Introduction to Econometrics

Lecture 7
Heteroskedasticity and
some further diagnostic testing

INEMET [U13783]

Guy Judge March 2007

Topics to be covered
Heteroskedasticity
Some further diagnostic testing
Normality of the disturbances
Multicollinearity

INEMET [U13783]

Guy Judge March 2007

Econometric problems

INEMET [U13783]

Guy Judge March 2007

Heteroskedasticity
What does it mean? The variance of the error term is not
constant
What are its consequences? The least squares results
are no longer efficient and t tests and F tests results may be
misleading

How can you detect the problem? Plot the residuals against
each of the regressors or use one of the more formal tests
How can I remedy the problem? Respecify the model look for
other missing variables; perhaps take logs or choose some
other appropriate functional form; or make sure relevant
variables are expressed per capita
INEMET [U13783]

Guy Judge March 2007

Consumption function example (cross-section data):

credit worthiness as a missing variable?
Scatter diagram and fitted line
Consumption

400
300
200
100
0
0

100

200

300

400

Income
INEMET [U13783]

Guy Judge March 2007

The Homoskedastic Case

INEMET [U13783]

Guy Judge March 2007

The Heteroskedastic Case

INEMET [U13783]

Guy Judge March 2007

The consequences of heteroskedasticity

OLS estimators are still unbiased (unless there are
also omitted variables)
However OLS estimators are no longer efficient or
minimum variance
The formulae used to estimate the coefficient
standard errors are no longer correct
so the t-tests will be misleading (if the error variance is
positively related to an independent variable then the
estimated standard errors are biased downwards and hence the
t-values will be inflated)
confidence intervals based on these standard errors will be
wrong

INEMET [U13783]

Guy Judge March 2007

Detecting heteroskedasticity
Visual inspection of scatter diagram or
the residuals
Goldfeld-Quandt test
suitable for a simple form of
heteroskedasticity

Breusch-Pagan test
a test of more general forms of
heteroskedastcity
INEMET [U13783]

Guy Judge March 2007

Residual plots
Plot residuals against one variable at a time

INEMET [U13783]

Guy Judge March 2007

Goldfeld-Quandt test (JASA, 1965)

Suppose it looks as if sui = suXi
i.e. the error variance is proportional to the square of one
of the Xs
Rank the data according to the culprit variable and
conduct an F test using RSS2/RSS1
where these RSS are based on regressions using the
first and last [n-c]/2 observations [c is a central section of
data usually about 25% of n]
Reject H0 of homoskedasticity if Fcal > Ftables

INEMET [U13783]

Guy Judge March 2007

Breusch-Pagan test
Regress the squared residuals on a constant,
the original regressors, the original regressors
squared and, if enough data, the cross-products
of the Xs
The null hypothesis of no heteroskedasticity will
be rejected if the value of the test statistic is too
high (P-value too low)
Both c2 and F forms are available in PcGive

INEMET [U13783]

Guy Judge March 2007

Remedies
Respecification of the model
Include relevant omitted variable(s)
Express model in log-linear form or some other
appropriate functional form
Express variables in per capita form

Where respecification wont solve the

problem use robust Heteroskedastic
Consistent Standard Errors (due to Hal
White, Econometrica 1980)
INEMET [U13783]

Guy Judge March 2007

ARCH
Note: with time series data, particularly highfrequency data (for example daily or hourly
financial data) a special form of
heteroskedasticity called Autoregressive
Conditional Heteroskedasticty (ARCH) may be
present
We can see it graphically as excessive volatility
of the time series in certain short bursts
I will say more about this when we look in more
detail at dynamic models
INEMET [U13783]

Guy Judge March 2007

Normality of the disturbances

Test null hypothesis of normality

Use c2 test with 2 degrees of freedom
At 5% level reject H0 if c2 > 5.99
non-normality may reflect outliers or a
skewed distribution of residuals

INEMET [U13783]

Guy Judge March 2007

Reset test

originated by Ramsey (1969)

tests for functional form mis-specification
run regression and get fitted values
now regress Y on Xs and powers of fitted Ys
if these additional regressors are significant
(judged by F test) then the original model is misspecified

INEMET [U13783]

Guy Judge March 2007

Multicollinearity
What does it mean? A high degree of correlation amongst the
explanatory variables
What are its consequences? It may be difficult to separate out
the effects of the individual regressors. Standard errors may
be overestimated and t-values depressed.
Note: a symptom may be high R2 but low t-values
How can you detect the problem? Examine the correlation
matrix of regressors - also carry out auxiliary regressions
amongst the regressors.
Look at the Variance Inflation Factors
NOTE:
be careful not to apply t tests mechanically without checking for multicollinearity
multicollinearity is a data problem, not a misspecification problem
INEMET [U13783]

Guy Judge March 2007

Variance Inflation Factor (VIF)

Multicollinearity inflates the variance of an
estimator
VIFJ = 1/(1-RJ2)
where RJ2 measures the R2 from a regression of Xj
on the other X variable/s
serious multicollinearity problem if VIFJ>5

INEMET [U13783]

Guy Judge March 2007