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Basic Econometrics

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Question 1: Conceptual Question (a) Model I: The major econometric issue is on the error term ui. The equation ui2=γ1+γ2x1,j indicates that the error term ui is related with the independent variable x1. Under the general assumptions, the error term us designed to capture ‘unexpected’ events, as such the error term should be random and the independent variable x1 is not random which means that its value if known. Therefore, model I breaks out this assumption, the error term ui is related with the independent variable x1 (not random), error term uiwill hence be not random as well. As a result, the dependent variable y will be not random which is wrong in econometrics. (b) Model II: The major econometric issue is on the error term vt. The equation vt=ρvt-1 indicates that for the pair of random error term vt and vt-1, there is linear association among them. Under the fourth assumption of the simple linear regression model, the covariance between any pair of random errors is zero, implying that there is no linear association among them. Therefore, model II breaks out this assumption, one random error term vt has a linear relationship with another random error term vt-1. (c) Model III: The major econometric issue is on the independent variable x1,i. x1,i~i.i.d(ux, σx2) indicates that x1,i is independent and identically distributed random variables. Under the fifth assumption of the simple linear regression model, it requires the regressors x1,i to be not stochastic (not random). Therefore, model III fails to satisfy assumption five. As a result, the error term wi and the independent variable are correlated, i.e. cov(wi,xi)≠0. (d) Model IV: The major econometric issue is that x1 has been dropped. Under the first classical assumption, it requires that the model does not omit important variables. Therefore, Model IV fails to

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