Instrumental Variables & 2SLS

y =
0
+
1
x
1
+
2
x
2
+ . . .
k
x
k
+ u
x
1
=
0
+
1
z +
2
x
2
+ . . .
k
x
k
+ v
Why Use Instrumental Variables?
Instrumental Variables (IV) estimation is
used when your model has endogenous xs
That is whene!er "o!(x,u) # $
Thus IV %an be used to address the
&roblem o' omitted !ariable bias
(mitted Variable )ias (re%a&)
( )
* 2 * *
* * $
2 2 * * $
+ +
then
+ +
+
estimate
but we
as gi!en is model true the Su&&ose



+ =
+ + =
+ + + =
E
u x y
u x x y
Summary o' ,ire%tion o' )ias
(re%a&)
"orr(x
1
, x
2
) - $ "orr(x
1
, x
2
) . $

2
- $
/ositi!e bias 0egati!e bias

2
. $
0egati!e bias /ositi!e bias
/ro1y Variables
What i' model is miss&e%i'ied be%ause no
data is a!ailable on an im&ortant x !ariable?
It may be &ossible to a!oid omitted
!ariable bias by using a &ro1y !ariable
2 &ro1y !ariable must be related to the
unobser!able !ariable
What i' a suitable &ro1y !ariable is also not
a!ailable? 3ay use IV or 2SLS 2&&roa%h4
What Is an Instrumental Variable?
In order 'or a !ariable z to ser!e as a !alid
instrument 'or x the 'ollowing must be true
The instrument must be e1ogenous
That is "o!(z,u) 5 $
The instrument must be %orrelated with the
endogenous !ariable x
That is "o!(z,x) # $
3ore on Valid Instruments
We ha!e to use %ommon sense and
e%onomi% theory to de%ide i' it ma6es sense
to assume "o!(z,u) 5 $
We %an test i' "o!(z,x) # $
7ust testing 8
$
9
1
5 $ in x =
0
+
1
z + v
Sometimes re'er to this regression as the
'irst:stage regression
IV ;stimation in the Sim&le
<egression "ase
=or y =
0
+
1
x + u and gi!en our
assum&tions
"o!(z,y) 5
1
"o!(z,x) > "o!(z,u) so

1
5 "o!(z,y) ? "o!(z,x)
Then the IV estimator 'or
1
is
( ) ( )
( )( )

=
x x z z
y y z z
i i
i i
*
@

The ;''e%t o' /oor Instruments

What i' our assum&tion that "o!(z,u) 5 $ is 'alse?
The IV estimator will be in%onsistent too
"an %om&are asym&toti% bias in (LS and IV
/re'er IV i' "orr(z,u)?"orr(z,x) . "orr(x,u)
x
u
x
u
u x Corr
x z Corr
u z Corr

+ =
+ =
) (
+
&lim 9 (LS
) (
) (
@
&lim 9 IV
* *
* *
In'eren%e with IV ;stimation
The homos6edasti%ity assum&tion in this %ase is
;(u
2
|z) 5
2
5 Var(u)
2s in the (LS %ase gi!en the asym&toti%
!arian%e we %an estimate the standard error
( )
2 ? *
2

2
*
)
@
(
@
z x x
R SST
se

=
IV !ersus (LS estimation
Standard error in IV %ase di''ers 'rom (LS
only in the R
2
'rom regressing x on z
Sin%e R
2
. * IV standard errors are larger
8owe!er IV is %onsistent while (LS is
in%onsistent when "o!(x,u) # $
The stronger the %orrelation between z and
x the smaller the IV standard errors
IV ;stimation in the 3ulti&le
<egression "ase
IV estimation %an be e1tended to the
multi&le regression %ase
"all the model we are interested in
estimating the stru%tural model
(ur &roblem is that one or more o' the
!ariables are endogenous
We need an instrument 'or ea%h
endogenous !ariable
3ulti&le <egression IV (%ont)
Write the stru%tural model as y
1
=
0
+
1
y
2

+
2
z
1
+ u
1
where y
2
is endogenous and z
1

is e1ogenous
Let z
2
be the instrument so "o!(z
2
,u
1
) 5 $
and
y
2
=
0
+
1
z
1
+
2
z
2
+ v
2
where
2
# $
This redu%ed 'orm eAuation regresses the
endogenous !ariable on all e1ogenous ones
Two Stage Least SAuares (2SLS)
Its &ossible to ha!e multi&le instruments
"onsider our original stru%tural model and
let y
2
=
0
+
1
z
1
+
2
z
2
+
3
z
3
+ v
2
8ere were assuming that both z
2
and z
3
are
!alid instruments B they do not a&&ear in
the stru%tural model and are un%orrelated
with the stru%tural error term u
1
)est Instrument
"ould use either z
2
or z
3
as an instrument
The best instrument is a linear %ombination
o' all o' the e1ogenous !ariables y
2
* =
0
+

1
z
1
+
2
z
2
+
3
z
3

We %an estimate y
2
* by regressing y
2
on z
1
,
z
2
and z
3
B %an %all this the 'irst stage
I' then substitute
2
'or y
2
in the stru%tural
model get same %oe''i%ient as IV
3ore on 2SLS
While the %oe''i%ients are the same the
standard errors 'rom doing 2SLS by hand
are in%orre%t so let Stata do it 'or you
3ethod e1tends to multi&le endogenous
!ariables B need to be sure that we ha!e at
least as many e1%luded e1ogenous !ariables
(instruments) as there are endogenous
!ariables in the stru%tural eAuation
Testing 'or ;ndogeneity
Sin%e (LS is &re'erred to IV i' we do not
ha!e an endogeneity &roblem then wed
li6e to be able to test 'or endogeneity
I' we do not ha!e endogeneity both (LS
and IV are %onsistent
Idea o' 8ausman test is to see i' the
estimates 'rom (LS and IV are di''erent
Testing 'or ;ndogeneity (%ont)
While its a good idea to see i' IV and (LS
ha!e di''erent im&li%ations its easier to use
a regression test 'or endogeneity
I' y
2
is endogenous then v
2
('rom the
redu%ed 'orm eAuation) and u
1
'rom the
stru%tural model will be %orrelated
The test is based on this obser!ation
Testing 'or ;ndogeneity (%ont)
Sa!e the residuals 'rom the 'irst stage
In%lude the residual in the stru%tural
eAuation (whi%h o' %ourse has y
2
in it)
I' the %oe''i%ient on the residual is
statisti%ally di''erent 'rom Cero reDe%t the
null o' e1ogeneity
I' multi&le endogenous !ariables Dointly
test the residuals 'rom ea%h 'irst stage
Testing (!eridenti'ying
<estri%tions
I' there is Dust one instrument 'or our
endogenous !ariable we %ant test whether
the instrument is un%orrelated with the error
We say the model is Dust identi'ied
I' we ha!e multi&le instruments it is
&ossible to test the o!eridenti'ying
restri%tions B to see i' some o' the
instruments are %orrelated with the error
The (!erI, Test
;stimate the stru%tural model using IV and
obtain the residuals
<egress the residuals on all the e1ogenous
!ariables and obtain the R
2
to 'orm nR
2
Under the null that all instruments are
un%orrelated with the error L3 +
A
2
where
q is the number o' e1tra instruments