Notes

M320
Cross Section and Panel Data Econometrics
Topic 2: Generalized Method of Moments
Part III: Testing
Dr. Melvyn Weeks
Faculty of Economics and Clare College
University of Cambridge

Outline

Outline
1
2
3

5
6

7
2

Motivation
The General Validity of Moment Restrictions
The Anatomy of 2SLS
The Bias of 2SLS
2SLS Bias and Weak Instruments
The Wald Estimator
The BJB Critique
Tests of Exogeneity and Weak Instruments
Overidentification Tests
A Test of a Subset of Orthogonality Conditions
A Test of Weak Identification
GMM Distance Tests of Endogeneity and Exogeneity
Endogeneity and the Linear Model
Isolating the effect of Education on wages from Ability
The Costs of GMM

Notes

Outline

Notes

Readings:
Angrist, J. and A. Krueger (1991). Does Compulsory
Schooling Attendance Affect Schooling and Earnings.
Quarterly Journal of Economics, 106, 979-1014.
Bekker, P. (1994). Alternative Approximations to the
Distribution of Instrumental Variables Estimators,
Econometrica 62, 657-681.
Bound, J., A. Jaeger and R. Baker (1996). Problems with
Instrumental Variables Estimation When the Correlation
Between the Instruments and the Endogenous Explanatory
Variable is Weak, Journal of the American Statistical
Association 90, 443-450.
Cameron, A.C. and P.K. Trivedi (2004). Microeconometrics:
Methods and Applications, Cambridge University Press
[Chapter 21]
3

Outline

Notes

Baum, C., M. Schaffer, and S. Stillman (2003): Instrumental

Variables and GMM: Estimation and Testing. Working Paper
No. 545, Boston College
J. Angrist and J. Pischke (2009): Mostly Harmless
Econometrics. Princeton University Press

Motivation

Notes

Remark
... An important cost of performing IV estimation when
x and are uncorrelated: the asymptotic variance of the
IV estimator is always larger, and sometimes much larger,
than the asymptotic variance of the OLS estimator
Wooldridge (2006), p.490. Introductory Econometrics: A Modern
Approach. 3rd Ed. New York: Thomson Learning.

The General Validity of Moment Restrictions

IV or more general GMM estimators trade-off consistency versus

the inevitable loss of efficiency,
The loss of efficiency may be a price worth paying IF the OLS
estimator is biased and inconsistent
This motivates a testing strategy.
may all or some of the included endogenous regressors be
treated as exogenous?
may all or some of the included instruments be treated as
exogenous?
These are all:
tests of orthogonality
Non-orthogonality between: regressors and errors
instruments and errors
And then some of the instruments may be weak!
6

Notes

The General Validity of Moment Restrictions

Road Map

Notes

Remark
We consider tests for instrument relevance, instrument exogeneity
and instrument weak exogeneity.
For instrument exogeneity we consider a of class of
overidentification tests that may be used with 2sls and GMM
estimators
In considering tests of weak instruments our point of departure is
the bias of 2sls. Although well known, since the early 1990s
empirical researchers have realised that this bias can be significant
when instruments are weak.
We will see that in finite samples IV estimates are biased in the
same direction as OLS, with the bias dependent on the fit of the
first-stage regression
We examine the in-famous Angrist Kruger (1991) study on returns
to education and operationalise all these tests with some real data.
7

The Anatomy of 2SLS

Notes

IV is consistent but biased in small samples

Locating good exogenous instruments is not easy.
Basing a good instrument on features such as weak exogeneity
may make an instrument weak.
In the presence of weak instruments the bias can be substantial.
If the fit of the first stage regression is low, then the sampling
distribution of GMM/IV statistics are non-normal
In such cases asymptotic theory will provide a poor guide to the
finite sample distribution of the IV estimator even if sample is is
very large

The Anatomy of 2SLS

Notes

M = K or low over-identification Conventional inference is not

so misleading, unless degree of endogeneity is very
high.
M > K , high over-identification
- may be the case in panel settings with internal
instruments.
- when instruments are interacted with other
exogenous variables to improve precision (see Angrist
and Krueger (1991).)
In the presence of many weak instruments standard estimation can
be biased and conventional methods for inference can be
misleading.
TSLS can exhibit very poor properties.

The Anatomy of 2SLS

Notes

The Angrist and Krueger Study.

yi = + ei + i

(1)

yi is log (yearly) earnings, ei is years education.

Endogeneity: pre-schooling ability impact ei and earnings
AK exploit variation in schooling levels that arise from differential
the impact of compulsory schooling laws.
School districts typically require a student to have turned six by
January 1st of the year the student enters school.
Individuals are required to stay in school till they turn sixteen
an individual born in the 1st quarter will have lower required
minimum schooling levels than individuals born in the last quarter.

10

The Anatomy of 2SLS

Notes

Figure : Schooling Laws

This variation may also vary across states,

11

The Anatomy of 2SLS

The Bias of 2SLS

Notes

Remark
Below we examine the nomenclature of the 2SLS estimator.
We show that the 2SLS is biased in finite samples
We first do this for a single instrument
The bias is magnified by the problem of weak instruments
..

12

The Anatomy of 2SLS

The Bias of 2SLS

Notes

Revision
1

Causal relationship of interest:

yi = + ei + i

(2)

ei = zi + 1i

(3)

First stage regression:

Second stage regression:

yi = + b
ei + 2i

Reduced form:
yi = + zi + ri

(4)

13

The Anatomy of 2SLS

The Bias of 2SLS

Notes

The reduced form (4) is obtained by substituting (3) into (2)

yi

=
=
=
=

+ ei + i
+ (zi + 1i ) + i
+ zi + ( 1i + i )
+ zi + ri

zi denotes the population fitted values from (3).

The second stage regression is
yi

= + b
ei + 2i
= + b
ei + (i + (ei b
ei ))

where b
ei = p
bzi denotes the first stage fitted values.
The estimator of in (5) is the IV estimator.
14

(5)

The Anatomy of 2SLS

The Bias of 2SLS

And Why is 2sls Biased

Notes

Remark
Bias in the 2sls estimator follows because the first stage is
estimated. Consider
e = z + 1
If were known then b
e = z.
These fitted values are uncorrelated with the second stage errors
For unknown , b
e =b
z.
b
e = zb

= Pz e
= z + Pz 1
Pz = z ( z 0 z ) 1 z 0 .
For endogenous e, Pz 1 is correlated with , resulting in a biased
2sls estimator.
15

The Anatomy of 2SLS

The Bias of 2SLS

The 2SLS bias with many instruments.

With multiple instruments the first stage is:
e = Z + 1.
OLS estimates are biased because i is correlated with 1i .
Instruments Zi are uncorrelated with i1 by construction and
uncorrelated with i by assumption.
The 2SLS estimator is:
b
2SLS = (e 0 PZ e )1 e 0 PZ y = + (e 0 PZ e )1 e 0 PZ
PZ = Z (Z 0 Z )1 Z 0 is the projection matrix that produces fitted
values from a regression of e on Z .
Substitute the 1st stage for e in e 0 PZ to get
b
2SLS = (e 0 PZ e )1 (0 Z 0 + 10 )PZ

= (e 0 PZ e )1 0 Z 0 + (e 0 PZ e )1 10 PZ
16

Notes

The Anatomy of 2SLS

2SLS Bias and Weak Instruments

Notes

Zi are uncorrelated with i and 1i

Therefore E [0 Z 0 ] = 0, and we have
E [b
2SLS ] (E [e 0 PZ e ])1 E [0 Z 0 ] + (E [e 0 PZ e ])1 E [ 10 PZ ]

= (E [e 0 PZ e ])1 E [ 10 PZ ].
Substitute in the first stage again.
E [b
2SLS ] (E [0 Z 0 + 10 )PZ (Z + 1 )])1 E [ 10 PZ ].
Note that E [0 Z 0 1 ] = 0, so we get no cross-terms:
E [b
2SLS ] [E (0 Z 0 Z ) + E ( 10 PZ 1 )]1 E ( 10 PZ ).

17

The Anatomy of 2SLS

2SLS Bias and Weak Instruments

Notes

If we continue this proof, it can be shown that the bias of 2sls is

approximately:
b2sls = E [ b
2sls ]

1 1
2 F + 1

(6)

F is the population analogue of the F-statistic for the joint

significance of the instruments in the first-stage regression.
0, 2 = 2e , and b2sls = bols = e2
1
e
= 0. All variation in the first stage is through 1 , variation in
e is the same as b
e
6= 0, F is small, then for F 0, b2sls

1
2
1

2SLS is biased towards OLS with weak instruments.

18

The Anatomy of 2SLS

2SLS Bias and Weak Instruments

Notes

Remark
When instruments are weak the finite (and large) sample bias of
2sls is accentuated.
When instruments are weak 2sls standard errors are biased
downwards.
[Recall: When instruments are valid, adding instruments can
reduce the variance of the two-stage least squares estimator.]
Weak instruments: confidence can be misleading in that the
mid-point is biased and their width too narrow

19

The Anatomy of 2SLS

The Wald Estimator

Notes

The Wald (IV) Estimator

Back to the Angrist Krueger study
Table 1, Panel A, shows average years of education and average
log earnings for individuals born in the first and fourth quarter,
using the 1990 census:
y4 y1
b
IV =
= 0.0893
e4 e1

(0.0105)

Y t et , are average log earnings and years of education for

individuals born in t th quarter. N = 162, 487
the ratio of the reduced form to the first stage regression.

20

The Anatomy of 2SLS

The Wald Estimator

Notes

A Generalisation: Multiple Instruments

Consider the following model
yi

= xi0 + i
= wi0 1 + ei 2 + i

xi = (wi0 , ei )0 is a 501 dimensional vector of included covariates.

wi is a 500 1 vector of state (50) times year (10) of birth
dummies.
AK then interact the binary instrument Qi with the state and year
birth dummies.
Qi = 1 (0) 4th (1st) quarter of birth
In Table 1, section A and B provide inference on education effects
with single and multiple instruments

21

The Anatomy of 2SLS

The Wald Estimator

Notes

The 2sls estimator is given by

b

2SLS
b
2,2SLS

= (X0 Z (Z0 Z ) 1 Z0 X ) 1 (X0 Z (Z0 Z ) 1 Z0 Y )

= 0.073 (0.008)

with dimensions for Y, X, Z :

N 1, N (K + M ), and N (L + M ) vector.
N 1, N 501, and a N 1000 vector.
K , M and L denote endogenous variables, included and excluded
instruments.

22

The Anatomy of 2SLS

The Wald Estimator

Notes

Table : Multiple Instruments

A: Summary Statistics Subject of AK Data
Variable
Year of Education
Log Earnings
Ratio

1st Quarter

4th Quarter

Difference

12.688
5.892

12.840
5.905

0.151
0.014
0.089

B: Real and Random QOB Estimates

Single Instrument

Real QOB
Random QOB

0.089
1.958

(0.011)
(18.116)

500 Instruments
TSLS
LIML
0.073
0.059

(0.008)
(0.085)

0.095
0.330

(0.017)
(0.1001)

23

The Anatomy of 2SLS

The BJB Critique

Notes

Bound, Jaeger and Baker (1995) show that randomly generated

instruments, designed to match the data of Angrist and Krueger
(1991), yield results remarkably similar to those based on the
actual instruments
Results are reported in section B of Table 1.
In the case of a large number of instruments, the results imply that
random Z can be used to infer the returns to education.

24

The Anatomy of 2SLS

The BJB Critique

Notes

Exam Question
Consider the following linear regression
yi
Si

= Si + i
= zi + i

yi , Si , denote, respectively, wages and a measure of schooling for

the i th individual. i and i are stochastic errors, and
Cov(Si , i ) 6= 0. zi is a scalar instrument where Cov(zi , i ) = 0.
and are unknown parameters.
a) In the case where zi is a binary instrument, show that the IV
estimator for is
=

E (yi |zi = 1) E (yi |zi = 0)

.
E (Si |zi = 1) E (Si |zi = 0)

25

The Anatomy of 2SLS

The BJB Critique

Notes

b) Table 2 presents estimates of the effects of education on the

logarithm of mens weekly earnings. Standard errors are given
in parenthesis.
Column 1 presents results for the OLS estimator using
different age controls. Given the presumed endogeneity of
education, columns 2-4 present parameter estimates for a
number of specifications based upon the use of instrumental
variables (IV), with differing degrees of identification.
The F statistic (FE ) for the test of the joint statistical
significance of the excluded instruments is reported.
Provide a succinct summary of the main results.

26

The Anatomy of 2SLS

The BJB Critique

Table : Estimated Effect of Completed Years of Education on Mens Log

Weekly Earnings

Coefficient

(1)
OLS

(2)
IV

(3)
IV

(4)
IV

.063
(.000)

.142
(.033)

.081
(.016)

.083
(.009)

13.486

4.747

2.428

x
x

x
x
x
180

FE

Notes

Age Control Variables

x
x

Age, Age2
9 Year of birth dummies

Excluded instruments
x

Quarter of birth
Quarter of birth year of birth
Quarter of birth state of birth
Number of excluded instruments

30

Calculated from the 5% Public-Use Sample of the 1980 US Census for men born 1930-1938.
Sample size is 329,509. All specifications include Race (1=black), SMSA (1=central city),
Married (1 = married, living with spouse), and 8 Regional dummies as control variables.
Column 4 also includes 50 state dummies as controls.
SMSA denotes Standard Metropolitan Statistical Area.
27

Tests of Exogeneity and Weak Instruments

The optimal GMM estimator, b

GMM , based upon moment
conditions (wi , ) minimises
QC () = [

1
N

(wi , )]0 CcN [ N i (wi , )]

i =1

Notes

(7)

i =1

b 1
Cc
N =S
b = Var(N 1 (wi , b
S
))
i
A general model specification test can be used where M > K .
This is a test of the population moment conditions.
H0 : E [(w, 0 )] = 0
b i , to 0, where
b i = (w i , b
- test closeness of n1
).
Just-identified models
b i = 0 is imposed and the test is not possible.
n 1
Over-identified models
b ij = 0, j = 1, ..., M
Cannot set all n1
28

(8)

Tests of Exogeneity and Weak Instruments

Notes

Remark
Under H0 : E [(w, 0 )] = 0, the value of QC () evaluated at the
efficient GMM estimator (b
GMM ) 2(M K )
Using this statistic, and for M > K , we can evaluate whether all
(or a subset) of the moment conditions (OC) are valid.
These are tests of overidentifying restrictions.
There are M K of them.

29

Tests of Exogeneity and Weak Instruments

Overidentification Tests

Notes

Remark
the overidentification test is a test of whether all the moment
conditions are satisfied.
If QC () is large either the moment conditions or the other model
assumptions (or both) are likely to be false.
Only if we are confident about the other assumptions can we
interpret a large value of QC (.) as evidence of the endogeneity of
some of the instruments in xi
Remark
Hansens J statistic is consistent in the presence of
heteroskedasticity; Sargans statistic is not.

30

Tests of Exogeneity and Weak Instruments

Overidentification Tests

Notes

Example
Taking the linear model as an example. Given the null hypothesis
H0 : E [(w, 0 )] = 0

(9)

then
1
b 1 [ 1 Z0 (y X)]
QC () = [ Z0 (y X)]0 C
N
n
n
a 2
(M k )
We will reject the overidentifying restrictions if the p-value
Pr(2(M k ) QC ())

(10)

is < the chosen significance level for the test.

31

Tests of Exogeneity and Weak Instruments

A Test of a Subset of Orthogonality Conditions

Consider the case when the number of zero restrictions is large

(M K is large).
Hansen/Sargan tests are Omnibus-type tests, and are therefore
likely to have low power.
We can divide the M instruments into two groups, and test the
validity of a subset of the instruments (say MB )
Vernacular: Difference-in-Sargan or C-tests
Let JA denote the efficient GMM test statistic using
MA = M MB orthog. conditions that are not being tested.
Proposition
b N is chosen optimally for both J statistics,
If the weighting matrix C
and restricted and unrestricted equations are well-specified.
C J JA a 2(M MA )
32

Notes

Tests of Exogeneity and Weak Instruments

A Test of a Subset of Orthogonality Conditions

Example: dividing the M instruments into two groups:

Notes

zi1 : MA variables that are known to satisfy orthogonality conditions

zi2 : M MA = MB variables that are suspected of being
endogenous
zi = (zi1 , zi2 )
Wish to test: E (zi2 i ) = 0
Remark
The basic notion is to compare two J statistics from 2 separate
GMM estimators of the same coefficient vector .
1

using instruments in zi1

using instruments in zi2 in addition to zi1

If the inclusion of zi2 substantially increases the J statistic, then

we have reason to suspect the predeterminedness of zi2 .
Testable restrictions: if MA > K .
33

Tests of Exogeneity and Weak Instruments

A Test of Weak Identification

Notes

Remark
One obvious informal test of weak instruments is to simply
correlate the set of instruments with the endogenous variable(s)
This will create pairwise correlation statistics.
The joint correlation across a set of multiple instruments can be
represented by the R 2 statistic from the first stage regression.
A test of identification A measure of the joint significance of a
set of instruments z is the F statistic.
A test of weak identification A rule of thumb suggested by
Staiger and Stock (1997):
an F statistic of less than 10 may indicate weak instruments.

34

Tests of Exogeneity and Weak Instruments

A Test of Weak Identification

Stock and Yogo (2005) introduce a formal test of weak

identification.

Notes

The null hypothesis: instruments are weak

The alternative hypothesis: instruments are not weak
One variant of the test which presumes overidentification, is
derived from the notion that in the presence of weak instruments
estimation bias of the IV estimator can be large and potentially
exceeds that of the OLS estimator.
The test: choose b the largest relative bias of the 2SLS estimator
relative to OLS that is acceptable. Critical values vary with b, the
number of endogenous variables (m) and the number of exclusion
restrictions (K ).
Example
b = 0.05, m = 1 and K = 3, the critical value of the test is 13.91
Reject the null of weak instruments if the calculated F statistics
> 13.91
35

GMM Distance Tests of Endogeneity and Exogeneity

Notes

A C-test of the exogeneity of one or more regressors or instruments.

STATA: the orthog option takes as its argument the list of
exogenous variables (Z2 above) whose exogeneity is called into
question.
- if the exogenous variable being tested are instruments, the
efficient GMM estimator that does not use the corresponding
orthogonality condition - simply drops the instruments.
This is illustrated below - the second regression is the estimation
implied by the orthog option in the first.
ivreg2
ivreg2

36

y
y

x1
x1

x2
x2

(x3
(x3

=
=

z1
z1

z2
z3

z3
z4)

z4),

orthog(z2)

GMM Distance Tests of Endogeneity and Exogeneity

Durbin-Wu-Hausman tests: estimate a model using OLS and IV

and compare estimated coefficient vectors.

Notes

H0 OLS estimator is consistent and efficient

Test Statistic:
bc
b e )0 G ? (
b
be )
H = n(

(11)

b c - estimator that is consistent (c) under H0 and Ha (IV);

b e - efficient (e) under H0 , inconsistent if null not true (OLS).

b c ) Var (
b e ))
G = (Var (
b ) is a consistent estimate of the asymptotic variance of ;
Var (
?
G denotes a generalized inverse.
H 2ke ; ke denotes number of regressors tested for endogeneity.
37

GMM Distance Tests of Endogeneity and Exogeneity

Notes

Remark
For a discussion of
- the Durbin-Wu-Hausman test of the endogeneity of regressors
- the generalisation of this test to subsets of regressors, and
- how the Hausman form of this test may be interpreted as a GMM
test
see Baum, C., M. Schaffer, and S. Stillman (2003)

38

Endogeneity and the Linear Model

Notes

We begin with the linear regression model

yi = xi + i

(12)

yi is N 1 and xi is N K
zi is a N r matrix of instruments.
zi satisfies the moment conditions
E [zi i ] = 0

(13)

The associated GMM estimator minimises

"
QN ( ) =

zi0 i

#0

"
CN

i =1

zi0 i

#
(14)

i =1

where CN is the r r weighting matrix.

39

Endogeneity and the Linear Model

An extended IV estimation STATA package is now available. The

components of the package:
1

ivreg2 extends STATAs ivreg, including facilities for GMM

(generalized method of moments), tests of exogeneity
conditions, and weak identification.
small requests that small-sample statistics (F and t) be
reported instead of large-sample statistics (chi-squared and
z-statistics). Large-sample statistics are the default.

Remark
ivreg2 provides extensions to Statas official ivreg. ivreg2 shares
the same command syntax as official ivreg and supports (almost)
all of its options.
Differences between ivreg2 and ivreg : optional two-step feasible
GMM estimation (gmm option); automatic output of the
Hansen-Sargan statistic for overidentifying restrictions;
40

Notes

Endogeneity and the Linear Model

Notes

An Instrumental variables (IV) estimation package - cont

1

orthog(varlist) requests that a C-statistic be calculated as a

test of the exogeneity of a subset of instruments.
gmm, robust and/or cluster, Hansens J statistic is
reported.
This statistic allows observations to be correlated within
groups.

2 ivhettest Heteroskedasticity tests for IV estimation.

3 overid Overidentification tests for IV estimation.

41

Endogeneity and the Linear Model

Notes

IVREG2
The gmm option implements the two-step efficient generalized
method of moments (GMM) estimator.
Efficiency gains of this estimator relative to the IV/2SLS estimator
derive from the use of the optimal weighting matrix.
Efficient GMM estimator: robust to the presence of
heteroskedasticity of unknown form
cluster option chosen, efficient GMM estimator uses a
cluster-robust optimal weighting matrix and the estimator is also
robust to arbitrary intra-cluster correlation.
Assumption of conditional homoskedasticity: efficient GMM
estimator becomes the traditional 2SLS estimator.

42

Endogeneity and the Linear Model

Isolating the effect of Education on wages from Ability

Example: Isolating the effect of Education on wages from

Ability

Notes

National Longitudinal Survey of Young Men: cohorts 1969 and

1980 (See Griliches (1976)).
RNS=dummy for residency in southern states, MRT=dummy for
marital status (1 if married)
SMSA = dummy for residency in metropolitan areas, MED =
mothers education (years)
KWW = score on Knowledge of Work test, IQ = IQ Score, AGE =
age of individual
S = completed years of schooling, EXPR = experience (years),
TENURE = tenure in years, LW = log wage
IQ: error-ridden and endogenous; also S may be endogenous.
43

Endogeneity and the Linear Model

Isolating the effect of Education on wages from Ability

Notes

Schooling is Endogenous in the Wage Equation?

LWi = 1 + 2 Si + 3 EXPRi + 4 IQi + i
1

Efficient two-step GMM estimation of with

zi = (1, EXPRi , AGEi , MEDi , Si ) as instruments.
zi1 = (1, EXPRi , AGEi , MEDi )

zi2 = (Si )
2
3
4

b
Compute J and the 5 5 matrix S
b1 (from S)
b corresponding to zi1 .
Extract the 4 4 submatrix S
Estimate the same coefficient by GMM with reduced set of
instruments.
Difference in J statistic from two different GMM a 2 (1)
Why is age predetermined here?

44

(15)

Endogeneity and the Linear Model

Isolating the effect of Education on wages from Ability

Notes

Below we introduce STATA syntax for estimation and testing in the

context of 2SLS and GMM estimaors
The files used during the STATA session reproduce Table 3.3 of
Hayashi (2000) Econometrics.

45

Endogeneity and the Linear Model

Isolating the effect of Education on wages from Ability

Notes

46

Endogeneity and the Linear Model

Isolating the effect of Education on wages from Ability

Notes
* Reproduce line 5 of table *, Hayashi (2000)
** standard IV/2SLS estimator with asymptotic standard errors
** - assumption - conditionally homoscedastic/independent errors
ivreg2 lw expr tenure rns smsa _I* (iq s = med kww mrt age)
** IV/2SLS estimator: robust to heteroscedasticity
** - robust option: Sargan statistic changes to Hansen J
ivreg2 lw expr tenure rns smsa _I* (iq s = med kww mrt age), robust
** IV/2SLS estimator: robust to heteroscedasticity
** small
ivreg2 lw expr tenure rns smsa _I* (iq s = med kww mrt age) , robust small
* Reproduce line 5 of table *, Hayashi (2000)
** 2 step GMM estimator: robust to heteroscedasticity
ivreg2 lw expr tenure rns smsa _I* (iq s = med kww mrt age) , gmm2s robust

47

Endogeneity and the Linear Model

Isolating the effect of Education on wages from Ability

Notes
** Testing Exogeneity of

Regressors or Instruments

** test H0: rns is a proper instrument

i) using orthog option ("Diff-Sargan" C statistic)
ivreg2

lw expr tenure rns smsa _I* (iq s = med kww mrt age), orthog(rns)

ii) ivreg2

lw expr tenure rns smsa _I* (iq s = med kww mrt age), endog(rns)

* cluster option: must reduce number of instruments below number of clusters

* in order to calculate the variance-covariance matrix
* (although standard ivreg does not impose that constraint)
ivreg2 lw expr tenure rns smsa _I* (iq s = med kww mrt age), robust cluster(age)
ivreg lw expr tenure rns smsa (iq s = med kww mrt age) , robust cluster(age)
ivreg2 lw expr tenure rns smsa (iq s = med kww mrt age) , small robust cluster(age)
* first and ffirst options
ivreg2 lw expr tenure rns smsa _I* (iq s = med kww mrt age) , ffirst
ivreg2 lw expr tenure rns smsa _I* (iq s = med kww mrt age) , first

48

The Costs of GMM

Notes

Remark
IV estimates of the standard errors are inconsistent in the presence
of heteroscedasticity, thereby compromising valid inference.
Standard diagnostic tests for endogeneity and overidentification are
also invalid.
The usual approach when facing heteroscedasticty of unknown
form is to use GMM.
Efficient GMM is consistent in the presence of arbitrary
heteroscedasticty, but at a cost of poor finite sample performance.
If heteroscedasticty is not present, then standard IV may be
preferable.

49

The Costs of GMM

Notes

The cost of GMM

If heteroscedasticity is present it is possible to improve on 2SLS
using GMM.
As Wooldridge (2001) notes, there are still a dearth of
applications, particulary cross-section, that utilise GMM.
The reason for this is that one can always run 2SLS using standard
errors that are robust to heteroscedasticity.
Moreover, the optimal weight matrix which is required for efficient
GMM is a function of fourth-order moments.
Reasonable estimates of fourth-order moments require a large
sample size
Consequence: poor small sample properties mean Wald tests tend
to over-reject the null

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