Introduction to Econometrics (3rd Updated Edition)

by
James H. Stock and Mark W. Watson

Solutions to End-of-Chapter Exercises: Chapter 9*

(This version August 17, 2014)

*Limited distribution: For Instructors Only. Answers to all odd-numbered questions

are provided to students on the textbook website. If you find errors in the solutions,
please pass them along to us at mwatson@princeton.edu.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 9

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9.1. As explained in the text, potential threats to external validity arise from differences
between the population and setting studied and the population and setting of
interest. The statistical results based on New York in the 1970s are likely to apply
to Boston in the 1970s but not to Los Angeles in the 1970s. In 1970, New York
and Boston had large and widely used public transportation systems. Attitudes
about smoking were roughly the same in New York and Boston in the 1970s. In
contrast, Los Angeles had a considerably smaller public transportation system in
1970. Most residents of Los Angeles relied on their cars to commute to work,
school, and so forth. The results from New York in the 1970s are unlikely to apply
to New York in 2014. Attitudes towards smoking changed significantly from 1970
to 2014.

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9.2. (a) When Yi is measured with error, we have Y!i = Yi + wi , or Yi = Y!i wi . Substituting
the 2nd equation into the regression model Yi = 0 + 1 X i + ui gives

Y!i wi = 0 + 1 X i + ui ,
or Y!i = 0 + 1 X i + ui + wi . Thus vi = ui + wi .
(b) (1) The error term vi has conditional mean zero given Xi:

E (vi |X i ) = E (ui + wi |X i ) = E (ui |X i ) + E (wi |X i ) = 0 + 0 = 0.

(2) Y!i = Yi + wi is i.i.d since both Yi and wi are i.i.d. and mutually independent; Xi
and Y!j (i j) are independent since Xi is independent of both Yj and wj.
Thus, ( X i , Y!i ), i = 1,, n are i.i.d. draws from their joint distribution.
(3) vi = ui + wi has a finite fourth moment because both ui and wi have finite
fourth moments and are mutually independent. So (Xi, vi) have nonzero
finite fourth moments.
(c) The OLS estimators are consistent because the least squares assumptions hold.
(d) Because of the validity of the least squares assumptions, we can construct the
confidence intervals in the usual way.
(e) The answer here is the economists On the one hand, and on the other hand.
On the one hand, the statement is true: i.i.d. measurement error in X means that
the OLS estimators are inconsistent and inferences based on OLS are invalid.
OLS estimators are consistent and OLS inference is valid when Y has i.i.d.
measurement error. On the other hand, even if the measurement error in Y is
i.i.d. and independent of Yi and Xi, it increases the variance of the regression
error ( v2 = u2 + w2 ), and this will increase the variance of the OLS estimators.
Also, measurement error that is not i.i.d. may change these results, although this
would need to be studied on a case-by-case basis.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 9

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9.3. The key is that the selected sample contains only employed women. Consider two
women, Beth and Julie. Beth has no children; Julie has one child. Beth and Julie are
otherwise identical. Both can earn $25,000 per year in the labor market. Each must
compare the $25,000 benefit to the costs of working. For Beth, the cost of working
is forgone leisure. For Julie, it is forgone leisure and the costs (pecuniary and other)
of child care. If Beth is just on the margin between working in the labor market or
not, then Julie, who has a higher opportunity cost, will decide not to work in the
labor market. Instead, Julie will work in home production, caring for children,
and so forth. Thus, on average, women with children who decide to work are
women who earn higher wages in the labor market.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 9

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9.4.
Estimated Effect of a 10%
Increase in Average Income
State
Calif.
Mass.

ln(Income)
11.57
(1.81)
16.53
(3.15)

Std. Dev. of
Scores
19.1
15.1

In Points
1.157
(0.18)
1.65
(0.31)

In Std. Dev.
0.06
(0.001)
0.11
(0.021)

The income effect in Massachusetts is roughly twice as large as the effect in California.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 9

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9.5. (a) Q =

1 0 0 1 1u 1v
+
.
1 1
1 1

and P =

0 0 u v
+
.
1 1 1 1

(b) E (Q ) =

1 0 0 1

, E ( P) = 0 0
1 1
1 1

(c)
2

1 2 2
1
2 2
2
2
Var (Q) =
( 1 u + 1 v ), Var ( P) =
( u + v ), and
1 1
1 1
2

1
2
2
Cov( P, Q) =
( 1 u + 1 V )
1 1

2 +2
p Cov(Q, P )
(d) (i) 1
= 1 u2 12 V ,
Var ( P)
u + V

Cov( P, Q)
p
0 E (Q) E ( P)
Var ( P)

p
(ii) 1 1 u (2+1 21 ) > 0, using the fact that 1 > 0 (supply curves slope up) and
2

1 < 0 (demand curves slope down).

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 9

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9.6. (a) The parameter estimates do not change. Nor does the the R2. The sum of squared
residuals from the 100 observation regression is

SER200 = (100 2) 15.12 = 22, 344.98, and the sum of squared residuals from the
200 observation regression is twice this value: SSR200 = 2 22, 344.98. Thus, the
SER from the 200 observation regression is SER200 =

1
2002

SSR200 = 15.02. The

standard errors for the regression coefficients are now computed using equation
2 2
200
2

(5.4) where i200

=1 ( X i X ) ui and i =1 ( X i X ) are twice their value from the

100 observation regression. Thus the standard errors for the 200 observation
regression are the standard errors in the 100 observation regression multiplied by
1002
2002

= 0.704. In summary, the results for the 200 observation regression are
Y = 32.1 + 66.8 X, SER = 15.02, R 2 = 0.81
(10.63) (8.59)

(b) The observations are not i.i.d.: half of the observations are identical to the other
half, so that the observations are not independent.

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9.7. (a) True. Correlation between regressors and error terms means that the OLS
estimator is inconsistent.
(b) True.

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9.8. Not directly. Test scores in California and Massachusetts are for different tests and
have different means and variances. However, converting (9.5) into units for
Massachusetts yields the implied regression to TestScore(MA units) = 740.9 1.80
STR, which is similar to the regression using Massachusetts data shown in
Column 1 of Table 9.2. After this adjustment the regression could be somewhat
useful, hower the regression in Column 1 of Table 9.2 has a low R2 suggesting that
it will not provide an accurate forecast of test scores.

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9.9. Both regressions suffer from omitted variable bias so that they will not provide
reliable estimates of the causal effect of income on test scores. However, the
nonlinear regression in (8.18) fits the data well, so that it could be used for
forecasting.

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9.10. There are several reasons for concern. Here are a few.
Internal consistency: omitted variable bias as explained in the last paragraph of the
box.
Internal consistency: sample selection may be a problem as the regressions were
estimated using a sample of full-time workers. (See exercise 9.3 for a related
problem.)
External consistency: Returns to education may change over time because of the
relative demands and supplies of skilled and unskilled workers in the economy. To
the extent that this is important, the results shown in the box (based on 2008 data)
may not accurately estimate todays returns to education.

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9.11. There are several reasons for concern. Here are a few.
Internal consistency: To the extent that price is affected by demand, there may be
simultaneous equation bias.
External consistency: The internet and introduction of E-journals may induce
important changes in the market for academic journals so that the results for 2000
may not be relevant for todays market.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 9

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9.12. (a) See the answer to part (c) of exercise 2.27.

(b) Because X! = E(X | Z), then E(X | X! ) = X! . Thus
E(w| X! ) = E[(X X! | X! )] = E(X | X! ) E( X! | X! ) = X! X! = 0.
(c) Xi = X! + wi, so that Yi = 0 + 1( X! + wi) + ui = 0 + 1 X! + vi, where vi = ui + 1
wi. Because E(u | Z) = 0 and X! depends only on Z (that is, X! = E(X | Z)), then
E(u| X! ) = 0. Together with the result in (b), this implies that E(vi | X! ) = 0. You
can then verify the other assumptions in Key Concept (4.3), and the result
follows from the consistency of the OLS estimator under these assumptions.

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Stock/Watson - Introduction to Econometrics - 3rd Updated Edition - Answers to Exercises: Chapter 9

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9.13. (a) 1 =

300
i=1

( X! i X! )(Yi Y )

i=1 ( X! i X! )2
300

. Because all of the Xis are used (although some are

used for the wrong values of Yj), X%= X , and

n
i =1

( X i X )2 . Also,

Yi Y = 1 ( X i X ) + ui u . Using these expressions:

0.8 n

1 = 1

i =1
n

( X i X )2

( X i X )2
i =1

+ 1

n
i = 0.8 n +1

( X%i X )( X i X )
n

( X i X )2
i =1

n
i =1

( X%i X )(ui u )

n
i =1

( X i X )2

1 0.8 n
1 n
2
% X )( X X ) 1 n ( X% X )(u u )
(
X

X
)
(
X

i
i
i
i
i
i =1
i = 0.8 n +1
i =1
= 1 n
+ 1 n
+n
1 n
1 n
1 n
( X i X )2
( X i X )2
( X i X )2

i =1
i =1
i =1
n
n
n
where n = 300, and the last equality uses an ordering of the observations so that
the first 240 observations (= 0.8n) correspond to the correctly measured
observations ( X% = Xi).
i

As is done elsewhere in the book, we interpret n = 300 as a large sample, so we

use the approximation of n tending to infinity. The solution provided here thus
shows that these expressions are approximately true for n large and hold in the
limit that n tends to infinity. Each of the averages in the expression for have
1

the following probability limits:

p
1 n
2
(
X

X
)

X2 ,

i
i =1
n
p
1 0.8n
2
(
X

X
)

0.8 X2 ,

i
i =1
n
p
1 n !
(
X

X
)(u

u
)

0 , and

i
n i=1 i
p
1 n
!
(
X

X
)(
X

X
)

0,

i
n i=0.8n+1 i

(continued on next page)

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9.13 (continued)

where the last result follows because X%i Xi for the scrambled observations and
p

Xj is independent of Xi for i j. Taken together, these results imply 1 0.81 .

p

(b) Because 1 0.81 , 1 / 0.8 1, so a consistent estimator of 1 is the OLS

estimator divided by 0.8.
(c) Yes, the estimator based on the first 240 observations is better than the adjusted
estimator from part (b). Equation (4.21) in Key Concept 4.4 (page 129) implies
that the estimator based on the first 240 observations has a variance that is
var( 1 (240obs )) =

1 var [( X i X )ui ]
.
2
240
[ var( X i )]

From part (a), the OLS estimator based on all of the observations has two
sources of sampling error. The first is

300
i=1

( X! i X )(ui u )

i=1 ( X i X )2
300

which is the usual

source that comes from the omitted factors (u). The second is

300
i=241

( X! i X )( X i X )

i=1 ( X i X )2
300

, which is the source that comes from scrambling the

data. These two terms are uncorrelated in large samples, and their respective
large-sample variances are:
300 ( X! X )(u u )
1 var ( X i X )ui

i
.
var i=1 300i
=
2
( X X )2 300

var(
X
)
i
i

i=1

and
300

( X! X )( X i X )
0.2

.
var 1 i=241 300i
= 12
2
300

(
X

X
)
i=1 i

(continued on next page)

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9.13 (continued)

Thus

(300obs)
1 1 var [( X i X )ui ]
2 0.2
var 1
=
+

1
2
0.8
0.64
300
300
var(
X
)

[
]

which is larger than the variance of the estimator that only uses the first 240
observations.

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