Introduction Examples Just-Identication Overidentication

Modelos Lineares
Variveis Instrumentais: Introduo
Cristine Campos de Xavier Pinto
CEDEPLAR/UFMG
Maio/2010
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Introduction Examples Just-Identication Overidentication
We assume that Y and X are random variables that satisfy
the following linear model:
Y
i
= X
i
+
i
, i = 1, .., N
However the assumption the assumption of zero conditional
mean of the error given the regressor is not satised
E[X
i

i
] ,= 0 =E[
i
[ X
i
] ,= 0
This is a much more serious violation that the one that allows
nonconstant variances and/or nonzero correlations across error
terms.
If the errors is correlated with the regressors, the OLS
estimator is inconsistent.
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Introduction Examples Just-Identication Overidentication
Using the matrix notation, we can write:

LS
=
_
X
/
X
_
1

_
X
/
y
_
= +
_
X
/
X
_
1
X
/

Using the Law of Large Numbers,

p lim
X
/
X
N
= p lim
_

N
i =1
X
/
i
X
i
_
N
= E
_
X
/
i
X
i
_
= M
XX
p lim
X
/

N
= p lim
_

N
i =1
X
/
i

i
_
N
= E
_
X
/
i

i
_
= M
X
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Introduction Examples Just-Identication Overidentication
and
p lim

LS
= +M
+
XX
M
X
. .

+
,=
This is only a problem if you want to identify rather than
+
.
Another way to think about this, is that when E
_
X
/
i

i
_
,= 0,
then ols is solving the wrong sample moment condition,
0 =
1
N
N

i =1
X
//
i
(Y
i
X
i
)
The classical solution for this problem is instrumental
variables.
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Introduction Examples Just-Identication Overidentication
We suppose that there is a vector of instruments Lx1, Z
t
which is observable and satises
E[Z
i

i
] = M
Z
= 0 for all i (IV1)
and
E
_
Z
i
X
/
i
_
= M
ZX
(IV2)
is a LxK matrix with full rank, rank [M
ZX
] = K.
This rank condition, which is a sucient condition for
identication, implies a weaker order condition which is a
necessary condition for identication
L _ K
The number of instrumental variables needs to be at least as
large as the number of regressors.
The instrumental variables are the exogenous variables in that
problem.
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Introduction Examples Just-Identication Overidentication
Under the assumptions, we solve our "identication problem".
Using the matrix notation
y = X+
where X = [1, X
2
, ..., X
K
] and we have a vector of instruments
Z = [1, X
2
, ..., X
K1
, Z
1
]
Using assumptions above, we have K population orthogonal
conditions:
E
_
Z
/

_
= 0
Multiplying the linear model by Z
/
, and taking the
expectations
E
_
Z
/
X
_
= E
_
Z
/
Y
_
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Introduction Examples Just-Identication Overidentication
This a system of K linear equations and K unkonws. Under
the full rank assumption
=E
_
Z
/
X
_
1
E
_
Z
/
Y
_
Assuming that we have a random sampling of
X
i
, Y
i
, Z
1i

N
i =1
, the sample analog estimator of is

=
_
1
N
N

i =1
Z
/
i
X
i
_
1

_
1
N
N

i =1
Z
/
i
Y
i
_
Note that conditions IV1 and IV2 are very important in
identifying .
Question: Can we test these conditions?
We cannot test IV1, but we can test if Z
1i
is partly correlated
with X
k
.
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Introduction Examples Just-Identication Overidentication
Example 1: Autocorrelation and Lagged Dependent
Variables: The population model is
Y
t
= X
t
+ Y
t1
+
t

t
=
t1
+u
t
where u
t

T
t=1
are i.i.d with mean zero and variance
2
u
, and
are independent of X
s
for all s.
Note that
E[Y
t1

t
] = E[Y
t2

t1
] + E
_

2
t1

,= 0 if ,= 0
Vector of instruments: Z
t
= (X
t
, X
t1
)
/
as instruments for
(X
t
, Y
t1
) .
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Introduction Examples Just-Identication Overidentication
Example 2 (natural experiment): Angrist (1990) studies
the eect of serving in Vietnam war on earnings of men.
Participation is not exogenous, for example is correlated with
unobserved ability.
Y
i
= X
i
+
i
but E[X
i

i
] ,= 0.
Instrumental Variable: Indicator variable that equals 1 if the
individual i had a low draft lottery number during the
Vietnam war years. The lottery was randomly determined.
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Introduction Examples Just-Identication Overidentication
Example 3 (Friedmans model of permanent income): In this
model, the individual consumption function is
Y
i
= + P
i
+
i
where Y
i
is consumption and P
i
is "permanent income". We
do not see permanent income, but a "measured income",
which assumes this form
X
i
= P
i
+v
i
where v
i
is a transitory income. There are two assumptions
that we can impose in the observable data to get an
instrumental variable.
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Introduction Examples Just-Identication Overidentication
Assumption 1: There are some other variables related to
permanent income, such as nancial wealth ("W
i
") that is
observed. Suppose that wealth is linearly related to
permanent income
W
i
= + P
i
+
i
where the "transitory components" (
i
, v
i
,
i
) are independent
of P
i
, and satisfy the following assumptions
E[
i
] = E[v
i
] = E[
i
] = 0
E[
i

i
] = E[v
i

i
] = 0
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Introduction Examples Just-Identication Overidentication
In this the model can be written as
Y
i
= + X
i
+
i
where

i
=
i
v
i
In this case: E[X
i

i
] ,= 0, but we can use W
i
as an instrument.
E[W
i

i
] = E[( + P
i
+
i
) (
i
v
i
)]
= 0
E[W
i
X
i
] = E[( + P
i
+
i
) (P
i
+v
i
)]
= E
_
P
2
i

,= 0 if ,= 0
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Introduction Examples Just-Identication Overidentication
Assumption 2: We have a "causal model" relating
permanent income to observable variable W
i
(nancial wealth
, education, work experience, etc.). We can write the model:
P
i
= W
/
i
+
i
where
i
, v
i
,
i
are independent of W
i
, with
E[
i
] = E[v
i
] = E[
i
] = 0.
If ,= 0, then W
i
is correlated with P
i
.
In this case,
E[W
i
X
i
] = E
_
W
i
_
W
/
i
+
i
+v
i
__
= E
_
W
i
W
/
i
_
,= 0
but
E[W
i

i
] = E[W
i
(
i
v
i
)] = 0
We can Z
i
=
_
1, W
/
i
_
as instruments for (1, X
i
)
/
.
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Introduction Examples Just-Identication Overidentication
Example 4: Supply and Demand Model
Demand Function: Q
i
= + P
i
+ Y
i
+
i
where Y
i
includes variables that shifts the demand function,
besides price, but it does not aect the supply.
The inverse supply function is
P
i
= + Q
i
+ W
i
+v
i
where W
t
are the "supply-shifter" variables, that does not
aect demand.
Assuming that (Y
t
, W
t
) are exogenous
E
_
Y
i

i
Y
i
v
i
W
i

i
W
i
v
i
_
= 0
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Introduction Examples Just-Identication Overidentication
Z
i
= (1, Y
i
, W
i
)
/
is uncorrelated with (
i
, v
i
), assuming
E[v
i
] = E[
i
] = 0
If ,= 0, E[W
i
P
i
] ,= 0
If ,= 0, E[Y
i
Q
i
] ,= 0
Under these conditions, we can use Z
i
= (1, Y
i
, W
i
) as
instrumental variables for (1, Y
i
, P
i
) in the demand function,
and for (1, Q
i
, W
i
) in the supply function.
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Introduction Examples Just-Identication Overidentication
Suppose we have a vector of Lx1 instrumental variables.
In the just identied case: K = L
In IV estimator for the linear model is well dened

IV
=
_
Z
/
X
_
1
Z
/
Y
=
_
1
N
N

i =1
X
/
i
Z
i
_
1

_
1
N
N

i =1
Z
/
i
Y
i
_
Under the assumptions IV1and IV2,

IV
= +
_
1
N
N

i =1
X
/
i
Z
i
_
1

_
1
N
N

i =1
Z
/
i

i
_
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Introduction Examples Just-Identication Overidentication
Using the weak law of large numbers and Slutskys theorem,
p lim
_
1
N
N

i =1
X
/
i
Z
i
_
1
= M
1
ZX
p lim
_
1
N
N

i =1
Z
/
i

i
_
= M
Z
= 0
so

IV

p
+M
1
ZX
M
Z
=
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Introduction Examples Just-Identication Overidentication
One interpretation for the IV estimator is as a method of
moments estimator.

IV
solves the IV estimating equations:
0 =
1
N
Z
_
Y X
/

IV
_
=
1
N
N

i =1
Z
/
i
_
Y
i
X
i

IV
_
which corresponds to the correct population moment
E
_
Z
/
i
(Y
i
X
i
)
_
= E[Z
i

i
] = M
Z
= 0
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Introduction Examples Just-Identication Overidentication
There are more instrumental variables than regressors: L > K.
In this case, we have an overdetermined system of equations
(more equations than unknown

components). In general,
the solution for this system of equations does not exist.
Strategy 1: "Throw out" some of the "extra" instruments to
make L = K.
General Strategy: Use a linear combination of the
instrumental variables. Premultiply the vector Z
i
, Lx1, by
some matrix (LxK),

and use the vector, Kx1,

/
Z
t
as
instruments.
The matrix

can be a random matrix.

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Introduction Examples Just-Identication Overidentication
Example (Special Case): Suppose we use a nonramdom
matrix

/
= (I
K
, 0)
This matrix will delete the last L K components.
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Introduction Examples Just-Identication Overidentication
We require that the square matrix

Z
t
X to have full rank K .
This assumption implies that the rank of

must be K with
probability one.
The generalized instrumental variable estimator:

GIV
_

_
=
_

/
Z
/
X
_
1
_

/
Z
/
Y
_
whose asymptotic properties will depend on the particular
sequence of

matrices, except in the case where

is
nonrandom and we are back to the just-identied case.
The traditional choice of

is

=
_
Z
/
Z
_
1
Z
/
X
where

is a LxK matrix of least squares coecients for the

regression of the columns of X on the matrix X.
The tted value of this regression is Z

is "correlated" with
X.
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Introduction Examples Just-Identication Overidentication
If we use the traditional choice of

, we have the two-stage

least squares (2SLS) estimator,

2SLS
=
_
X
/
Z
_
Z
/
Z
_
1
Z
/
X
_
1

_
X
/
Z
_
Z
/
Z
_
1
Z
/
Y
_
=
_

X
/
X
_
1

X
/
Y
where

X = Z

is the predicted values of X from the

regression of X on Z.
In this case, we use

X as instruments for X.
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Introduction Examples Just-Identication Overidentication
We can express this estimator using orthogonal projectors.
Note that
P
Z
= Z
_
Z
/
Z
_
1
Z
/

X = P
Z
X
We can the 2SLS estimator as

2SLS
=
_
X
/
P
Z
X
_
1

_
X
/
P
Z
Y
_
=
_

X
/

X
_
1

X
/
Y
We can obtain

2SLS
in two steps:
1 Fit a "reduced form" regression for X
i
on Z
i
, and get the
tted values.
2 Use the tted values as IVS in the second stage regression.
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Introduction Examples Just-Identication Overidentication
Under assumption IV1, IV2 and assuming that
rank
_
Z
/
Z
_
= L, we can show that

SLS

p

Note that we can write

2SLS
= +
_
_
_
1
N
N

i =1
X
/
i
Z
i
_

_
1
N
N

i =1
Z
/
i
Z
i
_
1

_
1
N
N
/

i =1i
Z
/
i
X
i
_
_
_
1

_
1
N
N

i =1
X
/
i
Z
i
_

_
1
N
N

i =1
Z
/
i
Z
i
_
1

_
1
N
N
/

i =1i
Z
/
i

i
_
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Introduction Examples Just-Identication Overidentication
Using the WLLN,
_
1
N
N

i =1
Z
/
i
Z
i
_
1

p
_
E
_
Z
/
Z
__
1
= M
ZZ
_
1
N
N

i =1
X
/
i
Z
i
_

p
M
XZ
_
1
N
N

i =1
Z
/
i

i
_

p
M
Z
= 0 (by assumption IV2)
At the end,

2SLS

p
+
_
M
XZ
M
1
ZZ
M
ZX

1
M
XZ
M
1
ZZ
0 =
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References
Rudd: 20
Hayashi: 3
Wooldridge: 5
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