Lecture1

Econometrics: ECOM30002 and ECOM90002
Lecture 1 Maximum Likelihood: Basics

Professor Vance L. Martin
Semester 1
Professor Vance L. Martin () Econometrics: ECOM30002 and ECOM90002 Lecture 1 Maximum Likelihood: Basics Semester 1 1 / 51
Learning Objectives
1
Course Information
2
Major Project
3
The Linear Regression Model Reviewed
4
Data Characteristics
Background Reading
1
GROUP_PROJECT.PDF, Handout on course website.
Source: Melbourne Age, 1/1/2010
AND
But what do the students say (student evaluations!).
Course Information
Coordinator: Professor Vance L. Martin
Prerequisites:
One of Intermediate Macroeconomics or Intermediate Microeconomics
or Business Finance.
One of Introductory Econometrics, Basic Econometrics, Statistics, or
an H2A or better in Quantitative Methods 2.
Contact:
Lectures: Two 1-hour lectures
One 1-hour tutorial per week beginning in the rst week
Tutor consultation times (times to be arranged)
On-line tutor (available from the course website)
Audio versions of the lectures are available on the web
Course Outline:
The course focuses on maximum likelihood methods to estimate and test
econometric models. Both analytical and numerical methods of estimation
are discussed, while likelihood ratio, Wald and Lagrange multiplier testing
frameworks are presented. Important special examples investigated are
probit and ordered probit regressions, Poisson regressions, linear and
nonlinear regression models with heteroskedasticity and autocorrelation,
ARCH models of volatility and simultaneous equations models. All
mathematical techniques including multivariate calculus and matrices, are
developed in the course.
Main Reading:
Lecture Notes
Lecture Handouts
Articles placed on the website
Background Reading:
Hill, R.C., Griths, W.E. and Lim, G.C. (2007), Principles of
Econometrics, 3rd Edition, Wiley.
Stock, J.H. and Watson, M.W. (2007), Introduction to Econometrics,
2nd Edition, Addison-Wesley Longman, Amsterdam.
Prescribed Text:
None.
Additional Reading:
Statistics: Griths, W.E., Hill, R.C. and Judge, G.G. (1993), Learning
and Practicing Econometrics, Wiley.
Calculus: Stewart, James (2008), Calculus, (6th ed.) Thomson
Publishers.
Matrices: Anton, H. and Rorres, C. (2005), Elementary Linear
Algebra, Applications Version, (9th ed.) John Wiley and Sons.
Calculators
Standard ordinary scientic calculators are allowed. Graphic and
programmable calculators are not allowed in the exam.
Note that calculators will be needed in the nal exam.
Software and Computers
EViews is available:
On campus in tutorial rooms and the Faculty computer lab.
O campus through a link on the course website.
Note that it will be necessary to be able to interpret EViews output in
the nal exam.
Who should do this course?
Econometrics is Important But Misunderstood
Source: http://www.theage.com.au/articles/2005/11/09/1131407702080.html
Forecasting is Important
Source: The Melbourne Age
Course Outline
Week Lectures Topic
1 1,2 Maximum Likelihood: Basics
2 3,4 Maximum Likelihood: General Case
3 5,6 Maximum Likelihood: Numerical Methods
4 7,8 Maximum Likelihood: Testing
5 9,10 Maximum Likelihood: Microeconometrics
6 11,12 Maximum Likelihood: Heteroskedasticity
7 13,14 Maximum Likelihood: Autocorrelation
8 15,16 Maximum Likelihood: Specication Analysis
9 17,18 Introduction to Simultaneous Equations
10 19,20 Introduction to Simultaneous Equations
11 21,22 Introduction to Asymptotic Distribution Theory
12 23,24 Course Prizes, Past Exams and the Future
Weeks 1 to 4: Principles of Maximum Likelihood Estimation
Specication
Estimation
Numerical Methods
Testing
Weeks 5 to 7: Applications
What determines monetary policy?
Weeks 5 to 7: Applications continued
Has capsicum spray reduced police injuries?
Source: Melbourne Age, 3/3/2008
The Great Moderation
Source: www.federalreserve.gov/BOARDDOCS/SPEECHES/2004
/20040220/default.htm
The Food Crisis
Source: Melbourne Age, 15/4/2008, p.1
Climate Change
Which could have been avoided by doing THIS COURSE!
Weeks 8 to 10: Extensions
Tru-es
Source: Melbourne Age, Epicure, 10/2/2009, p.8
Weeks 11 to 12: Asymptotic Distribution Theory, Presentations and
Exam Preparation
We bring home the bacon!
Who should NOT do this course?
Source: Melbourne Age, ODD SPOT, 4/2/2009, p.1
Assessment:
Assessment Weight Due Where
Tutorial homework I 2.5% Week 3 Tutorial Room
Tutorial homework II 2.5% Week 4 Tutorial Room
Tutorial homework III 2.5% Week 5 Tutorial Room
Tutorial homework IV 2.5% Week 6 Tutorial Room
Test (50 mins) 5% Week 7 Tutorial Room
Major Project 20% Week 9 Submit online
Final Exam (2 hours) 65% End of Semester Exam Room
Major Project
Details
i Due Wednesday of Week 9 by 4.00pm (submit online).
ii Worth 20%
iii Groups sizes can be a minimum of one and a maximum of 6. People
do NOT have to be in the same tutorial.
iv AIM: Use the techniques of the course to write a research paper on a
topic chosen by the group.
v You need to formulate your own hypotheses, collect the data,
undertake empirical analysis and write up the results.
vi The expected length of the research report should be about 10 pages,
with the maximum length not exceeding 15 pages, including all
graphs and tables.
vii Group decides on the weight allocated to each member of the group
(stop free-riders). Any issues please see me!
Major Project
Timeline
i Week 3: Form a group of at most 6 people and identify a topic.
ii Week 4: Discuss the topic with your tutor in the tutorial(s).
iii Week 5: Collect data.
iv Week 6: Write-up the introduction.
iv Week 7: Generate empirical results and write-up the results.
v Week 8: Write-up the implications of the results and formulate the
conclusions, together with an overall proofread of the project.
vi Week 9: Submission of project.
vii Week 10: Research essays marked and compared across tutorials.
viii Week 11: Projects are short-listed with names of projects given in the
Lecture and placed on the website.
xi Week 12: In the Monday lecture of Week 12, Groups on the short-list
present their project at the lecture. The Student Body chooses the
prize for the Best Research Essay.
Major Project
Some examples of projects from previous years:
1. Factors Determining an Actors Ability to Win an Actors Award
2. Tuberculosis: Understanding the post-1990 crisis
3. Curbing Gaming Expenditure in Australia
4. Happiness: An Empirical Study
5. To Marry of Not to Marry: A Maximum Likelihood Approach
6. Factors Inuencing the Performance of an AFL side
7. So, How Long will you Remain Single?
8. The English Premier League Trophy: A Poisson-ed Chalice?
Further details on the Major Project and other examples of potential
projects, are given on the website in GROUP_PROJECT.PDF.
The Linear Regression Model Reviewed
The linear regression model is given by the equation
y
t
=
0
+
1
x
t
+u
t
u
t
N
_
0,
2
_
where y
t
is the dependent variable, x
t
is the independent variable, u
t
is the disturbance term and
0
,
1
,
2
are unknown parameters.
For a sample of t = 1, 2, , T, observations, estimation is by
ordinary least squares
1
=

T
t=1
(x
t
x
t
) (y
t
y
t
)
T
t=1
(x
t
x
t
)
2
,

0
= y
t
1
x
t

2
=
1
T 2
T
t=1
_
y
t
1
x
t
_
2
, Note dof adjustment
Example (OLS Using EViews)
Estimate the linear regression equation
y
t
=
0
+
1
x
t
+u
t
u
t
N
_
0,
2
_
using the following annual data from 2003 to 2007 (T = 5)
t : 2003 2004 2005 2006 2007
y
t
: 3 5 10 15 20
x
t
: 2 4 7 6 10
Example (OLS Using EViews continued)
The EViews commands are: highlight y and x, double click the shaded
region
Open Equation.../OK
The output is below
Source: lecture1_example1.wf1
The estimates are:

0
= 1.788,

1
= 2.136,
2
= 3.126
2
= 9.772
Some extensions of regression models are
1. Dummy variables and seasonality: x
t
=
_
1 : True
0 : False
2. Dynamics: x
t
= fx
t1
, x
t2
, y
t1
, y
t2
, g
3. Nonlinearities: x
t
= flog (w)g , x
t
=
_
w
2
t
_
4. Heteroskedastcity: y
t
=
0
+
1
x
t
+u
t
u
t
N
_
0,
2
t
_
2
t
=
0
+
1
w
t
5. Autocorrelation: y
t
=
0
+
1
x
t
+u
t
u
t
= u
t1
+v
t
v
t
N
_
0,
2
t
_
An important assumption of this model is that u
t
is normally
distributed
f (u
t
) =
1
p
2
2
exp
_
u
2
t
2
2
_
, < u
t
<
This implies that y
t
is normal with conditional mean
0
+
1
x
t
and
variance
2
f (y
t
) =
1
p
2
2
exp
_
(y
t

0

1
x
t
)
2
2
2
_
, < y
t
<
or more compactly
y
t
N
_
0
+
1
x
t
,
2
_
with parameters
=
_
0
,
1
,
2
_
The linear regression model is just one class of models that
is a subset of the models discussed in this course (say 5%).
The least squares estimator is generally not appropriate to
estimate the parameters of these other models.
An important component of the course is to specify models
where the data are nonnormal.
Data Characteristics
The assumption that y
t
is normal need not apply to all data sets.
Types of data to consider are:
1. Binary data
2. Skewed data
3. Fat-tailed data
4. Ordered data
5. Count data
6. Duration data
The following examples show that the assumption of normality is just
a very special case.
Example (Binary Data)
Consider survey data based on a sample of T = 20 people where the
responses are in terms of yes/no answers (ie binary)
y
t
=
_
1 : Yes
0 : No
Here y
t
just takes on one of two values as highlighted by the histogram
0
2
4
6
8
10
12
0.0 0.2 0.4 0.6 0.8 1.0
Series: Y
Sample 1 20
Observations 20
Mean 0.550000
Median 1.000000
Maximum 1.000000
Minimum 0.000000
Std. Dev. 0.510418
Skewness -0.201008
Kurtosis 1.040404
Jarque-Bera 3.334694
Probability 0.188747
Clearly nonnormal.
Example (Binary Data continued)
One solution for modelling y
t
is to use a Bernoulli distribution
f (y
t
) =
y
t
(1 )
1y
t
, y
t
= 0, 1,
where = fg , is an unknown parameter with the property 0 < < 1.
This parameter represents a probability as
= P (y
t
= 1)
and hence
1 = P (y
t
= 0)
Example (Melbourne Age Survey)
Should Connex be allowed to ne train passengers for putting their feet on
seats? [The Age Readerss Poll, 4/2/2009]
Source: Melbourne Age, NEWS, 3/2/2009, p.3
The results of a survey of 1094 people found that
Yes : 55% (1094 0.55 ' 602 people)
No : 45% (1094 0.45 ' 492 people)
Example (Skewed Data)
The following gure gives a histogram of annual incomes ($) of 1,526
residents of a country in 2007.
0
40
80
120
160
200
240
280
320
0 20000 40000 60000 80000 100000
Series: Y
Sample 1 1526
Observations 1526
Mean 24584.16
Median 21854.38
Maximum 109712.4
Minimum 4153.896
Std. Dev. 12547.57
Skewness 1.547919
Kurtosis 7.273659
The data are all positive and the distribution is skewed to the right.
Clearly nonnormal.
Example (Skewed Data continued)
Alternatively, by transforming income into natural logarithms
LY = LOG (Y)
the histogram now appears normal
0
20
40
60
80
100
120
140
8.5 9.0 9.5 10.0 10.5 11.0 11.5
Series: LY
Sample 1 1526
Observations 1526
Mean 9.991775
Median 9.992157
Maximum 11.60562
Minimum 8.331802
Std. Dev. 0.488632
Skewness -0.066485
Kurtosis 3.049711
Example (Skewed Data continued)
This suggests using the lognormal distribution
f (y
t
) =
1
p
2
2
y
t
exp
_
(log y
t
)
2
2
2
_
, y
t
> 0
where =
_
,
2
_
are unknown parameters. An example is given below
with = 10, = 0.5
.00000
.00001
.00002
.00003
.00004
.00005
0 20000 40000 60000 80000 100000 120000
Y
F
Source: lecture1_lognormal.wf1
Example (Fat-tailed Data)
The following histogram in (a) gives daily asset returns (%) on the
S&P500 from the 10th of January 1989 to the 31st of July 2007.
(a) Empirical (S&P500) (b) Theoretical (Normal)
The data exhibit fat-tails and a sharp peak relative to the normal
distribution given in (b) (which is simulated returns using the mean and
the standard deviation of Y). Clearly the series is nonnormal.
Example (Fat-tailed Data continued)
One solution is to use the standardized Student t distribution
f (y
t
) =

_
+ 1
2
_
_
2
( 2)
_
2
_
_
1 +
_
y
t
( 2)
_
2
_
_
+1
2
_
, < y
t
<
where =
_
,
2
,
_
are unknown parameters and
(x) =

_
0
e
s
s
x1
ds
is the gamma function.
This distribution has fat-tails and a sharp peak at . The parameter is
known as the degrees of freedom parameter which controls the fatness
in the tails of the distribution.
Example (Ordered Data)
The key mechanism of monetary policy in Australia is the target rate.
When the Reserve Bank of Australia conducts monetary policy at the start
of each month, beginning February until December, it changes the target
rate by either a discrete amount (a multiple of 0.25% = 25 basis points),
or not at all
y
t
=
_
_
1.00% : Extreme Easing
0.75% : Strong Easing
0.50% : Moderate Easing
0.25% : Gentle Easing
0.00% : No change
0.25% : Gentle Tightening
0.50% : Moderate Tightening
0.75% : Strong Tightening
1.00% : Extreme Tightening
Example (Ordered Data continued)
Here is an example of the RBA cutting its interest rate by 75 basis points.
Source: http://business.theage.com.au/business/
rates-cut-to-525-20081104-5hgv.html
Here is an example of the RBA cutting its interest rate by 100 basis points.
A time series plot of the target rate, beginning 1st of October 1993 and
ending 30th of June 2004, is given below in (a). The series follows a step
function. The change in the target policy is given in (b)
Y = D (TARGET)
shows that the change in the target rate is nonnormal.
(a) Target (b) Change in Target
4.0
4.4
4.8
5.2
5.6
6.0
6.4
6.8
7.2
7.6
500 1000 1500 2000 2500
-0.8
-0.4
0.0
0.4
0.8
1.2
500 1000 1500 2000 2500
Example (Count Data)
The following table gives data on the number of strikes in the US for the
years 1968 to 1976, T = 9.
t : 1968 1969 1970 1971 1972 1973 1974 1975 1976
y
t
: 8 6 11 3 3 2 18 2 9
Source: Kennan (1985, 5-28), Journal of Econometrics
Clearly assuming that y
t
is normally distributed is inappropriate as the
data are integers and strictly positive. A natural way to model a
dependent variable that measures counts is to assume that y
t
has a
Poisson distribution
f (y
t
) =

y
t
exp ()
y
t
!
, y
t
= 0, 1, 2, , > 0
where = fg is an unknown parameter with the property > 0. This
parameter represents the mean of the distribution.
Example (Duration Data)
The following histogram gives data on the duration of strikes (in days) in
the US for the years 1968 to 1976, T = 62.
0
4
8
12
16
0 40 80 120 160 200
Series: Y
Sample 1 62
Observations 62
Mean 42.67742
Median 27.00000
Maximum 216.0000
Minimum 1.000000
Std. Dev. 45.84070
Skewness 1.624063
Kurtosis 5.402414
Source: lecture1_strikes.wf1
Source: Kennan (1985, 5-28), Journal of Econometrics
The data are nonnormal as (i) the distribution is skewed to the right, (ii)
the data are integers and (iii) the data are strictly positive.
Example (Duration Data continued)
A natural way to model a dependent variable that measures duration is to
assume that y
t
has an exponential distribution
f (y
t
) = exp [y
t
] , y
t
> 0
with unknown parameter = fg with the property > 0.
The parameter represents the inverse of the mean of the exponential
distribution. This suggests that an estimate of is given by the inverse of
the sample mean (y)
=
1
y
=
T
T
t=1
y
t
We want to show this more formally in this course.
The aim of maximum likelihood estimation is to use all of the
information in the data to estimate the unknown parameters in .
This requires using the data characteristics and hence knowledge of
the probability density function of y
t
.
Thus the aim is to estimate if the distribution is
1. Bernoulli
2. Poisson
3. Exponential
4. Student t
5. Lognormal
and even
6. Normal
Lecture Summary: Key things to know
1. The assumption of normality is used in the regression model, but it
does not apply in all situations.
2. There are other types of models that use alternative types of
distributions. Some examples of other distributions considered in this
course are:
a. Bernoulli
b. Poisson
c. Exponential
d. Student t
e. Lognormal
3. Maximum likelihood estimation provides a general framework to
estimate the unknown parameters for models based on alternative
types of distributions.
End of Lecture

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Econometrics: ECOM30002 and ECOM90002

Lecture 1 Maximum Likelihood: Basics

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