Utility of the Frisch-Waugh theorem

I am supposed to teach the Frish Waugh theorem in econometrics, which I have not studied.

I have understood the maths behind it and I hope the idea too “the coefficient you get for a particular coefficient from a multiple linear model is equal to the coefficient of the simple regression model if you “eliminate” the influence of the other regressors”.
So the theoretical idea is kind of cool. (If I totally misunderstood I do welcome a correction)

But does it have some classical/practical usages ?

EDIT : I have accepted an answer, but am still willing to have new ones that bring other examples/applications.

Answer

Consider the fixed effects panel data model, also known as Least Squares Dummy Variables (LSDV) model.

bLSDV can be computed by directly applying OLS to the model y=Xβ+Dα+ϵ,
where D is a NT×N matrix of dummies and α represent the individual-specific fixed effects.

Another way to compute bLSDV is to apply the so called within transformation to the usual model in order to obtain a demeaned version of it, i.e. M[D]y=M[D]Xβ+M[D]ϵ.
Here, M[D]=ID(DD)1D, the residual maker matrix of a regression on D.

By the Frisch-Waugh-Lovell theorem, the two are equivalent, as FWL says that you can compute a subset of regression coefficients of a regression (here, ˆβ) by

  1. regressing y on the other regressors (here, D), saving the residuals (here, the time-demeaned y or M[D]y, because regression on a constant just demeans the variables), then
  2. regressing the X on D and saving the residuals M[D]X, and
  3. regressing the residuals onto each other, M[D]y on M[D]X.

The second version is much more widely used, because typical panel data sets may have thousands of panel units N, so that the first approach would require you to run a regression with thousands of regressors, which is not a good idea numerically even nowadays with fast computers, as computing the inverse of (D:X)(D:X) would be very expensive, whereas time-demeaning y and X is of little cost.

Attribution
Source : Link , Question Author : Anthony Martin , Answer Author : Christoph Hanck

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