6.1 Significance testing

• Keep in mind that estimator $\hat{\beta}$ is a random vector with $(k+1)$ elements $\hat{\beta}_0$, $\hat{\beta}_1$, $\hat{\beta}_2, \dots,\hat{\beta}_k$

• Significance testing of each parameter individually requires standardization of it’s estimator $\hat\beta_j$ (by standardizing an estimator we get a random variable $z$ of standard normal distribution with zero mean and unit variance)

$$\begin{equation} z=\frac{\hat{\beta}_j-\beta_j}{se(\hat{\beta}_j)}=\frac{\hat{\beta}_j-\beta_j}{\sigma_u\sqrt{diag_j(x^{T}x)^{-1}}} \sim~N(0,~1) \tag{6.1} \end{equation}$$

• Standard deviation of error terms $\sigma_u$ is unknown, and expression (6.1) is preformulated: standardized variable $z$ is divided with the square root of the fraction between $\chi^2$ variable and degrees of freedom $df$ [see EQUATION (5.22)] $$\begin{equation} \frac{\frac{\hat{\beta}_j-\beta_j}{se(\hat{\beta}_j)}}{\sqrt{\frac{\chi^2}{df}}}=\frac{\frac{\hat{\beta}_j-\beta_j}{\sigma_u\sqrt{diag_j(x^{T}x)^{-1}}}}{\sqrt{\frac{\hat{\sigma}_u^{2}}{\sigma_u^{2}}}}=\frac{\hat{\beta}_j-\beta_j}{\hat{\sigma}_u\sqrt{diag_j(x^{T}x)^{-1}}} \sim~t_{(df=n-k-1)} \tag{6.2} \end{equation}$$

• Expression (6.2) defines the t-statistic which is used to test the significance of each parameter individually

Parameter $\beta_j$ is statistically significant if it’s estimated value is different from zero, i.e. whenever the null hypothesis is rejected $~H_0:~\beta_j=0$

• If the null hypothesis is true the t-statistic is a variable of Student’s t-distribution with degrees of freedom $df=n-k-1$ $$\begin{equation} t_j=\frac{\hat{\beta}_j-\beta_j}{se(\hat{\beta}_j)}=\frac{\hat{\beta}_j-0}{se(\hat{\beta}_j)}=\frac{\hat{\beta}_j}{se(\hat{\beta}_j)} \tag{6.3} \end{equation}$$

• Opposite to the null hypothesis 3 types of test can be performed [TABLE 6.1]

TABLE 6.1: Three types of alternative hypothesis

$~~~~~$Alternative$~~~~~$	P-value	$~~~~~$Test type$~~~~~$
$H_1: β_j ≠ 0$	$2P(t > |t_j|)$	two-sided
$H_1: β_j < 0$	$P(t < t_j)$	lower-sided
$H_1: β_j > 0$	$P(t > t_j)$	upper-sided

The null hypothesis $~H_0:~\beta_j=0~$ will be rejected whenever p-value is less than significance level (1%, 5% or 10%)

• For a given parameter we can assume not only value of zero but any real number -> $H_0:~\beta_j=a$

• We can also assume some linear restrictions on more than one parameter or possibly all parameters, e.g. considering a multivariate model without restrictions (so called full model) $$y_i=\beta_0+\beta_1x_{i,1}+\beta_2x_{i,2}+\beta_3x_{i,3}+u_i$$ we can test if variables $x_1$ and $x_2$ have the same effect on the variable $y$ and if $x_3$ has no effect on $y$!

• If the null hypothesis is true $~H_0:~\beta_1=\beta_2,~\beta_3=0~$ the model with restrictions becomes $$y_i=\beta_0+\beta_1(x_{i,1}+x_{i,2})+u_i$$

• After estimating both models using OLS method, residulas sums of squares $RSS's$ are obtained and F-statistic is calculated $$\begin{equation}F^\prime=\frac{RSS_R-RSS_U}{RSS_U}\times \frac{n-k-1}{q}, \tag{6.4}\end{equation}$$ where $RSS_R$ is residual sum of squares from restricted model and $RSS_U$ is residual sum of squares from unrestricted model, while $q$ is the number of restrictions (in given example $q=2$).

• Test statistic from F-distribution in (6.4) is defined with numerator degrees of freedom $df_1=q$ and denominator degrees of freedom $df_2=n-k-1$

• Number of restrictions $q$ is equal to the parameters difference between unrestricted and restricted model

• The null hypothesis can be written in matrix form $$\begin{equation}H_0:~R\beta=r, \tag{6.5}\end{equation}$$ where $R$ is restriction matrix, $\beta$ is vector of parameters from unrestricted model and $r$ is a vector of assumed values. In given example the null hypothesis is defined as

$$H_0:~\underbrace{\begin{bmatrix} ~0 & ~1 & -1 & ~0 \\ ~0 & ~0 & ~~0 & ~1 \end{bmatrix}}_{R} \underbrace{\begin{bmatrix}\beta_0 \\ \beta_1 \\ \beta_2 \\ \beta_3 \end{bmatrix}}_{\beta}=\underbrace{\begin{bmatrix}0 \\ 0 \end{bmatrix}}_{r}$$

• Testing the null hypothesis that all independent variables are not statistically significant $~H_0:~\beta_1=\beta_2=\beta_3=0~$ can also be written in matrix form $$H_0:~\underbrace{\begin{bmatrix} 0 & 1 & 0 & 0 \\ 0 & 0 & 1 & 0 \\ 0 & 0 & 0 & 1 \end{bmatrix}}_{R} \underbrace{\begin{bmatrix}\beta_0 \\ \beta_1 \\ \beta_2 \\ \beta_3 \end{bmatrix}}_{\beta}=\underbrace{\begin{bmatrix}0 \\ 0 \\ 0 \end{bmatrix}}_{r}$$

• If the null hypothesis is true the restricted model includes constant term only $$y_i=\beta_0+u_i,$$ where estimated value $\hat{\beta}_0$ presents a mean of dependent variable $\bar{y}$

• The joint test of significance refers to hypothesis testing that all RHS variables have no significant effect on dependent variable, which is usually performed within analysis of variance

• Analysis of variance as well as F-statistic and associated p-value are presented in ANOVA table

TABLE 6.2: ANOVA table

Source of variation	$~~~$Sum of squares$~~~$	df	Test statistic	P-value
$ESS$ (explained by the model)	$y^T y - β^T X^T y$	$k$	$F^{\prime} =\frac{ESS/k}{(RSS/ (n - k - 1)}$	$P(F>F^{\prime})$
$RSS$ (unexplained variations)	$β^T X^T y - (1/n) y^T J y$	$n - k - 1$
$TSS$ (total variation of variable $y$)	$y^T y - (1/n) y^T J y$	$n - 1$

• Fractions $\frac{ESS}{k}$ and $\frac{RSS}{n-k-1}$ are $\chi^2$ variables with degrees of freedom $k$ and $n-k-1$, respectively.

Analysis of variance implies that $TSS=ESS+RSS$, while the fraction $\frac{ESS}{TSS}$ provides information how well estimated model fits the data. Proportion of explained variations of dependent variable $y$ is known as coefficient of determination $$\begin{equation} R^2=\frac{ESS}{TSS};~~~~~~0 \leq R^2 \leq 1 \tag{6.6} \end{equation}$$

• If the null hypothesis is true in general $~H_0:~\beta_1=\beta_2=\dots=\beta_k=0~$ coefficient of determination from restricted model $R^2_R=0$ and number of restrictions is equal to the number of RHS variables from unrestricted model ($q=k$), and thus $$\begin{equation} F^{\prime}=\frac{R^2_U-0}{1-R^2_U}\times\frac{n-k-1}{k}=\frac{R^2/k}{(1-R^2)/(n-k-1)} \tag{6.7} \end{equation}$$

Testing the hypothesis that none of the RHS variables significantly effect dependent variable $y$ comes down to testing coefficient determination significance by F-statistic $$\begin{equation} H_0:~R^2=0;~~~~~~~~~F^{\prime}=\frac{R^2/k}{(1-R^2)/(n-k-1)} \tag{6.8} \end{equation}$$

• Alternative tests related to the F-statistic are also used to test certain linear restrictions on parameters:

  1. Wald test – W
  2. Likelihood ratio test – LR
  3. Lagrange multiplier test – LM

$~~~$

• Wald test $W$ requires estimating only the unrestricted model using OLS method

$$\begin{equation} W=(R\hat{\beta}-r)^{T}(R\hat{\Gamma}R^{T})^{-1}(R\hat{\beta}-r)\sim\chi^2_{(df=q)} \tag{6.9} \end{equation}$$

• Test statistic $W$ in (6.9) is $\chi^2$ variable with $q$ degrees of freedom

• Likelihood ratio test $LR$ requires estimating both models (unrestricted and restricted) using MLE method. The maximum value of the likelihood function is usually taken into logs and it is called log-Likelihood $$\begin{equation} LR=-2(logL_U-logL_R)=-2log\frac{L_U}{L_R}\sim\chi^2_{(df=q)} \tag{6.10} \end{equation}$$ where $L_U$ is a likelihood of unrestricted model and $L_R$ is a likelihood of restricted model.

• $LR$-statistic is asymptotically equivalent to $W$-statistic if the assumption of normality holds

• Lagrange multiplier test $LM$ requires estimating only the restricted model using OLS method in the first step. In the second step residuals from restricted model are regressed on all independent variables and coefficient of determination from test regression $R^2_{test}$ is multiplied by the sample size $n$ $$\begin{equation} LM=n R^2_{test} \sim\chi^2_{(df=q)} \tag{6.11} \end{equation}$$

• $LM$-statistic is also asymptotically equivalent to $W$-statistic. All three test statistics are approaching to the same $\chi^2$ value, so it is appropriate to use these tests in a large samples.

$$\begin{equation}\begin{matrix}qF=W \\ LM\leq LR\leq W\end{matrix} \tag{6.12} \end{equation}$$

Exercise 27. Using lm() command in RStudio and sample data from newdata object (already loaded a text file eu_countries.txt) estimate a multivariate model: $$y_i=\beta_0+\beta_1x_{i,1}+\beta_2x_{i,2}+\beta_3x_{i,3}+u_i,$$ where $y$=gdp, $x_1$=population, $x_2$=unemployment and $x_3$=education. Compute test statistics $F$, $W$, and $LR$ to check if variables $x_2$ and $x_3$ are redundant (significance level $\alpha=0.05$). Present results of unrestricted and restricted model using modelsummary() command.

Solution

Copy the code lines below to the clipboard, paste them into an R Script file opened in RStudio, and run them. Redundancy of variables $x_2$ and $x_3$ can be checked by testing the null hypothesis $H_0:\beta_2=\beta_3=0$ within $F-$statistic, $W-$statistic, or $LR-$statistic. All three types of tests reject the null hypothesis (p-value $\lt \alpha$), meaning that unemployment and education are not redundant variables.

# Unrestricted model and restricted model estimation
unrestricted=lm(gdp~population+unemployment+education,data=newdata)
restricted=lm(gdp~population,data=newdata)
# F-statistic within ANOVA table
anova(restricted,unrestricted)
# W-statistic requires "car" package to be installed and loaded from the library
install.packages("car")
library(car)
# Specifying the type of Wald test (F or Chi-square statistic)
linearHypothesis(unrestricted,c("unemployment=0","education=0"),test="Chisq")
# LR-statistic requires "lmtest" package to be installed and loaded from the library
install.packages("lmtest")
library(lmtest)
lrtest(restricted,unrestricted)
# Displaying results of both models in a single table
modelsummary(list(unrestricted,restricted),stars=TRUE,fmt=4)

$~~~$

Exercise 28. Considering a log-log model (object model2) from Exercise 23 perform appropriate tests to check if: (a) elasticity coefficient is significantly greater than zero (population has a positive effect on GDP) and (b) elasticity coefficient is significantly different from 1.

Solution

Copy the code lines below to the clipboard, paste them into an R Script file opened in RStudio, and run them. The null hypothesis $H_0:\beta_1=0$ can be tested against alternative $H_1:\beta_1 \gt 0$ to check if population has a positive effect on gdp (upper-sided test). Namely, upper-sided test does not require any action because the p-value for the upper-sided test is a half of the p-value for the two-sided test (already reported in the output of model summary). However, testing the null hypothesis $H_0:\beta_1=1$ against alternative $H_1:\beta_1 \ne 1$ requires implementation of linearHypothesis() command.

coeftest(model2) # Reports t-statistics and p-values of two-sided alternatives
linearHypothesis(model2,c("log(population)=1"),test="Chisq") # Reports Wald test results

$~~~$

• In multivariate model we can be interested in determining which RHS variable affects more dependent variable $y$!

• Are estimated coefficients comparable when RHS variables are given in different measurement units?

• How can we express RHS variables in the same units of measurement?

• Variables should be standardized -> estimating the model using standardized variables

• Any standardized variable has a nice property, i.e. it’s mean value is always zero and it’s standard deviation is always 1.

• Standardized econometric model has no constant term

• Interpretation of standardized coefficient: if independent variable increases for a one standard deviation the expected value of dependent variable changes by a given standard deviations

Exercise 29. Considering unrestricted model from Exercise 27 determine which of the RHS variables affects GDP more: population, unemployment or education? Save estimated model as an object standardized.

Solution

Copy the code lines below to the clipboard, paste them into an R Script file opened in RStudio, and run them. Only standardized coefficients can be compared to determine the relative importance of variables. Specifically, a larger absolute standardized coefficient indicates that population has a greater effect on gdp.

# Estimating standardized regression (without constant term)
standardized=lm(scale(gdp)~0+scale(population)+scale(unemployment)+scale(education),newdata)
# Reports coefficients from standardized regression, along with standard errors, t-statistics and p-values
coeftest(standardized) 

$~~~$