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Normalization in Econometrics 

Authors: James D. Hamilton ab;  Daniel F. Waggoner ab; Tao Zha ab
Affiliations:   a University of California, San Diego, California, USA
b Federal Reserve Bank of Atlanta, Atlanta, Georgia, USA
DOI: 10.1080/07474930701220329
Publication Frequency: 6 issues per year
Published in: journal Econometric Reviews, Volume 26, Issue 2 - 4 March 2007 , pages 221 - 252
Formats available: HTML (English) : PDF (English)
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Abstract

The issue of normalization arises whenever two different values for a vector of unknown parameters imply the identical economic model. A normalization implies not just a rule for selecting which among equivalent points to call the maximum likelihood estimate (MLE), but also governs the topography of the set of points that go into a small-sample confidence interval associated with that MLE. A poor normalization can lead to multimodal distributions, disjoint confidence intervals, and very misleading characterizations of the true statistical uncertainty. This paper introduces an identification principle as a framework upon which a normalization should be imposed, according to which the boundaries of the allowable parameter space should correspond to loci along which the model is locally unidentified. We illustrate these issues with examples taken from mixture models, structural vector autoregressions, and cointegration models.
Keywords: Cointegration; Local identification; Mixture distributions; Maximum likelihood estimate; Numerical Bayesian methods; Regime-switching; Small sample distributions; Vector autoregressions; Weak identification
JEL Classification: C1; C32
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