Introduction to Econometrics

Fall 2009
Wk14. Simultaneous Equations
and IV Technique

2
Structural and reduced-form
equation
Structural form
C =
0
+
1
Y+u
Y = C + I

Reduced form [endogenous variables
as a function of exogenous variables]
C = (
0
/1-
1
)+(
1
/1-
1
)I+(1/1-
1
)u
Y = (
0
/1-
1
)+(1/1-
1
)I+(1/1-
1
)u
3
Simultaneous equation bias
If you apply OLS on the structural
equations,
1
will be biased.
This is because there is a correlation
between the endogenous variable on
the RHS and the error of that equation.
i.e. Cov (Y,u)0
4
Indirect least squares
Estimate the reduced form model and
find the parameters of the structural
equation
Example from agriculture:
Demand: Q =
0
+
1
P +
2
Y + u
Supply: Q =
0
+
1
P +
2
R + v
where: Y is [exogenous] income
R is [exogenous] rainfall
5
Reduced form is:

P = (
0
-
0
)/(
1
-
1
) -
2
/(
1
-
1
)Y +
2
/(
1
-
1
)R + e
1

=
0
+
1
Y+
2
R+e
1

Q = (
0
+
1

0
) + (
1

1
+
2
)Y +
1

2
R + e
2
=
0
+
1
Y +
2
R +e
2

We can now run OLS to get estimates of
and .
6
Hence:
2
2
1

o =
1 1 1 2


o o =
|
|
.
|

\
|
+ =
1
2
1 1

o
o |
0 1 0 0


o o =
)

(

1 1 2 2
| o | =
)

1 1 0 0 0
| o o | + =
All structural parameters can be estimated
unambiguously.
7
Identification (Order condition)
X = number of exogenous variables in
the system of equations that are
excluded from a particular equation
N = number of endogenous variables on
the RHS of a particular equation
Equation not identified if X<N
Equation exactly identified if X=N
Equation overidentified if X>N
8
IV Estimator
Y =
0
+
1
X+u
Variables correlated with the error term
are called endogenous variables
Variables uncorrelated with the error
term are called exogenous variables
Instrumental variables technique is a
general single equation estimation
method useful to tackle endogeneity
issues.
9
Two conditions a valid instrument
What we need is a good instrument, Z.
Instrument relevance: corr(Z,X)0
Instrument exogeneity: corr(Z,u)=0
Then we do the following two-stage
least squares (2SLS)
10
2SLS
Stage 1: Regress X on instrumental variables
Z and included exogenous variables W using
OLS. Computed the predicted values for the
regression .
Stage 2: Regress Y on the predicted values
on the endogenous variables and
included exogenous variables W using OLS.

X