Requirement

Linearity

Multicollinearity

Heteroskedasticity
Autocorrelation

Normality

Outlier
 Conceptual Framework

Linearity is the property of a mathematical relationship or function which means

that it can be graphically represented as a straight line, that is, that one quantity is
simply proportional to another. It is represented as : y= m x + c

Multicollinearity is a phenomenon in which two or more predictor variables (Ind

variables) in a multiple regression model are highly correlated

One of the regression model assumption is that variance of errors is constant. If

the error terms do not have constant variance, they are said to be heteroskedastic.
Successive disturbance terms are uncorrelated and failure of this assumption is
termed as autocorrelation.

It arises due to omitting variable or other misspecification, due to data manipulation

e.g. using interpolated data or due to inertia which means that the momentum is
built into economic aggregates.

normality tests are used to determine if a data set is well-modeled by a normal

distribution and to compute how likely it is for a random variable underlying the
data set to be normally distributed.

An observation that is unusually small or large relative to the rest of observations.

 6x6 MATRIX
Submitted By: Sehar Salman Adil (ERP: 03228)

Consequences

When the equation is non linear, the change in X & Y variables is not proportionate.

Nonlinear equations are difficult to solve, nonlinear systems are commonly

approximated by linear equations.

An econometric problem that causes standard errors of the

coefficients to be overstated (variation within x values is low and disturbance
variance is high even if correlation is low) or t-ratios to be understated.

Important variables may appear statistically insignificant although overall

regression judged via F-test may be significant.

If multicolinearity is present,it is difficult to estimate the influence of individual X

variables on Y.

OLS estimates are less efficient

Standard errors are biased making statistical tests invalid.

OLS estimates (betas) are unbiased and consistent but less efficient and standard
error of coefficients is biased making tests invalid.

The main problem with autocorrelation is that it may make a model look better than
it actually is.

1. Coefficients are still unbiased

2. True variance of Beta hat is increased, by the presence of autocorrelations.
3. Estimated variance of Beta hat is smaller due to autocorrelation (downward
bias).
4. A decrease in SE(Beta hat) and an increase of the t-statistics; this results in the
estimator looking more accurate than it actually is.
5. R square becomes inflated.
All these problems result in hypothesis tests becoming invalid.

There are few consequences associated with a violation of the normality

assumption, as it does not contribute to bias or inefficiency in regression models. It
is only important for the calculation of p values for significance testing, but this is
only a consideration when the sample size is very small. When the sample size is
sufficiently large (>200), the normality assumption is not needed at all as the
Central Limit Theorem ensures that the distribution of disturbance term will
approximate normality.

The presence of outliers can lead to inflated error rates and substantial distortions
of parameter and statistic estimates when using either parametric or nonparametric
tests. It also has a significant effect on the mean and standard deviation.
RP: 03228)

Detection

The independent variables have power one.

It is often due to small sample sizes.High correlations

between X variables

Regress the squared residuals from the estimated model on

X variables.

May also be the result of model misspecification. Also,

Breusch-Pagan / Cook-Weisberg Test for
Heteroskedasticity, visual tests, Goldfeld-Quandt Test,
Likelihood Ratio Test and White Test can be used for
detection.
First order autocorrelation can be detected using Graphical
Approach or Durbin Watson Test.
d = 2 indicates no autocorrelation but less than 2 shows
serial correlation.

There are several statistics available to examine the

normality of variables. including skewness and kurtosis, as
well as numerous graphical depictions, such as the normal
probability plot. Histogram or a stem and leaf plot of the
residuals can be used to check the normality. If these
residuals are bell-shaped distributed, this might imply the
normality assumption might not be violated.

If substantial distortions are being seen in the data, the

presence of an outlier is the possibility.
 Remedial Measures General Remarks

Overall, a linear model is much more

simple than a quadratic model, and
If an equation is non linear you can differentiate it or often works just as well for most
use log to convert it to linear. purposes.However, it depends upon the
usage and applicability as to where it
can work the best.

Multicolleanity issue must be resolved if

the purpose of making the decision is to
A variable (with weak economic justification, not a
understand the demand function,
core variable) can be deleted
however if forecasting is the prime
purpose, it may not be that big an issue.

Use heteroskedasticity-consistent errors

Heteroskedasticity can be very
Apply a weighted least squares estimation method,
problematic with methods besides OLS.
in which OLS is applied to transformed or weighted
For example, in logistic regression
values of X and Y.
heteroskedasticity can produce biased
and misleading parameter estimates.
Use robust Standard Errors
 Detection of autocorrelation is of utmost
Use adjusted standard errors to account for
importance as In its presence, a
Autocorrelation.
business manager can make wrong
business decisions and may invest in
The approach is to use HAC (hetero-auto
expenditures which actually do not
corrected) standard errors.
impact the depedent variable.

When the distribution of the disturbance term is

found to deviate from normality, the best solution is
to use a more conservative p value (.01 rather
than .05) for conducting significance tests and
constructing confidence intervals.
Use non-parametric tests
The abuse of normal distributio is one of
the greatest hoaxes in the human
intellectual history. It is very essential to
note that the normality assumption
holds very true in real life scenarios.

Delete the outlier values that is bringing large

Outliers at all times should be avoided
changes in the results if its an influential
so that the data is not distorted and a
observation and due to data entry error etc. If its not
much clear situation in terms of
a measurement error, then judgement has to be
information is available to the user.
used.