This document discusses the problem of multicollinearity in regression analysis. It defines perfect and imperfect multicollinearity, and explains their consequences. Perfect multicollinearity occurs when an explanatory variable is a linear combination of other explanatory variables, causing the regression coefficients to be undefined. Imperfect multicollinearity exists when explanatory variables are highly correlated, increasing the standard errors of coefficients and potentially making them insignificant. The document also provides methods for detecting and resolving multicollinearity issues.
This document discusses the problem of multicollinearity in regression analysis. It defines perfect and imperfect multicollinearity, and explains their consequences. Perfect multicollinearity occurs when an explanatory variable is a linear combination of other explanatory variables, causing the regression coefficients to be undefined. Imperfect multicollinearity exists when explanatory variables are highly correlated, increasing the standard errors of coefficients and potentially making them insignificant. The document also provides methods for detecting and resolving multicollinearity issues.
This document discusses the problem of multicollinearity in regression analysis. It defines perfect and imperfect multicollinearity, and explains their consequences. Perfect multicollinearity occurs when an explanatory variable is a linear combination of other explanatory variables, causing the regression coefficients to be undefined. Imperfect multicollinearity exists when explanatory variables are highly correlated, increasing the standard errors of coefficients and potentially making them insignificant. The document also provides methods for detecting and resolving multicollinearity issues.
This document discusses the problem of multicollinearity in regression analysis. It defines perfect and imperfect multicollinearity, and explains their consequences. Perfect multicollinearity occurs when an explanatory variable is a linear combination of other explanatory variables, causing the regression coefficients to be undefined. Imperfect multicollinearity exists when explanatory variables are highly correlated, increasing the standard errors of coefficients and potentially making them insignificant. The document also provides methods for detecting and resolving multicollinearity issues.
Learning Objectives 1. Recognize the problem of multicollinearity in the CLRM. 2. Distinguish between perfect and imperfect multicol- linearity. 3. Understand and appreciate the consequences of perfect and imperfect multicollinearity on OLS estimates. 4. Detect problematic multicollinearity using econometric software. 5. Find ways of resolving problematic multicollinearity. Applied Econometrics 3rd edition
Multicollinearity Assumption number 8 of the CLRM requires that there are no exact linear relationships among the sample values of the explanatory variables (the Xs). So, when the explanatory variables are very highly correlated with each other (correlation coefficients either very close to 1 or to -1) then the problem of multicollinearity occurs. Applied Econometrics 3rd edition
Perfect Multicollinearity • When there is a perfect linear relationship. • Assume we have the following model: Y=β1+β2X2+ β3X3+e where the sample values for X2 and X3 are:
X2 1 2 3 4 5 6
X3 2 4 6 8 10 12 Applied Econometrics 3rd edition
Perfect Multicollinearity • We observe that X3=2X2 • Therefore, although it seems that there are two explanatory variables in fact it is only one. • This is because X2 is an exact linear function of X3 or because X2 and X3 are perfectly collinear. Applied Econometrics 3rd edition
Perfect Multicollinearity When this occurs then the equation: δ1X1+δ2X2=0 can be satisfied for non-zero values of both δ1 and δ2. In our case we have that (-2)X1+(1)X2=0 So δ1=-2 and δ2=1. Applied Econometrics 3rd edition
Perfect Multicollinearity Obviously if the only solution is δ1=δ2=0 (usually called as the trivial solution) then the two variables are linearly independent and there is no problematic multicollinearity. Applied Econometrics 3rd edition
Perfect Multicollinearity In case of more than two explanatory variables the case is that one variable can be expressed as an exact linear function of one or more or even all of the other variables. So, if we have 5 explanatory variables we have: δ1X1+δ2X2 +δ3X3+δ4X4 +δ5X5=0 An application to better understand this situation is the Dummy variables trap (explain on board). Applied Econometrics 3rd edition
Consequences of Perfect Multicollinearity
• Under Perfect Multicollinearity, the OLS
estimators simply do not exist. (prove on board) • If you try to estimate an equation in Eviews and your equation specifications suffers from perfect multicollinearity Eviews will not give you results but will give you an error message mentioning multicollinearity in it. Applied Econometrics 3rd edition
Imperfect Multicollinearity • Imperfect multicollinearity (or near multicollinearity) exists when the explanatory variables in an equation are correlated, but this correlation is less than perfect. • This can be expressed as: X3=X2+v where v is a random variable that can be viewed as the ‘error’ in the exact linear releationship. Applied Econometrics 3rd edition
Consequences of Imperfect Multicollinearity
• In cases of imperfect multicollinearity the OLS
estimators can be obtained and they are also BLUE. • However, although linear unbiassed estimators with the minimum variance property to hold, the OLS variances are often larger than those obtained in the absence of multicollinearity. Applied Econometrics 3rd edition
Consequences of Imperfect Multicollinearity
To explain this consider the expression that gives the variance of the partial slope of variable Xj: 2 var( ˆ2 ) 2 2 ( X X ) 2 (1 r 2 ) 2 var( ˆ3 ) 3 3 ( X X ) 2 (1 r 2 )
where r2 is the square of the sample correlation
coefficient between X2 and X3. Applied Econometrics 3rd edition
Consequences of Imperfect Multicollinearity
Extending this to more than two explanatory variables, we have: 2 var( ˆ j ) 2 2 ( X X ) 2 (1 R 2 j)
ˆ 2 1 var( 3 ) 3 3 ( X X ) 2 (1 R 2 j)
and therefore, what we call the Variance Inflation
• VIF values that exceed 10 are generally viewed as evidence of the existence of problematic multicollinearity. • This happens for R2j >0.9 (explain auxiliary reg) • So large standard errors will lead to large confidence intervals. • Also, we might have t-stats that are totally wrong. Applied Econometrics 3rd edition
Consequences of Imperfect Multicollinearity (Again) Concluding when imperfect multicollinearity is present we have: (a) Estimates of the OLS may be imprecise because of large standard errors. (b) Affected coefficients may fail to attain statistical significance due to low t-stats. (c) Sing reversal might exist. (d) Addition or deletion of few observations may result in substantial changes in the estimated coefficients. Applied Econometrics 3rd edition
Detecting Multicollinearity • The easiest way to measure the extent of multicollinearity is simply to look at the matrix of correlations between the individual variables. • In cases of more than two explanatory variables we run the auxiliary regressions. If near linear dependency exists, the auxiliary regression will display a small equation standard error, a large R2 and statistically significant F-value. Applied Econometrics 3rd edition
Resolving Multicollinearity • Approaches, such as the ridge regression or the method of principal components. But these usually bring more problems than they solve.
• Some econometricians argue that if the model
is otherwise OK, just ignore it. Note that you will always have some degree of multicollinearity, especially in time series data. Applied Econometrics 3rd edition
Resolving Multicollinearity • The easiest ways to “cure” the problems are (a) drop one of the collinear variables (b) transform the highly correlated variables into a ratio (c) go out and collect more data e.g. (d) a longer run of data (e) switch to a higher frequency Applied Econometrics 3rd edition
Examples We have quarterly data for Imports (IMP) Gross Domestic Product (GDP) Consumer Price Index (CPI) and Producer Price Index (PPI) Applied Econometrics 3rd edition
