# How to use Instrumental Variables

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1 How to use Instrumental Variables Questions that can be answered with experiments: 1) If I give people aspirin, what happens to their body temperature? 2) If I use fertilizer on tomato plants, do I get more tomatoes? Other conditions could affect outcome (hot room for body temperature, rainfall for plants) If I have the power to hold other conditions fixed, I do so. If I can t control other conditions, I randomize treatment so that treatment is uncorrelated with other changes in conditions. Questions that can t be answered with experiments: 1) What would happen to quantity demanded if I raise price, leave other determinants of demand the same? (Price elasticity of demand) Fool with price, see effect on quantity demanded. P º Q 2) What would happen to real GDP if I raise real interest rate, leave other determinants of real GDP the same? (Slope of IS curve) Fool with real interest rate, see effect on real GDP. r ºY

2 How you can t answer nonexperimental questions: collect data where variables of interest wriggle across time (time-series) units (cross-section) time & units (panel) and observe co-movements between variables. because other determinants/relevant conditions will be correlated with treatment 1) Anything that changes one economic variable changes others too -general equilibrium! 2) Reverse causality. In quantity demanded, treatment is P 1) other variables that affect Q D, perhaps correlated with P: I, other P s 2) supply Q S (P) In IS curve, treatment is r 1) other variables that affect Y, perhaps correlated with r: G, Y* (exports), Y e 2) Taylor rule r ' r % α(y&ȳ) % β(π&π ( )

3 How to approach nonexperimental questions 1) Ignore reverse causality and correlation with other determinants. - old papers - econometrics field, where goal is to demonstrate technique not answer questions 2) Answer question for a model, not real world In a model, you can exogenously wriggle variable of interest. To quantify parameters, assume model is true and fit reduced forms to data 3) Natural experiments Find some wriggles in treatment variable that are uncorrelated with other determinants Often involves instrumental variable: - something measureable that causes or indicates wriggles in treatment variable ( relevant ) - uncorrelated with other determinants ( valid ) e.g. in quantity demanded, variable that affects supply not demand in IS curve, exogenous variations in central bank setting of r

4 In terms of regressions Y ' β 1 % β 2 % ε (ε ' β 3 X 3 %...) Troublesome variable Control variable X 3... Unmeasurable determinants General equilibrium problems: Reverse causality: X 3 'α 31 %... 'α 13 X 3 %... ' α 14 X 4 %... X 3 ' α 34 X 4 %... ' α Y1 Y % α 15 X 5 %... º ' α Y1 β 1 % β 2 % ε % α 15 X 5 %... correlation with ε ü Instrumental variables Z: 1) Relevant: Z is correlated with ' γ Z1 Z 1 % γ Z2 Z 2 %... 2) Valid: Z is uncorrelated with ε (not cause or effect or common cause or...) X 3 ' 0 Z 1 % 0 Z 2 %... Exclusion restriction

5 Methods 1) 2SLS Good for small samples and/or probably-homoskedastic ε s 1) First stage Regress on Z. 2) Use first-stage coefficients to get predicted values ˆ Note there s lots of variation in not captured by ˆ 3) Second stage Regress Y on Note that it wouldn t be right to use SE s from second stage to judge significance - this wouldn t account for uncertainty about coefficients of first-stage regression. 2SLS SE s account for this. 2) GMM Good for large samples, heteroskedastic ε s Can allow for correlations across observations residuals. E.g. clustering (common in panels): ε s correlated across some observations, uncorrelated across others Problem! if instruments are weak (relevant but only weakly correlated with ) SE s too small and estimated coefficients biassed toward OLS values (though consistent as n Y 4) even in very large samples

6 How do you find instruments? How do you know if possible instruments are relevant and valid? 1) Think about why varies. List all possible reasons. 2) Think about other determinants of Y. List all possible X 3 s. 3) Which reasons for -variation are unrelated to X 3 and measurable? Of course, you must think about what causes Z to vary, and on and on... This is not a statistical issue. It s knowledge about the world (including economics). but there are..

7 Statistical methods to test whether candidate Z s are relevant, strong & valid 1) Look at first-stage regression. Check sign, significance, magnitude (plausible?) of coefficient on Z. Because of weak instrument problem, t-stats (or F-stats for multiple Z s) need to be lots bigger than 2. Rule of thumb : at least 10. 2) Look at reduced form regression of Y on Z Y ' β 1 γ Z1 Z 1 % γ Z2 Z 2 %... % β 2 % ε Sign, magnitudes of coefficients should be consistent with story. 3) If you have more than one Z ( is overidentified ) you can test one Z against others, see if results are consistent across Z s. Validity/exclusion restriction means all Z s uncorrelated with (Y & β 1 & β 2 ) a) Get estimates ˆβ 1, ˆβ 2 b) Calculate (Y& ˆβ 1 & ˆβ 2 ) c) Are Z s is uncorrelated with (Y& ˆβ 1 & ˆβ 2 )? Sargan test (for 2SLS), Hansen J-test (for GMM) Z s are OK if you fail to reject hypothesis.

8 Are lagged Y s and/or X s valid instruments? One of the most mechanical and naive, yet common, approaches to the choice of instruments uses atheoretical and hard-to-assess assumptions about dynamic relationships to construct instruments from lagged variables in time series or panel data. The use of lagged endogenous variables..is problematic if the equation error or omitted variables are serially correlated (Angrist & Krueger, 2001) E.g. in the Arellano-Bond panel estimator, identification results from lack of serial correlation in the errors (p. 293)

9 Are lagged Y s and/or X s valid instruments? (cont.) Example: supply and demand You want to estimate demand elasticity. Q D ' &bp t %ε t where ε t ' ρ D ε t&1 % ˆε t ρ D $0 Q S ' cp t %e t where e t ' ρ S e t&1 % ê t ρ S$0 ( β 1 '&b, α Y1 ' 1/c) so P t ' 1 b%c (ε t &e t ) Q t ' b b%c (ε t %e t ) 1) For P t&1 or Q t&1 to be relevant instruments for P t, and/or must be greater than zero. 2) but if, they are not valid ρ D 0 because they are correlated with ε t ρ D ρ S

10 Bottom line for you In every empirical anything, 1) Try to tell me why varies across observations within your sample 2) Choose one from below a) do not talk about effects (as in demand elasticity, IS curve slope,...) b) argue that most variation in is uncorrelated with unmeasurable determinants of Y variable c) use BS (fitted model) d) use instruments 3) If you choose d), i) Tell me what causes Z s to vary, why they are correlated with, why they are valid ii) Show first-stage and reduced-form regressions iii) Prove Z s are not weak with rule-of-thumb F-tests (or R 2 s) or other tests iv) Unless you can make very strong a priori case for validity, show Sargan or J-test

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