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Lecture # 2 (The Classical Linear Regression Model) PDF

The Classical Linear Regression Model (CLRM) makes 8 key assumptions: (1) the regression model is linear in parameters, (2) regressors are fixed, (3) the expected value of the error term is zero, (4) the variance of the error term is constant, (5) there is no correlation between error terms, (6) there are no perfect linear relationships among regressors, (7) the regression model is correctly specified, and (8) the error term follows a normal distribution. Under these assumptions, the Ordinary Least Squares (OLS) method provides estimators that are best linear unbiased estimators (BLUE), meaning they have minimum variance within the class of linear unbiased estimators

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350 views3 pages

Lecture # 2 (The Classical Linear Regression Model) PDF

The Classical Linear Regression Model (CLRM) makes 8 key assumptions: (1) the regression model is linear in parameters, (2) regressors are fixed, (3) the expected value of the error term is zero, (4) the variance of the error term is constant, (5) there is no correlation between error terms, (6) there are no perfect linear relationships among regressors, (7) the regression model is correctly specified, and (8) the error term follows a normal distribution. Under these assumptions, the Ordinary Least Squares (OLS) method provides estimators that are best linear unbiased estimators (BLUE), meaning they have minimum variance within the class of linear unbiased estimators

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Batool Sahabn
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|Page1

The Classical Linear Regression Model (CLRM)

The CLRM makes the following assumptions:

A-1: The regression model is linear in the parameters as in

𝑌𝑖 = 𝐵1 + 𝐵2 𝑋2𝑖 + 𝐵3 𝑋3𝑖 + ⋯ + 𝐵𝑘 𝑋𝑘𝑖 + 𝑢𝑖

it may or may not be linear in the variables Y and the Xs.

A-2: The regressors are assumed to be fixed or nonstochastic in the sense that their
values are fixed in repeated sampling. This assumption may not be appropriate
for all economic data, but as we will show later, if X and u are independently
distributed the results based on the classical assumption discussed below hold true
provided our analysis is conditional on the particular X values drawn in the
sample. However, if X and u are uncorrelated, the classical results hold true
asymptotically (i.e.in large samples.)1

A-3: Given the values of the X variables, the expected, or mean, value of the error term
is zero. That is,2

𝐸(𝑢𝑖 |X) = 0 (1.8)

where, for brevity of expression, X (the bold X) stands for all X variables in the
model. In words, the conditional expectation of the error term, given the values
of the X variables, is zero. Since the error term represents the influence of factors
that may be essentially random, it makes sense to assume that their mean or
average value is zero.
As a result of this critical assumption, we can write (1.2) as:

𝐸(𝑌𝑖 |X) = 𝑩𝑿 + 𝐸(𝑢𝑖 |X)


= 𝑩𝑿 (1.9)

which can be interpreted as the model for mean or average value of 𝑌𝑖 conditional
on the X values. This is the population (mean) regression function (PRF)
mentioned earlier. In regression analysis our main objective is to estimate this
function. If there is only one X variable, you can visualize it as the (population)
regression line. If there is more than one X variable, you will have to imagine it
to be a curve in a multi-dimensional graph. The estimated PRF, the sample
counterpart of Eq. (1.9), is denoted by 𝑌̂𝑖 = 𝑏𝑥. That is, 𝑌̂𝑖 = 𝑏𝑥 is an estimator of
𝐸(𝑌𝑖 |𝑋).

1
Note that independence implies no correlation, but no correlation does not necessarily imply
independence.
2
The vertical bar after 𝑢𝑖 is to remind that the analysis is conditional on the given values of X.
|Page2

A-4: The variance of each 𝑢𝑖 given the values of X, is constant, or homoscedastic


(homo means equal and scedastic means variance). That is,

𝑣𝑎𝑟(𝑢𝑖 |𝑋) = σ2 (1.10)

Note: There is no subscript on σ2 .

A-5: There is no correlation between two error terms. That is, there is no
autocorrelation. Symbolically,

Cov (𝑢𝑖 , 𝑢𝑗 | X) =0 i ≠j (1.11)

where Cov stands for covariance and i and j are two different error terms. Of
course, if I = j, Eq. (1.11) will give the variance of 𝑢 𝑖 given in Eq. (1.10).

A-6: There are no perfect linear relationships among the X variables. This is the
assumption of no multicollinearity. For example, relationships like 𝑋5 = 2𝑋3 +
4𝑋4 are ruled out.

A-7: The regression model is correctly specified. Alternatively, there is no


specification bias or specification error in the model used in empirical analysis.
It is implicitly assumed that the number of observations, n, is greater than the
number of parameters estimated.
Although it is not a part of the CLRM, it is assumed that the error term follows
the normal distribution with zero mean and (constant) variance 𝜎 2 .
Symbolically,

A-8: 𝑢𝑖 ~ N(0, 𝜎 2 ) (1.12)

On the basis of Assumptions A-1 to A-7, it can be shown that the method of ordinary
least squares (OLS), the method most popularly used in practice, provides estimators
of the parameters of the PRF that have several desirable statistical properties, such as:

1- The estimators are linear, that is, they are linear functions of the dependent
variable Y. Linear estimators are easy to understand and deal with
compared to nonlinear estimators.

2- The estimators are unbiased, that is, in repeated applications of the method,
on average, the estimators are equal to their true values.

3- In the class of linear unbiased estimators, OLS estimators have minimum


variance. As a result, the true parameter values can be estimated with least
possible uncertainty; an unbiased estimator with the least variance is called an
efficient estimator.

In short, under the assumed conditions, OLS estimators are BLUE: best linear
unbiased estimators. This is the essence of the well-known Gauss–Markov theorem,
which provides a theoretical justification for the method of least squares.
|Page3

With the added Assumption A-8, it can be shown that the OLS estimators are
themselves normally distributed. As a result, we can draw inferences about the true
values of the population regression coefficients and test statistical hypotheses. With the
added assumption of normality, the OLS estimators are best unbiased estimators
(BUE) in the entire class of unbiased estimators, whether linear or not. With normality
assumption, CLRM is known as the normal classical linear regression model
(NCLRM).

References:
- Gujarati, D., Econometrics by Example, 2012. McGraw Hill.

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