CHAPTER

2
BASIC IDEAS OF LINEAR REGRESSION:
THE TWO-VARIABLE MODEL

QUESTIONS

2.1. (a) It states how the population mean value of the dependent variable is
related to one or more explanatory variables.
(b) It is the sample counterpart of the PRF.
(c) It tells how the individual Y are related to the explanatory variables and
the stochastic error term, u, in the population as a whole.
(d) A model that is linear in the parameters, the Bs.
(e) It is a proxy for all omitted or neglected variables that affect the
dependent variable Y. The individual influence of each of these variables is
random and small so that on average their influence on Y is zero.
(f) It is the sample counterpart of the stochastic error term.
(g) The expected value of Y conditional upon a given value of X. It is
obtained from the conditional (probability) distribution of Y, given X.
(h) The expected value of an r.v. regardless of the values taken by other
random variables. It is obtained from the unconditional, or marginal,
probability distributions of the relevant random variables.
(i) The B coefficients in a linear regression model are called regression
coefficients or regression parameters.
(j) The bs, which tell how to compute the Bs, are called the estimators.
Numerical values taken by the bs are known as estimates.
2.2. A stochastic SRF tells how Yi in a randomly drawn sample from a Y

population are related to the explanatory variables and the residuals ei . A

stochastic PRF tells how the individual Yi are related to the explanatory

variables and the stochastic error term u i in the whole population.

1
2.3. The PRF is a theoretical, or idealized, model, just as the model of perfect
competition is an idealized model. But such idealized models help us to see
the essence of the problem.
2.4. (a) False. The residual ei is an approximation (i.e., an estimator) of the true

error term, u i .
(b) False. It gives the mean value of the dependent variable, given the
values of the explanatory variables.
(c) False. A linear regression model is linear in the parameters and not
necessarily linear in the variables.
(d) False, generally. The cause and effect relationship between the Xs and Y
must be justified by theory.
(e) False, unless the “conditioned” and conditioning variables are
independent.
(f) False. It is the other way around.
(g) False. It measures the change in the mean value of Y per unit change in
X.
(h) Uncertain. There are many a phenomena which can be explained by the
two-variable model. One example is the Market Model of portfolio theory
which regresses the rate of return on a single security on the rate of return on
a market index (e.g., S&P 500 stock index). The slope coefficient in this
model, popularly known as the beta coefficient, is used extensively in
portfolio analysis.
(i) True.
2.5. (a) b1 is an estimator of B1 .
(b) b2 is an estimator of B2 .

(c) ei is an estimator of u i .

We never observe B1 , B2 , and u. Once we have a specific sample, we can

obtain their estimates via b1 , b2 and e.
2.6. By simple algebra, we obtain:
X t = 2.5 − 2.5Yt

2
 Sometimes Okun's model is run in this format, regressing percent growth in
real output on the change in the unemployment rate.
2.7. (a) The answer will depend on how the various components of GDP
(consumption expenditure, investment expenditure, government expenditure
and expenditure on net exports) react to the higher interest rate. For
instance, ceteris paribus, investment expenditure and the interest rate are
inversely related.
(b) Positive. Ceteris paribus, the higher the interest rate is, the greater will
be the incentive to save.
(c) Generally positive.
(d) Positive, to maintain at least the status quo.
(e) Probably positive.
(f) Probably negative; familiarity may breed contempt.
(g) Probably positive.
(h) Positive. Statistics is a major foundation of econometrics.
(i) Positive. As income increases, discretionary income is likely to increase,
leading to an increased demand for more expensive cars. A large number of
Japanese cars are expensive. In general, the income elasticity of demand for
items like cars has been found to be not only positive but generally greater
than 1.

PROBLEMS

2.8. (a) Yes (b) Yes (c) Yes (d) Yes (e) No (f) No.
2.9 (a) The conditional expected values are:

Value of X E(Y | X ) Value of X E(Y | X )

80 65 180 125
100 77 200 137
120 89 220 149
140 101 240 161
160 113 260 173

3
 (b) and (c). This is straightforward.
(d) The mean of Y increases with X. That may not be true of the individual
Y values.
(e) PRF: Yi = B1 + B2 X i + u i

SRF: Yi = b1 + b2 X i + ei
(f) The scatter plot will show that the PRF is linear.
2.10. (a) This is straightforward.
(b) The relationship between the two is positive.
(c) SRF: Ŷi = 24.4545 + 0.5091 X i

The raw data give: ∑ Y = 1,110; ∑ X

i i = 1,700; ∑x 2
i = 33,000;

∑x y i i = 16,800, where the small letters denote deviations from the mean

values.
(d) This is straightforward.
(e) The two are close, but obviously they are not identical.
2.11. (a) From the time subscript t, it seems that this is a time series regression.
(b) The regression line is linear with a negative slope.
(c) The average number of cups of coffee consumed per person per day if
the price of coffee were zero. Economically speaking, this may or may not
make sense.
(d) Ceteris paribus, the mean consumption of coffee per day goes down by
about 1/2 cup a day as the price of coffee per pound increases by a $1.
(e) No. But with the confidence interval procedure discussed in the next
chapter, it is possible to tell, in probabilistic terms, what the PRF may be.
(f) We have information on the slope coefficient, but not on X and Y.
Therefore, we cannot compute the price elasticity coefficient from the given
information.
2.12. (a) and (b). The scattergram will show that the relationship between the
S&P 500 index and the CPI is positive.
ˆ P) = -195.5149 + 3.8264 CPI
(c) (S & t t

4
 These results show that on average S&P goes up by about 3.8 points per
unit increase in the CPI. The constant term suggests that if the value of the
CPI were zero, the mean value of S&P would be about -195.
Note: This example is further examined in problem 6.15.
(d) The positive slope may make economic sense, but the negative intercept
value may not.
(e) Most probably it was due to the October 1987 stock market crash.
2.13. (a) The scattergram will show a positive relationship between the nominal
interest rate and the inflation rate, as per economic theory (the so-called
Fisher effect). Notice that there is an extreme observation, called an outlier,
pertaining to Mexico.
(b) Ŷi = 2.7131 + 1.2320 X i
(c) The value of the slope coefficient is expected to be 1, because, according
to the Fisher equation, the following relationship holds true approximately:
nominal interest rate = expected real interest rate + expected inflation rate.
Thus, the intercept in the Fisher equation is the expected real rate of interest.
In the present example, we cannot tell whether the Fisher equation holds
because the inflation rate used is the actual inflation rate. In terms of the
actual inflation rate, the nominal rate, on average, seems to increase more
than one percent for a one percent increase in the (actual) inflation rate, for
the slope coefficient is 1.2320. Applying the techniques discussed in the
next chapter, this slope coefficient is statistically significantly greater than 1.
2.14. (a) This is straightforward.
ˆ = 0.0088 + 1.1274 RE
(b) NE US US

(c) Positive.
(d) Yes.
ˆ = 0.1233 + 1.0034 ln RE
(e) ln NE US US

Yes, the results are qualitatively the same. But note that the slope
coefficient in the double-log model represents the elasticity coefficient,
whereas that in the linear model represents the absolute rate of change in the

5
 (mean) value of NEUS for a unit change in REUS. See Chapter 5 for the
various functional forms.
2.15 (a) Repeating the five questions, we have:
• The scattergram is straightforward.
• As before, the relationship between the two is expected to be
positive.
• The regression equation for the 1990-2007 period is:
ˆ P) = -1611.5024 + 15.0550 CPI
(S & t t

• The positive slope makes economic sense but the intercept does not.
• The 1988 S&P decline is not applicable here.
(b) The results are in accord with prior expectations, although numerical
values of the two period regression coefficients are vastly different.
(c) Combining the two data sets, we get the following results:
ˆ P) = -906.8409 + 10.8914 CPI
(S & t t

(d) Since the regression results of the two sub-periods are different (which
can be proved using the dummy variable technique discussed in Chapter 6
or by the Chow test), the preceding regression results that are based on the
pooled data are not meaningful.
2.16. (a) ASP = - 88,220.4947 + 55,227.4336 GPA
It seems GPA has a positive impact on ASP.
(b) ASP = - 241,386.602 + 511.721 GMAT
GMAT also seems to have a positive impact on ASP.
(c) ASP = 42,878.332 + 1.635 TUITION
Tuition also seems to have positive impact on ASP.
Top business schools generally have top teachers and researchers. This
means that these schools have to pay higher salaries to attract quality
faculty. In this sense high tuition may be a proxy for high quality education,
which may result in higher ASP for graduates from such schools.
(d) ASP = -29,943.604 + 37,300.297 RECRUITER

6
 This positive relationship suggests that recruiter perception has a positive
bearing on ASP.
Note: In the next chapter we will see if the regressions presented above are
statistically significant.
2.17. (a) Given the formulation of Okun’s law in Equation (6.22), the new
variables based on the real GDP (RGDP) and the unemployment rate
(UNRATE) data from Table 2-13 can be calculated as follows:
CHUNRATE = Change in UNRATE = UNRATE – UNRATE(-1)
PCTCRGDP = % Change in RGDP = [RGDP / RGDP(-1)]*100-100
Note: UNRATE – UNRATE(-1) means subtracting the previous period’s
unemployment rate from the current period’s unemployment rate. For
example, looking at the first two observations, UNRATE – UNRATE(-1) =
6.7 – 5.5, and so on. Similarly for RGDP and RGDP(-1), except in this case
we divide by the previous period’s observation.
The regression equation is:
ˆ RATE = 1.2334 – 0.3734 PCTCRGDP
CHUN
The slope coefficients in the two regressions are about the same. If you
simplify (2.22), the result is: CHUNRATE = 1.00 – 0.40 PCTCRGDP.
Therefore, the intercepts in the two regressions are about the same. Perhaps
Okun's law may have some universal validity.
(b) Reversing the roles of CHUNRATE and PCTCRGDP, we have:
ˆ GDP = 3.3191 – 1.8630 CHUNRATE
PCTCR
For a unit change in CHUNRATE, real GDP growth changes by about 1.86
percent in the opposite direction.
(c) If CHUNRATE in (b) is zero, real GDP growth is about 3.3%. We may
interpret this as the natural rate of growth in real GDP. In the original Okun
model it was assumed to be about 2.5%, the growth rate then prevailing.
2.18. (a) Straightforward. Any minor differences may be solely due to rounding
issues.

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 (b) For model (2.24), the output is as follows:
obs Actual Fitted Residual Residual Plot
1980 118.780 491.045 -372.265 | .* | . |
1981 128.050 475.464 -347.414 | .* | . |
1982 119.710 497.694 -377.984 | .* | . |
1983 160.410 519.918 -359.508 | .* | . |
1984 160.460 508.464 -348.004 | .* | . |
1985 186.840 537.677 -350.837 | .* | . |
1986 236.340 571.107 -334.767 | .* | . |
1987 286.830 575.689 -288.859 | .* | . |
1988 265.790 553.415 -287.625 | .* | . |
1989 322.840 527.173 -204.333 | . * | . |
1990 334.590 537.145 -202.555 | . * | . |
1991 376.180 588.330 -212.150 | . * | . |
1992 415.740 693.353 -277.613 | .* | . |
1993 451.410 734.495 -283.085 | .* | . |
1994 460.420 636.776 -176.356 | . *| . |
1995 541.720 585.326 -43.6060 | . *| . |
1996 670.500 602.985 67.5145 | . |* . |
1997 873.430 601.027 272.403 | . | *. |
1998 1085.50 611.655 473.845 | . | .* |
1999 1327.33 618.326 709.004 | . | . * |
2000 1427.22 574.811 852.409 | . | . *|
2001 1194.18 693.353 500.827 | . | .* |
2002 993.940 1019.76 -25.8158 | . * . |
2003 965.230 1381.73 -416.496 | * | . |
2004 1130.65 1126.77 3.87696 | . * . |
2005 1207.23 719.870 487.360 | . | .* |
2006 1310.46 615.160 695.300 | . | . * |
2007 1477.19 630.453 846.737 | . | . *|

For model (2.25) the output is:

obs Actual Fitted Residual Residual Plot
1980 118.780 85.6288 33.1512 | . |* . |
1981 128.050 -165.161 293.211 | . | *. |
1982 119.710 167.138 -47.4280 | . *| . |
1983 160.410 371.507 -211.097 | . * | . |
1984 160.460 277.076 -116.616 | . *| . |
1985 186.840 485.819 -298.979 | .* | . |
1986 236.340 634.921 -398.581 | * | . |
1987 286.830 650.825 -363.995 | * | . |
1988 265.790 564.346 -298.556 | .* | . |
1989 322.840 422.202 -99.3620 | . *| . |
1990 334.590 482.837 -148.247 | . *| . |

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 1991 376.180 690.586 -314.406 | .* | . |
1992 415.740 886.407 -470.667 | *. | . |
1993 451.410 929.149 -477.739 | *. | . |
1994 460.420 802.909 -342.489 | .* | . |
1995 541.720 681.640 -139.920 | . *| . |
1996 670.500 730.346 -59.8463 | . *| . |
1997 873.430 725.376 148.054 | . |* . |
1998 1085.50 751.221 334.279 | . | *. |
1999 1327.33 766.131 561.199 | . | . * |
2000 1427.22 647.843 779.377 | . | . *|
2001 1194.18 886.407 307.773 | . | *. |
2002 993.940 1068.31 -74.3711 | . *| . |
2003 965.230 1127.95 -162.722 | . *| . |
2004 1130.65 1092.17 38.4826 | . |* . |
2005 1207.23 915.233 291.997 | . | *. |
2006 1310.46 759.173 551.287 | . | .* |
2007 1477.19 790.981 686.209 | . | . *|

The residual plots of the two models seem similar. To choose between the
two models, we need model selection criteria, discussed in Chapter 7.

2.19 (a) The graphs are as follows:

2500

2000
PRICE

1500

1000

500
100 120 140 160 180 200

AGE

9
 2500

2000

PRICE
1500

1000

500
4 6 8 10 12 14 16

NUMBER OF BIDDERS (NOBIDDERS)

This graph shows that the higher the number of bidders, the higher the price
is. This probably is true of the antique clock auction market. As a first
approximation, the linear model may be appropriate for the price/ age
relationship, but may not be quite appropriate for the price/number of
bidders relationship.

10
 (b) The plot of the number of bidders versus age is as follows:

200

180

160
AGE

140

120

100
4 6 8 10 12 14 16

NUMBER OF BIDDERS (NOBIDDERS)

This scatter plot shows a very weak negative relationship between clock age
and the number of bidders. This is most likely because, the higher the clock
age, the higher the price. There will be fewer people able to bid for the
older, more expensive clocks.

2.20. The scatter plot between actual Y (data from Table 2.4) and estimated
Ŷ values is as follows:

(Graph appears on the following page)

11
 650

600

550

500

450

400
400 420 440 460 480 500 520 540 560 580 600
Y (actual)

If the fitted model is a good one, the actual and estimated Y values should be very
close to each other. In the case where the model is a perfect fit, the scatter points
will lie on a straight line.

2.21. (a) MaleMath = 511.607 + 0.0259 MaleCR

(b) This regression suggests that as the male critical reading score goes up
by a unit, on average, the male math score goes up by about 0.0259 units.
(c) MaleCR = 499.734 + 0.0196 MaleMath
As per this regression if the male math score goes up by a unit, the average
male verbal score goes up by about 0.0196 units.
(d) If you multiply the slope coefficients in the two preceding equations, you
will obtain: (0.0259)(0.0196) = 0.0005
As we show in the next chapter, the r 2 value, which is a measure of how
good a chosen regression line fits the actual data, for either of the preceding
regressions is 0.0005, which is precisely equal to the product of the slope
coefficients in the two preceding regressions. The point to note here is that
in a bivariate regression, if we regress Y on X or vice versa, the r 2 value
remains the same.

OPTIONAL QUESTIONS

12
2.22. ∑ e = ∑ (Y − b − b X )
i i 1 2 i

= n Y − ∑ (Y − b X ) − b ∑ X 2 2 i [ Note : b1 = Y − b2 X ]

= n Y − n Y + b2 n X − b2 n X = 0

2.23. ∑ e X = ∑ (Y − b − b X ) X
i i i 1 2 i i

= ∑Y X − b ∑ X − b ∑ X i i 1 i 2 i
2

= 0, because of Equation (6.15).

2.24. ∑ e Ŷ = ∑ e (b + b X )
i i i 1 2 i

= b ∑e + b ∑e X
1 i 2 i i = 0 , using problems (2.22) and (2.23) above.

2.25. Since Yi = Ŷi + ei , summing over both sides over the sample, we obtain:

∑ Y = ∑ Ŷ + ∑ e
i i i

Dividing both sides by n, we obtain:

∑Y i / n = ∑ Ŷi / n + ∑ ei / n

Since the last term in this equation is zero (why?), the result follows.

2.26. ∑ x y = ∑ x (Y − Y ) = ∑ x Y − Y ∑ x = ∑ x Y , since Y is a constant and

i i i i i i i i i

since ∑ x = ∑ ( X − X ) = 0 , as shown in Equation (2.17). The other

i i

expressions in this problem can be derived similarly.

2.27. ∑ x = ∑(X
i i − X ) = ∑ X i − n X , since X is a constant

= n X − n X = 0 since X = ∑ X i / n

A similar result hold for ∑y . i

It is worth remembering that the sum of deviations of a random variable

from its mean value is always zero.

2.28. It is a simple matter of verification, save the rounding errors

13