CH 04 Wooldridge 5e PPT

Multiple Regression
Analysis: Inference
Chapter 4
Wooldridge: Introductory Econometrics:

A Modern Approach, 5e
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Multiple Regression
Analysis: Inference
Statistical inference in the regression model
Hypothesis tests about population parameters
Construction of confidence intervals
Sampling distributions of the OLS estimators
The OLS estimators are random variables
We already know their expected values and their variances
However, for hypothesis tests we need to know their distribution
In order to derive their distribution we need additional assumptions
Assumption about distribution of errors: normal distribution
Multiple Regression
Analysis: Inference
Assumption MLR.6 (Normality of error terms)
independently of
It is assumed that the unobserved

factors are normally distributed around
the population regression function.
The form and the variance of the

distribution does not depend on
any of the explanatory variables.
It follows that:
Multiple Regression
Analysis: Inference
Discussion of the normality assumption
The error term is the sum of "many" different unobserved factors
Sums of independent factors are normally distributed (CLT)
Problems:
• How many different factors? Number large enough?
• Possibly very heterogenuous distributions of individual factors
• How independent are the different factors?
The normality of the error term is an empirical question
At least the error distribution should be "close" to normal
In many cases, normality is questionable or impossible by definition
Multiple Regression
Analysis: Inference
Discussion of the normality assumption (cont.)
Examples where normality cannot hold:
• Wages (nonnegative; also: minimum wage)
• Number of arrests (takes on a small number of integer values)
• Unemployment (indicator variable, takes on only 1 or 0)
In some cases, normality can be achieved through transformations
of the dependent variable (e.g. use log(wage) instead of wage)
Under normality, OLS is the best (even nonlinear) unbiased estimator
Important: For the purposes of statistical inference, the assumption
of normality can be replaced by a large sample size
Multiple Regression
Analysis: Inference
Terminology
"Gauss-Markov assumptions" "Classical linear model (CLM) assumptions"
Theorem 4.1 (Normal sampling distributions)
Under assumptions MLR.1 – MLR.6:
The estimators are normally distributed The standardized estimators follow a

around the true parameters with the standard normal distribution
variance that was derived earlier
Multiple Regression
Analysis: Inference
Testing hypotheses about a single population parameter
Theorem 4.1 (t-distribution for standardized estimators)
Under assumptions MLR.1 – MLR.6:
If the standardization is done using the estimated

standard deviation (= standard error), the normal
distribution is replaced by a t-distribution
Note: The t-distribution is close to the standard normal distribution if n-k-1 is large.
Null hypothesis (for more general hypotheses, see below)

The population parameter is equal to zero, i.e. after
controlling for the other independent variables, there
is no effect of xj on y
Multiple Regression
Analysis: Inference
t-statistic (or t-ratio)
The t-statistic will be used to test the above null hypothesis.
The farther the estimated coefficient is away from zero, the
less likely it is that the null hypothesis holds true. But what
does "far" away from zero mean?
This depends on the variability of the estimated coefficient, i.e. its

standard deviation. The t-statistic measures how many estimated
standard deviations the estimated coefficient is away from zero.
Distribution of the t-statistic if the null hypothesis is true
Goal: Define a rejection rule so that, if it is true, H0 is rejected

only with a small probability (= significance level, e.g. 5%)
Multiple Regression
Analysis: Inference
Testing against one-sided alternatives (greater than zero)
Test against .
Reject the null hypothesis in favour of the

alternative hypothesis if the estimated coef-
ficient is „too large“ (i.e. larger than a criti-
cal value).
Construct the critical value so that, if the

null hypothesis is true, it is rejected in,
for example, 5% of the cases.
In the given example, this is the point of the t-

distribution with 28 degrees of freedom that is
exceeded in 5% of the cases.
! Reject if t-statistic greater than 1.701
Multiple Regression
Analysis: Inference
Example: Wage equation
Test whether, after controlling for education and tenure, higher work
experience leads to higher hourly wages
Standard errors
Test against .
One would either expect a positive effect of experience on hourly wage or no effect at all.
Multiple Regression
Analysis: Inference
Example: Wage equation (cont.)
t-statistic
Degrees of freedom;
here the standard normal
approximation applies
Critical values for the 5% and the 1% significance level (these

are conventional significance levels).
The null hypothesis is rejected because the t-statistic exceeds

the critical value.
"The effect of experience on hourly wage is statistically greater

than zero at the 5% (and even at the 1%) significance level."
Multiple Regression
Analysis: Inference
Testing against one-sided alternatives (less than zero)
Test against .

alternative hypothesis if the estimated coef-
ficient is „too small“ (i.e. smaller than a criti-
cal value).

In the given example, this is the point of the t-

distribution with 18 degrees of freedom so that
5% of the cases are below the point.
! Reject if t-statistic less than -1.734
Multiple Regression
Analysis: Inference
Example: Student performance and school size
Test whether smaller school size leads to better student performance
Percentage of students Average annual tea- Staff per one School enrollment
passing maths test cher compensation thou-sand (= school size)
students
Test against .
Do larger schools hamper student performance or is there no such effect?
Multiple Regression
Analysis: Inference
Example: Student performance and school size (cont.)
t-statistic
Degrees of freedom;
here the standard normal
approximation applies
Critical values for the 5% and the 15% significance level.
The null hypothesis is not rejected because the t-statistic is

not smaller than the critical value.
One cannot reject the hypothesis that there is no effect of school size on
student performance (not even for a lax significance level of 15%).
Multiple Regression
Analysis: Inference
Alternative specification of functional form:
R-squared slightly higher
Test against .
Multiple Regression
Analysis: Inference
t-statistic
Critical value for the 5% significance level ! reject null hypothesis
The hypothesis that there is no effect of school size on student performance

can be rejected in favor of the hypothesis that the effect is negative.
How large is the effect? + 10% enrollment ! -0.129 percentage points

students pass test
(small effect)
Multiple Regression
Analysis: Inference
Testing against two-sided alternatives
Test against .

alternative hypothesis if the absolute value
of the estimated coefficient is too large.

In the given example, these are the points

of the t-distribution so that 5% of the cases
lie in the two tails.
! Reject if absolute value of t-statistic is less

than -2.06 or greater than 2.06
Multiple Regression
Analysis: Inference
Example: Determinants of college GPA Lectures missed per week
For critical values, use standard normal distribution
The effects of hsGPA and skipped are

significantly different from zero at the
1% significance level. The effect of ACT
is not significantly different from zero,
not even at the 10% significance level.
Multiple Regression
Analysis: Inference
"Statistically significant“ variables in a regression
If a regression coefficient is different from zero in a two-sided test, the
corresponding variable is said to be "statistically significant“
If the number of degrees of freedom is large enough so that the nor-
mal approximation applies, the following rules of thumb apply:
"statistically significant at 10 % level“
Multiple Regression
Analysis: Inference
Guidelines for discussing economic and statistical significance
If a variable is statistically significant, discuss the magnitude of the
coefficient to get an idea of its economic or practical importance
The fact that a coefficient is statistically significant does not necessa-
rily mean it is economically or practically significant!
If a variable is statistically and economically important but has the
"wrong“ sign, the regression model might be misspecified
If a variable is statistically insignificant at the usual levels (10%, 5%,
1%), one may think of dropping it from the regression
If the sample size is small, effects might be imprecisely estimated so
that the case for dropping insignificant variables is less strong
Multiple Regression
Analysis: Inference
Testing more general hypotheses about a regression coefficient
Null hypothesis
Hypothesized value of the coefficient
t-statistic
The test works exactly as before, except that the hypothesized

value is substracted from the estimate when forming the statistic
Multiple Regression
Analysis: Inference
Example: Campus crime and enrollment
An interesting hypothesis is whether crime increases by one percent
if enrollment is increased by one percent
Estimate is different from

one but is this difference
statistically significant?
The hypothesis is
rejected at the 5%
level
Multiple Regression
Analysis: Inference
Computing p-values for t-tests
If the significance level is made smaller and smaller, there will be a
point where the null hypothesis cannot be rejected anymore
The reason is that, by lowering the significance level, one wants to
avoid more and more to make the error of rejecting a correct H0
The smallest significance level at which the null hypothesis is still
rejected, is called the p-value of the hypothesis test
A small p-value is evidence against the null hypothesis because one
would reject the null hypothesis even at small significance levels
A large p-value is evidence in favor of the null hypothesis
P-values are more informative than tests at fixed significance levels
Multiple Regression
Analysis: Inference
How the p-value is computed (here: two-sided test)
The p-value is the significance level at which

one is indifferent between rejecting and not
rejecting the null hypothesis.
These would be the In the two-sided case, the p-value is thus the
critical values for a
5% significance level probability that the t-distributed variable takes
on a larger absolute value than the realized
value of the test statistic, e.g.:
From this, it is clear that a null hypothesis is

rejected if and only if the corresponding p-
value is smaller than the significance level.
value of test statistic
For example, for a significance level of 5% the
t-statistic would not lie in the rejection region.
Multiple Regression
Analysis: Inference
Critical value of
two-sided test
Confidence intervals
Simple manipulation of the result in Theorem 4.2 implies that
Lower bound of the Upper bound of the Confidence level

Confidence interval Confidence interval
Interpretation of the confidence interval

The bounds of the interval are random
In repeated samples, the interval that is constructed in the above way
will cover the population regression coefficient in 95% of the cases
Multiple Regression
Analysis: Inference
Confidence intervals for typical confidence levels
Use rules of thumb
Relationship between confidence intervals and hypotheses tests
reject in favor of
Multiple Regression
Analysis: Inference
Example: Model of firms‘ R&D expenditures
Spending on R&D Annual sales Profits as percentage of sales
The effect of sales on R&D is relatively precisely estimated This effect is imprecisely estimated as the in-
as the interval is narrow. Moreover, the effect is significantly terval is very wide. It is not even statistically
different from zero because zero is outside the interval. significant because zero lies in the interval.
Multiple Regression
Analysis: Inference
Testing hypotheses about a linear combination of parameters
Example: Return to education at 2 year vs. at 4 year colleges
Years of education Years of education
at 2 year colleges at 4 year colleges
Test against .
A possible test statistic would be:

The difference between the estimates is normalized by the estimated
standard deviation of the difference. The null hypothesis would have
to be rejected if the statistic is "too negative" to believe that the true
difference between the parameters is equal to zero.
Multiple Regression
Analysis: Inference
Impossible to compute with standard regression output because
Usually not available in regression output

Alternative method
Define and test against .
Insert into original regression a new regressor (= total years of college)
Multiple Regression
Analysis: Inference
Total years of college
Estimation results
Hypothesis is rejected at 10%

level but not at 5% level
This method works always for single linear hypotheses
Multiple Regression
Analysis: Inference
Testing multiple linear restrictions: The F-test
Testing exclusion restrictions
Salary of major lea- Years in Average number of
gue base ball player the league games per year
Batting average Home runs per year Runs batted in per year
against
Test whether performance measures have no effect/can be exluded from regression.
Multiple Regression
Analysis: Inference
Estimation of the unrestricted model
None of these variabels is statistically significant when tested

individually
Idea: How would the model fit be if these variables were dropped from the regression?
Multiple Regression
Analysis: Inference
Estimation of the restricted model
The sum of squared residuals necessarily increases, but is the increase statistically significant?
Test statistic Number of restrictions
The relative increase of the sum of

squared residuals when going from
H1 to H0 follows a F-distribution (if
the null hypothesis H0 is correct)
Multiple Regression
Analysis: Inference
Rejection rule (Figure 4.7)
A F-distributed variable only takes on positive

values. This corresponds to the fact that the
sum of squared residuals can only increase if
one moves from H1 to H0.
Choose the critical value so that the null hypo-

thesis is rejected in, for example, 5% of the
cases, although it is true.
Multiple Regression
Analysis: Inference
Test decision in example Number of restrictions to be tested
Degrees of freedom in
the unrestricted model
The null hypothesis is overwhel-

mingly rejected (even at very
small significance levels).
Discussion
The three variables are "jointly significant"
They were not significant when tested individually
The likely reason is multicollinearity between them
Multiple Regression
Analysis: Inference
Test of overall significance of a regression
The null hypothesis states that the explanatory

variables are not useful at all in explaining the
dependent variable
Restricted model
(regression on constant)
The test of overall significance is reported in most regression

packages; the null hypothesis is usually overwhelmingly rejected
Multiple Regression
Analysis: Inference
Testing general linear restrictions with the F-test
Example: Test whether house price assessments are rational
The assessed housing value Size of lot
Actual house price
(before the house was sold) (in feet)
Square footage Number of bedrooms
In addition, other known factors should

not influence the price once the assessed
value has been controlled for.
If house price assessments are rational, a 1% change in the
assessment should be associated with a 1% change in price.
Multiple Regression
Analysis: Inference
Unrestricted regression
The restricted model is actually a

Restricted regression regression of [y-x1] on a constant
Test statistic
cannot be rejected
Multiple Regression
Analysis: Inference
Regression output for the unrestricted regression
When tested individually,

there is also no evidence
against the rationality of
house price assessments
The F-test works for general multiple linear hypotheses

For all tests and confidence intervals, validity of assumptions
MLR.1 – MLR.6 has been assumed. Tests may be invalid otherwise.

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Multiple Regression

Wooldridge: Introductory Econometrics:

Construction of confidence intervals

Sampling distributions of the OLS estimators

The OLS estimators are random variables

We already know their expected values and their variances

However, for hypothesis tests we need to know their distribution

In order to derive their distribution we need additional assumptions

Assumption about distribution of errors: normal distribution

It is assumed that the unobserved

The form and the variance of the

"Gauss-Markov assumptions" "Classical linear model (CLM) assumptions"

Theorem 4.1 (Normal sampling distributions)

Under assumptions MLR.1 – MLR.6:

The estimators are normally distributed The standardized estimators follow a

If the standardization is done using the estimated

Null hypothesis (for more general hypotheses, see below)

This depends on the variability of the estimated coefficient, i.e. its

Distribution of the t-statistic if the null hypothesis is true

Goal: Define a rejection rule so that, if it is true, H0 is rejected

Reject the null hypothesis in favour of the

Construct the critical value so that, if the

In the given example, this is the point of the t-

! Reject if t-statistic greater than 1.701

Critical values for the 5% and the 1% significance level (these

The null hypothesis is rejected because the t-statistic exceeds

"The effect of experience on hourly wage is statistically greater

Reject the null hypothesis in favour of the

Construct the critical value so that, if the

In the given example, this is the point of the t-

! Reject if t-statistic less than -1.734

Do larger schools hamper student performance or is there no such effect?

Critical values for the 5% and the 15% significance level.

The null hypothesis is not rejected because the t-statistic is

R-squared slightly higher

Critical value for the 5% significance level ! reject null hypothesis

The hypothesis that there is no effect of school size on student performance

How large is the effect? + 10% enrollment ! -0.129 percentage points

Reject the null hypothesis in favour of the

Construct the critical value so that, if the

In the given example, these are the points

! Reject if absolute value of t-statistic is less

For critical values, use standard normal distribution

The effects of hsGPA and skipped are

"statistically significant at 10 % level“

"statistically significant at 5 % level“

"statistically significant at 1 % level“

The test works exactly as before, except that the hypothesized

Estimate is different from

The p-value is the significance level at which

From this, it is clear that a null hypothesis is

Lower bound of the Upper bound of the Confidence level

Interpretation of the confidence interval

Use rules of thumb

Relationship between confidence intervals and hypotheses tests

A possible test statistic would be:

Usually not available in regression output

Define and test against .

Insert into original regression a new regressor (= total years of college)