RELAXING THE ASSUMPTIONS OF CLRM

Dr. Obid A.Khakimov Senior lecturer, Westminster International University in Tashkent

ASSUMPTIONS OF CLASSICAL LINEAR REGRESSION MODEL

The regression model is linear in parameters The values of independent variables are fixed in repeated sampling Conditional mean of residuals is equal to zero For given Xs there is no autocorrelation in the residuals Independent variables , Xs , and residuals of the regression are independent.

ASSUMPTIONS OF CLASSICAL LINEAR REGRESSION MODEL

The number of observations must be greater than number of parameters. There must be sufficient variability in the values of variables. The regression model should be correctly specified. There is no linear relationship among 2 independent ) ei ~ N (0, e variables. Residuals of the regression normally distributed

MULTICOLLINEARITY:
Agenda:
The nature of multicollinearity. Practical consequences. Detection. Remedial measures to alleviate the problem.

REASONS:
Data collection process Constraints on model or in the population being sampled. Model specification An over-determined models

PERFECT V.S LESS THAN PERFECT

X 1 +2 X 2 +3 X 3 ..... k X k = 0 1
3 k 2 X1 = X 2 + X 3 ..... X k 1 1 1

Perfect multicollinearity is the case when two ore more independe variables Can create perfect linear relationship.

Perfect multicollinearity is the case when two ore more independe variables Can create less than perfect linear relationship.
X1 =

2 1 X 2 + 3 X 3 ..... k X k + ei 1 1 1 1

MULTIPLE REGRESSION MODEL

Yi = 2 X 2 + 3 X 3 + ui

min u = (Yi 1 2 X 2i 3 X 3i )
2 i

1 = Y 2 X 2 3 X 3

( yi x2i ) ( x ) ( yi x3i )( x2i x3i ) 2 = 2 2 2 ( x2i )( x3i ) ( x2i x3i )

2 3i

3 = ( yi x3i ) ( x ) ( yi x2i )( x2i x3i ) 2 2 ( x2i )( x3i ) ( x2i x3i ) 2

2 2i

MULTIPLE REGRESSION MODEL

( yi x2i ) ( x32i ) ( yi x3i )( x2i x3i ) 2 = 2 2 2 ( x2i )( x3i ) ( x2i x3i )
2

X 2 i = X 3i

( y x )(x ) ( y x )( x x ) = ((x ) )( x ) (x x ) ( y x )(x ) ( y x )( x ) = = (( x )( x ) (x )

i 3i 2 3i i 3i 2 3i 2 3i 3i 2 3i 3i 3i i 3i 2 3i 2 i 3i 3i 2 3i 2 3i 2 3i 2

if _ = a

= ( yi x3i )a ( yi x3i ) a = 0 2 aa (a ) 2 0

OLS ESTIMATION
2 2 2 1 X 2 x3i + X 32 x2i 2 X 2 X 3 x2i x3i var(1 ) = + 2 2 2 n x2i x3i ( x2i x3i ) 2

2 var( 2 ) = 2 2 x2i (1 r2,3 )

cov( 2 , 3 ) =

2 var( 3 ) = 2 2 x3i (1 r2,3 )

r2,3 2

(1 r22,3 )

2 x2 i

2 x3i

As degree of collinearity approaches to one, the variances of coefficients approaches to infinity. Thus, the presence of high collinearity will

PRACTICAL CONSEQUENCES
The

OLS is BLUE but large variances and covariances making process estimation difficult. Large variances cause large confidence intervals and accepting or rejecting hypothesis are biased. T statistics are biased Although t-stats are low, R-square might be very high. The sensitivity of estimators and variances are very high to small changes

VARIANCE INFLATION FACTOR

2 2 1 2 var( 2 ) = = = VIF 2 2 2 2 2 x2i (1 r2,3 ) x2i (1 r2,3 ) x2i
120 100 80

I FV

60 40 20 0 0 0.2 0.4

Correlation

0.6

0.8

1.2

IMPLICATION FOR K VARIABLE MODELS

Yi = 0 X 0 + 1 X 1 + 2 X 2 + 3 X 3 ..... + k X k + ui
2 2 1 2 var( j ) = = = VIF 2 2 2 2 2 x j (1 R j ) x j (1 R j ) x j

X i = 0 X 0 + 1 X 1 + 2 X 2 + 3 X 3 ..... + k X k R2 = R2 j

CONFIDENCE INTERVALS AND TSTATISTICS

k 1.96 se( k ) VIF
k k 0 Due to low t-stats we can not reject our t= se( k ) VIF Null Hypothesis

H 0 : 2 = 3 = ... = k = 0
Ha: Not all slope coefficients are simultaneously zero

n k ESS n k R 2 R 2 /( k 1) F= = = 2 k 1 RSS k 1 1 R (1 R 2 ) /( n k )

Due to high R square the F-value will be very high and rejection of Ho will be easy

DETECTION
Multicollinearity is a question of degree. It is a feature of sample but not population.

How to detect :
High R square but low t-stats. High correlation coefficients among the independent variables. Auxiliary regression High VIF

Eigenvalue and condition index.***

AUXILIARY REGRESSION
Ho: The Xi variable is not collinear

X i = 0 X 0 + 1 X 1 + 2 X 2 + 3 X 3 ..... + k X k R2 = R2 j
Run regression where one X is dependent and other Xs are independent and Obtain R square

R 2 xi , x2 , x3 ... xk /( k 2) Fi = (1 R 2 xi , x2 , x3 ... xk ) /( n k +1)

Df num = k-2 Df denom = n-k+1

k- is the number of explanatory variables including intercept. n- is sample size. If F stat is higher than F critical then Xi variable is collinear Rule of thumb: if R square of auxiliary regression is higher than over R square then it might be troublesome.

WHAT TO DO ?
Do nothing. Combining cross section and time series Transformation of variables (differencing, ratio transformation) Additional data observations.

READING

Gujarati D., (2003), Basic Econometrics, Ch. 10