Saima Naureen 55\SE\MS-IBF\F12

ECONOMETRIC METHODS-I
HOME WORK 01
1. What is econometrics? Give its types and explain briefly the steps involved in conventional
econometric methodology.
Econometrics may be defined as the social science in which the tools of economic theory, mathematics,
and statistical inference are applied to the analysis of economic phenomena. Econometrics is concerned
with the empirical determination of economic laws. The method of econometric research aims,
essentially, at a conjunction of economic theory and actual measurements, using the theory and
technique of statistical inference as a bridge pier.
TYPES OF ECONOMETRICS
Econometrics is divided into two broad categories mentioned as under:
Theoretical econometrics
Theoretical econometrics is concerned with the development of appropriate methods for measuring
economic relationships specified by econometric models. In this aspect, econometrics leans heavily on
mathematical statistics. For example, one of the theoretical econometrics methods is least squares.
Theoretical econometrics must spell out the assumptions of this method, its properties, and what
happens to these properties when one or more of the assumptions of the method are not violated.
Applied econometrics
In applied econometrics we use the tools of theoretical econometrics to study some special fields of
economics and business, such as the production function, investment function, demand and supply
functions, portfolio theory, etc.
STEPS INVOLVED IN CONVENTIONAL ECONOMETRIC METHODOLOGY

The steps involved in conventional econometric methodology are mentioned as.
1. Statement of Theory or Hypothesis
Keynes postulated that the marginal propensity to consume (MPC), the rate of change of consumption
for a unit (say, a dollar) change in income, is greater than zero but less than 1.
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2. Specification of the Mathematical Model of
Consumption
Although Keynes postulated a positive relationship between
consumption and income, he did not specify the precise form of
the functional relationship between the two. For simplicity, a
mathematical economist might suggest the following form of
the Keynesian consumption function:
1 2 2
0< <1 Y X | | | = + Equation I
Where Y = consumption expenditure and X = income, and
where 1 and 2, known as the parameters of the model, are, respectively, the intercept and slope
coefficients. The slope coefficient measures the MPC. The variable appearing on the left side of the
equality sign is called the dependent variable and the variables on the right side are called the
independent variables.
3. Specification of the Econometric Model of Consumption
The relationships between economic variables are generally inexact. If we were to obtain data on
consumption expenditure and disposable income of a sample of, say, 500 American families and plot
these data on a graph paper with consumption expenditure on the vertical axis and disposable income
on the horizontal axis, we would not expect all 500 observations to lie exactly on the straight line
because, in addition to income, other variables affect consumption expenditure. For example, size of
family, ages of the members in the family, family religion, etc., are likely to exert some influence on
consumption.
To allow for the inexact relationships between economic variables, the econometrician would modify
the deterministic consumption function as follows:
1 2
Y X | | = + + . Equation II

Where u, known as the disturbance, or error, term. The disturbance term u may well represent all those
factors that affect consumption but are not taken into account explicitly.
4. Obtaining Data
To estimate the econometric model given in Equation II that is, to obtain the numerical values of 1 and
2, we need data.
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5. Estimation of the Econometric Model
Now that we have the data, our next task is to estimate the parameters of the consumption function. The
numerical estimates of the parameters give empirical content to the consumption function. The
statistical technique of regression analysis is the main tool used to obtain the estimates. Using this
technique we can obtain the estimates of 1 and 2 of the regression line.
6. Hypothesis Testing
Assuming that the fitted model is a reasonably good approximation of
reality, we have to develop suitable criteria to find out whether the estimates obtained in, are in accord
with the expectations of the theory that is being tested, Such confirmation of economic theories on the
basis of sample evidence is based on a branch of statistical theory known as statistical inference
(hypothesis testing).
7. Forecasting or Prediction
If the chosen model does not prove false the hypothesis or theory under consideration, we may use it to
predict the future value(s) of the dependent, or forecast, variable Y on the basis of known or expected
future value(s) of the explanatory, or predictor, variable X.
8. Use of the Model for Control or Policy Purposes
Government uses these models to formulate and implement policies with the help of such models and
trends.

2. Explain briefly different types of Data with examples.
Three types of data may be available for empirical analysis mentioned as under;
Time Series Data
A time series is a set of observations on the values that a variable takes at different times. Such data may
be collected at regular time intervals, such as daily (e.g., stock prices, weather reports), weekly (e.g.,
money supply figures), monthly [e.g., the unemployment rate, the Consumer Price Index (CPI)],
quarterly (e.g., GDP), annually (e.g., government budgets), or decennially (e.g., the census of population).
Cross-Section Data
Cross-section data are data on one or more variables collected at the same point in time, For instance
the data on consumer income/expenditures on food or set of families.
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Pooled data
In pooled or combined data are elements of both time series or cross section data. For example the data
on sales, profits and investment for a number of companies over a number of year. Data on gasoline
consumption, number of cars, income etc for a number of states or number of years.
3. What is a regression model? Write general form of a simple linear regression model and clearly
indicate its parameters.
Regression model attempts to explain the variations in a dependent variable using variation in
independent variable, it is a statistical measure to determine the strength between one dependent
variable and series of other changing (independent) variables.
1 2 t t t
Y X | | c = + +
, where,
( )
2
, ~ 0, , 1, 2,...,
t
N t T c o =
.
1, 2, Are the true parameters, they are unknown and unobservable known as driving forces of
regression model.

4. Explain assumptions of simple linear regression model given above.
The Gaussian, standard or CRLM is the cornerstone of most of econometric theory, makes 7
assumptions.
Assumption #1
Linear Regression Model
Linear regression means a regression that is linear in term of parameters (the s are raised to the
first power only)
It may or may not linear in the explanatory variables, the Xs

e.g Yt = 1 + 2Xt

Yt = 1 + 2Xt2
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Assumption # 2
Fixed X Values or X Values Are Independent of the Error Term
Values taken by the regressor X may be fixed in repeated samples (the case of fixed regression) or
they may be sampled along with the dependent variable Y (the case of stochastic regressor)

And X variables and error term are independent
i.e. cov(X,)=0

Assumption #3
Zero Mean Value of Distribution
Given the value of Xt, the mean or expected value of the random disturbance term c is zero.
Symbolically we have
E(ct /X) = 0
Or if X is no stochastic
E(ct ) = 0
Assumption #4
Homoscedasticity or Constant Variance
V(ct) = o2 , t = 1,2,3.,T -------------------Equation I

Variance of random variable
V(X) = E X2 - (EX)2
V(X) = E(ct 2) E(ct)2
As we know that E(ct) = 0
V(ct) = E(ct 2)
By equation 1
V(ct) = o2
o2 = E(ct 2)
Assumption #5
No Autocorrelation between the Disturbance (Between Error Term)
(c1,c2) = 0
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c1 has no relation with c2 or c3
Correl(c1 ,c2 ) = 0
Correl(c1 ,c3) = 0
Correl(c1 ,c4 ) = 0
.
.
.
.
Correl(c1 ,ct ) = 0
Correl(ci ,cj ) = 0 ij & i.j = 1,2,.,T

Assumption #6
The number of observation must be greater than the number of parameters to be estimated.

Assumption #7
The nature of X variables
- The X values in a given sample must not be the same
- The variable x must be positive number
- There can be no outliers in the values of the X variable, i.e. values that are very large in
relation to the rest of the observation


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5. Explain why error term is present in a regression model?
The error term, also known as the disturbance term, is the unobserved random component which
explains the difference between Y and Y^. This term can occur because of many things mentioned as
under.
- Vagueness of theory
- Unavailability of data
- Core variables versus peripheral variables
- Intrinsic randomness in human behavior
- Poor proxy variables
- Principle of parsimony
- Wrong functional form
- Omitted Variables
- Nonlinearities
- Measurement errors
- Unpredictable effects

Saima Naureen 55\SE\MS-IBF\F12

6. Find parameters of simple linear regression model using ordinary least squares (OLS) method.
i.e. find
^
1
|
and
^
2
|
.
OLS ESTIMATES OF SIMPLE LINEAR REGRESSION MODEL
Recall the bivariate,linear regression model
2
1 2
, (0, ), 1, 2,.......,
t t t
Y t T | | c c o = + X + N =

True parameters are 1 , 2 and o2
We use OLS method to estimate these parameters
Since OLS minimizes the RSS
i.e.
2
1
T
t
t
RSS e
=
=

_______________________equation I
The residual and the prediction error

^
t
t
e Y Y =


^ ^ ^
1 2
t
t
Y | | = + X

Now consider equation I
i.e.
2
1
T
t
t
RSS e
=
=

put the value of e and
^
t Y
in equation I
^ ^
2
1 2
1
( )
T
t t
t
Y | |
=
X

Minimize
^
1
|
and
^
2
|
by taking diffrentiatial of equation II
Differentiate equation of equation II w.r.t
^
1
|

Saima Naureen 55\SE\MS-IBF\F12

^ ^
2
1 2 ^ ^
1
1 1
^ ^ ^ ^
2 1
1 2 1 2 ^ ^
1
1 1
^ ^
1 2 ^
1
1
^ ^
1 2 ^
1
1
^
1
^ ^
1 2
1
^
1
( )
2 ( ) )
2 ( )(0 1 0)
2 ( )
0
0 2 ( )
0 (
T
t t
t
T
t t t t
t
T
t t
t
T
t t
t
T
t t
t
T
t
t
RSS
Y
RSS
Y Y
RSS
Y
RSS
Y
RSS
Put
Y
Y
| |
| |
| | | |
| |
| |
|
| |
|
|
| |
|
=

=
=
=
=
=
c c
= X
c c
c c
= X X
c c
c
= X
c
c
= X
c
c
=
c
= X
=

^
1 2
^ ^
1 2
1
^ ^
1
1 1 1
^ ^
1 2
1 1
^ ^
1 2
1 1
^ ^
1 2
1 1
Apply summation
)
( ) 0
_____________ A
t
T
t t
t
T T T
t t t
t t t
T T
t t
t t
T T
t t
t t
T T
t t
t t
Y
Y
Y T
Y T
Y T Equation
|
| |
| |
| |
| |
| |
=
= = =
= =
= =
= =
X
X =
X
X
X
= + X

Differentiate equation of equation II w.r.t
^
2
|

Saima Naureen 55\SE\MS-IBF\F12

^ ^
2
1 2 ^ ^
1
2 2
^ ^ ^ ^
2 1
1 2 1 2 ^ ^
1
2 2
^ ^
1 2 ^
1
2
^ ^
1 2 ^
1
2
^ ^
2
1 2 ^
1
2
( )
2 ( ) )
2 ( )(0 0 )
2 ( )( )
2 ( )

T
t t
t
T
t t t t
t
T
t t t
t
T
t t t
t
T
t t t t
t
RSS
Y
RSS
Y Y
RSS
Y
RSS
Y
RSS
Y
RSS
Put
| |
| |
| | | |
| |
| |
|
| |
|
| |
|
|
=

=
=
=
=
c c
= X
c c
c c
= X X
c c
c
= X X
c
c
= X X
c
c
= X X X
c
c
c

^
2
^ ^
2
1 2
1
^ ^
2
1 2
1
^ ^
2
1 2
1 1 1
^ ^
2
1 2
1 1 1
^ ^
2
1 2
1 1 1
0
0 2 ( )
0 ( )
0
0
_________________________ B
T
t t t t
t
T
t t t t
t
T T T
t t t t
t t t
T T T
t t t t
t t t
T T T
t t t t
t t t
Y
Y
Y
Y
Y Equation
| |
| |
| |
| |
| |
=
=
= = =
= = =
= = =
=
= X X X
= X X X
X X X =
X X X =
X = X + X

Multiply Equation B with T and equation A with
1
T
t
t =
X

,subtract resulting equations (former with later)

^ ^
2
1 2
1 1 1
^ ^
2
1 2
1 1 1 1
^ ^
2 2
2 2
1 1 1 1 1
( )
______________________________
( )
T T T
t t t t
t t t
T T T T
t t t t
t t t t
T T T T T
t t t t t t
t t t t t
T Y T T
Y T
T Y Y T
| |
| |
| |
= = =
= = = =
= = = = =
X = X + X
X = X X
X X = X X



Saima Naureen 55\SE\MS-IBF\F12

^
2 2
2
1 1 1 1 1
^
1 1 1
2
2 2
1 1
( )
____________________________ C
( )
T T T T T
t t t t t t
t t t t t
T T T
t t t t
t t t
T T
t t
t t
T Y Y T
T Y Y
Equation
T
|
|
= = = = =
= = =
= =
| |
X X = X X
|
\ .
X X
=
| |
X X
|
\ .




Put value of
^
2
|
in equation A

^
1 1 1
1
1 1 2 2
1 1
2 2
^
1 1 1
1
1 2 2
1 1
2 2 2 2
^
1 1 1 1 1 1
1
( )
( )
( )
T T T
t t t t T T
t t t
t t
T T
t t
t t
t t
T T T
t t t t T
t t t
t
T T
t
t t
t t
T T T T T T
t t t t t t t t
t t t t t t t
T Y Y
Y T
T
T Y Y
T Y
T
T Y Y T Y Y
T
|
|
|
= = =
= =
= =
= = =
=
= =
= = = = = =
X X
= + X
| |
X X
|
\ .
X X
=
| |
X X
|
\ .
X X X + X
=

1
2 2
1 1
2 2
^
1 1 1
1
2 2
1 1
( )
( )
T
T T
t t
t t
T T T
t t t t
t t t
T T
t t
t t
T
T Y Y
T
T
|
=
= =
= = =
= =
| |
X X
|
\ .
| |
X X
|
\ .
=
X X

2 2
^
1 1 1
1
2 2
1 1
( )
T T T
t t t t
t t t
T T
t t
t t
Y Y
T
|
= = =
= =
| |
X X
|
\ .
=
X X


_______________________________Equation D

Alternate formula for
^
1
|


Saima Naureen 55\SE\MS-IBF\F12

Divide equation with T on both sides

^
^
1 1 1
2
T T
t t
t t
Y
T
T T T
|
|
= =
X
= +




__ __ ^ ^
1 2
Y | | = + X


Where
__
Y
=
1
T
t
t
Y
T
=

,
__
X
=
1
T
t
t
T
=
X

Rearrange the equation


__ __ ^ ^
1 2
Y | | = X


Summary

2
1 2
, (0, ), 1, 2,.......,
t t t
Y t T | | c c o = + X + N =



2 2
^
1 1 1
1
2 2
1 1
( )
T T T
t t t t
t t t
T T
t t
t t
Y Y
T
|
= = =
= =
| |
X X
|
\ .
=
X X



__ __ ^ ^
1 2
Y | | = X



^
1 1 1
2
2 2
1 1
( )
T T T
t t t t
t t t
T T
t t
t t
T Y Y
T
|
= = =
= =
X X
=
| |
X X
|
\ .



Saima Naureen 55\SE\MS-IBF\F12


Saima Naureen 55\SE\MS-IBF\F12

7. Give expressions for the variances of OLS estimates, i.e.
( )
^
1
V |
and
( )
^
2
V |
, also calculate
( )
^ ^
1 2
, Cov | |
.


Cov
^=
cov (
^
,
^
)=E [(
^
-E(
^
))(
^
-E(
^
))
'
] eq(1)
But due to unbaisedness E(
^
)= eq(b)
As
^=
(X'X)
-1
X'Y eq(a)
But Y=X +
Putting the value of Y from eq(a) in eq(b)
= (X'X)
-1
X'(X +)
=(X'X)
-1
X'X +(X'X)
-1
X'
As AA
-1
=I

^
= +(X'X)
-1
X'

^
-=(X'X)
-1
X' eq(2)
Putting the value of
^
- in eq(1)
Cov (
^
)

=cov (
^
,
^
)=E [(
^
-E(
^
))(
^
-E(
^
))
'
]
Cov (
^
)

=cov (
^
,
^
)=E [{(X'X)
-1
X' }{(X'X)
-1
X'}]
Applying transpose
=E (X'X)
-1
X''X(X'X)
-1
As X is assumed to be fixed and expected value is defined for random value so we can write
above equation as
Cov (
^
)

=(X'X)
-1
X' E (') X (X'X)
-1
But E(')=
2
I
Cov (
^
)
=
(X'X)
-1
X'
2
I X (X'X)
-1
=
2
(X'X)
-1
X' X (X'X)
-1
Saima Naureen 55\SE\MS-IBF\F12

As AA
-1
=I
=
2
(X'X)
-1
I
Cov (
^
) =
2
(X'X)
-1




Saima Naureen 55\SE\MS-IBF\F12

8. Give an estimate of variance of error term. i.e. find
^2
o
.

2
^
RSS
T K
o =

,Where k is number of regressors

2
^
2
RSS
T
o =

Consider a multiple linear regression model
1 2 2 3 3
...
t t t k kt t
Y X X X | | | | c = + + + + +
, where,
( )
2
, ~ 0, , 1, 2,...,
t
N t T c o =

9. Write the above regression model in matrix form given below:
Y X| c = +
, where,
( )
2
~ 0,
T
N I c o
, where IT is identity matrix of order T.
Clearly state the dimensions (orders) of Y, X,
|
and
c
. Also indicate parameters of this
regression model.

MATRIX FORM OF MULTIPLE REGRESSION MODEL
Consider multiple linear regression model

2
1 2 2
.................................. , (0, ), 1, 2,...............,
t t k kt t t
Y t T | | | c c o = + X + X + N =


Writing model for each individual values

1 1 2 21 1 1
2 1 2 22 2 2
1 2 2
..................................
..................................
.
.
.
.
..................................
k k
k k
T T k kT T
Y
Y
Y
| | | c
| | | c
| | | c
= + X + X +
= + X + X +
= + X + X +

Saima Naureen 55\SE\MS-IBF\F12


Write above model in matrix form
1 21 1
2 22 2
1 X .....................
1 X .....................
. . . .
. . . .
. . .
K
K
T
Y X
Y
Y
| |
|
X
|
|
=
|
|
|
|
|
\ .
1 1
2 2
2
. .

. .
. . .
1 X ......................
T KT K T
X
| c
| c
| c
| | | | | |
| | |
| | |
| | |
+
| | |
| | |
| | |
| | |
| | |
\ . \ . \ .




Matrix Form of regression model

1 1 1 T T K K T
Y X | c

= +


We have to find E(c)

AS
1
2
.
.
.
T
c
c
c
c
| |
|
|
|
=
|
|
|
|
|
\ .


Apply expectation
1
2
.
( )
.
.
T
E E
c
c
c
c
| |
|
|
|
=
|
|
|
|
|
\ .

Saima Naureen 55\SE\MS-IBF\F12

1
2
( )
( )
.
( )
.
.
( )
T
E
E
E
E
c
c
c
c
| |
|
|
|
=
|
|
|
|
|
\ .

We know that E(c)=0
0
0
.
( )
.
.
0
E c
| |
|
|
|
=
|
|
|
|
|
\ .
=(0TX1)
Now we have to find cov(c)


Saima Naureen 55\SE\MS-IBF\F12

( )
1
2
1 2
1 1 1 2 1
2 1 2 2 2
( ) ( ')
.
( ) ...................
.
.
.....................
.....................
. .
( )
T
T
T
T
Cov E ee
Cov E
Cov E
c
c
c
c c c c
c
c c c c c c
c c c c c c
c
=
| |
|
|
|
=
|
|
|
|
|
\ .
=
1 1 1 1
2
1
.
. . .
. . .
..................
E( )
( )
T T
Cov E
c c c c c c
c
c
| |
|
|
|
|
|
|
|
|
\ .
=
1 2 1
2
2 1 2 2
E( ) ..................... ( )
( ) E( ) .........................E( )
. . .
. .
T
T
E
E
c c c c
c c c c c
2
1 1
.
. . .
( ) E( ) ................... ( )
T T T
E E c c c c c
| |
|
|
|
|
|
|
|
|
\ .


The two assumption of CRLM are
E(ct 2) = o2


And E (ci ,cj ) = 0 ij & i.j = 1,2,.,T

By looking on these assumptions

Saima Naureen 55\SE\MS-IBF\F12

2
2
0.........................0
0 .......................0
. . .
( )
. . .
. . .
0
Cov
o
o
c =
2

0......................... o
| |
|
|
|
|
|
|
|
|
\ .



2
( ) Cov I c o =

The following questions are related to multiple linear regression model given in question #9 above:

10. Find parameters of regression model given in Q#9 using OLS method. i.e. calculate
^
|

OR Prove that
( )
1
^
' ' X X X Y |

=


Consider matrix form of regression model

2
1 1 1
, (0, I)
T T K K T
Y X | c c o

= + N


True parameters are and o2
We use OLS method to estimate these unknown parameters
Since OLS minimizes RSS
i.e.
RSS=ee' Min

^
e Y Y =

^ ^
Y X | =


Consider
RSS=e'e
_______________________equation I
Put the values of e and
^
Y
in equation I
Saima Naureen 55\SE\MS-IBF\F12

'
^ ^
'
^ ^
RSS Y Y Y Y
RSS Y X Y X | |
| | | |
=
| |
\ . \ .
| | | |
=
| |
\ . \ .


^ ^
^ ^
RSS= ' ' (A-B)'=A'-B' AB'=B'A'
RSS= ' ' ' AB'=B'A'
Y X Y X
Y X Y X
| |
| |
| || |

| |
\ .\ .
| || |

| |
\ .\ .

^ ^ ^ ^
RSS=Y'Y-Y'X - ' ' ' ' X X Y X | | | | +
_____________________Equation II
AS Order of
^
Y'X|
is 1x1
So
^ ^
Y'X (Y'X ) ' | | =

^ ^
Y'X ' ' X Y | | =


By putting the value of
^
Y'X|
in equation II
^ ^ ^ ^
^ ^ ^
RSS=Y'Y- ' ' - ' ' ' ' X
RSS=Y'Y- 2 ' ' ' ' X
X Y X Y X
X Y X
| | | |
| | |
+
+


Differentiate equation 2 w.r.t
^
|



^ ^ ^
^ ^
^
^
^
= Y'Y- 2 ' ' ' ' X
0 2 ' 2 '
0
RSS
X Y X
RSS
X Y X X
RSS
Put
| | |
| |
|
|
|
c c
| |
+
|
\ .
c c
c
= +
c
c
=
c

Saima Naureen 55\SE\MS-IBF\F12

^
^
0 2 ' 2 '
2 ' 2 '
X Y X X
X Y X X
|
|
= +
=

( )
^
1
' ' X X X Y |

=





Saima Naureen 55\SE\MS-IBF\F12

11. Find variance-covariance matrix of OLS estimates, i.e calculate
( )
^
Cov |
.
OR Prove that
( ) ( )
1
^ 2
' Cov X X | o

=



^ ^ ^ ^ ^ ^ ^
( ) ( , ') ( ) ( ) ' Cov Cov E E E | | | | | | |
( | || |
= =
| |
(
\ .\ .

^
E( ) = due to unbaissed As | |

^ ^ ^
( ) ' Cov E | | | | |
( | || |
=
| |
(
\ .\ .
____________________Equation I
As we know
( )
^
1
' ' X X X Y |

=
______________________Equation II
And
Y X| c = +

Put the value of Y in equation II
^
1
^
1 1
( ' ) '( )
( ' ) ' ( ' ) '
X X X X
X X X X X X X
| | c
| | c

= +
= +



And simply recalling that AA-1 = 1
1
^
1
^
1
^
1
( ' ) '
( ' ) '
( ' ) '
( ' ) '
X X X X I
I X X X
X X X
X X X
| | c
| | c
| | c

=
= +
= +
=

Put the value of
^
| |
in equation I
( )( )
^
1 1
( ) ( ' ) ' ( ' ) ' ' Cov E X X X X X X | c c

(
=


Apply transpose
^
1 1
( ) ( ' ) ' . ' ( ' ) Cov E X X X X X X | c c

( =


Saima Naureen 55\SE\MS-IBF\F12

As X is assumed to be fixed and expectation is only applied on random variables so we can write
above equation

^
1 1
( ) ( ' ) ' ( . ') ( ' ) Cov X X X E X X X | c c

=

But we know that
( . ') E c c
=
2
I o

^
1 2 1
^
2 1 1
( ) ( ' ) ' ( ' )
( ) ( ' ) ' ( ' ) As AA'=I
Cov X X X IX X X
Cov X X X X X X
| o
| o


=
=

^
2 1
( ) ( ' ) Cov X X | o

=





12. Given the following data set:


Y X
23 42
45 13
21 23
26 34
42 54
13 21
14 42
34 33
25 18
41 29

Suppose we want to predict income using
education, i.e we want to construct the
following regression model,
1 2 t t t
Y X | | c = + +

where,
( )
2
~ 0, , 1, 2,...,
t
N t T c o =
.
Where,
Y is income of all individuals
X is education of the same individuals.
a. Estimate parameters of this regression model (
^
1
|
and
^
2
|
) using formula obtained in Q#6

Saima Naureen 55\SE\MS-IBF\F12

2 2
^
1 1 1
1
2 2
1 1
( )
T T T
t t t t
t t t
T T
t t
t t
Y Y
T
|
= = =
= =
| |
X X
|
\ .
=
X X


=
400340
14449
(
(

=27.70711

^
1 1 1
2
2 2
1 1
( )
T T T
t t t t
t t t
T T
t t
t t
T Y Y
T
|
= = =
= =
X X
=
| |
X X
|
\ .


=
324
14449
(
(

=0.022424

Suppose we write the regression model in matrix form as follows:
Y X| c = +
, where,
( )
2
~ 0,
T
N I c o

b. Estimate parameter (
^
|
) of this regression model using formula obtained in Q#11.






c. Compare the results obtained in Q# 6 and Q# 11. (Note: they must be same).

The obtained values in both questions are exactly same

d. Estimated regression model is:
^ ^ ^
1 2 t t
Y X | | = +
(put values of
^
1
|
and
^
2
|
to get your
regression line).

B^=(X'X)^-1*X'Y= 27.70711 =b1^
2X2 2X1

0.022424 =b2^
Saima Naureen 55\SE\MS-IBF\F12

e. Calulate
2
o
by using the relation,
2
2 1
'
2 2
T
t
t
e
e e
T T
o
=
= =

^2
o
=149.4592

f. Calculate covariance matrix of OLS estimate (
^
|
) by using the relation,
( ) ( )
1
^ ^2 ^2
324
'
' , ,
444
2
1 9
e e
Cov X X where
T
| o o

= =

(
(


( )
^
Cov |
=
( )
1
^2
' X X o

=


g. Calculate
( )
^
1
V |
and
( )
^
2
V |
by selecting diagonal entries of
( )
^
Cov |
calculated in part
(e) above.

( )
^
1
V |
=113.711
( )
^
2
V |
=0.10344
h. Calculate
( )
^
1
SE |
and
( )
^
2
SE |
.

( )
^
1
SE |
=10.66354

( )
^
2
SE |
=0.321621

113.7106 -3.19627
-3.19627 0.103439
Saima Naureen 55\SE\MS-IBF\F12


i. Interpret slope and intercept of your estimated regression model given in part (d) above.

The intercept value is 27.70711 means that when the education level is zero INCOME(Y) is
about to be 27.70711 on average.
And the slope is 0.022424 means that for each change of 1unit of EDU(X) INCOME(Y) changes
0.022242units on average

j. Test null hypothesis that
0 1
: 0 H | =
.
To test the hypothesis we use t-statistics
^
0
1 1
^
1
. ( )
H
tvalue
S E
| |
|

=

t cal=10.66354-0/27.70711
=0.38486644
CV= TINV(significance level, degree of freedom)
CV=2.30600414
UCV=2.30600414
LCV=-2.30600414
conclusion: since tcal is b/w upper and lower CV, so we do not reject H0 at 5% significance level

k. Test null hypothesis that
0 2
: 0 H | =

To test the hypothesis we use t-statistics

^
0
2 2
^
2
. ( )
H
tvalue
S E
| |
|

=

t cal= 0.321621-0/0.022424
t cal = 14.3429
Saima Naureen 55\SE\MS-IBF\F12

CV= TINV (significance level, degree of freedom)
CV= 2.306004
UCV=2.30600
LCV=-2.306004
Conclusion: since tcal is lies outside the region of CV, so we reject H0 at 5% significance level and
conclude that X2 is imp or it is significant at 5% significance level and should not be drooped.
l. What is coefficient of determination (R2). Give its formula.

Co efficient of determination (R2)



Where ESS = EXPLAINED SUM OF SQUARES(explained variation)

TSS = TOTLA SUM OF SQUARES(total variation)
R2 has zero minimum value and maximum values is 1.
Symbolically

2
0 1 R s >





2
ESS
R
TSS
=
Saima Naureen 55\SE\MS-IBF\F12

13. State and prove Gauss Markov Theorem in the context of regression model given in Q# 9
above. OR Prove that OLS estimates are BLUE.

Gauss Markov Theorem
Statement
The ordinary least Square estimates are BEST LLINEAR UNBAISSED and EFFICIENT

Consider matrix form of regression model
Y X| c = +
, where,
( )
2
~ 0,
T
N I c o

OLS estimates of ^ is
( )
^
1
' ' X X X Y |

=


1. BEST
OLS estimates are best

2. LINEAR
OLS estimates are linear function of dependent variable (Y)
Proof:
As we know that

( )
^
1
' ' X X X Y |

=


Let A=
1
( ' ) ' X X X

^
|
=AY
^
|
is a linear fit of Y
A is fixed because of assumption that X is fixed


Saima Naureen 55\SE\MS-IBF\F12

3. UNBAISSENESS
OLS Estimates are unbiased
i.e. E(
^
|
) =
|

Proof:
As
( )
^
1
' ' X X X Y |

=

Put the value of Y
Y X| c = +

^
1
^
1 1
( ' ) '( )
( ' ) ' ( ' ) '
X X X X
X X X X X X X
| | c
| | c

= +
= +

As
1
^
1
^
1
( ' ) '
( ' ) '
( ' ) '
X X X X I
I X X X
X X X
| | c
| | c

=
= +
= +


^
1
( ' ) ' X X X | | c

= +

Taking Expectation on both sides
( )
^
1
^
1
( ) ( ' ) '
( ) ( ' ) ' ( )
E E X X X
E X X X E
| | c
| | c

= +
= +


^
1
^
E( )=0
( ) ( ' ) '(0)
( ) 0
As
E X X X
E
c
| |
| |

= +
= +

^
( ) E | | =





Saima Naureen 55\SE\MS-IBF\F12



4. Efficiency:
OLS estimates are efficient
Prof:
OLS estimates have minimum variance in the class of all best linear unbiased estimates.