College of Distance and Continuing Education Department of Economics

UNITY UNIVERSITY

COLLEGE OF DISTANCE AND CONTINUING EDUCATION

DEPARTMENT OF ECONOMICS

ECONOMETRICS II (Econ-2062) Module

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

A. Course Overview
 Course Title: Econometrics II
 Course No: Econ-2062
 Credit Hours: 3
 Pre-requisite: Econ-2061
B. Course Description
This course is a continuation of Econometrics I. It aims at introducing the theory (and practice)
of regression on qualitative information, time series and panel data econometrics as well as
simultaneous equation modeling. It first makes an introduction to the basic concepts in
qualitative information modeling such as dummy variable regression and binary choice models
(LPM, Logit and Probit). Elementary time series models, estimations and tests for both stationary
and non-stationary data will then be discussed. It also covers introduction to simultaneous
equation modeling with alternative estimation methods. Introductory pooled cross-sectional and
panel data models will finally be highlighted.
C. Course objectives

After the completion of this course, students are expected to:

o Understand the basic concepts in regression involving dummy independent and

dependent variables;

o Know the theory and practice of elementary time series econometrics;

o Understand the motivation and estimation methods of simultaneous equation

modelling;

o Get introductory ideas on linear panel data models; and

D. Assessment/Evaluation
Worksheet 25%
Final Exam 2 75%
Total Mark 100%

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

E. Required text book:

 Gujarati, D. N. (2009). Basic Econometrics, 5th edition, McGraw-Hill.
F. Additional readings:

 Maddala, G. S. (2013). Introduction to Econometrics, 4th edition, Macmillan.

 Wooldridge, J. (2004). IntroductoryEconometrics: A Modern Approach, 2nd ed.

 Enders, W. (2004). Applied Econometric Time Series, John Wiley & Sons:
Singapore.

 Koutsoyiannis, A. (2001). Theory of Econometrics, Palgrave: New York.

 Johnston, J. (2015)., Econometric Methods, 3rd edition.

 Kmenta, J. (2008). Elements of Econometrics, 2nd edition.

 Intrilligator M.D, R.G. Bodkin, and D. Hsiao (1996). Econometric Models,

Techniques and Applications.

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

CHAPTER ONE

Regression Analysis with Qualitative Information: Binary (Dummy Variables)

Topic Learning Objectives

This chapter aims at introducing models with binary explanatory variable and specification
and estimation of qualitative/dummy variables.

In this chapter you will be able to:

 Familiarize yourself with regression models with binary explanatory variables

 Understand some of the specification of the model for dummy dependent and dummy
independent variables.

 Understand the basic concepts in qualitative information modeling such as dummy

variable regression and binary choice models (LPM, Logit and Probit).

Topic Outline

1.1. Describing Qualitative Information

1.2. Dummy as Independent Variables
1.3. Dummy as Dependent Variable
[Link] Linear Probability Model (LPM)
[Link] Logit and Probit Models
[Link] the Probit and Logit Model Estimates

1.4. Review questions

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

1.1. Describing Qualitative Information

In the regression analysis you discussed in Econometrics I, the dependent variable as well as the
explanatory variables was quantitative in nature. However, the dependent variable might not only
influenced by variables that can be readily quantified on some well-defined scale (e.g., income,
output, prices, costs, height, and temperature), but also by variables that are essentially
qualitative in nature (e.g., sex, race, color, religion, nationality, and changes in government
economic policy). For example, holding all other factors constant, female college professors are
found to earn less than their male counterparts, and nonwhites are found to earn less than whites.
This pattern may result from sex or racial discrimination, but whatever the reason, qualitative
variables such as sex and race does influence the dependent variable and clearly should be
included among the explanatory variables. Since such qualitative variables usually indicate the
presence or absence of a “quality” or an attribute, such as male or female, black or white, one
method of “quantifying” such attributes is by constructing artificial variables that take on values
of 1 or 0, 0 indicating the absence of an attribute and 1 indicating the presence (or possession) of
that attribute. For example, 1 may indicate that a person is a male, and 0 may designate a
female; or 1 may indicate that a person is a college graduate, and 0 that he is not, and so on.
Variables that assume such 0 and 1 values are called dummy variables. Alternative names are
indicator variables, binary variables, categorical variables, and dichotomous variables.

1.2. Dummy Variable as Independent Variable

1.2.1. Regression on one qualitative variable with two classes, or categories

Dummy variables can be used in regression models just as easily as quantitative variables. As a
matter of fact, a regression model 5may contain explanatory variables that are exclusively dummy,
or qualitative, in nature.

Example: =

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

Where =annual salary of a college professor

1 if male college professor

= 0 otherwise (i.e., female professor)

Note that (1.1) is like the two variable regression models encountered in econometrics I except
that instead of a quantitative X variable we have a dummy variable D (hereafter, we shall
designate all dummy variables by the letter D).

Model (1. 1) may enable us to find out whether sex makes any difference in a college professor’s
salary, assuming, of course, that all other variables such as age, degree attained, and years of
experience are held constant. Assuming that the disturbance satisfy the usually assumptions of
the classical linear regression model, we obtain from (1. 1).

Mean salary of female college professor: /

Mean salary of male college professor: /

That is, the intercept term α gives the mean salary of female college professors and the slope

coefficient β tells by how much the mean salary of a male college professor differs from the

mean salary of his female counterpart, α + β reflecting the mean salary of the male college

professor. A test of the null hypothesis that there is no sex discrimination ( H 0 : β=0) can be
easily made by running regression (1.1) in the usual manner and finding out whether on the basis

of the t- test the estimated β is statistically significant.

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

1.2.2. Regression on one quantitative variable and one qualitative variable with two classes

Consider the model: =

Where: Annual salary of a college professor

Years of teaching experience

1 if male

=0 otherwise

Model (1. 3) contains one quantitative variable (years of teaching experience) and one qualitative
variable (sex) that has two classes (or levels, classifications, or categories), namely, male and

female. What is the meaning of this equation? Assuming, as usual, that E(u i )=0 , we see that

Mean salary of female college professor: /

Mean salary of male college professor: /

Geometrically, we have the situation shown in fig. 1.1 (for illustration, it is assumed that α 1 >0 ).
In words, model 1. 1 postulates that the male and female college professors’ salary functions in

relation to the years of teaching experience have the same slope ( β ) but different intercepts. In
other words, it is assumed that the level of the male professor’s mean salary is different from that

of the female professor’s mean salary (by α 2 ) but the rate of change in the mean annual salary by
years of experience is the same for both sexes.

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

If the assumption of common slopes is valid, a test of the hypothesis that the two regressions
(1.4) and (1.5) have the same intercept (i.e., there is no sex discrimination) can be made easily by

running the regression (1.3) and noting the statistical significance of the estimated α 2 on the

basis of the traditional t- test. If the t test shows that α^ 2 is statistically significant, we reject the
null hypothesis that the male and female college professors’ levels of mean annual salary are the
same.

Before proceeding further, note the following features of the dummy variable regression model
considered previously.

1. To distinguish the two categories, male and female, we have introduced only one dummy

variable
Di . For example, if Di =1 always denotes a male, when D i =0 we know that
it is a female since there are only two possible outcomes. Hence, one dummy variable
suffices to distinguish two categories. The general rule is this: If a qualitative variable
has ‘m’ categories, introduce
8 only ‘m-1’ dummy variables. In our example, sex has two
categories, and hence we introduced only a single dummy variable. If this rule is not

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

followed, we shall fall into what might be called the dummy variable trap, that is, the
situation of perfect multicollinearity.
2. The assignment of 1 and 0 values to two categories, such as male and female, is arbitrary
in the sense that in our example we could have assigned D=1 for female and D=0 for
male.
3. The group, category, or classification that is assigned the value of 0 is often referred to as
the base, benchmark, control, comparison, reference, or omitted category. It is the base
in the sense that comparisons are made with that category.

4. The coefficient α 2 attached to the dummy variable D can be called the differential
intercept coefficient because it tells by how much the value of the intercept term of the
category that receives the value of 1 differs from the intercept coefficient of the base
category.

1.2.3. Regression on one quantitative variable and one qualitative variable with more than
two classes

Suppose that, on the basis of the cross-sectional data, we want to regress the annual expenditure
on health care by an individual on the income and education of the individual. Since the variable
education is qualitative in nature, suppose we consider three mutually exclusive levels of
education: less than high school, high school, and college. Now, unlike the previous case, we
have more than two categories of the qualitative variable education. Therefore, following the
rule that the number of dummies be one less than the number of categories of the variable, we
should introduce two dummies to take care of the three levels of education. Assuming that the
three educational groups have a common slope but different intercepts in the regression of annual
expenditure on health care on annual income, we can use the following model:

=
9
Where = Annual expenditure on health care

= Annual expenditure

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

1 if high school education

= 0 otherwise

1 if college education

= 0 otherwise

Note that in the preceding assignment of the dummy variables we are arbitrarily treating the “less

than high school education” category as the base category. Therefore, the intercept α 1 will
α
reflect the intercept for this category. The differential intercepts α 2 and 3 tell by how much the
intercepts of the other two categories differ from the intercept of the base category, which can be

readily checked as follows: Assuming E(u i )=0 , we obtain from (1.6)

which are, respectively the mean health care expenditure functions for the three levels of
education, namely, less than high school, high school, and college. Geometrically, the situation is

shown in fig 1.2 (for illustrative purposes it is assumed that

α 3 > α 2 ).

10

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

1.2.4. Regression on one quantitative variable and two qualitative variables

The technique of dummy variable can be easily extended to handle more than one qualitative
variable. Let us revert to the college professors’ salary regression (1.3), but now assume that in
addition to years of teaching experience and sex, the skin color of the teacher is also an important
determinant of salary. For simplicity, assume that color has two categories: black and white.
We can now write (1.3) as:

Where = annual salary

= years of teaching experience

= if female 11

=0 otherwise

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

= if white

=0 otherwise

Notice that, each of the two qualitative variables, sex and color, has two categories and hence
needs one dummy variable for each. Note also that the omitted, or base, category now is “black
female professor.”

Assuming = , we can obtain the following regression from (1.7)

Mean salary for black female professor:

Mean salary for black male professor:

Mean salary for white female professor:

Mean salary for white male professor:

Once again, it is assumed that the preceding regressions differ only in the intercept coefficient

but not in the slope coefficient β .

An OLS estimation of (1.6) will enable us to test a variety of hypotheses. Thus, if

α 3 is

12 that color does affect a professor’s salary. Similarly, if α 2 is

statistically significant, it will mean
statistically significant, it will mean that sex also affects a professor’s salary. If both these
differential intercepts are statistically significant, it would mean sex as well as color is an

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

important determinant of professors’ salaries. From the preceding discussion it follows that we
can extend our model to include more than one quantitative variable and more than two
qualitative variables. The only precaution to be taken is that the number of dummies for each
qualitative variable should be one less than the number of categories of that variable.

1.3. REGRESSION ON DUMMY DEPENDENT VARIABLE

1.3.1. INTRODUCTION

In all the regression models that we have considered so far, we have implicitly assumed that the
dependent variable Y is quantitative, whereas the explanatory variables are either quantitative,
qualitative (or dummy), or a mixture thereof. In fact, in the previous sections, on dummy
variables, we saw how the dummy explanatory variables are introduced in a regression model
and what role they play in specific situations. In this section we consider several models in which
the dependent variable itself is qualitative in nature. Although increasingly used in various areas
of social sciences and medical research, qualitative response regression models pose interesting
estimation and interpretation challenges.

Suppose we want to study the labor-force participation of adult males as a function of the
unemployment rate, average wage rate, family income, education, etc. A person either is in the
labor force or not. Hence, the dependent variable, labor-force participation, can take only two
values: 1 if the person is in the labor force and 0 if he or she is not. We can consider another
example. A family may or may not own a house. If it owns a house, it takes a value 1 and 0 if it
does not. There are several such examples where the dependent variable is dichotomous. A
unique feature of all the examples is that the dependent variable is of the type that elicits a yes or
no response; that is, it is dichotomous in nature. Now before we discuss the concept of
qualitative response models (QRM) involving dichotomous response variables, it is important to
note a fundamental difference between a regression model where the dependent variable Y is
13
quantitative and a model where it is qualitative. In a model where Y is quantitative, our objective
is to estimate its expected, or mean, value given the values of the explanatory variables. In terms
econometrics I, what we want is E(Yi | X1i , X2i , . . . , Xki), where the X’s are explanatory

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

variables, both quantitative and qualitative. In models where Y is qualitative, our objective is to
find the probability of something happening, or owning a house, or participating in a labour force
etc. Hence, qualitative response regression models are often known as probability models.

1.3.2. QUALITATIVE RESPONSE MODELS

Now we start our discussion of qualitative response models (QRM). These are models in which
the dependent variable is a discrete outcome. These models are analyzed in a general framework
of probability models. There are two broad categories of QRM.

A. Binomial Models: where the choice is between two alternatives

Example 1.3.1: + +
Y= 1, if individual attend college
= 0, otherwise
Therefore, the dependent variable Y takes on only two values (i.e., 0 and 1). Conventional
regression methods cannot be used to analyze a qualitative dependent variable model.

B. Multinomial Models: The choice is between more than two alternatives

Example 1.3.2: + +
In this case, the dependent variable Y takes more than two alternatives. For instances,

Y= 1, if individual attend college

Y= 2, if individual high school

Y= 3, otherwise

Since the discussion of multinomial QRMs is out of scope of this course, we start our study of
qualitative response models by considering the binary response regression model. There are
four approaches to estimating a probability
14 model for a binary response variable:

1. Linear Probability Models 3. The Probit Model

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

2. The Logit Model 4. The Tobit (Censored Regression) Model1.

[Link]. THE LINEAR PROBABILITY MODEL (LPM)

The linear probability model is the regression model applied to a binary dependent variable. To
fix ideas, consider the following simple model:

Yi =
β 0 + β 1 X + U ……………………………(1)
i i

Where X = family income and = is the disturbance term

Y = 1 if the family owns a house

= 0 if the family does not own a house

The independent variable Xi can be discrete or continuous variable. The model can be extended
to include other additional explanatory variables. The above model expresses the dichotomous Y i
as a linear function of the explanatory variable X i. Such kinds of models are called linear
probability models (LPM) since E(Yi/Xi) the conditional expectation of Yi given Xi, can be
interpreted as the conditional probability that the event will occur given X i; that is, Pr(Yi = 1/Xi).
Thus, in the preceding case, E(Yi/Xi) gives the probability of a family owing a house and whose
income is the given amount Xi. The justification of the name LPM can be seen as follows.

Assuming E(Ui) = 0, as usual (to obtain unbiased estimators), we obtain

E(Yi/Xi) =
β 0 + β 1 X …………………………………….(2)
i

Now, letting Pi = probability that Yi = 1 (that is, that the event occurs) and 1 – P i = probability
that Yi = 0 (that is, that the event does not occur), the variable Yi has the following distributions:
15

1
The Tobit model will not be discussed in this chapter

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

Probability

0
1-

Total 1

Therefore, by the definition of mathematical expectation, we obtain

E(Yi) = 0 (1 – Pi) + 1(Pi) = Pi ……………………………………..(3)

Now, comparing (2) with (3), we can equate

E(Yi/Xi) = Yi =
β 0 + β 1 X = P ……………………………………(4)
i i

i.e., the conditional expectation of the model (1) can, in fact, be interpreted as the conditional
probability of Yi. Since the probability Pi must lie between 0 and 1, we have the restriction 0 £ E
(Yi/Xi) £ 1 i.e., the conditional expectation, or conditional probability, must lie between 0 and 1.

Example: The LPM estimated by OLS (on home ownership) is given as follows:

Y^ i = -0.9457 + 0.1021X
i

(0.1228) (0.0082)

t = (-7.6984) (12.515) R2 = 0.8048

The above regression is interpreted as follows

 The intercept of –0.9457 gives the “probability” that a family with zero income will own
a house. Since this value is negative, and since probability cannot be negative, we treat
16
this value as zero. The slope value of 0.1021 means that for a unit change in income, on
the average the probability of owning a house increases by 0.1021 or about 10 percent.

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

This is so whether the income level is increased or not. This seems patently unrealistic. In
reality one would expect that Pi is non-linearly related to Xi (see next section).

Problems with the LPM

From the preceding discussion it would seem that OLS can be easily extended to binary
dependent variable regression models. So, perhaps there is nothing new here. Unfortunately, this
is not the case, for the LPM poses several problems. That is, while the interpretation of the
parameters is unaffected by having a binary outcome, several assumptions of the LPM are
necessarily violated.

1. Heteroscedasticity
The variance of the disturbance terms depends on the X’s and is thus not constant. Let us see this
as follows. We have the following probability distributions for U.

Probability

0
- - 1-

1
1- -

2
Now by definition = = ) since and for

all (no serial correlation) by assumption.

Therefore, using the preceding probability distribution of , we obtain

17
= E(Ui2) = (-

β 0 – β 1 X )2 (1-P ) + (1- β 0 – β 1 X )2 (P )
i i i i

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

=(-
β 0 – β 1 X )2(1- β 0 – β 1 X ) + (1- β 0 – β 1 X )2 ( β 0 + β 1 X )
i i i i

=(
β 0 + β 1 X ) (1- β 0 – β 1 X )
i i

or = E(Yi/Xi) [1 – E(Yi/Xi) = Pi (1 – Pi)

This shows that the variance of U i is heteroscedastic because it depends on the conditional
expectation of Y, which, of course, depends on the value taken by X. Thus the OLS estimator of
β is inefficient and the standard errors are biased, resulting in incorrect test.

2. Non-normality of Ui
Although OLS does not require the disturbance (U’s) to be normally distributed, we assumed
them to be so distributed for the purpose of statistical inference, that is, hypothesis testing, etc.
But the assumption of normality for U i is no longer tenable for the LPMs because like Y i, Ui
takes on only two values.

= Y i-

β0 – β1 X
i

Now when Yi = 1, =1-

β0 – β1 X
i

and when Yi = 0, =–

β0 – β1 X
i

Obviously cannot be assumed to

18 be normally distributed. Recall that normality is not required

for the OLS estimates to be unbiased.

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

3. Non-fulfillment of 0 £ E (Yi/Xi) £ 1
The LPM produces predicted values outside the normal range of probabilities (0, 1). It predicts
value of Y that are negative and greater than 1. This is the real problem with the OLS estimation
of the LPM.

4. Functional Form:

Since the model is linear, a unit increase in X results in a constant change of β in the probability
of an event, holding all other variables constant. The increase is the same regardless of the
current value of X. In many applications, this is unrealistic. When the outcome is a probability, it
is often substantively reasonable that the effects of independent variables will have diminishing
returns as the predicted probability approaches 0 or 1.

Remark: Because of the above mentioned problems the LPM model is not recommended for
empirical works.

[Link]. ALTERNATIVE MODEL TO LPM

As we have seen, the LPM is characterized by several problems such as non-normality of ui,
heteroscedasticity of ui and possibility of Yi lying outside the 0–1 range. But even then the
fundamental problem with the LPM is that it is not logically a very attractive model because it
assumes that Pi = E(Y =1| X) increases linearly with X, that is, the marginal or incremental effect
of X remains constant throughout. Thus, in our home ownership example we found that as X
increases by a unit (Birr 1000), the probability of owning a house increases by the same constant
amount of 0.10. This is so whether the income level is Birr 8000, Birr 10,000, Birr 18,000, or
Birr 22,000. This seems patently unrealistic. In reality one would expect that Pi is nonlinearly
related to Xi: At very low income a family will not own a house but at a sufficiently high level of
income, say, X*, it most likely will own a house. Any increase in income beyond X* will have
little effect on the probability of owning a house. Thus, at both ends of the income distribution,
19
the probability of owning a house will be virtually unaffected by a small increase in X.

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

Therefore, what we need is a (probability) model that has these two features: (1) As Xi increases,
Pi = E(Y = 1 | X) increases but never steps outside the 0–1 interval, and (2) the relationship
between Pi and Xi is nonlinear, that is, “one which approaches zero at slower and slower rates as
Xi gets small and approaches one at slower and slower rates as Xi gets very large.’’
Geometrically, the model we want would look something like Figure 1.1.

1 CDF

X
0
¥
-¥

Fig 1.1: A Cumulative Distribution Function (CDF

The above S-shaped curve is very much similar with the cumulative distribution function (CDF)
of a random variable. (Note that the CDF of a random variable X is simply the probability that it
takes a value less than or equal to X 0, were X0 is some specified numerical value of X. In short,
F(X), the CDF of X, is F(X = X0) = P(X £ X0). Therefore, one can easily use the CDF to model
regressions where the response variable is dichotomous, taking 0-1 values.

The CDFs commonly chosen to represent the 0-1 response models are.

1) the logistic – which gives rise to the logit model

2) the normal – which gives rise
20
to the probit (or normit) model

1. THE LOGIT MODEL

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

Now let us see how one can estimate and interpret the logit model. Recall that the LPM was (for
home ownership).

Pi = E(Y = 1 | Xi) = β1 + β2Xi

Where X is income and Y = 1 means the family owns a house. Now consider the following
representation of home ownership.

Pi = E(Y = 1 | Xi) =

Pi = = where =

This equation represents what is known as the (cumulative) logistic distribution function. As Zi
ranges from −∞ to +∞, Pi ranges between 0 and 1, and Pi is nonlinearly related to Zi (i.e., Xi),
thus, satisfying the two requirements considered earlier. Since the above equation is non linear in

both the X and the ’s. This means we cannot use the familiar OLS procedure to estimate the
parameters. This can be linear as follows. If Pi, the probability of owning a house, then (1 − Pi ),
the probability of not owning a house, is

1 − Pi =

= =

Now Pi/
Pi/ (1 − Pi)
Pi) is simply the odds ratio in favor of owning a house- the ratio of the probability
that a family will own a house to the probability that it will not own a house. Taking the natural
log of the odds ratio we obtain
21

Li = )= = 1+ 2

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

L(the log of the odds ratio) is linear in X as well as (the parameters). L is called the logit and
hence the name logit model is given to it.

The Estimation and Interpretation of the Logit Model

Now for estimation purposes, let us write the logit model as

Li = )= = 1+ 2 +

To estimate the above model we need values of Xi and Li. Standard OLS cannot be applied since
values of L are meaningless. Recall that Pi = 1 if a family owns a house and Pi = 0 if it does not
own a house. But if we put these values directly into the logit Li, we obtain:

Li = ) if a family own a house

Li = ) if a family does not own a house

Therefore estimation is by using the maximum likelihood method. Since derivation of
parameters using MLE method is out of the scope of this course, we will not discuss the method
here. The interpretation of the logit model is as follows:

β 1 – The slope measures the change in L for a unit change in X..

β 0 – The intercept tells the value of the log-odds in favor of owning a house if income is
zero. Like most interpretations of intercepts, this interpretation may not have any physical
meaning.

Example: Logit estimates. Assume that Y is linearly related to the variables Xi’s as follows:
22

Yi =
β 0 +β1 X + β 2 X + β 3 X + β 4 X + β 5 X + U
1 2 3 4 5 i

The logit estimate results are presented as::

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

Yi = -10.84 – 0.74X1 – 11.6X2 – 5.7X3 – 1.3X4 + 2.5X5

t = (-3.20) (-2.51) (-3.01) (-2.4) (-1.37) (1.62)

The variables X1, X2 and X3 are statistically significant at 99%. The variable X4 is significant at
90%. The above estimated result shows that the variables X 1, X2 and X3 have a negative effect on

the probability of an event to occur (i.e., y = 1). While the sign of or the variable X5 has a
positive effect on the probability of an event to occur.

Note: Parameters of the model are not the same as the marginal effects we are used to when
analyzing OLS.

1.5 THE PROBIT MODEL

The estimating model that emerges from the normal CDF is popularly known as the probit
model. Here the observed dependent variable Y, takes on one of the values 0 and 1 using the
following criteria.

¿
Define a latent variable Y* such that
Y i = X 1i β + Î
I

¿
Y = 1 if
Yi > 0

¿
Y
0 if i £ 0

The latent variable Y* is continuous (-¥ < Y* < ¥). It generates the observed binary variable Y.

An observed variable, Y can be observed in two states:

i. if an event occurs it takes a value of 1

ii. if an event does not occur it takes a value of 0
The latent variable is assumed to be a linear function of the observed X’s through the structural
23
model. Note that is a latent variable because it is unobserved.

Consider example of latent variable: Let Y measures whether one is employed or not. It is a
binary variable taking values 0 and 1. Y* - measures the willingness to participate in the labor

Course Title: Econometrics II( Econ-2062)

College of Distance and Continuing Education Department of Economics

market. This changes continuously and is unobserved. If X is a wage rate, then as X increases the
willingness to participate in the labor market will increase. (Y* - the willingness to participate
cannot be observed). The decision of the individual will be changed (becomes zero) if the wage
rate is below the critical point.

To motivate the probit model, assume that in our home ownership example the decision of the

family to own a house or not depends on an unobservable utility index (also known as a

latent variable), that is determined by one or more explanatory variables, say income , in

such a way that the larger the value of the index , the greater the probability of a family

owning a house. We express the index as

= β1 + β2Xi

where Xi is the income of the family.

Given the assumption of normality, the probability that is less than or equal to can be
computed from the standardized normal CDF as:

Pi = P(Y = 1 | X) = P ( ≤ ) = P ( ≤ β1 + β2 ) = F (β1 + β2 )

But now consider the following representation of home ownership:

P(Y = 1 | Xi) =

is the normal probability distribution function (i.e. )

Since Y* is continuous the model

24 avoids the problems inherent in the LPM model (i.e., the
problem of non-normality of the error term and heteroscedasticity). However, since the latent
dependent variable is unobserved the model cannot be estimated using OLS. Maximum
likelihood can be used instead.

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Most often, the choice is between normal errors and logistic errors, resulting in the probit
(normit) and logit models, respectively. The coefficients derived from the maximum likelihood
(ML) function will be the coefficients for the probit model, if we assume a normal distribution. If
we assume that the appropriate distribution of the error term is a logistic distribution, the
coefficients that we get from the ML function will be the coefficient of the logit model. In both

cases, as with the LPM, it is assumed that E [ / ] = 0. In the probit model, it is assumed that

/ In the logit model, it is assumed that / . Hence the estimates of the

parameters (β’s) from the two models are not directly comparable. But as Amemiya suggests, a
logit estimate of a parameter multiplied by 0.625 gives a fairly good approximation of the probit
estimate of the same parameter. Similarly the coefficients of LPM and logit models are related as
follows:

β LPM = 0.25 β Logit, except for intercept

β LPM = 0.25 β Logit + 0.5

0 for intercept

Marginal Effects of Logit and Probit Model Estimates

In the linear regression model, as you have discussed in Econometrics I, the slope coefficient
measures the change in the average value of the regressand for a unit change in the value of a
regressor, with all other variables held constant.

In the LPM, the slope coefficient measures directly the change in the probability of an event
occurring as the result of a unit change in the value of a regressor, with the effect of all other

variables held constant. In the case of linear models, is marginal effect as given by =

However, the coefficients in logit 25

and probit models are not easy to interpret directly. Hence, we
have to derive marginal effects to compare results from different model. That is, we need to

derive the probability of equals 1 with respect to the kth element in . Algebraically,

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= =

Hence, in probit model and logit models, respectively

= and =

Where denotes the standard CDF and normal density function respectively. The

marginal effects depends up on the values of . The sign of marginal effects corresponds to the
sign of its coefficients and direction of effect of explanatory variables X on the dependent
variable y.

Therefore, in the logit model the slope coefficient of a variable gives the change in the log of the
odds associated with a unit change in that variable, again holding all other variables constant.
But as noted previously, for the logit model the rate of change in the probability of an event

happening is given by Pi(1 − Pi ), where is the (partial regression) coefficient of the kth
regressor. But in evaluating Pi , all the variables included in the analysis are involved.

In the probit model, as we saw earlier, the rate of change in the probability is is given by

, where is the density function of the standard normal variable. Thus, in both
the logit and probit models all the regressors are involved in computing the changes in
probability, whereas in the LPM only the kth regressor is involved.

1.4. Review Questions

Answer the following questions briefly.

1. Explain the role of qualitative

26 explanatory variables in regression analysis.

2. What are the common and major features of the dummy variable regression model? State
them.

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3. Suppose that a researcher wants to regress the annual salaries of economics graduates on
the number of years of experience and education level of the graduates (Here we have
three levels of education: namely, BA, MSc and PhD)

A. How many dummy variables will be included in the model?

B. Specify the model considering BA as the base category.

C. Find the mean values of the annual salaries corresponding to different values of
the regressors.

4. What is a Linear Probabilty Model(LPM)? What are the shortcomings of this model?

5. Explain or outline the similarities and differences between the probit and logit models.

6. Specify the mathematical form of the logit and probit models.

7. Can we use the standard OLS method to estimate the probit and logit models? Why?

8. From data for 54 standard metropolitan statistical areas (SMSA), Demaris estimated the
following logit model to explain high murder rate versus low murder rate:

ln Oi = 1.1387 + 0.0014Pi + 0.0561Ci – 0.4050Ri

se = (0.0009) (0.0227) (0.1568)

where O = the odds of a high murder rate,

P =1980 population size in thousands,

C = population growth rate from 1970 to 1980,

R = reading quotient, and

the se are the asymptotic standard errors.

27
A. How would you interpret the various coefficients?

B. Which of the coefficients are individually statistically significant?

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C. What is the effect of a unit increase in the reading quotient on the odds of having
a higher murder rate?

D. What is the effect of a percentage point increase in the population growth rate on
the odds of having a higher murder rate?

CHAPTER TWO

Introduction to Basic Regression Analysis with Time Series Data

Topic Learning objectives

28 the discussion of regression analysis by incorporating a brief

The aim of this chapter is to extend
discussion of time series econometrics.

After the student has completed this chapter, he/she will

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 Understand the nature of time series data

 Understand the concept of stationarity.

 Distinguish between stationary stochastic and non- stationary stochastic process

 Distinguish between Trend Stationary (TS) and Difference Stationary (DS) Stochastic
Processes

 Define the concept of ‘Spurious Regression’

 Conduct a unit root test

Topic Outline

2.1. Introduction

2.2. The nature of Time Series Data

2.3. Stationary and non-stationary stochastic Processes

2.4. Trend Stationary and Difference Stationary Stochastic Processes

2.5. Integrated Stochastic Process

2.6. Tests of Stationarity: The Unit Root Test

2.7. Review questions

2.1. Nature of Time Series Data

Recall that one of the important types of data used in empirical analysis is time series data.
A time series data set consists of observations on a variable or several variables over time. These
are data that can be collected over time, for instances, weekly, monthly, quarterly, semiannually,
annually, etc. Examples of time series data include stock prices, money supply, consumer price
index, gross domestic product, and
29
automobile sales figures. Because past events can influence
future events and lags in behavior are prevalent in the social sciences, time is an important
dimension in time series data set. Unlike the arrangement of cross-sectional data, the
chronological ordering of observations in a time series conveys potentially important

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information. In this and the following sections we take a closer look at such data not only
because of the frequency with which they are used in practice but also because they pose several
challenges to econometricians and practitioners.

2.2. Stochastic Processes

From a theoretical point of view, a time series is a collection of random variables (X t). Such a
collection of random variables ordered in time is called a stochastic process. Loosely speaking, a
random or stochastic process is a collection of random variables ordered in time. The word
stochastic has a Greek origin and means "pertaining to chance." If we let Y denote a random
variable, and if it is continuous, we denote it as Y(t), but if it is discrete, we denoted it as Yt. We
distinguish two types of stochastic process: stationary and non-stationary stochastic processes.

2.2.1. Stationary Stochastic Processes

A type of stochastic process that has received a great deal of attention by time series analysts is
the so-called stationary stochastic process. A stochastic process is said to be stationary if its
mean and variance are constant over time and the value of the covariance between the two time
periods depends only on the distance or gap or lag between the two time periods and not the
actual time at which the covariance is computed. In the time series literature, such a stochastic
process is known as a weakly stationary, or covariance stationary, or second-order stationary, or
wide sense, stochastic process. To explain stationarity, let Yt be a stochastic time series with
these properties:

Mean: (2.1)

Variance: = (2.2)

Covariance: = (2.3)

where , the covariance (or autocovariance) at lag k, is the covariance between the values of

and , that is, between two Y values k periods apart. If k = 0, we obtain , which is simply the
30
variance of Y (= ); if k = 1, is the covariance between two adjacent values of Y (recall the
first-order autoregressive scheme).

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Suppose we shift the origin of Y from to (for instance, from the first quarter of 1970 to

the first quarter of 1975 say for GDP data). Now if is to be stationary, the mean, variance, and

autocovariances of must be the same as those of . In short, if a time series is stationary,

its mean, variance, and autocovariance (at various lags) remain the same no matter at what
point we measure them; that is, they are time invariant. Such a time series will tend to return to
its mean (called mean reversion) and fluctuations around this mean (measured by its variance)
will remain constant.

Why are stationary time series so important? Because if a time series is non-stationary, we can
study its behavior only for the time period under consideration. Each set of time series data will
therefore be for a particular time period. As a consequence, it is not possible to generalize it to
other time periods. Therefore, for the purpose of forecasting, such (non-stationary) time series
may be of little practical value. We call a stochastic process purely random (white noise, process)

if it has zero mean, constant variance , and is serially uncorrelated. Loosely speaking, the error

term is assumed to be a white noise process if ̴ IIDN (0, ); that is, is independently and
identically distributed as a normal distribution with zero mean and constant variance.

2.2.2. Nonstationary Stochastic Processes

Although our interest is in stationary time series, one often encounters non-stationary time series,
the classic example being the random walk model (RWM). That is, a non-stationary time series
will have a time varying mean or a time-varying variance or both. It is often said that asset
prices, such as stock prices or exchange rates, follow a random walk; that is, they are non-
stationary. We distinguish two types of random walks: (1) random walk without drift (i.e., no
constant or intercept term) and (2) random walk with drift (i.e., a constant term is present).

A) Random Walk without Drift. Suppose is a white noise error term with mean 0 and
31
variance σ2. Then the series Yt is said to be a random walk if

= + (2.4)

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In the random walk model, as (2.4) shows, the value of Y at time t is equal to its value at time (t
− 1) plus a random shock; thus it is an AR(1) model. We can think of (2.4) as a regression of Y at
time t on its value lagged one period. Believers in the efficient capital market hypothesis argue
that stock prices are essentially random and therefore there is no scope for profitable speculation
in the stock market: If one could predict tomorrow’s price on the basis of today’s price, we would
all be millionaires.
Now from (2.4) we can write

= +
= + = + +
= + = + + +
In general, if the process started at some time 0 with a value of , we have

= +∑ (2.5)
Therefore,

= +∑ = (why?) (2.6)
In like fashion, it can be shown that

(2.7)
As the preceding expression shows, the mean of Y is equal to its initial, or starting, value, which
is constant, but as t increases, its variance increases indefinitely, thus violating a condition of

stationarity. In short, the RWM without drift is a non-stationary stochastic process. In practice

is often set at zero, in which case = .

An interesting feature of RWM is the persistence of random shocks (i.e., random errors), which

is clear from (2.5): is the sum of initial plus the sum of random shocks. As a result, the

impact of a particular shock does not die away. For example, if = 2 rather than = 0, then all

’s from onward will be 2 units higher and the effect of this shock never dies out so that
32
random walk is said to have an infinite memory. As Kerry Patterson notes, random walk
remembers the shock forever; that is, it has infinite memory.

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Interestingly, if you write (2.4) as

- = = (2.8)

where is the first difference operator. It is easy to show that, while is non-stationary, its first
difference is stationary. In other words, the first differences of a random walk time series are
stationary.

B) Random Walk with Drift. Let us modify (2.4) as follows:

= + (2.9)
where δ is known as the drift parameter. The name drift comes from the fact that if we write the
preceding equation as

- = (2.10)

it shows that drifts (moves) upward or downward, depending on δ being positive or negative.
Note that model (2.9) is also an AR(1) model. Following the procedure discussed for random
walk without drift, it can be shown that for the random walk with drift model (2.9),

= +t (2.11)

(2.12)
Hence, for RWM with drift the mean as well as the variance increases over time, again violating
the conditions of stationarity. In short, RWM, with or without drift, is a non-stationary stochastic
process.

2.3. Unit Root Stochastic Process

Let us write the RWM (2.4) as:

= + (2.13)
This model resembles the Markov33first-order autoregressive model that we discussed in the case
of autocorrelation. If ρ = 1, (2.13) becomes a RWM (without drift). If ρ is in fact 1, we face what
is known as the unit root problem, that is, a situation of non-stationarity; we already know that

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in this case the variance of is not stationary. The name unit root is due to the fact that ρ = 12.
Thus the terms non-stationarity, random walk, and unit root can be treated as synonymous.

If, however, |ρ| ≤ 1, that is if the absolute value of ρ is less than one, then it can be shown that the

time series is stationary in the sense we have defined it 3. In practice, then, it is important to
find out if a time series possesses a unit root. In the next section we will discuss tests of unit root,
that is, tests of stationarity.

2.4. Trend Stationary (TS) and Difference Stationary (DS) Stochastic Processes
The distinction between stationary and non-stationary stochastic processes (or time series) has a
crucial bearing on whether the trend is deterministic or stochastic. Broadly speaking, if the
trend in a time series is completely predictable and not variable, we call it a deterministic trend,
whereas if it is not predictable, we call it a stochastic trend. To make the definition more formal,

consider the following model of the time series .

= β1 + β2t + β3 + (2.14)

where is a white noise error term and where t is time measured chronologically. Now we have
the following possibilities:
Pure random walk: If in (2.14) β1 = 0, β2 = 0, β3 = 1, we get

= + (2.15)
which is nothing but a RWM without drift and is therefore nonstationary. But note that, if we
write (2.15) as

= = (2.8)

2
A technical point: If ρ = 1, we can write (2.13) as Y t -Y t −1 = ut . Now using the lag operator L so that LY t = Y t −1,
L2Y t = Y t −2, and so on, we can write (2.13) as (1 − L)Y t = ut . The term unit root refers to the root of the
polynomial in the lag operator. If you set (1 − L) = 0, we obtain, L = 1, hence the name unit root.
34
3
If in (2.13) it is assumed that the initial value of Y (=Y 0 ) is zero, |ρ| ≤ 1, and ut is white noise and distributed
normally with zero mean and unit variance, then it follows that E ¿) = 0 and V ar ¿) = 1/(1 − ρ2). Since both these
are constants, by the definition of stationarity, Y t is stationary. On the other hand, as we saw before, if ñ =1, Y t is a
random walk or nonstationary.

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it becomes stationary, as noted before. Hence, a RWM without drift is a difference stationary
process (DSP).

Random walk with drift: If in (2.14) β1 0, β2 = 0, β3 = 1, we get

= β1 + (2.16a)
which is a random walk with drift and is therefore non-stationary. If we write it as

= = β1 + (2.16b)

this means will exhibit a positive (β1 > 0) or negative (β1 < 0) trend. Such a trend is called a

stochastic trend. Equation (2.16b) is a DSP process because the non-stationarity in can be
eliminated by taking first differences of the time series.

Deterministic trend: If in (2.14), β1 0, β2 0, β3 = 0, we obtain

= β1 + β1t + (2.17)

which is called a trend stationary process (TSP). Although the mean of is β1 + β1t, which is
not constant, its variance (= σ2) is. Once the values of β1 and β2 are known, the mean can be

forecast perfectly. Therefore, if we subtract the mean of from , the resulting series will be
stationary, hence the name trend stationary. This procedure of removing the (deterministic)
trend is called detrending.

Random walk with drift and deterministic trend: If in (21.5.1), β1 0, β2 0, β3 = 1, we

obtain:

= β1 + β2t + + (2.18a)
we have a random walk with drift and a deterministic trend, which can be seen if we write this
equation as

= β1 + β1t + 35 (2.18b)

Deterministic trend with stationary AR(1) component: If in (21.5.1) β1 0, β2 0, β3 < 1,

then we get

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= β1 + β2t +β3 + (2.19)

which is stationary around the deterministic trend.

2.5. Integrated Stochastic Processes

The random walk model is a specific case of a more general class of stochastic processes known
as integrated processes. Recall that the RWM without drift is non-stationary, but its first
difference, as shown in (2.8), is stationary. Therefore, we call the RWM without drift integrated

of order 1, denoted as . Similarly, if a time series has to be differenced twice (i.e., take the
first difference of the first differences) to make it stationary, we call such a time series
integrated of order 24. In general, if a (nonstationary) time series has to be differenced d times

to make it stationary, that time series is said to be integrated of order d. A time series

integrated of order d is denoted as ̴ . If a time series is stationary to begin with (i.e., it

does not require any differencing), it is said to be integrated of order zero, denoted by ̴ .
Thus, we will use the terms “stationary time series” and “time series integrated of order zero” to

mean the same thing. Most economic time series are generally ; that is, they generally
become stationary only after taking their first differences.

Properties of Integrated Series

The following properties of integrated time series may be noted: Let Xt , Yt ,and Zt be three time
series.

1. If ̴ and ̴ , then ; that is, a linear combination or sum of

stationary and non-stationary time series is non-stationary.

2. If ̴ , then ) = , where a and b are constants. That is, a linear

combination of a series is also . Thus, if ̴ , then ) ̴ .

3. If ̴ and ̴ , then ) ̴ , where < .

36

4
For example if Y t is I(2), then ∆ ∆ Y t = ∆ (Y t −Y t −1) = ∆ Y t−∆ Y t−1= Y t −2 Y t−1 + Y t −2will become stationary.
2
But note that ∆ ∆ Y t = ∆ Y t ≠ Y t −Y t −2.

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4. If ̴ and ̴ , then ) ̴ I(d*); d* is generally equal to d, but in some

cases d* < d. As you can see from the preceding statements, one has to pay careful attention in
combining two or more time series that are integrated of different order.

2.6. Spurious Regression

To see why stationary time series are so important, consider the following two random walk
models:

= + (2.20)

= + (2.21)

where we generated 500 observations of from ̴ N(0, 1) and 500 observations of from ̴

N(0, 1) and assumed that the initial values of both Y and X were zero. We also assumed that

and are serially uncorrelated as well as mutually uncorrelated. As you know by now, both
these time series are nonstationary; that is, they are I(1) or exhibit stochastic trends.

Suppose we regress on . Since and are uncorrelated I(1) processes, the R2 from the
regression of Y on X should tend to zero; that is, there should not be any relationship between the
two variables. Consider the regression results:
____________________________________________________________________
Variable Coefficient Std. error t statistic
------------------------------------------------------------------------------------------------------
C -13.2556 0.6203 -21.36856
X 0.3376 0.0443 7.61223
R2 = 0.1044 d = 0.0121
---------------------------------------------------------------------------------------------------------

As you can see, the coefficient of X is highly statistically significant, and, although the R2 value
is low, it is statistically significantly different from zero. From these results, you may be tempted
to conclude that there is a significant statistical relationship between Y and X, whereas a priori
37
there should be none. This is in a nutshell the phenomenon of spurious or nonsense regression,
first discovered by Yule. Yule showed that (spurious) correlation could persist in non-stationary
time series even if the sample is very large.

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The regression result is characterized by the extremely low Durbin–Watson d value, which
suggests very strong first-order autocorrelation. According to Granger and Newbold, an R2 > d is
a good rule of thumb to suspect that the estimated regression is spurious. That the regression
results presented above are meaningless can be easily seen from regressing the first differences

of (= ) on the first differences of (= ); remember that although and are non-

stationary, their first differences are stationary. In such a regression you will find that R2 is
practically zero, as it should be, and the Durbin–Watson d is about 2.

2.6. Tests of Stationarity

By now you have a good idea about the nature of stationary stochastic processes and their
importance. In practice we face two important questions: (1) how do we find out if a given time
series is stationary? (2) If we find that a given time series is not stationary, is there a way that it
can be made stationary?
2.6.1. The Unit Root Test
A test of stationarity (or non-stationarity) that has become widely popular over the past several
years is the unit root test. We will first explain it, and then illustrate it. To start with, we
consider equation (2.13).

= + (2.13)

where is a white noise error term.

We know that if ρ = 1, that is, in the case of the unit root, (2.13) becomes a random walk model
without drift, which we know is a non-stationary stochastic process. Therefore, to test whether

series Yt stationary or not, we regress on its (one period) lagged value and find out if the

estimated ρ is statistically equal to 1? If it is, then is non-stationary. This is the general idea
behind the unit root test of stationarity. For theoretical reasons, we manipulate (2.13) as follows:
38
Subtract from both sides of (2.13) to obtain:

= + =( + (2.22)
which can be alternatively written as:

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= + (2.23)

where δ = (ρ − 1) and , as usual, is the first-difference operator.

In practice, therefore, instead of estimating (2.13), we estimate (2.23) and test the (null)
hypothesis that δ = 0. If δ = 0, then ρ = 1, that is we have a unit root, meaning the time series
under consideration is non-stationary. Before we proceed to estimate (2.23), it may be noted that
if δ = 0, (2.23) will become

= = (2.24)

Since is a white noise error term, it is stationary, which means that the first differences of a
random walk time series are stationary, a point we have already made before.

Now let us turn to the estimation of (2.23). We take the first differences of and regress them on

and see if the estimated slope coefficient in this regression (= ) is zero or not. If it is zero,

we conclude that is non-stationary. But if it is negative, we conclude that is stationary. The

only question is which test we use to find out if the estimated coefficient of in (2.23) is zero
or not. You might be tempted to say, why not use the usual t test? Unfortunately, under the null

hypothesis that δ = 0 (i.e., ρ = 1), the t value of the estimated coefficient of does not follow
the t distribution even in large samples; that is, it does not have an asymptotic normal
distribution. This suggests that t-test is not applicable and instead we use widely used test called
Dickey-Fuller test.

Dickey and Fuller have shown that under the null hypothesis that δ = 0, the estimated t value of

the coefficient of in (2.23) follows the τ (tau) statistic. A sample of these critical values is
given D-F table. In the literature the tau statistic or test is known as the Dickey–Fuller (DF)
test, in honor of its discoverers.

39
The actual procedure of implementing the DF test involves several decisions. In discussing the
nature of the unit root process in sections 2.3 and 2.4, we noted that a random walk process may
have no drift, or it may have drift or it may have both deterministic and stochastic trends. To

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allow for the various possibilities, the DF test is estimated in three different forms, that is, under
three different null hypotheses.

is a random walk: = + (2.23)

is a random walk with drift: =β1 + + (2.25)

is a random walk with drift

around a stochastic trend: =β1+ β2t + + (2.26)

where t is the time or trend variable. In each case, the null hypothesis is that δ = 0; that is, there is
a unit root-the time series is non-stationary. The alternative hypothesis is that δ is less than zero;

that is, the time series is stationary. If the null hypothesis is rejected, it means that is a

stationary time series with zero mean in the case of (2.23), that is stationary with a non-zero

mean [= β1/(1 − ρ)] in the case of (2.25), and that is stationary around a deterministic trend in
(2.26).

It is extremely important to note that the critical values of the tau test to test the hypothesis that δ
= 0, are different for each of the preceding three specifications of the DF test, which can be seen
tau table. Moreover, if, say, specification (2.25) is correct, but we estimate (2.23), we will be
committing a specification error, whose consequences we already know from Chapter 4 of
Econometrics I.

The actual estimation procedure is as follows: Estimate (2.23), or (2.24), or (2.25) by OLS;

divide the estimated coefficient of in each case by its standard error to compute the (τ) tau
statistic; and refer to the DF tables (or any statistical package). If the computed absolute value of
the tau-statistic (|τ |) exceeds the DF or MacKinnon critical tau values, we reject the hypothesis
that δ = 0, in which case the time series is stationary. On the other hand, if the computed |τ | does
not exceed the critical tau value, we do not reject the null hypothesis, in which case the time
series is non-stationary. Make sure40that you use the appropriate critical τ values.

Example: The results of the regressions is as follows: The dependent variable in is

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= 28.2054 − 0.00136 (2.27)

t = (1.1576) (−0.2191) R2 = 0.00056 d = 1.35

Our primary interest here is in the t (= τ) value of the coefficient. The critical 1, 5, and
10 percent τ values are −3.5064, −2.8947, and −2.5842. The estimated δ coefficient is negative,
implying that the estimated ρ is less than 1. The estimated τ value is −0.2191, which in absolute
value is below even the 10 percent critical value of −2.5842. Since, in absolute terms, the former
is smaller than the latter, our conclusion is that the GDP time series is not stationary.

2.6.2. Transforming non-stationary time series

Now that we know the problems associated with non-stationary time series, the practical
question is what to do. To avoid the spurious regression problem that may arise from regressing a
non-stationary time series on one or more non-stationary time series, we have to transform non-
stationary time series to make them stationary. The transformation method depends on whether
the time series are difference stationary (DSP) or trend stationary (TSP). We consider each of
these methods in turn.
Difference-Stationary Processes
If a time series has a unit root, the first differences of such time series are stationary 5. Therefore,
the solution here is to take the first differences of the time series. Returning to our U.S. GDP
time series, we have already seen that it has a unit root. Let us now see what happens if we take
the first differences of the GDP series.

Let . For convenience, let = . Now consider the following

regression:

= 16.0049 − 0.06827
t = (3.6402) (−6.6303) (2.28)
41
R2 = 0.3435 d = 2.0344

5
If a time series is I(2), it will contain two unit roots, in which case we will have to
difference it twice. If it is I(d), it has to be differenced d times, where d is any integer.

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The 1 percent critical DF τ value is −3.5073. Since the computed τ (= t) is more negative than the
critical value, we conclude that the first-differenced GDP is stationary; that is, it is I(0).

Trend-Stationary Process
The simplest way to make Trend-Stationary Process time series stationary is to regress it on time
and the residuals from this regression will then be stationary. In other words, run the following
regression:

= β + β2t + (2.29)

where is the time series under study and where t is the trend variable measured
chronologically. Now

=( - - ) (2.30)

will be stationary. is known as a (linearly) detrended time series.

It should be pointed out that if a time series is DSP but we treat it as TSP, this is called
underdifferencing. On the other hand, if a time series is TSP but we treat it as DSP, this is called
overdifferencing. The consequences of these types of specification errors can be serious,
depending on how one handles the serial correlation properties of the resulting error terms.
In passing it may be noted that most macroeconomic time series are DSP rather than TSP.

2.8 Review Questions

Answer the following questions briefly.

1. What is meant by stationarity and unit roots ?

2. Discuss the concept of spurious regression?

3. Distinguish between Trend Stationary Process(TSP) and a Difference Stationary Process

42
(DSP)

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4. Proof mathemathecally that a random walk model without a drift is non-stationary while
its first-difference is stationary.

5. A time-series that has a unit root is called a random walk. Explain.

CHAPTER THREE

An Introduction to Simultaneous Equation Models

Topic Learning Objectives

The purpose of this chapter is to introduce the student very briefly about the concept
of simultaneous dependence of economic variables.

After the student has completed this chapter, he/she will

 Understand the concept of simultaneous equation

 Distinguish between endogeneous and exogeneous variables in a model

 Be able to derive reduced form equations from structural equations

 Understand the concept of inderidentified, identified and overidentified

equations.

 Be able to conduct test of simultaneity.

Topic Outline

3.1. The Nature of Simultaneous Equation Models

3.2. Simultaneity bias

3.3. Order and rank conditions of identification (without proof)

43

3.4. Indirect squares and 2SLS estimation of structural equations

3.5. Approaches to Estimation

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3.6. Review questions

3.1. Nature of Simultaneous Equation models

In all the previous chapters discussed so far, we have been focusing exclusively with the
problems and estimations of a single equation regression models. In such models, a dependent
variable is expressed as a linear function of one or more explanatory variables. The cause-and-
effect relationship in such models between the dependent and independent variable is
unidirectional. That is, the explanatory variables are the cause and the independent variable is
the effect. But there are situations where such one-way or unidirectional causation in the function
is not meaningful. This occurs if, for instance, Y (dependent variable) is not only function of X’s
(explanatory variables) but also all or some of the X’s are, in turn, determined by Y. There is,
therefore, a two-way flow of influence between Y and (some of) the X’s which in turn makes the
distinction between dependent and independent variables a little doubtful. Under such
circumstances, we need to consider more than one regression equations; one for each
interdependent variables to understand the multi-flow of influence among the variables. This is
precisely what is done in simultaneous equation models.

3.2. Simultaneous Bias

A system describing the joint dependence of variables is called a system of simultaneous

equation or simultaneous equations model. The number of equations in such models is equal to
the number of jointly dependent or endogenous variables involved in the phenomenon under
analysis. Unlike the single equation models, in simultaneous equation models it is not usually
possible (possible only under specific assumptions) to estimate a single equation of the model
without taking into account the information provided by other equation of the system. If one
44
applies OLS to estimate the parameters of each equation disregarding other equations of the
model, the estimates so obtained are not only biased but also inconsistent; i.e. even if the sample
size increases indefinitely, the estimators do not converge to their true values.

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The bias arising from application of such procedure of estimation which treats each equation of
the simultaneous equations model as though it were a single model is known as simultaneity bias
or simultaneous equation bias.

What happens to the parameters of the relationship if we estimate by applying OLS to each
equation without taking into account the information provided by the other equations in the
system? The application of OLS to estimate the parameters of economic relationships
presupposes the classical assumptions discussed in Econometrics I. One of the crucial
assumptions of the OLS is that the explanatory variables and the disturbance term is independent

i.e. the disturbance term is truly exogenous. Symbolically: . As a result, the linear
model could be interpreted as describing the conditional expectation of the dependent variable
(Y) given a set of explanatory variables. In the simultaneous equation models, such

independence of explanatory variables and disturbance term is violated i.e. . If this

assumption is violated, the OLS estimator is biased and inconsistent and hence we can treat
simultanoues bias as violation of assumption of independence of explanatory variables and the
disturbance term.

Simultaneity bias of OLS estimators: The two-way causation in a relationship leads to

violation of the important assumption of linear regression model, i.e. one variable can be
dependent variable in one of the equation but becomes also explanatory variable in the other

equations of the simultaneous-equation model. In this case may be different from zero.
To show simultaneity bias, let’s consider the following simple simultaneous equation model.

Y=α0+α1 X+U ¿} ¿¿¿

-------------------------------------------------- (3.1)
45

Suppose that the following assumptions hold (recall assumptions of classical regression model).

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Ε(U )=0 , Ε(V )=0

Ε(U 2 )=σ 2u , Ε(V 2 )=σ 2u
Ε(U i U j )=0 , Ε(V i V j )=0 , also Ε(UiVi )=0 ;

where X and Y are endogenous variables and Z is an exogenous variable.

The reduced form of X of the above model is obtained by substituting Y in the equation of X.

X =β 0 + β 1 ( α 0 + α 1 X +U )+ β 2 Z+ V

( ) ( )
β 0 +α 0 β 1 β2 β1 U +V
X= + Z+ −−−−−−−−−−−−−−−−−−−−−(3 . 2)
1−α 1 β 1 1−α 1 β 1 1−α 1 β1

Applying OLS to the first equation of the above structural model will result in biased estimator

becausecov ( X i U i )=Ε ( X i U j )≠0 . Now, let’s proof whether this is the case or not.

cov ( XU )=Ε [ { X−Ε( X ) }{ U−Ε (U ) } ]

=Ε [ { X −Ε( X ) } U ]−−−−−−−−−−−−−−−−−−−−−−−−−(3. 3 )

[{ ( ) ( ) ( ) }]
β 0+ α0 β 1 β2 β 1 U +V β 0 + α 0 β1 β2
=Ε + Z+ − − Z U
1−α 1 β1 1−α 1 β 1 1−α 1 β 1 1−α 1 β 1 1−α 1 β 1

=Ε
[{ U
( β U +V )
1−α 1 β 1 1 }]
=
( 1
1−α 1 β 1 ) 2
Ε( β 1 U +UV )

( )
β1 2 β1 σ 2u
= Ε(U )= ≠0
1−α 1 β 1 1−α 1 β 1
, since
46
That is, covariance between X and U is not zero. As a consequence, if OLS is applied to each
equation of the model separately the coefficients will turn out to be biased. Now, let’s examine
how the non-zero co-variance of the error term and the explanatory variable will lead to biasness

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in OLS estimates of the parameters. If we apply OLS to the first equation of the above structural

equation (10)
Y =α 0 +α 1 X +U , we obtain

Σ xy Σx(Y − Ȳ ) Σ xY Ȳ Σx
α^ 1= = =
Σx 2 Σx2 Σx2 ; (since Σx2 is zero)

Σx( α 0 + α 1 X + U ) α 0 Σx Σ xU Σ xU
= = 2
+ α1 +
Σx 2
Σx Σx 2 Σx 2

Σ xX
2
=1
But, we know that Σx=0 and Σx , hence

Σ xU
^
α=α 1+ −−−−−−−−−−−−−−−−−−−−−−(3 . 4 )
Σx2

Taking the expected values on both sides;

Ε( α^ )=α 1 + Ε
( Σ xU
Σx2 )
Since, we have already proved that Ε( Σ XU )≠0 ; which is the same as Ε( XU )≠0 .

Consequently, when Ε( XU )≠0 ; Ε( α^ )≠α , that is α^ 1 will be biased by the amount equivalent
Σ xu
2
to Σx .

3.3. Definitions of Some Concepts

I) Endogenous and exogenous variables

In simultaneous equation models variables are classified as endogenous and predetermined. The
endogenous variables are variables whose values are determined by the economic model (within
the system or model) and predetermined are those variables whose values are determined outside
47
the model. Predetermined variables can be divided into two categories. These are: exogenous as

well as current and lagged exogenous variables. For instance;

X t and X t−1 depict the current

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and lagged exogenous variables and

Y t−1 depicts lagged endogenous variable. This is on the
assumption that X’s symbolize the exogenous variables and Y’s symbolize the endogenous

variables. Thus,
X t , X t−1 and Y t−1 are regarded as predetermined variables.

Consider the demand and supply functions.

Qd =β0 +β 1 P+β 2 Y +U 1 −−−−−−−−−−−−−−−−−−(3. 5 )

Q s=α 0 +α 1 P+α 2 R+U 2−−−−−−−−−−−−−−−−−−−3 . 6)

where : Q=quantity , Y=income, P=price, R=Rainfalls, U 1 ∧U 2 are error terms.

Here P and Q are endogenous variables and Y and R are exogenous variables.

II) Structural models

A structural model describes the complete structure of the relationships among the economic
variables. Structural equations of the model may be expressed in terms of endogenous variables,
exogenous variables and disturbances (random variables). The parameters of structural model
express the direct effect of each explanatory variable on the dependent variable. Variables not
appearing in any function explicitly may have an indirect effect and is taken into account by the
simultaneous solution of the system. For instance, a change in consumption affects the
investment indirectly and is not considered in the consumption function. The effect of
consumption on investment cannot be measured directly by any structural parameter, but is
measured indirectly by considering the system as a whole.

Example: The following simple Keynesian model of income determination can be considered as
a structural model. 48

C=α + βY +U ----------------------------------------------- (3.7)

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Y =C + Z ---------------------------------------------------- (3.8)

for a >0 and 0<b<1

where: C=consumption expenditure

Z=non-consumption expenditure

Y=national income

C and Y are endogenous variables while Z is exogenous variable.

III) Reduced form of the model:

The reduced form of a structural model is the model in which the endogenous variables are
expressed a function of the predetermined variables and the error term only.

Illustration: Find the reduced form of the above structural model.

Since C and Y are endogenous variables and only Z is the exogenous variables, we have to
express C and Y in terms of Z. To do this substitute Y=C+Z into equation (16).

C=α + β ( C+ Z ) + U

C=α + βC+ βZ +U

C−βC=α + βZ+ U

C (1−β )=α + βZ +U

C=
α
+
β
1−β 1−β( ) U
Z + 49
1−β ---------------------------------- (3.9)

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Substituting again (9) into (8) we get;

Y=
α
+
1
1−β 1−β( )
Z+
U
1−β -------------------------------- (3.10)

Equation (9) and (10) are called the reduced form of the structural model of the above. We can
write this more formally as:

Structural form equations Reduced form equations

C    Y  U     U
C    Z 
1  1   1 

Y C  Z   1  U
Y    Z 
1  1   1 

Parameters of the reduced form measure the total effect (direct and indirect) of a change in
exogenous variables on the endogenous variable. For instance, in the above reduced form

equation(9),
( )
β
1−β measures the total effect of a unit change in the non-consumption

expenditure on consumption. This total effect is β , the direct effect, times

( 1−β
1
) ,the indirect
effect.

The reduced form equations can be obtained in two ways:

50
1) To express the endogenous variables directly as a function of the predetermined variables.
2) To solve the structural system of endogenous variables in terms of the predetermined
variables, the structural parameters, and the disturbance terms.

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3. 4. The Identification Problem

Note that since the reduced form coefficients can be estimated by the OLS method and these
coefficients are combinations of the structural coefficients, the possibility exist that the structural
coefficients can be “retrieved” from the reduced-form coefficients, and it is in the estimation of
the structural parameters that we may be ultimately interested. Unfortunately, retrieving the
structural coefficients from the reduced form coefficients is not always possible; this problem is
one way of viewing the identification problem.

By the identification problem we mean whether numerical estimates of the parameters of a

structural equation can be obtained from the estimated reduced-form coefficients. If this can be
done, we say that the particular equation is identified. If this cannot be done, then we say that the
equation under consideration is unidentified, or under identified. Note that the identification
problem is a mathematical (as opposed to statistical) problem associated with simultaneous
equation systems. It is concerned with the equation of the possibility or impossibility of
obtaining meaningful estimates of the structural parameters.

An identified equation may be either exactly (or fully or just) identified or over identified. It is
said to be over identified if more than one numerical value can be obtained for some of the
parameters of the structural equations. The circumstances under which each of these cases occurs
will be shown in the following discussion.

a) Under Identification

Example: Consider the following linear demand and supply models.

Demand function = a0 + a1Pt + U1t ……………………………... (3.11)

51

Supply function = b0 + b1Pt + U2t………………………………… (3.12)

Equilibrium Condition = ……………….……………………….. (3.13)

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Where = Quantity demanded, = Quantity supplied, P = price and t = time

By the equilibrium condition (i.e., = ) we obtain,

a0 + a1Pt + U1t = b0 + b1Pt + U2t …………………………… (3.14)

Solving (3.14) using the substitution technique, we obtain the equilibrium price

Pt = p0 + Vt …………………………………………..(3.15)

where = V1 =

Then, we obtain the following equilibrium quantity:

= + …………………………….. (3.16)

where = Wt =

Note that and , (the reduced-form-coefficients) contain all four structural parameters; a0,
a1, b0 and b1. But, there is no way in which the four structural unknowns can be estimated from
only two reduced form coefficients. Recall from Algebra for Economists that to estimate four
unknowns we must have four (independent) equations, and in general, to estimate k unknowns
we must have R (independent) equations. What all this means is that, given time series data on
p(price) and Q(quantity) and no other information, there is no way the researcher guarantee

whether he/she is estimating the demand function or the supply function. That is, a given and

represent simply the point of intersection of the appropriate demand and supply curves
because of the equilibrium condition that demand is equal to supply.

52
b) Just or Exact Identification

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The reason we could not identify the preceding demand function or the supply function was that
the same variables P and Q are present in both functions and there is no additional information.
But suppose we consider the following demand and supply model.

Demand function = a0 + a1Pt +a2It + U1t , a1 < 0, a2 > 0 ……………... (3.17)

Supply function = b0 + b1Pt + b2Pt-1 +U2t , b1 > 0, b2 > 0 ……………… (3.18)

where I = income of the consumer, an exogenous variable

Pt-1 = Price lagged one period, usually incorporated in the model to explain the supply of
many agricultural commodities. Note that Pt-1 is a predetermined variable because its value is
known at time t. By the market-clearing mechanism we have

a0 + a1Pt +a2 It + U1t = b0 + b1Pt + b2Pt-1 +U2t …………...............… (3.19)

Solving this equation, we obtain the following equilibrium price

Pt = p0 + p1It + p2Pt-1 + Vt ……………….............................. …………(3.20)

Where = =- = =

Substituting the equilibrium price (3.20) into the demand or supply equation of (3.17) or (3.18)
we obtain the corresponding equilibrium quantity:

Qt = p3 + p4It + psPt-1 + Wt …......................................……..(3.21)

where the reduced-form coefficients are

= = = =

the demand-and-supply model given in equations (3.17) and (3.18) contain six structural
53
coefficients a0, a1, a2, b0, b1, and b2 – and there are six reduced form coefficients - p0, p1, p2, p3,
p4 and p5 – to estimate them. Thus, we have six equations in six unknowns, and normally we

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should be able to obtain unique estimates. Therefore, the parameters of both the demand and
supply equations can be identified and the system as a whole can be identified.

c) Over identification

Note that for certain goods and services, wealth of the consumer is another important
determinant of demand. Therefore, the demand function (3.17) can be modified as follows,
keeping the supply function as before:

Demand function = a0 + a1Pt +a2It +a3Rt + U1t ……………... (3.22)

Supply function = b0 + b1Pt + b2Pt-1 +U2t ………………………… (3.23)

Where R represents wealth

Equating demand to supply, we obtain the following equilibrium price and quantity

Pt = p0 + p1It + p2Rt + p3Pt-1 + Vt ……………………………..….. (3.24)

Qt = p4 + p5It + p6Rt + p7Pt-1 + Wt ……………………………….... (3.25)

Where = = = =

= = = =

= = = =

The demand and supply model in (3.22) and (3.23) contains seven structural coefficients, but
54
there are eight equations to estimate them – the eight reduced form coefficients given above (i.e.,
p0 … p7). Notice that the number of equations is greater than the number of unknowns. As a

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result, unique estimation of all the parameters of our model is not possible. For example, one can
solve for b1 in the following two ways

= or =

That is, there are two estimates of the price coefficient in the supply function, and there is no
guarantee that these two values or solutions will be identical. Moreover, since b1 will be
transmitted to other estimates. Note that the supply function is identified in the system (3.17) and
(3.18) but not in the system (3.22) and (3.23), although in both cases the supply function remains
the same. This is because we have “too much” or an over sufficiency of information to identify
the supply curve. The over sufficiency of the information results from the fact that in the model
(3.22) and (3.23) the exclusion of the income variable form the supply function was enough to
identify it, but in the model (3.22) and (3.23) the supply function excludes not only the income
variable but also the wealth variable. However, this situation does not imply that over
identification is necessarily bad since the problem of too much information can be handled.

Notice that the situation is the opposite of the case of under identification where there is too little
information. The only way in which the structural parameters of unidentified (or under
identified) equations can be identified (and thus be capable of being estimated) is through
imposition of further restrictions, or use of more extraneous information. Such restrictions, of
course, must be imposed only if their validity can be defended.

In a simple example such as the forgoing, it is easy to check for identification; in more
complicated systems, however, it is not so easy. This time consuming procedure can be avoided
by resorting to either the orders condition or the rank condition of identification. Although the
order condition is easy to apply, it55provides only a necessary condition for identification. On the
other hand, the rank condition is both a necessary and sufficient condition for identification.
Hence, in the next section we discuss orders condition or the rank condition of identification.

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3.4.1 Establishing Identification from the Structural Form of the Model

There are two conditions which must be fulfilled for an equation to be identified.

1. The Order Condition for Identification

This condition is based on a counting rule of the variables included and excluded from the
particular equation. It is a necessary but not sufficient condition for the identification of an
equation. The order condition may be stated as follows.

For an equation to be identified the total number of variables (endogenous and exogenous)
excluded from it must be equal to or greater than the number of endogenous variables in the
model less one. Given that in a complete model the number of endogenous variables is equal to
the number of equations of the model, the order condition for identification is sometimes stated
in the following equivalent form. For an equation to be identified the total number of variables
excluded from it but included in other equations must be at least as great as the number of
equations of the system less one.

Let: G = total number of equations (= total number of endogenous variables)

K= number of total variables in the model (endogenous and predetermined)

M= number of variables, endogenous and exogenous, included in a particular equation.

Then the order condition for identification may be symbolically expressed as:

( K − M )≥ (G −1 )
[ excluded ¿ ] ¿ ¿ ¿ ¿
¿
¿

For example, if a system contains 10 equations with 15 variables, ten endogenous and five
exogenous, an equation containing
56 11 variables is not identified, while another containing 5
variables is identified.

a. For the first equation we have

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G=10 K =15 M =11

Order condition:

( K−M )≥(G−1)
(15−11)<(10−1 ) ; that is, the order condition is not satisfied.

b. For the second equation we have

G=10 K =15 M =5

order condition:

( K−M )≥(G−1)
(15−5 )<(10−1) ; that is, the order condition is satisfied.

The order condition for identification is necessary for a relation to be identified, but it is not
sufficient, that is, it may be fulfilled in any particular equation and yet the relation may not be
identified.

2. The Rank Condition for Identification

The rank condition states that: in a system of G equations any particular equation is identified if
and only if it is possible to construct at least one non-zero determinant of order (G-1) from the
coefficients of the variables excluded from that particular equation but contained in the other
equations of the model. The practical steps for tracing the identifiability of an equation of a
structural model may be outlined as follows.

Firstly. Write the parameters of all the equations of the model in a separate table, noting that the
parameter of a variable excluded from an equation is equal to zero.

Example 1: For example let a structural model be:

57
y 1 =3 y 2−2 x 1 + x 2 +u 1

y 2 = y 3 + x 3 +u2

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y 3 = y 1 − y 2 −2 x 3 + u3

where the y’s are the endogenous variables and the x’s are the predetermined variables. This
model may be rewritten in the form

− y 1 +3 y 2 +0 y 3 −2 x 1 + x 2 + 0 x3 +u1 =0

0 y 1 − y 2 + y 3 +0 x 1 +0 x 2 + x 3 +u 2=0

y 1 − y 2 − y 3 +0 x 1 +0 x 2 −2 x 3 +u3 =0

Ignoring the random disturbance the table of the parameters of the model is as follows:

Variables

Equations Y1 Y2 Y3 X1 X2 X3

1st equation -1 3 0 -2 1 0

2nd equation 0 -1 1 0 0 1

3rd equation 1 -1 -1 0 0 -2

Secondly. Strike out the row of coefficients of the equation which is being examined for
identification. For example, if we want to examine the identifiability of the second equation of
the model we strike out the second row of the table of coefficients.

Thirdly. Strike out the columns in which a non-zero coefficient of the equation being examined
appears. By deleting the relevant row and columns we are left with the coefficients of variables
not included in the particular equation, but contained in the other equations of the model. For
example, if we are examining for identification the second equation of the system, we will strike
out the second, third and the sixth columns of the above table, thus obtaining the following
58
tables.

Table of structural parameters Table of parameters of excluded variables

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Y1 Y2 Y3 X1 X2 X3 Y3 X1 X2
¯ ¯ ¯
st
1 -1 3 0 -2 1 0 -1 -2 1

®2nd 0 -1 1 0 0 1
3rd
1 -1 -1 0 0 -2 1 0 0

Fourthly. Form the determinant(s) of order (G-1) and examine their value. If at least one of
these determinants is non-zero, the equation is identified. If all the determinants of order (G-1)
are zero, the equation is underidentified. In the above example of exploration of the
identifiability of the second structural equation, we have three determinants of order (G-1)=3-
1=2. They are:

Δ 1= ¿|−1 −2 ¿|¿ ¿ ¿
¿
(the symbol Δ stands for ‘determinant’) We see that we can form two non-zero determinants of
order G-1=3-1=2; hence the second equation of our system is identified.

Fifthly. To see whether the equation is exactly identified or overidentified we use the order

condition ( K−M )≥(G−1). With this criterion, if the equality sign is satisfied, that is if
( K−M )=(G−1) , the equation is exactly identified. If the inequality sign holds, that is, if
( K−M )<(G−1 ) , the equation is overidentified.

In the case of the second equation we have:

G=3 K=6 M=3

And the counting rule ( K−M )≥(G−1) gives

59
(6-3)>(3-1)

Therefore the second equation of the model is overidentified.

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Example 2. Assume that we have a model describing the market of an agricultural product.
From the theory of partial equilibrium we know that the price in a market is determined by the
forces of demand and supply. The main determinants of the demand are the price of the
commodity, the prices of other commodities, incomes and tastes of consumers. Similarly, the
most important determinants of he supply are the price of the commodity, other prices,
technology, the prices of factors of production, and weather conditions. The equilibrium
condition is that demand be equal to supply. The above theoretical information may be
expressed in the form of the following mathematical model.

D=a0 + a1 P1 + a2 P2 + a3 Y + a4 t+u

D=b0 +b1 P1 +b2 P2 +b3 C+b4 t+w

D=S

Where: D= quantity demanded

S= quantity supplied

P1 = price of the given commodity

P2 = price of other commodities

Y= income

C= costs (index of prices of factors of production)

t= time trend. In the demand function it stands for ‘tastes’; in the supply function it
stands for ‘technology’.

60 complete in the sense that it contains three equations in three

The above model is mathematically
endogenous variables, D,S and P1. The remaining variables, Y, P 2, C, t are exogenous. Suppose
we want to identify the supply function. We apply the two criteria for identification:

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1. Order condition: ( K−M )≥(G−1)

In our example we have: K=7 M=5 G=3

Therefore, (K-M)=(G-1) or (7-5)=(3-1)=2

Consequently the second equation satisfies the first condition for identification.

2. Rank condition
The table of the coefficients of the structural model is as follows.

Variables

Equations D P1 P2 Y t S C

1st equation -1 a1 a2 a3 a4 0 0
b1 b2 0 b4
2nd equation 0 -1 b3
0 0 0
3rd equation 1 0 1 0

Following the procedure explained earlier we strike out the second row an the second, third,
fifth, sixth and seventh columns. Thus we are left with the table of the coefficients of excluded
variables:

Complete table of Table of parameters

of variables
Structural parameters excluded from the
second equation

-1 a1 a2 a3 a4 0 0 -1 a3
b1 b2 0 b4 b3
0 1
0 0 0 1
1 0 1 -1 0

From this table we can form only 61

one non-zero determinant of order

(G-1) = (3-1) =2

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Δ=¿|−1 a3 ¿|¿ ¿ ¿
¿

The value of the determinant is non-zero, provided that

a 3≠0 .

We see that both the order and rank conditions are satisfied. Hence the second equation of the
model is identified. Furthermore, we see that in the order condition the equality holds: (7-5) =
(3-1) = 2. Consequently the second structural equation is exactly identified.

3.5. Approaches to Estimation

As we have discussed in section 3.2, the bias arising from application of OLS estimation
which treats each equation of the simultaneous equations model as though it were a single
model is known as simultaneity bias or simultaneous equation bias. To avoid this bias we
use other methods of estimation, such as, Indirect Least Square (ILS), Two Stage Least
Square (2SLS), three Stage Least Square(3SLS), Maximum Likelihood Methods and the
Method of Instrumental Variable (IV). However, in view of the introductory nature of this
course we shall consider very briefly the following techniques.

1. The Method of Indirect Least Squares (ILS)

For just or exactly identified structural equation, the method of obtaining the estimates of the
structural coefficients from the OLS estimators of the reduced form coefficients is known as the
method of indirect least squares (ILS). ILS involves the following three steps

Step I: - We first obtain the reduced form equations.

Step II: - Apply OLS to the reduced form equations individually.

Step III: - Obtain estimates of the original structural coefficients from the estimated reduced
62
form coefficients obtained in step II.

2. The Method of two stage least squares (2SLS)

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This method is applied in estimating an over identified equation. Theoretically, the two stages
least squares may be considered as an extension of ILS method. The 2SLS method boils down to
the application of ordinary list squares in two stages. That is, in the first stage, we apply least
squares to the reduced form equations in order to obtain an estimate of the exact and random
components of the endogenous variables appearing in the right hand side of the equation with
their estimated value and then we apply OLS to the transformed original equation to obtain
estimates of the structural parameters.

Note, however, that since 2SLS is equivalent to ILS in the just-identified case, it is usually
applied uniformly to all identified equations in the system.

3.6. Review Questions

Answer the following questions briefly.

1. What do we mean by simultaneous equation?

2. What do we mean by simultaneity bias?

3. When do we say a model is over identified? What is the consequence of over

identification?

4. Briefly explain the ILS and 2SLS approaches to estimation.

5. What is the economic meaning of the imposition of “Zero restriction” on the parameters
of a model?

6. Consider the following hypothetical model:

It=0 +α1Yt +ut

Yt=Qt+It 63

A. Identify the endogeneous and exogeneous variables.

B. Write the reduced form equation expressed.

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7. Given the simple Keynesian Model of Income –determination , derive the reduced form
of the behavioral equations.

Ct=0 +α1Yt +u1

It=0 +β1Yt + β2 Yt-1 +u2

Yt=Ct+It+ Gt+u3

8. Take as a model of wage-price behavior:

W t =a0 +a1 (UN )t +a2 Pt +ε 1 t ,

Pt =b 0 +b1 M t +b2 (UN )t + b3 W t +ε 2 t ,

where

W = the percentage change in wages,

UN = the rate of unemployment,

P = the percentage change in prices,

Mt = the percentage change in the money supply, and

ε 1 and ε 2= disturbance terms .

Assume that
ε 1t and ε 2t have zero means, constant variances, are not autocorrelated, and

are independent of (UN)t and Mt.

A. Are the above equations identified ? Explain. If so what type of

identification is it?
64

B. Outline an estimation procedure for the identified equation.

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9. Suppose that private investment spending is such that

I it = a +b 1 r it +b2 Si( t−1 )+uit , i = 1,. . ., N,

r it=r t +b3 I it +ε it ,

where

Iit = investment expenditures of the ith firm at time t,

rit = the rate of interest it must pay for investment funds,

Si(t-1) = its sales in period t – 1 , and

rt = the economy-wide average interest rate for investment funds,

We assume that these N firms are large so that the level of their investment expenditure affects

the interest rate they face. Assume the standard conditions concerning u it and
ε it . Assume also
that we have only cross-sectional data.

Discuss whether or not the equations are identified.(Hint: use the rank condition for
identification)

10. Consider the model

65

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C t =b0 +b1 C t−1 +b 2 Y t +ε 1 t (1)

Y t =I t +Ct , (2 )

I t =a 0 +a 1 Y t +a2 Y t−1 +a 3 r t +ε 2 t , (3 )

where C, I, Y, and r are, respectively, consumer expenditures, investment, income, and

the interest rate. Assume that ε 1 and ε 2 are not autocorrelated and are independent of rt.

a. List the endogenous variables and the predetermined variables in the model.

b. How would you estimate equation (1)?

c. How would you estimate equation (3)?

CHAPTER FOUR

Panel Data Regression Models

Topic Learning Objectives

The aim of this chapter is to introduce the students with the basic concept of panel data and panel
data regression models.

After studying this chapter students will be able to

 Understand the nature of panel data

 Identify the advantages of panel data.

 See the estimation of panel data regression models

 Distinguish between Fixed effect and Random effect models.

Topic outline
66

4.1. Introduction

4.2. Estimation of Panel Data Regression Model: The Fixed Effects Approach

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4.3. Estimation of Panel Data Regression Model: The Random Effects Approach

4.4. Fixed Effects (LSDV) versus Random Effects Model

4.5. Review exercise

4.1. Introduction

In Econometrics I we discussed briefly the types of data that are generally available for empirical
analysis, namely, time series, cross section, and panel. In time series data we observe the
values of one or more variables over a period of time (e.g., GDP for several quarters or years). In
cross-section data, values of one or more variables are collected for several sample units, or
entities, at the same point in time (e.g., crime rates for 50 states in the United States for a given
year). In panel data the same cross-sectional unit (say a family or a firm or a state) is surveyed
over time. In short, panel data have space as well as time dimensions.

There are other names for panel data, such as pooled data (pooling of time series and cross-
sectional observations), combination of time series and cross-section data, micropanel data,
longitudinal data (a study over time of a variable or group of subjects), event history analysis
(e.g., studying the movement over time of subjects through successive states or conditions),
cohort analysis (e.g., following the career path of 1965 graduates of a business school).
Although there are subtle variations, all these names essentially connote movement over time of
cross-sectional units. We will therefore
67 use the term panel data in a generic sense to include one
or more of these terms. And we will call regression models based on such data panel data
regression models.

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Why panel data?

What are the advantages of panel data over cross-section or time series data? Baltagi lists the
following advantages of panel data:

1. Since panel data relate to individuals, firms, states, countries, etc.,over time, there is bound to
be heterogeneity in these units. The techniques of panel data estimation can take such
heterogeneity explicitly into account by allowing for individual-specific variables, as we shall
show shortly. We use the term individual in a generic sense to include microunits such as
individuals, firms, states, and countries.

2. By combining time series of cross-section observations, panel data give “more informative
data, more variability, less collinearity among variables, more degrees of freedom and more
efficiency.”

3. By studying the repeated cross section of observations, panel data are better suited to study the
dynamics of change. Spells of unemployment, job turnover, and labor mobility are better studied
with panel data.

4. Panel data can better detect and measure effects that simply cannot be observed in pure cross-
section or pure time series data. For example, the effects of minimum wage laws on employment
and earnings can be better studied if we include successive waves of minimum wage increases in
the federal and/or state minimum wages.

5. Panel data enables us to study more complicated behavioral models. For example, phenomena
such as economies of scale and technological change can be better handled by panel data than by
pure cross-section or pure time series data.

6. By making data available for several thousand units, panel data can minimize the bias that
might result if we aggregate individuals or firms into broad aggregates.

In short, panel data can enrich empirical

68 analysis in ways that may not be possible if we use only
cross-section or time series data. This is not to suggest that there are no problems with panel data
modeling. We will discuss them after we cover some theory and discuss an example.

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Panel data: an illustrative example

To set the stage, let us consider a concrete example. Consider the data given in Table 16.1, which
are taken from a famous study of investment theory proposed by Y. Grunfeld. Grunfeld was

interested in finding out how real gross investment (Y) depends on the real value of the firm ( )

and real capital stock ( ). Although the original study covered several companies, for
illustrative purposes we have obtained data on four companies, General Electric (GE), General
Motor (GM), U.S. Steel (US), and Westinghouse. Data for each company on the preceding three
variables are available for the period 1935–1954. Thus, there are four cross-sectional units and
20 time periods. In all, therefore, we have 80 observations. A priori, Y is expected to be

positively related to and .

In principle, we could run four time series regressions, one for each company or we could run 20
cross-sectional regressions, one for each year, although in the latter case we will have to worry
about the degrees of freedom (see the raw data). Pooling, or combining, all the 80 observations,
we can write the Grunfeld investment function as:

= 1, 2, 3, 4 and t = 1, 2, . . . , 20
where i stands for the ith cross-sectional unit and t for the tth time period.

As a matter of convention, we will let i denote the cross-section identifier and t the time
identifier. It is assumed that there are a maximum of N cross sectional units or observations and a
maximum of T time periods. If each cross-sectional unit has the same number of time series
observations, then such a panel (data) is called a balanced panel. In the present example we
have a balanced panel, as each company in the sample has 20 observations.

If the number of observations differs among panel members, we call such a panel an unbalanced
69
panel. In this chapter we will largely be concerned with a balanced panel. Initially, we assume
that the X’s are non-stochastic and that the error term follows the classical assumptions, namely,

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E( ) N(0, σ2).Notice carefully the double and triple subscripted notation, which should be
self-explanatory. How do we estimate (4.1)? The answer follows.

4.1. Estimation of Panel Data Regression Models: The Fixed Effects Approach

Estimation of (4.1) depends on the assumptions we make about the intercept, the slope

coefficients, and the error term, . There are several possibilities:

1. Assume that the intercept and slope coefficients are constant across time and space and the
error term captures differences over time and individuals.
2. The slope coefficients are constant but the intercept varies over individuals.
3. The slope coefficients are constant but the intercept varies over individuals and time.
4. All coefficients (the intercept as well as slope coefficients) vary over individuals.
5. The intercept as well as slope coefficients vary over individuals and time.

As you can see, each of these cases introduces increasing complexity (and perhaps more reality)
in estimating panel data regression models, such as (4.1). Of course, the complexity will increase
if we add more regressors to the model because of the possibility of collinearity among the
regressors. To cover each of the preceding categories in depth will require a separate book, and
there are already several ones on the market. In what follows, we will cover some of the main
features of the various possibilities, especially the first four. Our discussion is nontechnical.

1. All Coefficients Constant across Time and Individuals

The simplest, and possibly naive, approach is to disregard the space and time dimensions of the
pooled data and just estimate the usual OLS regression. That is, stack the 20 observations for
each company one on top of the other, thus giving in all 80 observations for each of the variables
in the model. The OLS results are as follows

= −63.3041 + 0.1101 + 0.3034

70
se = (29.6124) (0.0137) (0.0493)
t = (−2.1376) (8.0188) (6.1545) (4.2)
= 0.7565, Durbin–Watson = 0.2187, n = 80 and df = 77

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If you examine the results of the pooled regression, and applying the conventional criteria, you
will see that all the coefficients are individually statistically significant, the slope coefficients
have the expected positive signs and the R2 value is reasonably high. As expected, Y is positively
related to X2 and X3. The “only” fly in the ointment is that the estimated Durbin–Watson statistic
is quite low, suggesting that perhaps there is autocorrelation in the data. Of course, as we know, a
low Durbin–Watson value could be due to specification errors also. For instance, the estimated
model assumes that the intercept value of GE, GM, US, and Westinghouse are the same. It also
assumes that the slope coefficients of the two X variables are all identical for all the four firms.
Obviously, these are highly restricted assumptions. Therefore, despite its simplicity, the pooled
regression (4.1) may distort the true picture of the relationship between Y and the X’s across the
four companies. What we need to do is find some way to take into account the specific nature of
the four companies. How this can be done is explained next.

2. Slope Coefficients Constant but the Intercept Varies across Individuals: The Fixed
Effects or Least-Squares Dummy Variable (LSDV) Regression Model
One way to take into account the “individuality” of each company or each cross-sectional unit is
to let the intercept vary for each company but still assume that the slope coefficients are constant
across firms. To see this, we write model (4.1) as:

(4.3)
Notice that we have put the subscript i on the intercept term to suggest that the intercepts of the
four firms may be different; the differences may be due to special features of each company, such
as managerial style or managerial philosophy.

In the literature, model (4.3) is known as the fixed effects (regression) model (FEM). The term
“fixed effects” is due to the fact that, although the intercept may differ across individuals (here
the four companies), each individual’s intercept does not vary over time; that is, it is time
71
invariant. Notice that if we were to write the intercept as β1 it , it will suggest that the intercept of
each company or individual is time variant. It may be noted that the FEM given in (4.3) assumes
that the (slope) coefficients of the regressors do not vary across individuals or over time.

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How do we actually allow for the (fixed effect) intercept to vary between companies? We can
easily do that by the dummy variable technique, particularly, the differential intercept
dummies. Therefore, we write (4.3) as:

(4.4)

where = 1 if the observation belongs to GM, 0 otherwise; = 1 if the observation

belongs to US, 0 otherwise; and = 1 if the observation belongs to WEST, 0 otherwise.

Since we have four companies, we have used only three dummies to avoid falling into the
dummy-variable trap (i.e., the situation of perfect collinearity). Here there is no dummy for
GE. In other words, α1 represents the intercept of GE and α2, α3, and α4, the differential
intercept coefficients, tell by how much the intercepts of GM, US, and WEST differ from the
intercept of GE. In short, GE becomes the comparison company.

Of course, you are free to choose any company as the comparison company. Incidentally, if
you want explicit intercept values for each company, you can introduce four dummy
variables provided you run your regression through the origin, that is, drop the common
intercept in (4.4); if you do not do this, you will fall into the dummy variable trap. Since we
are using dummies to estimate the fixed effects, in the literature the model (4.4) is also
known as the LSDV model. So, the terms fixed effects and LSDV can be used
interchangeably. In passing, note that the LSDV model (4.4) is also known as the covariance
model and X2 and X3 are known as covariates.
The results based on (4.4) are as follows:

= −245.7924 + 161.5722D2i + 339.6328D3i + 186.5666D3i + 0.1079X2i + 0.3461X3i

se = (35.8112) (46.4563) (23.9863) (31.5068) (0.0175) (0.0266)
t = (−6.8635) (3.4779) (14.1594) (5.9214) (6.1653) (12.9821)

= 0.9345, d = 1.1076, and df = 74 (4.5)

72
Compare this regression with (4.1). In (4.5) all the estimated coefficients are individually highly
significant, as the p values of the estimated t coefficients are extremely small. The intercept
values of the four companies are statistically different; being −245.7924 for GE, −84.220

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(=−245.7924 + 161.5722) for GM, 93.8774 (=−245.7924 + 339.6328) for US, and −59.2258
(=−245.7924 + 186.5666) for WEST. These differences in the intercepts may be due to unique
features of each company, such as differences in management style or managerial talent.
Which model is better—(4.1) or (4.5)? The answer should be obvious, judged by the statistical
significance of the estimated coefficients, and the fact that the R2 value has increased
substantially and the fact that the Durbin–Watson d value is much higher, suggesting that model
(4.1) was mis-specified. The increased R2 value, however, should not be surprising as we have
more variables in model (4.5).

We can also provide a formal test of the two models. In relation to (4.5), model (4.1) is a
restricted model in that it imposes a common intercept on all the companies. Therefore, we can
use the restricted F test discussed in Chapter 8. Using formula (8.7.10), the reader can easily
check that in the present instance the F value is:

F= = = (4.6)
where the restricted R2 value is from (4.1) and the unrestricted R2 is from (4.5) and where the
number of restrictions is 3, since model (4.1) assumes that the intercepts of the GE, GM, US, and
WEST are the same. Clearly, the F value of 66.9980 (for 3 numerator df and 74 denominator df)
is highly significant and, therefore, the restricted regression (4.1) seems to be invalid.

The Time Effect. Just as we used the dummy variables to account for individual (company)
effect, we can allow for time effect in the sense that the Grunfeld investment function shifts over
time because of factors such as technological changes, changes in government regulatory and/or
tax policies, and external effects such as wars or other conflicts. Such time effects can be easily
accounted for if we introduce time dummies, one for each year. Since we have data for 20 years,
from 1935 to 1954, we can introduce 19 time dummies (why?), and write the model (4.4) as:

73
(4.7)
where Dum35 takes a value of 1 for observation in year 1935 and 0 otherwise, etc. We are treating
the year 1954 as the base year, whose intercept value is given by λ0 (why?)

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We are not presenting the regression results based on (4.7), for none of the individual time
dummies were individually statistically significant. The R2 value of (4.7) was 0.7697, whereas
that of (4.1) was 0.7565, an increment of only 0.0132. It is left as an exercise for the reader to
show that, on the basis of the restricted F test, this increment is not significant, which probably
suggests that the year or time effect is not significant. This might suggest that perhaps the
investment function has not changed much over time.

We have already seen that the individual company effects were statistically significant, but the
individual year effects were not. Could it be that our model is mis-specified in that we have not
taken into account both individual and time effects together? Let us consider this possibility.

3. Slope Coefficients Constant but the Intercept Varies over Individuals As Well As Time
To consider this possibility, we can combine (16.3.4) and (16.3.6), as follows:

(4.8)

When we run this regression, we find the company dummies as well as the coefficients of the X
are individually statistically significant, but none of the time dummies are. Essentially, we are
back to (4.5). The overall conclusion that emerges is that perhaps there is pronounced individual
company effect but no time effect. In other words, the investment functions for the four
companies are the same except for their intercepts. In all the cases we have considered, the X
variables had a strong impact on Y.

4. All Coefficients Vary across Individuals

Here we assume that the intercepts and the slope coefficients are different for all individual, or
cross-section, units. This is to say that the investment functions of GE, GM, US, and WEST are
all different. We can easily extend
74 our LSDV model to take care of this situation. Reconsider

(16.3.4). There we introduced the individual dummies in an additive manner. But in Chapter 1

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on dummy variables, we showed how interactive, or differential, slope dummies, can account for
differences in slope coefficients. To do this in the context of the Grunfeld investment function,
what we have to do is multiply each of the company dummies by each of the X variables [this
will add six more variables to (16.3.4)]. That is, we estimate the following model:
Yit = α1 + α2D2i + α3D3i + α4D4i + β2X2it + β3X3it + γ1(D2i X2it) + γ2(D2i X3it)
+γ3(D3i X2it) + γ4(D3i X3it) + γ5(D4i X2it) + γ6(D4i X3it) + uit (4.9)
You will notice that the γ ’s are the differential slope coefficients, just as α2, α3, and α4 are the
differential intercepts. If one or more of the γ coefficients are statistically significant, it will tell
us that one or more slope coefficients are different from the base group. For example, say β2 and
γ1 are statistically significant. In this case (β2 + γ1) will give the value of the slope coefficient of
X2 for General Motors, suggesting that the GM slope coefficient of X2 is different from that of
General Electric, which is our comparison company. If all the differential intercept and all the
differential slope coefficients are statistically significant, we can conclude that the investment
functions of General Motors, United States Steel, and Westinghouse are different from that of
General Electric. If this is in fact the case, there may be little point in estimating the pooled
regression (4.2).

Let us examine the regression results based on (4.9). For ease of reading, the regression results of
(4.9) are given in tabular form in Table 4.2. As these results reveal, Y is significantly related to
X2 and X3. However, several differential slope coefficients are statistically significant. For
instance, the slope coefficient of X2 is 0.0902 for GE, but 0.1828 (0.0902 + 0.092) for GM.
Interestingly, none of the differential intercepts are statistically significant.
Table 4.1 Results of regression

Variable Coefficient Std. error t value p value

Intercept - 9.9563 76.3518 -0.1304 0.8966

D2i -139.5104 109.2808 -1.2766 0.2061

75

D3i -40.1217 129.2343 -0.3104 0.7572

D4i 9.3759 93.1172 0.1006 0.9201

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X2i 0.0926 0.0424 2.1844 0.0324

X3i 0.1516 0.0625 2.4250 0.0180

D2iX2i 0.0926 0.0424 2.1844 0.0324

D2iX3i 0.2198 0.0682 3.2190 0.0020

D3iX2i 0.1448 0.0646 2.2409 0.0283

D3iX3i 0.2570 0.1204 2.1333 0.0365

D4iX2i 0.0265 0.1114 0.2384 0.8122

D4iX3i -0.0600 0.3785 -0.1584 0.8745

R2 = 0.9511 d = 1.0896

All in all, it seems that the investment functions of the four companies are different. This might
suggest that the data of the four companies are not “poolable,” in which case one can estimate
the investment functions for each company separately. This is a reminder that panel data
regression models may not be appropriate in each situation, despite the availability of both time
series and cross-sectional data.

σ2 A Caution on the Use of the Fixed Effects, or LSDV, Model. Although easy to use, the
LSDV model has some problems that need to be borne in mind.
First, if you introduce too many dummy variables, as in the case of model (16.3.7), you will run
up against the degrees of freedom problem. In the case of (16.3.7), we have 80 observations, but
only 55 degrees of freedom—we lose 3 df for the three company dummies, 19 df for the 19 year
dummies, 2 for the two slope coefficients, and 1 for the common intercept. Second, with so many
variables in the model, there is always
76 the possibility of multicollinearity, which might make
precise estimation of one or more parameters difficult.

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Third, suppose in the FEM (16.3.1) we also include variables such as sex, color, and ethnicity,
which are time invariant too because an individual’s sex color, or ethnicity does not change over
time. Hence, the LSDV approach may not be able to identify the impact of such time-invariant
variables.
Fourth, we have to think carefully about the error term uit. All the results we have presented so
far are based on the assumption that the error term follows the classical assumptions, namely, uit
∼ N(0, σ2). Since the i index refers to cross-sectional observations and t to time series
observations, the classical assumption for uit may have to be modified. There are several
possibilities.
1. We can assume that the error variance is the same for all crosssection units or we can assume
that the error variance is heteroscedastic.
2. For each individual we can assume that there is no autocorrelation over time. Thus, for
example, we can assume that the error term of the investment function for General Motors is
nonautocorrelated. Or we could assume that it is autocorrelated, say, of the AR(1) type.
3. For a given time, it is possible that the error term for General Motors is correlated with the
error term for, say, U.S. Steel or both U.S. Steel and Westinghouse.7 Or, we could assume that
there is no such correlation.
4. We can think of other permutations and combinations of the error term. As you will quickly
realize, allowing for one or more of these possibilities will make the analysis that much more
complicated. Space and mathematical demands preclude us from considering all the possibilities.
However, some of the problems may be alleviated if we resort to the so-called random effects
model, which we discuss next.

4.3. Estimation Of Panel Data Regression Models: The Random Effects

Approach

Although straightforward to apply, fixed effects, or LSDV, modeling can be expensive in terms
of degrees of freedom if we have several
77 cross-sectional units. Besides, as Kmenta notes:

An obvious question in connection with the covariance [i.e., LSDV] model is whether the
inclusion of the dummy variables—and the consequent loss of the number of degrees of freedom

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—is really necessary. The reasoning underlying the covariance model is that in specifying the
regression model we have failed to include relevant explanatory variables that do not change
over time (and possibly others that do change over time but have the same value for all cross-
sectional units), and that the inclusion of dummy variables is a cover up of our ignorance. If the
dummy variables do in fact represent a lack of knowledge about the (true) model, why not
express this ignorance through the disturbance term uit? This is precisely the approach suggested
by the proponents of the so called error components model (ECM) or random effects model
(REM).

The basic idea is to start with:

Yit = β1i + β2X2it + β3X3it + uit ………………………………………………………….(4.10)

Instead of treating β1i as fixed, we assume that it is a random variable with a mean value of β1
(no subscript i here). And the intercept value for an individual company can be expressed as

β1i = β1 + εi i = 1, 2, . . . , N ……………………………………………………….(4.11)

where εi is a random error term with a mean value of zero and variance of σ2 ε .

What we are essentially saying is that the four firms included in our sample are a drawing from a
much larger universe of such companies and that they have a common mean value for the
intercept ( = β1) and the individual differences in the intercept values of each company are
reflected in the error term εi .

Substituting (4.11) into (4.10), we obtain:

Yit= β1 + β2X2it+ β3X3it+ εi+ uit

= β1 + β2X2it+ β3X3it+ wit (4.12)

78
where

wit = εi + uit (4.13)

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The composite error term wit consists of two components, εi , which is the cross-section, or
individual-specific, error component, and uit , which is the combined time series and cross-
section error component. The term error components model derives its name because the
composite error term wit consists of two (or more) error components.

The usual assumptions made by ECM are that

Ɛit N(0,δ2)

uit N(0,δ2)……………………………………………………………. (4.14)

E(εiuit) = 0 E(εiεj ) =0 (i = j )

E(uituis) = E(uitujt) = E(uitujs) =0 (i = j ; t = s).

that is, the individual error components are not correlated with each other and are not
autocorrelated across both cross-section and time series units. Notice carefully the difference
between FEM and ECM. In FEM each cross-sectional unit has its own (fixed) intercept value, in
all N such values for N cross-sectional units. In ECM, on the other hand, the intercept β1
represents the mean value of all the (cross-sectional) intercepts and the error component εi
represents the (random) deviation of individual intercept from this mean value. However, keep in
mind that εi is not directly observable; it is what is known as an unobservable, or latent,
variable.

As a result of the assumptions stated above, it follows that

E(wit) = 0 ……………………………………………………….(4.15)

var (wit) = σ2ε+ σ2u ……………………………………………..(4.16)

Now if σ2ε= 0, there is no difference between models (4.1) and (4.12), in which case we can
79
simply pool all the (cross-sectional and time series) observations and just run the pooled
regression, as we did in (4.2).

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As (4.16) shows, the error term wit is homoscedastic. However, it can be shown that wit and wis
(t _= s) are correlated; that is, the error terms of a given cross-sectional unit at two different
points in time are correlated. The correlation coefficient, corr (wit, wis), is as follows:

corr (wit, wis) = σ2εσ2ε+ σ2u……………………………………..(4.17)

Notice two special features of the preceding correlation coefficient. First, for any given cross-
sectional unit, the value of the correlation between error terms at two different times remains the
same no matter how far apart the two time periods are. This is in strong contrast to the first-order
[AR(1)] scheme, where we found that the correlation between time periods declines over time.
Second, the correlation structure given in (4.17) remains the same for all cross sectional units;
that is, it is identical for all individuals.

If we do not take this correlation structure into account, and estimate (4.12) by OLS, the
resulting estimators will be inefficient. The most appropriate method here is the method of
generalized least squares (GLS).

We will not discuss the mathematics of GLS in the present context because of its complexity.
Since most modern statistical software packages now have routines to estimate ECM (as well as
FEM), we will only present the results for our investment example. But before we do that, it may
be noted that we can easily extend (4.13) to allow for a random error component to take into
account variation over time.

The results of ECM estimation of the Grunfeld investment function are presented in the
following Table. Several aspects of this regression should be noted. First, if you sum the random
effect values given for the four companies, it will be zero, as it should (why?). Second, the mean
value of the random error component, εi, is the common intercept value of −73.0353. The
random effect value of GE of −169.9282 tells us by how much the random error component of
GE differs from the common intercept
80 value. Similar interpretation applies to the other three
values of the random effects. Third, the R2 value is obtained from the transformed GLS
regression.

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If you compare the results of the ECM model given in the following table with those obtained
from FEM, you will see that generally the coefficient values of the two X variables do not seem
to differ much, except for those given in the previous table, where we allowed the slope
coefficients of the two variables to differ across cross-sectional units.

Table 4.2: ECM estimation of the Grunfeld investment function

Variable Coefficient Std. error t statistic p value

Intercept -73.0353 83.9495 -0.8699 0.3870

X2 0.1076 0.0168 6.4016 0.0000

X3 0.3457 0.0168 13.0235 0.0000

Random effect:

GE -169.9282

GM -9.5078

USS 165.5613

Westinghouse 13.87475

R2 = 0.9323 (GLS)

4.4. Fixed Effects (LSDV) versus Random Effects Model

The challenge facing a researcher is: Which model is better, FEM or ECM? The answer to this
question hinges around the assumption one makes about the likely correlation between the
individual, or cross-section specific, error component εi and the X regressors.

If it is assumed that εi and the X’s are uncorrelated, ECM may be appropriate, whereas if εi and
the X’s are correlated, FEM may 81
be appropriate. Why would one expect correlation between the
individual error component εi and one or more regressors? Consider an example. Suppose we
have a random sample of a large number of individuals and we want to model their wage, or
earnings, function. Suppose earnings are a function of education, work experience, etc. Now if

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we let εi stand for innate ability, family background, etc., then when we model the earnings
function including εi it is very likely to be correlated with education, for innate ability and family
background are often crucial determinants of education. As Wooldridge contends, “In many
applications, the whole reason for using panel data is to allow the unobserved effect [i.e., εi] to
be correlated with the explanatory variables.” The assumptions underlying ECM is that the εi are
a random drawing from a much larger population. But sometimes this may not be so. For
example, suppose we want to study the crime rate across the 50 states in the United States.
Obviously, in this case, the assumption that the 50 states are a random sample is not tenable.

Keeping this fundamental difference in the two approaches in mind, what more can we say about
the choice between FEM and ECM? Here the observations made by Judge et al. may be helpful:

1. If T (the number of time series data) is large and N (the number of cross-sectional units) is
small, there is likely to be little difference in the values of the parameters estimated by FEM and
ECM. Hence the choice here is based on computational convenience. On this score, FEM may be
preferable.

2. When N is large and T is small, the estimates obtained by the two methods can differ
significantly. Recall that in ECM β1i = β1 + εi , where εi is the cross-sectional random
component, whereas in FEM we treat β1i as fixed and not random. In the latter case, statistical
inference is conditional on the observed cross-sectional units in the sample. This is appropriate if
we strongly believe that the individual, or cross-sectional, units in our sample are not random
drawings from a larger sample. In that case, FEM is appropriate. However, if the cross-sectional
units in the sample are regarded as random drawings, then ECM is appropriate, for in that case
statistical inference is unconditional.

3. If the individual error component εi and one or more regressors are correlated, then the ECM
estimators are biased, whereas those obtained from FEM are unbiased.

4. If N is large and T is small, and if the assumptions underlying ECM hold, ECM estimators are
82
more efficient than FEM estimators.

Is there a formal test that will help us to choose between FEM and ECM? Yes, a test was
developed by Hausman in 1978. We will not discuss the details of this test, for they are beyond

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the scope of this book. The null hypothesis underlying the Hausman test is that the FEM and
ECM estimators do not differ substantially. The test statistic developed by Hausman has an
asymptotic χ2 distribution. If the null hypothesis is rejected, the conclusion is that ECM is not
appropriate and that we may be better off using FEM, in which case statistical inferences will be
conditional on the εi in the sample.

Panel data regressions: some concluding comments

As noted at the outset, the topic of panel data modeling is vast and complex. We have barely
scratched the surface. Among the topics that we have not discussed, the following may be
mentioned.

1. Hypothesis testing with panel data.

2. Heteroscedasticity and autocorrelation in ECM.

3. Unbalanced panel data.

4. Dynamic panel data models in which the lagged value(s) of the regressand (Yit) appears as an
explanatory variable.

5. Simultaneous equations involving panel data.

6. Qualitative dependent variables and panel data.

One or more of these topics can be found in the references cited in this chapter, and the reader is
urged to consult them to learn more about this topic. These references also cite several empirical
studies in various areas of business and economics that have used panel data regression models.
The beginner is well advised to read some of these applications to get a feel about how
researchers have actually implemented such models.

83
Summary and conclusions

1. Panel regression models are based on panel data. Panel data consist of observations on the
same cross-sectional, or individual, units over several time periods.

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2. There are several advantages to using panel data. First, they increase the sample size
considerably. Second, by studying repeated cross-section observations, panel data are better
suited to study the dynamics of change. Third, panel data enable us to study more complicated
behavioral models.

3. Despite their substantial advantages, panel data pose several estimation and inference
problems. Since such data involve both cross-section and time dimensions, problems that plague
cross-sectional data (e.g., heteroscedasticity) and time series data (e.g., autocorrelation) need to
addressed. There are some additional problems, such as cross-correlation in individual units at
the same point in time.

4. There are several estimation techniques to address one or more of these problems. The two
most prominent are (1) the FEM and (2) the REM or error components model (ECM).

5. In FEM the intercept in the regression model is allowed to differ among individuals in
recognition of the fact each individual, or cross sectional, unit may have some special
characteristics of its own. To take into account the differing intercepts, one can use dummy
variables. The FEM using dummy variables is known as the least-squares dummy variable
(LSDV) model. FEM is appropriate in situations where the individual specific intercept may be
correlated with one or more regressors. A disadvantage of LSDV is that it consumes a lot of
degrees of freedom when the number of cross-sectional units, N, is very large, in which case we
will have to introduce N dummies (but suppress the common intercept term).

6. An alternative to FEM is ECM. In ECM it is assumed that the intercept of an individual unit is
a random drawing from a much larger population with a constant mean value. The individual
intercept is then expressed as a deviation from this constant mean value. One advantage of ECM
over FEM is that it is economical in degrees of freedom, as we do not have to estimate N cross-
sectional intercepts. We need only to estimate the mean value of the intercept and its variance.
ECM is appropriate in situations where the (random) intercept of each cross-sectional unit is
uncorrelated with the regressors. 84

7. The Hausman test can be used to decide between FEM and ECM.

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8. Despite its increasing popularity in applied research, and despite increasing availability of
such data, panel data regressions may not be appropriate in every situation. One has to use some
practical judgment in each case.

4.5. Review question

Answer the following questions briefly

1. Write the difference among cross section, time series and pooled data.

2. List the advantages of panel data.

3. Differentiate FEM from that of REM

4. Explain the Hausman test.

85

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