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The Random Effects Model
Original equation
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σ λ σλ .. σ u + σ λ
2 2 2
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Random Effects (GLS Estimation)
The Random Effects estimator has the standard
generalised least squares form summed over all
individuals in the dataset i.e.
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βˆ RE = ∑ ( X i Ω X i )
' −1
∑ i yi
X '
Ω −1
i =1 i =1
−1 / 2 1 θ σu
Ω = I T − ee ' where θ = 1 -
σu T T σ λ2 + σ u2
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Fixed Effects (GLS Estimation)
-1 T
T
1
βˆ FE = ∑ ( X i MX i )
'
∑ X My i where M = I T − ee '
i
'
i =1 i =1 T
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Relationship between Random
and Fixed Effects
The random effects estimator is a weighted combination of the
“within” and “between” estimators. The “between” estimator is
formed from:
βˆ RE = Ψ βˆ Between + ( I K − Ψ ) βˆWithin
Ψ depends on θ in such a way that if θ → 1 then the
RE and FE estimators coincide. This occurs when the variability of
the individual effects is large relative to the random errors.
θ → 0 correspond s to OLS (because the individual effects are small
relative to the random error).
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Random or Fixed Effects?
For random effects:
•Random effects are efficient
•Assumption one set of unobservables fixed and the other
random?
•Sample information more common than from the entire
population?
•Can deal with regressors that are fixed across individuals
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The Hausman Test
Is a test for the independence of the λi and the xkit.
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W = ( β RE − β FE )' Σ ( β RE − β FE ) ~ χ ( k )
ˆ 2
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