Basic Econometrics, Gujarati and Porter

CHAPTER 3:
TWO-VARIABLE REGRESSION MODEL:
THE PROBLEM OF ESTIMATION
3.1

(1) Yi = 1 + 2 Xi + ui . Therefore,
E(Yi X i ) = E[( 1 + 2 Xi + ui) X i ]
= 1 + 2 Xi + E (ui X i ), since the 's are constants and X
is nonstochastic.
= 1 + 2 Xi , since E(ui X i ) is zero by assumption.
(2) Given cov(uiuj) = 0 for for all i,j (i j), then
cov(YiYj) = E{[Yi - E(Yi)][Yj - E(Yj)]}
= E(uiuj), from the results in (1)
= E(ui)E(uj), because the error terms are not
correlated by assumption,
= 0, since each ui has zero mean by assumption.
(3) Given var(ui\Xi) = 2 , var (Yi\Xi) = E[Yi - E(Yi)]2 = E(ui2) =
var(ui\Xi) = 2 , by assumption.

3.2

Yi

Xi

yi

xi

xiyi

xi2

4
1
-3
-3
9
9
5
4
-2
0
0
0
7
5
0
1
0
1
12
6
5
2
10
4
------------------------------------------------------------------------sum 28
16
0
0
19
14
------------------------------------------------------------------------Note: Y = 7 and X = 4

Therefore, 2 =

xy

i i

3.3

=
2

19
= 1.357; 1 = Y 2 X = 1.572
14

The PRF is: Yi = 1 + 2 Xi + ui

Situation I: 1 = 0, 2 = 1, and E(ui) = 0, which gives E(Yi X i ) = Xi

Situation 2: 1 = 1, 2 = 0 , and E(ui) = (Xi - 1), which gives
E(Yi X i ) = Xi
which is the same as Situation 1. Therefore, without the assumption
E(ui) = 0, one cannot estimate the parameters, because, as just
shown, one obtains the same conditional distribution of Y although
the assumed parameter values in the two situations are quit different.

17

Basic Econometrics, Gujarati and Porter

3.4

Imposing the first restriction, we obtain:

ui = (Yi - 1 - 2 Xi) = 0
Simplifying this yields the first normal equation.
Imposing the second restriction, we obtain:

u Xi = [(Y

- 2 Xi)Xi ] = 0
Simplifying this yields the second normal equation.
The first restriction corresponds to the assumption that E(ui\Xi) = 0.
The second restriction corresponds to the assumption that the
population error term is uncorrelated with the explanatory variable
Xi, i.e., cov(uiXi) = 0.
i

3.5

From the Cauchy-Schwarz inequality it follows that:

E ( XY ) 2
1
E ( X 2 ) E (Y 2 )
( xiyi ) 2

2
Now r =
1 , by analogy with the Cauchy-Schwarz
xi 2 yi 2
inequality. This also holds true of 2 , the squared population
correlation coefficient.

3.6

Note that:

yx =

xiyi

and xy =

xy
y

i i
i

Multiplying the two, we obtain the expression for r2, the squared
sample correlation coefficient.

3.7

Even though yx . xy =1, it may still matter (for causality and

theory) if Y is regressed on X or X on Y, since it is just the product

of the two that equals 1. This does not say that yx = xy .

3.8

The means of the two-variables are:

Y =X=

correlation between the two rankings is:

xiyi
r=

x y
i

n +1
2 and the

(1)

where small letters as usual denote deviation from the mean values.
Since the rankings are permutations of the first n natural numbers,

18

Basic Econometrics, Gujarati and Porter

( Xi ) 2

= Xi

n(n + 1)(2n + 1) n(n + 1) 2 n(n 2 1)

=
6
4
12

and similarly,
n(n 2 1)
2
yi = 12 , Then

= ( Xi Yi ) =
=

(X

+ Yi 2 2 XiYi )

2n(n + 1)(2n + 1)
2 XiYi
6

Therefore,

XY =
i i

n(n + 1)(2n + 1)

xy = XY
i i

i i

n(n + 1)(2n + 1)

(2)

X Y
i

Since

, using (2), we obtain

2
2

n(n + 1)
n(n 1)
=

4
12

(3)

Now substituting the preceding equations in (1), you will get the
answer.

3.9

(a) 1 = Y 2 Xi and 1 = Y 2 x [Note: xi = (Xi - X )]

= Y , since

var( 1 ) =

n xi 2

x =0
i

2 and var( 1 ) =

n xi 2

2 =

2
n

Therefore, neither the estimates nor the variances of the two

estimators are the same.

(b) 2 =

xy

xy

i i

i i

and 1 =
2

19

, since xi = (Xi - X )
2

Basic Econometrics, Gujarati and Porter

It is easy to verify that var( 2 ) = var( 2 ) =

That is, the estimates and variances of the two slope estimators are
the same.
(c) Model II may be easier to use with large X numbers, although
with high speed computers this is no longer a problem.

3.10

Since

x = y = 0 , that is, the sum of the deviations from mean

i

value is always zero, x = y = 0 are also zero. Therefore,

1 = y - 2 x = 0. The point here is that if both Y and X are

expressed as deviations from their mean values, the regression line
will pass through the origin.

( x x)( y y )
i

xy

2 =

i i

( x x)
i

, since means of the two

2

variables are zero. This is equation (3.1.6).

3.11

Let Zi = aXi + b and Wi = cYi + d. In deviation form, these become:

zi = axi and wi = cyi. By definition,

zw
i

ac xiyi

r2 =

z w
i

= r1 in Eq.(3.5.13)
ac

x y
i

3.12 (a) True. Let a and c equal -1 and b and d equal 0 in Question 3.11.

20

Basic Econometrics, Gujarati and Porter

(b) False. Again using Question 3.11, it will be negative.

(c) True. Since rxy = ryx > 0, Sx and Sy (the standard deviations of X
Sx
and Y, respectively) are both positive, and ryx = yx
and rxy =
Sy
Sy
xy , then xy and yx must be positive.
Sx

3.13 Let Z = X1 + X2 and W = X2 and X3. In deviation form, we can write

these as z = x1 + x2 and w = x2 + x3. By definition the correlation
between Z and W is:

zw
i

( x + x )( x
1

rzw =

+ x 3)

z w
i

(x + x ) (x

+ x3) 2

, because the X's are

=
( x + x 2 )( x 2 + x3 )
2
1

uncorrelated. Note: We have omitted the observation subscript for

convenience.
2
1
=
= , where 2 is the common variance.
2
2
(2 + 2 ) 2
The coefficient is not zero because, even though the X's are
individually uncorrelated, the pairwise combinations are not.
As just shown,

zw =

, meaning that the covariance between z

and w is some constant other than zero.

3.14 The residuals and fitted values of Y will not change. Let
Yi = 1 + 2 Xi + ui and Yi = 1 + 2 Zi + ui , where Z = 2X
Using the deviation form, we know that

2 =

2 =

xy
x

, omitting the observation subscript.

2

zy

2 xiyi

i i

=
i

4 xi 2

21

1
2
2

Basic Econometrics, Gujarati and Porter

1 = Y 2 X ; 1 = Y 2 Z = 1 (Note: Z = 2 X )
That is the intercept term remains unaffected. As a result, the fitted
Y values and the residuals remain the same even if Xi is multiplied
by 2. The analysis is analogous if a constant is added to Xi.

3.15 By definition,
2

( yiy i )
( y i + ui )( yi )
=
=
( yi 2 )( yi 2 )
( yi 2 )( yi 2 )
2

ryy 2

since

y u

i i

(
= 0. =

2 2 xi 2

x )2

2 i

=
2

= r2, using (3.5.6).

3.16 (a) False. The covariance can assume any value; its value depends
on the units of measurement. The correlation coefficient, on the
other hand, is unitless, that is, it is a pure number.
(b) False. See Fig.3.11h. Remember that correlation coefficient
is a measure of linear relationship between two variables. Hence,
as Fig.3.11h shows, there is a perfect relationship between Y and
X, but that relationship is nonlinear.
(c) True. In deviation form, we have
yi = yi + ui
Therefore, it is obvious that if we regress yi on yi , the slope
coefficient will be one and the intercept zero. But a formal proof can
proceed as follows:
If we regress yi on yi , we obtain the slope coefficient, say, as:

y y

xiyi

i i

=
2

2 xi 2

2
= 1 , because
2

yi = xi and xi yi = xi2 for the two-variable model. The

intercept in this regression is zero.

3.17 Write the sample regression as: Yi = 1 + ui . By LS principle, we

2
want to minimize:
u = (Y ) 2 . Differentiate this equation

22

Basic Econometrics, Gujarati and Porter

with the only unknown parameter and set the resulting expression to
zero, to obtain:
2
d (ui. )
= 2 (Yi 1 )(1) = 0

d
1

which on simplification gives 1 = Y ,that is, the sample mean. And

we know that the variance of the sample mean is

y2

, where n is the
n
sample size, and 2 is the variance of Y. The RSS is
yi2
RSS

2
2
2
(Yi Y ) = yi and = (n 1) = (n 1) . It is worth adding the
X variable to the model if it reduces 2 significantly, which it will if
X has any influence on Y. In short, in regression models we hope
that the explanatory variable(s) will better predict Y than simply its
mean value. As a matter of fact, this can be looked at formally.
Recall that for the two-variable model we obtain from (3.5.2),
RSS = TSS - ESS
= yi2 yi2
- 22 xi2
Therefore, if is different from zero, RSS of the model that
=

2
i

contains at least one regressor, will be smaller than the model with no
regressor. Of course, if there are more regressors in the model and
their slope coefficients are different from zero, the RSS will be much
smaller than the no-regressor model.

Empirical Exercises
3.18 Taking the difference between the two ranks, we obtain:
d -2 1 -1 3 0 -1 -1 -2 1 2
d2

4 1

9 0

1 1

1 4 ; d2 = 26

Therefore, Spearman's rank correlation coefficient is

6 d 2

6(26)
= 0.842
n(n 1)
10(102 1)
Thus there is a high degree of correlation between the student's
midterm and final ranks. The higher is the rank on the midterm, the
higher is the rank on the final.
rs = 1

= 1

3.19 (a) The slope value of 2.250 suggests that over the period 1985-2005,
for every unit increase in the ratio of the US to Canadian CPI, on
average, the Canadian to US dollar exchange rate ratio increased by
about 2.250 units. That is, as the US dollar strengthened against the
23

Basic Econometrics, Gujarati and Porter

Canadian dollar, one could get more Canadian dollars for each US
dollar. Literally interpreted, the intercept value of -0.912 means that
if the relative price ratio were zero, a US dollar would exchange for 0.912 Canadian dollars (would lose money). Of course, this
interpretation is not economically meaningful. With a fairly low to
moderate r2 of 0.440, we should realize that there is a lot of
variability in this result.
(b) The positive value of the slope coefficient makes economic sense
because if U.S. prices go up faster than Canadian prices, domestic
consumers will switch to Canadian goods because they can buy more,
thus increasing the demand for GM, which will lead to appreciation
of the German mark. This is the essence of the theory of purchasing
power parity (PPP), or the law of one price.
(c) In this case the slope coefficient is expected to be negative, for the
higher the Canadian CPI relative to the U.S. CPI, the lower the
relative inflation rate in Canada which will lead to depreciation of the
U.S. dollar. Again, this is in the spirit of the PPP.

3.20 (a) The scattergrams are as follows:

Business Sector: Compensation vs Output
180.0

160.0

140.0

120.0

100.0

80.0

60.0

40.0

20.0

0.0
40.0

60.0

80.0

100.0
Output per Hour

24

120.0

140.0

160.0

Basic Econometrics, Gujarati and Porter

Nonfarm Business Sector: Compensation vs Output

180

160

140

120

100

80

60

40

20

0
40

50

60

70

80

90

100

110

120

130

Output per Hour

(b) As both the diagrams show, there is a positive relationship

between wages and productivity, which is not surprising in view of
the marginal productivity theory of labor economics.
(c) As the preceding figures show, the relationship between wages is
relatively linear, except for a slight upward curve at the lower end of
the Output range. Therefore, if we try to fit a straight line regression
model to the data we may not get a perfect fit. In a later chapter we
will see what types of models are appropriate in this situation. But if
we routinely fit the linear model to the data, we obtain the following
results.
Business:

Nonfarm Business:

Compensation = -102.3662 + 1.9924 Output

se = (4.5035) (0.0506)
r2 = 0.9724
Compensation = -111.6407 + 2.0757 Output
se = (4.8662) (0.0543)
r2 = 0.9708

25

140

Basic Econometrics, Gujarati and Porter

As expected, the relationship between the two is positive.

Surprisingly, the r2 value is quite high.

Y X

3.21

X Y X Y

2
i

i i

Original data: 1110 1700 205500 322000 132100

Revised data 1110 1680 204200 315400 133300
Therefore, the corrected coefficient of correlation is 0.9688

3.22 (a)
Gold Prices, CPI, and the NYSE Index Over Time
9000.00

8000.00

7000.00

6000.00

5000.00

Gold Price
NYSE
CPI

4000.00

3000.00

2000.00

1000.00

20
06

20
04

20
02

20
00

19
98

19
96

19
94

19
92

19
90

19
88

19
86

19
84

19
82

19
80

19
78

19
76

19
74

0.00

If you plot these variables against time, you will see that there is
considerable price volatility for gold, but the NYSE and CPI seem
relatively stable.
(b) If the hypothesis were true, we would expect 2 1 .
Gold Pricet = 215.286 + 1.038 CPIt
se = (54.469)
(0.404)
NYSEt = -3444.992 + 50.297 CPIt
se
(533.966) (3.958)

26

r2 = 0.1758
r2 = 0.8389

Basic Econometrics, Gujarati and Porter

It seems the stock market is a better hedge against inflation than gold.

3.23 (a) The plot is as follows, where NGDP and RGDP are nominal and real
GDP.
NGDP and RGDP Over Time
14,000.0

12,000.0

10,000.0

8,000.0
NGDP
RGDP
6,000.0

4,000.0

2,000.0

19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05

0.0

(b)

NGDPt = - 496268 + 252.58 Year

se = (21089) (10.64)

RGDPt = -351335 + 180.263 Year

se = (9070) (4.576)

r2 = 0.926
r2 = 0.972

(c) The slope here gives the rate of change of GDP per year.
(d) The difference between the two represents inflation over time. As
the figure and regression results indicate, nominal GDP has been
growing at a faster rate than real GDP suggesting that inflation has
been rising over time.

3.24 This is straightforward.

3.25 (a) See figure in Exercise 2.16 (d)

27

Basic Econometrics, Gujarati and Porter

(b) The regression results are:

Yt = 31.76 + 1.0485 X t
se = (47.80)

( 0.0937 )

r 2 = 0.786
where Y = female reading score and X = male reading score.
(c) As pointed out in the text, a statistical relationship, however
strong, does not establish causality, which must be established
a priori. In this case, there is no reason to suspect causal relationship
between the two variables.

3.26 The regression results are:

Yt = 257.02 + 1.416 X t
se= (29.35)

(0.0559)

r 2 = 0.950

3.27 This is a class project.

28

Basic Econometrics, Gujarati and Porter

3.28
Cell Phone Subscribers vs PC Ownership
120

100

80

60

40

20

0
0

10

20

30

40

50

60

70

PC Ownership

There does seem to be a somewhat positive relationship between

these variables, but it is probably better characterized as more
logarithmic than linear.

29

80