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 Wooldridge
Introductory
Econometrics

Introductory
A Modern Approach 7e

Econometrics
A Modern Approach
7e
Jeffrey M. Wooldridge

SE/Author/Author, Title Xe   ISBN-13: 978XXXXXXXXXX ©2015 Designer:

Printer:   Binding: Casebound  Trim: 8" x 10"  CMYK
 Introductory
Econometrics
A Modern Approach

Seventh Edition

Jeffrey M. Wooldridge
Michigan State University

Australia • Brazil • Mexico • Singapore • United Kingdom • United States

58860_fm_hr_i-xxii.indd 1 10/23/18 6:11 PM

 Introductory Econometrics: A Modern © 2020, 2016 Cengage Learning, Inc.
Approach, Seventh Edition Unless otherwise noted, all content is © Cengage.
Jeffrey M. Wooldridge
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 Brief Contents

Chapter 1 The Nature of Econometrics and Economic Data 1

Part 1: Regression Analysis with Cross-Sectional Data 19

Chapter 2 The Simple Regression Model 20
Chapter 3 Multiple Regression Analysis: Estimation 66
Chapter 4 Multiple Regression Analysis: Inference 117
Chapter 5 Multiple Regression Analysis: OLS Asymptotics 163
Chapter 6 Multiple Regression Analysis: Further Issues 181
Chapter 7 Multiple Regression Analysis with Qualitative Information 220
Chapter 8 Heteroskedasticity262
Chapter 9 More on Specification and Data Issues 294

Part 2: Regression Analysis with Time Series Data 333

Chapter 10 Basic Regression Analysis with Time Series Data 334
Chapter 11 Further Issues in Using OLS with Time Series Data 366
Chapter 12 Serial Correlation and Heteroskedasticity in Time Series Regressions 394

Part 3: Advanced Topics 425

Chapter 13 Pooling Cross Sections across Time: Simple Panel Data Methods 426
Chapter 14 Advanced Panel Data Methods 462
Chapter 15 Instrumental Variables Estimation and Two-Stage Least Squares 495
Chapter 16 Simultaneous Equations Models 534
Chapter 17 Limited Dependent Variable Models and Sample Selection Corrections 559
Chapter 18 Advanced Time Series Topics 604
Chapter 19 Carrying Out an Empirical Project 642

Appendices
Math Refresher A Basic Mathematical Tools 666
Math Refresher B Fundamentals of Probability 684
Math Refresher C Fundamentals of Mathematical Statistics 714
Advanced Treatment D Summary of Matrix Algebra 749
Advanced Treatment E The Linear Regression Model in Matrix Form 760

Answers to Going Further Questions 775

Statistical Tables 784
References791
Glossary797
Index812

iii

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 Contents

Preface xii 2-4 Units of Measurement and Functional Form 36

About the Author xxii 2-4a The Effects of Changing Units of Measurement
on OLS Statistics 36
2-4b Incorporating Nonlinearities in Simple
chapter 1The Nature of Econometrics Regression 37
and Economic Data 1 2-4c The Meaning of “Linear” Regression 40

1-1 What Is Econometrics? 1 2-5 Expected Values and Variances of the OLS
Estimators 40
1-2 Steps in Empirical Economic Analysis 2
2-5a Unbiasedness of OLS 40
1-3 The Structure of Economic Data 5 2-5b Variances of the OLS Estimators 45
1-3a Cross-Sectional Data 5 2-5c Estimating the Error Variance 48
1-3b Time Series Data 7
2-6 Regression through the Origin and Regression
1-3c Pooled Cross Sections 8 on a Constant 50
1-3d Panel or Longitudinal Data 9
2-7 Regression on a Binary Explanatory
1-3e A Comment on Data Structures 10 Variable 51
1-4 Causality, Ceteris Paribus, and Counterfactual 2-7a Counterfactual Outcomes, Causality, and Policy
Reasoning 10 Analysis 53
Summary 14 Summary 56
Key Terms 15 Key Terms 57
Problems 15 Problems 58
Computer Exercises 15 Computer Exercises 62

Part 1 chapter 3 Multiple Regression Analysis:

Regression Analysis with Estimation 66
­Cross-Sectional Data 19 3-1 Motivation for Multiple Regression 67
3-1a The Model with Two Independent Variables 67
chapter 2 The Simple Regression Model 20 3-1b The Model with k Independent Variables 69
3-2 Mechanics and Interpretation of Ordinary Least
2-1 Definition of the Simple Regression Model 20
Squares 70
2-2 Deriving the Ordinary Least Squares Estimates 24
3-2a Obtaining the OLS Estimates 70
2-2a A Note on Terminology 31
3-2b Interpreting the OLS Regression Equation 71
2-3 Properties of OLS on Any Sample of Data 32 3-2c On the Meaning of “Holding Other Factors Fixed”
2-3a Fitted Values and Residuals 32 in Multiple Regression 73
2-3b Algebraic Properties of OLS Statistics 32 3-2d Changing More Than One Independent Variable
2-3c Goodness-of-Fit 35 Simultaneously 74

iv

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 Contents v

3-2e OLS Fitted Values and Residuals 74 4-2e A Reminder on the Language of Classical
3-2f A “Partialling Out” Interpretation of Multiple Hypothesis Testing 132
Regression 75 4-2f Economic, or Practical, versus Statistical
3-2g Comparison of Simple and Multiple Regression Significance 132
Estimates 75 4-3 Confidence Intervals 134
3-2h Goodness-of-Fit 76 4-4 Testing Hypotheses about a Single Linear
3-2i Regression through the Origin 79 Combination of the Parameters 136
3-3 The Expected Value of the OLS Estimators 79 4-5 Testing Multiple Linear Restrictions: The
3-3a Including Irrelevant Variables in a Regression F Test 139
Model 83 4-5a Testing Exclusion Restrictions 139
3-3b Omitted Variable Bias: The Simple Case 84 4-5b Relationship between F and t Statistics 144
3-3c Omitted Variable Bias: More General Cases 87 4-5c The R-Squared Form of the F Statistic 145
3-4 The Variance of the OLS Estimators 87 4-5d Computing p-values for F Tests 146
3-4a The Components of the OLS Variances: 4-5e The F Statistic for Overall Significance of a
Multicollinearity 89 Regression 147
3-4b Variances in Misspecified Models 92 4-5f Testing General Linear Restrictions 148
3-4c Estimating s2: Standard Errors of the OLS 4-6 Reporting Regression Results 149
Estimators 93
4-7 Revisiting Causal Effects and Policy
3-5 Efficiency of OLS: The Gauss-Markov Analysis 151
Theorem 95
Summary 152
3-6 Some Comments on the Language of Multiple
Key Terms 154
Regression Analysis 96
Problems 154
3-7 Several Scenarios for Applying Multiple
Regression 97 Computer Exercises 159
3-7a Prediction 98
3-7b Efficient Markets 98 chapter 5 Multiple Regression Analysis: OLS
3-7c Measuring the Tradeoff between Two Asymptotics 163
Variables 99
3-7d Testing for Ceteris Paribus Group 5-1 Consistency 164
Differences 99 5-1a Deriving the Inconsistency in OLS 167
3-7e Potential Outcomes, Treatment Effects, and Policy 5-2 Asymptotic Normality and Large Sample
Analysis 100 Inference 168
Summary 102 5-2a Other Large Sample Tests: The Lagrange
Key Terms 104 Multiplier Statistic 172
Problems 104 5-3 Asymptotic Efficiency of OLS 175
Computer Exercises 109 Summary 176
Key Terms 176

chapter 4 Multiple Regression Analysis: Problems 176

Inference 117 Computer Exercises 178

4-1 Sampling Distributions of the OLS chapter 6 Multiple Regression Analysis:

Estimators 117 Further Issues 181
4-2 Testing Hypotheses about a Single Population
Parameter: The t Test 120 6-1 Effects of Data Scaling on OLS Statistics 181
4-2a Testing against One-Sided Alternatives 122 6-1a Beta Coefficients 184
4-2b Two-Sided Alternatives 126 6-2 More on Functional Form 186
4-2c Testing Other Hypotheses about bj 128 6-2a More on Using Logarithmic Functional
4-2d Computing p-Values for t Tests 130 Forms 186

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 vi Contents

6-2b Models with Quadratics 188 7-7 Interpreting Regression Results with Discrete
6-2c Models with Interaction Terms 192 Dependent Variables 249
6-2d Computing Average Partial Effects 194 Summary 250
6-3 More on Goodness-of-Fit and Selection of Key Terms 251
Regressors 195 Problems 251
6-3a Adjusted R-Squared 196
Computer Exercises 256
6-3b Using Adjusted R-Squared to Choose between
Nonnested Models 197
6-3c Controlling for Too Many Factors in Regression
chapter 8 Heteroskedasticity 262
Analysis 199
8-1 Consequences of Heteroskedasticity for OLS 262
6-3d Adding Regressors to Reduce the Error
Variance 200 8-2 Heteroskedasticity-Robust Inference after OLS
Estimation 263
6-4 Prediction and Residual Analysis 201
8-2a Computing Heteroskedasticity-Robust LM
6.4a Confidence Intervals for Predictions 201
Tests 267
6-4b Residual Analysis 205
8-3 Testing for Heteroskedasticity 269
6-4c Predicting y When log(y) Is the Dependent
Variable 205 8-3a The White Test for Heteroskedasticity 271
6-4d Predicting y When the Dependent Variable Is 8-4 Weighted Least Squares Estimation 273
log(y) 207 8-4a The Heteroskedasticity Is Known up to a
Summary 209 Multiplicative Constant 273
8-4b The Heteroskedasticity Function
Key Terms 211
Must Be Estimated: Feasible GLS 278
Problems 211 8-4c What If the Assumed Heteroskedasticity Function Is
Computer Exercises 214 Wrong? 281
8-4d Prediction and Prediction Intervals with
chapter 7 Multiple Regression Analysis with Heteroskedasticity 283
Qualitative Information 220 8-5 The Linear Probability Model Revisited 284
Summary 286
7-1 Describing Qualitative Information 221 Key Terms 287
7-2 A Single Dummy Independent Problems 287
Variable 222
Computer Exercises 290
7-2a Interpreting Coefficients on Dummy
Explanatory Variables When the Dependent
Variable Is log(y) 226 chapter 9 More on Specification and
7-3 Using Dummy Variables for Multiple Data Issues 294
Categories 228
7-3a Incorporating Ordinal Information by Using 9-1 Functional Form Misspecification 295
Dummy Variables 230 9-1a RESET as a General Test for Functional
Form Misspecification 297
7-4 Interactions Involving Dummy Variables 232
9-1b Tests against Nonnested Alternatives 298
7-4a Interactions among Dummy Variables 232
7-4b Allowing for Different Slopes 233 9-2 Using Proxy Variables for Unobserved Explanatory
Variables 299
7-4c Testing for Differences in Regression Functions
across Groups 237 9-2a Using Lagged Dependent Variables as Proxy
Variables 303
7-5 A Binary Dependent Variable: The Linear
9-2b A Different Slant on Multiple Regression 304
Probability Model 239
9-2c Potential Outcomes and Proxy Variables 305
7-6 More on Policy Analysis and Program
Evaluation 244 9-3 Models with Random Slopes 306
7-6a Program Evaluation and Unrestricted Regression 9-4 Properties of OLS under Measurement Error 308
Adjustment 245 9-4a Measurement Error in the Dependent Variable 308

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 Contents vii

9-4b Measurement Error in an Explanatory Problems 361

Variable 310 Computer Exercises 363
9-5 Missing Data, Nonrandom Samples, and Outlying
Observations 313
chapter 11 Further Issues in Using OLS with
9-5a Missing Data 313
9-5b Nonrandom Samples 315 Time Series Data 366
9-5c Outliers and Influential Observations 317
11-1 Stationary and Weakly Dependent Time
9-6 Least Absolute Deviations Estimation 321 Series 367
Summary 323 11-1a Stationary and Nonstationary Time Series 367
Key Terms 324 11-1b Weakly Dependent Time Series 368
Problems 324 11-2 Asymptotic Properties of OLS 370
Computer Exercises 328 11-3 Using Highly Persistent Time Series in Regression
Analysis 376
Part 2 11-3a Highly Persistent Time Series 376
11-3b Transformations on Highly Persistent Time
Regression Analysis with Time Series 380
11-3c Deciding Whether a Time Series Is I(1) 381
Series Data 333
11-4 Dynamically Complete Models and the Absence of
Serial Correlation 382
chapter 10 Basic Regression Analysis with 11-5 The Homoskedasticity Assumption for Time
Time Series Data 334 Series Models 385
Summary 386
10-1 The Nature of Time Series Data 334
Key Terms 387
10-2 Examples of Time Series Regression
Models 335 Problems 387
10-2a Static Models 336 Computer Exercises 390
10-2b Finite Distributed Lag Models 336
10-2c A Convention about the Time Index 338 chapter 12 Serial Correlation and
10-3 Finite Sample Properties of OLS under Classical Heteroskedasticity in Time Series
Assumptions 339
Regressions 394
10-3a Unbiasedness of OLS 339
10-3b The Variances of the OLS Estimators and the 12-1 Properties of OLS with Serially Correlated
Gauss-Markov Theorem 342 Errors 395
10-3c Inference under the Classical Linear Model 12-1a Unbiasedness and Consistency 395
Assumptions 344 12-1b Efficiency and Inference 395
10-4 Functional Form, Dummy Variables, and Index 12-1c Goodness-of-Fit 396
Numbers 345 12-1d Serial Correlation in the Presence
10-5 Trends and Seasonality 351 of Lagged Dependent Variables 396
10-5a Characterizing Trending Time Series 351 12-2 Serial Correlation–Robust Inference
10-5b Using Trending Variables in Regression after OLS 398
Analysis 354 12-3 Testing for Serial Correlation 401
10-5c A Detrending Interpretation of Regressions 12-3a A t Test for AR(1) Serial Correlation with
with a Time Trend 356 Strictly Exogenous Regressors 402
10-5d Computing R-Squared When the Dependent 12-3b The Durbin-Watson Test under Classical
Variable Is Trending 357 Assumptions 403
10-5e Seasonality 358 12-3c Testing for AR(1) Serial Correlation without
Summary 360 Strictly Exogenous Regressors 404
Key Terms 361 12-3d Testing for Higher-Order Serial Correlation 406

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 viii Contents

12-4 Correcting for Serial Correlation with Strictly Summary 451

Exogenous Regressors 407 Key Terms 452
12-4a Obtaining the Best Linear Unbiased
Problems 452
Estimator in the AR(1) Model 408
Computer Exercises 453
12-4b Feasible GLS Estimation with AR(1)
Errors 409
12-4c Comparing OLS and FGLS 411 chapter 14 Advanced Panel
12-4d Correcting for Higher-Order Serial Data Methods 462
Correlation 413
12-4e What if the Serial Correlation Model Is 14-1 Fixed Effects Estimation 463
Wrong? 413 14-1a The Dummy Variable Regression 466
12-5 Differencing and Serial Correlation 414 14-1b Fixed Effects or First Differencing? 467
14-1c Fixed Effects with Unbalanced Panels 468
12-6 Heteroskedasticity in Time Series
Regressions 415 14-2 Random Effects Models 469
12-6a Heteroskedasticity-Robust Statistics 416 14-2a Random Effects or Pooled OLS? 473
12-6b Testing for Heteroskedasticity 416 14-2b Random Effects or Fixed Effects? 473
12-6c Autoregressive Conditional 14-3 The Correlated Random Effects Approach 474
Heteroskedasticity 417 14-3a Unbalanced Panels 476
12-6d Heteroskedasticity and Serial Correlation in 14-4 General Policy Analysis with Panel Data 477
Regression Models 418 14-4a Advanced Considerations with Policy
Summary 419 Analysis 478
Key Terms 420 14-5 Applying Panel Data Methods to Other Data
Problems 420 Structures 480
Computer Exercises 421 Summary 483
Key Terms 484
Part 3 Problems 484
Computer Exercises 486
Advanced Topics 425
chapter 15 Instrumental Variables Estimation
chapter 13 Pooling Cross Sections across and Two-Stage Least Squares 495
Time: Simple Panel Data Methods 426
15-1 Motivation: Omitted Variables in a Simple
Regression Model 496
13-1 Pooling Independent Cross Sections across
Time 427 15-1a Statistical Inference with the IV
Estimator 500
13-1a The Chow Test for Structural Change across
Time 431 15-1b Properties of IV with a Poor Instrumental
Variable 503
13-2 Policy Analysis with Pooled Cross Sections 431
15-1c Computing R-Squared after IV Estimation 505
13-2a Adding an Additional Control Group 436 15-2 IV Estimation of the Multiple Regression
13-2b A General Framework for Policy Analysis Model 505
with Pooled Cross Sections 437
15-3 Two-Stage Least Squares 509
13-3 Two-Period Panel Data Analysis 439 15-3a A Single Endogenous Explanatory
13-3a Organizing Panel Data 444 Variable 509
13-4 Policy Analysis with Two-Period Panel 15-3b Multicollinearity and 2SLS 511
Data 444 15-3c Detecting Weak Instruments 512
13-5 Differencing with More Than Two Time 15-3d Multiple Endogenous Explanatory
Periods 447 Variables 513
13-5a Potential Pitfalls in First Differencing Panel 15-3e Testing Multiple Hypotheses after 2SLS
Data 451 Estimation 513

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 Contents ix

15-4 IV Solutions to Errors-in-Variables Problems 514 17-2 The Tobit Model for Corner Solution
15-5 Testing for Endogeneity and Testing Overidentifying Responses 571
Restrictions 515 17-2a Interpreting the Tobit Estimates 572
15-5a Testing for Endogeneity 515 17-2b Specification Issues in Tobit Models 578
15-5b Testing Overidentification Restrictions 516 17-3 The Poisson Regression Model 578
15-6 2SLS with Heteroskedasticity 518 17-4 Censored and Truncated Regression Models 582
15-7 Applying 2SLS to Time Series Equations 519 17-4a Censored Regression Models 583
15-8 Applying 2SLS to Pooled Cross Sections 17-4b Truncated Regression Models 586
and Panel Data 521 17-5 Sample Selection Corrections 588
Summary 522 17-5a When Is OLS on the Selected Sample
Consistent? 588
Key Terms 523
17-5b Incidental Truncation 589
Problems 523
Summary 593
Computer Exercises 526
Key Terms 593
Problems 594
Simultaneous Equations
chapter 16
Computer Exercises 596
Models 534
16-1 The Nature of Simultaneous Equations chapter 18 Advanced Time Series Topics 604
Models 535
16-2 Simultaneity Bias in OLS 538 18-1 Infinite Distributed Lag Models 605
16-3 Identifying and Estimating a Structural 18-1a The Geometric (or Koyck) Distributed Lag
Equation 539 Model 607
16-3a Identification in a Two-Equation System 540 18-1b Rational Distributed Lag Models 608
16-3b Estimation by 2SLS 543 18-2 Testing for Unit Roots 610
16-4 Systems with More Than Two Equations 545 18-3 Spurious Regression 614
16-4a Identification in Systems with Three or More 18-4 Cointegration and Error Correction Models 616
Equations 545 18-4a Cointegration 616
16-4b Estimation 546 18-4b Error Correction Models 620
16-5 Simultaneous Equations Models with Time 18-5 Forecasting 622
Series 546
18-5a Types of Regression Models Used for
16-6 Simultaneous Equations Models with Panel Forecasting 623
Data 549 18-5b One-Step-Ahead Forecasting 624
Summary 551 18-5c Comparing One-Step-Ahead Forecasts 627
Key Terms 552 18-5d Multiple-Step-Ahead Forecasts 628
Problems 552 18-5e Forecasting Trending, Seasonal, and Integrated
Computer Exercises 555 Processes 631
Summary 635
chapter 17 Limited Dependent Variable Models Key Terms 636
and Sample Selection Corrections 559 Problems 636
Computer Exercises 638
17-1 Logit and Probit Models for Binary
Response 560
17-1a Specifying Logit and Probit Models 560 chapter 19Carrying Out an Empirical
17-1b Maximum Likelihood Estimation of Logit and Project 642
Probit Models 563
17-1c Testing Multiple Hypotheses 564 19-1 Posing a Question 642
17-1d Interpreting the Logit and Probit Estimates 565 19-2 Literature Review 644

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 x Contents

19-3 Data Collection 645 B-2 Joint Distributions, Conditional Distributions,

19-3a Deciding on the Appropriate Data Set 645 and Independence 688
19-3b Entering and Storing Your Data 646 B-2a Joint Distributions and Independence 688
19-3c Inspecting, Cleaning, and Summarizing Your B-2b Conditional Distributions 690
Data 647 B-3 Features of Probability Distributions 691
19-4 Econometric Analysis 648 B-3a A Measure of Central Tendency: The Expected
19-5 Writing an Empirical Paper 651 Value 691
19-5a Introduction 651 B-3b Properties of Expected Values 692
19-5b Conceptual (or Theoretical) B-3c Another Measure of Central Tendency: The
Framework 652 Median 694
19-5c Econometric Models and Estimation B-3d Measures of Variability: Variance and Standard
Methods 652 Deviation 695
19-5d The Data 654 B-3e Variance 695
19-5e Results 655 B-3f Standard Deviation 696
19.5f Conclusions 656 B-3g Standardizing a Random Variable 696
19-5g Style Hints 656 B-3h Skewness and Kurtosis 697
Summary 658 B-4 Features of Joint and Conditional
Distributions 697
Key Terms 658
B-4a Measures of Association: Covariance and
Sample Empirical Projects 658 Correlation 697
List of Journals 664 B-4b Covariance 697
Data Sources 665 B-4c Correlation Coefficient 698
B-4d Variance of Sums of Random Variables 699
Math Refresher A  Basic Mathematical B-4e Conditional Expectation 700
Tools 666 B-4f Properties of Conditional Expectation 702
B-4g Conditional Variance 704
A-1 The Summation Operator and Descriptive B-5 The Normal and Related Distributions 704
Statistics 666 B-5a The Normal Distribution 704
A-2 Properties of Linear Functions 668 B-5b The Standard Normal Distribution 705
A-3 Proportions and Percentages 671 B-5c Additional Properties of the Normal
A-4 Some Special Functions and Their Distribution 707
Properties 672 B-5d The Chi-Square Distribution 708
A-4a Quadratic Functions 672 B-5e The t Distribution 708
A-4b The Natural Logarithm 674 B-5f The F Distribution 709
A-4c The Exponential Function 677 Summary 711
A-5 Differential Calculus 678 Key Terms 711
Summary 680 Problems 711
Key Terms 681
Problems 681 Math Refresher C  Fundamentals of
Mathematical Statistics 714
Math Refresher B Fundamentals of
Probability 684 C-1 Populations, Parameters, and Random
Sampling 714
B-1 Random Variables and Their Probability C-1a Sampling 714
Distributions 684 C-2 Finite Sample Properties of Estimators 715
B-1a Discrete Random Variables 685 C-2a Estimators and Estimates 715
B-1b Continuous Random Variables 687 C-2b Unbiasedness 716

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 Contents xi

C-2c The Sampling Variance of Estimators 718 D-2e Partitioned Matrix Multiplication 752
C-2d Efficiency 719 D-2f Trace 753
C-3 Asymptotic or Large Sample Properties of D-2g Inverse 753
Estimators 721 D-3 Linear Independence and Rank of a
C-3a Consistency 721 Matrix 754
C-3b Asymptotic Normality 723 D-4 Quadratic Forms and Positive Definite
C-4 General Approaches to Parameter Estimation 724 Matrices 754
C-4a Method of Moments 725 D-5 Idempotent Matrices 755
C-4b Maximum Likelihood 725 D-6 Differentiation of Linear and Quadratic
C-4c Least Squares 726 Forms 755
C-5 Interval Estimation and Confidence Intervals 727 D-7 Moments and Distributions of Random
C-5a The Nature of Interval Estimation 727 Vectors 756
C-5b Confidence Intervals for the Mean from a Normally D-7a Expected Value 756
Distributed Population 729 D-7b Variance-Covariance Matrix 756
C-5c A Simple Rule of Thumb for a 95% Confidence D-7c Multivariate Normal Distribution 756
Interval 731 D-7d Chi-Square Distribution 757
C-5d Asymptotic Confidence Intervals for Nonnormal D-7e t Distribution 757
Populations 732 D-7f F Distribution 757
C-6 Hypothesis Testing 733 Summary 757
C-6a Fundamentals of Hypothesis Testing 733
Key Terms 757
C-6b Testing Hypotheses about the Mean in a Normal
Problems 758
Population 735
C-6c Asymptotic Tests for Nonnormal
Populations 738
Advanced Treatment E  The Linear Regression
C-6d Computing and Using p-Values 738 Model in Matrix Form 760
C-6e The Relationship between Confidence Intervals
and Hypothesis Testing 741 E-1 The Model and Ordinary Least
Squares Estimation 760
C-6f Practical versus Statistical Significance 742
E-1a The Frisch-Waugh Theorem 762
C-7 Remarks on Notation 743
E-2 Finite Sample Properties of OLS 763
Summary 743
E-3 Statistical Inference 767
Key Terms 744
E-4 Some Asymptotic Analysis 769
Problems 744 E-4a Wald Statistics for Testing Multiple
Hypotheses 771
Advanced Treatment D  Summary of Matrix Summary 771
Algebra 749 Key Terms 771
Problems 772
D-1 Basic Definitions 749
Answers to Going Further Questions 775
D-2 Matrix Operations 750
D-2a Matrix Addition 750 Statistical Tables 784
D-2b Scalar Multiplication 750 References 791
D-2c Matrix Multiplication 751 Glossary 797
D-2d Transpose 752 Index 812

58860_fm_hr_i-xxii.indd 11 10/23/18 6:11 PM

 Preface

In ALL content, please indent the first paragraph as well, like the following ones. My motivation
for writing the first edition of Introductory Econometrics: A Modern Approach was that I saw a fairly
wide gap between how econometrics is taught to undergraduates and how empirical researchers think
about and apply econometric methods. I became convinced that teaching introductory econometrics
from the perspective of professional users of econometrics would actually simplify the presentation,
in addition to making the subject much more interesting.
Based on the positive reactions to the several earlier editions, it appears that my hunch was correct.
Many instructors, having a variety of backgrounds and interests and teaching students with different
levels of preparation, have embraced the modern approach to econometrics espoused in this text. The
emphasis in this edition is still on applying econometrics to real-world problems. Each econometric
method is motivated by a particular issue facing researchers analyzing nonexperimental data. The focus
in the main text is on understanding and interpreting the assumptions in light of actual empirical appli-
cations: the mathematics required is no more than college algebra and basic probability and statistics.

Designed for Today’s Econometrics Course

The seventh edition preserves the overall organization of the sixth. The most noticeable feature
that distinguishes this text from most others is the separation of topics by the kind of data being ana-
lyzed. This is a clear departure from the traditional approach, which presents a linear model, lists all
assumptions that may be needed at some future point in the analysis, and then proves or asserts results
without clearly connecting them to the assumptions. My approach is first to treat, in Part 1, mul-
tiple regression analysis with cross-sectional data, under the assumption of random sampling. This
setting is natural to students because they are familiar with random sampling from a population in
their introductory statistics courses. Importantly, it allows us to distinguish assumptions made about
the underlying population regression model—assumptions that can be given economic or behavioral
­content—from assumptions about how the data were sampled. Discussions about the consequences of
nonrandom sampling can be treated in an intuitive fashion after the students have a good grasp of the
multiple regression model estimated using random samples.
An important feature of a modern approach is that the explanatory variables—along with the
dependent variable—are treated as outcomes of random variables. For the social sciences, allow-
ing random explanatory variables is much more realistic than the traditional assumption of nonran-
dom explanatory variables. As a nontrivial benefit, the population model/random sampling approach
reduces the number of assumptions that students must absorb and understand. Ironically, the classical
approach to regression analysis, which treats the explanatory variables as fixed in repeated samples
and is still pervasive in introductory texts, literally applies to data collected in an experimental setting.
In addition, the contortions required to state and explain assumptions can be confusing to students.
My focus on the population model emphasizes that the fundamental assumptions underlying
regression analysis, such as the zero mean assumption on the unobservable error term, are properly

xii

58860_fm_hr_i-xxii.indd 12 10/23/18 6:11 PM

 Preface xiii

stated conditional on the explanatory variables. This leads to a clear understanding of the kinds of
problems, such as heteroskedasticity (nonconstant variance), that can invalidate standard inference
procedures. By focusing on the population, I am also able to dispel several misconceptions that arise
in econometrics texts at all levels. For example, I explain why the usual R-squared is still valid as a
goodness-of-fit measure in the presence of heteroskedasticity (Chapter 8) or serially correlated errors
(Chapter 12); I provide a simple demonstration that tests for functional form should not be viewed
as general tests of omitted variables (Chapter 9); and I explain why one should always include in a
regression model extra control variables that are uncorrelated with the explanatory variable of inter-
est, which is often a key policy variable (Chapter 6).
Because the assumptions for cross-sectional analysis are relatively straightforward yet realis-
tic, students can get involved early with serious cross-sectional applications without having to worry
about the thorny issues of trends, seasonality, serial correlation, high persistence, and spurious regres-
sion that are ubiquitous in time series regression models. Initially, I figured that my treatment of
regression with cross-sectional data followed by regression with time series data would find favor
with instructors whose own research interests are in applied microeconomics, and that appears to be
the case. It has been gratifying that adopters of the text with an applied time series bent have been
equally enthusiastic about the structure of the text. By postponing the econometric analysis of time
series data, I am able to put proper focus on the potential pitfalls in analyzing time series data that do
not arise with cross-sectional data. In effect, time series econometrics finally gets the serious treat-
ment it deserves in an introductory text.
As in the earlier editions, I have consciously chosen topics that are important for reading journal
articles and for conducting basic empirical research. Within each topic, I have deliberately omitted
many tests and estimation procedures that, while traditionally included in textbooks, have not with-
stood the empirical test of time. Likewise, I have emphasized more recent topics that have clearly
demonstrated their usefulness, such as obtaining test statistics that are robust to heteroskedasticity
(or serial correlation) of unknown form, using multiple years of data for policy analysis, or solving
the omitted variable problem by instrumental variables methods. I appear to have made fairly good
choices, as I have received only a handful of suggestions for adding or deleting material.
I take a systematic approach throughout the text, by which I mean that each topic is presented by
building on the previous material in a logical fashion, and assumptions are introduced only as they
are needed to obtain a conclusion. For example, empirical researchers who use econometrics in their
research understand that not all of the Gauss-Markov assumptions are needed to show that the ordi-
nary least squares (OLS) estimators are unbiased. Yet the vast majority of econometrics texts intro-
duce a complete set of assumptions (many of which are redundant or in some cases even logically
conflicting) before proving the unbiasedness of OLS. Similarly, the normality assumption is often
included among the assumptions that are needed for the Gauss-Markov Theorem, even though it is
fairly well known that normality plays no role in showing that the OLS estimators are the best linear
unbiased estimators.
My systematic approach is illustrated by the order of assumptions that I use for multiple regres-
sion in Part 1. This structure results in a natural progression for briefly summarizing the role of each
assumption:
MLR.1: Introduce the population model and interpret the population parameters (which we hope
to estimate).
MLR.2: Introduce random sampling from the population and describe the data that we use to
estimate the population parameters.
MLR.3: Add the assumption on the explanatory variables that allows us to compute the estimates
from our sample; this is the so-called no perfect collinearity assumption.
MLR.4: Assume that, in the population, the mean of the unobservable error does not depend on the
values of the explanatory variables; this is the “mean independence” assumption combined with a
zero population mean for the error, and it is the key assumption that delivers unbiasedness of OLS.

58860_fm_hr_i-xxii.indd 13 10/23/18 6:11 PM

 xiv Preface

After introducing Assumptions MLR.1 to MLR.3, one can discuss the algebraic properties of ordi-
nary least squares—that is, the properties of OLS for a particular set of data. By adding Assumption
MLR.4, we can show that OLS is unbiased (and consistent). Assumption MLR.5 (homoskedastic-
ity) is added for the Gauss-Markov Theorem and for the usual OLS variance formulas to be valid.
Assumption MLR.6 (normality), which is not introduced until Chapter 4, is added to round out the
classical linear model assumptions. The six assumptions are used to obtain exact statistical inference
and to conclude that the OLS estimators have the smallest variances among all unbiased estimators.
I use parallel approaches when I turn to the study of large-sample properties and when I treat
regression for time series data in Part 2. The careful presentation and discussion of assumptions
makes it relatively easy to transition to Part 3, which covers advanced topics that include using pooled
cross-sectional data, exploiting panel data structures, and applying instrumental variables methods.
Generally, I have strived to provide a unified view of econometrics, where all estimators and test sta-
tistics are obtained using just a few intuitively reasonable principles of estimation and testing (which,
of course, also have rigorous justification). For example, regression-based tests for heteroskedasticity
and serial correlation are easy for students to grasp because they already have a solid understanding
of regression. This is in contrast to treatments that give a set of disjointed recipes for outdated econo-
metric testing procedures.
Throughout the text, I emphasize ceteris paribus relationships, which is why, after one chapter on
the simple regression model, I move to multiple regression analysis. The multiple regression setting
motivates students to think about serious applications early. I also give prominence to policy analysis
with all kinds of data structures. Practical topics, such as using proxy variables to obtain ceteris pari-
bus effects and interpreting partial effects in models with interaction terms, are covered in a simple
fashion.

Designed at Undergraduates, Applicable

to Master’s Students
The text is designed for undergraduate economics majors who have taken college algebra and
one-semester of introductory probability and statistics. (Math Refresher A, B, and C contain the
requisite background material.) A one-semester or one-quarter econometrics course would not be
expected to cover all, or even any, of the more advanced material in Part 3. A typical introduc-
tory course includes Chapters 1 through 8, which cover the basics of simple and multiple regres-
sion for cross-sectional data. Provided the emphasis is on intuition and interpreting the empirical
examples, the material from the first eight chapters should be accessible to undergraduates in most
economics departments. Most instructors will also want to cover at least parts of the c­ hapters
on regression analysis with time series data, Chapters 10 and 12, in varying degrees of depth.
In the one-semester course that I teach at Michigan State, I cover Chapter 10 fairly carefully,
give an overview of the material in Chapter 11, and cover the material on serial correlation in
Chapter 12. I find that this basic one-semester course puts students on a solid footing to write
empirical papers, such as a term paper, a senior seminar paper, or a senior thesis. Chapter 9
­c ontains more specialized topics that arise in analyzing cross-sectional data, including data
­problems such as outliers and nonrandom sampling; for a one-semester course, it can be skipped
without loss of continuity.
The structure of the text makes it ideal for a course with a cross-sectional or policy analysis
focus: the time series chapters can be skipped in lieu of topics from Chapters 9 or 15. The new mate-
rial on potential outcomes added to the first nine chapters should help the instructor craft a course
that provides an introduction to modern policy analysis. Chapter 13 is advanced only in the sense
that it treats two new data structures: independently pooled cross sections and two-period panel data
analysis. Such data structures are especially useful for policy analysis, and the chapter provides

58860_fm_hr_i-xxii.indd 14 10/23/18 6:11 PM

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