xb = y − X(X0 X)−1 X0 y = (I − X(X0 X)−1 X0 )y = My

= y − Xb = y − X(X0 X)−1 X0 y = (I − X(X0 X)−1 X0 )y = My

= y − Xb = y − X(X0 X)−1 X0 y = (I − X(X0 X)−1 X0 )y = My

= y − Xb = y − X(X0 X)−1 X0 y = (I − X(X0 X)−1 X0 )y = My

= y − Xb = y − X(X0 X)−1 X0 y = (I − X(X0 X)−1 X0 )y = My