y = X + u

where

If the unknown vector in above equation is replaced by some
estimate b, this defines a vector of residuals e,
e = y Xb
The least-squaresq principle is to choose b to minimize the residual
sum of squares, ee, namely
R = ee
= !y Xb"! y Xb"
= yy bXy yXb # bXXb
= yy $bXy # bXXb
The first order conditions are
%ivin& the normal equations
!XX)b = Xy
1
1
1
1
]
1

1
1
1
1
]
1

k kn n
k
k
X X
X X
X X
X

$
'
$
$ $$
' $'
and
'
'
'
( $ $
" !
+

Xb X y X
b
RSS
y X X X b
'
" !
' $
" ! " !

X X b Var
Decomposition of the Sum of Squares
!yy ny
$
" = !bXXb ny
$
" # ee
T = ) R
Goodness of Fit/ Fit of Various Specifications

** The ad+usted R
$
takes e,plicit account of the number of
re&ressors used in the equation- It is useful for comparin& the
fit of specifications that differ in the addition or deletion of
e,planatory variables-
** The unad+usted R
$
will never decrease with the addition of any
variable to the set of re&ressors-
Schwarz Criterion
Akaike Information Criterion
)!u" = ( and
.ar!u" = )!uu" =
$
I
TSS
RSS
TSS
ESS
R '
$
k n
n
R R

'
" ' ! '
$ $
n
n
k
n
e e
SC ln ln +

n
k
n
e e
AIC
$
ln +

(
(
(
(
" !
" !
" !
" !
$
'
$
'

1
1
1
1
]
1

1
1
1
1
]
1

1
1
1
1
]
1

n n
u E
u E
u E
u
u
u
E u E
The matri, is the variance and-covariance matri, of the
disturbance term- The variances are displayed on the main
dia&onal and the covariances in the off-dia&onal positions-
The first assumption is that the disturbance variance is constant
and finite at each sample point- This condition of contancy of
variance is termed as homoscedasticity, and the observed
condition, where the disturbance variances are not same at all
points, is termed as heteroscedasticity-
The second assumption is that the disturbances are pairwise
uncorrelated. In other words, the / terms of all observations
are all statistically independent and not interrelated- 0hen this
condition of mutual statistical independence of disturbance
fails, the disturbances are said to be autocorrelated or serially
correlated-
[ ]

,
_

,
_

1
1
1
1
]
1

" ! " ! " !
" ! " ! " !
" ! " ! " !
" !
$
$ '
$
$
$ ' $
$ '
$
'
$ '
$
'
n n n
n
n i
n
n
u E u u E u u E
u u E u E u u E
u u E u u E u E
u u u
u
u
u
E u u E

I
u u u u u
u u u u u
u u u u u
n n n
n
n
$
$
$
$
$ '
$ $ ' $
' $ ' '
( (
( (
( (
" var! " cov! " cov!
" cov! " var! " cov!
" cov! " cov! " var!

,
_

,
_