Two stage least square method

Seminar 7
 Econometric analysis - procedure
 Formulating of an assumption or a hypothesis
Eg. Keynes model of income: what the economic theory says about the influence of income on consumption
 Specification of an economic model
C = B1 + B2Y B2 < 0
Y=C+I
 Formulation of the econometric model
 y1t = γ11x1t + β12y2t + u1t y1= consumption y2 = income
y2t = β21y1t + γ12x2t + u2t x1=constant x2= investment
 Identification of variables in the model
1. equation: 1=1
2. equation: 1=1 model is exactly identified
 Data collection
 Time series.
Cross sectional data
 Panel data
 Estimation of parameters
β12t β21 is estimated through indirect least square method.
Simultaneous model overidentified are estimated with the use of the 2SLS or other method.
 Testing of the hypothesis of the parameter significance
Is our assumption on B2≠ 0 adequately supported by the data?
 Use of model for prognosis
What will be the consumption trend in next 3 years if the income declines by 1% per year?
Methods of structural parameters
estimation

• Methods with full information

Maximum Likelihood method, 3 stage LS,
• Methods with partial information:
OLS, TSLSM, Minimization of variance ratio
 Simple models

• Each equation is estimated by the use of

the oLS
• Procedure is the same as in case of the
single equational models
 Recursive models - OLS
Eg. Model of wages and prices

y1t= γ11 x1t + γ16 y1t-1 + γ12 X2 + γ13 X3t + γ14 x4t + u1t
y2t = β21y1t + γ21 x1t + + γ25 x5t + u2t

RECURSIVE MODELS
y1=variation in prices
Second equation represents one-
y2= variation in wages
directional causal dependence (y1t affects
x1= constant.
y2t but not wise versa).
X2 = variation in capital prices
X3= variation in import prices Although y1t is an endogenous variable,
X4= variation in labour productivity its presence in the second equation has
X5= unemployment rate an exogenous character.
X6= variation in wages in t-1

Thus, OLS is sufficient for the parameter

estimation.
 Simultaneous models
• Eg.: Model of income Problem: The assumption of the
y1t = γ11x1t + β12y2t + u1t independence of the endogenous and the
random variable is violated cov (ui, Xi)=0
y2t = β21y1t + γ12x2t + u2t
Parameters estimated with the OLS are
not consistent – betas in sample do not
y1= consumption
converge to betas in population
y2 = income
x1= constant β12 estimated = β 12 real + Σy2tu1t/y1t2
x2= investment

In case of simultaneous models, USE OF

THE OLS PRODUCES BIAS, therefore we
CANNOT USE OLS !!!

One possible solution: to remove the

simultaneous component, and then
apply OLS
 Simultaneous models exactly
identified
Can be estimated via INDIRECT LEAST SQUARE M.

Procedure:
• We transform the equations into the REDUCED form (on right hand side
there are only exogenous variables)
y1t = m11x1t + m12x2t + v1t
y2t =m21x1t + m22x2t + v2t
• We apply OLS we get values of parameters m
• Return from REDUCED to STRUCTURAL form (by solving 4 equations with
4 variables)
Overidentified simultaneous models
We estimate with TWO STAGE LEAST SQUARE METHOD

Procedure:
• Overidentified models have a problem of transforming from reduced to structural
form (one equation in reduced form can correspond to more equations in simultaneous
forms)
•We must start from the structural form
• The trick is to replace endogenous variables on the right hand side of the equation by
an artificial (instrumental) variable – removing the simultaneous component
• We perform a regression of that particular endogenous variable on all exogenous
variables in the whole model
•After obtaining the instrumental variables, we substitute them into equation and apply
OLS
 Review of the estimation methods

• Simple and recursive models - OLS

• Simultaneous exactly identified – Indirect LS
• Simultaneous overidentified models – 2 stage
LS, Minimization of variance ratio
• Simulatenous models underidentified – cannot
be estimated
 TSLSM
• Input matrices:
y1 vector of endogenous variable on the LEFT hand-side
Y2 matrix of other endogenous variables included in the
equation on the RIGHT hand side

X* matrix of the exogenous variables INCLUDED in the

equation

X matrix of all exogenous variables in the whole model

y∆ = y1 Y2 X* n x kv
X=
nxk
Xn n x kn
n x gv n x1 n x (gv –1)
 Input matrices
• Example for this equation :
y2t = ß24y4t + γ21x1t + γ23x3t + u2t

Input matrices:

y1= y2t
Y2= y4t
Xv= x1, x3
X= x1, x2, x3
 Principle of the TSLSM
1) Replacing matrix Y2 by theoretical Y^2 –
regression on all X
Y^2 = X ( XTX)-1 XT Y 2

• Based on OLS, we estimate parameters:

ß2 T
= (PT P)-1 PT y1 P = [Y^2, Xv ]
Γ 1v T
 Principle of the TSLSM

OLS: b= (PT P)-1 PT y1

PT = Y^2T x P = [Y^2, Xv ]
Xv T

-1
Y^2T Y^2 Y2T Xv Y^2T
ß2 T
y1
=
XvT Y2 XvT Xv XvT
Γ 1v T
 Matrices in the TSLSM

-1
Y^2T Y^2 Y^2T Xv Y^2T
ß2 T
y1
= Matrix kT
Xv Y2
T
Xv Xv XvT
Γ 1v T
-1
Y^2T Y^2 Y^2T Xv Y^2T
ß2 T

= Matrix c y1
XvT Y2 XvT Xv XvT
Γ 1v T