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Wooldridge InstrumentalVariablesEstimation 2005
Wooldridge InstrumentalVariablesEstimation 2005
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to Econometric Theory
INSTRUMENTAL VARIABLES
ESTIMATION WITH PANEL DATA
JEFFREY M. WOOLDRIDGE
Michigan State University
The system two stage least squares estimator for the linear panel data model is
shown to have different characterizations depending on the choice of instrument
matrix. The more general estimator, where, in effect, separate reduced form lin-
ear projections are estimated for each time period, also has the advantage of being
applicable when the number of instruments changes across time periods. The issue
of efficient estimation is also treated.
Address correspondence to Jeffrey M. Wooldridge, Department of Economics, Michigan State University, East
Lansing, MI 48824-1038, USA; e-mail: wooldril @msu.edu.
t can include the observed history of the response variable up through time
t - 2. For the asymptotic analysis, we assume fixed T with N ox.
Define the T X K matrix of explanatory variables Xi as
xii
Xi= ( (2)
XiT/
Zil ? ? ? ?
? Zi2 ? 0 )
zi= 0 0 * 0 0 *(3)
O O O O ZiT
[( E j i )( z i )(EZi Xi)]
N N -1 N \
X _j Z'Z (4)
(a) For each time period t, run separate reduced form regressions, xit on zit,
i = 1, ... , N, and obtain the fitted values, xit, i = 1,.. , N. (Remember, for
each i and t, the fitted value is a 1 X K vector regardless of the dimen-
sion of zit)
(b) Obtain f3 by applying pooled IV to (1) using instruments xit for xit. In
other words,
N T eIm N T
Zil
Z.lZi2 (6)
ZiT/
If we use this choice of Zi in equation (4), how can we describe the resulting
estimator? In particular, how does it differ from the estimator that uses (3) as
the IV matrix?
(iv) How would you obtain an estimator more asymptotically efficient than
either of the estimators in (i) or (iii)?
The proofs of the results require only straightforward matrix algebra and least
squares mechanics. Of perhaps more interest is what the results have to say for
how to use instruments in panel data settings.
(i) Straightforward partitioned multiplication shows that
~Z~1 0 0 0 0
N
EZiZi= o o o 0
i=1 ~~~0 0 .0 0
O 0 * 0
N
O O 0 0 ZiTZiT
i=l
N N
i1 X i Zi1 Yi1
Nf N
N N
N N
i=1 ~~~~~~~~i=1
N /N \-/ N
T N N T
A A
= ,XitXi, =,t, xitxit,
t-l i=i= t=l
where Ait = zallt and Ii = ( zitzit)' (X$= Z'xi,) is the matrix of first-
stage regression coefficients (for time period t). Similarly,
N \ N -1 N \ T N N T
E XiZi } E ZiZ
i=1 / i1t= 1 i
period
for xit.
(ii) As with cross-sectional IV, estimation of the linear projection L(xi, I zit)
zitut by xit = Zitlt does not affect the first-order asymptotic properties of IV.
(Technically, N-12 i= = I)'uit=N-1 '=1(zitHt)'uit + op(l).) Never-
theless, without further assumptions, the errors {Uit: t = 1,2,..., T} can be arbi-
trarily serially correlated and heteroskedastic. Let Uit = Yit - xA8 denote the
IV residuals where, as usual, these depend on xit, not xi. Then
X -1 v iX
/ N T -1 N T T
N T \-
mation with instruments xi,, where each cross-sectional observation acts as its
own cluster.
(iii) With Zi as in (6), the system 2SLS estimator-say, a-is easily seen to
be
_N T N T -1 N T _-1
/N T N T I- N T \
REFERENCES
Arellano, M. & S.R. Bond (1991) Some specification tests for panel data models: Monte Car
evidence and an application to employment equations. Review of Economic Studies 58, 277
Wooldridge, IM. (2002) Econometric Analysis of Cross Section and Panel Data. MIT Press