ECONOMETRICS

TWO-VARIABLE REGRESSION: INTERVAL ESTIMATION

AND HYPOTHESIS TESTING
 Introduction

• The theory of estimation consists of two parts: point estimation and interval
estimation. We have discussed point estimation thoroughly in the previous
two chapters. In this chapter we first consider interval estimation and then
take up the topic of hypothesis testing, a topic related to interval estimation.
 INTERVAL ESTIMATION: SOME BASIC IDEAS

• Look at the estimated MPC in Yˆi = 24.4545 + 0.5091Xi , which is a single

(point) estimate of the unknown population MPC β2. How reliable is this
estimate? A single estimate is likely to differ from the true value, although
in repeated sampling its mean value is expected to be equal to the true value.
• In statistics the reliability of a point estimator is measured by its standard
error. Therefore, we may construct an interval around the point estimator,
say within two or three standard errors on either side of the point estimator,
such that this interval has, say, 95 percent probability of including the true
parameter value.
• Assume that we want to find out how “close” is, say, βˆ2 to β2. We try to find
out two positive numbers δ and α, the latter lying between 0 and 1, such
that the probability that the random interval (βˆ2 − δ, βˆ2 + δ) contains the
true β2 is 1 − α. Symbolically,
• Pr (βˆ2 − δ ≤ β2 ≤ βˆ2 + δ) = 1 − α (5.2.1)
• Such an interval, if it exists, is known as a confidence interval.
• 1 − α is known as the confidence coefficient; and
• α (0 < α < 1) is known as the level of significance.
• The endpoints of the confidence interval are known as the confidence limits
(also known as critical values), βˆ2 − δ being the lower confidence limit and
βˆ2 + δ the upper confidence limit.
• If α = 0.05, or 5 percent, (5.2.1) would read: The probability that the
(random) interval shown there includes the true β2 is 0.95, or 95 percent.
The interval estimator thus gives a range of values within which the true β2
may lie.
• It is very important to know the following aspects of interval estimation:
• 1. Equation (5.2.1) does not say that the probability of β2 lying between the
given limits is 1 − α. What (5.2.1) states is that the probability of
constructing an interval that contains β2 is 1 − α.
• 2. The interval (5.2.1) is a random interval; that is, it will vary from one
sample to the next because it is based on βˆ2, which is random.
• 3. (5.2.1) means: If in repeated sampling confidence intervals like it are
constructed a great many times on the 1 − α probability basis, then, in the
long run, on the average, such intervals will enclose in 1 − α of the cases the
true value of the parameter.
• 4. The interval (5.2.1) is random so long as βˆ2 is not known. Once βˆ2 is
known, the interval (5.2.1) is no longer random; it is fixed. In this situation
β2 is either in the fixed interval or outside it. Therefore, the probability is
either 1 or 0, if the 95% confidence interval were obtained as (0.4268 ≤ β2 ≤
0.5914), we cannot say the probability is 95% that this interval includes the
true β2. That probability is either 1 or 0.
 CONFIDENCE INTERVALS FOR REGRESSION
COEFFICIENTS β1 AND β2

• Confidence Interval for β2

• With the normality assumption for ui, the OLS estimators βˆ1 and βˆ2 are
themselves normally distributed with means and variances given therein.
Therefore, for example, the Variable

• is a standardized normal variable. Therefore, we can use the normal

distribution to make probabilistic statements about β2. If σ2 is known, an
important property of a normally distributed variable with mean μ and
variance σ2 is that the area under the normal curve between μ ± σ is about
68 percent, that between the limits μ ± 2σ is about 95 percent, and that
between μ ± 3σ is about 99.7 percent.
• But σ2 is rarely known, and in practice it is determined by the unbiased
• estimator σˆ2. If we replace σ by σˆ, (5.3.1) may be written as:

• where the se (βˆ2) now refers to the estimated standard error. Therefore,
instead of using the normal distribution, we can use the t distribution to
establish a confidence interval for β2 as follows:
• Pr (−tα/2 ≤ t ≤ tα/2) = 1 − α (5.3.3)
• where tα/2 is the value of the t variable obtained from the t distribution for α/2
level of significance and n − 2 df; it is often called the critical t value at α/2
level of significance.
• Substitution of (5.3.2) into (5.3.3) Yields

• Rearranging (5.3.4), we obtain

• Pr [βˆ2 − t α/2 se (βˆ2) ≤ β2 ≤ βˆ2 + tα/2 se (βˆ2)] = 1 − α (5.3.5)
• Equation (5.3.5) provides a 100(1 − α) percent confidence interval for β2,
which can be written more compactly as
• 100(1 − α)% confidence interval for β2:
• βˆ2 ± tα/2 se (βˆ2) (5.3.6)
• Arguing analogously, and using (4.3.1) and (4.3.2), we can then write:
• Pr [βˆ1 − tα/2 se (βˆ1) ≤ β1 ≤ βˆ1 + tα/2 se (βˆ1)] = 1 − α (5.3.7)
• or, more compactly,
• 100(1 − α)% confidence interval for β1:
• βˆ1 ± tα/2 se (βˆ1) (5.3.8)
• Notice an important feature of the confidence intervals given in (5.3.6) and
(5.3.8): In both cases the width of the confidence interval is proportional to
the standard error of the estimator. That is, the larger the standard error, the
larger is the width of the confidence interval. Put differently, the larger the
standard error of the estimator, the greater is the uncertainty of estimating
the true value of the unknown parameter.
• We found that βˆ2 = 0.5091, se (βˆ2) = 0.0357, and df = 8. If we assume α =
5%, that is, 95% confidence coefficient, then the t table shows that for 8 df the
critical tα/2 = t0.025 = 2.306. Substituting these values in (5.3.5), the 95%
confidence interval for β2 is as follows:
• 0.4268 ≤ β2 ≤ 0.5914 (5.3.9)
• Or, using (5.3.6), it is
• 0.5091 ± 2.306(0.0357)
• that is,
• 0.5091 ± 0.0823 (5.3.10)
• The interpretation of this confidence interval is: Given the confidence
coefficient of 95%, in 95 out of 100 cases intervals like (0.4268, 0.5914) will
contain the true β2. But, we cannot say that the probability is 95 percent that
the specific interval (0.4268 to 0.5914) contains the true β2 because this
interval is now fixed; therefore, β2 either lies in it or does not.
• Confidence Interval for β1
• Following (5.3.7), we can verify that the 95% confidence interval for β1 of
the consumption–income example is
• 9.6643 ≤ β1 ≤ 39.2448 (5.3.11)
• Or, using (5.3.8), we find it is
• 24.4545 ± 2.306(6.4138)
• that is,
• 24.4545 ± 14.7902 (5.3.12)
• In the long run, in 95 out of 100 cases intervals like (5.3.11) will contain the
true β1; again the probability that this particular fixed interval includes the
true β1 is either 1 or 0.
 CONFIDENCE INTERVAL FOR σ2

• As pointed before, under the normality assumption, the variable

• χ2 = (n− 2) σˆ2/σ2 (5.4.1)
• follows the χ2 distribution with n − 2 df. Therefore, we can use the χ2
distribution to establish a confidence interval for σ2
• Pr (χ2 1−α/2
1−α/2 ≤ χ ≤ χ α/2 ) = 1 − α
2 2 (5.4.2)
• Where χ2 1−α/2 and χ2 α/2 are two critical values of χ2 obtained from the chi-
square table for n − 2 df.
• Substituting χ2 from (5.4.1) into (5.4.2) and rearranging the terms, we obtain

• which gives the 100(1 − α)% confidence interval for σ2.

• To illustrate, we obtain σˆ2 = 42.1591 and df = 8. If α is chosen at 5 percent,
the chi-square table for 8 df gives the following critical values:
• χ2 0.025 = 17.5346, and χ2 0.975 = 2.1797.
• These values show that the probability of a chi-square value exceeding
17.5346 is 2.5 percent and that of 2.1797 is 97.5 percent. Therefore, the
interval between these two values is the 95% confidence interval for χ2, as
shown diagrammatically in Figure 5.1.
• Substituting the data of our example into (5.4.3 the 95% confidence interval
for σ2 is as follows:
• 19.2347 ≤ σ2 ≤ 154.7336 (5.4.4)
• The interpretation of this interval is: If we establish 95% confidence limits
on σ2 and if we maintain a priori that these limits will include true σ2, we shall
be right in the long run 95 percent of the time.
(Note the skewed characteristic of the chi-square distribution.)
 HYPOTHESIS TESTING: THE CONFIDENCE-INTERVAL
APPROACH

• Two-Sided or Two-Tail Test

• To illustrate the confidence-interval approach, look at the consumption–
income example, the estimated (MPC), βˆ2, is 0.5091. Suppose we postulate
that:
• H0: β2 = 0.3 and H1: β2 ≠ 0.3
• that is, the true MPC is 0.3 under the null hypothesis but it is less than or
greater than 0.3 under the alternative hypothesis. The alternative hypothesis
is a two-sided hypothesis. It reflects the fact that we do not have a strong
expectation about the direction in which the alternative hypothesis should
move from the null hypothesis.
• Is the observed βˆ2 compatible with H0? To answer this question, let us refer
to the confidence interval (5.3.9). We know that in the long run intervals
like (0.4268, 0.5914) will contain the true β2 with 95 percent probability.
• Consequently, in the long run such intervals provide a range or limits within
which the true β2 may lie with a confidence coefficient of, say, 95%.
• Therefore, if β2 under H0 falls within the 100(1 − α)% confidence interval, we
do not reject the null hypothesis; if it lies outside the interval, we may reject
it. This range is illustrated schematically in Figure 5.2.
• Decision Rule: Construct a 100(1 − α)% confidence interval for β2. If the β2
under H0 falls within this confidence interval, do not reject H0, but if it falls
outside this interval, reject H0.
• Following this rule, H0: β2 = 0.3 clearly lies outside the 95% confidence
interval given in (5.3.9). Therefore, we can reject the hypothesis that the
true MPC is 0.3, with 95% confidence.
• In statistics, when we reject the null hypothesis, we say that our finding is
statistically significant. On the other hand, when we do not reject the null
hypothesis, we say that our finding is not statistically significant.
• One-Sided or One-Tail Test
• If we have a strong theoretical expectation that the alternative hypothesis is
one-sided or unidirectional rather than two-sided. Thus, for our
consumption–income example, one could postulate that
• H0: β2 ≤ 0.3 and H1: β2 > 0.3
• Perhaps economic theory or prior empirical work suggests that the
marginal propensity to consume is greater than 0.3. Although the procedure
to test this hypothesis can be easily derived from (5.3.5), the actual
mechanics are better explained in terms of the test-of-significance approach
discussed next.
 HYPOTHESIS TESTING:
THE TEST-OF-SIGNIFICANCE APPROACH

• Testing the Significance of Regression Coefficients: The t Test

• An alternative to the confidence-interval method is the test-of-significance
approach. It is a procedure by which sample results are used to verify the
truth or falsity of a null hypothesis. The decision to accept or reject H0 is
made on the basis of the value of the test statistic obtained from the data at
hand. Recall

• follows the t distribution with n − 2 df.

• The confidence-interval statements such as the following can be made:
• Pr [−tα/2 ≤ (βˆ2 − β*2)/se (βˆ2) ≤ tα/2 ]= 1 − α (5.7.1)
• where β*2 is the value of β2 under H0. Rearranging (5.7.1), we obtain
• Pr [β*2 − tα/2 se (βˆ2) ≤ βˆ2 ≤ β*2 + tα/2 se (βˆ2)] = 1 − α (5.7.2)
• which gives the confidence interval in with 1 − α probability.
• (5.7.2) is known as the region of acceptance and the region(s) outside the
confidence interval is (are) called the region(s) of rejection (of H0) or the
critical region(s).
• Using consumption–income example. We know that βˆ2 = 0.5091, se (βˆ2) =
0.0357, and df = 8. If we assume α = 5 percent, tα/2 = 2.306. If we let:
• H0: β2 = β*2 = 0.3 and H1: β2 ≠ 0.3, (5.7.2) becomes
• Pr (0.2177 ≤ βˆ2 ≤ 0.3823) = 0.95 (5.7.3)
• Since the observed βˆ2 lies in the critical region, we reject the null hypothesis
that true β2 = 0.3.
• In practice, there is no need to estimate (5.7.2) explicitly. One can compute
the t value in the middle of the double inequality given by (5.7.1) and see
whether it lies between the critical t values or outside them. For our example,
• t = (0.5091 − (0.3)) / (0.0357) = 5.86 (5.7.4)
• which clearly lies in the critical region of Figure 5.4. The conclusion
remains the same; namely, we reject H0.

• A statistic is said to be statistically significant if the value of the test statistic

lies in the critical region. By the same token, a test is said to be statistically
insignificant if the value of the test statistic lies in the acceptance region.

• We can summarize the t test of significance approach to hypothesis testing

as shown in Table 5.1.
• Testing the Significance of σ2: The χ2 Test
• As another illustration of the test-of-significance methodology, consider the
following variable:
• χ 2 = n − 2 ( σˆ 2 / σ2 ) (5.4.1)
• which, as noted previously, follows the χ2 distribution with n − 2 df. For the
hypothetical example, σˆ2 = 42.1591 and df = 8. If we postulate that
• H0: σ2 = 85 vs. H1: σ2 ≠ 85, Eq.
• (5.4.1) provides the test statistic for H0. Substituting the appropriate values in
(5.4.1), it can be found that under H0, χ2 = 3.97. If we assume α = 5%, the
critical χ2 values are 2.1797 and 17.5346.
• Since the computed χ2 lies between these limits, we do not reject H0. The χ2
test of significance approach to hypothesis testing is summarized in Table
5.2.
 HYPOTHESIS TESTING: SOME PRACTICAL ASPECTS

• The Meaning of “Accepting” or “Rejecting” a Hypothesis

• If on the basis of a test of significance in accepting H0, do not say we accept
H0. Why? To answer this, let us revert to our consumption–income example
and assume that H0: β2 (MPC) = 0.50. Now the estimated value of the MPC
is βˆ2 = 0.5091 with a se (βˆ2) = 0.0357. Then on the basis of the t test we find
that t = (0.5091 − 0.50)/0.0357 = 0.25, which is insignificant, say, at α = 5%.
Therefore, we say “accept” H0. But now let us assume H0: β2 = 0.48. Applying
the t test, we obtain t = (0.5091 − 0.48)/0.0357 = 0.82, which too is statistically
insignificant. So now we say “accept” this H0. Which of these two null
hypotheses is the “truth”? We do not know. It is therefore preferable to say
“do not reject” rather than “accept.”
• The “Zero” Null Hypothesis and the “2-t” Rule of Thumb
• A null hypothesis that is commonly tested in empirical work is H0: β2 = 0,
that is, the slope coefficient is zero.
• This null hypothesis can be easily tested by the confidence interval or the t-
test approach discussed in the preceding sections. But very often such formal
testing can be shortcut by adopting the “2-t” rule of significance, which may
be stated as
• The rationale for this rule is not too difficult to grasp. From (5.7.1) we know
that we will reject H0: β2 = 0 if
• t = βˆ2 / se (βˆ2) > tα/2 when βˆ2 > 0
or
• t = βˆ2 / se (βˆ2) < −tα/2 when βˆ2 < 0
or when
• |t| = | βˆ2 / se (βˆ2) | > tα/2 (5.8.1)
for the appropriate degrees of freedom.
• Now if we examine the t, we see that for df of about 20 or more a computed t
value in excess of 2 (in absolute terms), say, 2.1, is statistically significant at
the 5 percent level, implying rejection of the null hypothesis.
• Forming the Null and Alternative Hypotheses
• Very often the phenomenon under study will suggest the nature of the null
and alternative hypotheses. Consider the capital market line (CML) of
portfolio theory,
• Ei = β1 + β2σi ,
• where E = expected return on portfolio and σ = the standard deviation of
return, a measure of risk. Since return and risk are expected to be positively
related, natural alternative hypothesis to the null hypothesis that β2 = 0 would
be β2 > 0. That is, one would not choose to consider values of β2 less than zero.
• Consider the case of the demand for money. Studies have shown that the
income elasticity of demand for money has typically ranged between 0.7 and
1.3. Therefore, in a new study of demand for money, if one postulates that the
income-elasticity coefficient β2 is 1, the alternative hypothesis could be that β2 ≠
1, a two-sided alternative hypothesis.
• Thus, theoretical expectations or prior empirical work or both can be relied
upon to formulate hypotheses.
• Choosing α, the Level of Significance
• To reject or not reject the H0 depends critically on α, or the probability of
committing a Type I error—the probability of rejecting the true hypothesis.
But even then, why is α commonly fixed at the 1, 5, or at the most 10 percent
levels? For a given sample size, if we try to reduce a Type I error, a Type II
error increases, and vice versa. That is, given the sample size, if we try to
reduce the probability of rejecting the true hypothesis, we at the same time
increase the probability of accepting the false hypothesis.
• Now the only way we can decide about the tradeoff is to find out the
relative costs of the two types of errors.
• Applied econometricians generally follow the practice of setting the value of
α at a 1 or a 5 or at most a 10 percent level and choose a test statistic that
would make the probability of committing a Type II error as small as
possible. Since one minus the probability of committing a Type II error is
known as the power of the test, this procedure amounts to maximizing the
power of the test.
• The Exact Level of Significance: The p Value
• Once a test statistic is obtained in a given example, why not simply go to the
appropriate statistical table and find out the actual probability of obtaining
a value of the test statistic as much as or greater than that obtained in the
example? This probability is called the p value (i.e., probability value), also
known as the observed or exact level of significance or the exact probability
of committing a Type I error. More technically, the p value is defined as the
lowest significance level at which a null hypothesis can be rejected.
• To illustrate, given H0 that the true MPC is 0.3, we obtained a t value of 5.86
in (5.7.4). What is the p value of obtaining a t value of as much as or greater
than 5.86? Looking up the t table, for 8 df the probability of obtaining such
a t value must be much smaller than 0.001 (one-tail) or 0.002 (two-tail). This
observed, or exact, level of significance of the t statistic is much smaller than
the conventionally, and arbitrarily, fixed level of significance, such as 1, 5,
or 10 percent. If we were to use the p value just computed, and reject the
null hypothesis, the probability of our committing a Type I error is only
about 0.02 percent, that is, only about 2 in 10,000!
 REGRESSION ANALYSIS AND ANALYSIS OF VARIANCE

• In Chapter 3, the following identity is developed:

• Σy2i =yˆ2i + Σuˆ2i = βˆ22 Σx2i + Σuˆ2i (3.5.2)
• that is, TSS = ESS + RSS. A study of these components of TSS is known as
the analysis of variance (ANOVA).
• Associated with any sum of squares is its df, the number of independent
observations on which it is based. TSS has n − 1df because we lose 1 df in
computing the sample mean Y¯. RSS has n − 2df.
• ESS has 1 df which follows from the fact that
• ESS = βˆ22 Σx2i is a function of βˆ2 only, since x2i is known.
• Let us arrange the various sums of squares and their associated df in Table
5.3, which is the standard form of the AOV table, sometimes called the
ANOVA table. Given the entries of Table 5.3, we now consider the following
variable:
• F = (MSS of ESS) / (MSS of RSS)
• = βˆ22 Σ x2i / (Σ uˆ2i / (n− 2)) (5.9.1)
• = βˆ22 Σ x2i / σˆ2
• If we assume that the disturbances ui are normally distributed, and if H0 is
that β2 = 0, then it can be shown that the F variable of (5.9.1) follows the F
distribution with 1 df in the numerator and (n − 2) df in the denominator.
• What use can be made of the preceding F ratio? It can be shown that
• Eβˆ22 Σ x2i = σ2 + β22 Σ x2i (5.9.2)
• and
• E Σuˆ2i / n−2 = E(σˆ2) = σ2 (5.9.3)
• (Note that β2 and σ2 appearing on the right sides of these equations are the
true parameters.) Therefore, if β2 is in fact zero, Eqs. (5.9.2) and (5.9.3) both
provide us with identical estimates of true σ2. In this situation, the
explanatory variable X has no linear influence on Y whatsoever and the
entire variation in Y is explained by the random disturbances ui. If, on the
other hand, β2 is not zero, (5.9.2) and (5.9.3) will be different and part of the
variation in Y will be ascribable to X. Therefore, the F ratio of (5.9.1)
provides a test of the null hypothesis H0: β2 = 0.
• To illustrate, the ANOVA table for consumption–income is as shown in
Table 5.4. The computed F value is seen to be 202.87. The p value of this F
statistic using electronic statistical tables is 0.0000001, the computed F of
202.87 is obviously significant at this level. Therefore, reject the null
hypothesis that β2 = 0.
 REPORTING THE RESULTS OF REGRESSION ANALYSIS

• Employing the consumption–income example of as an illustration:

• Yˆi = 24.4545 + 0.5091Xi
• se = (6.4138) (0.0357) r2 = 0.9621 (5.11.1)
• t = (3.8128) (14.2605) df = 8
• p = (0.002571) (0.000000289) F1,8 = 202.87

• Thus, for 8 df the probability of obtaining a t value of 3.8128 or greater is

0.0026 and the probability of obtaining a t value of 14.2605 or larger is
about 0.0000003.
• Under the null hypothesis that the true population intercept value is zero,
the p value of obtaining a t value of 3.8128 or greater is only about 0.0026.
Therefore, if we reject this null hypothesis, the probability of our
committing a Type I error is about 26 in 10,000. The true population
intercept is different from zero.
• If the true MPC were in fact zero, our chances of obtaining an MPC of
0.5091 would be practically zero. Hence we can reject the null hypothesis
that the true MPC is zero.
• Earlier we showed the intimate connection between the F and t statistics,
namely, F1, k = t2k . Under the null hypothesis that the true β2 = 0, the F
value is 202.87, and the t value is about 14.24, as expected, the former value
is the square of the latter value.
 EVALUATING THE RESULTS OF REGRESSION ANALYSIS

• How “good” is the fitted model? We need some criteria with which to
answer this question.
• First, are the signs of the estimated coefficients in accordance with
theoretical or prior expectations? e.g., the income consumption model
should be positive.
• Second, if theory says that the relationship should also be statistically
significant. The p value of the estimated t value is extremely small.
• Third, how well does the regression model explain variation in the
consumption expenditure? One can use r2 to answer this question, which is
a very high.
• There is one assumption that we would like to check, the normality of the
disturbance term, ui.
• Normality Tests
• Although several tests of normality are discussed in the literature, we will
consider just three:
• (1) histogram of residuals;
• (2) normal probability plot (NPP), a graphical device; and
• (3) the Jarque–Bera test.
• Histogram of Residuals.
• A histogram of residuals is a simple graphic device that is used to learn
something about the shape of the probability density function PDF of a
random variable.
• If you mentally superimpose the bell shaped normal distribution curve on
the histogram, you will get some idea as to whether normal (PDF)
approximation may be appropriate.
• Normal Probability Plot.
• A comparatively simple graphical device is the normal probability plot
(NPP). If the variable is in fact from the normal population, the NPP will be
approximately a straight line. The NPP is shown in Figure 5.7. We see that
residuals from our illustrative example are approximately normally
distributed, because a straight line seems to fit the data reasonably well.
• Jarque–Bera (JB) Test of Normality.
• The JB test of normality is an asymptotic, or large-sample, test. It is also
based on the OLS residuals. This test first computes the skewness and
kurtosis, measures of the OLS residuals and uses the following test statistic:
• JB = n[S2 / 6 + (K − 3)2 / 24] (5.12.1)
• where n = sample size, S = skewness coefficient, and K = kurtosis coefficient.
For a normally distributed variable, S = 0 and K = 3. In that case the value
of the JB statistic is expected to be 0.
• The JB statistic follows the chi-square distribution with 2 df.
• If the computed p value of the JB statistic in an application is sufficiently
low, which will happen if the value of the statistic is very different from 0,
one can reject the hypothesis that the residuals are normally distributed. But if
the p value is reasonably high, which will happen if the value of the statistic
is close to zero, we do not reject the normality assumption.
• The sample size in our consumption–income example is rather small. If we
mechanically apply the JB formula to our example, the JB statistic turns
out to be 0.7769. The p value of obtaining such a value from the chi-square
distribution with 2 df is about 0.68, which is quite high. In other words, we
may not reject the normality assumption for our example. Of course, bear
in mind the warning about the sample size.
 A CONCLUDING EXAMPLE

• Let us return to Example 3.2 about food expenditure in India. Using the
data given in (3.7.2) and adopting the format of (5.11.1), we obtain the
following expenditure equation:
• FoodExpˆi = 94.2087 + 0.4368 TotalExpi
• se = (50.8563) (0.0783)
• t= (1.8524) (5.5770)
• p= (0.0695) (0.0000)*
• r 2 = 0.3698; df = 53
• F1,53 = 31.1034 (p value = 0.0000)*
• As expected, there is a positive relationship between expenditure on food
and total expenditure. If total expenditure went up by a rupee, on average,
expenditure on food increased by about 44 paise.
• If total expenditure were zero, the average expenditure on food would be
about 94 rupees.
• The r2 value of about 0.37 means that 37 percent of the variation in food
expenditure is explained by total expenditure, a proxy for income.
• Suppose we want to test the null hypothesis that there is no relationship
between food expenditure and total expenditure, that is, the true slope
coefficient β2 = 0.
• The estimated value of β2 is 0.4368. If the null hypothesis were true, what is
the probability of obtaining a value of 0.4368? Under the null hypothesis,
we observe from (5.12.2) that the t value is 5.5770 and the p value of
obtaining such a t value is practically zero. In other words, we can reject the
null hypothesis. But suppose the null hypothesis were that β2 = 0.5. Now
what? Using the t test we obtain:
• t = 0.4368 − 0.5 / 0.0783 = −0.8071
• The probability of obtaining a |t | of 0.8071 is greater than 20 percent.
Hence we do not reject the hypothesis that the true β2 is 0.5.
• Notice that, under the null hypothesis, the true slope coefficient is zero.
• The F value is 31.1034. Under the same null hypothesis, we obtained a t
value of 5.5770. If we square this value, we obtain 31.1029, which is about
the same as the F value, again showing the close relationship between the t
and the F statistic.
• Using the estimated residuals from the regression, what can we say about
the probability distribution of the error term? The information is given in
Figure 5.8. As the figure shows, the residuals from the food expenditure
regression seem to be symmetrically distributed.
• Application of the Jarque–Bera test shows that the JB statistic is about
0.2576, and the probability of obtaining such a statistic under the normality
assumption is about 88 percent. Therefore, we do not reject the hypothesis
that the error terms are normally distributed. But keep in mind that the
sample size of 55 observations may not be large enough.
 END

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