violationsofclassicallinearregressionassumptions.docVIP

Violations of Classical Linear Regression Assumptions Mis-Specification Assumption 1. Y=X?+? a. What if the true specification is Y=X?+Z?+? but we leave out the relevant variable Z? Then the error in the estimated equation is really the sum Z?+?. Multiply the true regression by X’ to get the mis-specified OLS: X’Y=X’X?+X’Z?+X’?. The OLS estimator is b=(X’X)-1X’Y= (X’X)-1X’X?+(X’X)-1X’Z?+(X’X)-1X’?. The last term is on average going to vanish, so we get b=?+(X’X)-1X’Z??? Unless ?=0 or in the data, the regression of X on Z is zero, the OLS b is biased. b. What if the true specification is Y