Lahore School of Economics

BSc ECONOMETRICS II
Spring 2013
Problem set No.3 Proposed Key

Due Date: Monday, 27
th
Jan 2014 in class. Students may work together on problem sets, with a maximum of
three students per group. However, each student in the group must turn in their OWN responses to the problem set
(i.e. one assignment with three names on it will not be accepted). The groups assignments should be turned in stapled
together.
Question 1:
(Linear Probability Model) Below is the results obtained by Cohen, Rea and Lerman (1970) based on a
linear probability estimation of the factors that affect female labor force participation in the US


a) What is the economic interpretation of the coefficient of 65 and over? (Make sure to
identify the base category and use this base category in your economic interpretation).
The coefficient of 0.2753 attached to the variable age 65 and over means, holding all
other factors constant, the probability of participation in the labor force by women in this
age group is smaller by about 27 percent (as compared with the base category of women
aged 22 to 54).

b) What is the economic interpretation of 16 and over? (Make sure to identify the base
category and use this base category in your economic interpretation).
The coefficient of 0.3061 attached to the variable 16 or more years of schooling
means, holding all other factors constant, the probability of women with this much
education participating in the labor force is higher by about 31 percent (as compared with
women with less than 5 years of schooling, the base category).

c) What is the economic interpretation of the coefficient of the interaction term of the
variables Never Married and 65 and over?
The labor-force participation probability is higher by some 29 percent for those women
who were never married (as compared with the base category) and smaller by about 28
percent for those women who are 65 and over (again in relation to the base category).

But the probability of participation of women who were never married and are 65 or over
is smaller by about 20 percent as compared with the base category. This implies that
women aged 65 and over but never married are likely to participate in the labor force
more than those who are aged 65 and over and are married or fall into the other
category.

d) What is the economic interpretation of the coefficient of the interaction term of the
variables Age and Years of Schooling?
The labor-force participation probability is smaller by 16.28% for those women who have
years of schooling above 16 years and age 65 and above as compared to base category. This
implies that women aged 65 and over and with some years of educations are less likely to
participate in the labor force as compared to the base category.

e) What is the conditional probability of a woman working for a married woman (listed as
other in the table), aged 22 to 54, with 12 to 15 years of schooling, with an unemployment
rate of 2.5-3.4 percent relative employment opportunities of 74 percent and over and
FILOW of &7500 and over?
If we want to find the probability for married women (other), aged 22 to 54, with 12 to 15
years of schooling, with an unemployment rate of 2.5 to 3.4 percent, employment change of
3.5 to 6.49 percent, relative employment opportunities of 74 percent and over, and with
FILOW of $7500 and over, we obtain
0.4368 + 0.1523 + 0.2231 0.0213 + 0.0301 + 0.0571 0.2455 = 0.6326
In other words, the probability of labor-force participation by women with the preceding
characteristics is estimated to be about 63 percent.


Question 2:
(Linear Probability Model) Based on a pooled time series and cross-sectional data of 200 Aa (high-
quality) and BAA (medium-quality) bonds over the period 1961 1966, Joseph Cappelleri estimated
the following bond rating prediction model.

a) A priori, why are
2
and
4
expected to be negative?
If the debt capitalization ratio is high, the firm is expected to have a lower bond rating.
Higher the standard deviation of the profit rate, more variability in the profit, lower the
bond rating.
b) A priori, why are
3
and
5
expected to be positive?
Higher the profit of the company, higher the bond rating. High net total assets means
greater amount of assets available in case of default, hence higher the bond rating.


c) Give economic interpretations of all the slope coefficients in the regression results above
All but the coefficient of X4 have the correct signs. It is left to finance students to
rationalize why the profit rate variability coefficient has a positive sign, for one would expect
that the greater the variability in profits, the less likely it is Moodys would give an Aa rating,
other things remaining the same.
The interpretation of the regression is straightforward. For example, 0.0486 attached to X3
means that, other things being the same, a 1 percentage point increase in the profit rate will
lead on average to about a 0.05 increase in the probability of a bond getting the Aa rating.
Similarly, the higher the squared leveraged ratio, the lower by 0.02 is the probability of bond
being classified as an Aa bond per unit increase in this ratio.


Question 3:
(Binomial Logit Model) Suppose an econometrician ran a regression to check the effect of personalized
system of instruction on course grades. The dependent variable used is the students final grade in an
intermediate microeconomics course, with Y = 1 if the grade is an A and equal to zero if the final
grade was a B or a C.

The independent variables used are:
GPA: the entering grade point average
TUCE: score on an examination given at the beginning of the term to test entering knowledge of
macroeconomics
PSI= 1 if the new teaching method is used and 0 otherwise

The table below gives us the regression results

a) What is the conventional measure of goodness of fit used in regression results? Why is it
not used here?
The conventional measure of goodness of fit is R
2
, is not particularly meaningful in
binary regressand models.
b) Give interpretation of the slope coefficient of GPA.
The GPA coefficient of 2.8261 means, with other variables held constant, that if GPA
increases by a unit, on average the estimated logit increases by about 2.83 units,
suggesting a positive relationship between the two
c) Which coefficients are significant at 1%, 5% and 10% significance level?
All are significant at 5% significance level (p-value less than 0.05) except for TUCE.
d) What is the interpretation of the PSI coefficient in terms of odds?
If you take the antilog of the PSI coefficient of 2.3786 you will get 10.7897 ( e
2.3786
).
This suggests that students who are exposed to the new method of teaching are more
than 10 times likely to get an A than students who are not exposed to it, other things
remaining the same.




e) What is the probability of getting an A grade for a student who does not use the new
teaching method and has a GPA = 3.92 and TUCE grade= 29?
Plug in the values (put PSI = 0), the estimated logit value for this student is 0.8178.
Question 4:
(Identification Problem) Consider the following extended Keynesian model of income determination:
Consumption function: Ct = 1 + 2Yt 3Tt + u1t
Investment function: It = 0 + 1Yt1 + u2t
Taxation function: Tt = 0 + 1Yt + u3t
Income identity: Yt = Ct + It + Gt
where C = consumption expenditure
Y = income
I = investment
T = taxes
G = government expenditure
us = the disturbance terms
By applying the order condition, check the identifiability of each of the equations in the
system.
In the model the endogenous variables are C, I, T, and Y and the predetermined variables are G and
Y
t1
. For this model, M = 4 and K = 2. By the order condition, the equation for C is identified, and
those for I and T are overidentified.


























Question 5:
(Reduced form Equation) Obtain the reduced form of the IS model given below.

where Y = national income
C = consumption spending
I = planned or desired net investment
G = given level of government expenditure
T = taxes
Yd = disposable income
r = interest rate.

If you substitute Y
dt
and T
t
into C
t
and substitute the resulting equation for C and I
t
and G
t
into
Y
t
, you should obtain, IS equation


The IS equation, or the goods market equilibrium gives us the combinations of the interest rate
and level of income such that the goods market clears or is in equilibrium.