Basic Econometrics: Old exam questions with answers and hints

Mns Sderbom
Note: The answers provided below are formulated in such a way as to provide students with a few
checkpoints and pointers. They are not always perfect exam answers typically, a bit more
discussion is required to give top marks.

March 2012: Question 3

(a) State and interpret the main assumptions under which the Gauss-Markov theorem holds
for time series regression applications. [20%]
>> These are the five assumptions TS.1-TS.5 discussed in Chapter 10.
(b) Using a dataset consisting of 108 monthly observations on automobile accidents for
California between January 1981 and December 1989, we estimate the following model:
( ) = 0 + 1 + 2 + 3 + 12 +

where totacc is the total number of accidents, t is time (measured in months), and febt,
marcht,,dect are dummy variables indicating whether time period t corresponds to the
appropriate month. We obtain the following OLS results:
Source |
SS
df
MS
-------------+-----------------------------Model | 1.00244071
12 .083536726
Residual | .255496765
95
.00268944
-------------+-----------------------------Total | 1.25793748
107 .011756425

Number of obs
F( 12,
95)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

108
31.06
0.0000
0.7969
0.7712
.05186

-----------------------------------------------------------------------------ltotacc |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------t |
.0027471
.0001611
17.06
0.000
.0024274
.0030669
feb | -.0426865
.0244475
-1.75
0.084
-.0912208
.0058479
mar |
.0798245
.0244491
3.26
0.002
.031287
.1283621
apr |
.0184849
.0244517
0.76
0.452
-.030058
.0670277
may |
.0320981
.0244554
1.31
0.193
-.0164521
.0806483
jun |
.0201918
.0244602
0.83
0.411
-.0283678
.0687515
jul |
.0375826
.024466
1.54
0.128
-.0109886
.0861538
aug |
.053983
.0244729
2.21
0.030
.0053981
.1025679
sep |
.042361
.0244809
1.73
0.087
-.0062397
.0909617
oct |
.0821135
.0244899
3.35
0.001
.0334949
.130732
nov |
.0712785
.0244999
2.91
0.005
.02264
.1199171
dec |
.0961572
.0245111
3.92
0.000
.0474966
.1448178
_cons |
10.46857
.0190028
550.89
0.000
10.43084
10.50629
------------------------------------------------------------------------------

Is there a trend in total accidents? Is there seasonality in total accidents? [20%]

>> The coefficient on the time variable (t) is positive and highly statistically significant. This
indicates a positive trend in accidents. The point estimate is 0.0027 and the dependent
variable is in logarithmic form. Hence the number of accidents grows by 0.27% per month (or
1

approximately 3.2% per year). The results also suggest there is seasonality in the number of
accidents, since several of the month dummies are significantly different from zero (January
is the base month). To test formally for seasonality we would test the null hypothesis that all
the eleven months are insignificant, against the alternative that the null is not true.
(c) Consider the following time series model:
= 1 1 +

where follows a white noise process. What is the condition we need to impose on 1 in
order for the series to be weakly stationary? Why? [20%]

>> 1 needs to be strictly higher than -1 and strictly lower than 1; otherwise the variance of
y(t) will depend on t which is ruled out under weak stationarity (recall, weak stationarity
requires the mean and the variance of y(t) to be independent of time, and the covariance
between y(t) and y(t-k) to be independent on t, but may be dependent on k). To see why we
require 1 to be strictly lower than one, calculate the variance if 1 =1. Suppose our series
starts in time period 1. Then, for any y(t), if 1 = 1, we have y(t)=u(1)+u(2)+u(3)++u(t).
Since u(t) is white noise, it follows that var(y(t)) = var(u(1)) + var(u(2))+ var(u(3))++
var(u(t)). Thus, the variance is increasing in the number of time periods t. If the variance of u
is constant, var(u(s)) = var(u) for any s, we have var(y(t)) = t*var(u), which clearly is a
function of t. Exactly the same result can be obtained for 1 = 1.
(d) Consider the following time series model:
= 0 + 1 1 + 2 2 +

where yt is some outcome variable of interest, and xt1 and xt2 are strictly exogenous
explanatory variables. How would you test for the presence of serial correlation in the residual
ut? [20%]

>> The simplest procedure would be as follows: First, run a regression in which y(t) is the
dependent variable and x1(t) and x2(t) are the two explanatory variables. Next, based on the
OLS estimates of beta0, beta1, beta2, obtain the predicted residual for each time period (we
would refer to the predicted residual as uhat(t)). Finally, run a regression of the following
type: uhat(t) = a0 + a1*uhat(t-1) + e(t), where a0 and a1 are parameters to be estimated; under
the null hypothesis of no serial correlation, we have a1=0; thus use a simple t-test to
distinguish between H0: a1=0, and H1: a10. See textbook for more details.
(e) Briefly explain how you would carry out econometric analysis of the model in (d) if ut is
found to be stationary, but positively serially correlated. [20%]
>> One option would be to use the same model as in (d) and compute the standard errors
using some method that does not require the residual to be serially uncorrelated (e.g. NeweyWest). Note that the Gauss-Markov assumptions are not fulfilled in this case. An alternative
option would be to transform the original specification in such a way that that new,
transformed residual, becomes serially uncorrelated. FGLS would be one such approach see
textbook for details.
2

May 2012: Question 2

(a) Suppose the true population model for the outcome variable y has two explanatory
variables (x1 and x2) and an error term (u):
= 0 + 1 1 + 2 2 + .

(2.1)

Assume that this model satisfies the Gauss-Markov assumptions. Suppose our primary
interest is in 1 and suppose we do not have data on the variable 2 . Summarize the

direction of the bias in the estimate of 1 when 2 is omitted in estimating equation

(2.1) by means of OLS. Explain how you arrived at your answer. (25%)

>> To provide a good answer to this question you need to understand the discussion in
the textbook summarized in Table 3.2. See also the analysis of omitted variables
showing that E(beta1_tilda) = beta1 + delta*beta2, where delta is the slope coefficient
in a regression of the omitted variable x2 on x1. Key point to discuss is that there will
be omitted variable bias unless delta=0 (i.e. if x2 and x1 are uncorrelated) or beta2=0
(no effect of x2 on y), and that the sign of the bias is equal to the sign of delta*beta2.
(b) Why is a good proxy variable a bad instrument? (25%)
>> NOTE: PROXY VARIABLES ARE NO LONGER COVERED IN THIS
COURSE. A good proxy variable must be correlated with the omitted variable, while
an instrumental variable must be uncorrelated with the omitted variable (exogeneity).
(c) Consider the following model of household savings:
savings = 0 + 1inc + 2 hhsize + 3 age + 4 educ +

where inc denotes household income, hhsize is household size, age and educ denote
the age and years of schooling the household head, and is an error term. It is often
the case that household income is mis-reported in survey data. If we estimate savings
model above using OLS, how may the presence of measurement errors in reported
income affect your results and conclusions? (25%)
>> If we assume that reported income = true income + measurement error, which we
write as rinc = inc + me, where me is uncorrelated with inc, we have the classical
errors-in-variables model for which the estimated coefficient on reported income

will be biased toward zero. To see why, note that the model that you can estimate is
written
savings = beta0 + beta1*rinc beta1*me + beta2*hhsize + beta3*age + beta4*educ +
epsilon
savings = beta0 + beta1*rinc + beta2*hhsize + beta3*age + beta4*educ + {epsilon
beta1*me}
where the error term is the expression in { }. The key result here is that the equation
residual { } is correlated with rinc. If beta1>0, then the error term is negatively
correlated with rinc, resulting in downward bias in the estimate of beta1; if beta1<0,
then the error term is positively correlated with rinc, resulting in upward bias. Thus,
regardless of the sign of beta1, there will be bias toward zero; also, t-statistics will be
lower, making it less likely we will be able to reject the null hypothesis that beta1=0.
In the special case in which there is only one explanatory variable in the model (so
that beta2=beta3=beta4=0), we can obtain a formula for the bias see textbook for
details.
If, in contrast, the measurement error is uncorrelated with rinc, there will be no bias,
however the standard errors will be higher than if there are no measurement errors.
(d) Write down a suitable model of log wages that allows the partial effect of experience
to vary with the level of experience. Explain how the parameters of your model should
be interpreted. (25%)
>> The partial effect: d log wage / d exper = beta1 + (2*beta2)*exper. This requires
the regression model to contain experience and experience squared as explanatory
variables, e.g: log wage = beta0 + beta1*exper + beta2*exper^2 + u. In this model, a
one year increase in experience results in a percentage increase in wage by about 100*
beta1 + (2*beta2)*exper). Thus, if, say, beta1=0.05 and beta2=-0.002, an increase in
experience from 10 to 11 would result in a wage increase of about 100*(0.052*.002*10)% = 1%; while an increase in experience from 2 to 3 would result in a
wage increase of about 100*(0.05-2*.002*2)%= 4.2%. The result that the partial effect
differs depending on the baseline level of experience is due to the nonlinearity driven
by the squared term in the model.
May 2012: Question 3b
4

Our goal is to determine the causal effect of a new garbage incinerator on housing values in North
Andover, Massachusetts. The rumour that a new incinerator would be built in North Andover began in
1978, and construction began in 1981. The incinerator began operating in 1985. We have access to
data on prices of houses that sold in 1978 and another sample on those that sold in 1981.
(b) Table 3.2 below shows results from a difference-in-differences estimator for which we
have used both waves of the data available (the variable y81 is a dummy variable equal to 1 if
the year is 1981 and zero otherwise; the variable y81_nearinc is an interaction term defined as
y81 times nearinc). Based on these results, would you argue that the new garbage incinerator
had a negative causal effect on housing values? Explain. (33%)
Table 3.2. Effects of incinerator location on housing prices: OLS results
(1)

Dependent variable: rprice

(2)

(3)

Constant

82,517
(2,727)

89,117
(2,406)

13,808
(11,167)

y81

18,790
(4,050)

21,321
(3,444)

13,928
(2,799)

Nearinc

-18,824
(4,875)

9,398
(4,812)

3,780
(4,453)

y81_nearinc

-11,864
(7,457)

-21,920
(6,360)

-14,178
(4,987)

Other controls

No

age, age2

Full Set

Observations
R-squared

321
0.174

321
0.414

321
0.660

Independent variable

Note: The numbers in parentheses are standard errors.

>> Key components of a good answer: i) Explain logic of dif-in-dif; ii) explain how to
estimate the dif-in-dif using regression analysis, carefully explaining how the explanatory
variables are defined; iii) explain why it may make sense to include control variables. In
this particular case we have a negative and statistically significant effect, suggesting the
incinerator had a negative causal effect on house prices.

November 2012: Question 2d

(d)

Suppose now you want investigate whether the gender difference in the effect of

education on wages (the quantity of interest in Question 2c) itself has changed over time say
between 1980 and 2010. Carefully explain what type of data you would have to use, propose a
suitable model specification, state your null hypothesis and alternative hypothesis, and explain
how you would test the null hypothesis.
>> I will need cross-sectional data for the two years of interest (1980 and 2010). (Panel data
are probably less suited for this purpose since in order to be included in the panel individuals would be quite young in 1980 and quite old (30 years older) in 2010 perhaps we
may worry that the determinants of wages in 2010 for this group of relatively old individuals
is not very representative of the population in 2010.)

I would write down a model in which log wage depends on a dummy for females and
education and the interaction between female and education (this interaction measures the
gender difference in the effect of education on wages), and I would add a dummy variable for
2010 (yr_2010), and interaction terms between the year dummy and: education, the female
dummy, and the education-female interaction term:
log wage = 0 + 1 educ + 2 female + 3 female_educ + 4 yr_2010 + 5 educ_yr2010
+ 6 female_yr2010 + 7 female_educ_yr2010 + u
where female_educ_yr2010 = female*educ*yr2010.

If the gender difference in the effect of education on wages is constant over time, we would
have 7=0; if the gender difference in the effect of education on wages is different in 2010
compared to 1980 we would have 70. Hence we specify the null hypothesis as H0: 7=0 and
the alternative hypothesis as H1: 70. We may use a t-test to distinguish between these
hypotheses.

November 2012: Question 3e

Using panel data on 545 young men observed each year between 1980 and 1987 we estimate wage
equations ()

e)

Table 3.3 shows instrumental variable estimates of the wage equation where we have

treated education as endogenous and used hisp, as well as all exogenous variables in the wage
equation, as instruments. State the key assumptions underlying this instrumental variable estimator,
and briefly discuss the results. Are you convinced this approach addresses the problem that education
may be endogenous?

Table 3.3: Instrumental Variables Estimates of Wage Equation

ivregress 2sls lwage (educ = hisp black ) black exper expersq married union d81-d87
Instrumental variables (2SLS) regression

Number of obs =
4360
Wald chi2(13) = 708.75
Prob > chi2
= 0.0000
R-squared
= 0.1848
Root MSE
= .48083
-----------------------------------------------------------------------------lwage |
Coef.
Std. Err.
z
P>|z|
[95% Conf. Interval]
-------------+---------------------------------------------------------------educ |
.0657287
.032881
2.00
0.046
.0012831
.1301743
black |
-.140182
.0234258
-5.98
0.000
-.1860956
-.0942683
exper |
.0579594
.0179889
3.22
0.001
.0227017
.093217
expersq | -.0028089
.0009863
-2.85
0.004
-.004742
-.0008759
married |
.1154583
.0183905
6.28
0.000
.0794135
.1515031
union |
.1834889
.0171585
10.69
0.000
.1498588
.217119
d81 |
.069649
.0336761
2.07
0.039
.003645
.135653
d82 |
.0864554
.0450846
1.92
0.055
-.0019087
.1748196
d83 |
.0987127
.0598585
1.65
0.099
-.0186079
.2160333
d84 |
.14123
.0768759
1.84
0.066
-.009444
.291904
d85 |
.1749919
.095511
1.83
0.067
-.0122061
.36219
d86 |
.2235071
.1154983
1.94
0.053
-.0028654
.4498797
d87 |
.2718849
.1366931
1.99
0.047
.0039713
.5397985
_cons |
.4272106
.4284706
1.00
0.319
-.4125764
1.266998
-----------------------------------------------------------------------------Instrumented: educ
Instruments:
black exper expersq married union d81 d82 d83 d84 d85 d86 d87
hisp

>> An instrumental variable must satisfy the relevance and the exogeneity assumptions.
Relevance in this application implies that the coefficient on hisp in the reduced form equation
specifying educ as a function of all the exogenous variables must be different from zero;
exogeneity means hisp must not correlate with the residual in the structural equation (in this
case the wage equation).
In order to test whether relevance is fulfilled we could look at the results for the reduced form
regression. These are not shown here. However, we know that, should relevance not be
fulfilled, the IV estimator is not defined and its variance will tend to infinity. Since educ
remains significant at the 5% level in the IV regression above, we have reason to believe
relevance is satisfied.

We cannot test for exogeneity, since the residual (u) is unobserved. This assumption zero
correlation between hisp and the residual u must be taken on faith. In other words, we have
to believe that the only way in which hisp affects wages is through education hisp may have
no independent, direct effect on wage. If there is wage discrimination by race, this assumption
would not be satisfied. While we cannot say for sure, we should probably be quite skeptical:
wage discrimination by race is not uncommon, and in order to it rule out we should learn
more about the labour market under study.

December 2012: Question 3

Time series econometrics

Assess whether the statements in (a)-(c) are true or false, and explain why.
(a) One of the assumptions that needs to hold for the process { } to be weakly stationary
is that ( , ) is constant over time and depends on both and . (10%)

>> FALSE. The covariance may depend on k, but most not vary with time (t) itself.
(b) A white noise process is a non-stationary process for which all autocorrelations are
equal to zero. (10%)
>> FALSE. The white noise process is a weakly stationary process (not nonstationary).
(c) If our series are non-stationary, it is safe to use OLS as our estimation method. (10%)
>> FALSE, in general. For example, using time series with strong persistence (unit
root) in a regression equation can lead to very misleading results if the CLM
assumptions are violated.

Assume we have the following model:

= + +

(1)

where the explanatory variable is strictly exogenous, and the residual is serially
correlated.
(d) Why is serial correlation often present in time series data? (Hint: Think of the
structure of time series) (15%)

>> Because the data are ordered chronologically, and many time series tend to change
slowly and gradually over time. Examples of serially correlated variables would
include temperature, per capita GDP, the stock market index,
(e) Why is the presence of serial correlation in the residual a problem? Please provide a
detailed answer. (20%)
>> First of all, serial correlation in the residual violates one of the Gauss-Markov
assumptions that have to hold for OLS to be BLUE. Hence, serial correlation implies
OLS is not the best linear unbiased estimator; a better (=lower variance) estimator
exists. Second, the conventional standard errors will be wrong if the residual is serially
correlated. Indeed, it can be shown that if there is positive serial correlation in the
error term and in the explanatory variables, the estimated standard errors are too low
which means you will tend to reject the null hypothesis too often.

Suppose we can express serial correlation in in equation (1) above as follows:

= 1 +

(2)

(f) State the null hypothesis for testing serial correlation in equation (2). (15%)
>> H0: =0. H1: 0.
(g) The residual is usually unobserved. How would you estimate it? (Hint: Keep in
mind that is the error term from equation (1)) (20%)
>> First, run a regression in which y(t) is the dependent variable and x(t) is the
explanatory variable. Next, based on the OLS estimates of alpha and beta, obtain the
predicted residual for each time period:
uhat(t) = y(t) alpha_hat beta_hat*x(t).
Finally, run a regression of the following type: uhat(t) = a0 + a1*uhat(t-1) + e(t),
where a0 and a1 are parameters to be estimated; under the null hypothesis of no serial
correlation, we have a1=0; thus use a simple t-test to distinguish between H0: a1=0,
and H1: a10. See textbook for more details.