Lecture 17: Asymptotics

Economics 326 — Introduction to Econometrics II

Part I: Consistency

Why we need large-sample theory

• The OLS estimator \hat{\beta} has desirable properties:

  • \hat{\beta} is unbiased if the errors are strongly exogenous: \mathrm{E}\left[U \mid X\right] =0.

  • If in addition the errors are homoskedastic, then \widehat{\mathrm{Var}}\left(\hat{\beta}\right)=s^{2}/\sum_{i=1}^{n}\left( X_{i}-\bar{X}\right) ^{2} is an unbiased estimator of the conditional variance of \hat{\beta}.

  • If in addition the errors are normally distributed (given X), then T=\left( \hat{\beta}-\beta \right) /\sqrt{\widehat{\mathrm{Var}}\left(\hat{\beta}\right)} has a t distribution which can be used for hypothesis testing.

Limitations of finite-sample theory

• If the errors are only weakly exogenous: \mathrm{E}\left[X_{i}U_{i}\right] =0, the OLS estimator is in general biased.

• If the errors are heteroskedastic: \mathrm{E}\left[U_{i}^{2} \mid X_{i}\right] =h\left( X_{i}\right), the “usual” variance formula is invalid; we also do not have an unbiased estimator for the variance in this case.

• If the errors are not normally distributed conditional on X, then T- and F-statistics do not have t and F distributions under the null hypothesis.

• Asymptotic (large-sample) theory allows us to derive approximate properties and distributions of estimators and test statistics by assuming that the sample size n is very large.

Convergence in probability and LLN

• Let \theta _{n} be a sequence of random variables indexed by the sample size n. We say that \theta _{n} converges in probability if \lim_{n\rightarrow \infty }P\left( \left\vert \theta _{n}-\theta \right\vert \geq \varepsilon \right) =0\text{ for all }\varepsilon >0.

• We denote this as \theta _{n}\rightarrow _{p}\theta or p\lim \theta _{n}=\theta.

• An example of convergence in probability is a Law of Large Numbers (LLN):

  Let X_{1},X_{2},\ldots ,X_{n} be a random sample such that \mathrm{E}\left[X_{i}\right] =\mu for all i=1,\ldots ,n, and define \bar{X}_{n}=\frac{1}{n}\sum_{i=1}^{n}X_{i}. Then, under certain conditions, \bar{X}_{n}\rightarrow _{p}\mu.

LLN

• Let X_{1},\ldots ,X_{n} be a sample of independent identically distributed (iid) random variables. Let \mathrm{E}\left[X_{i}\right]=\mu. If \mathrm{Var}\left(X_{i}\right)=\sigma ^{2}<\infty, then \bar{X}_{n}\rightarrow _{p}\mu.

• In fact when the data are iid, the LLN holds if \mathrm{E}\left[\left\vert X_{i}\right\vert\right] <\infty, but we prove the result under a stronger assumption that \mathrm{Var}\left(X_{i}\right)<\infty.

Markov’s inequality

• Markov’s inequality. Let W be a random variable. For \varepsilon >0 and r>0, P\left( \left\vert W\right\vert \geq \varepsilon \right) \leq \frac{\mathrm{E}\left[\left\vert W\right\vert ^{r}\right]}{\varepsilon ^{r}}.

• With r=2, we have Chebyshev’s inequality. Suppose that \mathrm{E}\left[X\right]=\mu. Take W\equiv X-\mu and apply Markov’s inequality with r=2. For \varepsilon >0,

  \begin{aligned} P\left( \left\vert X-\mu \right\vert \geq \varepsilon \right) &\leq \frac{\mathrm{E}\left[\left\vert X-\mu \right\vert ^{2}\right]}{\varepsilon ^{2}} \\ &= \frac{\mathrm{Var}\left(X\right)}{\varepsilon ^{2}}. \end{aligned}

• The probability of observing an outlier (a large deviation of X from its mean \mu) can be bounded by the variance.

Proof of the LLN

Fix \varepsilon >0 and apply Markov’s inequality with r=2:

\begin{aligned} P\left( \left\vert \bar{X}_{n}-\mu \right\vert \geq \varepsilon \right) &= P\left( \left\vert \frac{1}{n}\sum_{i=1}^{n}X_{i}-\mu \right\vert \geq \varepsilon \right) \\ &= P\left( \left\vert \frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\mu \right) \right\vert \geq \varepsilon \right) \\ &\leq \frac{\mathrm{E}\left[\left( \frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\mu \right) \right) ^{2}\right]}{\varepsilon ^{2}} \\ &= \frac{1}{n^{2}\varepsilon ^{2}}\left( \sum_{i=1}^{n}\mathrm{E}\left[\left( X_{i}-\mu \right) ^{2}\right]+\sum_{i=1}^{n}\sum_{j\neq i}\mathrm{E}\left[\left( X_{i}-\mu \right) \left( X_{j}-\mu \right)\right] \right) \\ &= \frac{1}{n^{2}\varepsilon ^{2}}\left( \sum_{i=1}^{n}\mathrm{Var}\left(X_{i}\right)+\sum_{i=1}^{n}\sum_{j\neq i}\mathrm{Cov}\left(X_{i},X_{j}\right)\right) \\ &= \frac{n\sigma ^{2}}{n^{2}\varepsilon ^{2}} = \frac{\sigma ^{2}}{n\varepsilon ^{2}} \rightarrow 0 \text{ as }n\rightarrow \infty \text{ for all }\varepsilon >0. \end{aligned}

Averaging and variance reduction

• Let X_{1},\ldots ,X_{n} be a sample and suppose that

  \begin{aligned} \mathrm{E}\left[X_{i}\right] &= \mu \text{ for all }i=1,\ldots ,n, \\ \mathrm{Var}\left(X_{i}\right) &= \sigma ^{2}\text{ for all }i=1,\ldots ,n, \\ \mathrm{Cov}\left(X_{i},X_{j}\right) &= 0\text{ for all }j\neq i. \end{aligned}

• The mean of the sample average:

  \begin{aligned} \mathrm{E}\left[\bar{X}_{n}\right] &= \mathrm{E}\left[\frac{1}{n}\sum_{i=1}^{n}X_{i}\right] \\ &= \frac{1}{n}\sum_{i=1}^{n}\mathrm{E}\left[X_{i}\right] \\ &= \frac{1}{n}\sum_{i=1}^{n}\mu = \frac{1}{n}n\mu =\mu. \end{aligned}

Variance of the sample average

• The variance of the sample average:

  \begin{aligned} \mathrm{Var}\left(\bar{X}_{n}\right) &= \mathrm{Var}\left(\frac{1}{n}\sum_{i=1}^{n}X_{i}\right) \\ &= \frac{1}{n^{2}}\mathrm{Var}\left(\sum_{i=1}^{n}X_{i}\right) \\ &= \frac{1}{n^{2}}\left( \sum_{i=1}^{n}\mathrm{Var}\left(X_{i}\right)+\sum_{i=1}^{n}\sum_{j\neq i}\mathrm{Cov}\left(X_{i},X_{j}\right)\right) \\ &= \frac{1}{n^{2}}\left( \sum_{i=1}^{n}\sigma ^{2}+\sum_{i=1}^{n}\sum_{j\neq i}0\right) \\ &= \frac{1}{n^{2}}n\sigma ^{2}=\frac{\sigma ^{2}}{n}. \end{aligned}

• The variance of the average approaches zero as n\rightarrow \infty if the observations are uncorrelated.

Convergence in probability: properties

• Slutsky’s Lemma. Suppose that \theta _{n}\rightarrow _{p}\theta, and let g be a function continuous at \theta. Then, g\left( \theta _{n}\right) \rightarrow _{p}g\left( \theta \right).

  • If \theta _{n}\rightarrow _{p}\theta, then \theta _{n}^{2}\rightarrow _{p}\theta ^{2}.

  • If \theta _{n}\rightarrow _{p}\theta and \theta \neq 0, then 1/\theta _{n}\rightarrow _{p}1/\theta.

• Suppose that \theta _{n}\rightarrow _{p}\theta and \lambda _{n}\rightarrow _{p}\lambda. Then,

  • \theta _{n}+\lambda _{n}\rightarrow _{p}\theta +\lambda.

  • \theta _{n}\lambda _{n}\rightarrow _{p}\theta \lambda.

  • \theta _{n}/\lambda _{n}\rightarrow _{p}\theta /\lambda provided that \lambda \neq 0.

Consistency

• Let \hat{\beta}_{n} be an estimator of \beta based on a sample of size n.

• We say that \hat{\beta}_{n} is a consistent estimator of \beta if as n\rightarrow \infty, \hat{\beta}_{n}\rightarrow _{p}\beta.

• Consistency means that the probability of the event that the distance between \hat{\beta}_{n} and \beta exceeds \varepsilon >0 can be made arbitrarily small by increasing the sample size.

Consistency of OLS

• Suppose that:

  1. The data \left\{ \left( Y_{i},X_{i}\right) :i=1,\ldots ,n\right\} are iid.

  2. Y_{i}=\beta _{0}+\beta _{1}X_{i}+U_{i}, where \mathrm{E}\left[U_{i}\right] =0.

  3. \mathrm{E}\left[X_{i}U_{i}\right] =0.

  4. 0<\mathrm{Var}\left(X_{i}\right)<\infty.

• Let \hat{\beta}_{0,n} and \hat{\beta}_{1,n} be the OLS estimators of \beta _{0} and \beta _{1} based on a sample of size n. Under Assumptions 1–4, \begin{aligned} \hat{\beta}_{0,n} &\rightarrow _{p}\beta _{0}, \\ \hat{\beta}_{1,n} &\rightarrow _{p}\beta _{1}. \end{aligned}

• The key identifying assumption is Assumption 3: \mathrm{Cov}\left(X_{i},U_{i}\right)=0.

Proof of consistency

• Write

  \begin{aligned} \hat{\beta}_{1,n} = \frac{\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) Y_{i}}{\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}} &= \beta _{1}+\frac{\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}}{\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}} \\ &= \beta _{1}+\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}}. \end{aligned}

• We will show that \begin{aligned} \frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i} &\rightarrow _{p}0, \\ \frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2} &\rightarrow _{p}\mathrm{Var}\left(X_{i}\right), \end{aligned}

• Since \mathrm{Var}\left(X_{i}\right)\neq 0, \hat{\beta}_{1,n} = \beta _{1}+\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}} \rightarrow _{p} \beta _{1}+\frac{0}{\mathrm{Var}\left(X_{i}\right)}= \beta _{1}.

Numerator converges to zero

\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i} = \frac{1}{n}\sum_{i=1}^{n}X_{i}U_{i}-\bar{X}_{n}\left( \frac{1}{n}\sum_{i=1}^{n}U_{i}\right).

By the LLN,

\begin{aligned} \frac{1}{n}\sum_{i=1}^{n}X_{i}U_{i} &\rightarrow _{p}\mathrm{E}\left[X_{i}U_{i}\right] =0, \\ \bar{X}_{n} &\rightarrow _{p}\mathrm{E}\left[X_{i}\right], \\ \frac{1}{n}\sum_{i=1}^{n}U_{i} &\rightarrow _{p}\mathrm{E}\left[U_{i}\right] =0. \end{aligned}

Hence,

\begin{aligned} \frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i} &= \frac{1}{n}\sum_{i=1}^{n}X_{i}U_{i}-\bar{X}_{n}\left( \frac{1}{n}\sum_{i=1}^{n}U_{i}\right) \\ &\rightarrow _{p}0-\mathrm{E}\left[X_{i}\right] \cdot 0 = 0. \end{aligned}

Denominator converges to \mathrm{Var}\left(X_i\right)

• First,

  \begin{aligned} \frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2} &= \frac{1}{n}\sum_{i=1}^{n}\left( X_{i}^{2}-2\bar{X}_{n}X_{i}+\bar{X}_{n}^{2}\right) \\ &= \frac{1}{n}\sum_{i=1}^{n}X_{i}^{2}-2\bar{X}_{n}\frac{1}{n}\sum_{i=1}^{n}X_{i}+\bar{X}_{n}^{2} \\ &= \frac{1}{n}\sum_{i=1}^{n}X_{i}^{2}-2\bar{X}_{n}\bar{X}_{n}+\bar{X}_{n}^{2} = \frac{1}{n}\sum_{i=1}^{n}X_{i}^{2}-\bar{X}_{n}^{2}. \end{aligned}

• By the LLN, \frac{1}{n}\sum_{i=1}^{n}X_{i}^{2}\rightarrow _{p}\mathrm{E}\left[X_{i}^{2}\right] and \bar{X}_{n}\rightarrow _{p}\mathrm{E}\left[X_{i}\right].

• By Slutsky’s Lemma, \bar{X}_{n}^{2}\rightarrow _{p}\left( \mathrm{E}\left[X_{i}\right]\right) ^{2}.

• Thus, \frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}=\frac{1}{n}\sum_{i=1}^{n}X_{i}^{2}-\bar{X}_{n}^{2}\rightarrow _{p}\mathrm{E}\left[X_{i}^{2}\right] -\left( \mathrm{E}\left[X_{i}\right]\right) ^{2}=\mathrm{Var}\left(X_{i}\right).

Multiple regression

• Under similar conditions to 1–4, one can establish consistency of OLS for the multiple linear regression model: Y_{i}=\beta _{0}+\beta _{1}X_{1,i}+\ldots +\beta _{k}X_{k,i}+U_{i}, where \mathrm{E}\left[U_{i}\right]=0.

• The key assumption is that the errors and regressors are uncorrelated: \mathrm{E}\left[X_{1,i}U_{i}\right] =\ldots =\mathrm{E}\left[X_{k,i}U_{i}\right] =0.

Omitted variables and OLS inconsistency

• Suppose that the true model has two regressors: \begin{aligned} &Y_{i}=\beta _{0}+\beta _{1}X_{1,i}+\beta _{2}X_{2,i}+U_{i}, \\ &\mathrm{E}\left[X_{1,i}U_{i}\right] =\mathrm{E}\left[X_{2,i}U_{i}\right] =0. \end{aligned}

• Suppose that the econometrician includes only X_{1} in the regression when estimating \beta _{1}:

  \begin{aligned} \tilde{\beta}_{1,n} &= \frac{\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) Y_{i}}{\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}} \\ &= \frac{\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) \left( \beta _{0}+\beta _{1}X_{1,i}+\beta _{2}X_{2,i}+U_{i}\right) }{\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}} \\ &= \beta _{1}+\beta _{2}\frac{\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) X_{2,i}}{\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}}+\frac{\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) U_{i}}{\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}}. \end{aligned}

Inconsistency proof: noise term

• From the previous slide: \tilde{\beta}_{1,n}=\beta _{1}+\beta _{2}\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) X_{2,i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}}+\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}}.

• As before,

  \begin{aligned} \frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}} &= \frac{\frac{1}{n}\sum_{i=1}^{n}X_{1,i}U_{i}-\bar{X}_{1,n}\bar{U}_{n}}{\frac{1}{n}\sum_{i=1}^{n}X_{1,i}^{2}-\bar{X}_{1,n}^{2}} \\ &\rightarrow _{p}\frac{0}{\mathrm{E}\left[X_{1,i}^{2}\right]-\left( \mathrm{E}\left[X_{1,i}\right]\right) ^{2}} \\ &= \frac{0}{\mathrm{Var}\left(X_{1,i}\right)}=0. \end{aligned}

Inconsistency proof: bias term

• From the previous slide: \tilde{\beta}_{1,n}=\beta _{1}+\beta _{2}\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) X_{2,i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}}+\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}}.

• However,

  \begin{aligned} \frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) X_{2,i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}} &= \frac{\frac{1}{n}\sum_{i=1}^{n}X_{1,i}X_{2,i}-\bar{X}_{1,n}\bar{X}_{2,n}}{\frac{1}{n}\sum_{i=1}^{n}X_{1,i}^{2}-\bar{X}_{1,n}^{2}} \\ &\rightarrow _{p}\frac{\mathrm{E}\left[X_{1,i}X_{2,i}\right] -\mathrm{E}\left[X_{1,i}\right] \mathrm{E}\left[X_{2,i}\right]}{\mathrm{E}\left[X_{1,i}^{2}\right]-\left( \mathrm{E}\left[X_{1,i}\right]\right) ^{2}} \\ &= \frac{\mathrm{Cov}\left(X_{1,i},X_{2,i}\right)}{\mathrm{Var}\left(X_{1,i}\right)}. \end{aligned}

Omitted variable bias formula

• We have

  \begin{aligned} \tilde{\beta}_{1,n} &= \beta _{1}+\beta _{2}\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) X_{2,i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}}+\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{1,i}-\bar{X}_{1,n}\right) ^{2}} \\ &\rightarrow _{p}\beta _{1}+\beta _{2}\frac{\mathrm{Cov}\left(X_{1,i},X_{2,i}\right)}{\mathrm{Var}\left(X_{1,i}\right)}+\frac{0}{\mathrm{Var}\left(X_{1,i}\right)} \\ &= \beta _{1}+\beta _{2}\frac{\mathrm{Cov}\left(X_{1,i},X_{2,i}\right)}{\mathrm{Var}\left(X_{1,i}\right)}. \end{aligned}

• Thus, \tilde{\beta}_{1,n} is inconsistent unless:

  1. \beta _{2}=0 (the model is correctly specified).

  2. \mathrm{Cov}\left(X_{1,i},X_{2,i}\right)=0 (the omitted variable is uncorrelated with the included regressor).

OVB through the composite error

• In this example, the model contains two regressors: \begin{aligned} &Y_{i}=\beta _{0}+\beta _{1}X_{1,i}+\beta _{2}X_{2,i}+U_{i}, \\ &\mathrm{E}\left[X_{1,i}U_{i}\right] =\mathrm{E}\left[X_{2,i}U_{i}\right] =0. \end{aligned}

• However, since X_{2} is not controlled for, it goes into the error term: \begin{aligned} Y_{i} &= \beta _{0}+\beta _{1}X_{1,i}+V_{i},\text{ where} \\ V_{i} &= \beta _{2}X_{2,i}+U_{i}. \end{aligned}

• For consistency of \tilde{\beta}_{1,n} we need \mathrm{Cov}\left(X_{1,i},V_{i}\right) = 0; however,

  \begin{aligned} \mathrm{Cov}\left(X_{1,i},V_{i}\right) &= \mathrm{Cov}\left(X_{1,i},\beta _{2}X_{2,i}+U_{i}\right) \\ &= \mathrm{Cov}\left(X_{1,i},\beta _{2}X_{2,i}\right)+\mathrm{Cov}\left(X_{1,i},U_{i}\right) \\ &= \beta _{2}\mathrm{Cov}\left(X_{1,i},X_{2,i}\right)+0 \\ &\neq 0\text{, unless }\beta _{2}=0\text{ or }\mathrm{Cov}\left(X_{1,i},X_{2,i}\right)=0. \end{aligned}

Part II: Asymptotic Normality

Why do we need asymptotic normality?

• In the previous lectures, we showed that the OLS estimator has an exact normal distribution when the errors are normally distributed.

  • The same assumption is needed to show that the T statistic has a t-distribution and the F statistic has an F-distribution.

• In this lecture, we argue that even when the errors are not normally distributed, the OLS estimator has an approximately normal distribution in large samples, provided that some additional conditions hold.

  • This property is used for hypothesis testing: in large samples, the T statistic has a standard normal distribution and the F statistic has a \chi^{2} distribution (approximately).

Asymptotic normality

• Let W_{n} be a sequence of random variables indexed by the sample size n.

  • Typically, W_{n} will be a function of some estimator, such as W_{n}=\sqrt{n}\left( \hat{\beta}_{n}-\beta \right).

• We say that W_{n} has an asymptotically normal distribution if its CDF converges to a normal CDF.

• Let W be any random variable with a normal N\left( 0,\sigma^{2}\right) distribution. We say that W_{n} has an asymptotically normal distribution if for all x\in \mathbb{R}:

  F_{n}\left( x\right) =P\left( W_{n}\leq x\right) \rightarrow P\left( W\leq x\right) =F\left( x\right) \text{ as }n\rightarrow \infty .

  • We denote this as W_{n}\rightarrow _{d}W or W_{n}\rightarrow _{d}N\left( 0,\sigma ^{2}\right).

Convergence in distribution

• Asymptotic normality is an example of convergence in distribution.

• We say that a sequence of random variables W_{n} converges in distribution to W (denoted as W_{n}\rightarrow _{d}W) if the CDF of W_{n} converges to the CDF of W at all points where the CDF of W is continuous.

• Convergence in distribution is convergence of the CDFs.

Central Limit Theorem (CLT)

• An example of convergence in distribution is a CLT.

• Let X_{1},\ldots ,X_{n} be a sample of iid random variables such that \mathrm{E}\left[X_{i}\right] =0 and \mathrm{Var}\left(X_{i}\right) =\sigma ^{2}>0 (finite). Then, as n\rightarrow \infty,

  \frac{1}{\sqrt{n}}\sum_{i=1}^{n}X_{i}\rightarrow _{d}N\left( 0,\sigma^{2}\right) .

CLT with non-zero mean

• For the CLT we impose 3 assumptions: (1) iid; (2) Mean zero; (3) Finite variance different from zero.

• If X_{1},\ldots ,X_{n} are iid but \mathrm{E}\left[X_{i}\right] =\mu \neq 0, then consider X_{i}-\mu. Since \mathrm{E}\left[X_{i}-\mu\right] =0, we have

  \frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\mu \right) \rightarrow_{d}N\left( 0,\mathrm{Var}\left(X_{i}\right) \right) .

  Then

  \begin{aligned} \frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\mu \right) &= \sqrt{n}\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\mu \right) \\ &= \sqrt{n}\left( \frac{1}{n}\sum_{i=1}^{n}X_{i}-\frac{1}{n}\sum_{i=1}^{n}\mu \right) \\ &= \sqrt{n}\left( \bar{X}_{n}-\mu \right) . \end{aligned}

CLT for the sample average

• From the previous slide: \frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\mu \right) = \sqrt{n}\left( \bar{X}_{n}-\mu \right) .

• Thus, the CLT can be stated as

  \sqrt{n}\left( \bar{X}_{n}-\mu \right) \rightarrow _{d}N\left( 0,\mathrm{Var}\left(X_{i}\right) \right) .

• By the LLN,

  \bar{X}_{n}-\mu \rightarrow _{p}0,

  and

  \mathrm{Var}\left(\sqrt{n}\left( \bar{X}_{n}-\mu \right)\right) = n\mathrm{Var}\left(\bar{X}_{n}\right) = n\frac{\mathrm{Var}\left(X_{i}\right)}{n} = \mathrm{Var}\left(X_{i}\right).

Properties

• Suppose that W_{n}\rightarrow _{d}N\left( 0,\sigma ^{2}\right) and \theta _{n}\rightarrow _{p}\theta. Then,

  \theta _{n}W_{n}\rightarrow _{d}\theta N\left( 0,\sigma ^{2}\right) \stackrel{d}{=} N\left( 0,\theta ^{2}\sigma ^{2}\right) ,

  and

  \theta _{n}+W_{n}\rightarrow _{d}\theta +N\left( 0,\sigma ^{2}\right) \stackrel{d}{=} N\left( \theta ,\sigma ^{2}\right) .

• Suppose that Z_{n}\rightarrow _{d}Z\sim N\left( 0,1\right). Then,

  Z_{n}^{2}\rightarrow _{d}Z^{2}\equiv \chi _{1}^{2}.

• If W_{n}\rightarrow _{d}c= constant, then W_{n}\rightarrow _{p}c.

Asymptotic normality of OLS

• Suppose that:

  1. The data \left\{ \left( Y_{i},X_{i}\right) :i=1,\ldots ,n\right\} are iid.
  2. Y_{i}=\beta _{0}+\beta _{1}X_{i}+U_{i}, where \mathrm{E}\left[U_{i}\right] =0.
  3. \mathrm{E}\left[X_{i}U_{i}\right] =0.
  4. 0<\mathrm{Var}\left(X_{i}\right) <\infty.
  5. 0<\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) ^{2}U_{i}^{2}\right] <\infty and 0<\mathrm{E}\left[U_{i}^{2}\right] <\infty.

• Let \hat{\beta}_{1,n} be the OLS estimator of \beta _{1}. Then,

  \sqrt{n}\left( \hat{\beta}_{1,n}-\beta _{1}\right) \rightarrow _{d}N\left( 0,\frac{\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) ^{2}U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right) \right) ^{2}}\right).

• V=\dfrac{\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) ^{2}U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right) \right) ^{2}} is called the asymptotic variance of \hat{\beta}_{1,n}.

Large-sample approximation for OLS

• Let \overset{a}{\sim} denote “approximately in large samples.”

• The asymptotic normality

  \sqrt{n}\left( \hat{\beta}_{1,n}-\beta _{1}\right) \rightarrow _{d}N\left(0,V\right)

  can be viewed as the following large-sample approximation:

  \sqrt{n}\left( \hat{\beta}_{1,n}-\beta _{1}\right) \overset{a}{\sim} N\left(0,V\right) ,

  or

  \hat{\beta}_{1,n}\overset{a}{\sim} N\left( \beta _{1},V/n\right) .

Proof: decomposition

Write

\hat{\beta}_{1,n}=\beta _{1}+\frac{\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}}{\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}}.

Now

\hat{\beta}_{1,n}-\beta _{1}=\frac{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}},

and

\sqrt{n}\left( \hat{\beta}_{1,n}-\beta _{1}\right) =\frac{\frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}}.

Proof: combining the limits

\sqrt{n}\left( \hat{\beta}_{1,n}-\beta _{1}\right) =\frac{\frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}}.

In Part I, we established

\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}\rightarrow_{p}\mathrm{Var}\left(X_{i}\right).

We will show that

\frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}\rightarrow _{d}N\left( 0,\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2}\right] \right),

so that

\begin{align*} \sqrt{n}\left( \hat{\beta}_{1,n}-\beta _{1}\right) &= \frac{\frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i}}{\frac{1}{n}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) ^{2}} \\ &\rightarrow _{d}\frac{N\left( 0,\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) ^{2}U_{i}^{2}\right] \right)}{\mathrm{Var}\left(X_{i}\right)} \\ &\stackrel{d}{=} N\left( 0,\frac{\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right) \right) ^{2}}\right). \end{align*}

Proof: numerator CLT

\begin{aligned} \frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\bar{X}_{n}\right) U_{i} &= \frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\mathrm{E}\left[X_{i}\right]+\mathrm{E}\left[X_{i}\right]-\bar{X}_{n}\right) U_{i} \\ &= \frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) U_{i}+\left( \mathrm{E}\left[X_{i}\right]-\bar{X}_{n}\right) \frac{1}{\sqrt{n}}\sum_{i=1}^{n}U_{i}. \end{aligned}

We have

\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) U_{i}\right] = \mathrm{E}\left[X_{i}U_{i}\right]-\mathrm{E}\left[X_{i}\right]\mathrm{E}\left[U_{i}\right]=0,

and 0<\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) ^{2}U_{i}^{2}\right] <\infty, so by the CLT,

\frac{1}{\sqrt{n}}\sum_{i=1}^{n}\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) U_{i}\rightarrow_{d}N\left( 0,\mathrm{E}\left[\left( X_{i}-\mathrm{E}\left[X_{i}\right]\right) ^{2}U_{i}^{2}\right]\right).

Proof: second term vanishes

It is left to show that

\left( \mathrm{E}\left[X_{i}\right]-\bar{X}_{n}\right) \frac{1}{\sqrt{n}}\sum_{i=1}^{n}U_{i}\rightarrow _{p}0.

We have \mathrm{E}\left[U_{i}\right]=0 and 0<\mathrm{E}\left[U_{i}^{2}\right]<\infty. By the CLT,

\frac{1}{\sqrt{n}}\sum_{i=1}^{n}U_{i}\rightarrow _{d}N\left(0,\mathrm{E}\left[U_{i}^{2}\right]\right).

By the LLN,

\mathrm{E}\left[X_{i}\right]-\bar{X}_{n}\rightarrow _{p}0.

Hence, the result follows.

Part III: Asymptotic Variance

Asymptotic variance

• In Part II, we showed that when the data are iid and the regressors are exogenous, \begin{aligned} Y_{i} &= \beta_{0} + \beta_{1}X_{i} + U_{i}, \\ \mathrm{E}\left[U_{i}\right] &= \mathrm{E}\left[X_{i}U_{i}\right] = 0, \end{aligned} the OLS estimator of \beta_{1} is asymptotically normal: \begin{aligned} \sqrt{n}\left(\hat{\beta}_{1,n} - \beta_{1}\right) &\rightarrow_{d} N\left(0, V\right), \\ V &= \frac{\mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right)\right)^{2}}. \end{aligned}

• For hypothesis testing, we need a consistent estimator of the asymptotic variance V: \hat{V}_{n} \rightarrow_{p} V.

Simplifying V under homoskedasticity

• Assume that the errors are homoskedastic: \mathrm{E}\left[U_{i}^{2} \mid X_{i}\right] = \sigma^{2} \text{ for all } X_{i}\text{'s.}

• In this case, the asymptotic variance can be simplified using the Law of Iterated Expectation: \begin{aligned} \mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2}\right] &= \mathrm{E}\left[\mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2} \mid X_{i}\right]\right] \\ &= \mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2} \mathrm{E}\left[U_{i}^{2} \mid X_{i}\right]\right] \\ &= \mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2} \sigma^{2}\right] \\ &= \sigma^{2}\,\mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2}\right] = \sigma^{2}\mathrm{Var}\left(X_{i}\right). \end{aligned}

Estimating V: method of moments

• Thus, when the errors are homoskedastic with \mathrm{E}\left[U_{i}^{2}\right] = \sigma^{2}, V = \frac{\mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right)\right)^{2}} = \frac{\sigma^{2}\mathrm{Var}\left(X_{i}\right)}{\left(\mathrm{Var}\left(X_{i}\right)\right)^{2}} = \frac{\sigma^{2}}{\mathrm{Var}\left(X_{i}\right)}.

• Let \hat{U}_{i} = Y_{i} - \hat{\beta}_{0,n} - \hat{\beta}_{1,n}X_{i}, where \hat{\beta}_{0,n} and \hat{\beta}_{1,n} are the OLS estimators of \beta_{0} and \beta_{1}.

• A consistent estimator for the asymptotic variance can be constructed using the Method of Moments: \begin{aligned} \hat{\sigma}_{n}^{2} &= \frac{1}{n}\sum_{i=1}^{n}\hat{U}_{i}^{2}, \\ \widehat{\mathrm{Var}}\left(X_{i}\right) &= \frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}, \text{ and} \\ \hat{V}_{n} &= \frac{\hat{\sigma}_{n}^{2}}{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}}. \end{aligned}

Why the LLN does not apply directly

• From the previous slide: \hat{V}_{n} = \frac{\hat{\sigma}_{n}^{2}}{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}},\quad \hat{\sigma}_{n}^{2} = \frac{1}{n}\sum_{i=1}^{n}\hat{U}_{i}^{2},\quad \hat{U}_{i} = Y_{i} - \hat{\beta}_{0,n} - \hat{\beta}_{1,n}X_{i}.

• When proving the consistency of OLS (Part I), we showed that \frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2} \rightarrow_{p} \mathrm{Var}\left(X_{i}\right), and to establish \hat{V}_{n} \rightarrow_{p} V, we need to show that \hat{\sigma}_{n}^{2} \rightarrow_{p} \sigma^{2}.

• The LLN cannot be applied directly to \frac{1}{n}\sum_{i=1}^{n}\hat{U}_{i}^{2} because the \hat{U}_{i}’s are not iid: they are dependent through \hat{\beta}_{0,n} and \hat{\beta}_{1,n}.

Proof of \hat{\sigma}^{2}_{n} \rightarrow_{p} \sigma^{2}

• First, write \begin{aligned} \hat{U}_{i} &= Y_{i} - \hat{\beta}_{0,n} - \hat{\beta}_{1,n}X_{i} \\ &= \left(\beta_{0} + \beta_{1}X_{i} + U_{i}\right) - \hat{\beta}_{0,n} - \hat{\beta}_{1,n}X_{i} \\ &= U_{i} - \left(\hat{\beta}_{0,n} - \beta_{0}\right) - \left(\hat{\beta}_{1,n} - \beta_{1}\right)X_{i}. \end{aligned}

• Now, \hat{\sigma}_{n}^{2} = \frac{1}{n}\sum_{i=1}^{n}\hat{U}_{i}^{2} = \frac{1}{n}\sum_{i=1}^{n}\left(U_{i} - \left(\hat{\beta}_{0,n} - \beta_{0}\right) - \left(\hat{\beta}_{1,n} - \beta_{1}\right)X_{i}\right)^{2}.

Completing the consistency proof

• We have \begin{aligned} \hat{\sigma}_{n}^{2} &= \frac{1}{n}\sum_{i=1}^{n}\left(U_{i} - \left(\hat{\beta}_{0,n} - \beta_{0}\right) - \left(\hat{\beta}_{1,n} - \beta_{1}\right)X_{i}\right)^{2} \\ &= \frac{1}{n}\sum_{i=1}^{n}U_{i}^{2} + \left(\hat{\beta}_{0,n} - \beta_{0}\right)^{2} + \left(\hat{\beta}_{1,n} - \beta_{1}\right)^{2}\frac{1}{n}\sum_{i=1}^{n}X_{i}^{2} \\ &\quad -2\left(\hat{\beta}_{0,n} - \beta_{0}\right)\frac{1}{n}\sum_{i=1}^{n}U_{i} - 2\left(\hat{\beta}_{1,n} - \beta_{1}\right)\frac{1}{n}\sum_{i=1}^{n}U_{i}X_{i} \\ &\quad +2\left(\hat{\beta}_{0,n} - \beta_{0}\right)\left(\hat{\beta}_{1,n} - \beta_{1}\right)\frac{1}{n}\sum_{i=1}^{n}X_{i}. \end{aligned}

• By the LLN, \frac{1}{n}\sum_{i=1}^{n}U_{i}^{2} \rightarrow_{p} \mathrm{E}\left[U_{i}^{2}\right] = \sigma^{2}.

• Because \hat{\beta}_{0,n} and \hat{\beta}_{1,n} are consistent, \hat{\beta}_{0,n} - \beta_{0} \rightarrow_{p} 0 \text{ and } \hat{\beta}_{1,n} - \beta_{1} \rightarrow_{p} 0.

Using s^2 instead of \hat{\sigma}^2_n

• Thus, when the errors are homoskedastic, \hat{V}_{n} = \frac{\hat{\sigma}_{n}^{2}}{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}}, \text{ with } \hat{\sigma}_{n}^{2} = \frac{1}{n}\sum_{i=1}^{n}\hat{U}_{i}^{2}, is a consistent estimator of V = \frac{\sigma^{2}}{\mathrm{Var}\left(X_{i}\right)}.

• Similarly, s^{2} = \frac{1}{n-2}\sum_{i=1}^{n}\hat{U}_{i}^{2} \rightarrow_{p} \sigma^{2}, and therefore \hat{V}_{n} = \frac{s^{2}}{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}} is also a consistent estimator of V = \frac{\sigma^{2}}{\mathrm{Var}\left(X_{i}\right)}.

• This version has an advantage over the one with \hat{\sigma}_{n}^{2}: in addition to being consistent, s^{2} is also an unbiased estimator of \sigma^{2} if the regressors are strongly exogenous.

Asymptotic approximation

• The result \sqrt{n}\left(\hat{\beta}_{1,n} - \beta_{1}\right) \rightarrow_{d} N\left(0, V\right) is used as the following approximation: \hat{\beta}_{1,n} \overset{a}{\sim} N\left(\beta_{1}, \frac{V}{n}\right), where \overset{a}{\sim} denotes approximately in large samples. Thus, the variance of \hat{\beta}_{1,n} can be taken as approximately V/n.

• With \hat{V}_{n} = \frac{s^{2}}{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}} we have \frac{\hat{V}_{n}}{n} = \frac{s^{2}}{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}} \cdot \frac{1}{n} = \frac{s^{2}}{\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}}.

Connection to the exact result

• From the previous slide: \frac{\hat{V}_{n}}{n} = \frac{s^{2}}{\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}}

• Thus, in the case of homoskedastic errors we have the following asymptotic approximation: \hat{\beta}_{1,n} \overset{a}{\sim} N\left(\beta_{1}, \frac{s^{2}}{\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}}\right).

• In finite samples, we have the same result exactly, when the regressors are strongly exogenous and the errors are normal.

Asymptotic T-test

• Consider testing H_{0}: \beta_{1} = \beta_{1,0} vs H_{1}: \beta_{1} \neq \beta_{1,0}.

• Consider the behavior of the T statistic under H_{0}: \beta_{1} = \beta_{1,0}. Since \sqrt{n}\left(\hat{\beta}_{1,n} - \beta_{1}\right) \rightarrow_{d} N\left(0, V\right) \text{ and } \hat{V}_{n} \rightarrow_{p} V, we have \begin{aligned} T = \frac{\hat{\beta}_{1,n} - \beta_{1,0}}{\sqrt{\hat{V}_{n}/n}} &= \frac{\sqrt{n}\left(\hat{\beta}_{1,n} - \beta_{1,0}\right)}{\sqrt{\hat{V}_{n}}} \\ &\overset{H_{0}}{=} \frac{\sqrt{n}\left(\hat{\beta}_{1,n} - \beta_{1}\right)}{\sqrt{\hat{V}_{n}}} \\ &\rightarrow_{d} \frac{N\left(0, V\right)}{\sqrt{V}} \stackrel{d}{=} N\left(0, 1\right). \end{aligned}

Asymptotic T-test: rejection rule

• Under H_{0}: \beta_{1} = \beta_{1,0}, T = \frac{\hat{\beta}_{1,n} - \beta_{1,0}}{\sqrt{\hat{V}_{n}/n}} \rightarrow_{d} N\left(0, 1\right), provided that \hat{V}_{n} \rightarrow_{p} V (the asymptotic variance of \hat{\beta}_{1,n}).

• An asymptotic size \alpha test rejects H_{0}: \beta_{1} = \beta_{1,0} against H_{1}: \beta_{1} \neq \beta_{1,0} when \left|T\right| > z_{1-\alpha/2}, where z_{1-\alpha/2} is a standard normal critical value.

• Asymptotically, the variance of the OLS estimator is known; we behave as if the variance were known.

Heteroskedastic errors

• In general, the errors are heteroskedastic: \mathrm{E}\left[U_{i}^{2} \mid X_{i}\right] is not constant and changes with X_{i}.

• In this case, \hat{V}_{n} = \frac{s^{2}}{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}} is not a consistent estimator of the asymptotic variance V = \frac{\mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right)\right)^{2}}: \begin{aligned} \frac{s^{2}}{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}} &\rightarrow_{p} \frac{\mathrm{E}\left[U_{i}^{2}\right]}{\mathrm{Var}\left(X_{i}\right)} \\ &= \frac{\mathrm{Var}\left(X_{i}\right)\cdot\mathrm{E}\left[U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right)\right)^{2}} \\ &\neq \frac{\mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right)\right)^{2}}. \end{aligned}

HC estimator of asymptotic variance

• In the case of heteroskedastic errors, a consistent estimator of V = \frac{\mathrm{E}\left[\left(X_{i} - \mathrm{E}\left[X_{i}\right]\right)^{2}U_{i}^{2}\right]}{\left(\mathrm{Var}\left(X_{i}\right)\right)^{2}} can be constructed as follows: \hat{V}_{n}^{HC} = \frac{\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}\hat{U}_{i}^{2}}{\left(\frac{1}{n}\sum_{i=1}^{n}\left(X_{i} - \bar{X}_{n}\right)^{2}\right)^{2}}.

• One can show that \hat{V}_{n}^{HC} \rightarrow_{p} V whether the errors are heteroskedastic or homoskedastic.

• We have the following asymptotic approximation: \hat{\beta}_{1,n} \overset{a}{\sim} N\left(\beta_{1}, \frac{\hat{V}_{n}^{HC}}{n}\right), and the standard errors can be computed as \mathrm{se}\left(\hat{\beta}_{1,n}\right) = \sqrt{\hat{V}_{n}^{HC}/n}.

HC standard errors in R

• In R, the HC estimator of standard errors can be obtained using the sandwich package:

  library(wooldridge)
  library(lmtest)
  library(sandwich)
  data("wage1")
  reg <- lm(wage ~ educ + exper + tenure, data = wage1)

• Standard (homoskedastic) standard errors:

  coeftest(reg)

  
  t test of coefficients:
  
               Estimate Std. Error t value  Pr(>|t|)    
  (Intercept) -2.872735   0.728964 -3.9408 9.225e-05 ***
  educ         0.598965   0.051284 11.6795 < 2.2e-16 ***
  exper        0.022340   0.012057  1.8528   0.06447 .  
  tenure       0.169269   0.021645  7.8204 2.935e-14 ***
  ---
  Signif. codes:  0 '***' 0.001 '**' 0.01 '*' 0.05 '.' 0.1 ' ' 1

• HC (robust) standard errors:

  coeftest(reg, vcov = vcovHC(reg, type = "HC1"))

  
  t test of coefficients:
  
               Estimate Std. Error t value  Pr(>|t|)    
  (Intercept) -2.872735   0.807415 -3.5579 0.0004078 ***
  educ         0.598965   0.061014  9.8169 < 2.2e-16 ***
  exper        0.022340   0.010555  2.1165 0.0347731 *  
  tenure       0.169269   0.029278  5.7814 1.277e-08 ***
  ---
  Signif. codes:  0 '***' 0.001 '**' 0.01 '*' 0.05 '.' 0.1 ' ' 1