EC3304EconometricsII(2011/12SemI) AnswerstoTutorial3(forweek6) 1.

(i)

1 =

x y = x ( x u ) = + x (u u ) = + x u x x x x
i i i 2 i 1 i 2 i * i i i 1 2 i 1

i i 2 i

xi E (ui | X i ) ] = ,usinglawofiteratedexpectations. E ( 1 ) = 1 + Ex [ 1 xi2

1 xiui n p lim 1 = 1 + = 1 1 2 p lim xi n p lim
NumeratorconvergestothecovariancebetweenXandu,whichisassumedzerobythe conditionE(u|X)=0anddenominatorconvergestothevarianceofX,assumedaconstant. Digression: E (ui | X i ) = 0 Cov(ui , X i ) = 0.

Yi = 0 + 1 X i + ui ,Assume E (ui ) = 0 .Thisisatechnicalassumption.Iftheregressionhasan interceptterm,thenthisassumptionwillbesatisfied.Forexample,let ui = + i , E ( i ) = 0 ,

* E (ui ) = .Thenyourregressionwillbe Yi = 0 + 1 X i + + i = 0 + 1 X i + i , where

0* = 0 + .
Thecrucialassumptionis E (ui | X i ) = 0 .Populationregressionis

E (Yi | X i ) = 0 + 1 X i + E (ui | X i ) = 0 + 1 X i if E (ui | X i ) = 0 .

Note: Cov(ui , X i ) = E (ui X i ) E (ui ) E ( X i ) = E (ui X i ). Usingthelawofiteratedexpectation

E (ui X i ) = Ex [ E (ui X i | X i )] = Ex [ E (ui | X i ) X i ] = 0 .Therefore, E (ui | X i ) = 0 Cov(ui , X i ) = 0. Theconverseisnotnecessarilytrue.

(ii)

= ( X X ) 1 X y = ( X X ) 1 X ( X + u ) = + ( X X ) 1 X u

E ( ) = + E x [( X X ) 1 X E (u | X )] = ,usinglawofiteratedexpectations.

1 1 p lim = + p lim( X X ) 1. p lim( X u )] = n n

As n , ( X ) 1 convergestothevariancecovariancematrixofXvariables,whichis X assumedtobeapositivedefinitematrixand ( X u ) convergesto(kx1)vectorofzeros

1 n

1 n becauseXisassumedtobeexogenous, E (ui | X 1i ,..., X k 1,i ) = 0, uncorrelatedwithu.

ui 1 1 X 1i ui Note X u = . . n n X k 1,i ui
(iii)If Cov(ui , X i ) 0 theestimatorisbiasedandinconsistent.Therearebiasedestimatorsbut consistent,i.e.,assamplesizegrowsbiasgoestozero,variancegoestozero.Therearethree caseswhere Cov(ui , X i ) 0 thatleadstobiasedandinconsistentestimators: Note: (a)EndogeneityofXorsimultaneitybetweenyandX (b)ErrorsinX(errorsinvariables) (c)OmittedvariablesthatarecorrelatedwithX.

1 xiui Cov( X , u ) n = + = 1 + = 1 + xu 2x u = 1 + xu u p lim 1 1 1 Var ( X ) x x p lim xi2 n p lim

where xu isthecorrelationbetweenXandu. (Iv)ThisisaclassicexampleofbiasduetoerrorsintheXvariable. Write Ct = 0 + 1Yt + ut andweexpect 0 = 0, 1 = k .

 1 = = =

(Ct C )(Yt Y )

[(C

(Y Y )
t t

(C

+ vt C v )(Yt + wt Y w)

(Y + w Y w)
t t 2

C ) + (vt v )][(Yt Y ) + ( wt w)]

[(Y Y )(C C ) + ...) (Y Y ) + (w w) + ...] [(Y Y )(k (Y Y )) + ...) = (Y Y ) + (w w) + ...

t t 2 2 t t t t 2 2 t t

[(Y Y ) + (w w)]
t t

Note:Idroppedthetermsthataregoingtodropwhenwetakeplim.Youshouldexpandthe wholeexpressionandgetplimtoseewhathappens.

p lim 1 =

p lim

1 k (Yt Y ) 2 + 0) T

1 p lim [ (Yt Y ) 2 + ( wt w) 2 + 0] n

=k

2 y <k 2 2 y +w

MPCisunderestimatedbecauseoftheerrorsintheRHSvariableY.Noticethattheerrorsinthe dependentvariabledoesnotthisproblem.

0 = C 1Y = 0 + 1Y + u 1Y = 0 + ( 1 1 )Y + u

k 2 p lim 0 = 0 + ( 1 2 y 2 ) y > 0 ,why? y +w

2.Computerexercise. (ii)Themagnitudeofthecoefficientsindicatesthatthevariablescanbewrittenindifferenceform.This indicatesthepresenceofaunitrootineachseries. (iii),(iv)TheUSdollarplaysthemostimportantroleinsettingtheSINexchangerate.Buttheweighton theUSdollargoesdowninmorerecentperiods.AUSdollaremergesasanimportantcurrency.Interpret othercoefficientsaswell. (v)Needtoworkoutadummyvariablecarefullytocapturethecrisisperiodandthenintroduceittothe modeltoshifttheintercepttermandalsotochangeslopes.Tochangeslopesyouhavetointroduce interactiontermstothemodel.