Journal of Econometrics 5 (1977) 389-401.

0 North-Holland Publishing Company

ERRORS IN VARIABLES IN SIMULTANEOUS

EQUATION MODELS*

Jerry A. HAUSMAN
Massachusetts Institute of Technology, Cambridge, MA 02139, USA

Received December 1974, final version received July 1976

The simultaneous equation model is considered when errors in variables are present in the
exogenous variables. By means of a distributional assumption on the exogenous variables, the
system is transformed into an augmented structural model. Full information estimation by
means of maximum-likelihood and instrumental variables is proposed. Depending on the
assumptions on the errors of observation, restrictions may be imposed on the covariance
matrix of the augmented structural residuals.

1. Introduction

The errors in variables model played a large role in the early development of
econometrics. The instrumental variable method of estimation was developed to
deal explicitly with the problem of a ‘right-hand side’ variable in a regression
model being non-orthogonal to the “error” in the regression specification.
However, the outstanding problem with instrumental variables estimators has
always been to specify where the candidates to form instruments come from.
In the usual simultaneous equation specifications this problem does not exist;
the included endogenous variables in an equation are non-orthogonal to the
structural disturbance but the excluded predetermined variables in an identified
system always yield enough additional candidates to form instruments to permit
estimation. This result follows from identification of the structural model under
the usual assumptions. The single-equation errors in variables specification does
not have these convenient instruments to use. Recently Zellner (1970) and
Goldberger (1972) have attempted to surmount this problem by making the
unobserved exogenous variable a (stochastic) linear function of observable
variables. This procedure provides a partial solution to the problem although
in many cases the specification of the linear relationship may be very difficult.
In this paper I investigate the simultaneous equation estimation problem when
errors in variables exist in the exogenous variables. That is, the true structural

*This paper was presented at the Winter meetings of the Econometric Society, 1974. I would
like to thank the discussants, especially P. Dhrymes. I have also benefitted from many conversa-
tions about the errors in variables problem with P.A. Samuelson.
390 J.A. Hausman, Errors in variables

specification contains an unobservable variable. A ‘proxy variable’ for thts

variable is observed. The estimation problem is to incorporate additional
information to permit estimation. If the proxy variable is used in place of the
true, unobservable variable, inconsistent estimates result. Instrumental variables
may be applied to this situation with resulting consistent estimates. Instead,
I make a distributional assumption on the exogenous variables and convert
the system back into structural form. Efficient estimators are then proposed for
the system.’ Depending on the stochastic assumptions made about the original
structural disturbances and the error of observation, different estimators result.
While a full-information maximum-likelihood estimator (FIML) may be used
in all cases, under one set of stochastic assumptions three-stage least-squares
(3SLS) is seen to be asymptotically efficient in the sense of attaining the Cramer-
Rao bound. In the two other cases 3SLS does not attain this bound. It turns out
that the inclusion of errors in variables leads to restrictions on the covariance
matrix of the errors in these situations; but, otherwise, the standard set-up
remains. To date little work has been done on the standard simultaneous
equation model with restrictions on the covariance matrix - only the case of a
diagonal covariance matrix has been studied. While FIML provides an asympto-
tically efficient estimation scheme, alternative efficient estimators would be
desirable to decrease the computational requirements.
In section 2 the standard simultaneous equation model is specified. Estimation
by instrumental variables when there exist errors in the exogenous variables is
discussed in section 3. Next a full-information approach to the problem is
studied when the exogenous variable with error appears in only one equation.
FIML and 3SLS are both efficient in the case of an unrestricted covariance
matrix, but only FIML imposes all the restrictions in the other case studied.
Lastly, the situation is generalized to the case when the unobserved exogenous
variable enters more than one equation. This situation may lead to the problem
of nonlinear restrictions on the covariance matrix containing the structural
parameters. More work on estimators needs to be done in this last area.

2. Specification of the model

Consider the standard linear simultaneous equation model containing no

lagged endogenous variables where all identities (assumed not to contain
unobserved variables) have been substituted out of the equation system

YB+ZT = U,

where Y is the T x M matrix of jointly dependent variables, Z is the T x K matrix

‘Alternative estimation schemes have been proposed recently by Joreskog (1974) and Geraci
(1974).
 J. A. Hausman, Errors in variables 391

of exogenous variables, and U is a T x M matrix of the structural disturbances of

the system. The model thus has M equations and T observations. The usual
assumptions are:
64.1) All equations satisfy the rank condition for identification.
(A-2) B is non-singular.
(4.3) The exogenous variables (assumed not to be lagged endogenous) are
assumed orthogonal with respect to the disturbances, E(Z’U) = 0, or
asymptotically plim T-‘Z’U = 0.’
(A.4) The second-order moment matrices of the current predetermined and the
endogenous variables are assumed to have non-singular probability
limits.
(A.5) The structural disturbances are distributed as a non-singular normal
distribution, U N N(0, 10 IT), where Z is a positive definite matrix of
rank M and no restrictions are placed on 2.
The identifying assumptions will take the form of exclusion restrictions so
after choice of a normalization let yi and si be the number of included jointly
dependent and predetermined right-hand side variables, respectively, in the
ith equation. Rewriting the equation system (2. I),

yi = Xj6i+Uj, i= l,...,M, (2.2)

where
Xi = [ YiZi] and 6i =

Xi containing the r,+si variables whose coefficients are not known a priori to
be zero. Therefore, yi and ui are T vectors, Xi is a TX (ri+si) matrix, and 6i
is a (ri+sJ-dimensional vector. Then stacking the M equations into a system,

y = X6+24, (2.3)
where

a=[:] and u=[z].

‘The analysis of errors in lagged endogenous variables in a simultaneous equation context

introduces additional complications not considered here. A moving average error process
results which may be treated by time series methods.
392 J.A. Hausman, Errors in variables

3. Instrumental variable approach to errors in variables

The traditional errors in variables specification [cf. Kendall and Stuart

(1971, p. 378) or Goldberger (1972, p. l)] is to consider the observation of an
exogenous variable subject to error. Let us consider the first column of the
Z matrix and denote the unobservable, ‘true’ column zi as zy. Instead of 27,
we observe z”r, which is determined by the true exogenous variable zf, according
to the relationship

z1 = Z:+El, (3.1)

where the components of s1 are i.i.d. with zero mean and constant variance oE,.
Also &I is assumed independent of Z and in particular of zf. Consideration
of errors of this type in the endogenous variables is not interesting since they are
observationally equivalent to the errors in the equations. In fact, the traditional
approach is to assume an exact linear relationship without a structural distur-
bance, and the error in observing the endogenous variable provides the error
term in the usual regression format [see Kendall and Stuart (1971)].
The instrumental variable procedure is usually a single-equation approach;
consider the ith equation assumed to contain zr,

yi = X~6+Ui, (3.2)
where
Xi* = [ Y,z;“Z,],

zi being the matrix Zi with the first column deleted. Now if one replaces the
unobservable zT by the observable z”, , then eq. (3.2) becomes

Yi = YiBi+z”,yil+~i’Y”i+ui-&lYil, (3.3)

where Zi and r”i are the matrix Zi and vector yi with the first column and element
removed, respectively. If ?I is treated as an exogenous variable, inconsistent
estimates result since z”r is not independent of si. However, a consistent estima-
tion procedure proposed by Chernoff and Rubin (1953) and by Sargan (1958)
is to treat z”i as another endogenous variable. Then an instrumental variable
estimator uses instruments Wi to estimate

bi = (w,lx,)-‘w;y,. (3.4)

The requirements on the instruments are that they be distributed independently

of the error vi = ui - slyil, and they be correlated with Xi,

plim T-’ W,lvi = 0 and plim T-l WiXi = Qi, (3.5)

 J.A. Hausman, Errors in variables 393

where Qi is a finite matrix with rank (ri+si) with probability one. Note that all
predetermined variables except z1 are candidates to form instruments; at least
rifsi must be used to insure satisfaction of the rank condition. Chernoff and
Rubin propose a LIML type procedure which is asymptotically equivalent to the
procedure of Sargan which uses all such predetermined variables except z1 to
form the instruments

w; = xi’z(zI’z)-‘z’, (3.61

where 2 denotes the 2 matrix with the first column removed. By construction
and Assumption A.3, the estimates are consistent with asymptotic covariance
matrix

cov (8) = all(X,‘Z(Z’Z)-‘Z’Xi)-‘. (3.7)

In fact, Sargan shows that this choice of instruments is best asymptotically given
the choice of all candidates to form instruments from Z the matrix of predeter-
mined variables. That is, any choice of a subset of 2 to form instruments will have
a covariance matrix at least as large.
Note that the rank condition on the instruments places an additional restric-
tion on equation i. Qi must have rank ri+si which requires at least rifsi
variables to form the instruments Wi. By the order condition for identification,
K 2 r,+s,. But since z”, cannot be used to form instruments we have only
K- 1 candidates.3 Thus, if equation i is just identified, K = ri+si, then the
instrumental variable procedure cannot be used since Q, will not have full rank.
I will refer to identification when neglecting the presence of exogenous variables
measured with error as conditional identification. Then to have consistent
estimates by the instrumental variable technique, equation i must be conditionally
over-identified. Only then will there be sufficient variables to form the instruments
to insure the rank condition in Qi.

4. Full-information estimation of errors in variables

Consider the structure of the instrumental variable procedure. The instruments

must be correlated with Xi and uncorrelated with the errors in equation i. The
usual approach of instrumental variables procedures used in the simultaneous
equation context, such as 2SLS, uses the predetermined variables to form the
instruments. This procedure is natural since by Assumption A.2 the reduced

3As Sargan notes, exogenous variables from other equations may be used to form instru-
ments even if they are observed with error so long as their error of observation is uncorrelated
with Us and with E,. Of course, these variables must be correlated with the included exogenous
variables to form proper instruments.
394 J.A. Hausman, Errors in variables

form exists,

Y=ZL!+V, (4.1)

where I7 = -TB-’ and V = UB-I. Thus the elements of yi are certainly

correlated with some of the elements ofZ.4 Also the elements ofZ, are correlated
with 2 since 2 contains Zi. Lastly, Z and ui are uncorrelated by Assumption
A.3. Now when z1 is measured with error, the instrumental variable approach
requires that ?r be correlated with Zi and that Zi be independent of u1 . Again,
this approach seems reasonable since Z is independent of ui by Assumption A.3,
and Z is independent of s1 by assumption. Note that the assumption has been
made that zT is not orthogonal to all the other exogenous variables. This
assumption seems reasonable although it must be admitted it does not have
the force of the assumption that yi is correlated with Z which comes from the
structure of the reduced form in eq. (4.1).
Given the assumption of correlation among the ‘true’ exogenous variables
we now make an additional distributional assumption about the exogenous
variables which embodies the correlation relationship. A natural assumption is
to consider a row of the Z matrix, zt , and assume the K-dimensional vector to be
distributed as multivariate normal,

64.6) z, = ht, * * *,d - WPL,4.

For many cases, especially cross-section data, it is reasonable to assume that all
z,, for t = 1,. . , T, are distributed identically with the same p and A. For time
series specifications, an assumption such as this for variables with a time trend
removed might be plausible. Still, the assumption of a fixed mean and covariance
matrix is quite strong beyond the usual assumptions where only finite second
moments need exist. For instance, the ‘incidental parameter problem’ of errors
in variables [Kendall and Stuart (1971)] disappears since estimates of the constant
mean are trivial to obtain. Then by a well-known theorem on multivariate
normal distributions [cf. Anderson (1958, p. 28)], the regression of the column
vector z1 on the rest of the columns of Z, say 2, gives the conditional expectation
of zl, given Z,

z1 = a,+z:a,+E2,

where the usual independence assumptions of the regression model are satisfied
and e2 N N(0, oJ). Since in our model z1 is the unobservable variable z:, and
we observe z”l by eq. (3.1), the unobservable variable .z: satisfies the stochastic

417 will normally contain zeros only in triangular systems.

 J.A. Hawnan, Errors in variables 395

relationship

21* = cc,+iz’a,S&*. (4.4)

Reformulating an unobservable exogenous variable as a stochastic linear

function of other exogenous variables underlies the approach recently advocated
by Goldberger (1972) in the non-simultaneous equation framework.
Given Assumption A.6 in eq. (4.2) or straightforwardly assuming eq. (3.4) as
does Goldberger, where he assumes s2 N N(0, a,,Z), permits a full-information
approach to the problem. ’
Consider the system of equations which describe the structural relationships
and the relationships of the unobservable variable z: and its proxy z”r (for now
z1 is assumed to only occur in equation 1; later, the system will be generalized),

Yl = w,+zT~,,+~ly",+~l, (4.5)
Yi = yiPi+ziYi+Ui9 i = 2,. . ., M,

Zl = Z:+E1, (4.6)
2: = ao+Zcr,+EZ,

where in eq. (4.5) 2, denotes Z1 , with the first column deleted, and in eq. (4.6)
z stands for the complete predetermined variable matrix 2 with the first column
deleted. By direct substitution eq. (4.5) and eq. (4.6) are combined to form the
equation system

Yl = YlB, +zv,, +%71 +u, +Y11&2, (4.7a)

Yi = yiPt+ziYi+ui, i = 2, . . ., M, (4.7b)

.Z, = ZcZ+s1+s2, (4.7c)

where 2 is now the matrix 2 with a column of ones added to include the constant
if it is not already present, and a = (2) is the combined vector for the unknown
coefficients in eq. (4.6). Note that .?! contains all the predetermined variables
except z:, and 2, contains the included predetermined variables from equation 1
with z: removed. This approach of adding equations for variables measured
with error generalizes so that one additional equation follows from each such
variable measured with error. By Assumption A.1, equation 1 of the structural

%Zellner (1970) considers the case where in eq. (4.4) c2 = 0. Thus the unobservable variable
is known as an exact linear relation of observable variables. While this assumption leads to an
interesting statistical problem, the assumption seems so strong that this case will not be
considered.
396 J.A. Hausman, Errors in variables

system is conditionally identified so 2, contains no more than (K-r,- 1)

predetermined variables. However, just as with the instrumental variables
procedure discussed in section 3, for the full-information method to be applicable
equation 1 must be conditionally overidentified. Therefore 2, must contain no
more than K- ri- 2 predetermined variables and z: must be (partially) correlated
with at least one excluded exogenous variable.
Now consider the following estimation procedure for the equation system
contained in (4.7); rewriting eq. (4.7~) as

where vM+r = s1+s2, note that by assumption the elements of vM+r are
distributed independent normally with zero mean and constant variance.
Furthermore, by Assumption A.3 and eq. (3.1), 2 and v~+~ are contempor-
aneously independent. Therefore a consistent estimator of a is the least-squares
regression

Given & one can form a consistent estimate of z”, from 22, and this conditional
predictor may be substituted into eq. (4.7a). Consistent estimation of eq. (4.7a)
for 6, then proceeds in the usual way by instrumental variables. Note that this
procedure is exactly the instrumental variable procedure outlined in section 3
since

which is the procedure used in eq. (3.6) to form the instruments Wi. Thus no
gain in efficiency is offered by the stochastic specification of the predetermined
variables in eq. (4.2) which lead to the linear structural relationship of eq. (4.4).
However, some structural information has been neglected so now consider the
system in a full-information context.
The equation system (4.7) has the usual format of a structural simultaneous
equation system. The errors are distributed normally, and denoting the errors
as vi for i = 1, . . ., M+ 1 equations,

(4.11)
 J.A. Hausman, Errors in variables 391

To explicitly write the covariance matrix C we must make a stochastic assump-

tion about the relationship of the Ui and s1 and Ed. Two assumptions, leading to
two different estimators are made :
(D.l) C is assumed unrestricted so that the Ui’s and Q’S are allowed to be
correlated.
(D.2) The uI)s and Q’Sare assumed uncorrelated so in the last row and column
of C, all entries are zero except for the first and last6
To estimate the structural system (4.7) under Assumption D.l of correlation
among the U’Sand the E’Sfirst, rewrite it in stacked form
y = 26+v, (4.12)
where now there are M+ 1 equations and ?I is treated as an endogenous variable
and 6 contains the unknown /3i)s, yi)s, and ~1.Given the distribution of V in
eq. (4.1 I), the log likelihood function is

L(6, C’) = K-glogdet (C)+Tlogdet ].I]

-NV-Z@‘(C 0 ~T)-YY-ml, (4.13)

where J is the Jacobian of the transformation from v to y. Therefore J is now

an M+ 1 square matrix which has the form

B ‘Yll
1O
J= I* 1 ’ (4.14)
--_- 0
o***o 1 1

where B is the M-square matrix of the original endogenous variables. Since under
Assumption D. 1 C is unrestricted, it has the form

(4.15)

The first-order conditions for the likelihood functions may be found and an
algorithm specified [e.g., Hausman (1975)]. However, since C is unrestricted,
alternative asymptotically equivalent estimators are easily specified. For instance,
3SLS applied to eq. (4.12) will produce efficient estimates. Alternatively, a full-

‘This assumption relaxes the need to assume that equation 1 is conditionally overidentified
for identification since it leads to restrictions on the covariance matrix.
398 J. A. Hausman, Errors in variables

information instrumental variable estimator might be used. Both are fully

efficient as proved in Hausman (1975). As I show, the latter estimator if iterated
gives the FIML estimates. It is interesting to note that if 3SLS is used, the last
equation may be discarded and the original system (2.3) used where zr is treated
as an endogenous variable. Since eq. (4.7~) is just identified, Narayanan (1969)
shows that in the sample (and of course asymptotically) the 3SLS estimates
remain the same if all just-identified equations are ignored.7 Thus, the full-
information analogue of the instrumental variables procedure discussed in
section 3 gives efficient estimates. The additional structural information of
eq. (4.4) leads to no gain in efficiency since a just-identified equation has been
added to the structural system. Only if some of the exogenous variables are
known a priori to be independent of zi, the added distribution assumption
(Assumption A.6) will lead to more efficient estimates. For them some of the rxl
of eq. (4.3) are known apriori to be zero, and eq. (4.7~) would be overidentified.
Then 3SLS on the complete system would be more efficient than is 3SLS when
the (M+ 1)st equation is neglected or treated as just-identified.
However, under Assumption D.2 of no correlation among the ui’s and ai’s
the situation changes markedly. This assumption seems natural since it assumes
that the error in observation c1 in eq. (3.1) is uncorrelated with the errors in the
equations and that Ed is also uncorrelated with the errors in the equations.
Lastly, s1 and Ed are assumed uncorrelated. The covariance matrix C of the V’s
is no longer unrestricted,

1
2
(-Jll+Yll GE2 ’ -Y11 gel
1 0

1 :
C= c I * (4.16)
I O
- - - - - -
I---T-----
I -Y11~,, I o...o 1 00 +o,,

As was previously noted, since C now has zero restrictions, the requirement
of conditional overidentification for identification is not needed. Identification
can now be analyzed using the methods of Fisher (1966, ch. 4). The first and last
elements in the last row and column of C put no restrictions on C beyond the
usual symmetry restriction since they are ‘just-identified’, but C~j forj = 2, . . .,
M- 1 are now zero. The likelihood function remains that given in eq. (4.13),
but now the simplification to 3SLS or full-information unstrumental variables
is no longer possible since Cis now restricted. Thus under Assumption D.2,3SLS
is still consistent but no longer attains the Cramer-Rao bound asymptotically

70f course, more efficient estimates ofa are obtained by estimating eq. (4.7~) jointly with the
other equations. Since this equation does not form part of the structural system, one may not
be interested in its coefficients. By the same reasoning, the second equation in Goldberger
(1972, p. 7) may be ignored with no loss in efficiency.
 J.A. Hausman, Errors in variables 399

under Assumption A.5 on the distribution of U. Unless the complete system is

just-identified it still is better asymptotically than the single-equation instru-
mental variable estimator discussed in section 3. Of course, 3SLS could be
altered to use the apriori zeros in C. However, the asymptotic distribution of the
3SLS estimator does not change since it is based only on a consistent estimate
of C. The Cramer-Rao bound changes due to the restrictions imposed on the
covariance matrix.* To attain the CR bound then FIML or an equivalent
minimum x2 technique must be used which impose the restrictions on the
covariance matrix.

5. Full-information estimation when the unobserved variable enters more than

one equation
So far the situation considered has been when the unobservable ‘true’ variable
zT enters only the first equation. A natural generalization which leads to an
interesting estimation problem is to allow the unobservable variable to enter
additional equations, The full generality of the situation is conveyed when zT
enters the first two equations and notational problems are minimized so only
that particular case is considered. Thus the equation system in (4.7) is altered
to reflect the presence of zT in the first two equations,

Y, = Y,B,+~~y,,+Z~P1+u,+r,,&,, (5.la)

Yz = Y,P2+~~y,,+Z,y”,+u,+YZ1&2, (5.lb)
_Yi= Y$,+Ziyi+Ui, i = 3,. . ., M, (5.lc)

- = %+a1+a2,
z1 (5.ld)

where 2 is the matrix of all observable exogenous variables, 2, and 2, contain

the exogenous variables from the first two equations with z1 removed, and y”r
and ‘y2 are the unknown parameters corresponding to the exogenous variables
in 2, and 2,. The system is again stacked in the form
y = 26+u, (5.2)
where v has the distribution

(5.3)

See Rothenberg (1973) who calculates the change in the CR bound for the special case of a
completely diagonal covariance matrix.
400 J.A. Hausman, Errors in variables

This system of equations still has the standard form of a simultaneous equation
system with the likelihood function given by eq. (4.13). The Jacobian of the
transformation has the form

J= (5.4)

If Assumption D.1 is made so that C is unrestricted, the analysis of section 4

holds true. So long as the second equation is conditionally overidentified,
treating zT as endogenous still leaves the equation identified. FIML can be
derived, or asymptotically efficient estimators such as 3SLS or a full-information
instrumental variable estimator which offer significant computational simplifi-
cation can be used. Again eq. (5.ld) is just-identified so that it may be neglected
when doing 3SLS with no loss of efficiency. Eq. (5.ld) need only be considered
explicitly if it is known a priori that z: is independent of certain of the exogenous
variables.
As before the situation changes markedly when distributional Assumption
D.2 of no correlation among the ui’s and aI)s is made. For then C is restricted
and has the form

cll+Yll 2%2 I Yllae*

I
~12+YllY21~e2
0
C= c
II .
Y210e=
. (5.5)
I :
__-____------- - 0
YllUQ Y21CE2 o--o aEI+OE2_

This covariance matrix has an even more complicated structure than the co-
variance matrix of eq. (4.16). Not only are there zeros present in the last row and
column but C,,,,, and C,,.,,, must satisfy the nonlinear restriction

c M+l,lICM+l,2 = YlllY21. (5.6)

Thus again 3SLS no longer attains the CR bound under Assumption A.5. The
nonlinear restriction of eq. (5.6) adds an additional restriction to the covariance
matrix.’ Thus to attain the CR bound, FIML is needed.

‘Note that if eq. (5.lb) were conditionally just identified, identification could be achieved
using the equality of eq. (5.6). For further details of identification see Geraci (1974).
 J.A. Hausman, Errors in variables 401

6. Conclusion

In this paper the simultaneous equation model has been enlarged to permit
errors in the exogenous variables. By making an explicit distributional assump-
tion on the relationship of the exogenousvariables, the errors in variables problem
is transformed to a structural specification. The error-ridden variable is then
treated as endogenous, and a just-identified structural equation is added to the
model. In the case of an unrestricted covariance matrix, the 3SLS and FIML
estimators retain their usual properties.
The other case considered is when the error covariance matrix is not un-
restricted. Then only FIML attains the CR bound. Thus the other main con-
clusion of this paper is that the addition of errors in variables to the simultaneous
equation model may lead to restrictions on the structural covariance matrix.
A topic for further research is the practical importance of imposing the restric-
tions. Recent work by Joreskog and Goldberger (1975) and Rothenberg (1973)
does not indicate large gains accrue to imposing zero restrictions on the co-
variance matrix.

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