Economics 120c

Professor Yongil Jeon

Summer 2005

Name: _________________________
Student ID#: _________________________
Answer to Homework #2
(Final Exam, Summer 2004)

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(1) (20 points) To study the determinants of growth among the countries of the world,
researchers have used panels of countries and observations spanning long periods of
time (e.g. 1965-1975, 1975-1985, 1985-1990). Some of these studies have focused on
the effect that inflation has on growth, and found that although the effect is small for
a given time period, it accumulates over time and therefore has an important negative
effect.
(a) (5 points) Explain why the OLS estimator may be biased in this case.

Answer: The presence of simultaneous causality is highly likely since inflation may
respond to growth. Depending on the list of regressors, omitted variables can also
bias the estimator for the effect of the inflation rate.
(b) (10 points) Explain how methods using panel data could potentially alleviate the
problem.
Answer: Country fixed effects or differencing the data can solve the problem if
inflation stays relatively constant over time from one country to the other.
Unfortunately if the effect of inflation on growth is the focus of the study, then much
of the cross-sectional information is lost using this approach.
(c) (5 points) Some authors have suggested using an index of central bank
independence as an instrument, since the central bank independence is in general
determined independently and separately by concerns on inflation. Discuss whether
or not such an index would be a valid instrument.

Th

Answer: For this index to be valid, central bank independence has to be relevant and
exogenous. If inflation rates are correlated with the index, then central bank
independence is a relevant instrument. Although there is a high correlation for
developed countries, there is little to no correlation when data for all countries are
considered. Whether or not the index is exogenous cannot be tested unless the
coefficients of the equation are overidentified. Otherwise personal judgment is the
only guide. An argument that central bank independence is exogenous would have to
rely on it being based on institutional arrangements which are independent of
inflation. Although the independence of central banks in many countries was initially
determined by concerns independent of inflation, there have been many situations
where the institutional arrangements were altered as a result of high inflation.

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Answer to HW #2, ECO 120C, SUMMER 2005

(2) (30 points) Two authors published a study in 1992 of the effect of minimum wages on
teenage employment using a U.S. state panel. The paper used annual observations for
the years 1977-1989 and included all 50 states plus the District of Columbia. The
estimated equation is of the following type
Eit = 0 + 1 (Mit /Wit ) + 2D2i + + nD51i + 2B2t + + TB13t + uit,
where E is the employment to population ratio of teenagers, M is the nominal
minimum wage, and W is average wage in the state. In addition, other explanatory
variables, such as the prime-age male unemployment rate, and the teenage population
share were included.

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(a) (10 points) Briefly discuss the advantage of using panel data in this situation
rather than pure cross-sections or time series.

Answer: There are likely to be omitted variables in the above regression. One way to
deal with some of these is to introduce state and time effects. State effects will
capture the influence of omitted variables that are state specific and do not vary over
time, while time effects capture those of countrywide variables that are common to all
states at a point in time. Furthermore, there are more observations when using panel
data, resulting in more variation.
(b) (5 points) Estimating the model by OLS but including only time fixed effects
results in the following output
_

Eit = 0 0.33 (Mit /Wit ) + 0.35 ( SHYit ) 1.53 uramit ; R 2 = 0.20

(0.08)
(0.28)
(0.13)

where SHY is the proportion of teenagers in the population, and uram is the prime-age
male unemployment rate. Coefficients for the time fixed effects are not reported.
Numbers in parentheses are (homoskedasticity-only) standard errors.

Th

Comment on the above results. Are the coefficients statistically significant? Since
these are level regressions, how would you calculate elasticities?

Answer: There is a negative relationship between minimum wages and the

employment to population ratio. Increases in the share of teenagers in the population
result in a higher employment to population ratio, and increases in the prime-age male
unemployment rate lower the employment to population ratio. 20 percent of
employment to population of teenagers variation is explained by the above regression.
The relative minimum wage and the prime-age male unemployment rate are
significant using a 1% significance level, while the proportion of teenagers in the
population is not. Elasticities vary with levels here. One possibility is to report
elasticities at sample means.

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Answer to HW #2, ECO 120C, SUMMER 2005

(c) (5 points) Adding state fixed effects changes the above equation as follows:
Eit = 0 + 0.07 (Mit /Wit ) 0.19 ( SHYit ) 0.54 uramit ; R 2 = 0.69
(0.10)
(0.22)
(0.11)

Compare the two results. Why would the inclusion of state fixed effects change the
coefficients in this way?

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Answer: The parameter of interest here is the coefficient on the relative minimum
wage. While it was highly significant in the previous regression, it now has changed
signs and is statistically insignificant. The explanatory power of the equation has
increased substantially. The size of the other two coefficients has also decreased. The
results suggest that omitted variables, which are now captured by state fixed effects,
were correlated with the regressors and caused omitted variable bias.
(d) (10 points) The significance of each coefficient decreased, yet R 2 increased. How is
that possible? What does this result tell you about testing the hypothesis that all of the
state fixed effects can be restricted to have the same coefficient? How would you test
for such a hypothesis?
Answer: The influence of the state effects is large. These are bound to be statistically
significant and the hypothesis to restrict these same coefficients is bound to fail. Since
these are linear hypotheses that are supposed to hold simultaneously, an F-test is
appropriate here.

3. (30 points) Consider a simple model to estimate the effect of personal computer (PC)
ownership on college grade point average for graduating seniors at a large public
university
GPA = 0 + 1 PC + u
where PC is a binary variable indicating PC ownership.

Th

(a) (10 points) Why might PC ownership be correlated with u?

(Answer) It has been fairly well established that socioeconomic status affects student
performance. The error term u contains, among other things, family income, which has a
positive effect on GPA and is also very likely to be correlated with PC ownership.
(b) (10 points) Explain why PC is likely to be related to parents annual income. Does
this mean parental income is a good IV for PC? Why or why not?
(Answer) Families with higher incomes can afford to buy computers for their children.
Therefore, family income certainly satisfies the second requirement for an instrumental
variable: it is correlated with the endogenous explanatory variables. But as we suggested
in part (i), faminc has a positive effect on GPA, so the first requirement for a good IV,

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Answer to HW #2, ECO 120C, SUMMER 2005

fails for faminc. If we had faminc we would include it as an explanatory variable in the
equation; if it is the only important omitted variable correlated with PC, we could then
estimate the expanded equation by OLS.
(c) (10 points) Suppose that, four years ago, the university gave grants to buy
computers to roughly one-half of the incoming students, and the students who
received grants were randomly chosen. Carefully explain how you would use this
information to construct an instrumental variable for PC?

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(Answer) This is a natural experiment that affects whether some students own computers.
Some students who buy computers when given the grant would not have without the
grant. Define a dummy variable, grant, equal to one if the student received a grant, and
zero otherwise. Then, if grant was randomly assigned, it is uncorrelated with u. In
particular, it is uncorrelated with family income and other socioeconomic factors in u.
Further, grant should clearly be correlated with PC: the probability of owning a PC
should be significantly higher for students receiving grants. Incidentally, if the university
gave grant priority to low income students, grant would be negatively correlated with u,
and IV would be inconsistent.

4) (20 points) Describe the consequences of estimating an equation by OLS in the presence
of an endogenous regressor. How can you overcome these obstacles? Present an
alternative estimator.

Th

(Answer) In the case of an endogenous regressor, there is correlation between the

variable and the error term. In this case, the OLS estimator is inconsistent. To get a
consistent estimator in this situation, instrumental variable techniques, such as 2SLS
should be used. If one or more valid instruments can be found, meaning that the
instrument must be relevant and exogenous, then a consistent estimator can be
derived.

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