ECO 311- Class Notes

Instrumental Variable (IV)

Regression

Prof. Erdinç
American University in Bulgaria
Econometrics II, ECO 311 IV Regression Page 1
 Instrumental Variables

 Motivation: When is it useful?

 Intuition
 Use: What are the requirements for good
instruments?

IV Regression Page 2
 Motivation

Suppose you are interested in the wage returns to

education.
log(wage) = b0 + b1educ + b2 exp+ b3 exp2 + u

Is it reasonable to assume Cov(educ,u) = 0 and Cov(exp,u) = 0

? Are educ and exp independent of the error term? Are
the unobserved determinants of wages uncorrelated
with education and exp? Are factors which might
influence wages and how much schooling one gets?
--intelligence: it might influence wages and educ (so in
error term it hides, and makes educ to be correlated
with u)
Econometrics II, ECO 311 IV Regression Page 3
 Motivation

--persistence
-- good health?
–good social network
---need to control for these..

Endogeneity issue: educ and u are contemporanously

correlated! (intelligence in u and educ)

Econometrics II, ECO 311 IV Regression Page 4

 Basic Idea

• If we do not control for these potential confounders,

our OLS estimators will be biased. (see the
exogeneity requirement for OLS consistency:
all regressors, including educ must have
Cov(educ,u) = 0
• We would like to use the variation in education that
is not correlated with the error term, u. (potential
instruments!)
• An instrument is a variable that determines the
endogenous regressor but affects the dependent
variable only through its effect on the independent
variables. It can not have a direct effect on wages.
Econometrics II, ECO 311 IV Regression Page 5
 Basic Idea

• Potential instruments for education:

-- Distance to nearest college (Card, 1995)
--Quarter of birth (Angrist & Krueger, 1991)

• Call the instrument, Z. We would like the isntrument

to be independent of the error term. Cov(Z,u) = 0

• But Cov(Z, educ) ¹ 0 It must be sufficiently

correlated with what it is instrumenting..

Econometrics II, ECO 311 IV Regression Page 6

 Two Stage Least Squares

 First Stage: Regress educ on all regressors inc. Z

educ = d0 + d1Z + d2 exp+ d3 exp2 + e
 Get the estimated regression (first stage)

educ^ = dˆ0 + dˆ1Z + dˆ2 exp+ dˆ3 exp2

 educ^ is an unbiased estimate of educ. Why? (Z, exp
are uncorrelated with u in the wage equation, so its
linear combination is also uncorrelated with u.
 Hence, educ^ is also uncorrelated with u. Therefore, it
can be used in the wage equation. This is the second
stage equation.
log(wage) = b0 + b1educ_hat + b2 exp+ b3 exp2 + u
 Now, beta 1 hat will be an unbiased estimate of beta.
IV Regression Page 7
 Weak Instruments Problem

• Correlation of instrument and the endogenous variable

must be sufficiently strong, i.e. Cov(Z, educ) ¹ 0
• Rule of Thumb: Do an F test on the null hypothesis
that the coefficients on the instruments in the first
stage are zero. (F should be at least 10; preferably 12.)
We must reject the null (Stata: estat firststage
command gives Partial Rsq, and F value along with the
critical values)
• IV estimates are as good as the instruments they use.
This is relatively easier to assess than the next issue:
The validity of the instruments…

Econometrics II, ECO 311 IV Regression Page 8

 Validity of the Instruments

• If an instrument has a direct causal effect on the

dependent variable, it is correlated with the errors in
the equation and it is not valid (it should only
influence, be correlated with what it is instrumenting,
e.g. educ), so we must have Cov(Z, log(wage)) = 0
• We must have another requirement in place for a
valid instrument which is Cov(Z,u) = 0
• But this is much more difficult to test empirically.
Exception: If you have more than one plausible instrument, you
can see if both give you the same answers in the first stage (Sargan
test)
• The IV estimator is asymptotically consistent but biased towards OLS
in finite samples. The size of the bias is inversely related to the size of
the sample but positively related to the weakness of the instruments.

Econometrics II, ECO 311 IV Regression Page 9

 Tests in Stata

• After ivregress 2sls Y X (endo_var Z)

• Conduct estat endog (Durbin-Wu test for endogenity)
• estat firststage gives you the partial Rsq and F test for the
strength of the instruments.
• estat overid gives you the test for the validity of the
instruments (provided you have more than 1 instruments for
each endogenous variable): Sargan Test

Econometrics II, ECO 311 IV Regression Page 10

 IV and Simultaneous Equations

Consider the two simultaneous equations (structural equations): Why are

y1 and y2 endogenous?

(1) y1 = b0 + b1y2 + b2 z1 +u1

(2) y2 = d0 + d1y1 + d2 z2 + u2

First, find the reduced form for this model (express both y1 and y2 in
terms of the exogenous variables z1 and z2) and estimate these two (first
stage) by OLS.

Second, Use the estimated y1^ and y2^ from the first stage reduced form
in the second stage structural equations by replacing y2 with y2^ in the (1)
equation and by replacing y1 with y1^ in the (2) equation.

Econometrics II, ECO 311 IV Regression Page 11