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12/10/2007
1
Prediction, Goodness-of-Fit, and Modeling Issues
Prepared by Vera Tabakova, East Carolina University
4.1 Least Squares Prediction
4.2 Measuring Goodness-of-Fit
d li4.3 Modeling Issues
4.4 Log-Linear Models
Slide 4-2Principles of Econometrics, 3rd Edition
where e0 is a random error. We assume that andWe also ass me that and
(4.1)0 1 2 0 0β βy x e= + +
( )0 1 2 0E y x= β +β
( ) 0E ( ) 2. We also assume that and
Slide 4-3Principles of Econometrics, 3rd Edition
( )0 0E e = ( ) 20var e = σ
( )0cov , 0 1,2, ,ie e i N= = …
(4.2)0 1 2 0y b b x= +
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Figure 4.1 A point prediction
Slide 4-4Principles of Econometrics, 3rd Edition
(4.3)( ) ( )0 0 1 2 0 0 1 2 0ˆf y y x e b b x= − = β +β + − +
( ) ( ) ( ) ( )1 2 0 0 1 2 0E f x E e E b E b x= β +β + − ⎡ + ⎤⎣ ⎦
Slide 4-5Principles of Econometrics, 3rd Edition
(4.4)2
2 02
( )1var( ) 1( )i
x xf
N x x⎡ ⎤−
= σ + +⎢ ⎥−⎣ ⎦∑
( ) ( ) ( ) ( )
[ ]
1 2 0 0 1 2 0
1 2 0 1 2 00 0
E f x E e E b E b x
x x
β +β + ⎡ + ⎤⎣ ⎦
= β +β + − β +β =
The variance of the forecast error is smaller when
i. the overall uncertainty in the model is smaller, as measured by the variance of the random errors ;
ii. the sample size N is larger; iii. the variation in the explanatory variable is larger; andp y g ;iv. the value of is small.
Slide 4-6Principles of Econometrics, 3rd Edition
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3
22 0
2
1 ( )ˆvar( ) 1( )i
x xfN x x
⎡ ⎤−= σ + +⎢ ⎥−⎣ ⎦∑
Slide 4-7Principles of Econometrics, 3rd Edition
(4.5)
(4.6)
( ) ( )se varf f=
( )0ˆ secy t f±
Figure 4.2 Point and interval prediction
Slide 4-8Principles of Econometrics, 3rd Edition
y
0 1 2 0ˆ 83.4160 10.2096(20) 287.6089y b b x= + = + =
22 0
2
1 ( )ˆvar( ) 1( )i
x xfN x x
⎡ ⎤−= σ + +⎢ ⎥−⎣ ⎦∑
Slide 4-9Principles of Econometrics, 3rd Edition
( )
2 22 2
0 2
22 2
0 2
ˆ ˆˆ ( )( )
ˆˆ ( ) var
i
x xN x x
x x bN
⎣ ⎦
σ σ= σ + + −
−
σ= σ + + −
∑
[ ]0ˆ se( ) 287.6069 2.0244(90.6328) 104.1323,471.0854cy t f± = ± =
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(4.7)
(4 8)
1 2 i i iy x e= β +β +
( )y E y e= +
Slide 4-10Principles of Econometrics, 3rd Edition
(4.8)
(4.9)
(4.10)
( )i i iy E y e= +
ˆ ˆi i iy y e= +
ˆ ˆ( )i i iy y y y e− = − +
Figure 4.3 Explained and unexplained components of yi
Slide 4-11Principles of Econometrics, 3rd Edition
(4 11)2 2 2ˆ ˆ( ) ( )∑ ∑ ∑
( )22ˆ
1i
y
y yN
−σ =
−∑
Slide 4-12Principles of Econometrics, 3rd Edition
(4.11)2 2 2ˆ ˆ( ) ( )i i iy y y y e− = − +∑ ∑ ∑
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= total sum of squares = SST: a measure of total variation in y about the sample mean.
= sum of squares due to the regression = SSR: that part of total variation in y, about the sample mean, that is explained by, or due to, the regression. Also known as the “explained sum of squares ”
2( )iy y−∑
2ˆ( ) iy y−∑
known as the “explained sum of squares.”
= sum of squares due to error = SSE: that part of total variation in y about its mean that is not explained by the regression. Also known as the unexplained sum of squares, the residual sum of squares, or the sum of squared errors.
SST = SSR + SSE
Slide 4-13Principles of Econometrics, 3rd Edition
2ˆ ie∑
(4.12)2 1SSR SSER
SST SST= = −
The closer R2 is to one, the closer the sample values yi are to the fitted regression
equation . If R2= 1, then all the sample data fall exactly on the fitted
least squares line, so SSE = 0, and the model fits the data “perfectly.” If the sample
data for y and x are uncorrelated and show no linear association, then the least
squares fitted line is “horizontal,” so that SSR = 0 and R2 = 0.
Slide 4-14Principles of Econometrics, 3rd Edition
1 2i iy b b x= +
(4.13)
(4.14)
cov( , )var( ) var( )
xyxy
x y
x yx y
σρ = =
σ σ
ˆˆ ˆ
xyxyr
σ=
Slide 4-15Principles of Econometrics, 3rd Edition
(4.14)
(4.15)
ˆ ˆxyx yσ σ
( )
( )
( )
2
2
ˆ ( )( ) 1
ˆ ( ) 1
ˆ ( ) 1
xy i i
x i
y i
x x y y N
x x N
y y N
σ = − − −
σ = − −
σ = − −
∑
∑
∑
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2 2xyr R=
2 2ˆyyR r=
R2 measures the linear association, or goodness-of-fit, between the sample data
and their predicted values. Consequently R2 is sometimes called a measure of
“goodness-of-fit.”
Slide 4-16Principles of Econometrics, 3rd Edition
( )
( )
2
2 2
495132.160
ˆ ˆ 304505.176
i
i i i
SST y y
SSE y y e
= − =
= − = =
∑
∑ ∑
Slide 4-17Principles of Econometrics, 3rd Edition
2 304505.1761 1 .385495132.160
SSERSST
= − = − =
( )( )ˆ 478.75 .62
ˆ ˆ 6.848 112.675xy
xyx y
rσ
= = =σ σ
Figure 4.4 Plot of predicted y, against y
Slide 4-18Principles of Econometrics, 3rd Edition
y
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FOOD_EXP = weekly food expenditure by a household of size 3, in dollars
INCOME = weekly household income, in $100 units
283.42 10.21 .385FOOD_EXP = INCOME R+ =
* indicates significant at the 10% level** indicates significant at the 5% level*** indicates significant at the 1% level
Slide 4-19Principles of Econometrics, 3rd Edition
* *** (se) (43.41) (2.09)
4.3.1 The Effects of Scaling the DataChanging the scale of x:
* *1 2 1 2 1 2 = ( )( / ) = y x e c x c e x e= β +β + β + β + β +β +
* *h β β d
Changing the scale of y:
Slide 4-20Principles of Econometrics, 3rd Edition
2 2where β β and c x x c= =
* * * *1 2 1 2/ ( / ) ( / ) ( / ) or y c c c x e c y x e= β + β + = β +β +
Variable transformations:Power: if x is a variable then xp means raising the variable to the power p; examples
are quadratic (x2) and cubic (x3) transformations.
The natural logarithm: if x is a variable then its natural logarithm is ln(x).g g ( )
The reciprocal: if x is a variable then its reciprocal is 1/x.
Slide 4-21Principles of Econometrics, 3rd Edition
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Figure 4.5 A nonlinear relationship between food expenditure and income
Slide 4-22Principles of Econometrics, 3rd Edition
The log-log model
The parameter β is the elasticity of y with respect to x.1 2ln( ) ln( )y x= β +β
The log-linear model
A one-unit increase in x leads to (approximately) a 100 β2 percent change in y.
The linear-log model
A 1% increase in x leads to a β2/100 unit change in y.
Slide 4-23Principles of Econometrics, 3rd Edition
1 2ln( )i iy x= β +β
( ) ( )2
1 2 ln or 100 100
yy xx x
Δ β= β +β =
Δ
The reciprocal model is
1 21_FOOD EXP e
INCOME= β +β +
The linear-log model is
Slide 4-24Principles of Econometrics, 3rd Edition
1 2_ ln( )FOOD EXP INCOME e= β +β +
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Remark: Given this array of models, that involve different transformations of the dependent and independent variables, and some of which have similar shapes, what are some guidelines for choosing a functional form?
Slide 4-25Principles of Econometrics, 3rd Edition
g g
1. Choose a shape that is consistent with what economic theory tells us about the relationship.
2. Choose a shape that is sufficiently flexible to “fit” the data
3. Choose a shape so that assumptions SR1-SR6 are satisfied, ensuring that the least squares estimators have the desirable properties described in Chapters 2 and 3.
Figure 4.6 EViews output: residuals histogram and summary statistics for food expenditure example
Slide 4-26Principles of Econometrics, 3rd Edition
The Jarque-Bera statistic is given by
( )22 3
6 4KNJB S
⎛ ⎞−= +⎜ ⎟⎜ ⎟
⎝ ⎠
where N is the sample size, S is skewness, and K is kurtosis.
In the food expenditure example
Slide 4-27Principles of Econometrics, 3rd Edition
( )22 2.99 340 .097 .063
6 4JB
⎛ ⎞−= − + =⎜ ⎟⎜ ⎟
⎝ ⎠
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Figure 4.7 Scatter plot of wheat yield over time
Slide 4-28Principles of Econometrics, 3rd Edition
1 2t t tYIELD TIME e= β +β +
Slide 4-29Principles of Econometrics, 3rd Edition
2.638 .0210 .649 (se) (.064) (.0022)
t tYIELD TIME R= + =
Figure 4.8 Predicted, actual and residual values from straight line
Slide 4-30Principles of Econometrics, 3rd Edition
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Figure 4.9 Bar chart of residuals from straight line
Slide 4-31Principles of Econometrics, 3rd Edition
31 2t t tYIELD TIME e= β +β +
3 1000000TIMECUBE TIME
Slide 4-32Principles of Econometrics, 3rd Edition
20.874 9.68 0.751 (se) (.036) (.082)
t tYIELD TIMECUBE R= + =
3 1000000TIMECUBE TIME=
Figure 4.10 Fitted, actual and residual values from equation with cubic term
Slide 4-33Principles of Econometrics, 3rd Edition
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4.4.1 The Growth Model
( ) ( ) ( )0ln ln ln 1tYIELD YIELD g t
t
= + +
β +β
Slide 4-34Principles of Econometrics, 3rd Edition
1 2t= β +β
( )ln .3434 .0178 (se) (.0584) (.0021)
tYIELD t= − +
4.4.2 A Wage Equation
( ) ( ) ( )0
1 2
ln ln ln 1WAGE WAGE r EDUC
EDUC
= + +
= β +β
Slide 4-35Principles of Econometrics, 3rd Edition
1 2β β
( )ln .7884 .1038 (se) (.0849) (.0063)
WAGE EDUC= + ×
4.4.3 Prediction in the Log-Linear Model
( )( ) ( )1 2ˆ exp ln expny y b b x= = +
( ) ( ) 2ˆ2 2ˆ ˆ ˆ2E b b σ
Slide 4-36Principles of Econometrics, 3rd Edition
( ) ( )2 21 2exp 2c ny E y b b x y eσ= = + + σ =
( )ln .7884 .1038 .7884 .1038 12 2.0335WAGE EDUC= + × = + × =
( ) 2ˆ 2ˆ ˆ 7.6408 1.1276 8.6161c ny E y y eσ= = = × =
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4.4.4 A Generalized R2 Measure
( ) 22 2ˆ,ˆcorr ,g y yR y y r= ⎡ ⎤ =⎣ ⎦
R2 values tend to be small with microeconomic, cross-sectional data, because the
variations in individual behavior are difficult to fully explain.
Slide 4-37Principles of Econometrics, 3rd Edition
( ) 22 2ˆcorr , .4739 .2246g cR y y= ⎡ ⎤ = =⎣ ⎦
4.4.5 Prediction Intervals in the Log-Linear Model
( ) ( )( ) ( ) ( )( )exp ln se ,exp ln sec cy t f y t f⎡ ⎤− +⎢ ⎥⎣ ⎦
Slide 4-38Principles of Econometrics, 3rd Edition
( ) ( ) [ ]exp 2.0335 1.96 .4905 ,exp 2.0335 1.96 .4905 2.9184,20.0046⎡ − × + × ⎤ =⎣ ⎦
coefficient of determinationcorrelationdata scaleforecast error
linear modellinear relationshiplinear-log modellog-linear modellog-log model
Slide 4-39Principles of Econometrics, 3rd Edition
forecast standard errorfunctional formgoodness-of-fitgrowth modelJarque-Bera testkurtosisleast squares predictor
log-normal distributionpredictionprediction intervalR2
residualskewness
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Slide 4-40Principles of Econometrics, 3rd Edition
( ) ( )0 0 1 2 0 0 1 2 0ˆf y y x e b b x= − = β +β + − +
Slide 4-41Principles of Econometrics, 3rd Edition
( ) ( ) ( ) ( ) ( )
( ) ( ) ( )
20 1 2 0 1 0 2 0 1 2
2 2 22 20 02 2 2
ˆvar var var var 2 cov ,
2i
i i i
y b b x b x b x b b
x xx xN x x x x x x
= + = + +
σ σ −= + + σ
− − −∑
∑ ∑ ∑
( )( ) ( ) ( )
( )( ) ( )
22 2 2 2 2 2 2 200
0 2 2 2 2 2
2 2 2 22 0 0
2ˆvar
2
i
i i i i i
i
x xx Nx x NxyN x x N x x x x x x N x x
x Nx x x x x
⎡ ⎤ ⎡ ⎤⎧ ⎫ ⎧ ⎫σ −σ σ σ σ⎪ ⎪ ⎪ ⎪⎢ ⎥ ⎢ ⎥= − + + +⎨ ⎬ ⎨ ⎬− − − − −⎢ ⎥ ⎢ ⎥⎪ ⎪ ⎪ ⎪⎩ ⎭ ⎩ ⎭⎣ ⎦ ⎣ ⎦
⎡ ⎤− − += σ +⎢ ⎥
∑∑ ∑ ∑ ∑ ∑
∑
Slide 4-42Principles of Econometrics, 3rd Edition
( ) ( )
( )( )
( )( )
( )
2 2
2 22 0
2 2
22 01
i i
i
i i
N x x x x
x x x xN x x x x
x xN x
= σ +⎢ ⎥− −⎢ ⎥⎣ ⎦
⎡ ⎤− −= σ +⎢ ⎥
− −⎢ ⎥⎣ ⎦
−= σ +
∑ ∑
∑∑ ∑
( )2i x
⎡ ⎤⎢ ⎥
−⎢ ⎥⎣ ⎦∑
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~ (0,1)var( )
f Nf
( )2
2 01 ( )ˆvar 1 x xf⎡ ⎤−
= σ + +⎢ ⎥
Slide 4-43Principles of Econometrics, 3rd Edition
(4A.1)
(4A.2)
( ) 2var 1( )i
fN x x
= σ + +⎢ ⎥−⎣ ⎦∑
( )0 0
( 2)ˆ
~se( )var
Nf y y t
ff−
−=
( ) 1c cP t t t− ≤ ≤ = −α
0 0ˆ[ ] 1
se( )c cy yP t t
f−
− ≤ ≤ = −α
[ ]ˆ ˆse( ) se( ) 1P y t f y y t f− ≤ ≤ + = −α
Slide 4-44Principles of Econometrics, 3rd Edition
[ ]0 0 0se( ) se( ) 1c cP y t f y y t f− ≤ ≤ + = −α
( ) [ ]22 2 2ˆ ˆ ˆ ˆ ˆ ˆ( ) ( ) 2( )i i i i i i iy y y y e y y e y y e− = − + = − + + −
( )2 2 2ˆ ˆ ˆ ˆ( ) 2 ( )+ +∑ ∑ ∑ ∑
Slide 4-45Principles of Econometrics, 3rd Edition
( ) 2 2( ) 2 ( )i i i i iy y y y e y y e− = − + + −∑ ∑ ∑ ∑
( ) ( )1 2
1 2
ˆ ˆ ˆ ˆ ˆ ˆ ˆ
ˆ ˆ ˆ
i i i i i i i i
i i i i
y y e y e y e b b x e y e
b e b x e y e
− = − = + −
= + −
∑ ∑ ∑ ∑ ∑
∑ ∑ ∑
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( )1 2 1 2ˆ 0i i i i ie y b b x y Nb b x= − − = − − =∑ ∑ ∑ ∑
( ) 2ˆ 0x e x y b b x x y b x b x= − − = − − =∑ ∑ ∑ ∑ ∑
Slide 4-46Principles of Econometrics, 3rd Edition
If the model contains an intercept it is guaranteed that SST = SSR + SSE. If, however, the model does not contain an intercept, then and SST ≠ SSR + SSE.
( )1 2 1 2 0i i i i i i i i ix e x y b b x x y b x b x= − − = − − =∑ ∑ ∑ ∑ ∑
( )ˆ ˆ 0i iy y e− =∑
ˆ 0ie ≠∑
Suppose that the variable y has a normal distribution, with mean μ and variance σ2. If we consider then is said to have a log-normaldistribution.
yw e= ( ) ( )2ln ~ ,y w N= μ σ
( ) 2 2E μ+σ
Slide 4-47Principles of Econometrics, 3rd Edition
( ) 2E w eμ+σ=
( ) ( )2 22var 1w e eμ+σ σ= −
Given the log-linear model
If we assume that
( ) 1 2ln y x e= β +β +
( )2~ 0,e N σ
( ) ( ) ( )1 2 1 2i i i ix e x eE y E e E e eβ +β + β +β= = =
Slide 4-48Principles of Econometrics, 3rd Edition
( ) ( ) ( )( )
1 2 1 2
221 2 1 2 1 2 22
i i i i
i i i i
i
x e x x
E y E e E e e
e E e e e e
β β β β
β +β β +β β +β +σσ
= = =
= =
( ) 21 2 ˆ 2ib b x
iE y e + +σ=
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The growth and wage equations:
and( )2 ln 1 rβ = + 2 1r eβ= −
( ) ( )( )22~ varb N b x xβ = σ ∑
Slide 4-49Principles of Econometrics, 3rd Edition
( ) ( )( )2 2 2~ ,var ib N b x xβ = σ −∑
( )2 22 var /2bbE e eβ +⎡ ⎤ =⎣ ⎦( )2 2var /2ˆ 1b br e += −
( ) ( )222 ˆvar ib x x= σ −∑
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