Lecture sheet on econometrics: Chapter five

Simultaneous-equation methods

1. Single-equation methods and system methods

If the system of simultaneous equations is underidentified, all its
structural parameters cannot be estimated by any econometric method.
A system is underidentified when one or more of its equations are
underidentified. However, an underidentified system may contain some
identified equations which can be estimated by some econometric
method(s).

If all the equations of a system are exactly identified the whole system is
exactly identified. If some (or all) the equations of a system are
overidentified the whole system is overidentified.

Assuming that an equation in a simultaneous-equation model is

identified (either exactly or over), we have several methods to estimate
it. These methods fall into two broad categories: Single-equation
methods and system methods.

The methods which are applied to estimate a system of simultaneous

equations by estimating each equation (provided it is identified) of the
system separately are called single-equation methods. They are
1. Ordinary least squares (OLS)
2. The reduced-form method, or indirect least squares (ILS)
3. The method of instrumental variables (IV)
4. Two-stage least squares (2SLS)
5. Limited information maximum likelihood (LIML)
6. The mixed estimation method

The methods which are applied to estimate a system of simultaneous

equations by estimating all the (identified) equations of the system
simultaneously are called system methods. They are
1. Three stage least squares (3SLS)
2. Full information maximum likelihood (FIML)

Single-equation methods are sometimes called ‘limited information’

methods because they only utilize knowledge of the restrictions in the
particular equation being estimated.
System methods are sometimes called ‘full information’ methods
because they incorporate knowledge of all the restrictions in the system
when estimating each parameter.

For reasons of economy, specification errors, etc. the single-equation

methods are by far the most popular. Three commonly used
single-equation methods are OLS, ILS, and 2SLS.

2. Ordinary least squares (OLS)

Although OLS is, in general, inappropriate in the context of simultaneous
-equation models, it can be applied to the so-called recursive models
where there is a definite but unidirectional cause-and-effect relationship
among the endogenous variables.

Note the following points regarding OLS in the context of system of

simultaneous equations:

It is possible to use the OLS estimator and simply accept its asymptotic
bias. This can be defended in several ways.
(a) Although the OLS estimator is biased, in small samples so also are all
alternative estimators. Furthermore, the OLS estimator has minimum
variance among these alternative estimators. Thus it is quite possible
that in small samples the OLS estimator has minimum mean square error.
Monte Carlo studies have shown, however, that this is true only in very
small samples.

(b) Accordingly to Monte Carlo studies, the properties of the OLS

estimator are less sensitive than the alternative estimators to the
presence of estimation problems such as multicollinearity, errors in
variables or mis-specifications, particularly in small samples.

(c) Predictions from simultaneous-equation models estimated by OLS

often compare quite favourably with predictions from the same models
estimated by alternative means.

(d) OLS can be useful as a preliminary or exploratory estimator.

(e) If a simultaneous-equation system is recursive, OLS is no longer

asymptotically biased and is unbiased if there are no lagged endogenous
variables and no correlation between disturbances in different
equations.
3. The reduced-form method, or indirect least squares (ILS) method
The reduced-form method is a single-equation method in that it is
applied to one equation of a system at a time. It is appropriate when the
equations of the structural system contain both predetermined and
endogenous variables among the set of explanatory variables, provided
that the equations of the system are exactly identified.

The reduced-form method, which is also known as indirect least squares

(ILS) method.

For a just or exactly identified structural equation, the method of

obtaining the estimates of the structural coefficients from the OLS
estimates of the reduced-form coefficients is known as the method of
indirect least squares (ILS), and the estimates thus obtained are known
as the indirect least squares estimates.

ILS method involves the following three steps:

Step I. We first obtain the reduced-form of the structural model by

rewriting the equations in such a way that the endogenous variables are
expressed as a function of the predetermined variables and the
stochastic error terms only.

Step II. We apply OLS to the reduced-form equations individually. This

operation is permissible since the explanatory variables in these
equations are predetermined and hence uncorrelated with the
stochastic disturbances. The estimates thus obtained are consistent.

Step III. We obtain estimates of the original structural coefficients from

the estimated reduced-form coefficients obtained in Step II. If an
equation is exactly identified, there is a one-to-one correspondence
between the structural and reduced-form coefficients; that is, one can
derive unique estimates of the former from the latter.

As this three-step procedure indicates, the name ILS derives from the
fact that structural coefficients are obtained indirectly from the OLS
estimates of the reduced-form coefficients.

To illustrate the application of the indirect least squares we will take an

example from the theory of price determination. Assume that the
market mechanism of a given commodity is described by the following
system of simultaneous equations

D  a0  a1 P  a2Y  u1
S  b0  b1 P  b2W  u 2
DS

where, D  quantity demanded, S  quantity supplied, P  price, Y 

income, W  index of weather conditions.

This is the structural model which is mathematically complete in the

sense that it contains three equations in three endogenous variables
D, S , P  . The system contains two exogenous variables, income Y ,
and weather conditions W . The system is exactly identified since it can
be shown that each behavioural equation is exactly identified.

The reduced-form model, in which the endogenous variables are

expressed as a function of the exogenous variables only, may be
obtained by continuous substitutions. It is

a0b1  a1b0 ab  a1b2 u1b1  u 2 a1

D  2 1 Y W  v1 (where v1  )
b1  a1 b1  a1 b1  a1 b1  a1
a b a2  b2 u u
P 0 0  Y W  v2 (where v2  1 2 )
b1  a1 b1  a1 b1  a1 b1  a1

Using the conventional notation of  ’s for the reduced-form

coefficients, we have,

D   10   11Y   12W  v1
P   20   21Y   22W  v2

Obviously,

a0b1  a1b0 ab  a1b2

 10  ,  11  2 1 ,  12 
b1  a1 b1  a1 b1  a1
a b a2  b2
 20  0 0 ,  21  ,  22 
b1  a1 b1  a1 b1  a1

which are the relationship between the reduced-form parameters and

the structural parameters, called the ‘system of coefficients’
relationships’. These relationships will provide unique values for the
structural parameters, since our structural model is exactly identified.
Here we have six equations in six unknowns, which are structural
coefficients a0 , a1 , a2 , b0 , b1 , b2 .

Solving the ‘system of coefficients’ relationships’, for the structural

parameters we will have

     
a0   20  10  12 , b0   20  10  11 
  20  22    20  21 
 12  11
a1  , b1 
 22  21
     
a2   21  11  12 , b2   22  12  11 
  21  22    22  21 

Using sample data on D, P, Y , W we may apply OLS to the first of

reduced-form equations

D   10   11Y   12W  v1

and obtain ˆ10 , ˆ11 , ˆ12 .

We next apply OLS to the second of reduced-form equations

P   20   21Y   22W  v2

and obtain the estimates ˆ 20 , ˆ 21 , ˆ 22 .

We next substitute the ˆ10 , ˆ11 , ˆ12 , ˆ 20 , ˆ 21 , ˆ 22 into the system of

coefficients’ relationships and obtain aˆ0 , aˆ1 , aˆ 2 , bˆ0 , bˆ1 , bˆ2 ; which are
the ILS estimates of the structural parameters. That is,
 ˆ ˆ   ˆ ˆ 
aˆ0  ˆ 20  10  12  bˆ0  ˆ 20  10  11 
 ˆ 20 ˆ 22   ˆ 20 ˆ 21 
ˆ ˆ
aˆ1  12 bˆ1  11
ˆ 22 ˆ 21
 ˆ ˆ   ˆ ˆ 
aˆ 2  ˆ 21  11  12  bˆ2  ˆ 22  12  11 
 ˆ 21 ˆ 22   ˆ 22 ˆ 21 
The asymptotic variances and covariances of the structural estimates
may be derived from that of the reduced-form estimates by use of the
general formulae for asymptotic variances and covariances of functions
of random variables.

4. Assumptions of the ILS or reduced form method

The method of ILS is based on the following assumptions.

Firstly. The structural equations must be exactly identified.

Secondly. The random variable v of the reduced- form equations,

which is a linear combination of the random variables of the structural
model ( u ’s) and the structural parameters, must satisfy the six
stochastic assumptions of ordinary least squares as
(i) v is random
(ii) v has zero mean, E vi   0
(iii) v has constant variance, E vi    v
2 2

(iv) v is serially independent, E vi v j   0 (for i  j )

(v) v is normally distributed, that is v follows N 0,  v 
2

(vi) v is independent of the exogenous variables of the model,

E vi X j   0 .

Thirdly. The exogenous variables of the model must not be perfectly

collinear.

Fourthly. The macro-variables must be properly aggregated.

From the above it should be clear that the ILS method is based on all the
assumptions of OLS and on the additional one that the model be exactly
identified.

5. Properties of ILS estimators

If the assumptions of ILS are fulfilled, the estimates of the reduced-form
coefficients ( ˆ ’s) will be best, linear, unbiased (and consistent).
However,

1. The estimates of the structural parameters ( b̂ ’s) obtained from these

optimal ˆ ’s, are biased for small samples but they are consistent, that is
their bias tends to zero as the size of the sample increases and their
distribution collapses on the true structural parameter b , while the OLS
estimates are inconsistent.

2. The estimates of the structural parameters are in general not fully

efficient, that is, in general the estimates of the structural parameters
have not the minimum sampling variance.

Yet ILS is generally preferred to OLS because of the consistency property

of its estimates and because of its simplicity as compared with other
methods which give consistent estimates.

6. Two-stage least square squares (2SLS) method

This method has been developed by Henri Theil and independently by
Robert L. Basmann. It is a single-equation method, being applied to one
equation of the system at a time, which is overidentified.

Theoretically two-stage least squares may be considered as an extension

of indirect least squares (ILS) and of the instrumental variables (IV)
method.

As the name indicates, the method involves the application of OLS in

two stages.

In the first stage, each endogenous variable is regressed on all the

predetermined variables of the system. These are now the reduced-
form equations.

In the second stage, the predicted rather than the actual values of the
endogenous variables are used to estimate the structural equations of
the model. The predicted values of the endogenous variables are
obtained by substituting the observed values of the exogenous variables
into the reduced-form equations. Following the OLS theory, the
predicted values of the endogenous variables are uncorrelated with the
error terms, leading to consistent 2SLS structural-parameter estimates.

Let the ith structural equation is of the general form

yi  bi1 y1  bi 2 y2  . . .  biG yG   i1 x1   i 2 x2  . . .   ik xk  ui
(1)

where
yi ’s will denote endogenous variables i  1, 2, . . ., G 
xi ’s will denote predetermined variables i  1, 2, . . ., k 
b ’s will represent the coefficients of endogenous variablesr
 ’s wil represent the coefficients of the predetermined variables
G  number of endogenous variables of the model
k  number of predetermined variables of the model
ui ’s  stochastic disturbance terms.

The reduced form of the ith endogenous variable is of the form

yi   i1 x1   i 2 xi 2  . . .   ik xik  vi (2)

where  ’s are the reduced-form coefficients of the exogenous variables,

x ’s and vi is a function of the random variables ( u ’s) and parameters
( b ’s) of the structural equations.

In the first stage we apply OLS to the reduced-form equations to obtain

estimates of the  ’s

y1   11 x1   12 x2  . . .   1k xk  v1
y 2   21 x1   22 x2  . . .   2 k xk  v2
.......... .......... .......... .......... .......... ..........
.......... .......... .......... .......... .......... ..........
.......... .......... .......... .......... .......... ..........
yG   G1 x1   G 2 x2  . . .   Gk xk  vG

Using the reduced-form coefficients, ˆ ’s, we obtain a set of estimated

(computed) values for the endogenous variables: yˆ1 , yˆ 2 , . . ., yˆ G .

yˆ1  ˆ11 x1  ˆ12 x2  . . .  ˆ1k xk

yˆ 2  ˆ 21 x1  ˆ 22 x2  . . .  ˆ 2 k xk
....................................................
....................................................
....................................................
yˆ G  ˆ G1 x1  ˆ G 2 x2  . . .  ˆ Gk xk
In the second stage we substitute the ŷ ’s into the structural equation
and obtain the transformed functions. We have

y1  yˆ1  v1
y2  yˆ 2  v2
.................
.................
.................
yG  yˆ G  vG

Substituting these into (1) we obtain

yi  bi1  yˆ1  v1   bi 2  yˆ 2  v2   ...  biG  yˆ G  vG    i1 x1   i 2 x1  ...   ik xk  ui

Rearranging we obtain

yi  bi1 yˆ1  bi 2 yˆ 2  ...  biG yˆ G   i1 x1   i 2 x1  ...   ik xk  ui


(3)

where ui   ui  bi1v1  bi 2 v2  ...  biG vG

Applying OLS to the transformed structural equation (3) we obtain the

2SLS estimates of the structural parameters.

7. Assumptions of two stage least squares (2SLS)

2SLS involves the application of the classical least squares to two types
of functions: to the reduced form equations and to the transformed
structural function, the transformation consisting of the replacement of
the endogenous variables by their estimated values ( ŷ ’s) obtained from
the reduced-form equations. The assumptions of this method may be
outlined as follows.

Firstly. The disturbance term u of the original structural equations

must satisfy the usual stochastic assumptions of zero mean, constant
variance and zero covariance. Otherwise the reduced-form error terms
vi ’s will not posses these characteristics and hence the whole method
breaks down.

Secondly. The error term of the reduced form equations vi must satisfy
the usual stochastic assumptions, that is (a) v has zero mean, constant
variance, zero covariance, and (b) v must be independent of the
exogenous variables of the whole structural model  x1 , x2 , . . ., xk  .
The assumptions of zero mean, constant variance and zero covariance
for vi are fulfilled as soon as the random terms of all structural
equations ( u ’s) satisfy these conditions, because vi is an exact linear
function of the structural u ’s.

Thirdly. The explanatory variables are not perfectly multicollinear, and

all macro-variables are properly aggregated.

Fourthly. It is assumed that the specification of the model is correct so

far as the exogenous variables are concerned. That is we assume
knowledge of all the exogenous (predetermined) variables of the system,
irrespective of the equations in which they appear. It is not necessary to
know the mathematical formulation of the whole system in all its details,
but we must know correctly all the exogenous variables of the system.

Fifthly. It is assumed that the sample is large enough, and in particular

that the number of observations is greater than the number of
predetermined variables in the structural system. If the sample size is
small in relation to the total number of exogenous variables, it may not
be possible to obtain significant estimates of the reduced-form
coefficients (  ’s) when applying ordinary least squares at the first stage.
If the sample size is small, one might try to reduce the number of
exogenous variables by applying the method of principle components.

8. Properties of 2SLS estimates:

Provided that the above assumptions are satisfied the estimates
obtained from the 2SLS have the following properties.

(i) For small samples the estimates are biased.

(ii) However, in large samples (as n   ) the bias tends to zero, that is,
the 2SLS estimates are asymptotically unbiased.

(iii) The 2SLS estimates are consistent, that is, their distribution collapses
on the true parameter b as n   .

(iv) The 2SLS estimates are asymptotically efficient under certain

assumptions about the distribution of the disturbances.
9. Some remarks on 2SLS
1. The method of 2SLS is appropriate for the estimation of overidentified
equations. When the equation is exactly identified it can be proved that
the 2SLS estimates are identical with the estimates of ILS method. Two
stage least squares also does not have any advantage over ordinary least
squares in the estimation of recursive models.

2. The method of two-stage least squates yields consistent estimates

under conditions in which the classical least squares method fails (that is
in overidentified relations).

3. The method of 2SLS is more general than the instrumental variables

method, because it takes into account the influence on the dependent
variable of all the predetermined variables of the system, while the
method of instrumental variables chooses only a certain subset of the
predetermined variables (as instruments), and ignores the effects of the
other exogenous variables.

4. The method of two-stage least squares assumes knowledge of all the

predetermined variables of the complete system of simultaneous
equations. If the specification of these variables is not correct, the
estimates of the parameters will not have the optimal properties
mentioned above. In other words 2SLS, as indeed any other econometric
technique, is sensitive to specification errors.

5. The method of 2SLS requires rather a large number of observations,

especially if the model includes many predetermined variables, which
will be used in the first stage for obtaining the estimated values ( ŷ ’s) of
the endogenous variables.

6. The method is fairly simple in conception and in computations. It has

yielded more satisfactory results than any of the other econometric
methods and has become the most important technique for the
estimation of overidentified functions.

10. 2SLS versus ILS

ILS fails when our model is overidentified. It is in this situation that 2SLS
technique has an advantage over ILS. 2SLS provides a single estimates of
the parameter which is overidentified. However, when model is exactly
identified the ILS and 2SLS procedures give identical estimates. 2SLS
procedure is, therefore, used extensively in practice for the following
points over the ILS procedure of estimation:

(i) Unlike ILS, which provides multiple estimates of the parameters

when applied to the overidentified equations, 2SLS provides only one
estimate per parameter.

(ii) Although 2SLS has been specially designed to handle overidentified

equations, this method can also be applied to exactly identified
equations. ILS and 2SLS give identical result in such situation.

(iii) In the application of ILS, there is no simple method of estimation of

standard errors of the structural coefficients from the standard errors of
the reduced- form coefficients. But this can be done easily in case of
2SLS estimates because the structural coefficients are directly estimated
from the second stage (OLS) regressions. However, the estimated
standard errors in the second-stage regression need to be modified.

Advantages of 2SLS over ILS

One advantage of 2SLS over ILS is that 2SLS can be used to obtain
consistent structural-parameter estimates for the overidentified as well
as for the exactly identified equations in a system of
simultaneous-equations.

Another important advantage is that 2SLS (but not ILS) gives the
standard error of the estimated structural parameters directly.

Since most identified models are in fact overidentified, 2SLS is very

useful. Indeed, 2SLS is the simplest and one of the best and most
common of all simultaneous-equations estimators.
Problem 2: Assume that the market mechanism of a given commodity is
described by the following system of simultaneous equations

D  a0  a1 P  a2Y  u1
S  b0  b1 P  b2W  u 2
DS

where, D  quantity demanded, S  quantity supplied, P  price, Y 

income, W  index of weather conditions.

This is the structural model which is mathematically complete in the

sense that it contains three equations in three endogenous variables
D, S , P  . The system contains two exogenous variables, income Y ,
and weather conditions W . Using the conventional notation of  ’s for
the reduced-form coefficients, we have,

D   10   11Y   12W  v1
P   20   21Y   22W  v2
S   30   31Y   32W  v3

(i) Show that the system is exactly identified.

(ii) Show that

a0b1  a1b0 ab  a1b2

 10  ,  11  2 1 ,  12 
b1  a1 b1  a1 b1  a1
a b a2  b2
 20  0 0 ,  21  ,  22 
b1  a1 b1  a1 b1  a1

(iii) Verify that

     
 20  10  12   a0  20  10  11   b0
  20  22    20  21 
 12  11
 a1  b1
 22  21

     
 21  11  12   a2  22  12  11   b2
  21  22    22  21 
Lab 2: Assume that the market mechanism of a given commodity is
described by the following system of simultaneous equations

D  a0  a1 P  a2Y  u1
S  b0  b1 P  b2W  u 2
DS

where, D  quantity demanded, S  quantity supplied, P  price, Y 

income, W  index of weather conditions. The data relevant to the
model are given in the following table.

Observations Demand=Supply Price Income Weather (index

DS (P) (Y ) of rain fall)
( Q in tons) £ per ton £m (W )
1 12917 2260 1089 100
2 17920 2150 1169 110
3 18475 1970 1281 110
4 28180 1620 1335 112
5 26330 1380 1388 105
6 31029 1200 1452 107
7 41430 1310 1516 110
8 48924 1080 1536 100
9 52739 1180 1558 105
10 55009 1390 1587 105
11 50100 1340 1625 98
12 67559 1350 1693 105
13 61986 1360 1774 95
14 55986 1250 1826 88
15 60311 1210 1899 95

(a) Examine the identification condition of the equations of the model.

(b) Obtain OLS, ILS and 2SLS estimates of the parameters of the model.
Interpret the estimated results.
Lab 3: Consider the following simple model of an economy
C  a0  a1Y  u1
I  b0  b1 P  u 2
Y C  I G
where C  consumption, Y  national income, I  investment,
P  profits, G  government expenditures.
(Endogenous variables C , I , Y )
(a) Verify that the consumption function is over-identified.
(b) Can we estimate the investment function by OLS? Why?
(c) Using the data of the following table, estimate the consumption
function by OLS and by 2SLS. (Variables are measured in ＄ millions.)
Compare the results of the two methods.
Year Y C I P G
1966 484 311 75 29 97
1967 504 325 75 27 104
1968 520 335 72 27 113
1969 560 355 83 31 122
1970 591 375 87 33 128
1971 632 401 94 38 137
1972 685 433 108 47 144
1973 750 466 121 50 162
1974 794 492 116 47 185
1975 866 537 126 50 203

Lab 4: Consider the following model, expressed in deviations of the

variables from their means.
y1  b1 y2  u
y2  c1 y1  c2 x1  v
Use the following observations (which are given in deviation form)
y1 y2 x1
-4 2 -2
0 3 -1
3 2 0
1 -7 3
(i) Establish the identification condition of each equation.
(ii) Estimate the first equation (a) by OLS, (b) by ILS, (c) by 2SLS and
compare your results.Which method is the most appropriate in this case?
Why?
(iii) Which method would you adopt for estimating the second equation?
Why?