SIMULTANEOUS EQUATION SYSTEMS

In the previous units, we concentrated attention on the estimation of single equations in

which it is assumed that the only endogenous variable was the dependent variable and that
the explanatory variables are truly exogenous. It was implicitly assumed that the only
relationship between the variables in an equation was that described by the equation itself.
However, economic models typically involves a set of relationships designed to explain the
behaviour of additional relationships between the dependent and explanatory variables in any
single equation may exist and the explanatory variables may themselves be endogenous.

With respect to the demand function, economic analysis suggests that price and quantity are
typically determined simultaneously by the workings of the market; and a market model does
not consist of a single equation but of three equations - a demand function, a supply and an
equilibrium condition. Letting Q d represent quantity demanded, Qs quantity supplied, we can
write

Q dt = β1 + β 2 P t + β 3 Y t +u1 t
Q dt = β 4 + β 5 Pt +u1 t
Q dt =Q st

Similarly, the consumption function is normally analysed in the context of a model of income
determination. A very simple Keynesian model incorporating the consumption function is
given by the following two-equations model which includes investment (1) and government
spending (G) as independent variables

Q t = β 1 + β 2 Y t +u1 t
Y t =C t + I t +G t

Strictly speaking THE EQUATIONS ABOVE represents a three-equations model

C t = β 1 + β 2 Y t + u1t
Et =C t + I t +G t
Y t=Et

Where Et represents aggregate expenditure and Y t =Et gives the national equilibrium
condition.

To simplify the presentation in this unit, we use the two-equation version of the model given
by (6.2). in model (6.2), the first equation relates consumption to the level of income but the
second equation shows that income is itself determined in part by the level of aggregate
consumption Ct and Yt are jointly determined variables.

From the above it is evident that a model is a set of equations describing hypotheses about
economic relations. Equations may be of three kinds. They may definitions or identities
such as Y = C + I + G, the second equation (6.2) is of this type. Note that an identity is not
an equation to be estimated by econometric procedures and it does not include a random
disturbance term, it simply defines an equality, equations may be behavioural, showing the
assumptions made about the way in which economic agents, or groups of economic agent
behave in (6.1) and (6.2) the demand and supply equations and the consumptions function
equations are of this kind. These behavioural equation are the ones with parameters to be
estimated by econometric procedures from real world data; also, model equations may
state equilibrium conditions, for example the third equation in (6.1) the market model,
states that for equilibrium in the market place the quantity demanded must equal the
quantity supplied.

Not only are there different types of equation, there are also different types of variables in the
construction of models. Consider a three-equation supply-demand model described as
follows

Supply Q dt =α 1 +α 2 Pt + α 3 P t −1 + ∈1 t
1
Behavioural (6.3)
Demand Q dt =β1 + β 2 P t + β 3 Y t +u1 t

Equilibrium Qd s
t =Q t

The supply and demand equation plus the equilibrium condition will determine the market
price and the quantity supplied (and demanded) when the market is in equilibrium. As such,
d s
the variables Q t =Q t and Pt are often called endogenous variables; they are determined
within the system of equations. The model contains two other variables whose values are not
determined directly within the system. These so-called predetermined variables help to cause
the movement of the endogenous variables within the system P t –1 and Yt are both
predetermined variables in the model. However, these two predetermined variable are
different, in that, Pt –1 is in fact determined within the system – by past values of the variables,
and this gives rise to the idea of lagged endogenous variables. The variable Y t is determined
completely outside the model system and is called an exogenous variable.

Because P and Q are endogenous, applying OLS to the estimation of the supply (or the
demand) equation will generate biased (simultaneous equation bias) and inconsistent
estimators.
Thus, if we have a two-way causation in a function this implies that the function cannot be
treated in isolation as a single equation model, but belongs to a wide system of equations,
which describes the relationships among all relevant variables. If Y = f(x) and X =f(Y) we
have a joint dependence of variables. A system describing the joint dependence of variables
is called a system of simultaneous equations.

6.1 THE PROBLEM OF IDENTIFICATION

Identification is a problem of model formulation, rather than a model estimation or

appraisal. Wherein a model is in a unique statistical form such that unique estimates of its
parameters can be made from sample data, the model is said to be identified.

R.L. Thomas put it this way: “an equation is identified provided it is not possible to
derive, by taking linear combinations of equations in the model, another equation of exactly
the same form as the equation being considered”.

To explain the problem of identification, imagine that we wished to estimate the demand
curve for some typical non-durable household commodity and to this end collected time
series data on the price P, of the commodity and in the quantity bought and sold Q. if we just
regress (by OLS quantity Q on price P we are likely to notice that what we have does not bear
relation to the demand curve we wished to estimate. If even this case proved to bear relation
to demand, we would wonder how we would estimate a supply curve, since it also sketches a
relationship between P and Q given the ceteris parabus assumption

Consider the two equation model with the assumption that the market always clears:

Q=α O P+α 2 PS +α 3 Y +u demand equation

s
Q=β O + β 1 P+ β 2 P +V sup ply equation

α 2 and β 2 are unknown parameters, Y income of purchases of the commodity, P s is price

of close substitute and U and V are disturbances. P and Q are the endogenous variables,
Ps and Y are assumed to be endogenous variables. If we assume that actually the exogenous
variables aid remain constant, we structural equation could be written as:

Q=α O +α 1 P+ u demand equation

¿

Q=β O + β 1 P+ V sup ply equation

¿

(6.4a)

¿
α O =α 0 PS +α 2 Ps +α 3 Y , β 0 =β 0 + β 2 P s are cons tan ts .
¿

where
If we assume u and v were always identically zero, all we could observe under these
conditions would be a single pair of values for P and Q, those at the intersection point of the
¿ ¿
curves
Q=α +α P and Q=β + β P
0 1 0 1 . There would be no scatter of points, our time
series would continue to observe this single point.

What would happen if the disturbances u and v were non-zero and varied from period to
period. Any scatter of points obtained over different periods would merely be a series of
intersection points generated by the continually shifting demand and supply curves – an
illustration is given in Fig 6.1 any attempt to fit such scatter points by OLS will produce
neither a demand nor a supply curve but what is commonly known as the “Mongrel” curve.
This is the simplest case of the problem of identification.

Identification of either curve can only be achieved if one remains stationary over time while
the other curve shifts. For example in Fig. 6.2 the supply curve S remains stationary while
the demand curve shifts.

The intersection points obtained trace out a supply curve. The shifts in demand curve might
be due to a sharp variation of the demand disturbance from period to period with little or no
variation in the supply disturbance. It might also be due to a sharp change in the income
variable over time. Where it was possible for the supply curve to shift while the demand
curve is stationary cannot be established by the supply curve so specified in the equation.

Considering the model above(6.4), suppose both P and Q are exogenous

Adding the two equations and making Q the subject of the formula gives

λα 0 + μβ 0
λ+μ
+ ( λα 1 + μβ 1
λ+ μ ) (
P+
λα 2 + μβ 2
λ+ μ ) ( )
Ps +
λα 3
λ+ μ
Y+
λu+ λv
λ+ μ
(6.5)
The supply equation in (6.4) is completely different from (6.5) because (6.5) contain the
variable Y where as the second equation in (6.4) does not. We can clearly state the supply
equation is identified since it is not possible to derive an equation of similar form by any
linear combination of equation in (6.4). since the demand equation is identical to the
equation in (6.5), that means it is not unique in statistical form, then the demand equation in
(6.4) is unidentified. If an equation is unidentified there is no way or manner in which
unbiased or even consistent parameter estimators can be obtained

6.1.1. ESTABLISING IDENTIFICATION FROM THE STRUCTURAL FORM OF

THE MODEL

There are two conditions which must be fulfilled for an equation to be identified – the order
and rank conditions.

The order condition is based on a counting rule of the variables included and excluded from
the particular equation. The order condition is a necessary but not sufficed condition. The
order condition is as follows:
For an equation to be identified the total number of variables (endogenous and exogenous)
excluded from it must be equal to or greater than the number of endogenous variables in the
model less one. Equivalently, it can be stated that ‘for an equation to be identified the total
number of variables excluded from it but included in other equations must be at least as great
as the number of equations of the system less than one. This is formally stated as:

(K – M) ≥ (G – 1)
Excluded Total number of
Variables equations less one

The rank condition states that ‘in a system of G equations any particular equation is identified
if and only if (iff) it is possible to construct at least one non-zero determinant of order (G – 1)
form the coefficients of the variables excluded from that particular equation but contained in
the other equations of the model.

For example let the structural model be

X1= 4y2 – 3x1 + x2 + u1

Y2 = 3y3 + 2x3 + u2

Y3 = y1 - y2 + x3 + u3

Where the y’s is the endogenous variables and the x’s are the predetermined variables

The order condition equation by equation is as follows:

1st equation G =3 K=6 M=4

and the counting rule (K – M) ≥ (G – 1) gives (6 – 4) = (3 – 1).

From the order condition, equation 1 is just (exactly) identified

2nd equation G = 3 K=6 M=3

This equation 2 is over identified.

3rd equation G =3 K=6 M=4

(6 - 4) = (3 –1)
Equation 3 is just identified.

We then need to certify the above by the rank condition – that is looking at the rank of the
matrix of parameters of excluded variables. To do this we rewrite the model in the form
 − y 1 +4 y 2 +0 y 3−3 x 1 +ox 3 +u1=0
oy 1 − y 2 +3 y 3 +0 x 1 +2 x 3 +u2 =0
y 1 − y 2 − y 3 +0 x 1 +0 x 2 −x 3 +u3 =0
Ignoring the random disturbances the table of the parameters of the model is as follows:

Variables

Equations Y1 Y2 Y3 X1 X2 X3
1st -1 4 0 -3 1 0

2nd 0 -1 3 0 0 2

3rd 1 -1 -1 0 0 -1

To examine the first equation, strike out row 1 of the table, then strike out the column in
which a non-zero coefficient appears in the first equation. This leaves the coefficients of
variables not included in the particular equations, but contained in the other equations of the
model. The following will illustrate the point.
Table of structural parameters Table of parameters of
excluded variables
Y1 Y2 Y3 X1 X2 X3 Y3 X3
-1 4 0 -3 1 0 3 2

0 -1 3 0 0 2 -1 -1

1 -1 -1 0 0 -1

From the table of parameters of excluded variables we form determinants of order (G – 1)

and examine their value. If at least one of these determinants is non-zero, the equation is
identified. If all of the determinants of order (G-1) are zero, the equation is under identified
(unidentified). From the above example we have three determinants of order (G – 1) = 3 – 1
= 2 as follows:
3 2
-1 -1 = -1
≠ 0
Since the determinant is non-zero and of order G – 1 the first equation is identified.

**
The identification of the second and third equations is a class exercises.

6.1.2 ESTABLISHING IDENTIFICATION FROM THE REDUCED FORM

Here also, the order condition is invariably the same as it is for the structural form.
That is,
(K – M) ≥ (G – 1)
Total number of number of equations
Excluded Variables less one

The rank condition is also based on an examination of the rank of the matrix of
reduced form parameters of excluded variables. An equation containing G*
endogenous variables is identified if and only if it is possible to construct at least one
non-zero determinant of order G*-1 from the reduced form coefficients of the
exogenous (predetermined) variables excluded from that particular equations.

The practical steps involved in this method of identification can be outlined as

follows:

Obtain the reduced form of the structural model

Assume that the original mode is :

y 1 =β 12 y 2 +r 11 x 1 +r 12 x 2 +u1
y 2 =β 22 y 3 +r 23 x 3 +u2
y 2 =β 31 y 1 +β 32 y 2 +r 33 x3 +u3
The system is complete since it contains three equations in three endogenous
variables. The model contains 6 variables (3 endogenous, y 1 y2 and y3 and 3
exogenous x1,x2, x3)
Solving the above equations for the endogenous variables gives the reduced form

y 1 =π 11 x1 + π 12 x 2 + π 13 x 3 + v 1
y 2 =π 21 x 1 + π 22 x 2 + π 23 x 3 + v 2
y 3 =π 31 x 1 + π 32 x 2 + π 33 x 3 + v 3
Where the π ' s are functions of structural parameters.

Form the complete table of the reduced form coefficients

Exogenous variables

Equations x1 x2 x3

1st equation. Y1 π11 π12 π13

2nd equation y2 π21 π22 π23
3rd equation y3 π31 π32 π33

Strike out the rows corresponding to endogenous variables excluded from the
particular equation being examined for identifiability. Also strike out all the columns
referring to exogenous variables included in the structural form of the particular
equation. This leaves us with the reduced form coefficients of exogenous variables
excluded (absent) from the structural equation. That is, we are left with a matrix, if
the order is (G – 1) and the values of the determinant is non-zero then the equation is
identified.

For example consider the identification of the first equation. The reduced form
coefficients relevant to the identification are found by striking out the third row (since
Y3 does not appear in the first equation) and the first and second columns (x 1 and x2
are included in the equation).

Complete table of reduced form Table of reduced form coefficients

of excluded exogenous variables

π11 π12 π13 π13

π21 π22 π23 π23
π31 π32 π33

Then examine the order of the determinant of the π ' s of excluded exogenous
variables and evaluate them. If the order of the largest non-zero determinant is G* -
1, the equation is identified, otherwise the equation is not identified.
Numerical example. Consider the structural model:

y 1 =4 y 2−3 x 1 + x 2 +u 1
y 2 =3 y 3 +2 x 3 + u2
y 2 = y 1 − y 2 + x 3 +u 3

Examine the identification of each structural equation using the reduced form approach.
Order condition satisfied.

Rank condition.

Excluded exogenous variables Y1

Included exogenous variable X3

Table of reduced form coefficients Table of π ' s excluded exogenous variables

3 1 3 9 3
− −
8 2 2 8 8

9 3 3 3 1
− −
8 8 8 8 8

3 1 17
−
8 8 8
The order of the determinant of π ' s of the excluded exogenous variables is 2 x 2 and the
value is zero
9
− 3
8 8

3
−1 =0
8 8
Thus the highest non-zero determinant which we may form from the π ' s is 1 x 1. the second
equation contains two endogenous variables i.e. G* = 2. therefore the order of highest non-
zero determinant is G* - 1 = 1. therefore the second equation is identified. More precisely,
the second equation, using order condition (6 – 3) > (3 – 1) is over identified.

Third equation
Y2 = y1 – y2 + x3 + u3
Order condition
K=6 M=3 G=3

(6 – 3) = (3 – 1)
Order condition is satisfied:
Excluded endogenous variables: none
Included exogenous variables: x3
Table of all π ' s Table of π ' s of excluded exogenous Variables

3 1 3 3 3
− −
8 2 2 2 2

9 3 3 8 3
− −
8 8 8 8 8

3 1 17 3 1
− −
8 8 8 8 8

The highest non-zero determinant is of order 1 x 1 since

3 1
3
−
1 −
2 2 2 2 9 3
− =0
9 3 1 8 8
−
3 8 8 3 1
8 − −
8 = 0 = 0 8 8

G* = 3, G* - 1 = 2. Thus, order of largest non-zero determinant is less than G* - 1. rank

condition not satisfied, third equation is not identified even though the order condition is
satisfied.

With the above rules for identification, it is necessary to state that customarily identification
is established by making one of the following assumptions.

Imposition of restrictions on the values of the parameters of some variables in the form of
zero restrictions, equality restrictions , or other linear relationships between some of the
parameters.

*Extraneous estimates of some parameters.

*Imposition of restrictions concerning the relative variances of the random variables
of the various equations of the model.

It is the nature of identification that determines how the model can be estimated. When an
equation is just (exactly identified or over identified it is identified. An equation that is under
identified is unidentified. Where an equation is exactly identified the indirect least squares
(ILS) method is considered equivalent to the instrumental variable (Ivs) method. Where an
equation is over identified the IV method or two stage least squares (2SLS) is
appropriate.

6.2 SINGLE-EQUATION ESTIMATION METHODS IN SIMULTANEOUS

EQUATION MODELS
In order to estimate the structural parameters of a particular equation of a simultaneous
equation model, that equation must be either just identified or over identified.

If an equation is just identified the ILS method is applied and these can be illustrated given
the following two equation model in (6.4).

Q= α 0 +α 1 P+ α 2 P S + α 3 Y + u demand equation
S
Q= β O + β 1 P+ β 2 P +v sup ply equation
The demand equation is not identified whereas the supply equation is identified.
The reduced form of the equation are

Q=
α 0 β1 −α 1 β 0
β 1 −α 1
+ 2 1
[
α β −α 1 β 2
β 1−α 1 ] [
α β
P S+ 3 1
β1 −α 1
β u−α 1 v
Y+ 1
β 1 −α 1 ]
….(6.7)
P=
α 0 −b o
β 1 −α 1 [
α −β 2
+ 2
β 1−α 1
α
PS + 3
] [ ]
β 1−α 1
Y+
u−v
β 1−α 1

(6.7) can be rewritten (ignoring the disturbance) as

Q=π 10 + π 11 Ps + π 12 Y
P=π 20 + π 21 P S + π 22 Y
Where
α β −α 1 β 0
π 10= 0 1
β 1 −α 1
π 11 2 1
[
α β −α 1 β 2
β 1 −α 1 ] π 12=
[α 3 β1
β1 −α 1 ]
π 20=

(6.8)
α 0 −b o
β 1 −α 1
π 21=
[ α 2− β2
β 1−α 1 ] π 22=
[ α3
β 1 −α 1 ]
The π ' s are the reduced form parameters which are functions of α ' s and β ' s (the structural
parameters).

The reduced form parameters measure the total effect, direct and indirect, of a change in the
pre-determined variable on the endogenous variables, after taking account of the
interdependence among the jointly dependent endogenous variables, while a structural
parameter indicates only the direct effect within a single sector of the economy. For
example, the total effect (measured by π 12 )
 ( )
α3 β 1 α
π 12= =α 3 1+ 1
β 1 −α 1 β 1−α 1
α3 α1
or π 12=α 3 +
β 1 −α 1
[Total effect] = [direct effect] + [indirect effect]

The reduced form coefficients are used for forecasting and policy analysis since it is the total
effect of a change in the exogenous variables on the dependent variable (s) that is of interest
to the policy maker.

π 10−α 1 π 20=α 0 π 10−β 1 π 20=β 0

π 11 −α 1 π 21=α 2 π 11 −β 1 π 21=β 2
Given that:
π 12−α 1 π 22=α 3 (6 . 8) π 12−β 1 π 22=0
(6 . 9)
The subsystem (6.8) refers to demand equation and it is clear that we have three linear
equations in four unknowns 0 1 2
α α α and α
3 . Thus, it is not possible to derive unique
values for the structural parameters of the unidentified demand equation. Considering the
β , β and β 2 .
subsystem (6.9) we see that there are three linear equations in three unknowns 0 1
It may be solved after applying OLS to the reduced form equation. The solution being
β 1=π 12 / π 22 , β 2 =π 11−[ π 12 /π 22 ] π 21 and
β o =π 10−[ π 12 / π 22 ] π 20
(6.10)

this indicates that given knowledge of the reduced form parameters, it is possible to derive
the parameters of the identified supply equation.
For example suppose the reduced form parameters in (6.7) were known to have the following
values
π 10=0 . 3 π 11=0. 2 π 12=0 .1
π 20=0 . 2 π 21=0 .1 π 22=0 . 3
we could then derive unique values for the supply equation parameters using (6.10). that

is
β 1=0. 333 , β 2=0 . 167 and β0 =0 . 233

The supply equation becomes

Q=0.233 + 0.333P + 0.167Ps + v

(6.11)

All that has been stated is that the supply equation in (6.4) may be estimated by ILS. The
method involves applying the OLS technique to the reduced form equations of the model in
this case the equation in 6.7 OLS may therefore be used to obtain unbiased and consistent
estimates of the reduced form parameters. That is, we compute the sample regression
equations.

^ π^ + π
Q= ^ 11 Ps + π
^ 12 Y
10
^ π^ + π
P= ^ P s+ π ^ Y
20 21 22
Where the π^ ' s are the OLS estimates of the π ' s

The form of the estimators is given by (6.10). we have

^ = π^ + π
β ^ =π^ −[ π
^ 22 , β ^ /π
^ 22 ] π̈ 21 and
1 12 2 11
^ =π^ −[ π
β ^ 12 / π^ 22 ] π 21
0 10
^ ^ ^ ^ ^ ^
the estimators β 0 , χ 1 and β 2 of the structural parameters β 0 , χ 1 and β 2 are known as the
^
ILS estimators. Since the πs are consistent estimators of the reduced form parameters. β s
are consistent estimators of the structural parameters of the supply equation. However, the
β^ s
are not unbiased despite the fact that the π^ s have this property. Thus the ILS estimators
have desirable large sample properties only.

To further illustrate the ILS technique, consider the following model in which both structural
equations are exactly identified:
y 1 t =β12 y 2t +Y 11 x 1t +u1 t
y 2 t =β 21 y 1t +Y 22 x2 t +u2t

(6.12)
The reduced form equations are
Y 11 β 12 Y 22
y1 t= x1 t+ x + v 1t
1−β12 β 21 1−β 12 β 21 2t
(6.13)

β21 Y 11 Y 22
y2 t= x1 t+ x 2 t + v 2t
` 1− β12 β 21 1− β 12 β21
Where
u1t + β 12 u2 t β 21 u1t +u2 t
v 1t = and v 2 t =
1−β 12 β 21 1− β 12 β 21

let the estimators of the reduced form coefficients be given by π^ s ij = i,j = 1, 2.

The estimators of the structural coefficients are therefore given by
 π^ 12 π^
β^ 12= , β^ 21= 21
π^ 22 π^ 11
Y^ 11 =π^ 11 [ 1− β^ 12 β^ 21 ] ; Y^ 22= π^ 22 [ 1− β^ 12 β^ 21
(6.14)
When an equation is over identified, there is more than one relationship between reduced
form and structural parameters
The methods of estimation appropriate are instrumental variable (IV) method or the second
stage least squares (2SLS).
Consider the following equations in the model below:
y 1 t =β12 y 2t +Y 11 x 1t +Y 13 x3 t +u1t
(6.15)
y 2 t =β 21 y 1t +Y 22 x2 t +u2t

In (6.15) the first equation is exactly identified and the second equation over identified. To
apply the IV technique, we need to choose as our instrument for y 1t a variable, which is
correlated with y1t, but is uncorrelated with the stochastic disturbance term u 2t. an obvious
instrument to choose is one of the predetermined variable which does not appear in the
second equation.
Σχ u =Σx2 t ut =0
Say, we choose χ 1 ∈ as the instrument with the conditions 1t 2t

Σχ 1t y 2 =β 21 Σx1 y1 +Y 22 Σx1 x 2
Σχ 2 y 2=β 21 Σx 21 Σχ 2 y 1 +Y 22 Σx 22
(6.16)

Solving equation (6.16) for the IV estimators of

β 21 and Y 22 , we obtain
2
Σχ 2 Σχy 2 −Σχ 1 χ 2 Σχ 2 y 2
β^ 21 = 2
IV
Σχ 2 Σχy1 −Σχ1 χ 2 Σχ 2 y 1

IV
Σχ 1 y 1 Σχ 2 y 2−Σχ 2 Υ 1 Σχ 1 y 2
γ^ 22 =
Σχ 22 Σχy1 −Σχ 1 χ 2 Σχ 2 y 1

Note, however, that had we chosen x3 rather than x, as our instrument we would have
obtained the following IV estimators
 Σx 22 Σx 3 y 2 −Σχ 2 x 3 Σx 2 y 2
β^ 21 =
IV
Σx 22 Σx 3 y 1−Σx 2 x3 Σx 2 y 1

IV
Σx 3 y 1 Σx 2 y 2 −Σχ 2 y 1 Σx 3 y 2
γ^ 22 =
Σx 22 Σx 3 y 1 −Σx 2 x 3 Σx 2 y 1
Hence, the IV estimators are not unique when the equation is overidentifed..

When an equation is overidentified two-stage least squares (2SLS) provides a very useful
estimation procedure. Two-stage least-squares estimation uses the information available
from the specification of an equation system to obtain a unique estimate for each structural
parameter. Intuitively, the first stage of 2SLS involves the creation of an instrument, while
the second stage involves a variant of instrumental – variables estimation. Below is a brief
description of the workings of 2SLS and an outline of some of its properties.

Consider the supply model described in (6.17). the structural model and the resulting reduced
from would be given in (6.18).

Structural model:

Supply:
q t =α 2 p t + ∈t
(6.17)

Demand:
q t = β 2 y t + β3 y t + β 4 w t +u t

q t =π 12 y t +π 13 wt +v 1 t
Reduced form:
pt =π 22 y t +π 23 w t +v 2t
(6.18)
The supply equation is (6.17) is over identified, so that ILS does not yield unique parameter
estimates. If we want to use IV method we have to make a choice between two estimators of
the parameter α 2 . Both parameter estimators (using either y 1t or wt as instruments are
consistent, and as such a criterion to choose between the two is needed. The 2SLS gets over
this problem easily as illustrated below.

Firstly, the reduced form equation for p t is estimated using OLS. This is accomplished by
regressing pt on all the predetermined variables in the equation system. From this stage the
fitted values of the dependent variable are determined. That is from the equation
^pt = π^ 22 y t + π^ 23 w t , where π^ 22 and π^ 23
are the OLS parameter estimators. The fitted values
^pt will be construction be independent
∈
of the error terms t and ut . Thus, the first stage process allows us to construct a variable
which is linearly related to the predetermined model variables (through least squares
estimation) and which is purged of any correlation with the error term in the supply equation.
In the second-stage regression, the supply equation of the structural model is estimated by
replacing the variables Pt with the first stage fitted variable
P^ t . The use of OLS in the second
stage will yield a consistent estimator of the supply parameter α 2 . If additional
predetermined variables appeared in the supply equation, 2SLS would also estimate those
parameters consistently.

By construction, 2SLS eliminates the problem of an oversupply of instruments by using

combinations of the predetermined variables to create a new instrument. When an equation is
exactly identified, 2SLS estimation is identical to ILS and IV estimation. This can be
illustrated by examining the model:

sup ply : q t =α 2 p t +∈
demand : qt =β 2 pt + β 3 y t +ut
(6.19a)

α 2 β3 α u −β 2 ∈t
with qt = yt + 2 t =π 12 y t + v 1t
α 2 −β 2 α 2 −β2

β3 ut −∈t
pt = yt + =π 22 y t + v 2t
α 2− β 2 α2− β 2
(6.19b)

Use OLS to estimate the second part of (6.19b). then calculate the fitted values

Σp t y t
^ = π^ y where π^ =
P t 22 t 22
Σy 2t

Then use OLS to estimate the equation t q =α p^ + ∈t

2 t
2
Σp ^ t q t Σy t qt ( Σp t y t / Σy t )
hence α^ 2 ***= = 2
Σp ^ 2t Σy t ( Σp t y t / Σy 2t )2

Σyt q t
Σp t y t { 2
= α^ ** u sin g ILS

= α^ 2∗ u sin g IVs .