2 ) Basic Ideas of Linear Regression: The Two-Variable Model

In this chapter we introduced some cardinal thoughts of arrested development analysis. Get downing with the cardinal construct of the population arrested development map ( PRF ) . we developed the construct of additive PRF. This book is chiefly concerned with additive PRFs. that is. arrested developments that are additive in the parametric quantities irrespective of whether or non they are additive in the variables. We so introduced the thought of the stochastic PRF and discussed in item the nature and function of the stochastic mistake term u. PRF is. of class. a theoretical or idealised concept because. in pattern. all we have is a sample ( s ) from some population.

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This necessitated the treatment of the sample arrested development map ( SRF ) . We so considered the inquiry of how we really go about obtaining the SRF. Here we discussed the popular method of ordinary least squares ( OLS ) and presented the appropriate expressions to gauge the parametric quantities of the PRF. We illustrated the OLS method with a to the full worked-out numerical illustration every bit good as with several practical illustrations. Our following undertaking is to happen out how good the SRF obtained by OLS is as an calculator of the true PRF. We undertake this of import undertaking in Chapter 3.

3 ) The Two-Variable Model: Hypothesis Testing

In Chapter 2 we showed how to gauge the parametric quantities of the two-variable additive arrested development theoretical account. In this chapter we showed how the estimated theoretical account can be used for the intent of pulling illations about the true population arrested development theoretical account. Although the two-variable theoretical account is the simplest possible additive arrested development theoretical account. the thoughts introduced in these two chapters are the foundation of the more involved multiple arrested development theoretical accounts that we will discourse in resulting chapters. As we will see. in many ways the multiple arrested development theoretical account is a straightforward extension of the two-variable theoretical account.

4 ) Multiple Arrested development: Appraisal and Hypothesis Testing

In this chapter we considered the simplest of the multiple arrested development theoretical accounts. viz. . the three-variable additive arrested development model—one dependant variable and two explanatory variables. Although in many ways a straightforward extension of the two-variable additive arrested development theoretical account. the three-variable theoretical account introduced several new constructs. such as partial arrested development coefficients. adjusted and unadjusted multiple coefficient of finding. and multicollinearity. Insofar as appraisal of the parametric quantities of the multiple arrested development coefficients is concerned. we still worked within the model of the classical additive arrested development theoretical account and used the method of ordinary least squares ( OLS ) . The OLS calculators of multiple arrested development. like the two-variable theoretical account. possess several desirable statistical belongingss summed up in the Gauss-Markov belongings of best linear indifferent calculators ( BLUE ) .

With the premise that the perturbation term follows the normal distribution with nothing mean and changeless discrepancy ?2. we saw that. as in the two-variable instance. each estimated coefficient in the multiple arrested development follows the normal distribution with a average equal to the true population value and the discrepancies given by the expressions developed in the text. Unfortunately. in pattern. ?2 is non known and has to be estimated. The OLS calculator of this unknown discrepancy is. But if we replace ?2 by. so. as in the two-variable instance. each estimated coefficient of the multiple arrested development follows the t distribution. non the normal distribution. The cognition that each multiple arrested development coefficient follows the t distribution with d. f. equal to ( n – K ) . where K is the figure of parametric quantities estimated ( including the intercept ) . means we can utilize the T distribution to prove statistical hypotheses about each multiple arrested development coefficient separately.

This can be done on the footing of either the t trial of significance or the assurance interval based on the t distribution. In this regard. the multiple arrested development theoretical account does non differ much from the two-variable theoretical account. except that proper allowance must be made for the d. f. . which now depend on the figure of parametric quantities estimated. However. when proving the hypothesis that all partial incline coefficients are at the same time equal to nothing. the single T proving referred to earlier is of no aid.

Here we should utilize the analysis of discrepancy ( ANOVA ) technique and the attendant F trial. Incidentally. proving that all partial incline coefficients are at the same time equal to zero is the same as proving that the multiple coefficient of finding R2 is equal to nothing. Therefore. the F trial can besides be used to prove this latter but tantamount hypothesis. We besides discussed the inquiry of when to add a variable or a group of variables to a theoretical account. utilizing either the t trial or the F trial. In this context we besides discussed the method of restricted least squares.

5 ) Functional Forms of Regression Models

In this chapter we considered theoretical accounts that are additive in parametric quantities. or that can be rendered as such with suited transmutation. but that are non needfully linear in variables. There are a assortment of such theoretical accounts. each holding particular applications. We considered five major types of nonlinear-in-variable but linear-in-parameter theoretical accounts. viz. : 1. The log-linear theoretical account. in which both the dependant variable and the explanatory variable are in logarithmic signifier. 2. The log-lin or growing theoretical account. in which the dependant variable is logarithmic but the independent variable is additive. 3. The lin-log theoretical account. in which the dependant variable is additive but the independent variable is logarithmic. 4. The mutual theoretical account. in which the dependant variable is additive but the independent variable is non. 5. The polynominal theoretical account. in which the independent variable enters with assorted powers. Of class. there is nil that prevents us from uniting the characteristics of one or more of these theoretical accounts.

Therefore. we can hold a multiple arrested development theoretical account in which the dependant variable is in log signifier and some of the X variables are besides in log signifier. but some are in additive signifier. We studied the belongingss of these assorted theoretical accounts in footings of their relevancy in applied research. their incline coefficients. and their snap coefficients. We besides showed with several illustrations the state of affairss in which the assorted theoretical accounts could be used. Gratuitous to state. we will come across several more illustrations in the balance of the text. In this chapter we besides considered the regression-through-the-origin theoretical account and discussed some of its characteristics. It can non be overemphasized that in taking among the viing theoretical accounts. the overruling aim should be the economic relevancy of the assorted theoretical accounts and non simply the drumhead statistics. such as R2.

Model edifice requires a proper balance of theory. handiness of the appropriate informations. a good apprehension of the statistical belongingss of the assorted theoretical accounts. and the elusive quality that is called practical judgement. Since the theory underlying a subject of involvement is ne’er perfect. there is no such thing as a perfect theoretical account. What we hope for is a moderately good theoretical account that will equilibrate all these standards. Whatever theoretical account is chosen in pattern. we have to pay careful attending to the units in which the dependant and independent variables are expressed. for the reading of arrested development coefficients may hinge upon units of measuring.

6 ) Dummy Variable Regression Models

In this chapter we showed how qualitative. or silent person. variables taking values of 1 and 0 can be introduced into arrested development theoretical accounts aboard quantitative variables. As the assorted illustrations in the chapter showed. the dummy variables are basically a data-classifying device in that they divide a sample into assorted subgroups based on qualities or properties ( sex. matrimonial position. race. faith. etc. ) and implicitly run single arrested developments for each subgroup. Now if there are differences in the responses of the dependant variable to the fluctuation in the quantitative variables in the assorted subgroups. they will be reflected in the differences in the intercepts or incline coefficients of the assorted subgroups. or both. Although it is a various tool. the dummy variable technique has to be handled carefully. First. if the arrested development theoretical account contains a changeless term ( as most theoretical accounts normally do ) . the figure of dummy variables must be one less than the figure of categorizations of each qualitative variable.

Second. the coefficient attached to the dummy variables must ever be interpreted in relation to the control. or benchmark. group—the group that gets the value of nothing. Finally. if a theoretical account has several qualitative variables with several categories. debut of dummy variables can devour a big figure of grades of freedom ( d. f. ) . Therefore. we should weigh the figure of dummy variables to be introduced into the theoretical account against the entire figure of observations in the sample. In this chapter we besides discussed the possibility of perpetrating a specification mistake. that is. of suiting the incorrect theoretical account to the informations. If intercepts every bit good as inclines are expected to differ among groups. we should construct a theoretical account that incorporates both the differential intercept and incline silent persons.

In this instance a theoretical account that introduces merely the differential intercepts is likely to take to a specification mistake. Of class. it is non ever easy a priori to happen out which is the true theoretical account. Thus. some sum of experimentation is required in a concrete survey. particularly in state of affairss where theory does non supply much counsel. The subject of specification mistake is discussed farther in Chapter 7. In this chapter we besides briefly discussed the additive chance theoretical account ( LPM ) in which the dependant variable is itself binary. Although LPM can be estimated by ordinary least square ( OLS ) . there are several jobs with a everyday application of OLS. Some of the jobs can be resolved easy and some can non. Therefore. alternate estimating processs are needed. We mentioned two such options. the logit and probit theoretical accounts. but we did non discourse them in position of the slightly advanced nature of these theoretical accounts ( but see Chapter 12 ) .

7 ) Model Choice: Criteria and Trials

The major points discussed in this chapter can be summarized as follows: 1. The classical additive arrested development theoretical account assumes that the theoretical account used in empirical analysis is “correctly specified. ” 2. The term right specification of a theoretical account can intend several things. including: a. No theoretically relevant variable has been excluded from the theoretical account. B. No unneeded or irrelevant variables are included in the theoretical account. c. The functional signifier of the theoretical account is right.

d. There are no mistakes of measuring.

3. If a theoretically relevant variable ( s ) has been excluded from the theoretical account. the coefficients of the variables retained in the theoretical account are by and large biased every bit good as inconsistent. and the mistake discrepancy and the standard mistakes of the OLS calculators are biased. As a consequence. the conventional T and F trials remain of questionable value. 4. Similar effects ensue if we use the incorrect functional signifier. 5. The effects of including irrelevant variables ( s ) in the theoretical account are less serious in that estimated coefficients still remain indifferent and consistent. the mistake discrepancy and standard mistakes of the calculators are right estimated. and the conventional hypothesis-testing process is still valid. The major punishment we pay is that estimated standard mistakes tend to be comparatively big. which means parametric quantities of the theoretical account are estimated instead inexactly.

As a consequence. assurance intervals tend to be slightly wider. 6. In position of the possible earnestness of specification mistakes. in this chapter we considered several diagnostic tools to assist us happen out if we have the specification mistake job in any concrete state of affairs. These tools include a graphical scrutiny of the remainders and more formal trials. such as MWD and RESET. Since the hunt for a theoretically right theoretical account can be exacerbating. in this chapter we considered several practical standards that we should maintain in head in this hunt. such as ( 1 ) parsimoniousness. ( 2 ) identifiability. ( 3 ) goodness of tantrum. ( 4 ) theoretical consistence. and ( 5 ) prognostic power. As Granger notes. “In the ultimate analysis. theoretical account edifice is likely both an art and a scientific discipline. A sound cognition of theoretical econometrics and the handiness of an efficient computing machine plan are non plenty to guarantee success. ”

8 ) Multicollinearity: What Happens If Explanatory Variables are Correlated? An of import premise of the classical additive arrested development theoretical account is that there is no exact additive relationship ( s ) . or multicollinearity. among explanatory variables. Although instances of exact multicollinearity are rare in pattern. state of affairss of close exact or high multicollinearity occur often. In pattern. hence. the term multicollinearity refers to state of affairss where two or more variables can be extremely linearly related. The effects of multicollinearity are as follows. In instances of perfect multicollinearity we can non gauge the single arrested development coefficients or their standard mistakes. In instances of high multicollinearity single arrested development coefficients can be estimated and the OLS calculators retain their BLUE belongings.

But the standard mistakes of one or more coefficients tend to be big in relation to their coefficient values. thereby cut downing T values. As a consequence. based on estimated T values. we can state that the coefficient with the low T value is non statistically different from nothing. In other words. we can non measure the fringy or single part of the variable whose t value is low. Remember that in a multiple arrested development the incline coefficient of an X variable is the partial arrested development coefficient. which measures the ( fringy or single ) consequence of that variable on the dependant variable. keeping all other Xvariables constant.

However. if the aim of survey is to gauge a group of coefficients reasonably accurately. this can be done so long as collinearity is non perfect. In this chapter we considered several methods of observing multicollinearity. indicating out their pros and cons. We besides discussed the assorted redresss that have been proposed to work out the job of multicollinearity and noted their strengths and failings. Since multicollinearity is a characteristic of a given sample. we can non announce which method of observing multicollinearity or which remedial step will work in any given concrete state of affairs.

9 ) Heteroscedasticity: What Happens If the Error Variance Is Nonconstant? A critical premise of the classical additive arrested development theoretical account is that the perturbations ui all have the same ( i. e. . homoscedastic ) discrepancy. If this premise is non satisfied. we have heteroscedasticity. Heteroscedasticity does non destruct the unbiasedness belongings of OLS calculators. but these calculators are no longer efficient. In other words. OLS calculators are no longer BLUE. If heteroscedastic discrepancies ?i2 are known. so the method of leaden least squares ( WLS ) provides Blue calculators. Despite heteroscedasticity. if we continue to utilize the usual OLS method non merely to gauge the parametric quantities ( which remain indifferent ) but besides to set up assurance intervals and trial hypotheses. we are likely to pull deceptive decisions. as in the NYSE Example 9. 8. This is because estimated standard mistakes are likely to be biased and hence the ensuing t ratios are likely to be biased. excessively.

Therefore. it is of import to happen out whether we are faced with the heteroscedasticity job in a specific application. There are several diagnostic trials of heteroscedasticity. such as plotting the estimated remainders against one or more of the explanatory variables. the Park trial. the Glejser trial. or the rank correlativity trial ( See Problem 9. 13 ) . If one or more diagnostic trials reveal that we have the heteroscedasticity job. remedial steps are called for. If the true mistake discrepancy ?i2 is known. we can utilize the method of WLS to obtain BLUE calculators. Unfortunately. knowledge about the true mistake discrepancy is seldom available in pattern.

As a consequence. we are forced to do some plausible premises about the nature of heteroscedasticity and to transform our informations so that in the transformed theoretical account the error term is homoscedastic. We so use OLS to the transformed information. which amounts to utilizing WLS. Of class. some accomplishment and experience are required to obtain the appropriate transmutations. But without such a transmutation. the job of heteroscedasticity is indissoluble in pattern. However. if the sample size is moderately big. we can utilize White’s process to obtain heteroscedasticity-corrected standard mistakes.

10 ) Autocorrelation: What Happens If Mistake Footings Are Correlated? The major points of this chapter are as follows:

1. In the presence of autocorrelation OLS calculators. although indifferent. are non efficient. In short. they are non BLUE. 2. Assuming the Markov first-order autoregressive. the AR ( 1 ) . strategy. we pointed out that the conventionally computed discrepancies and standard mistakes of OLS calculators can be earnestly biased. 3. As a consequence. standard T and F trials of significance can be earnestly misdirecting. 4. Therefore. it is of import to cognize whether there is autocorrelation in any given instance. We considered three methods of observing autocorrelation: a. graphical plotting of the remainders

b. the tallies trial

c. the Durbin-Watson vitamin D trial

5. If autocorrelation is found. we suggest that it be corrected by suitably transforming the theoretical account so that in the transformed theoretical account there is no autocorrelation. We illustrated the existent mechanics with several illustrations.

11 ) Coincident Equation Models

In contrast to the individual equation theoretical accounts discussed in the preceding chapters. in coincident equation arrested development theoretical accounts what is a dependant ( endogenous ) variable in one equation appears as an explanatory variable in another equation. Therefore. there is a feedback relationship between the variables. This feedback creates the simultaneousness job. rendition OLS inappropriate to gauge the parametric quantities of each equation separately. This is because the endogenous variable that appears as an explanatory variable in another equation may be correlated with the stochastic mistake term of that equation. This violates one of the critical premises of OLS that the explanatory variable be either fixed. or nonrandom. or if random. that it be uncorrelated with the error term. Because of this. if we use OLS. the estimations we obtain will be biased every bit good as inconsistent. Besides the simultaneousness job. a coincident equation theoretical account may hold an designation job.

An designation job means we can non unambiguously gauge the values of the parametric quantities of an equation. Therefore. before we estimate a coincident equation theoretical account. we must happen out if an equation in such a theoretical account is identified. One cumbersome method of happening out whether an equation is identified is to obtain the decreased signifier equations of the theoretical account. A decreased signifier equation expresses a dependant ( or endogenous ) variable entirely as a map of exogenic. or predetermined. variables. that is. variables whose values are determined outside the theoretical account. If there is a one-to-one correspondence between the decreased signifier coefficients and the coefficients of the original equation. so the original equation is identified. A cutoff to finding designation is via the order status of designation. The order status counts the figure of equations in the theoretical account and the figure of variables in the theoretical account ( both endogenous and exogenic ) .

Then. based on whether some variables are excluded from an equation but included in other equations of the theoretical account. the order status decides whether an equation in the theoretical account is underidentified. precisely identified. or overidentified. An equation in a theoretical account is underidentified if we can non gauge the values of the parametric quantities of that equation. If we can obtain alone values of parametric quantities of an equation. that equation is said to be precisely identified. If. on the other manus. the estimations of one or more parametric quantities of an equation are non alone in the sense that there is more than one value of some parametric quantities. that equation is said to be overidentified. If an equation is underidentified. it is a dead-end instance. There is non much we can make. short of altering the specification of the theoretical account ( i. e. . developing another theoretical account ) .

If an equation is precisely identified. we can gauge it by the method of indirect least squares ( ILS ) . ILS is a two-step process. In measure 1. we apply OLS to the reduced signifier equations of the theoretical account. and so we retrieve the original structural coefficients from the decreased signifier coefficients. ILS calculators are consistent ; that is. as the sample size additions indefinitely. the calculators converge to their true values. The parametric quantities of the overidentified equation can be estimated by the method of two-stage least squares ( 2SLS ) . The basic thought behind 2SLS is to replace the explanatory variable that is correlated with the error term of the equation in which that variable appears by a variable that is non so correlative. Such a variable is called a placeholder. or instrumental. variable. 2SLS calculators. like the ILS calculators. are consistent calculators.

12 ) Selected Topics in Single Equation Regression Models

In this chapter we discussed several subjects of considerable practical importance. The first subject we discussed was dynamic mold. in which clip or slowdown explicitly enters into the analysis. In such theoretical accounts the current value of the dependant variable depends upon one or more lagged values of the explanatory variable ( s ) . This dependance can be due to psychological. technological. or institutional grounds. These theoretical accounts are by and large known as distributed slowdown theoretical accounts. Although the inclusion of one or more lagged footings of an explanatory variable does non go against any of the standard CLRM premises. the appraisal of such theoretical accounts by the usual OLS method is by and large non recommended because of the job of multicollinearity and the fact that every extra coefficient estimated means a loss of grades of freedom. Therefore. such theoretical accounts are normally estimated by enforcing some limitations on the parametric quantities of the theoretical accounts ( e. g. . the values of the assorted lagged coefficients decline from the first coefficient onward ) .

This is the attack adopted by the Koyck. the adaptative outlooks. and the partial. or stock. accommodation theoretical accounts. A alone characteristic of all these theoretical accounts is that they replace all lagged values of the explanatory variable by a individual lagged value of the dependant variable. Because of the presence of the lagged value of the dependent variable among explanatory variables. the ensuing theoretical account is called an autoregressive theoretical account. Although autoregressive theoretical accounts achieve economic system in the appraisal of distributed slowdown coefficients. they are non free from statistical jobs. In peculiar. we have to guard against the possibility of autocorrelation in the mistake term because in the presence of autocorrelation and the lagged dependant variable as an explanatory variable. the OLS calculators are biased every bit good as inconsistent.

In discoursing the dynamic theoretical accounts. we pointed out how they help us to measure the short- and long-term impact of an explanatory variable on the dependant variable. The following subject we discussed related to the phenomenon of specious. or nonsensical. arrested development. Specious arrested development arises when we regress a nonstationary random variable on one or more nonstationary random variables. A clip series is said to be ( decrepit ) stationary. if its mean. discrepancy. and covariances at assorted slowdowns are non clip dependent. To happen out whether a clip series is stationary. we can utilize the unit root trial. If the unit root trial ( or other trials ) shows that the clip series of involvement is stationary. so the arrested development based on such clip series may non be specious. We besides introduced the construct of cointegration. Two or more clip series are said to be cointegrated if there is a stable. long-run relationship between the two even though separately each may be nonstationary.

If this is the instance. arrested development affecting such clip series may non be specious. Next we introduced the random walk theoretical account. with or without impetus. Several fiscal clip series are found to follow a random walk ; that is. they are nonstationary either in their average value or their discrepancy or both. Variables with these features are said to follow stochastic tendencies. Stock monetary values are a premier illustration of a random walk. It is difficult to state what the monetary value of a stock will be tomorrow merely by cognizing its monetary value today. The best conjecture about tomorrow’s monetary value is today’s monetary value plus or minus a random mistake term ( or daze. as it is called ) . If we could foretell tomorrow’s monetary value reasonably accurately. we would wholly be millionaires!

The following subject we discussed in this chapter was the dummy dependant variable. where the dependant variable can take values of either 1 or 0. Although such theoretical accounts can be estimated by OLS. in which instance they are called additive chance theoretical accounts ( LPM ) . this is non the recommended process since chances estimated from such theoretical accounts can sometimes be negative or greater than 1. Therefore. such theoretical accounts are normally estimated by the logit or probit processs. In this chapter we illustrated the logit theoretical account with concrete illustrations. Thankss to excellent computing machine bundles. appraisal of logit and probit theoretical accounts is no longer a cryptic or prohibiting undertaking.