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SIMULTANEOUS-EQUATION SYSTEM

IDENTIFICATION

THE PROBLEM OF IDENTIFICATION STATED

Identification is a problem of model formulation, rather than of model estimation or apprasial. We say a
model is identified if it is in a unique statistical form, enabling unique estimates of its parameters to be
subsequently made from sample data. If a model is not identified then estimates of parameters of
relationships between variables measured in samples may relate to the model in question, or to another
model, or to a mixture of models.

An econometric model is frequently in the form of a system of simultaneous equations. The model may
be said to be complete if it contains at least as many independent’ equations as endogenous variables. For
identification of the entire model, it is necessary for the model to be complete and for each equation in it
to be identified.

To illustrate the meaning of the identification problem let us take an example from the theory of market
equilibrium. Assume that the market mechanism for a certain commodity is given by the following simple
model

𝐷 = 𝑏0 + 𝑏1 𝑃 + µ

𝑆 = 𝑎0 + 𝑎1 𝑃 + 𝑣

𝐷=𝑆

𝑤ℎ𝑒𝑟𝑒 𝐷 = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑, 𝑆 = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑, 𝑃 = 𝑝𝑟𝑖𝑐𝑒.

The first equation is the demand function, the second expresses the supply function and the third is the
equilibrium condition of the market (or clearance equation). The model is complete in that there are three
equations and three endogenous variables (S, D, P). But is each equation identified?

Assume we are interested in the measurement of the coefficients of the demand equation. To obtain
estimates of 𝑏0 and 𝑏1 we normally use published time series reporting the quantity bought of the
commodity. However, the quantity bought is identical with the quantity sold at any particular price.
Market data register points of equilibrium of supply and demand at the price prevailing in the market at a
certain point of time. A sample of time-series observations shows simultaneously the quantity demanded,
D, and the quantity supplied, S, at the prevailing market price, P. If we use these data for estimation, we
actually measure the coefficients of a function of the form 𝑸 = 𝒇(𝑷).

This equation may be either the demand function or the supply function (or even a ‘bogus’ equation, as
we will presently see). How can we be sure which function we do really measure? If two econometricians
use these data and one claims that he has estimated a demand function, while the other claims that he has
estimated a supply function, how are we to decide who is right? Clearly, we need some criteria which will
enable us to verify that the estimated coefficients belong to the one or the other relationship. Such criteria
are known as ‘identification conditions’ of a function and will be developed in a subsequent section.
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Paradox of identification: the identification of a function depends on variables absent from it, while at
the same time being operative in the other function(s) of the model. We are able to identify a function by
what variables it does not include.

A function belonging to a system of simultaneous equations is identified if it has a unique Statistical

form, that is if there is no other equation in the system, or formed by algebraic manipulation of the other
equations of the system, which contains the same variables as the function in question. To illustrate this
definition let us return to our earlier example of the model of the market mechanism of a certain product

𝐷 = 𝑏0 + 𝑏1 𝑃 + µ (15.1)

𝑆 = 𝑎0 + 𝑎1 𝑃 + 𝑣 (15.2)

𝐷=𝑆 (15.3)

We want to find out whether the estimates, which we may obtain by using sample data on demand and
price can be identified as estimates of the true demand parameters 𝑏0 and 𝑏1 We may substitute S in
equation (15.3) and obtain

𝐷 = 𝑎0 + 𝑎1 𝑃 + 𝑣 (15.4)

We thus have two equations (15.1) and (15.4) of the same statistical form, that is containing the same
variables (𝐷 𝑎𝑛𝑑 𝑃). However, the first contains the demand parameters (𝑏0 , 𝑏1 ), while the second
contains the supply parameters (𝑏0 , 𝑏1 ). Regressing D on P with sample data we cannot be sure that the
estimates which we will obtain are really the b’s or the a’s.

The demand equation has not a unique statistical form, hence its parameters cannot be statistically
identified. Let us proceed further. By algebraic manipulations we may form an infinite number of
equations which have the same statistical form with the demand function.

For example multiplying equations (15.1) and (15.4) by 𝑘 𝑎𝑛𝑑 𝑐 (arbitrary constants) respectively we
obtain

𝑘𝐷 = 𝑘𝑏0 + 𝑘𝑏1 𝑃 + 𝑘µ

𝑐𝐷 = 𝑐𝑎0 + 𝑐𝑎1 𝑃 + 𝑐𝑣

Adding these expressions we obtain

(𝑘 + 𝑐)𝐷 = (𝑘𝑏0 + 𝑐𝑎0 ) + (𝑘𝑏1 + 𝑐𝑎1 )𝑃 + (𝑘µ + 𝑐𝑣)

or
𝑘𝑏0 + 𝑐𝑎0 𝑘𝑏1 + 𝑐𝑎1 𝑘µ + 𝑐𝑣
𝐷=( )+( )𝑃 + ( )
𝑘+𝑐 𝑘+𝑐 𝑘+𝑐
𝑘𝑏0 + 𝑐𝑎0 𝑘𝑏1 + 𝑐𝑎1 𝑘µ + 𝑐𝑣
𝐴0 = 𝐴1 = 𝑢⋇ =
𝑘+𝑐 𝑘+𝑐 𝑘+𝑐

we may write the above expression in the form

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𝐷 = 𝐴0 + 𝐴1 𝑃 + 𝑢⋇

This equation contains the same variables as the first equation of the structural model, but its parameters
are a mixture (linear combination) of the parameters of the demand function, of the supply function and of
the arbitrary constants (k, c). Thus by manipulating the relations of the structural model we obtained a
‘bogus’ equation, an equation which is neither the supply nor the demand function, but a mixture of both,
which, however, has the same statistical form as the demand function.

Consequently the demand function is not identified (or, more precisely, the parameters of the demand
function are not identified). Under the above circumstances, if we use a sample of actual observations and
perform the regression D = f(P) we cannot be sure whether we obtain estimates of the b’s, the a’s, or of
the mixed coefficients 𝐴0 𝑎𝑛𝑑 𝐴1 .

The conclusion from the above discussion is that

a) The identification of a system boils down to the identification of each one of its equations;
b) Identification of the parameters of any equation is established if we can prove that its statistical
form is unique.

There are two formal rules with which we can establish the identification of a relationship. These rules set
conditions for the identifiability of a relationship. They are

i. The order condition and

ii. The rank condition for identification.

Before examining formally these conditions we must give some traditional definitions referring to
identification.

In econometric theory two possible situations of identifiability are traditionally distinguished:

1. Equation underidentified.
2. Equation identified
a) Exactly identified.
b) Overidentified.

An equation is underidentified if its statistical form is not unique. A system is underidentified when one
or more of its equations are underidentified.

If an equation has a unique statistical form we say that it is identified. It may be exactly identified or
overidentified. But in both cases it is identified. A system is identified if all its equations are identified.

It should be noted that identification problems arise only for those equations which contain coefficients
which must be estimated statistically (from sample data).

Identification difficulties do not arise for definitional equations, identities, or statements of equilibrium
conditions, because such relationships do not require measurement.

IMPLICATIONS OF THE IDENTIFICATION STATE OF A MODEL

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Identification is closely related to the estimation of the model.

1. If an equation (or a model) is underidentified it is impossible to estimate all its parameters with
any econometric technique.
2. If an equation is identified, its coefficient can, in general, be statistically estimated. In particular:
a) If the equation is exactly identified, the appropriate method to be used for its estimation is
the method of indirect least squares (ILS)
b) If the equation is overidentified, indirect least squares cannot be applied, because it will
not yield unique estimates of the structural parameters. There are various other methods
which can be used in this case, for example two-stage least squares (2SLS), or maximum
likelihood methods.

FORMAL RULES (CONDITIONS) FOR IDENTIFICATION

Identification may be established either by the examination of the specification of the structural model, or
by the examination of the reduced form of the model.

Traditionally identification has been approached via the reduced form. Actually the term ‘identification’
was originally used to denote the possibility (or impossibility) of deducing the values of the parameters of
the structural relations from a knowledge of the reduced-form parameters.

In this section we will examine both approaches. However, we think that the reduced form approach is
conceptually confusing and computationally more difficult than the structural model approach, because it
requires the derivation of the reduced form first and then examination of the values of the determinant
formed from some of the reduced form coefficients. The structural form approach is simpler and more
useful.

In applying the identification rules we should either ignore the constant term, or, if we want to retain it,
we must include in the set of variables a dummy variable (say Xo) which would always take on the value
1. Either convention leads to the same results as far as identification is concerned.

ESTABLISHING IDENTIFICATION FROM THE STRUCTURAL FORM OF THE MODEL

We mentioned earlier that there are two conditions which must be fulfilled for an equation to be
identified.

1. The Order Condition for Identification:

This condition is based on a counting rule of the variables included and excluded from the particular
equation. It is a necessary but not sufficient condition for the identification of an equation. The order
condition may be stated 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. Given that
in a complete model the number of endogenous variables is equal to the number of equations of the
model, the order condition for identification is sometimes stated in the following equivalent form.
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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 one.

Let 𝐺 = 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛𝑠 (𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑛𝑑𝑜𝑔𝑒𝑛𝑜𝑢𝑠 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑠)

𝐾 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑚𝑜𝑑𝑒𝑙 (𝑒𝑛𝑑𝑜𝑔𝑒𝑛𝑜𝑢𝑠 𝑎𝑛𝑑 𝑝𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑)

𝑀 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝑠, 𝑒𝑛𝑑𝑜𝑔𝑒𝑛𝑜𝑢𝑠 𝑎𝑛𝑑 𝑒𝑥𝑜𝑔𝑒𝑛𝑜𝑢𝑠, 𝑖𝑛𝑐𝑙𝑢𝑑𝑒𝑑 𝑖𝑛 𝑎 𝑝𝑎𝑟𝑡𝑖𝑐𝑢𝑙𝑎𝑟 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛.

Then the order condition for identification may be symbolically expressed as

(𝐾 − 𝑀) ≥ (𝐺 − 1)

[excluded variables] ≥ [total number of equations — 1]

For example, if a system contains 10 equations with 15 variables, ten endogenous and five exogenous, an
equation containing 11 variables is not identified, while another containing 5 variables is identified.

a) For the first equation we have

𝐺 = 10 𝐾 = 15 𝑀=5
Order condition:

(𝐾 − 𝑀) ≥ (𝐺 − 1)

(15 − 5) ≥ (10 − 1)

that is, the order condition is satisfied. The order condition for identification is necessary for a relation to
be identified, but it is not sufficient, that is, it may be fulfilled in any particular equation and yet the
relation may not be identified.

2. The Rank Condition for Identification

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

The practical steps for tracing the identifiability of an equation of a structural model may be outlined as
follows.

Firstly, Write the parameters of all the equations of the model in a separate table, noting that the
parameter of a variable excluded from an equation is equal to zero.

For example let a structural model be

𝑦1 = 3𝑦2 − 2𝑥1 + 𝑥2 + 𝑢1
𝑦2 = 𝑦3 + 𝑥3 + 𝑢2
𝑦3 = 𝑦1 − 𝑦2 − 2𝑥3 + 𝑢3

Where the y’s are the endogenous variables and the x’s are the predetermined variables.
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This model may be rewritten in the form

−𝑦1 + 3𝑦2 + 0𝑦3 − 2𝑥1 + 𝑥2 + 0𝑥3 + 𝑢1 = 0

0𝑦1 − 𝑦2 + 𝑦3 − 0𝑥1 + 0𝑥2 + 𝑥3 + 𝑢2 = 0
𝑦1 − 𝑦2 − 𝑦3 + 0𝑥1 + 0𝑥2 − 2𝑥3 + 𝑢3 = 0

Ignoring the random disturbances the table of the parameters of the model is as follows.

Equations Variables
𝑦1 𝑦2 𝑦2 𝑥1 𝑥2 𝑥3
st
1 Equations -1 3 0 -2 1 0
2nd Equations 0 -1 1 0 0 1
3rd Equations 1 -1 -1 0 0 -2

Secondly, Strike out the row of coefficients of the equation which is being examined for identification.
For example if we want to examine the identifiability of the second equation of the model we strike out
the second row of the table of coefficients.

Thirdly, Strike out the columns in which a non-zero coefficient of the equation being examined appears.
By deleting the relevant row and columns we are left with the coefficients of variables not included in the
particular equation, but contained in the other equations of the model.

For example if we are examining for identification the second equation of the system, we will strike out
the second, third and the sixth columns of the above table, thus obtaining the following tables.

Table of structural parameters

𝑦1 𝑦2 𝑦2 𝑥1 𝑥2 𝑥3
1st -1 3 0 -2 1 0
2nd 0 -1 1 0 0 1
3rd 1 -1 -1 0 0 -2

Table of parameters excluded variables

𝑦1 𝑥1 𝑥2
-1 -2 1
1 0 0

Fourthly, Form the determinant(s) of order (G — 1) and examine their value. If at least one of these
determinants is non-zero, the equation is identified. If all the determinants of order (G — 1) are zero, the
equation is underidentified.

In the above example of exploration of the identifiability of the second structural equation we have three
determinants of order (𝐺 — 1) = 3 — 1 = 2. 𝑇ℎ𝑒𝑦 are
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−1 −2 −2 1 −1 1
∆1 = | |≠0 ∆2 = | |=0 ∆3 = | |≠0
1 0 1 0 1 0

(the symbol A stands for ‘determinant’) We see that we can form two non-zero determinants of order
𝐺 — 1 = 3 — 1 = 2; hence the second equation of our system is identified.

Fifthly, To see whether the equation is exactly identified or overidentified.

We use the order condition (𝐾 — 𝑀) ≥ (𝐺 — 1). with this criterion, if the equality sign is satisfied,

that is if (𝐾 — 𝑀) = (𝐺 — 1), the equation is exactly identified. If the inequality sign holds, that is, if
(K —M) > (G — 1), the equation is overidentified.

In the case of the second equation we have

𝐺=3 𝐾=6 𝑀=3

and the counting rule (K —M) ≥ (G — 1) gives

(6 − 3) > (3 − 1)

Therefore the second equation of the model is overidentified. The identification of a function is achieved
by assuming that some variables of the model have a zero coefficient in this equation, that is, we assume
that some variables do not directly affect the dependent variable in this equation. This, however, is an
assumption which can be tested with the sample data. We will examine some fests of identifying
restrictions in a subsequent section.

Some examples will illustrate the application of the two formal conditions for identification.

Example 1. Assume that we have a model describing the market of an agricultural product. From the
theory of partial equilibrium we know that the price in a market is determined by the forces of demand
and supply. The main determinants of the demand are the price of the commodity, the prices of other
commodities, incomes and tastes of consumers. Similarly, the most important determinants of the supply
are the price of the commodity, other prices, technology, the prices of factors of production, and weather
conditions. The equilibrium condition is that demand be equal to supply. The above theoretical
information may be expressed in the form of the following mathematical model

𝐷 = 𝑎0 + 𝑎1 𝑃1 + 𝑎2 𝑃2 + 𝑎3 𝑌 + 𝑎4 𝑡 + 𝑢

𝑆 = 𝑏0 + 𝑏1 𝑃1 + 𝑏2 𝑃2 + 𝑎3 𝐶 + 𝑏4 𝑡 + 𝑤

𝐷=𝑆

Where

𝐷 = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑆 = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑

𝑃, = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑔𝑖𝑣𝑒𝑛 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦

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𝑃, = 𝑝𝑟𝑖𝑐𝑒𝑠 𝑜𝑓 𝑜𝑡ℎ𝑒𝑟 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑖𝑒𝑠

𝑌 = 𝑖𝑛𝑐𝑜𝑚𝑒

𝐶 = 𝑐𝑜𝑠𝑡𝑠 (𝑖𝑛𝑑𝑒𝑥 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒𝑠 𝑜𝑓 𝑓𝑎𝑐𝑡𝑜𝑟𝑠 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛)

𝑡 = Time trend, in the demand function it stands for ‘tastes’ in the supply function it stands for
‘technology’.

The above model is mathematically complete in the sense that it contains three equations in three
endogenous variables, D, S and 𝑃1 . The remaining variables, Y, 𝑃2 C, t are exogenous. Suppose we want
to identify the supply function. We apply the two criteria for identification:

1. Order condition:
(𝐾 — 𝑀) ≥ (𝐺 — 1)
In our example we have
𝑘=7 𝑀=5 𝐺=3
(𝐾 — 𝑀) = (𝐺 — 1)
(7 — 5) = (3 — 1) = 2

Consequently the second equation satisfies the first condition for identification.

2. Rank condition

The table of the coefficients of the structural model is as follows.

Equations Variables
D 𝑃1 𝑃2 Y t S C
st
1 Equation -1 𝑎1 𝑎2 𝑎3 𝑎4 0 0
2nd Equation 0 𝑏1 𝑏2 0 𝑏4 -1 𝑏3
3rd Equation -1 0 0 0 0 1 0

Following the procedure explained earlier we strike out the second row and the second, third, fifth, sixth
and seventh columns. Thus we are left with the table of the coefficients of excluded variables:

Complete table of structural parameters

-1 𝑎1 𝑎2 𝑎3 𝑎4 0 0
0 𝑏1 𝑏2 0 𝑏4 -1 𝑏3
-1 0 0 0 0 1 0

Table of parameters of variables excluded from the second equation

-1 𝑎3
-1 0
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From this table we can form only one non-zero determinant of order (G — 1) = (3 — 1) =2

−1 𝑎3
∆2 = | | = 𝑎3
−1 0

(0)(−1)— (−1)(𝑎3 ) = 𝑎3

The value of the determinant is non-zero, provided that 𝑎3 ≠ 0. We see that both the order and rank
conditions are satisfied. Hence the second equation of the model is identified. Furthermore, we see that in
the order condition the equality holds: (7 — 5) = (3 — 1) = 2. Consequently the second structural
equation is exactly identified.

Example 2. Assume the following simple version of the Keynesian model of income determination.
Consumption function:

Consumption function: 𝐶𝑡 = 𝑎0 + 𝑎1 𝑌𝑡 — 𝑎 2 𝑇 + 𝑢

Investment function: 𝐼𝑡 = 𝑏0 + 𝑏1 𝑌𝑡−1 + 𝑣

Taxation function: 𝑇𝑡 = 𝑐0 + 𝑐1 𝑌𝑡 + 𝑤

Definition: 𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡 + 𝐺𝑡

This model is mathematically complete in the sense that it contains as many equations as endogenous
variables. There are four endogenous variables, C, I, T, Y, and two predetermined variables, lagged
income (𝑌𝑡−1 ) and government expenditure (G).

A. The first equation (consumption function) is not identified

1. Order condition:

(𝐾 — 𝑀) ≥ (𝐺 — 1).

There are six variables in the model (K = 6) and four equations (G = 4). The consumption function
contains three variables (M = 3).

(𝐾 — 𝑀) = 3 𝑎𝑛𝑑 (𝐺 — 1) = 3

Thus (𝐾 — 𝑀) = (𝐺 — 1), which shows that the order condition for identification is satisfied?

2. Rank condition

The table of structural coefficients is as follows.

Equations Variables
C Y T I 𝑌𝑡−1 G
1st Equation -1 𝑎1 𝑎2 0 0 0
2nd Equation 0 0 0 -1 𝑏1 0
3rd Equation 0 𝑐1 -1 0 0 0
4th Equation 1 -1 0 1 0 1
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We strike out the first row and the three first columns of the table and thus obtain the table of coefficients
of excluded variables:

Complete table of structural parameters

C Y T I 𝑌𝑡−1 G
-1 𝑎1 𝑎2 0 0 0
0 0 0 -1 𝑏1 0
0 𝑐1 -1 0 0 0
1 -1 0 1 0 1

Table of coefficients of excluded variables

-1 𝑏1 0
0 0 0
1 0 1

We evaluate the determinant of this table. Clearly the value of this determinant is zero, since the second
row contains only zeros. Consequently we cannot form any nonzero determinant of order 3(= G — 1).
The rank condition is violated. Hence we conclude that the consumption function is not identified, despite
the satisfaction of the order criterion.

B. The investment function is overidentified

1. Order condition

The investment function includes two variables. Hence 𝐾 − 𝑀 = 6 − 2

Clearly (K — M) > (G — 1), given that G — 1 = 3. The order condition is fulfilled.

2. Rank condition

Deleting the second row and the fourth and fifth columns of the structural-coefficients table we obtain

Complete table of structural parameters

C Y T I 𝑌𝑡−1 G
-1 𝑎1 𝑎2 0 0 0
0 0 0 -1 𝑏1 0
0 𝑐1 -1 0 0 0
1 -1 0 1 0 1

Table of coefficients of excluded variables

-1 𝑎1 𝑎2 0
0 𝑐1 -1 0
1 -1 0 1
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The value of the first 3 x 3 determinant of the parameters of excluded variables is

−1 𝑐1 0 −1 0 𝑐1
∆1 = −1 | | − 𝑎1 | | + 𝑎2 | | = 1 + 𝑎1 − 𝑎2 𝑐1 ≠ 0
−1 0 1 0 1 −1
(Provided 𝑎1 − 𝑎2 𝑐1 ≠ −1)

The rank condition is satisfied since we can construct at least one non-zero determinant of order 3 = (G-
1).

Applying the counting rule (K —M) ≥ (G — 1) we see that the inequality sign holds:

4 > 3; hence the investment function is overidentified.

ESTABLISHING IDENTIFICATION FROM THE REDUCED FORM

There are two conditions for identification based on the reduced form of the model, an order condition
and a rank condition. The order condition is the same as in the structural model. The rank condition here
refers to the value of the determinant formed from some of the reduced form parameters π.

1. Order condition (necessary condition), as applied to the reduced form. An equation belonging to a
system of simultaneous equations is identified if
(𝐾 − 𝑀) ≥ (𝐺 − 1)
[excluded variables] ≥ [total number of equations — 1]

Where K, M and G have the same meaning as before:

K = total number of variables, endogenous and exogenous, in the entire model

M= number of variables, endogenous and exogenous, in any particular equation

G = number of structural equations = number of all endogenous variables in the model.

If (K — M) = (G — 1), the equation is exactly identified, provided that the rank condition set out below is
also satisfied. If (K — M) > (G — 1), the equation is overidentified, while if (K — M) < (G — 1), the
equation is underidentified, under the same proviso.

2. Rank condition as applied to the reduced form. Let G* stand for the number of endogenous
variables contained in a particular equation. The rank condition as applied to the reduced form
may be stated as follows.

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 equation.

The practical steps involved in this method of identification may be outlined as follows.

Firstly, Obtain the reduced form of structural model. For example assume that the original model is

𝑦1 = 𝑏12 𝑦2 + 𝑦11 𝑥1 + 𝑦12 𝑥2 + 𝑢1

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𝑦2 = 𝑏23 𝑦3 + 𝑦23 𝑥3 + 𝑢2

𝑦3 = 𝑏31 𝑦1 + 𝑦32 𝑥3 + 𝑦33 𝑥3 + 𝑢3

This model is complete in the sense that it contains three equations in three endogenous variables. The
model contains altogether six variables, three endogenous (𝑦1 , 𝑦2 , 𝑦3 ) and three exogenous (𝑥1 , 𝑥2 , 𝑥3 ).

The reduced form of the model is obtained by solving the original equations for the exogenous variables.
The reduced form in the above example is

𝑦1 = 𝜋11 𝑥1 + 𝜋12 𝑥2 + 𝜋13 𝑥3 + 𝑣1

𝑦2 = 𝜋21 𝑥1 + 𝜋22 𝑥2 + 𝜋23 𝑥3 + 𝑣2

𝑦3 = 𝜋31 𝑥1 + 𝜋32 𝑥2 + 𝜋33 𝑥3 + 𝑣3

Where the π’s are functions of the structural parameters.

Secondly, Form the complete table of the reduced form coefficients.

Equations Variables
𝑥1 𝑥2 𝑥3
st
1 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.

After these deletions we are left with the reduced form coefficients of exogenous variables excluded
(absent) from the structural equation. For example assume that we are investigating the identifiability of
the second equation. The reduced form coefficients relevant to the identification procedure are found by
striking out the first row (since y, does not appear in the second equation) and the third column (since x, is
included in this equation).

Complete table of reduced-form coefficients

𝜋11 𝜋12 𝜋13

𝜋21 𝜋22 𝜋23
𝜋31 𝜋32 𝜋33

Table of reduced form coefficients of excluded exogenous variables

𝜋21 𝜋22
𝜋31 𝜋32
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Thirdly, Examine the order of the determinants 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. Assume that a structural model is of the form

𝑦1 = 3𝑦2 − 2𝑥1 + 𝑥2 + 𝑢1

𝑦2 = 𝑦3 + 𝑥3 + 𝑢2

𝑦3 = 𝑦1 − 𝑦2 − 2𝑥3 + 𝑢3

We will examine the identification of each structural equation using the reduced-form approach.

The reduced form of the structural model is

𝑦1 = 𝜋11 𝑥1 + 𝜋12 𝑥2 + 𝜋13 𝑥3 = 4𝑥1 − 2𝑥2 + 3𝑥3

𝑦2 = 𝜋21 𝑥1 + 𝜋22 𝑥2 + 𝜋23 𝑥3 = 2𝑥1 − 𝑥2 + 𝑥3

𝑦3 = 𝜋31 𝑥1 + 𝜋32 𝑥2 + 𝜋33 𝑥3 = 2𝑥1 − 𝑥2

First equation: 𝑦1 = 3𝑦2 − 2𝑥1 + 𝑥2 + 𝑢1

1. Order condition:

(𝐾 — 𝑀) ≥ (𝐺 — 1)

𝐾=6 𝑀=4 𝐺=3

(𝐾 — 𝑀) = (𝐺 — 1)

(6 — 4) = (3 − 1)

Thus the equation satisfies the necessary condition for identification.

2. Rank condition

Excluded endogenous variables: 𝑦3

Included exogenous variables: 𝑥1 , 𝑥2

Table of all reduced form coefficients

4 -2 3
2 -1 1
2 1 0

Table of m’s of excluded exogenous variables

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3
1

From the table of m’s of excluded exogenous variables we can form two non-zero determinants of
order 1×1.

Now G* = 2, since the first equation contains two endogenous variables. Thus the order of the
determinant of π’s relating to excluded X’s is one:

(𝐺 ∗ − 1) = 1

The rank condition is satisfied and the equation is identified. Furthermore, by virtue of the order condition
we see that the first equation is exactly identified since the equality sign holds for this condition

(𝑡ℎ𝑎𝑡 𝑖𝑠 𝐾 — 𝑀 = 𝐺 — 1).

Second equation: 𝑦2 = 𝑦3 + 𝑥3 + 𝑢2

1. Order condition

𝐾=6 𝑀=3 𝐺=3

(𝐾 — 𝑀) > (𝐺 — 1)

(6 — 3) > (3 − 1)

Thus the order condition is satisfied.

2. Rank condition

Excluded endogenous variables: 𝑦1

Included exogenous variables: 𝑥3

Table of all π’s

4 -2 3
2 -1 1
2 -1 0

Table of n's of excluded exogenous variables

2 -1
2 -1

The order of the determinant of π’s of the excluded exogenous variables is 2 x 2; however its value is
zero:
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2 −1
𝛥=| |=0
2 −1
Hence the highest non-zero determinant which we may form from the π’s is 1 x 1. The second equation
contains two endogenous variables, that is G* = 2. Therefore the order of highest non-zero determinant is
𝐺 ∗ — 1 = 1. Consequently the second equation is identified.

Furthermore, using the order condition (6 — 3) > (3 — 1) we conclude that the second structural equation
is overidentified.

Third equation: 𝑦3 = 𝑦1 − 𝑦2 − 2𝑥3 + 𝑢3

1. Order condition

𝐾=6 𝑀=4 𝐺=3

(𝐾 − 𝑀) = (𝐺 = 1)

(6 − 4) = (3 − 1)

The order condition is satisfied

2. Rank condition

Excluded endogenous variables: none

Included exogenous variables: 𝑥3

Table of all π’s

4 -2 3
2 -1 1
2 -1 0

Table of π’s of excluded exogenous variables

4 -2
2 -1
2 -1

The highest non-zero determinant is of order 1 × 1, since,

4 −2 2 −1
𝛥=| | = 0 and 𝛥 = | |=0
2 −1 2 −1
The equation contains three endogenous variables, that is G* = 3.

Hence (𝑜𝑟𝑑𝑒𝑟 𝑜𝑓 𝑙𝑎𝑟𝑔𝑒𝑠𝑡 𝑛𝑜𝑛 − 𝑧𝑒𝑟𝑜 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑛𝑡) < (𝐺 ∗ — 1).

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The rank condition is not satisfied and therefore the third equation is not identified, despite the fulfillment
of the first condition for identification.