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Applied Econometrics 3 Edition: Dimitrios Asteriou and Stephen G Hall

This document discusses the use of dummy variables in econometrics modeling. Dummy variables allow qualitative information to be included in models by assigning numerical values to different categories of a variable. The document provides examples of how intercept and slope dummy variables are used and interpreted. It also discusses how multiple dummy variables can be included to account for variables with more than two categories, and how seasonal dummy variables are used with time series data. Tests for structural stability using dummy variables are also introduced.

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2K views

Applied Econometrics 3 Edition: Dimitrios Asteriou and Stephen G Hall

This document discusses the use of dummy variables in econometrics modeling. Dummy variables allow qualitative information to be included in models by assigning numerical values to different categories of a variable. The document provides examples of how intercept and slope dummy variables are used and interpreted. It also discusses how multiple dummy variables can be included to account for variables with more than two categories, and how seasonal dummy variables are used with time series data. Tests for structural stability using dummy variables are also introduced.

Uploaded by

maaz ahmed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Applied Econometrics 3rd edition

Dimitrios Asteriou
and
Stephen G Hall
Applied Econometrics 3rd edition

DUMMY VARIABLES

1. The Nature of Qualitative Information


2. The Use of Dummy Variables
3. Special Cases of Dummy Variables
4. Dummy Variables with Multiple Categories
5. Tests for Structural Stability
Applied Econometrics 3rd edition

Learning Objectives
1. Understand the various forms of possible misspecification in the
CLRM.
2. Appreciate the importance and learn the consequences of omitting
influential variables in the CLRM.
3. Distinguish among the wide range of functional forms and understand
the meaning and interpretation of their coefficients.
4. Understand the importance of measurement errors in the data.
5. Perform misspecification tests using econometric software.
6. Understand the meaning of nested and non-nested models.
7. Be familiar with the concept of data mining and choose an appropriate
econometric model.
Applied Econometrics 3rd edition

The Nature of Qualitative Information


Sometimes we can not obtain a set of numerical
values for all the variables we want to use in a
model.
This is because some variables can not be quantified
easily.
Examples:
(a) Gender may play a role in determining salary levels
(b) Different ethnic groups may follow different consumption patterns
(c) Educational levels can affect earnings from employment
Applied Econometrics 3rd edition

The Nature of Qualitative Information


It is easier to have dummies for cross-sectional
variables, but sometimes we do have for time series
as well.
Examples
(a) Changes in a political regime may affect production
(b) A war can have an impact on economic activities
(c) Certain days in a week or certain months in a year can have different
effects in the fluctuation of stock prices
(d) Seasonal effects are often observed in demand of various products
Applied Econometrics 3rd edition

The Use of Dummy Variables


Consider the following cross-sectional model:
Yi=β1+β2X2i+ ui
The constant term in this equation measures the mean
value of Yi when X2i is equal to zero.
This model assumes that the constant will be the same
for all the observations in our data set.
But what if we have two different subgroups (male,
female for example)?
Applied Econometrics 3rd edition

The Use of Dummy Variables


The question here is how to quantify the information
that comes from the difference in the two groups.
One solution is to create a dummy variable as follows:
1 for male
D =
0 for female
Note that the choice of which of the two different
outcomes is to be assigned the value of 1 does not
alter the results.
Applied Econometrics 3rd edition

The Use of Dummy Variables


Entering this dummy in the equation we have the
following model:
Yi=β1+β2X2i+β3Di+ui
Now we have two cases
Di=0 Yi=β1+β2X2i+ β3(0) +ui
Yi=β1+β2X2i+ui

Di=1 Yi=β1+β2X2i+β3(1)+ui
Yi=(β1+β3) +β2X2i+ui
Applied Econometrics 3rd edition

Intercept Dummy Variable


Y

Red Points: Male

Grey Points: Female

X2
Applied Econometrics 3rd edition

Intercept Dummy Variable


Y

β1+β3

β1

X2
Applied Econometrics 3rd edition

Slope Dummy Variable


Consider the same case but now with the dummy
affecting the slope
Yi=β1+β2X2i+β3DiX2i+ui
Now we have two cases
Di=0 Yi=β1+β2X2i+β3(0)iX2i+ui
Yi=β1+β2X2i+ui

Di=1 Yi=β1+β2X2i+β3(1)iX2i+ui
Yi=β1+(β2+β3)X2i+ui
Applied Econometrics 3rd edition

Slope Dummy Variable


700000

600000

500000

400000
Y

300000

200000

100000

0
0 200 400 600 800 1000 1200 1400
X2
Applied Econometrics 3rd edition

The Combined Effect

Males
Y

d Females
b 1 +d

b1
Applied Econometrics 3rd edition

Dummies with Multiple Categories


Consider the case of education:
D1= 1 primary; 0 otherwise

D2= 1 if secondary; 0 otherwise

D3= 1 if tertiary; 0 otherwise

D4 = 1 if BSc; 0 otherwise

D5 = 1 if MSc; 0 otherwise
Applied Econometrics 3rd edition

The Plug in Solution


So we estimate:
Y=β1+β2X2+ a1 D2+a2D3+a3D4+a4D5+u

Note that one dummy (in this case D1) is excluded


from the model in order to avoid dummy variable
trap.

Consider various cases,


i.e. D2=1, D3=D4=D5=0 etc.
Applied Econometrics 3rd edition

Multiple Categories
700000

600000

500000

400000
COST

300000

200000

100000

0
0 200 400 600 800 1000 1200 1400
-100000
N

Technical schools Vocational schools General schools Workers' schools


Applied Econometrics 3rd edition

Using More than One Dummy


GENDER (male; female)
EDUC (primary, secondary, tertiary; BSc; MSc)
AGE (less than 30, 30 to 40; more than 40)
OCUP (unskilled, skilled, clerical, self-employed)
etc
The interpretation (although it seems more
complicated) is the same as before
Applied Econometrics 3rd edition

Seasonal Dummy Variables


Depends on the frequency of the data
Quarterly – 4 dummies – DQ1, DQ2, DQ3, DQ4
Monthly – 12 dummies – one for each month
Daily – 5 dummies – Dmon, Dtue, Dwed etc.

Again we either exclude one and include a constant


(always better) or if we use all we never include a
constant (dummy variable trap).
Applied Econometrics 3rd edition

The Chow Test


for Structural Stability
Step 1: Estimate the basic regression equation.
Yi=β1+β2X2i+ui
for three different data sets
(a)whole sample, n;
(b)Period before the shock, n1;
(c)Period after the shock, n2.
Step 2: Obtain the SSR for each of the three subsets
and label them SSRN, SSR1 and SSR2 respectively.
Applied Econometrics 3rd edition

The Chow Test


for Structural Stability
Step 3: Calculate the F-statistic
(SSRN  [ RSS1  RSS2 ]) / k
F 
( RSS1  RSS2 ) /(n  2k )

Step 4: If F-statistical bigger than F-critical


F(k,n-2k) then reject the null that the
parameters are stable for the whole data set.
Applied Econometrics 3rd edition
The Dummy Variable Test
for Structural Stability
The Dummy Variable Test is much better because:
• A single equation is used to provide a set of the
estimated coefficients for tow or more structures
• Only one degree of freedom is lost for every
dummy used.
• A larger sample is being used for the estimation
• It provides us with information regarding the exact
nature of the parameter instability.

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