# Lecture 16. Endogeneity & Instrumental Variable Estimation (continued)

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1 Lecture 16. Endogeneity & Instrumental Variable Estimation (continued) Seen how endogeneity, Cov(x,u) 0, can be caused by Omitting (relevant) variables from the model Measurement Error in a right hand side variable Simultaneity (interdependence) between variables Solution: instrumental variable estimation - Find variable(s) correlated with the problem variable but which does not suffer from endogeneity So b1 IV = Cov( Z, y) Cov( Z, X ) (compare with b1 OLS = Cov( X, y) Var( X ) ) 1

2 This process of using extra exogenous variables as instruments for endogenous RHS variables is known as identification If there are no additional exogenous variables outside the original equation that can be used as instruments for the endogenous RHS variables then the equation is said to be unidentified 2

3 Consider the previous example Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + v (2) We know Price and Wage are interdependent so can t use OLS Consider each equation in turn In (1) 1 Endogenous right hand side variable (Wage) so we need an instrument variable that is correlated with wage but not with error term e In this case we can use unemployment, since it is not in (1) but is correlated with wages via (2) and is uncorrelated with e by the assumption of the model Equation (1) said to be (just) identified. There is an instrument for Wage (which is Unemployment) so can use IV on equation (1) 3

4 Now consider equation (2) in the system Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + v (2) Would like to estimate effect of prices on wages in (2), but because prices and wages are interdependent, OLS estimates suffer from endogeneity bias 4

5 Now consider equation (2) in the system Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + v (2) Would like to estimate effect of prices on wages in (2), but because prices and wages are interdependent, OLS estimates suffer from endogeneity bias Now in equation (2) 1 Endogenous rhs variable (Price) 5

6 Now consider equation (2) in the system Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + v (2) Would like to estimate effect of prices on wages in (2), but because prices and wages are interdependent, OLS estimates suffer from endogeneity bias Now in equation (2) 1 Endogenous rhs variable (Price) 1 Exogenous rhs variables (Unemployment) 6

7 Now consider equation (2) in the system Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + v (2) Would like to estimate effect of prices on wages in (2), but because prices and wages are interdependent, OLS estimates suffer from endogeneity bias Now in equation (2) 1 Endogenous rhs variable (Price) 1 Exogenous rhs variables (Unemployment) Can we find an instrument for price this time? 7

8 Now consider equation (2) in the system Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + v (2) Would like to estimate effect of prices on wages in (2), but because prices and wages are interdependent, OLS estimates suffer from endogeneity bias Now in equation (2) 1 Endogenous rhs variable (Price) 1 Exogenous rhs variables (Unemployment) Can we find an instrument for price this time? This time given the model equation (2) is not identified. Since there are no available instruments that appear in (1) so can t use IV 8

9 Suppose now that Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) 9

10 Suppose now that Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) ie added another exogenous variable, Productivity, to (2). and we assume Cov(Productivity, v) = 0 (ie it is exogenous) 10

11 Suppose now that Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) ie added another exogenous variable, Productivity, to (2). and we assume Cov(Productivity, v) = 0 (ie it is exogenous) Want to estimate effect of wages on prices in (1) and because wages and prices interdependent we know that OLS would gives us biased estimates of b1 11

12 Suppose now that Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) ie added another exogenous variable, Productivity, to (2). and we assume Cov(Productivity, v) = 0 (ie it is exogenous) Want to estimate effect of wages on prices in (1) and because wages and prices interdependent we know that OLS would gives us biased estimates of b1 In this case equation (1) said to be over-identified 12

13 Suppose now that Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) ie added another exogenous variable, Productivity, to (2). and we assume Cov(Productivity, v) = 0 (ie it is exogenous) Want to estimate effect of wages on prices in (1) and because wages and prices interdependent we know that OLS would gives us biased estimates of b1 In this case equation (1) said to be over-identified (more instruments - other exogenous variables that do not appear in (1) in this case unemployment & productivity ) than strictly necessary for IV estimation) 13

14 If in an over-identified equation there are more instruments (other exogenous variables) than strictly necessary for IV estimation which instrument to use? 14

15 Again consider the model Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) 15

16 Again consider the model Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) If use unemployment then as before, the IV estimator ^ Cov( Z, y ) b IV = = Cov( Z, X ) Cov( Unemp, Pr ice) Cov( Unemp, Wage) 16

17 Again consider the model Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) If use unemployment then as before, the IV estimator ^ Cov( Z, y ) b IV = = Cov( Z, X ) Cov( Unemp, Pr ice) Cov( Unemp, Wage) If instead use Productivity then ^ Cov( Z, y ) b IV = = Cov( Z, X ) Cov(Pr od, Pr ice) Cov(Pr od, Wage) 17

18 Again consider the model Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) If use unemployment then as before, the IV estimator ^ Cov( Z, y ) b IV = = Cov( Z, X ) Cov( Unemp, Pr ice) Cov( Unemp, Wage) If instead use Productivity then ^ Cov( Z, y ) b IV = = Cov( Z, X ) Cov(Pr od, Pr ice) Cov(Pr od, Wage) Which is best? 18

19 Again consider the model Price = b0 + b1wage + e (1) Wage = d0 + d1price + d2unemployment + d3productivity + v (2) If use unemployment then as before, the IV estimator ^ Cov( Z, y ) Cov( Unemp, Pr ice) b IV = = Cov( Z, X ) Cov( Unemp, Wage) If instead use Productivity then ^ Cov( Z, y ) b IV = = Cov( Z, X ) Cov(Pr od, Pr ice) Cov(Pr od, Wage) Which is best? Both will give unbiased estimate of true value, but likely (especially in small samples) that estimates will be different. 19

20 In practice use both at the same time 20

21 In practice use both at the same time - removes possibility of conflicting estimates 21

22 In practice use both at the same time - removes possibility of conflicting estimates - is more efficient (smaller variance) at least in large samples. 22

23 In practice use both at the same time - removes possibility of conflicting estimates - is more efficient (smaller variance) at least in large samples. (Remember though with small samples more efficient to use the minimum number of instruments) 23

24 How in practice is this done (using both instruments at once)? 24

25 How in practice is this done (using both instruments at once)? Given Price = b0 + b1wage + e (1) We know 25

26 How in practice is this done (using both instruments at once)? Given Price = b0 + b1wage + e (1) We know Wage = d0 + d1price + d2unemployment + d3productivity + v (2) 26

27 How in practice is this done (using both instruments at once)? Given Price = b0 + b1wage + e (1) We know Wage = d0 + d1price + d2unemployment + d3productivity + v (2) and that Wage is related to the exogenous variables only by Wage = g0 + g1unemployment + g2productivity+ w (3) 27

28 How in practice is this done (using both instruments at once)? Given Price = b0 + b1wage + e (1) We know Wage = d0 + d1price + d2unemployment + d3productivity + v (2) and that Wage is related to the exogenous variables only by Wage = g0 + g1unemployment + g2productivity+ w (3) (the equation which expresses the endogenous right hand side variables solely as a function of exogenous variables is said to be a reduced form) 28

29 How in practice is this done (using both instruments at once)? Given Price = b0 + b1wage + e (1) We know Wage = d0 + d1price + d2unemployment + d3productivity + v (2) and that Wage is related to the exogenous variables only by Wage = g0 + g1unemployment + g2productivity+ w (3) (the equation which expresses the endogenous right hand side variables solely as a function of exogenous variables is said to be a reduced form) Idea is then to estimate (3) and save the predicted values 29

30 How in practice is this done (using both instruments at once)? Given Price = b0 + b1wage + e (1) We know Wage = d0 + d1price + d2unemployment + d3productivity + v (2) and that Wage is related to the exogenous variables only by Wage = g0 + g1unemployment + g2productivity+ w (3) (the equation which gives the endogenous right hand side variables solely as a function of exogenous variables is a reduced form) Idea is then to estimate (3) and save the predicted values ^ ^ ^ ^ wage = g 0 + g1unemp + g 2 Pr od and use these predicted values as the instrument for Wage in (1) 30

31 ^ The predicted variablewage = ^ g 0 + ^ g1unemp + ^ g 2 Pr od satisfies properties of an instrument since clearly correlated with variable of interest and because it is an average only of exogenous variables, is uncorrelated with the residual e in (1) (by assumption) 31

32 ^ The predicted variablewage = ^ g 0 + ^ g1unemp + ^ g 2 Pr od satisfies properties of an instrument since clearly correlated with variable of interest and because it is an average only of exogenous variables, is uncorrelated with the residual e in (1) (by assumption) This strategy is called Two Stage Least Squares (2SLS) and in general the formula for the 2SLS estimator is given by 32

33 ^ The predicted variablewage = ^ g 0 + ^ g1unemp + ^ g 2 Pr od satisfies properties of an instrument since clearly correlated with variable of interest and because it is an average only of exogenous variables, is uncorrelated with the residual e in (1) (by assumption) This strategy is called Two Stage Least Squares (2SLS) and in general the formula for the 2SLS estimator is given by ^ ^ Cov( X, y) ^ Cov( Z, y ) b2 sls = compare with the IV formula b ^ IV = Cov( Z, X ) Cov( X, X ) 33

34 ^ The predicted variablewage = ^ g 0 + ^ g1unemp + ^ g 2 Pr od satisfies properties of an instrument since clearly correlated with variable of interest and because it is an average only of exogenous variables, is uncorrelated with the residual e in (1) (by assumption) This strategy is called Two Stage Least Squares (2SLS) and in general the formula for the 2SLS estimator is given by ^ ^ Cov( X, y) ^ Cov( Z, y ) b2 sls = compare with the IV formula b ^ IV = Cov( Z, X ) Cov( X, X ) which in the example above becomes ^ ^ Cov( Wage, Pr ice) b2 sls = ^ Cov( Wage, Wage) 34

35 Note: In many cases you will not have a simultaneous system. More than likely will have just one equation but there may well be endogenous RHS variable(s). In this case the principle is exactly the same. - Find additional exogenous variables that are correlated with the problem variable but uncorrelated with the error ( as if there were another equation in the system). 35

36 Note: In many cases you will not have a simultaneous system. More than likely will have just one equation but there may well be endogenous RHS variable(s). In this case the principle is exactly the same. - Find additional exogenous variables that are correlated with the problem variable but uncorrelated with the error ( as if there were another equation in the system). Not easy 36

37 Note: In many cases you will not have a simultaneous system. More than likely will have just one equation but there may well be endogenous RHS variable(s). In this case the principle is exactly the same. - Find additional exogenous variables that are correlated with the problem variable but uncorrelated with the error ( as if there were another equation in the system). Not easy - in time series data sets you may be able to use lagged values of the data as possible instruments since lagged values are less likely to be influenced by current shocks 37

38 Note: In many cases you will not have a simultaneous system. More than likely will have just one equation but there may well be endogenous RHS variable(s). In this case the principle is exactly the same. - Find additional exogenous variables that are correlated with the problem variable but uncorrelated with the error ( as if there were another equation in the system). Not easy - in time series data sets you may be able to use lagged values of the data as possible instruments since lagged values are less likely to be influenced by current shocks Cov(Xt, ut) 0 but Cov(Xt-1, ut) = 0 38

39 Eg. GDPt = b0 + b1educationt + ut 39

40 Eg. GDPt = b0 + b1educationt + ut Both interdependent since education may well affect a country s growth potential, but equally richer countries can afford to spend more on education So OLS on (A) would give us biased estimates because of endogeneity 40

41 Eg. GDPt = b0 + b1educationt + ut Both interdependent since education may well affect a country s growth potential, but equally richer countries can afford to spend more on education So OLS on (A) would give us biased estimates because of endogeneity Better to used lagged values of Education since harder to argue that GDP growth now affects education expenditure 5 ((or 10) years ago 41

42 Eg. GDPt = b0 + b1educationt + ut Both interdependent since education may well affect a country s growth potential, but equally richer countries can afford to spend more on education So OLS on (A) would give us biased estimates because of endogeneity Better to used lagged values of Education since harder to argue that GDP growth now affects education expenditure 5 ((or 10) years ago Same argument applies to using lagged values of right hand side variables as instruments 42

43 Example two (line inflation time) (line avearn time, xlabel( ) ytitle(% change) clpattern(dash)) % change time annual % change in retail prices annual % change in earnings The data set prod.dta contains quarterly time series data on wage, price, unemployment and productivity changes The graph suggests that wages and prices move together over time and suggests may want to run a regression of inflation on wage changes where by assumption (and nothing else) the direction of causality runs from changes in wages to changes in inflation. reg inf avearn Source SS df MS Number of obs =

44 F( 1, 138) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = inflation Coef. Std. Err. t P> t [95% Conf. Interval] avearn _cons which suggests an almost one-for-one relation between inflation and wage changes over this period. However you might equally run a regression of wage changes on prices (where now the implied direction of causality is from changes in the inflation rate to changes in wages). reg avearn inf Source SS df MS Number of obs = F( 1, 138) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = avearn Coef. Std. Err. t P> t [95% Conf. Interval] inflation _cons this suggests wages grow at constant rate of around 2.5% a year (the coefficient on the constant) and then each 1 percentage point increase in the inflation rate adds a.89 percentage point increase in wages. Which is right specification? In a sense both, since wages affect prices but prices also affect wages. The 2 variables are interdependent and said to be endogenous. This means that Cov(X,u) 0 ie a correlation between right hand side variables and the residuals which makes OLS estimates biased and inconsistent. 44

45 Need to instrument the endogenous right hand side variables. ie find a variable that is correlated with the suspect right hand side variable but uncorrelated with the error term. Now it is not easy to come up with good instruments in this example since many macro-economic variables are all interrelated, but one possible solution with time series data is to use lags of the endogenous variable. The idea is that while inflation may affect wages and vice versa it is less likely that inflation can influence past values of wages and so they might be used as instruments for wages Suppose decide to use the 3 and 4 year lag of wages as instruments for wages in the inflation regression Which instrument to use? Both should give same estimate if sample size is large enough but in finite (small) samples the two IV estimates can be quite different. sort year q /* important to sort the data before taking lags */ g wlag3=avearn[_n-12] (16 missing values generated) g wlag4=avearn[_n-16] (20 missing values generated) /* note lose observations when take lags cant calculate lags of values toward the start of the time period */ 45

46 Using the 3 year lag as an instrument ivreg inf (avear=wlag3) Instrumental variables (2SLS) regression Source SS df MS Number of obs = F( 1, 126) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = inflation Coef. Std. Err. t P> t [95% Conf. Interval] avearn _cons Instrumented: avearn Instruments: wlag3 Using the 4 year lag as an instrument ivreg inf (avear=wlag4) Instrumental variables (2SLS) regression Source SS df MS Number of obs = F( 1, 122) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = inflation Coef. Std. Err. t P> t [95% Conf. Interval] avearn _cons Instrumented: avearn Instruments: wlag4 46

47 Both estimates are similar and higher than original OLS estimate So which one? Best idea (which also gives more efficient estimates ie ones with lower standard errors) is to use all the instruments at the same time at least in large samples 1. Regress endogenous variables (wages) on both instruments (wage t-3 and wage t-4 ). reg avearn wlag4 wlag3 Source SS df MS Number of obs = F( 2, 121) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = avearn Coef. Std. Err. t P> t [95% Conf. Interval] wlag wlag _cons Save predicted wage. predict wagehat /* stata command to save predicted value of dep. var. */ 2. Include this instead of wages on the right hand side of the inflation regression. reg inf wagehat Source SS df MS Number of obs = F( 1, 122) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE =

48 inflation Coef. Std. Err. t P> t [95% Conf. Interval] wagehat _cons This gives unbiased estimate of effect of wages on prices. Compare with original (biased) estimate, can see wage effect is a little larger, (though standard error of IV estimate is larger than in OLS). reg inf avearn if e(sample) Source SS df MS Number of obs = F( 1, 122) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = inflation Coef. Std. Err. t P> t [95% Conf. Interval] avearn _cons Stata does all this automatically using the ivreg2 command. Adding first to the command will also give the first stage of the two stage least squares regression which will help you decide whether the instruments are weak or not. ivreg2 inf (avearn=wlag3 wlag4), first First-stage regression of avearn: Ordinary Least Squares (OLS) regression Number of obs = 124 F( 2, 121) = Prob > F = Total (centered) SS = Centered R2 = Total (uncentered) SS = Uncentered R2 = Residual SS = Root MSE = avearn Coef. Std. Err. t P> t [95% Conf. Interval] wlag

49 wlag _cons Partial R-squared of excluded instruments: Test of excluded instruments: F( 2, 121) = Prob > F = Summary results for first-stage regressions: Shea Variable Partial R2 Partial R2 F( 2, 121) P-value avearn Instrumental variables (2SLS) regression Number of obs = 124 F( 1, 122) = Prob > F = Total (centered) SS = Centered R2 = Total (uncentered) SS = Uncentered R2 = Residual SS = Root MSE = inflation Coef. Std. Err. z P> z [95% Conf. Interval] avearn _cons Sargan statistic (overidentification test of all instruments): Chi-sq(1) P-val = Instrumented: avearn Instruments: wlag3 wlag4 Note that the instruments are jointly significant in the first stage (as suggested by the F value and the R 2 ) 49

50 Finding instruments is not easy - in time series data sets you may be able to use lagged values of the data as possible instruments since lagged values are less likely to be influenced by current shocks - in cross sections there may be economic policy interventions that could be plausibly exogenous but correlated with endogenous variable Eg. Raising of the school leaving age as an instrument for education exogenous since government policy but is correlated with average level of education) 50

51 Weak Instruments - The two stage least squares approach is also useful in helping illuminate whether the instrument(s) is good or not Can show that IV estimation strategy may not always be better than biased OLS if the correlation between the instrument and the endogenous variable is weak (at least in small samples) Sometimes instruments may be statistically significant from zero in the 1 st stage and still not good enough. 51

52 How do you know if instrument is weak? 52

53 How do you know if instrument is weak? The t value on the instrument will tell you if, net of the other coefficients, the instrument is a good one (it should at a minimum be significantly different from zero) 53

54 How do you know if instrument is weak? The t value on the instrument will tell you if, net of the other coefficients, the instrument is a good one (it should at a minimum be significantly different from zero) Cannot use the R 2 from the 1 st stage since this could be high purely because of the exogenous variables in the model and not the instruments 54

55 How do you know if instrument is weak? The t value on the instrument will tell you if, net of the other coefficients, the instrument is a good one (it should at a minimum be significantly different from zero) Cannot use the R 2 from the 1 st stage since this could be high purely because of the exogenous variables in the model and not the instruments Instead there is a rule of thumb (at least in the case of a single endogenous variable) that should only proceed with IV estimation if the F value (strictly net of the other exogenous variables on the right hand side of the model) in the test of the goodness of fit of the on the 1 st stage of 2SLS > 10 55

56 Can also look at the partial R 2 which is based on a regression that nets out the effect of the exogenous variable X2 on both endogenous variable X1 and the instrument, Z and is obtained from the following regression ^ 1. Regress X2 on X1 and save the predicted value X 2 2. Regress Z on X1 and save the predicted valuez ^ ^ 3. Regress X 2 on Z ^ The R 2 from this regression is the partial R 2 ( partials out the effect of X1 ) No threshold for the partial R 2 but the higher the value the greater the correlation between instrument and endogenous variable 56

57 If there is more than one potentially endogenous rhs variable in your equation the order condition (above) tells us that you will have to find at least one different instrument for each endogenous rhs variable (eg 2 endogenous rhs variables requires 2 different instruments). Again, each instrument should be correlated with the endogenous rhs variable it replaces net of the other existing exogenous rhs variables. In this case two stage least squares estimation means predicting a value for each of the endogenous variables based on the instruments. 57

58 The examples above are based on models where there is only an endogenous variable on the right hand side of the model In many cases you will have a combination of exogenous variables (X1) and endogenous variables (X2) on the right hand side Y = b0 + b1x1 + b2x2 + u In this case the only difference in estimation procedures is to make sure that you include the exogenous variables X1 at both stages of the two stage estimation process 58

59 Example 2: Poor Instruments & IV Estimation Often a poor choice of instrument can make things much worse than the original OLS estimates. Consider the example of the effect of education on wages (taken from the data set video2.dta). Policy makers are often interested in the costs and benefits of education. Some people argue that education is endogenous (because it also picks up the effects of omitted variables like ability or motivation and so is correlated with the error term). The OLS estimates from a regression of log hourly wages on years of education suggest that. reg lhw yearsed Source SS df MS Number of obs = F( 1, 4471) = Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = lhw Coef. Std. Err. t P> t [95% Conf. Interval] yearsed _cons extra year of education is associated with 7.6% increase in earnings. If endogeneity is a problem, then these estimates are biased, (upward if ability and education are positively correlated see lecture notes on omitted variable bias). So try to instrument instead. For some reason you choose whether the individual owns a dvd recorder. To be a good instrument the variable should be a) uncorrelated with the residual and by extension the dependent variable (wages) but b) correlated with the endogenous right hand side variable (education). 59

60 However when you instrument years of education using dvd ownership. ivreg lhw (yearsed=dvd) Instrumental variables (2SLS) regression Source SS df MS Number of obs = F( 1, 4471) = 0.16 Model Prob > F = Residual R-squared = Adj R-squared =. Total Root MSE = lhw Coef. Std. Err. t P> t [95% Conf. Interval] yearsed _cons Instrumented: yearsed Instruments: dvd The IV estimates are now negative (and insignificant). This does not appear very sensible. The reason is that dvd ownership is hardly correlated with education as the 1 st stage of the regression below shows. ivreg lhw (yearsed=dvd), first First-stage regressions Source SS df MS Number of obs = F( 1, 4471) = 3.64 Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = yearsed Coef. Std. Err. t P> t [95% Conf. Interval] dvd _cons

61 Moral: Always check the correlation of your instrument with the endogenous right hand variable. The first option on stata s ivreg command will always print the 1 st stage of the 2SLS regression ie the regression above in which you can tell if the proposed instrument is correlated with the endogenous variable by simply looking at the t value. Using the rule of thumb (at least in the case of a single endogenous variable) that should only proceed with IV estimation if the F value on the 1 st stage of 2SLS > 10. In the example above this is clearly not the case. In practice you will often have a model where some but not all of the right hand side variables are endogenous. Y = b 0 + b 1 X 1 = b 2 X 2 + u where X 1 is exogenous and X 2 is endogenous The only difference between this situation and the one described above is that you must include the exogenous variables X 1 in both stages of the 2SLS estimation process Example 3. The data set ivdat.dta contains information on the number of GCSE passes of a sample of 16 year olds and the total income of the household in which they live. Income tends to be measured with error. Individuals tend to mis-report incomes, particularly third-party incomes and non-labour income. The following regression may therefore be subject to measurement error in one of the right hand side variables. ivreg2 nqfede (inc1=ranki) female, first First-stage regressions Number of obs = 252 F( 2, 249) = Prob > F = Total (centered) SS = Centered R2 = Total (uncentered) SS = Uncentered R2 = Residual SS = Root MSE = inc1 Coef. Std. Err. t P> t [95% Conf. Interval] female ranki

62 _cons Partial R-squared of excluded instruments: Test of excluded instruments: F( 1, 249) = Prob > F = IV (2SLS) regression with robust standard errors Number of obs = 252 F( 2, 249) = Prob > F = R-squared = Root MSE = Robust nqfede Coef. Std. Err. t P> t [95% Conf. Interval] inc female _cons Instrumented: inc1 Instruments: female ranki Note that the exogenous variable female appears in both stages 62

63 Testing Instrumental Validity (Overidentifying Restrictions) If you have more instruments than endogenous right hand side variables (the equation is overidentified hence the name for the test) then it is possible to test whether (some of the) instruments are valid in the sense that they satisfy the assumption of being uncorrelated with the residual in the original model. Cov (z, u) =0 63

64 Testing Instrumental Validity (Overidentifying Restrictions) If you have more instruments than endogenous right hand side variables (the equation is overidentified hence the name for the test) then it is possible to test whether (some of the) instruments are valid in the sense that they satisfy the assumption of being uncorrelated with the residual in the original model. Cov(Z,u)=0 One way to do this would be, as in the example above, to compute two different 2SLS estimates, one using one instrument and another using the other instrument. If these estimates are radically different you might conclude that one (or both) of the instruments was invalid (not exogenous). If these estimates were similar you might conclude that both instruments were exogenous. 64

65 Testing Instrumental Validity (Overidentifying Restrictions) If you have more instruments than endogenous right hand side variables (the equation is overidentified hence the name for the test) then it is possible to test whether (some of the) instruments are valid in the sense that they satisfy the assumption of being uncorrelated with the residual in the original model. Cov(Z,u)=0 One way to do this would be, as in the example above, to compute two different 2SLS estimates, one using one instrument and another using the other instrument. If these estimates are radically different you might conclude that one (or both) of the instruments was invalid (not exogenous). If these estimates were similar you might conclude that both instruments were exogenous. 65

66 An implicit test of this that avoids having to compute all of the possible IV estimates - is based on the following idea Sargan Test (after Denis Sargan ) 66

67 Given y = b0 + b1x + u and Cov(X,u) 0 If an instrument Z is valid (exogenous) it is uncorrelated with u To test this simply regress u on all the possible instruments. u = d0 + d1z1 + d2z2 +. dlzl + v If the instruments are exogenous they should be uncorrelated with u and so the coefficients d1.. dl should all be zero (ie the Z variables have no explanatory power) 67

68 To test this simply regress u on all the possible instruments. u = d0 + d1z1 + d2z2 +. dlzl + v If the instruments are exogenous they should be uncorrelated with u and so the coefficients d1.. dl should all be zero (ie the Z variables have no explanatory power) Since u is never observed have to use a proxy for this. This turns out to be the residual from the 2SLS estimation estimated using all the possible instruments ^ 2sls ^ ^ u = y b 2sls b 2sls 0 1 X (since this is a consistent estimate of the true unknown residuals) 68

69 So to Test Overidentifying Restrictions 1. Estimate model by 2SLS and save the residuals 2. Regress these residuals on all the exogenous variables (including those X1 variables in the original equation that are not suspect) 2 ^ u sls = d0 + b1x1 + d1z1 + d2z2 +. dlzl + v and save the R 2 3. Compute N*R 2 4. Under the null that all the instruments are uncorrelated then N*R 2 ~ χ 2 with L-k degrees of freedom (L is the number of instruments and k is the number of endogenous right hand side variables in the original equation) 69

70 So to Test Overidentifying Restrictions 1. Estimate model by 2SLS and save the residuals 2. Regress these residuals on all the exogenous variables (including those X1 variables in the original equation that are not suspect) 2 ^ u sls = d0 + b1x1 + d1z1 + d2z2 +. dlzl + v and save the R 2 3. Compute N*R 2 4. Under the null that all the instruments are uncorrelated then N*R 2 ~ χ 2 with L-k degrees of freedom (L is the number of instruments and k is the number of endogenous right hand side variables in the original equation) Note that can only do this test if there are more instruments than endogenous right hand side variables (in just identified case the residuals and right hand side variables are uncorrelated by construction) Also this test is again only valid in large samples 70

71 Example: using the prod.dta file we can test whether some of the instruments (wage t-3 and wage t-4 ) are valid instruments for wages 1 st do the two stage least squares regression using all the possible instruments ivreg inf (avearn=wlag3 wlag4) Now save these 2sls residuals. predict ivres, resid and regress these on all the exogenous variables in the system (remember there may be situations where the original equation contained other exogenous variables, in which case include them here also). reg ivres wlag3 wlag4 Source SS df MS Number of obs = F( 2, 121) = 0.02 Model Prob > F = Residual R-squared = Adj R-squared = Total Root MSE = ivres Coef. Std. Err. t P> t [95% Conf. Interval] wlag wlag _cons The test is N*R 2 = 124* = 0.04 which is ~ χ 2 (L-k = 2-1) (L=2 instruments and k=1 endogenous right hand side variable) Since χ 2 (1) critical = 3.84, estimated value is below critical value so accept null hypothesis that some of the instruments are valid Can obtain these results automatically using the command: overid 71

72 Tests of overidentifying restrictions: Sargan N*R-sq test Chi-sq(1) P-value = Basmann test Chi-sq(1) P-value =

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