Zellner StatisticalAnalysisEconometric 1979

Statistical Analysis of Econometric Models
Author(s): Arnold Zellner

Source: Journal of the American Statistical Association , Sep., 1979, Vol. 74, No. 367
(Sep., 1979), pp. 628-643
Published by: Taylor & Francis, Ltd. on behalf of the American Statistical Association
Stable URL: https://www.jstor.org/stable/2286981
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Statistical Analysis of
Econometric Models
ARNOLD ZELLNER*
In this article, a summary of some research bearing on the statistical

econometric modeling that we take for granted today. It
analysis of econometric models is reviewed. Many estimation, testing,
and prediction techniques used in econometrics have just large- was necessary to develop fundamental concepts such as
sample justifications. Selected Bayesian inference results relating to complete model, identification, autonomous structural
econometric models are reviewed. On the problem of constructing
relationships, exogeneity, dynamic multipliers, and sto-
econometric models, an approach that is a blend of traditional
econometric and modern time series analysis techniques is described. chastic equilibrium, to name a few, that play an impor-
Many statistical problems requiring further analysis are noted. It is tant role in linking statistical analyses and economic
concluded that better solutions to these problems, better data, more theory.
sophisticated use of economic theory, application of more rigorous
diagnostic checks, including forecasting checks and use of well- Many statistical estimation, testing, and prediction
designed simulation experiments, probably will produce improved techniques have been developed for use in connection
macroeconometric models.
with many different kinds of econometric models, in-
KEY WORDS: Econometric statistics; Econometric modeling; cluding linear and nonlinear interdependent structural
Bayesian econometrics estimation; Prediction; Hypothesis testing.
models, models involving qualitative and quantitative
1. INTRODUCTION
variables, models with time series complications, models
for combined time series and cross-section data, and
Substantial progress has been made in developing
models with random parameters. This research on sta-
data, concepts, and techniques for the construction and
tistical techniques and computer programs implementing
statistical analysis of econometric models. Comprehensive
them, a joint product of statisticians and econometricians,
data systems, including national income and product ac-
has been extremely important in the development of
counts, price, wage and interest rate data, monetary modern econometric modeling techniques.
data, and many other measures, have been developed for Given this past record of solid achievement in the
almost all countries. In many cases, annual measure-
areas of measurement, concepts, and statistical tech-
ments have been augmented by quarterly and monthly
niques, it is relevant to ask how current statistical
measurements of a broad array of economic variables. In analyses of econometric models can be improved so as to
recent years, scientifically designed sample surveys have
yield models with better forecasting and policy-analysis
been employed to expand data bases of a number of performance. To answer this question, I shall first try,
countries. While research continues to improve data in Section 2, to summarize the main features of current
bases, we must recognize that the work that produced or traditional econometric modeling techniques. Tradi-
our current, extensive data bases is a major accomplish- tional econometric analyses, like many statistical analy-
ment in the field of scientific measurement and enables ses, tend to concentrate attention mainly on given
economic analysts to avoid the charge of "theory without models and not on procedures for discovering and re-
measurement." pairing defects of proposed models. Section 3 describes
In reviewing the development of concepts for the an approach that emphasizes the latter aspect of econo-
statistical analysis of econometric models, it is very easy metric model construction and is a blend of traditional
to forget that in the opening decades of this century a econometric techniques and modern time series tech-
major issue was whether a statistical approach is ap- niques. While this approach, called structural econometric
propriate for the analysis of economic phenomena. For- modeling time series analysis (SEMTSA), is not a
tunately, the recognition of the scientific value of panacea for all problems, it probably will be helpful in
sophisticated statistical methods in economics and busi- improving the quality of econometric models. A con-
ness has buried this issue. To use statistics in a sophis- cluding section considers prospects for the future.
ticated way required much research on basic concepts of
2. THE TRADITIONAL ECONOMETRIC
* Arnold Zellner is H.G.B. Alexander Professor of Economics and MODELING APPROACH
Statistics, Graduate School of Business, University of Chicago, 1101
East 58th St., Chicago, IL 60637. Research was financed by NSF In this section, I shall attempt to characterize tradi-
Grant SOC 7305547 and by income from the H.G.B. Alexander
tional econometric modeling techniques, to provide a
Endowment Fund, University of Chicago. The author is grateful to
David C. Hoaglin, Stephen E. Fienberg, and two anonymous
referees for helpful comments. An earlier version of this article was ? Journal of the American Statistical Association
presented to the American Statistical Association's meeting in September 1979, Volume 74, Number 367
Chicago, August 1977. Invited Paper
628

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Zeliner: Statistical Analysis of Econometric Models 629
summary of statistical procedures used in econometric Model-Building Activities:

modeling, and to describe some of the statistical needs of A Schematic Representation
traditional econometric model builders.

Stage 1: Statement of Objectives
Feasibility Studya
Choice of Methodologyb
2.1 Overview of the Traditional Approach
The schematic diagram in the figure represents, in

broad outline, the activities of many econometric Stage 2: Preparatory Work
modelers. Whatever the problem, there is usually a state- Review of Literature
Preliminary Data Analysis

ment of objectives, although, at times, the statement may
not be so clear-cut and specific as could be desired. Some-
times, objectives are so ambitious that, given our present Stage 3: Formulation of
knowledge, data, and techniques, they may be practically Initial Model (MO}
unattainable. The next steps in traditional econometric
modeling involve a review of the theoretical and empirical Mathematical Analysis Statistical Analysis of
Computer Simulation Old and New Data
literature bearing on the objectives of a modeling project,
preparation of a data base, and preliminary data analysis. New Research
The objective of these activities is the formulation of an Findings
initial variant of an econometric model. Unfortunately,

most econometrics and statistics texts are woefully silent
Reformulation of
on the basic methodology of how to formulate an initial Model MO
variant of a model. General prescriptions, such as "use
relevant economic theory" and "formulate as simple a
model as possible," are valuable guidelines. Often the 1st IterationO: Formulation of
relevant economic theory does not yield precise informa- Model M,
tion regarding functional forms of relationships, lag

Mathematical Analysis < Statistical Analysis of
structures, and other elements involved in a stochastic Computer Simulation n Old and New Data
specification of a model. Further, model simplicity has
yet to be defined in a completely satisfactory manner. New Research
Findings
Still, it is worthwhile to emphasize the importance of
using elements of economic theory, other outside informa-
tion, and simplicity in formulating an initial variant of Reformulation of
a model. For example, models that imply unexploited Model M,
profit opportunities probably will be unsatisfactory be-

cause exploitation of such profit opportunities will gen-
2nd Iteration: Formulation of
erally upset properties of the proposed model that
| Model M2 |
contains them.
Once an initial variant of a model, denoted by Mo, has
been formulated, it is traditionally subjected to a number NOTE: For further discussion of this approach to modeling, see Hamilton et al.
of mathematical, statistical, computer simulation, and (1969) and Zellner (1970).

a It is assumed that this study shows the project to be feasible.
judgmental checks. These include simple mathematical b It is assumed that a modeling approach is selected.
checks on the number of equations and number of endog- e The iterative procedure may disclose problems in the original formulation of
goals, feasibility, and methodology so that refining and reformulation of the effort
enous variables, consistency of variables' units of mea- may not be confined solely to the model itself. Also, it is possible that other feed-
surement, conditions for parameter identification, and back loops, not shown in the figure, may be important in the process of converging
on a satisfactory variant of a model.
compatibility with results from mathematical economic
theory. Computer simulation experiments are often em-
ployed to gain information about local and global dy- work is undertaken to reformulate Mo and to produce a
namic and other properties of Mo. Statistical checks in- new variant of the model, M1i. Then M1 is subjected to
volve formal hypothesis testing procedures, forecasting the battery of checks mentioned previously. This process
tests, residual analysis, data evaluation, and other of checks and reformulation continues, using as much new
diagnostic checks. In evaluating the adequacy of Mo, a data as possible, until a satisfactory version of the model
good deal of judgment or prior information is employed,is obtained, satisfactory in the senses that it passes
usually informally. For example, the algebraic signs and diagnostic checks satisfactorily and accomplishes the ob-
magnitudes of parameter estimates are reviewed to jectives of the model-building project.
ascertain whether they are compatible with results pro- In connection with realizing the objectives of a model-
vided by economic theory, by previous studies, and by building project, it is useful to havre formulated as simple
judgmental information. a model as possible. If the objectives require the model
If Mo is found to be inadequate in certain respects, builder to capture much detail, the model probably will

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630 Journal of the American Statistical Association, September 1979
be large, but with care in model building it can still be policy making. Thus, econometric research has placed a
sophisticatedly simple. Large and simple models seem heavy emphasis on statistical estimation problems.
preferable to large and complicated models. In fact, a
very disturbing feature of some large, complicated models 2.2.1 Asymptotically Justified Estimation Procedures.
in the literature is that it is not known whether they have Research since the 1940's has resulted in a greatly en-
a unique solution or many solutions. hanced understanding of estimation problems associated
In the past, model builders have used some or some- with SEM's and a relatively large number of operational
times all the elements of the approach described before, procedures for obtaining consistent, asymptotically
but generally have not been vigorous enough in applying normally distributed, and efficient parameter estimates
the various checks. Mathematical analyses have often for some or all parameters of linear and nonlinear, static,
been superficial and incomplete. Simulation experiments and dynamic SEM's with serially uncorrelated or serially
have not been very extensive or well designed in general. correlated errors. These procedures, which are discussed
Statistical checks on the quality of data and on specifying at length in econometric textbooks and the econometric
assumptions have not been pursued vigorously enough. literature, include maximum likelihood, two- and three-
The relationship of models' properties to relevant eco- stage least squares, 32-class, double 32-class, instrumental-
nomic theory has not been examined thoroughly in a variable, nonlinear maximum likelihood, nonlinear two-
number of instances. Finally, many econometric model and three-stage least squares, and other procedures.
builders have not stressed simplicity enough. Some cur- Further, many of the parameter estimates produced by
rently operating econometric models are highly complex such procedures approximate Bayesian posterior means
systems of a hundred or more nonlinear stochastic differ- of parameters in large samples. A most important result
ence equations with hundreds of parameters that have of this research, aside from providing asymptotically
to be estimated from highly aggregated time series data. justified estimation procedures, has been to rule out a
Failure to take account of Ockham's Razor, the Jeffreys- number of proposed inconsistent and/or asymptotically
Wrinch Simplicity Postulate, and the Principle of inefficient estimation procedures. For example, it is well
Parsimony in formulating econometric models has had known by now that misapplication of the classical least
very serious consequences in much traditional economet- squares (CLS)' estimation procedure to estimate struc-
ric model building. See Jeffreys (1957, 1967) for evidence tural parameters produces inconsistent estimates except
of the importance of simplicity in science. in the very special case of a fully recursive SEM.
These criticisms of traditional econometric models Choice among alternative asymptotically justified
have to be tempered, however, because many methodo- estimates has often been made on the basis of ease of
logical techniques needed in a sensible model-building computation. For example, with systems linear in the
process are not yet available. Good formal sequential parameters, calculation of two- and three-stage least
testing procedures for model construction remain to be squares estimates involves just simple algebraic opera-
developed. Even for a given structural econometric tions, whereas computation of maximum likelihood esti-
model, exact finite-sample tests and optimal finite- mates involves more complex numerical procedures.
sample estimates and predictors have not been available. Some current computer packages compute a number of
Good or optimal designs for simulation experiments re- asymptotically justified estimates and leave the difficult
main to be derived. The problems of missing and imper- choice among them to the user. Of course, in truly large
fect data have not been completely solved. Tried and samples, asymptotically equivalent estimates should not
tested economic theory dealing with stochastic markets, be very far different. If in practice such estimates, based
dynamic reactions, and a number of other important on a given large sample of data, are radically different,
issues has not been available. Thus econometric model this may be interpreted as indicating that the asymptotic
building has been a mixture of economic and statistical properties of different estimates take hold at different
theory and empirical practice. It is probable that such sample sizes or, more likely, that specification errors are
interaction between theory and practice will produce present and affect alternative estimates differently. Un-
improvements in both. fortunately, not much analysis is available on the sensi-
To illustrate elements of recent statistical practice in tivity of alternate asymptotically justified estimates to
traditional econometric model building, I next review various kinds of specification errors; one recent paper in
some estimation, testing, and prediction techniques and this area is Hale, Mariano, and Ramage (1978). More
provide some indications of current developments and systematic analysis of this range of problems and pro-
open problems. duction of asymptotically justified estimates that are
relatively robust to specification errors would be welcome
and would serve as a useful additional guide to users in
2.2 Statistical Estimation Problems
selecting estimates when the sample size is truly large.
Learning the values of parameters appearing in struc- On the other hand, if the sample size is not truly large,
tural econometric models (SEM's) is important in
checking the implications of alternative economic theories 1 Some use the term ordinary least squares (OLS); I prefer classical
and in using SEM's for prediction, forecasting, and least squares (CLS), since the least squares principle is not ordinary.

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Zellner: Statistical Analysis of Econometric Models 631
even if a SEM is correctly specified, various asymptoti- is clearly inadmissible. This is not to say that MSE is the
cally justified estimates of the same parameter can assume only criterion for judging estimators, but it has received
quite different values. considerable attention in this area of research. As stated
Students and others invariably ask for a definition of before, these results have been surprising to many, par-
what constitutes a truly large sample. An easy answer to ticularly those who narrowly emphasize unbiasedness, or
this question is hard to give. The sample size alone is not minimum M\SE, or minimum-variance unbiasedness as
usually all that is relevant. Values of the parameters and criteria for judging estimators or who uncritically accept
features of input or exogenous variables also must be asymptotic justifications. To illustrate that these criteria
considered. Because parameter values usually are un- are inadequate even for the simple case in which a struc-
known and the object of estimation, prior information tural parameter 0 is equal to the reciprocal of a reduced-
about them is needed before one can say with any conform regression coefficient, ir, that is, 0 1/7r, the ML
fidence what is a truly large sample in connection with the and almost all other asymptotically justified estimation
estimation of a specific SEM. Needless to say, if the procedures would recommend estimating 0 by 0 = 1/*,
sample size is not truly large, the asymptotic justifica- where 7r is the least squares estimator of the regression
tions for estimation and other large-sample inference coefficient 7r. Because *r is normally distributed, 0 is the
procedures become dubious. In a Bayesian context, one reciprocal of a normally distributed variable and hence
can compute the posterior distribution for a parameter does not possess finite moments of any order. Thus 0 has
and check to see that it is approximately normal with infinite risk and is inadmissible relative to quadratic and
posterior mean equal to the maximum likelihood esti- many other loss functions.
mate and posterior variance equal to the relevant element In addition to exact distributional work on the finite-
of the inverse of the estimated Fisher information matrix. sample properties of asymptotically justified estimators,
If so, large-sample conditions have been encountered. research has provided approximations to the moments of
These considerations do not give a justification for using these estimators, surprisingly even sometimes when mo-
the large-sample normal approximation to the posterior ments do not exist. As Anderson (1977) has pointed out,
distribution without computing the exact finite-sample these moment expressions approximate moments of
posterior distribution. truncated Taylor or other series approximations to the
estimators and not moments of the estimators. How im-
2.2.2 Finite-Sample Problems and Procedures. Recogni- portant this distinction is remains to be seen. Further,
tion that large-sample justifications for estimation pro- very fruitful work that uses Edgeworth-Charlier series
cedures do not contain explicit information on how large approximations to the moments and distributions of
a sample must be for them to hold and that practical estimators has been reported by Sargan (1976).
workers often must deal with limited data has prompted Monte Carlo studies also have been employed in an
considerable research on the finite-sample properties of effort to determine the finite-sample properties of alterna-
estimation procedures. A good deal of research has been tive estimators (see Sowey 1973). Generally, these studies
concentrated on obtaining analytically the exact finite- have been marred by an inadequate coverage of the high-
sample distributions of certain asymptotically justified dimensional parameter spaces associated with models,
estimators, for example, maximum likelihood (ML), two- even simple two-equation supply-and-demand models
stage least squares (2SLS), and other estimators for that usually contain about 10 or more parameters. Be-
parameters in relatively simple models. This ingenious cause risk functions of estimators usually intersect, failure
and difficult distributional work unfortunately has shown to examine the entire parameter space can yield mislead-
that the finite-sample distributions of estimators, derived ing and confusing results regarding the dominance of one
in the main from an underlying noncentral Wishart dis- estimator relative to another in terms of, for example,
tribution, are rather complicated and involve a number MSE. Thus, the results of Monte Carlo experiments that
of parameters with unknown values. The latter fact investigate the behavior of estimators over a limited
makes the application of these distributional results to number of points in the parameter space must be con-
concrete problems difficult. This research has shown that sidered very cautiously. See Thornber (1967) for a
asymptotically equivalent estimators have very different valuable illustration of this point.
finite-sample properties. For example, the (limited-in- While much effort has been directed at determining
formation) ML estimator does not possess finite moments the finite-sample properties of given, asymptotically
of any order, and in certain frequently encountered cases justified estimators, relatively little work has been done
the 2SLS estimator does not possess a mean or higher on the problem of producing estimates that have a small-
moments. Also, certain asymptotically unbiased estima- sample justification. Using approximate moment expres-
tors can have serious finite-sample biases. Further, and sions, Nagar (1959) attempted to define an approximate
perhaps surprising, under some conditions, the inconsis-minimal-MSE estimator for structural coefficients within
tent CLS or OLS estimator has a smaller mean squared the 32-class. Unfortunately, his "estimator" depends on
error (MSE) than consistent estimators that possess a parameters with unknown values that have to be esti-
finite-sample second moment. Of course, if an estimator mated to operationalize his estimator. When these
fails to possess a second moment, it has infinite MSE and parameters are estimated, it appears that the "optimal"

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632 Journal of the American Statistical Association. Seotember 1979
properties of his estimator are vitally affected. His work properties in analyzing a particular set of data is not
provides some evidence that use of a value of X3 less than clear. Further, as many, including Tiao and Box (1975),
one, the value that produces the 2SLS estimate, is prob- have emphasized, the computed value of an optimal point
ably better than the value of one. Analysis by Sawa estimator can be a very bad representation of the in-
(1972) provides the approximate MSE of a Jc-class formation in a given set of data. Likelihood advocates
estimator for a structural parameter of a simple model emphasize the importance of studying properties of likeli-
and points in the same direction, namely, that finite- hood functions, while Bayesians emphasize the desir-
sample MSE usually is lower, and sometimes much ability of studying both likelihood functions and posterior
lower, when a value of 3C < 1 is employed. Sawa (1972) distributions to understand the information content of a
also has reported properties of estimators that are a given sample for possible values of parameters of a
linear combination of the 2SLS and the inconsistent CLS model. For both likelihood advocates and Bayesians, a
estimators. By appropriate choice of the weights, he has point estimate is just a summary measure that does not
obtained approximately unbiased and approximate necessarily convey all or most of the information in a
minimal-MSE estimators. These results do not appear sample regarding parameters' probable values.
relevant for cases in which the second moment of the
2SLS estimator does not exist, and the justification for .2.3 Bayesian Estimation Results. In the past 15
considering a linear combination of a consistent and an years, there has been a growing amount of research con-
inconsistent estimator is not apparent. cerned with developing and applying the Bayesian ap-
Recently, Fuller (1977) has presented modified limited- proach to the problems of estimating values of parame-
information ML and modified fixed 32-class estimators ters in SEM's and other econometric models, and ele-
that have finite moments. Restricting these modified ments of the Bayesian approach have appeared in
estimators to have the same, but arbitrary, bias, he shows econometric textbooks. As is well known, inferences abo
that to order T-2, where T is the sample size, the modified parameters' values, for example, elements of a parameter
ML estimator dominates in terms of approximate MSE. vector 0, are based on the posterior probability density
In almost all the analytical finite-sample work on the function (pdf) for 0,
sampling properties of estimates, problems with time
series complications have not been analyzed, for example, p(O I D, I) = cp( II)t(0 I D) (2.1)
estimates of parameters of models with lagged endog-
where c = [f p(01I)t(OID)d0]-' is a normalizing con-
enous variables and/or serially correlated error terms.
stant, D denotes the data, I denotes the prior informa-
Relatively little effort has been devoted to obtaining good
tion, p (OIl) is the prior pdf, and t(O ID) is the likelihood
finite-sample estimates of error terms' covariance
function. The following points are relevant particularly
matrices. Recent statistical work by Perlman, Eaton, and
for analyses of SEM's.
others certainly seems relevant. It is highly probable
that all, or almost all, the asymptotically justified estima- 1. The posterior pdf in (2.1) is an exact finite-sample
tors mentioned are inadmissible under quadratic loss and pdf, and, hence, large-sample approximations, while
sometimes convenient and useful, are, in principle, not
other loss functions over a wide range of conditions. This
needed. This statement applies to the analysis of all kinds
range of "Steinian" issues has received very little atten-
tion in connection with finite-sample work on structural of models, including static and dynamic SEM's.
parameter estimators' properties. The impact of pre- 2. Use of the prior pdf, p (OII), enables an investigator
testing on the finite-sample properties of the usual to incorporate prior information in an analysis, as much
or as little as he sees fit. Of course, if no sample informa-
structural-coefficient estimators is relatively unexplored.
For example, I have conjectured that the limited- tion were available, as is the case in some low-income
information ML estimator's distribution subject to a countries, prior information would be the only kind of
favorable outcome of the rank test for identifiability information
will available. In connection with SEM's, prior
possess finite moments. In the simple case in which a information must be introduced in some form to identify
structural parameter is the reciprocal of a reduced-form structural parameters. In sampling-theory approaches,
regression coefficient, 0= 1/7r, it is easy to establish the identifying information almost always has been in-
that the ML estimator O' 1/*, subject to the outcome
troduced as exact restrictions on parameter values (e.g.,
of a t test that rejects r = 0, possesses finite moments, setting certain coefficients equal to zero, equivalent to
where * is the least squares (ML) estimate of 7r. Last and using a degenerate or dogmatic prior pdf for these
most basic, the relevance of sampling-theory criteria, parameters in a Bayesian setting). Use of prior pdf's
such as unbiasedness, admissibility, and minimal MSE enables investigators to represent this required prior
of estimators for the analysis of a given sample of data information more flexibly; see Dr6ze (1975) and Kadane
has not been considered adequately in the econometric (1975).
literature. Sampling properties of procedures seem 3. Use of Bayes's Theorem provides the complete
relevant before we take the data in connection with design posterior pdf for parameters of interest and not just a
problems or in characterizing average properties of summary point estimate. If a point estimate is desired,
estimation procedures. The relevance of these average however, it usually can be obtained readily. For example,

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for quadratic loss functions, it is well known that the zero mean vector and g X g pds covariance matrix
mean of the posterior pdf, if it exists, is an optimal pointog= (r-1)/2;r-1.
estimate in the sense of minimizing posterior expected Under the assumptions made earlier, the parameters
loss. II and Zg of the URF system in (2.4) are identified and
4. Generally, Bayesian estimates have very good can be estimated by using Bayesian or non-Bayesian
sampling properties, because they minimize average risk techniques whether or not the structural parameters in
when average risk is finite and are admissible. r, B, and 2 are identified. It has long been recognized
5. In large samples under general conditions, the that, under the assumptions made before, r, B, and 2
posterior pdf, p(0 D, I), assumes a normal form with are not identified and that additional prior information
mean vector equal to the ML estimate of 0 and covariance must be added in order to identify these structural pa-
matrix equal to the inverse of the estimated Fisher in- rameters. Identifying prior information can take various
formation matrix. Thus, in large samples there is a dove- forms. Here we discuss only the case in which it involves
tailing of Bayesian and sampling-theory numerical restrictions that subsets of structural parameters assume
results; however, their interpretation is quite different. zero values. In addition, it is necessary to adopt a
normalization rule for elements of the r matrix. Here
I now turn from the general features of the Bayesian
let all diagonal elements of r be equal to 1. We shall wr
approach to a brief review of some Bayesian estimation
the system in (2.2) with identifying restrictions and
results for the SEM. A representation of the linear (in
normalization rule imposed as
the parameters) SEM is
Yrr = XBr + U (2.6)
Y r = X B + U (2.2)
nXg gXg nXk kXg nXg
Then the restricted reduced-form system is given by
where Y is an n X g matrix of observations on gyendoge-
XBrrr-1 + Urr-1 (2.7)
nous (or dependent) variables and X is an n X k matrix
of observations on k predetermined variables, assumed XH1r + Vr (2.8)
of rank k. Predetermined variables include both exoge-
Obviously, the fundamental f
nous (independent) and lagged endogenous variables. r
to reduce the number of fre
is a g X g structural parameter matrix, assumed non-
by so doing, to provide a m
singular, and B is a k X g matrix of structural parameters.
free structural parameters in rr and Br are identified.
U is an n X g matrix of disturbance or error terms. It
Explicit statements of the conditions for identification of
will be assumed that the rows of U have been inde-
structural parameters are given in econometrics text-
pendently drawn from a g-dimensional normal distribu-
books and other works. Since the free parameters in rr,
tion with zero mean vector and g X g positive definite
Bry and z are identified, their number cannot exceed the
symmetric (pds) covariance matrix 2. Note that if
number of parameters in the URF system in (2.4),
r = ig, the system in (2.2) is in the form of a multi-
namely, kg parameters in 11 and g(g + 1)/2 distinct
variate regression model when X contains no lagged
parameters in the g X g RF covariance matrix Q.
endogenous variables or in the form of a multivariate
The likelihood function for the restricted structural
autoregressive system with input variables when X con-
system in (2.6) is
tains both exogenous (or independent) and lagged
endogenous variables. In the special case r = Ig, 4(rr, analysis
Br, 2; 1 D) oC% I mod {rr I } n 1Z -n/2
of (2.2) from the Bayesian point of view would proceed .exp { -I tr(Yrr - XBr)'( Yrr - XBr) 2;} (2.9)
pretty much along multivariate regression lines if initial
values for the lagged endogenous variables are taken as where o denotes proportionality, D denotes the data,
and mod rr I denotes the absolute value of the Jacobian
given (see Zellner (1971) and the references cited there).
The unrestricted reduced-form (URF) system as- determinant, irr. , for the transformation from the n
sociated with the SEM in (2.2) is given by postmultiply-rows of U to the n rows of Y in (2.6). If the system in
ing both sides of (2.2) by r- to yield: (2.6) is autoregressive, (2.9) is the likelihood function
conditional upon initial values (assumed given). Then,
Y = XBr-P + ur-P (2.3)
from (2.1), the posterior pdf for the free parameters in
or rr, Br, and z is given by
Y = X HI + V (2.4)
nXg nXk kXg nxg p(rr, Br, 2jID, I) o p(rr, Br, 2;II)(irr, Br, 2D) (2.10)
where
II = Br- and V = Ur-, (2.5)
where p (rr, Br, III) is the prior distribution and the
prior information is denoted by I. Given a prior distribu-
with the k X g matrix H being the tion (URF) coefficient
and the likelihood function, the technical problems
matrix and the n X q matrix V the URF disturbance or of analyzing properties of the posterior distribution,
error matrix. The assumptions about the rows of U imply that is, obtaining its normalizing constant, its marginal
that the rows of V can be considered independently distributions, and its moments, remain.
drawn from a g-dimensional normal distribution with In the special case of a fully recursive SEM, F,. is in

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triangular form, implying that stricted

Ir, = multivariate
1, and regression
2 is as-problem with the struc-
sumed to have a diagonal form. These assumptions tural parameters yi and 51 involved in the restrictions on
simplify the likelihood function in (2.9) considerably and the elements of =i and Hi. A necessary condition for the
also simplify the analysis of the posterior pdf in (2.10) identification of yi, gi, and oal is that k - k, > mi. Note
(see Zellner 1971 for details). The fully recursive case, that (2.13) reflects restrictions arising from just the
however, is a very special case of a SEM. In the general first equation (2.11) of a system. The information in
case, work has concentrated on the analysis of (2.10) restrictions similar to (2.13) associated with other
using the likelihood function in (2.9). In several studies, structural equations is not taken into account in estimat-
the posterior distribution in (2.10) has been computed ing yi, 51, and all and hence the nomenclature, limited-
for a few simple models. Dreze and Morales (1976), information or single-equation analysis.
Harkema (1971), Morales (1971), and Richard (1973) Previous research has shown that ML, 2SLS, and
have analyzed it by using several different informative 3SLS estimates are approximate means of posterior
prior distributions. Except for some approximate results pdf's for structural parameters under special conditions.
provided by Zellner (1971) and Zellner and Vandaele Of course, given complete posterior pdf's for paramaters,
(1975), it is necessary to use numerical integration tech- optimal point estimates can be computed, that is,
niques to analyze features of the posterior distribution. posterior means for quadratic loss functions and medians
These approximate results have been used by Mehta and for absolute-error loss functions. A particularly simple
Swamy (1978) to provide a ridgelike Bayesian estimate. optimal point estimate under a generalized quadratic
Kloek and van Dijk (1976) have studied the application loss function can be derived as follows. Upon multiplying
of Monte Carlo numerical-integration techniques in both sides of (2.13) on the left by X = (Xi:Xo), we
analyzing posterior distributions. Although more experi- obtain
ence with applications, assessing and using various prior
X7c = XIIJYi + X151 = Zlbl (2.14)
distributions, and computational procedures would be
useful, past research has yielded results that will be where Z1 = (XH1X1) and 6', = (y'1"'1). Take as loss
valuable in obtaining better analyses of given SEM's, function,
particularly in small-sample cases. L = (X=l - Zid1)'(Xi -Zdi)
Bayesian research also has focused on limited-informa-
= (1 - d )'Z'iZ(Bl - di) (2.15)
tion analyses, that is, estimation of parameters of a
single equation or of a subset of equations of a SEM. a generalized quadratic loss function. Given a posterior
Complete posterior distributions for these problems have pdf for the reduced form parameters =1 and HII, the
been obtained and analyzed by Dreze (1972, 1976), posterior expectation of L in the first line of (2.15) can
Morales (1971), Reynolds (1977), Rothenberg (1975), be evaluated yielding EL = E- lX'X=l-2d'lEZ'iX=l
and Zellner (1971). A single equation of the system in + d'iEZ'iZidi, where E is the posterior expectation
(2.6), say the first, is given by operator. Then the value of di that minimizes expected
loss, di*, termed a minimum-expected-loss (MELO)
Yi = Yi Ti + X1 0i + ui (2.11)
nXl nXml mlXl nXkl klXl nXl estimate, is given by Zellner (1978):
where Yi and Y, are components of Y, that is, di* = (EZ'iZi)-1EZ'iX=i (2.16)

Y (y'. YI. Y0) with the variables in Yo not appearing
When the system in (2.12) is analyzed under a diffuse
in (2.11), X1 is a submatrix of X, X = (X1i:X0) with the
prior for the regression coefficients =1 and Hi and for the
variables in X0 not appearing in (2.11), and ul is a sub-
error covariance matrix, the marginal posterior pdf for
vector of U, U = (ul. Uo) and y, and 51 are parameter (7ci. Hi) is in the matrix Student t form, and, hence, the
vectors to be estimated. The assumptions introduced
expectations in (2.16) are readily available. In this case,
about the rows of U imply that the elements of u, have
Zellner (1978) has shown that di* is in the form of a
been independently drawn from a normal distribution
3C-class estimate with a value of 3C that depends on the
with zero mean and variance oai. The URF equations for
sample size and is less than one in finite samples. Also,
y, and Yl, a subset of the equations in (2.4), are di* possesses at least first and second sampling moments
(y1 Y1) = X(=li. Hi) + (v1 V1) (2.12) (Zellner and Park 1979). Further, the optimal estimate
of yi is a matrix-weighted average of the 2SLS and CLS
On postmultiplying both sides of (2.12) by (1. -'l)' estimates with the weight on the CLS estimate going to
and comparing the result with (2.11), we achieve com- zero as the sample size increases (Zellner 1976). In small
patibility, given that
samples, however, the optimal estimate of yi and 51 can
be very close to or exactly equal to the CLS estimate.
=1 = I'lrl + (2.13) Thus, empirical workers who have persisted in their use
of CLS estimates may not be very far from an optimal
where the zero vector on the right side of (2.13) is estimate in small samples. Further, this averaging of
(k - k) X 1, and ui = v - Viyi. From (2.12) and 2SLS and CLS estimates bears some resemblance to the
(2.13), the estimation problem can be viewed as a re- work of Sawa, mentioned previously; however, the

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weights that Sawa uses and those that associated with The quality of the approximation and finite-sample
(2.16) are different. Last, this point-estimation ap- power functions for widely used large-sample approxi-
proach has been applied to yield a MELO estimate of mate tests are relatively unexplored topics in econometric
parameters appearing in all equations of a system, that research.
iS, ?1, 2, 6..., 8a} where Bi' = (y'i 'i). Also see Mehta
Another topic that has received very little attention in
and Swamy (1978) for some useful Bayesian results for econometric research is the effects of pretests on the
obtaining point estimates of the B*'s that are related to properties of subsequent tests and on estimators' and
ridge-regression results. predictors' properties. That pretesting can vitally affect
Some additional issues regarding the Bayesian ap- properties of estimators is evident from consideration of
proach have been aptly summarized in the following simple cases, for example, Ylt = YY2t + ult and Y2t
remarks by Tukey (1978): = 7r2Xt + U2t. The RF equations for this simple system
It is my impression that rather generally, not just in economet- are Ylt = 7r1xt + vit and Y2t = 7r2Xt + V21 with a = 7ri/r2-
rics, it is considered decent to use judgment in choosing aThe ML estimator for y is j = 7r/72, where *i = Xxtyit/
functional form, but indecent to use judgment in choosing a
Ixt2, i = 1, 2. - does not possess finite moments; however,
coefficient. If judgment about important things is quite all
the distribution of - subject to the outcome of a pretest
right, why should it not be used for less important ones as well?
Perhaps the real purpose of Bayesian techniques is to let us do that rejects 72 = 0, namely, L*21 > CS72 > 0, where c
the indecent thing while modestly concealed behind a formal is a critical value and S,T2 is the standard error associated
apparatus. If so, this would not be a precedent. When Fisher
introduced the formalities of the analysis of variance in the with *2, does possess finite moments.
early 1920's, its most important function was to conceal the fact Work on Bayesian posterior odds ratios for selected
that the data was being adjusted for block means, an important hypotheses relating to SEM's parameters' values is re-
step forward which if openly visible would have been con-
sidered by too many wiseacres of the time to be "cooking the ported in Reynolds (1977). The posterior odds ratio, K12,
data." If so, let us hope the day will soon come when the role for two mutually exclusive hypotheses, H1 and II2, is
of "decent concealment" can be freely admitted. given by
2.3 Hypothesis Testing and SEM's

K12 = 012 X f pi(O)l1( I y)dO f p2(O)f2(Oly)d,
Sampling-theory procedures used for testing hypothe-
(2. 17)
ses relating to structural coefficients' values have in the
main been large-sample procedures, usually large-sample where 012 is the prior odds ratio, and for iX-1, 2, Pi(O)
likelihood-ratio tests or large-sample tests based on the is the prior pdf, and fi(0ly) is the likelihood function. If
Wald criterion, that is, for testing the rank condition for H1 and H2 are mutually exclusive and exhaustive, and
identifiability, overidentifying restrictions on structural H1 is 0 = 00, while H2 is 0 # 00, a pretest estimate that is
parameters, and general linear hypotheses regarding optimal relative to quadratic loss is given by
structural parameters' values. Recent research (Berndt
= P'00 + p2082
and Savin 1975, Savin 1976) has emphasized that as-
ymptotically equivalent testing procedures can produce = 00 + (62 - 0)/(K12 + 1) (2.18)
conflicting results when used in finite-sample situations
with a given nominal significance level. Analysis of as- where K12 = P1/P2 -p/(l - p1), where pi a
ymptotic power functions by Morgan and Vandaele the posterior probabilities on H1 and H2, res
and 02 iS the posterior mean for 0 under H2
(1974) has demonstrated that certain ad hoc testing pro-
pretest estimate, which also can be computed for other
cedures are dominated by standard large-sample testing
kinds of hypotheses, is a neat solution to the pretesting
procedures. Also, finite-sample approximations to the
problem as it relates to estimation. Similar considerations
sampling distribution of the likelihood-ratio test statistic
have received little, if any, attention in the econometric apply in obtaining combined, optimal predictions from
two or more alternative models.
literature.
In special cases, the exact finite-sample distribution of
2.4 Prediction Procedures for SEM's
a test statistic is available. In one such case the null
hypothesis specifies the values of all coefficients of endoge- Several alternative methods for generating predictions
nous variables in an equation, for example, y, = y1O and from SEM's have been discussed in the literature. First,
#ii 0 in yi = Yiyi + X1g, + ui. Conditional on it has been recognized that the URF system Y =XII
yi = 'y?, it is seen that yi -Y1Y1 = XXU1 + +u Viscan inbe fitted by least squares and used to generate
the form of a multiple regression given that X1 does not unrestricted reduced-form predictions (URFP's). Such
contain lagged endogenous variables. In this special predictions will not generally be efficient because re-
situation, test statistics that have exact t or F distribu- strictions on structural coefficients that imply restrictions
tions are available; however, the requirement that the on the elements of II are not reflected in URFP's. Second,
null hypothesis specify values for all elements of Ti is from the restricted SEM, YJi' = XBr + U, we can
quite restrictive. Also, when the system is dynamic, that obtain the restricted reduced-form system Y = XBrPv'
is, when X1 contains lagged endogenous variables, only + Vr, and restricted reduced-form predictions (RRFP's)
approximate large-sample test procedures are available. can be obtained from V'.t = X'firPr-, where x=f is a given

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vector and Ar and 'r are estimated restricted structural-regressive-integrated-moving-average (ARIMA) time
coefficient estimates. Such predictions will be asymp- series and econometric models has been the subject of
totically efficient if Pr and r'r are asymptotically efficient
much research (Leuthold et al. 1970; Cooper 1972;
estimates and if, of course, there are no specification Nelson 1972; Christ 1975; also see Section 3).
errors. If Br and rr are estimated by inefficient but con-
sistent methods, it is not always the case that a predictor
3. THE SEMTSA APPROACH
based on them will be better in large samples than an
URFP (Dhrymes 1973). Last, the partially restricted As mentioned before, much past econometric research
reduced form (PRRF) equations can be used to generate has concentrated on the analysis of given models and
predictions, namely, yi = XIIiyi + X? S + vi, i = 1, 2, yielded relatively little on formal methods for checking
whether formulated models are consistent with informa-
... . g. Estimates of Hi, yi, and 5i along with given vectors
x'1 and X'if yield the PRRFP's P = x' fIiti + X/f i, tion in sample data and for improving models. In addi-
i = 1, 2, ..., g. Since the PRRFP's use more prior in- tion, many time series aspects of econometric modeling
formation than the URFP's in overidentified SEM's, have not been adequately treated. This is not to say that
they will have higher precision in large samples than time series considerations were totally absent from
URFP's. On the other hand, they will not generally be econometric research, but rather that there was no sys-
as precise as RRFP's in large samples when no specifica- tematic synthesis of econometric modeling and time
tion errors are present in the SEM. Approximate expres- series analysis.
sions for the variance-covariance matrix of forecast error Most important in stimulating some econometricians'
vectors are available in the literature for the prediction interest in time series techniques was the good forecasting
procedures mentioned previously. Further, it is apparent performance of simple, univariate time series models
that specification errors can vitally affect relative large- relative to that of large econometric models in the work
sample properties of these predictors. Then, too, only of Cooper (1972) and Nelson (1972). Much earlier,.
limited attention has been given to the problems of pre- Milton Friedman suggested that econometric models'
dicting future values of the exogenous variables in X. forecasts be compared with those of simple, univariate
It has been pointed out in the literature that the RRF "naive" models, a suggestion implemented by Christ
predictor, y'A = XIfP3rr-1 will not in general possess (1951). The relatively good forecasting performance of
finite moments, whereas the other predictors mentioned simple univariate autoregressive (AR) or Box-Jenkins'
will have finite moments in general for the URF predictor ARIMA models surprised econometric model builders.
and in most situations for the PRRF predictor (Knight In theory, a properly specified multiequation econometric
1977). More thorough analyses of alternative predictors' model should yield more precise forecasts than a uni-
finite-sample properties would be most valuable; see variate time series model, since the former incorporates
Schmidt (1977) for Monte Carlo experimental evidence much more sample and prior information. The reasonable
that led him to conclude that "The first main conclusion conclusion, drawn by many from these forecasting studies,
... is that inferences about forecasts are not terribly is that the econometric models considered in these studies
reliable, unless one's sample is fairly large" (p. 1004). probably contain serious specification errors (e.g., see
From the Bayesian point of view, the predictive Hickman 1972). For example, the econometric models
probability function for the URF system, Y = XII + V, may contain incorrect functional forms for relations, in-
is available. Its mean vector is an optimal point prediction appropriate lag structures, incorrect assumptions about
relative to a quadratic loss function. Optimal multistep the exogeneity of variables, incorrect assumptions about
predictions for the URF when it has autoregressive com- error terms' properties, and so forth. Because the rela-
plications have been obtained by Chow (1973). Richard tionship between econometric models and univariate
(1973) has studied predictive pdf's for the SEM and has ARIMA processes was not clearly understood, many
applied some of his results that incorporate restrictions econometricians considered simple time series models to
on structural coefficients in the analysis of small models. be ad hoc, mechanical, alternative models. Further, it
Further work to enlarge the range of prior pdf's used in was not apparent how time series analysis could be used
these analyses and to provide computer programs to to improve properties of SEM's. These issues were taken
perform calculations conveniently would be worthwhile. up in an article by Zellner and Palm (1974) and have
Some other issues that arise in use of econometric since been pursued in a number of other works such as
models for forecasting are (a) procedures for using Evans (1975, 1976, 1978), Palm (1976, 1977), Plosser
judgmental information and econometric models in (1976), Prothero and Wallis (1976), Trivedi (1975),
making forecasts; (b) ways of combining forecasts from Wallis (1976, 1977), and Zellner and Palm (1975).
alternative models (Nelson 1972; Granger and Newbold This research on the SEMTSA approach has, first,
1977); (c) criteria for the evaluation of the accuracy of emphasized that dynamic, linear (in the parameters)
forecasts (Granger and Newbold 1973, 1977); (d) data SEM's are a special case of multivariate or multiple time
quality and forecasting (Zellner 1958); and (e) seasonal series processes, such as studied by Quenonille (1957)
adjustment and forecasting (Plosser 1976). Further, the and others. Second, it has been shown that assuming
relative forecasting performance of univariate auto- variables to be exogenous places important restrictions

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on the parameters of a multiple time series process. Third, denotes the exogenous variables. Then (3.1) can be
the transfer-function (TF) equation system associated written as
with a dynamic linear SEM has been derived and shown
to be strongly restricted by structural assumptions. While
(H1l H12\I'yt\ (F11 F12N(e1t\
the TF equation system had appeared in the econometric (H21 | H22AXt F21 F22i\e2J 3
literature earlier under other names, its role in economet- where the partitioning of H (L) = { Ht}, F (L)- {Fij}
ric model building had not been emphasized. Fourth, in and et has been made to conform to that for Z't = (y't .X'
the case of random exogenous variables generated by a The assumption that xt is exogenous places the following
multiple time series process, it is possible to derive the restrictions on the matrix lag operators in (3.3):
final equations (FE's), associated with the SEM, and
H21-O, F12 0, and F21-O . (3.4)
individual FE's are in the form of ARIMA processes of
the type studied by Box and Jenkins (1970) and others. On inserting (3.4) in (3.3), we have
Thus, as emphasized in the SEMTSA approach, the
Hilyt + H12xt = Flelt, (3.5)
Box-Jenkins ARIMA processes are not ad hoc, alterna-
and
tive (to SEM's), mechanical models but are, in fact,
H22xt = F22et . (3.6)
implied by SEM's (see the studies cited previously for
explicit examples). In addition, assumptions about The equation system in (3.5) is the dynamic structural-
structural equations' properties have strong implications equation system, while that in (3.6) is the multivariate
for the forms of FE's and TF's that can be tested. ARMA process generating the exogenous variables in xt.
To make some of these considerations explicit, a By multiplying both sides of (3.5) on the left by the
multiple time series process for a p X 1 vector of random adjoint matrix associated with Hi,, denoted by Hi,*, we
variables Zt (assumed mean-corrected for convenience) obtain the TF system,
is represented as follows (Quenouille 1957):
l H1 I 3yt + H11*Hl2xt = Hii*Fi1eit . (3.7)
H(L) zt = F(L) et t = 1, 2, ..., T (3.1)
Last, the FE's associated with (3.5) to (3.6) are obtained
PXP PXl PXP PXl
by multiplying both sides of (3.6) on the left by H22*, the
where H(L) and F(L) are finite-order matrix polynomials adjoint matrix associated with H22, to obtain
(assumed of full rank) in the lag operator L, and et is a
vector of serially uncorrelated errors with zero mean
I H2x2 l t = H22*F22e2t , (3.8)
vector and identity covariance matrix. If, for example, and substituting for xt in (3.7) from (3.8) to yield
F(L) is of degree zero in L, that is, F(L) = Fo, with Fo
I H11 I I H22 It =-Hll*Hl2H22*F22e2t
of full rank, then the error vector in (3.1) is F0et with
zero mean and only a nonzero contemporaneous co- + IH221Hii*Fileit . (3.9)
variance matrix, EF0ete'tF'0 = FoF'o. Other specifica- Equations (3.8) and (3.9) are the FE's for the variables
tions of F(L) allow for moving-average error terms. For in xt and yt, respectively. Each variable has an ARMA
stationarity I H(L) I = 0 must have all its roots outside process, as mentioned before. Simple modifications of the
the unit circle, while for invertibility the roots of IF (L) I analysis presented previously to take account of non-
= 0 must lie outside the unit circle. stochastic exogenous variables, such as time trends, and
Upon multiplying both sides of (3.1) by the adjoint seasonal or other "dummy" variables, can easily be made.
matrix associated with H(L), denoted by H*(L), we In structural econometric modeling in the past, workers
obtain have concentrated attention on the SEM given in (3.5).
Economic and other considerations have been employed
IH(L) I zt = H*(L)F(L)et (3.2)
to justify the classification of variables into the two cate-
a set of FE's for the elements of Zt. Each of the FE's in gories, endogenous and exogenous. Further special as-
(3.2) is in autoregressive-moving-average (ARMA) form sumptions regarding the matrices Hi,, H12, and F11 are
that is, jH(L) zit = 'iet, where IH(L) j is an auto- required to achieve identification (e.g., see Hannan
1971). These assumptions place restrictions on lag
regressive polynomial, and a'i, a 1 X p vector of poly-
nomial operators, is the ith row of H*(L)F(L). That patterns in equations, serial correlation properties of error
terms, and on which variables appear with nonzero
atet, a sum of moving-average processes, can be repre-
sented as a moving-average process in a single random coefficients in equations of the system. If the resultant
variable has been proved in the literature. Thus even system is appropriately specified and estimated, it of
with the general multiple time series process in (3.1), course can be used for forecasting, control, and structural
processes on individual variables will be in the Box- analysis, the traditional objectives of SEM's. It must be
Jenkins form. recognized, however, that a large number of specifying
In structural econometric modeling it is usually as- assumptions have to be made to implement the SEM in
sumed that some of the variables in Zt are exogenous. (3.5),
Ljet and the probability that errors will be made in
Zt= (y'tj*x't), where yt, a pi X 1 vector, denotes the specifying an initial variant of (3.5) generally will be
vector of endogenous vrariables and Xt, a p2 X 1 vector, high. The solution to this problem is not to discard the

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initial variant of (3.5), which may contain much valuable finding remedies for them. When the initial variant of a
information, but to pursue complementary analyses that SEM has been reformulated, its implications for the
can help to identify problems in the formulation of the forms of FE's and TF's can be checked empirically. Also,
initial variant and to suggest appropriate reformulation the roots of FE's and TF's can be calculated, estimated,
of specifying assumptions. Also, it is important that these and examined for reasonableness.
complementary analyses yield useful results along the The SEMTSA approach provides an operational and
way toward obtaining a good SEM; useful synthesis of traditional econometric and time
In the SEMTSA approach, it is suggested that workers series analysis techniques that can produce SEM's with
use economic theory and other outside information to fewer specification errors and better forecasting per-
formulate an initial, tentative form for (3.5). The next formance. As with traditional SEM's, however, some
step involves deducing algebraically the forms of the TF statistical problems associated with the SEMTSA ap-
system in (3.7) and the FE's in (3.9). As is obvious from proach require further research. First, there is the problem
the forms of the TF and FE systems, assumptions re- of determining the forms of the FE's from sample data.
garding the SEM in (3.5) will result in a number of im- Box and Jenkins' well-known suggested techniques based
portant restrictions on TF's and FE's that can be checked on properties of estimated autocorrelation and partial
empirically. For example, from (3.7), (3.8), and (3.9), it autocorrelation functions are helpful in ruling out a
is seen that the AR parts of the FE's and TF's will be number of forms for FE's; however, these techniques are
identical when lag operators do not contain common rather informal. For nested FE models, large-sample
factors. As pointed out in Zellner and Palm (1974), sys- likelihood-ratio tests can be employed to aid in dis-
tems with special features, that is, fully recursive systems criminating among alternative FE models. For nested and
or systems in which Hi, is block-diagonal, will lead to nonnested models, Bayesian posterior odds ratios also
cancellation, and thus the AR parts of FE's and TF's are useful. For example, in discriminating between a
will not be identical. Also, other special assumptions white-noise process and a first-order moving-average
about the forms of H11 arid H12 in (3.5) will result in process, Evans (1978) has shown that the posterior odds
TF's and FE's with different AR lag polynomials (see ratio is a function not only of the first-order sample serial
Zellner and Palm 1975 for an example). Work on examin- correlation coefficient, ri, but also of higher-order sample
ing the implications of specific SEM's for the forms of serial correlation coefficients, r2, r3, . . ., the latter having
FE's and TF's is extremely important in enhancing under- weights that decline as the sample size increases. Be-
standing of SEM's. For example, the effect of changing a cause ri is not a sufficient statistic and because the ri's
variable's classification from exogenous to endogenous are highly correlated in small samples, a large-sample test
on the forms of the TF's and FE's can be easily deter- using just r1 does not use all the sample information and
mined. Also, structural assumptions about lag structures, can lead to erroneous inferences. Posterior odds ratios
properties of structural error terms, and forms of policy also are useful in situations in which roots of AR poly-
makers' control policies all result in strong restrictions on nomials lie on the unit circle, a situation in which it is
TF's and FE's. In addition, Quenouille (1957, Ch. 5) has known that usual large-sample likelihood-ratio tests
provided valuable analysis of the effects of incorrect based on x2 statistics are invalid. Geisel (1976) has re-
inclusion or exclusion of variables, measurement errors, ported work indicating that Bayesian posterior odds
parameters varying with time, nonlinearities, and so on. ratios performed better than variants of Box-Jenkins pro-
When the forms of TF's and FE's associated with a cedures in discriminating among alternative ARIMA
SEM have been derived, the next step in the SEMTSA schemes. Extensions of this work and the early work of
approach is to analyze data to determinie or identify the Whittle (1951) on Bayesian hypothesis testing in time
forms of FE's and TF's to check that the empirically de- aeries analysis would be very valuable. This work also
termined FE's and TF's are compatible with those im- can shed light on the problem of determining the degree,
plied by the tentatively formulated SEM. Of course this if any, of differencing required to induce stationarity.
work not only provides checks on a SEM but also esti- Note that in formulating a posterior odds ratio, station-
mates FE's that can be used for prediction and TF's that arity is not required. Stationarity is required for most
can be used for prediction and control. If the analysis ofuses of sample autocorrelation and partial autocorrela-
the FE's and TF's provides results compatible with the tion functions.
implications of the SEM, the SEM's parameters can be Second, there is the problem of determining the forms
estimated, and it can be used for prediction, control, and of TF's. Important work on this problem for simple
structural analysis. If, as is usually the case, the results TF's has been reported by Box and Jenkins (1970, 1976),
of FE and TF analysis do not confirm the implications ofHaugh and Box (1977), Haugh (1972), Granger and
an initial variant of a SEM, the SEM must be reformu- Newbold (1977), and others. Also, the econometric work
lated. This reformulation process is facilitated consider- on distributed lag models is relevant (e.g., see Aigner
ably by knowing the results of TF and FE analyses. That 1971, Dhrymes 1971, Griliches 1967, and Nicholls,
is, the latter analyses usually indicate specific deficiencies Pagan, and Terrell 1975). Recent work of Sims (1972,
of the initial variant of a SEM, and many times recogni- 1975), Pierce and Haugh (1977), Skoog (1976), Wu
tion of these deficiencies is an important first step in (1978), and others on tests for special recursive structures,

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along with procedures suggested by Box, Jenkins, Haugh, tematic measurement errors and (t is a vector of random
Granger, Newbold, and others, may be useful in checking measurement errors. In this form, the SEM becomes
the assumptions about input variables' properties. In what engineers call a state-variable model. Perhaps use
TF's with several input variables, it may be advisable to of results in the engineering literature would be useful
reduce the number of free parameters by using some of in work with SEM's. Measurement problems are not
the assumptions in the distributed-lag literature regard- insignificant: Initial and subsequently revised figures for
ing coefficients of current and lagged input variables GNP and other important quarterly economic series
(e.g., see Shiller 1973). As with determining the forms of differ considerably, in some cases systematically, and
FE's, it is probable that posterior odds ratios will be found provide different information regarding cyclical turning
useful in discriminating among alternative forms for points (see Zellner 1958). Similar results have been ob-
TF's and in obtaining posterior probabilities associated tained in current work with preliminary and revised
with alternative variants of TF's. figures for quarterly nominal GNP. Revisions in the
Third, there is the problem of obtaining good estimatespreliminary estimates of quarterly GNP amounting to 5
of parameters in FE's, TF's, and SEM's. Currently, to 10 billion dollars are common. For example, the first
various asymptotically justified estimates are available, and subsequently revised figures (in billions of current
and some of these take account of random initial condi- dollars) for GNP in the fourth quarter of 1954 are 361.0,
tions and restrictions implied by the assumptions of 362.0, 367.1, 367.1, 367.7, and 373.4; for the fourth
stationarity and invertibility. The small-sample proper- quarter of 1965, the preliminary and subsequently re-
ties of these asymptotically justified estimates require vised figures are 694.6, 697.2, 704.4, 708.4, 710.0, and
much further investigation, a point also emphasized by 710.0. These figures illustrate an important measurement
Newbold (1976), who writes, "As regards estimation, I problem confronting econometric model builders and
am not sure that uncritical use of maximum likelihood forecasters that has not been adequately treated in the
estimates is justified in small samples without some in-literature.
vestigation of their sampling properties." As pointed out Sixth, aggregation problems have received increased
in Section 2, ML estimators do not in general possess attention in recent work. Articles by Geweke (1976),
good finite-sample properties. These comments imply Rose (1977), Tiao and Wei (1976), and Wei (1976)
that more work to obtain good finite-sample estimates is provide valuable results on temporal and other kinds of
required. Extensions of the valuable work of Box and aggregation in the context of time series models. In work
Jenkins (1970, 1976), Newbold (1973), Tiao and Hillmer by Laub (1971, 1972), Peck (1973, 1974) and Levedahl
(1976), and others on Bayesian estimation of time series
(1976), attention has been focused on economic models
models seem to be possible and can provide additional for individual firms and consumers using panel data and
good finite-sample estimation results. the implications of these microanalyses for aggregate
Fourth, the problems associated with seasonality are dividend, investment, and automobile expenditure func-
important in formulating and analyzing SEM's and yet tions. At the microlevel, discrete decisions, such as
have received relatively little attention. Because seasonalbuy/not buy or change/don't change the dividend rate,
variation accounts for a large fraction of the variation are extremely important. Yet macroformulations of be-
of many economic variables, a proper treatment of havioral relationships that are incorporated in many
seasonality is critical. In much econometric work, sea- SEM's do not properly take account of this discrete
sonally adjusted variables are used with little or no microbehavior and as a result are misspecified. Many
attention to the procedures employed for seasonal ad- estimated investment, dividend, and automobile expendi-
justment and their possible effects on determination of ture functions that are based on partial adjustment
lag structures and other features of SEM's. In the models show long response lags that are spurious and are
SEMTSA approach, Plosser (1976) and Wallis (1976) the result of aggregation over buyers and nonbuyers or
have provided valuable analyses of seasonality in SEM's. corporations that change and those that do not change the
Fifth, the problem of measurement errors in economic dividend rate in a particular quarter. Levedahl (1976) has
time series requires much more attention. It is well shown analytically and empirically that the adjustment
known that a number of economic series are derived coefficient in a partial adjustment model for automobile
wholly or in part from sample surveys. Many statistical expenditures is related to the proportion of consumers
analyses of such data are based on the usually erroneous purchasing a car in a particular period. Because this
assumption of simple random sampling. Analyses that proportion varies considerably over time, the adjustment
take proper account of the designs of sample surveys, coefficient is an unstable parameter, and models fitted
their sampling errors, and possible biases would be most under the assumption that it is stable have obvious
welcome. Further work to consider SEM's subject to problems in forecasting. These findings relating to defects
measurement error would also be valuable. For example, of widely used partial adjustment equations have serious
(3.5) could be formulated in terms of the true values of implications for SEM's that incorporate such equations.
variables, Z't = (y't-.x't). The measured values of vari- Further work on formulating macro-SEM's that takes
ables Zem' = (yam', Xem') could be assumed given by Ztm = account of discrete elements in economic behavior
better
seems very important in obtainiing better models.
Rze + {t, where R is a matrix of coeffcients reflecting sys-

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Seventh, forms of policy makers' control may change 4. CONCLUSIONS
and thus cause instability in lag parameters and other
This review of some of the research on SEM's has
features of a model, a point emphasized by Lucas (1973).
emphasized the following major points:
Analyses using subsamples of data may indicate the
empirical importance of this problem. 1. Substantial progress has been made in research on
Last, time series analysts have identified relatively statistical methods for constructing, analyzing, and using
simple, low-order ARIMA processes for economic vari- econometric models.
ables appearing in SEM's. On the other hand, the 2. There is a serious need for developing and vigorously
ARIMA processes or FE's associated with most SEM's applying additional statistical, mathematical, computer
usually are complicated, high-order schemes. To il- simulation, and economic diagnostic checks of properties
lustrate, Leuthold et al. (1970) formulated and estimated of the SEM's.
a SEM for analysis of hog markets with daily data. They 3. For given SEM's, more work has to be done to
also identified and fitted ARIMA processes for the daily develop and apply estimation, testing, and prediction
price and quantity variables. Their time series model procedures that have finite-sample justifications. In this
for price was found to be a simple random walk. As shown connection, the present author and others believe that
in Zellner (1975), the form of their SEM implies FE's for Bayesian procedures offer good solutions for many finite-
price and quantity with AR parts of at least third order, sample problems.
quite at variance with their random walk finding for the 4. More formal procedures for using prior information
price variable. It seems that they forced a misspecified in the analysis of given SEM's are required, a problem
SEM on the data, one that involves the implicit assump- area that can be approached most satisfactorily at
tion of unexploited profit opportunities in the hog present by use of the Bayesian approach.
markets. Indeed Muth (1961, p. 327, fn. 11), in his path- 5. Most serious is the need for formal, sequential sta-
breaking paper on rational expectation models (i.e., tistical procedures for constructing SEM's.
models that do not imply unexploited profit opportuni- 6. The synthesis of traditional econometric model-
ties), writes in connection with a general supply and de- building techniques and modern time series analysis
mand model, "If the production and consumption flows techniques, called the SEMTSA approach previously,
are negligible compared with the speculative inventory probably will lead to improved SEM's, a view of the
level, the process [on price] approaches a random walk. present writer, Granger and Newbold (1975), and others.
This would apply to daily or weekly price movements of 7. Further use of existing economic theory, such as the
a commodity whose production lag is a year." Thus, theory of efficient markets (see Fama 1970 for a review
economic theory provides some support for the empirical of this theory), and rational expectations theory probably
finding that daily hog prices follow a random walk and will yield better SEM's. Having SEM's consistent with
that the SEM for the hog markets is probably elements of sound economic theory has long been em-
misspecified. phasized in the econometric literature, and further
Similar considerations apply to the Hendry (1974) attention to this point in current work with SEM's is
model of the UK analyzed in Prothero and Wallis (1976). critical.
The latter workers identified rather simple ARIMA
processes for variables appearing in Hendry's SEM. The So that this listing of research needs not be construed
FE's associated with Hendry's estimated model have as misrepresenting the quality of current U.S. macro-
ninth-order AR parts. Prothero and Wallis (1976, p. 483) SEM's that are used to generate quarterly forecasts of
apparently take this finding of a ninth-order AR part of important economic variables, such as GNP, unemploy-
the FE's of Hendry's model seriously and attribute the ment, prices, and interest rates, it is relevant to consider
relatively low orders of the empirically identified FE's to Christ's (1975) thoughtful and relatively favorable review
"relatively small coefficients of higher powers of L [the of the forecasting properties of such models. In the open-
lag operator], which proved difficult to detect in our uni- ing sentence of his article, he writes, "Econometric models
variate analyses." Also, they state that "the size of the of the U.S. economy have been developed to the point
available sample [42 quarterly observations] has clearly where forecasters who use them can forecast real and
restricted our ability to detect subtle higher-order nominal GNP two or three quarters ahead with root mean
effects." Whether these subtle higher-order effects are square errors of less than one percent, and six quarters
real or are results of specification errors present in the ahead with RMS errors of one to two percent." This
eight-equation Hendry model is a point that deserves rather optimistic summary statement fails to take ac-
further attention. In addition, the burgeoning literature count of the fact that population RMS errors have been
on rational expectation economic models has important estimated from rather small samples of forecast errors and
implications for the formulation and analysis of SEM's hence are not very precise. A confidence interval at a
(for some examples, see Evans 1975, Grossman 1975, reasonable level for the population RMS error would
McCallum 1977, Nelson 1975, Ranson 1974, Sargent and probably be rather broad. Also, the implication of a 1
Wallace 1975, Wickens 1976, and Flood and Garber to 2 percent error for nominal GENP that now exceeds
1978). 1.5 trillion (1,000 billion) dollars, is about a 15 to 03

86.59.13.237 on Mon, 11 Dec 2023 22:48:56 +00:00
billion dollar or greater error, which would be considered on lack of expertise in the practical aspects of modelling that
substantial by most analysts. instances have occurred where well-built univariate models have
done better than poorly built multivariate "econometric" ones.
Further with respect to the very same models that yield
RMS errors of 1 percent or 2, Christ (1975) in the second In closing, it must be concluded from what has been
paragraph of his article writes, "... though the models presented and from Christ's remarks, that, while con-
forecast well over horizons of four to six quarters, they siderable progress has been made in work with SEM's,
disagree so strongly about the effects of important an econometric model as satisfactory as the Ford Model
monetary and fiscal policies that they cannot be con- T has not as yet appeared.
sidered reliable guides to such policy effects, until it can
be determined which of them are wrong in this respect [Received July 1977. Revised April 1979.]
and which (if any) are right." This statement clearly
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Tukey, J.W. (1976), "Discussion of Granger on Seasonality," paper Estimators for Functions of Parameters and Structural Coeffi-
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Comment
DAVID A. BELSLEY and EDWIN KUH*
Zellner's article marks a significant step in econometric actual practice of econometric model building-including
writings, for it is one of the first pieces by a maj or its trial-and-error (or iterative) aspects that are often
econometrician that recognizes the full spectrum of the viewed askance by econometric theorists. Implicit in
Zellner's broad-gauged view is a realization that the
* David A. Belsley is Professor, Department of Economics, Boston
classical statistical techniques, in their purist sense, pro-
College, Chestnut Hill, MA 02167, and Visiting Professor, MIT
Center for Computational Research in Economics and Management
Science. Edwin Kuh is Professor of Economics, Sloan School of
Management, Massachusetts Institute of Technology, Cambridge, a Journal of the American Statistical Association
MA 02139, and Director of the MIT Center for Computational September 1979, Volume 74, Number 367
Research in Economics and Management Science. Invited Paper

86.59.13.237 on Mon, 11 Dec 2023 22:48:56 +00:00

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Statistical Analysis of Econometric Models

Author(s): Arnold Zellner

Stable URL: https://www.jstor.org/stable/2286981

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In this article, a summary of some research bearing on the statistical

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summary of statistical procedures used in econometric Model-Building Activities:

traditional econometric model builders.

The schematic diagram in the figure represents, in

Preliminary Data Analysis

initial variant of an econometric model. Unfortunately,

tion regarding functional forms of relationships, lag

a model. For example, models that imply unexploited Model M,

profit opportunities probably will be unsatisfactory be-

of mathematical, statistical, computer simulation, and (1969) and Zellner (1970).

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triangular form, implying that stricted

where Yi and Y, are components of Y, that is, di* = (EZ'iZi)-1EZ'iX=i (2.16)

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2.3 Hypothesis Testing and SEM's

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