Identification, weak instruments and statistical inference in

econometrics

Jean-Marie Dufour

Université de Montréal
First version:May 2003
This version: July 2003

This paper is based on the author’s Presidential Address to the Canadian Economics Association given on May
31, 2003, at Carleton University (Ottawa). The author thanks Bryan Campbell, Tarek Jouini, Lynda Khalaf, William Mc-
Causland, Nour Meddahi, Benoît Perron and Mohamed Taamouti for several useful comments. This work was supported
by the Canada Research Chair Program (Chair in Econometrics, Université de Montréal), the Alexander-von-Humboldt
Foundation (Germany), the Canadian Network of Centres of Excellence [program on Mathematics of Information Tech-
nology and Complex Systems (MITACS)], the Canada Council for the Arts (Killam Fellowship), the Natural Sciences and
Engineering Research Council of Canada, the Social Sciences and Humanities Research Council of Canada, the Fonds
de recherche sur la société et la culture (Québec), and the Fonds de recherche sur la nature et les technologies (Québec).

Canada Research Chair Holder (Econometrics). Centre interuniversitaire de recherche en analyse des organisa-
tions (CIRANO), Centre interuniversitaire de recherche en économie quantitative (CIREQ), and Département de sciences
économiques, Université de Montréal. Mailing address: Département de sciences économiques, Université de Montréal,
C.P. 6128 succursale Centre-ville, Montréal, Québec, Canada H3C 3J7. TEL: 1 514 343 2400; FAX: 1 514 343 5831;
e-mail: jean.marie.dufour@umontreal.ca. Web page: http://www.fas.umontreal.ca/SCECO/Dufour .
ABSTRACT
We discuss statistical inference problems associated with identification and testability in econo-
metrics, and we emphasize the common nature of the two issues. After reviewing the relevant
statistical notions, we consider in turn inference in nonparametric models and recent developments
on weakly identified models (or weak instruments). We point out that many hypotheses, for which
test procedures are commonly proposed, are not testable at all, while some frequently used econo-
metric methods are fundamentally inappropriate for the models considered. Such situations lead to
ill-defined statistical problems and are often associated with a misguided use of asymptotic distri-
butional results. Concerning nonparametric hypotheses, we discuss three basic problems for which
such difficulties occur: (1) testing a mean (or a moment) under (too) weak distributional assump-
tions; (2) inference under heteroskedasticity of unknown form; (3) inference in dynamic models
with an unlimited number of parameters. Concerning weakly identified models, we stress that valid
inference should be based on proper pivotal functions — a condition not satisfied by standard Wald-
type methods based on standard errors — and we discuss recent developments in this field, mainly
from the viewpoint of building valid tests and confidence sets. The techniques discussed include
alternative proposed statistics, bounds, projection, split-sampling, conditioning, Monte Carlo tests.
The possibility of deriving a finite-sample distributional theory, robustness to the presence of weak
instruments, and robustness to the specification of a model for endogenous explanatory variables
are stressed as important criteria assessing alternative procedures.
Key-words : hypothesis testing; confidence set; confidence interval; identification; testability;
asymptotic theory; exact inference; pivotal function; nonparametric model; Bahadur-Savage; het-
eroskedasticity; serial dependence; unit root; simultaneous equations; structural model; instrumen-
tal variable; weak instrument; weak identification; simultaneous inference; projection; split-sample;
conditional test; Monte Carlo test; bootstrap.
JEL classification numbers: C1, C12, C14, C15, C3, C5.
i
RÉSUMÉ
Nous analysons les problèmes d’inférence associés à l’identification et à la testabilité en
économétrie, en soulignant la similarité entre les deux questions. Après une courte revue des no-
tions statistiques requises, nous étudions tour à tour l’inférence dans les modèles non-paramétriques
ainsi que les résultats récents sur les modèles structurels faiblement identifiés (ou les instruments
faibles). Nous remarquons que beaucoup d’hypothèses, pour lesquelles des tests sont régulièrement
proposés, ne sont pas en fait testables, tandis que plusieurs méthodes économétriques fréquem-
ment utilisées sont fondamentalement inappropriées pour les modèles considérés. De telles situa-
tions conduisent à des problèmes statistiques mal posés et sont souvent associées à un emploi mal
avisé de résultats distributionnels asymptotiques. Concernant les hypothèses non-paramétriques,
nous analysons trois problèmes de base pour lesquels de telles difficultés apparaissent: (1) tester
une hypothèse sur un moment avec des restrictions trop faibles sur la forme de la distribution;
(2) l’inférence avec hétéroscédasticité de forme non spécifiée; (3) l’inférence dans les modèles
dynamiques avec un nombre illimité de paramètres. Concernant les modèles faiblement identifiés,
nous insistons sur l’importance d’utiliser des fonctions pivotales — une condition qui n’est pas sat-
isfaite par les méthodes usuelles de type Wald basées sur l’emploi d’écart-types — et nous passons
en revue les développements récents dans ce domaine, en mettant l’accent sur la construction de test
et régions de confiance valides. Les techniques considérées comprennent les différentes statistiques
proposées, l’emploi de bornes, la subdivision d’échantillon, les techniques de projection, le condi-
tionnement et les tests de Monte Carlo. Parmi les critères utilisés pour évaluer les procédures, nous
insistons sur la possibilité de fournir une théorie distributionnelle à distance finie, sur la robustesse
par rapport à la présence d’instruments faibles ainsi que sur la robustesse par rapport la spécification
d’un modèle pour les variables explicatives endogènes du modèle.
Mots clés : test d’hypothèse; région de confiance; intervalle de confiance; identification; testabil-
ité; théorie asymptotique; inférence exacte; fonction pivotale; modèle non-paramétrique; Bahadur-
Savage; hétéroscédasticité; dépendance sérielle; racine unitaire; équations simultanées; modèle
structurel; variable instrumentale; instrument faible; inférence simultanée; projection; subdivision
d’échantillon; test conditionnel; test de Monte Carlo; bootstrap.
Classification JEL: : C1, C12, C14, C15, C3, C5.
ii
Contents
List of Propositions and Theorems iii
1. Introduction 1
2. Models 4
3. Statistical notions 5
3.1. Hypotheses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.2. Test level and size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3.3. Confidence sets and pivots . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3.4. Testability and identification . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
4. Testability, nonparametric models and asymptotic methods 9
4.1. Procedures robust to nonnormality . . . . . . . . . . . . . . . . . . . . . . . . 9
4.2. Procedures robust to heteroskedasticity of unknown form . . . . . . . . . . . . . 12
4.3. Procedures robust to autocorrelation of arbitrary form . . . . . . . . . . . . . . 13
5. Structural models and weak instruments 14
5.1. Standard simultaneous equations model . . . . . . . . . . . . . . . . . . . . . . 15
5.2. Statistical problems associated with weak instruments . . . . . . . . . . . . . . 16
5.3. Characterization of valid tests and confidence sets . . . . . . . . . . . . . . . . 17
6. Approaches to weak instrument problems 18
6.1. Anderson-Rubin statistic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
6.2. Projections and inference on parameter subsets . . . . . . . . . . . . . . . . . . 21
6.3. Alternatives to the AR procedure . . . . . . . . . . . . . . . . . . . . . . . . . 21
7. Extensions 26
7.1. Multivariate regression, simulation-based inference and nonnormal errors . . . . 26
7.2. Nonlinear models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
8. Conclusion 29
List of Propositions and Theorems
4.1 Theorem : Mean non-testability in nonparametric models . . . . . . . . . . . . . . 10
4.2 Theorem : Characterization of heteroskedasticity robust tests . . . . . . . . . . . . . 12
4.4 Theorem : Unit root non-testability in nonparametric models . . . . . . . . . . . . . 13
iii
1. Introduction
The main objective of econometrics is to supply methods for analyzing economic data, building
models, and assessing alternative theories. Over the last 25 years, econometric research has led
to important developments in many areas, such as: (1) new fields of applications linked to the
availability of new data, financial data, micro-data, panels, qualitative variables; (2) new models:
multivariate time series models, GARCH-types processes; (3) a greater ability to estimate nonlinear
models which require an important computational capacity; (4) methods based on simulation: boot-
strap, indirect inference, Markov chain Monte Carlo techniques; (5) methods based on weak distri-
butional assumptions: nonparametric methods, asymptotic distributions based on “weak regularity
conditions”; (6) discovery of various nonregular problems which require nonstandard distributional
theories, such as unit roots and unidentified (or weakly identified) models.
An important component of this work is the development of procedures for testing hypotheses
(or models). Indeed, a view widely held by both scientists and philosophers is that testability or the
formulation of testable hypotheses constitutes a central feature of scientific activity — a view we
share. With the exception of mathematics, it is not clear a discipline should be viewed as scientific if
it does not lead to empirically testable hypotheses. But this requirement leaves open the question of
formulating operational procedures for testing models and theories. To date, the only coherent — or,
at least, the only well developed — set of methods are those supplied by statistical and econometric
theory.
Last year, on the same occasion, MacKinnon (2002) discussed the use of simulation-based in-
ference methods in econometrics, specifically bootstrapping, as a way of getting more reliable tests
and confidence sets. In view of the importance of the issue, this paper also considers questions as-
sociated with the development of reliable inference procedures in econometrics. But our exposition
will be, in a way, more specialized, and in another way, more general — and critical. Specifically,
we shall focus on general statistical issues raised by identification in econometric models, and more
specifically on weak instruments in the context of structural models [e.g., simultaneous equations
models (SEM)]. We will find it useful to bring together two separate streams of literature: namely,
results (from mathematical statistics and econometrics) on testability in nonparametric models, and
the recent econometric research on weak instruments.
1
In particular, we shall emphasize that identi-
fication problems arise in both literatures and have similar consequences for econometric methodol-
ogy. Further, the literature on nonparametric testability sheds light on various econometric problems
and their solutions.
Simultaneous equations models (SEM) are related in a natural way to the concept of equilib-
rium postulated by economic theory, both in microeconomics and macroeconomics. So it is not
surprising that SEM were introduced and most often employed in the analysis of economic data.
Methods for estimating and testing such models constitute a hallmark of econometric theory and
represent one of its most remarkable achievements. The problems involved are difficult, raising
among various issues the possibility of observational equivalence between alternative parameter
values (non-identification) and the use of instrumental variables (IV). Further, the finite-sample
1
By a nonparametric model (or hypothesis), we mean a set of possible data distributions such that a distribution [e.g.,
the “true” distribution] cannot be singled out by fixing a finite number of parameter values.
1
distributional theory of estimators and test statistics is very complex, so inference is typically based
on large-sample approximations.
2
IV methods have become a routine part of econometric analysis and, despite a lot of loose
ends (often hidden by asymptotic distributional theory), the topic of SEM was dormant until a
few years ago. Roughly speaking, an instrument should have two basic properties: first, it should
be independent (or, at least, uncorrelated) with the disturbance term in the equation of interest
(exogeneity); second, it should be correlated with the included endogenous explanatory variables
for which it is supposed to serve as an instrument (relevance). The exogeneity requirement has
been well known from the very beginning of IV methods. The second one was also known from the
theory of identification, but its practical importance was not well appreciated and often hidden from
attention by lists of instruments relegated to footnotes (if not simply absent) in research papers. It
returned to center stage with the discovery of so-called weak instruments, which can be interpreted
as instruments with little relevance (i.e., weakly correlated with endogenous explanatory variables).
Weak instruments lead to poor performance of standard econometric procedures and cases where
they have pernicious effects may be difficult to detect.
3
Interest in the problem also goes far beyond
IV regressions and SEM, because it underscores the pitfalls in using large-sample approximations,
as well as the importance of going back to basic statistical theory when developing econometric
methods.
A parameter (or a parameter vector) in a model is not identified when it is not possible to
distinguish between alternative values of the parameter. In parametric models, this is typically
interpreted by stating that the postulated distribution of the data — as a function of the parameter
vector (the likelihood function) — can be the same for different values of the parameter vector.
4
An important consequence of this sort of situation is a statistical impossibility: we cannot design
a data-based procedure for distinguishing between equivalent parameter values (unless additional
information is introduced). In particular, no reasonable test can be produced.
5
In nonparametric
models, identification is more difficult to characterize because a likelihood function (involving a
finite number of parameters) is not available and parameters are often introduced through more
abstract techniques (e.g., functionals of distribution functions). But the central problem is the same:
can we distinguish between alternative values of the parameter? So, quite generally, an identification
problem can be viewed as a special form of non-testability. Specifically,
• identification involves the possibility of distinguishing different parameter values on the basis
of the corresponding data distributions, while
• testability refers to the possibility of designing procedures that can discriminate between sub-
sets of parameter values.
2
For reviews, see Phillips (1983) and Taylor (1983).
3
Early papers which called attention to the problem include: Nelson and Startz (1990a, 1990b), Buse (1992), Choi
and Phillips (1992), Maddala and Jeong (1992), and Bound, Jaeger, and Baker (1993, 1995).
4
For general expositions of the theory of identification in econometrics and statistics, the reader may consult Rothen-
berg (1971), Fisher (1976), Hsiao (1983), Prakasa Rao (1992), Bekker, Merckens, and Wansbeek (1994) and Manski
(1995, 2003).
5
By a reasonable test, we mean here a test that both satisfies a level constraint and may have power superior to the
level when the tested hypothesis (the null hypothesis) does not hold. This will be discussed in greater detail below.
2
Alternatively, a problem of non-testability can be viewed as a form of non-identification. (or un-
deridentification). These problems are closely related. Furthermore, it is well known that one can
create a non-identified model by introducing redundant parameters, and conversely identification
problems can be eliminated by transforming the parameter space (e.g., by reducing the number of
parameters). Problems of non-identification are associated with bad parameterizations, inappro-
priate choices of parameter representations. We will see below that the same remark applies quite
generally to non-testability problems, especially in nonparametric setups.
In this paper, we pursue two main objectives: first, we analyze the statistical problems associated
with non-identification within the broader context of testability; second, we review the inferential
issues linked to the possible presence of weak instruments in structural models. More precisely,
regarding the issue of testability, the following points will be emphasized:
1. many models and hypotheses are formulated in ways that make them fundamentally non-
testable; in particular, this tends to be the case in nonparametric setups;
2. such difficulties arise in basic apparently well-defined problems, such as: (a) testing an hy-
pothesis about a mean when the observations are independent and identically distributed (i.i.d.
; (b) testing an hypothesis about a mean (or a median) with heteroskedasticity of unknown
form; (c) testing the unit root hypothesis on an autoregressive model whose order can be
arbitrarily large;
3. some parameters tend to be non-testable (badly identified) in nonparametric models while
others are not; in particular, non-testability easily occurs for moments (e.g., means, variances)
while it does not for quantiles (e.g., medians); from this viewpoint, moments are not a good
way of representing the properties of distributions in nonparametric setups, while quantiles
are;
4. these phenomena underscore parametric nonseparability problems: statements about a given
parameter (often interpreted as the parameter of interest) are not empirically meaningful with-
out supplying information about other parameters (often called nuisance parameters); but hy-
potheses that set both the parameter of interest and some nuisance parameters may well be
testable in such circumstances, so that the development of appropriate inference procedures
should start from a joint approach;
5. to the extent that asymptotic distributional theory is viewed as a way of producing statistical
methods which are valid under “weak” distributional assumptions, it is fundamentally mis-
leading because, under nonparametric assumptions, such approximations are arbitrarily bad
in finite samples.
Concerning weak instruments, we will review the associated problems and proposed solutions,
with an emphasis on finite-sample properties and the development of tests and confidence sets which
are robust to the presence of weak instruments. In particular, the following points will be stressed:
1. in accordance with basic statistical theory, one should always look for pivots as the funda-
mental ingredient for building tests and confidence sets; this principle appears to be especially
important when identification problems are present;
3
2. parametric nonseparability arises in striking ways when some parameters may not be iden-
tified, so that proper pivots may easily involve many more parameters than the parameter of
interest; this also indicates that the common distinction between parameters of interest and
nuisance parameters can be quite arbitrary, if not misleading;
3. important additional criteria for evaluating procedures in such contexts include various forms
of invariance (or robustness), such as: (a) robustness to weak instruments; (b) robustness
to instrument exclusion; (c) robustness to the specification of the model for the endogenous
explanatory variables in the equation(s) of interest;
4. weak instrument problems underscore in a striking way the limitations of large-sample argu-
ments for deriving and evaluating inference procedures;
5. very few informative pivotal functions have been proposed in the context of simultaneous
equations models;
6. the early statistic proposed by Anderson and Rubin (1949, AR) constitutes one of the (very
rare) truly pivotal functions proposed for SEM; furthermore, it satisfies all the invariance
properties listed above, so that it may reasonably be viewed as a fundamental building block
for developing reliable inference procedures in the presence of weak instruments;
7. a fairly complete set of inference procedures that allow one to produce tests and confidence
sets for all model parameters can be obtained through projection techniques;
8. various extensions and improvements over the AR method are possible, especially in improv-
ing power; however, it is important to note that these often come at the expense of using
large-sample approximations or giving up robustness.
The literature on weak instruments is growing rapidly, and we cannot provide here a complete
review. In particular, we will not discuss in any detail results on estimation, the detection of weak
instruments, or asymptotic theory in this context. For that purpose, we refer the reader to the
excellent survey recently published by Stock, Wright, and Yogo (2002).
The paper is organized as follows. In the next two sections, we review succinctly some basic
notions concerning models (section 2) and statistical theory (section 3), which are important for
our discussion. In section 4, we study testability problems in nonparametric models. In section 5,
we review the statistical difficulties associated with weak instruments. In section 6, we examine a
number of possible solutions in the context of linear SEM, while extensions to nonlinear or non-
Gaussian models are considered in Section 7. We conclude in section 8.
2. Models
The purpose of econometric analysis is to develop mathematical representations of data, which we
call models or hypotheses (models subject to restrictions). An hypothesis should have two basic
features.
4
1. It must restrict the expected behavior of observations, be informative. A non-restrictive hy-
pothesis says nothing and, consequently, does not teach us anything: it is empirically empty,
void of empirical content. The more restrictive a model is, the more informative it is, and the
more interesting it is.
2. It must be compatible with available data; ideally, we would like it to be true.
However, these two criteria are not always compatible:
1. the information criterion suggests the use of parsimonious models that usually take the form
of parametric models based on strong assumptions; note the information criterion is empha-
sized by an influential view in philosophy of science which stresses falsifiability as a criterion
for the scientific character of a theory [Popper (1968)];
2. in contrast, compatibility with observed data is most easily satisfied by vague models which
impose few restrictions; vague models may take the form of parametric models with a large
number of free parameters or nonparametric models which involve an infinite set of free
parameters and thus allow for weak assumptions.
Models can be classified as being either deterministic or stochastic. Deterministic models ,
which claim to make arbitrarily precise predictions, are highly falsifiable but always inconsistent
with observed data. Accordingly, most models used in econometrics are stochastic. Such models are
unverifiable: as with any theory that makes an indefinite number of predictions, we can never be sure
that the model will not be put in jeopardy by new data. Moreover, they are logically unfalsifiable:
in contrast with deterministic models, a probabilistic model is usually logically compatible with all
possible observation vectors.
Given these facts, it is clear any criterion for assessing whether an hypothesis is acceptable must
involve a conventional aspect. The purpose of hypothesis testing theory is to supply a coherent
framework for accepting or rejecting probabilistic hypotheses. It is a probabilistic adaptation of the
falsification principle.
6
3. Statistical notions
In this section, we review succinctly basic statistical notions which are essential for understanding
the rest of our discussion. The general outlook follows modern statistical testing theory, derived
from the Neyman-Pearson approach and described in standard textbooks, such as Lehmann (1986).
3.1. Hypotheses
Consider an observational experiment whose result can be represented by a vector of observations
X
(n)
= (X
1
, . . . , X
n
)

(3.1)
6
For further discussion on the issues discussed in this section, the reader may consult Dufour (2000).
5
where X
i
takes real values, and let
¯
F(x) =
¯
F(x
1
, . . . , x
n
) = P[X
1
≤ x
1
, . . . , X
n
≤ x
n
] (3.2)
be its distribution, where x = (x
1
, . . . , x
n
). We denote by F
n
the set of possible distribution
functions on R
n
[
¯
F ∈ F
n
].
For various reasons, we prefer to represent distributions in terms of parameters. There are
two ways of introducing parameters in a model. The first is to define a function from a space of
probability distributions to a vector in some Euclidean space:
θ : F
n
−→R
p
. (3.3)
Examples of such parameters include: the moments of a distribution (mean, variance, kurtosis,
etc.), its quantiles (median, quartiles, etc.). Such functions are also called functionals. The second
approach is to define a family of distribution functions which are indexed by a parameter vector θ :
F(x) = F
0
(x| θ) (3.4)
where F
0
is a distribution function with a specific form. For example, if F
0
(x| θ) represents a
Gaussian distribution with mean µ and variance σ
2
[e.g., corresponding to a Gaussian law], we have
θ = (µ, σ
2
).
A model is parametric if the distribution of the data is specified up to a finite number of (scalar)
parameters. Otherwise, it is nonparametric. An hypothesis H
0
on X
(n)
is an assertion
H
0
:
¯
F ∈ H
0
, (3.5)
where H
0
is a subset of F
n
, the set of all possible distributions F
n
. The set H
0
may contain: a single
distribution (simple hypothesis), or several distributions (composite hypothesis). In particular, if we
can write θ = (θ
1
, θ
2
), H
0
often takes the following form:
H
0
≡ {F(·) : F(x) = F
0
(x| θ
1
, θ
2
) and θ
1
= θ
0
1
} . (3.6)
We usually abbreviate this as:
H
0
: θ
1
= θ
0
1
. (3.7)
In such a case, we call θ
1
the parameter of interest, and θ
2
a nuisance parameter: the parameter
of interest is set by H
0
but the nuisance parameter remains unknown. H
0
may be interpreted as
follows: there is at least one distribution in H
0
that can be viewed as a representation compatible
with the observed “behavior” of X
(n)
. Then we can say that:
H
0
is acceptable ⇐⇒
_
(∃F ∈ H
0
) F is acceptable
_
(3.8)
or, equivalently,
H
0
is unacceptable ⇐⇒
_
(∀F ∈ H
0
) F is unacceptable
_
. (3.9)
6
It is important to note here that showing that H
0
is unacceptable requires one to show that all
distributions in H
0
are incompatible with the observed data.
3.2. Test level and size
A test for H
0
is a rule by which one decides to reject or accept the hypothesis (or to view it as
incompatible with the data). It usually takes the form:
reject H
0
if S
n
(X
1
, . . . , X
n
) > c ,
do not reject H
0
if S
n
(X
1
, . . . , X
n
) ≤ c .
(3.10)
The test has level α iff
P
F
[Rejecting H
0
] ≤ α for all F ∈ H
0
(3.11)
or, equivalently,
sup
F∈H
0
P
F
[Rejecting H
0
] ≤ α, (3.12)
where P
F
[ · ] is the function (probability measure) giving the probability of an event when the data
distribution function is F. The test has size α if
sup
F∈H
0
P
F
[Rejecting H
0
] = α. (3.13)
H
0
is testable if we can find a finite number c that satisfies the level restriction. Probabilities of
rejecting H
0
for distributions outside H
0
(i.e., for F / ∈ H
0
) define the power function of the test.
7
Power describes the ability of a test to detect a “false” hypothesis. Alternative tests are typically
assessed by comparing their powers: between two tests with the same level, the one with the highest
power against a given alternative distribution F / ∈ H
0
is deemed preferable (at least, under this
particular alternative). Among tests with the same level, we typically like to have a test with the
highest possible power against “alternatives of interest”.
As the set H
0
gets larger, the test procedure must satisfy a bigger set of constraints: the larger
is the set of distributions compatible with a null hypothesis, the stronger are the restrictions on the
test procedure. In other words, the less restrictive an hypothesis is, the more restricted will be the
corresponding test procedure. It is easy to understand that imposing a large set of restrictions on a
test procedure may reduce its power against specific alternatives. There may be a point where the
restrictions are no longer implementable, in the sense that no procedure which has some power can
satisfy the level constraint: H
0
is non-testable. In such a case, we have an ill-defined test problem.
In a framework such as the one in (3.6), where we distinguish between a parameter of interest
θ
1
and a nuisance parameter θ
2
, this is typically due to heavy dependence of the distribution of
S
n
on the nuisance parameter θ
2
. If the latter is specified, we may be able to find a (finite) critical
value c = c(α, θ
2
) that satisfies the level constraint (3.11). But, in ill-defined problems, c(α, θ
2
)
7
More formally, the power function can be defined as the function: P(F) = P
F
[Rejecting H
0
] for F ∈ H
1
\ H
0
,
where H
1
is an appropriate subset of the set of all possible distributions F
n
. Sometimes, it is also defined on the set
H
1
∪ H
0
, in which case it should satisfy the level constraint for F ∈ H
0
.
7
depends heavily on θ
2
, so that it is not possible to find a useful (finite) critical value for testing H
0
,
i.e. sup
θ
2
c(α, θ
2
) = ∞. Besides, even if this is the case, this does not imply that an hypothesis
that would fix both θ
1
and θ
2
, is not testable, i.e. the hypothesis H

0
: (θ
1
, θ
2
) = (θ
0
1
, θ
0
2
) may
be perfectly testable. But only a complete specification of the vector (θ
1
, θ
2
) does allow one to
interpret the values taken by the test statistic S
n
(nonseparability).
3.3. Confidence sets and pivots
If we consider an hypothesis of the form
H
0

0
1
) : θ
1
= θ
0
1
(3.14)
and if we can build a different test S
n

0
1
; X
1
, . . . , X
n
) for each possible value of θ
0
1
, we can
determine the set of values that can be viewed as compatible with the data according to the tests
considered:
C =
_
θ
0
1
: S
n

0
1
; X
1
, . . . , X
n
) ≤ c(θ
0
1
)
_
. (3.15)
If
P
F
_
Rejecting H
0

0
1
)
¸
≤ α for all F ∈ H(F
0
, θ
0
1
) , (3.16)
we have
inf
θ
1

2
P[θ
1
∈ C] ≥ 1 −α . (3.17)
C is a confidence set with level 1 − α for θ
1
. The set C covers the “true” parameter value θ
1
with
probability at least 1 −α. The minimal probability of covering the true value of θ
1
, i.e. inf
θ
1

2
P[θ
1

C], is called the size of the confidence set.
In practice, confidence regions (or confidence intervals) were made possible by the discovery of
pivotal functions (or pivots): a pivot for θ
1
is a function S
n

1
; X
1
, . . . , X
n
) whose distribution
does not depend on unknown parameters (nuisance parameters); in particular, the distribution does
not depend on θ
2
. More generally, the function S
n

1
; X
1
, . . . , X
n
) is boundedly pivotal if its
distribution function may depend on θ but is bounded over the parameter space [see Dufour (1997)].
When we have a pivotal function (or a boundedly pivotal function), we can find a point c such that:
P[S
n

1
; X
1
, . . . , X
n
) ≥ c] ≤ α , ∀θ
1
. (3.18)
For example, if X
1
, . . . , X
n
i.i.d.
∼ N[µ, σ
2
], the t-statistic
t
n
(µ) =

n(
¯
X
n
−µ)/s
X
(3.19)
where
¯
X
n
=
n

i=1
X
i
/n and s
X
=
n

i=1
(X
i

¯
X
n
)/(n − 1), follows a Student t(n − 1) distribution
which does not depend on the unknown values of µ and σ; hence, it is a pivot. By contrast,

n(
¯
X
n

µ) is not a pivot because its distribution depends on σ. More generally, in the classical linear model
with several regressors, the t statistics for individual coefficients [say, t(β
i
) =

n(
ˆ
β
i
− β
i
)/ˆ σ
ˆ
β
i
]
8
constitute pivots because their distributions do not depend on unknown nuisance parameters; in
particular, the values of the other regression coefficients disappear from the distribution.
3.4. Testability and identification
When formulating and trying to solve test problems, two types of basic difficulties can arise. First,
there is no valid test that satisfies reasonable properties [such as depending upon the data]: in such
a case, we have a non-testable hypothesis, an empirically empty hypothesis. Second, the proposed
statistic cannot be pivotal for the model considered: its distribution varies too much under the null
hypothesis to determine a finite critical point satisfying the level restriction (3.18).
If an hypothesis is non-testable, we are not able to design a reasonable procedure for deciding
whether it holds (without the introduction of additional data or information). This difficulty is
closely related to the concept of identification in econometrics. A parameter θ is identifiable iff
θ(F
1
) = θ(F
2
) =⇒F
1
= F
2
. (3.20)
For θ
1
= θ
2
, we can, in principle, design a procedure for deciding whether θ = θ
1
or θ = θ
2
. The
values of θ are testable. More generally, a parametric transformation g(θ) is identifiable iff
g[θ(F
1
)] = g[θ(F
2
)] =⇒F
1
= F
2
. (3.21)
Intuitively, these definitions mean that different values of the parameter imply different distributions
of the data, so that we may expect to be able to “tell” the difference by looking at the data. This is
certainly the case when a unique distribution is associated with each parameter value [for example,
we may use the Neyman-Pearson likelihood ratio test to make the decision], but this may not be the
case when a parameter covers several distributions. In the next section, we examine several cases
where this happens.
4. Testability, nonparametric models and asymptotic methods
We will now discuss three examples of test problems that look perfectly well defined and sensible
at first sight, but turn out to be ill-defined when we look at them more carefully. These include:
(1) testing an hypothesis about a mean when the observations are independent and identically dis-
tributed (i.i.d.); (2) testing an hypothesis about a mean (or a median) with heteroskedasticity of
unknown form; (3) testing the unit root hypothesis on an autoregressive model whose order can be
arbitrarily large.
8
4.1. Procedures robust to nonnormality
One of the most basic problems in econometrics and statistics consists in testing an hypothesis
about a mean, for example, its equality to zero. Tests on regression coefficients in linear regressions
8
Further discussion on the issues discussed in this section is available in Dufour (2001). For rrelated discussions, see
also Horowitz (2001), Maasoumi (1992) and Pötscher (2002).
9
or, more generally, on parameters of models which are estimated by the generalized method of
moments (GMM) can be viewed as extensions of this fundamental problem. If the simplest versions
of the problem have no reasonable solution, the situation will not improve when we consider more
complex versions (as done routinely in econometrics).
The problem of testing an hypothesis about a mean has a very well known and neat solution
when the observations are independent and identically (i.i.d.) distributed according to a normal
distribution: we can use a t test. The normality assumption, however, is often considered to be too
“strong”. So it is tempting to consider a weaker (less restrictive) version of this null hypothesis,
such as
H
0

0
) : X
1
, . . . , X
n
are i.i.d. observations with E(X
1
) = µ
0
. (4.1)
In other words, we would like to test the hypothesis that the observations have mean µ
0
, under the
general assumption that X
1
, . . . , X
n
are i.i.d. Here H
0

0
) is a nonparametric hypothesis because
the distribution of the data cannot be completely specified by fixing a finite number of parameters.
The set of possible data distributions (or data generating processes) compatible with this hypothesis,
i.e.,
H(µ
0
) = {Distribution functions F
n
∈ F
n
such that H
0

0
) is satisfied} , (4.2)
is much larger here than in the Gaussian case and imposes very strong restrictions on the test.
Indeed, the set H(µ
0
) is so large that the following property must hold.
Theorem 4.1 MEAN NON-TESTABILITY IN NONPARAMETRIC MODELS. If a test has level α for
H
0

0
), i.e.
P
F
n
[Rejecting H
0

0
)] ≤ α for all F
n
∈ H(µ
0
) , (4.3)
then, for any µ
1
= µ
0
,
P
F
n
[Rejecting H
0

0
)] ≤ α for all F
n
∈ H(µ
1
) . (4.4)
Further, if there is at least one value µ
1
= µ
0
such that
P
F
n
_
Rejecting H
0

0
)
¸
≥ α for at least one F
n
∈ H(µ
1
) , (4.5)
then, for all µ
1
= µ
0
,
P
F
n
_
Rejecting H
0

0
)
¸
= α for all F
n
∈ H(µ) . (4.6)
PROOF. See Bahadur and Savage (1956).
In other words [by (4.4)], if a test has level α for testing H
0

0
), the probability of rejecting
H
0

0
) should not exceed the level irrespective how far the “true” mean is from µ
0
. Further [by
(4.6)], if “by luck” the power of the test gets as high as the level, then the probability of rejecting
should be uniformly equal to the level α. Here, the restrictions imposed by the level constraint are
so strong that the test cannot have power exceeding its level: it should be insensitive to cases where
the null hypothesis does not hold! An optimal test (say, at level .05) in such a problem can be run
10
as follows: (1) ignore the data; (2) using a random number generator, produce a realization of a
variable U according to a uniform distribution on the interval (0, 1), i.e., U ∼ U(0, 1); (3) reject
H
0
if U ≤ .05. Clearly, this is not an interesting procedure. It is also easy to see that a similar result
will hold if we add various nonparametric restrictions on the distribution, such as a finite variance
assumption.
The above theorem also implies that tests based on the “asymptotic distribution” of the usual t
statistic for µ = µ
0
[t
n

0
) defined in (3.19)] has size one under H
0

0
) :
sup
F
n
∈H(µ
0
)
P
F
n
_
|t
n

0
)| > c
¸
= 1 (4.7)
for any finite critical value c. In other words, procedures based on the asymptotic distribution of a
test statistic have size that deviate arbitrarily from their nominal size.
A way to interpret what happens here is through the distinction between pointwise convergence
and uniform convergence. Suppose, to simplify, that the probability of rejecting H
0

0
) when it is
true depends on a single nuisance parameter γ in the following way:
P
n
(γ) ≡ P
γ
_
|t
n

0
)| > c
¸
= 0.05 + (0.95)e
−|γ|n
(4.8)
where γ = 0. Then, for each value of γ, the test has level 0.05 asymptotically, i.e.
lim
n→∞
P
n
(γ) = 0.05 , (4.9)
but the size of the test is one for all sample sizes:
sup
γ>0
P
n
(γ) = 1 , for all n. (4.10)
P
n
(γ) converges to a level of 0.05 pointwise (for each γ), but the convergence is not uniform, so
that the probability of rejection is arbitrarily close to one for γ sufficiently close to zero (for all
sample sizes n).
Many other hypotheses lead to similar difficulties. Examples include:
1. hypotheses about various moments of X
t
:
H
0

2
) : X
1
, . . . , X
n
are i.i.d. observations such that Var(X
t
) = σ
2
,
H
0

p
) : X
1
, . . . , X
n
are i.i.d. observations such that E(X
p
t
) = µ
p
;
2. most hypotheses on the coefficients of a regression (linear or nonlinear), a structural equation
(as in SEM), or a more general estimating function [Godambe (1960)]:
H
0

0
) : g
t
(Z
t
, θ
0
) = u
t
, t = 1 , . . . , T , where u
1
, . . . , u
T
are i.i.d.
In econometrics, models of the form H
0

0
) are typically estimated and tested through a variant of
the generalized method of moments (GMM), usually with weaker assumptions on the distribution
11
of u
1
, . . . , u
T
; see Hansen (1982), Newey and West (1987a), Newey and McFadden (1994) and
Hall (1999). To the extent that GMM methods are viewed as a way to allow for “weak assumptions”,
it follows from the above discussion that they constitute pseudo-solutions of ill-defined problems.
It is important to observe that the above discussion does not imply that all nonparametric hy-
potheses are non testable. In the present case, the problem of non-testability could be eliminated by
choosing another measure of central tendency, such as a median:
H
0.5
0
(m
0
) : X
1
, . . . , X
n
are i.i.d. continuous r.v.’s such that
Med(X
t
) = m
0
, t = 1 , . . . , T .
H
0.5
0
(m
0
) can be easily tested with a sign test [see Pratt and Gibbons (1981, Chapter 2)]. More
generally, hypotheses on the quantiles of the distribution of observations in random sample remain
testable nonparametrically:
H
p
0
(Q
p0
) : X
1
, . . . , X
n
are i.i.d. observations such that
P
_
X
t
≤ Q
p0
¸
= p , t = 1 , . . . , T .
Moments are not empirically meaningful functionals in nonparametric models (unless strong distri-
butional assumptions are added), though quantiles are.
4.2. Procedures robust to heteroskedasticity of unknown form
Another common problem in econometrics consists in developing methods which remain valid in
making inference on regression coefficients when the variances of the observations are not identi-
cal (heteroskedasticity). In particular, this may go as far as looking for tests which are “robust to
heteroskedasticity of unknown form”. But it is not widely appreciated that this involves very strong
restrictions on the procedures that can satisfy this requirement. To see this, consider the prob-
lem which consists in testing whether n observations are independent with common zero median,
namely:
H
0
: X
1
, . . . , X
n
are independent random variables
each with a distribution symmetric about zero.
(4.11)
Equivalently, H
0
states that the joint distribution F
n
of the observations belongs to the (huge) set
H
0
= {F
n
∈ F
n
: F
n
satisfies H
0
} : H
0
allows heteroskedasticity of unknown form. In such a
case, we have the following theorem.
Theorem 4.2 CHARACTERIZATION OF HETEROSKEDASTICITY ROBUST TESTS. If a test has
level α for H
0
, where 0 < α < 1, then it must satisfy the condition
P[ Rejecting H
0
| |X
1
|, . . . , |X
n
| ] ≤ α under H
0
. (4.12)
PROOF. See Pratt and Gibbons (1981, Section 5.10) and Lehmann and Stein (1949).
In other words, a valid test with level α must be a sign test — or, more precisely, its level must
be equal to α conditional on the absolute values of the observations (which amounts to considering
12
a test based on the signs of the observations). From this, the following remarkable property follows.
Corollary 4.3 If, for all 0 < α < 1, the condition (4.12) is not satisfied, then the size of the test is
equal to one, i.e.
sup
F
n
∈H
0
P
F
n
[Rejecting H
0
] = 1 . (4.13)
In other words, if a test procedure does not satisfy (4.12) for all levels 0 < α < 1, then its true
size is one irrespective of its nominal size. Most so-called “heteroskedasticity robust procedures”
based on “corrected” standard errors [see White (1980), Newey and West (1987b), Davidson and
MacKinnon (1993, Chapter 16), Cushing and McGarvey (1999)] do not satisfy condition (4.12) and
consequently have size one.
9
4.3. Procedures robust to autocorrelation of arbitrary form
As a third illustration, let us now examine the problem of testing the unit root hypothesis in the con-
text of an autoregressive model whose order is infinite or is not bounded by a prespecified maximal
order:
X
t
= β
0
+
p

k=1
λ
k
X
t−k
+u
t
, u
t
i.i.d.
∼ N[0 , σ
2
] , t = 1 , . . . , n, (4.14)
where p is not bounded a priori. This type of problem has attracted a lot of attention in recent
years.
10
We wish to test:
˜
H
0
:
p

k=1
λ
k
= 1 (4.15)
or, more precisely,
˜
H
0
: X
t
= β
0
+
p

k=1
λ
k
X
t−k
+u
t
, t = 1 , . . . , n, for some p ≥ 0 ,
p

k=1
λ
k
= 1 and u
t
i.i.d.
∼ N[0 , σ
2
] .
(4.16)
About this problem, we can show the following theorem and corollary.
Theorem 4.4 UNIT ROOT NON-TESTABILITY IN NONPARAMETRIC MODELS. If a test has level
α for
˜
H
0
, i.e.
P
F
n
[Rejecting
˜
H
0
] ≤ α for all F
n
satisfying
˜
H
0
, (4.17)
then
P
F
n
[Rejecting
˜
H
0
] ≤ α for all F
n
. (4.18)
PROOF. See Cochrane (1991) and Blough (1992).
9
For examples of size distortions, see Dufour (1981) and Campbell and Dufour (1995, 1997).
10
For reviews of this huge literature, the reader may consult: Banerjee, Dolado, Galbraith, and Hendry (1993), Stock
(1994), Tanaka (1996), and Maddala and Kim (1998).
13
Corollary 4.5 If, for all 0 < α < 1, the condition (4.18) is not satisfied, then the size of the test is
equal to one, i.e.
sup
F
n
∈H
0
P
F
n
[Rejecting
˜
H
0
] = 1
where H
0
is the set of all data distributions F
n
that satisfy
˜
H
0
.
As in the mean problem, the null hypothesis is simply too “large” (unrestricted) to allow testing
from a finite data set. Consequently, all procedures that claim to offer corrections for very general
forms of serial dependence [e.g., Phillips (1987), Phillips and Perron (1988)] are affected by these
problems: irrespective of the nominal level of the test, the true size under the hypothesis
˜
H
0
is equal
to one.
To get a testable hypothesis, it is essential to fix jointly the order of the AR process (i.e., a
numerical upper bound on the order) and the sum of the coefficients: for example, we could consider
the following null hypothesis where the order of the autoregressive process is equal to 12:
H
0
(12) : X
t
= β
0
+
12

k=1
λ
k
X
t−k
+u
t
, t = 1 , . . . , n,
12

k=1
λ
k
= 1 and u
t
i.i.d.
∼ N[0 , σ
2
] .
(4.19)
The order of the autoregressive process is an essential part of the hypothesis: it is not possible to
separate inference on the unit root hypothesis from inference on the order of the process. Similar
difficulties will also occur for most other hypotheses on the coefficients of (4.16). For further
discussion of this topic, the reader may consult Sims (1971a, 1971b), Blough (1992), Faust (1996,
1999) and Pötscher (2002).
5. Structural models and weak instruments
Several authors in the past have noted that usual asymptotic approximations are not valid or lead to
very inaccurate results when parameters of interest are close to regions where these parameters are
no longer identifiable. The literature on this topic is now considerable.
11
In this section, we shall
examine these issues in the context of SEM.
11
See Sargan (1983), Phillips (1984, 1985, 1989), Gleser and Hwang (1987), Koschat (1987), Phillips (1989), Hillier
(1990), Nelson and Startz (1990a, 1990b), Buse (1992), Choi and Phillips (1992), Maddala and Jeong (1992), Bound,
Jaeger, and Baker (1993, 1995), Dufour and Jasiak (1993, 2001), McManus, Nankervis, and Savin (1994), Angrist and
Krueger (1995), Hall, Rudebusch, and Wilcox (1996), Dufour (1997), Shea (1997), Staiger and Stock (1997), Wang and
Zivot (1998), Zivot, Startz, and Nelson (1998), Hall and Peixe (2000), Stock and Wright (2000), Hahn and Hausman
(2002a, 2002b, 2002c), Hahn, Hausman, and Kuersteiner (2001), Dufour and Taamouti (2000, 2001b, 2001a), Startz,
Nelson, and Zivot (2001), Kleibergen (2001b, 2001a, 2002a, 2002b, 2003), Bekker (2002), Bekker and Kleibergen (2001),
Chao and Swanson (2001, 2003), Moreira (2001, 2003a, 2003b), Moreira and Poi (2001), Stock and Yogo (2002, 2003),
Stock, Wright, and Yogo (2002)], Wright (2003, 2002), Imbens and Manski (2003), Kleibergen and Zivot (2003), Perron
(2003), and Zivot, Startz, and Nelson (2003).
14
5.1. Standard simultaneous equations model
Let us consider the standard simultaneous equations model:
y = Y β +X
1
γ +u, (5.1)
Y = X
1
Π
1
+X
2
Π
2
+V , (5.2)
where y and Y are T × 1 and T × G matrices of endogenous variables, X
1
and X
2
are T × k
1
and T × k
2
matrices of exogenous variables, β and γ are G × 1 and k
1
× 1 vectors of unknown
coefficients, Π
1
and Π
2
are k
1
×Gand k
2
×Gmatrices of unknown coefficients, u = (u
1
, . . . , u
T
)

is a T ×1 vector of structural disturbances, and V = [V
1
, . . . , V
T
]

is a T ×G matrix of reduced-
form disturbances. Further,
X = [X
1
, X
2
] is a full-column rank T ×k matrix (5.3)
where k = k
1
+ k
2
. Finally, to get a finite-sample distributional theory for the test statistics, we
shall use the following assumptions on the distribution of u :
u and X are independent; (5.4)
u ∼ N
_
0, σ
2
u
I
T
¸
. (5.5)
(5.4) may be interpreted as the strict exogeneity of X with respect to u.
Note that the distribution of V is not otherwise restricted; in particular, the vectors V
1
, . . . , V
T
need not follow a Gaussian distribution and may be heteroskedastic. Below, we shall also consider
the situation where the reduced-form equation for Y includes a third set of instruments X
3
which
are not used in the estimation:
Y = X
1
Π
1
+X
2
Π
2
+X
3
Π
3
+V (5.6)
where X
3
is a T ×k
3
matrix of explanatory variables (not necessarily strictly exogenous); in partic-
ular, X
3
may be unobservable. We view this situation as important because, in practice, it is quite
rare that one can consider all the relevant instruments that could be used. Even more generally, we
could also assume that Y obeys a general nonlinear model of the form:
Y = g(X
1
, X
2
, X
3
, V, Π) (5.7)
where g(·) is a possibly unspecified nonlinear function and Π is an unknown parameter matrix.
The model presented in (5.1) - (5.2) can be rewritten in reduced form as:
y = X
1
π
1
+X
2
π
2
+v , (5.8)
Y = X
1
Π
1
+X
2
Π
2
+V , (5.9)
15
where π
1
= Π
1
β +γ , v = u +V β , and
π
2
= Π
2
β . (5.10)
Suppose now that we are interested in making inference about β.
(5.10) is the crucial equation governing identification in this system: we need to be able to
recover β from the values of the regression coefficients π
2
and Π
2
. The necessary and sufficient
condition for identification is the well-known rank condition for the identification of β :
β is identifiable iff rank(Π
2
) = G. (5.11)
We have a weak instrument problem when either rank(Π
2
) < k
2
(non-identification), or Π
2
is
close to having deficient rank [i.e., rank(Π
2
) = k
2
with strong linear dependence between the rows
(or columns) of Π
2
]. There is no compelling definition of the notion of near-nonidentification, but
reasonable characterizations include the condition that det(Π

2
Π
2
) is “close to zero”, or that Π

2
Π
2
has one or several eigenvalues “close to zero”.
Weak instruments are notorious for causing serious statistical difficulties on several fronts: (1)
parameter estimation; (2) confidence interval construction; (3) hypothesis testing. We now consider
these problems in greater detail.
5.2. Statistical problems associated with weak instruments
The problems associated with weak instruments were originally discovered through its conse-
quences for estimation. Work in this area includes:
1. theoretical work on the exact distribution of two-stage least squares (2SLS) and other “con-
sistent” structural estimators and test statistics [Phillips (1983), Phillips (1984), Rothenberg
(1984), Phillips (1985), Phillips (1989), Hillier (1990), Nelson and Startz (1990a), Nelson
and Startz (1990a), Buse (1992), Maddala and Jeong (1992), Choi and Phillips (1992), Du-
four (1997)];
2. weak-instrument (local to non-identification) asymptotics [Staiger and Stock (1997), Wang
and Zivot (1998), Stock and Wright (2000)];
3. empirical examples [Bound, Jaeger, and Baker (1995)].
The main conclusions of this research can be summarized as follows.
1. Theoretical results show that the distributions of various estimators depend in a complicated
way on unknown nuisance parameters. Thus, they are difficult to interpret.
2. When identification conditions are not satisfied, standard asymptotic theory for estimators
and test statistics typically collapses.
3. With weak instruments,
16
(a) the 2SLS estimator becomes heavily biased [in the same direction as ordinary least
squares (OLS)];
(b) the distribution of the 2SLS estimator is quite far from the normal distribution (e.g.,
bimodal).
4. A striking illustration of these problems appears in the reconsideration by Bound, Jaeger, and
Baker (1995) of a study on returns to education by Angrist and Krueger (1991, QJE). Using
329000 observations, these authors found that replacing the instruments used by Angrist and
Krueger (1991) with randomly generated (totally irrelevant) instruments produced very simi-
lar point estimates and standard errors. This result indicates that the original instruments were
weak.
For a more complete discussion of estimation with weak instruments, the reader may consult Stock,
Wright, and Yogo (2002).
5.3. Characterization of valid tests and confidence sets
Weak instruments also lead to very serious problems when one tries to perform tests or build confi-
dence intervals on the parameters of the model. Consider the general situation where we have two
parameters θ
1
and θ
2
[i.e., θ = ( θ
1
, θ
2
)] such that θ
2
is no longer identified when θ
1
takes a certain
value, say θ
1
= θ
0
1
:
L(y | θ
1
, θ
2
) ≡ L(y | θ
0
1
) . (5.12)
Theorem 5.1 If θ
2
is a parameter whose value is not bounded, then the confidence region C with
level 1 −α for θ
2
must have the following property:
P
θ
[C is unbounded] > 0 (5.13)
and, if θ
1
= θ
0
1
,
P
θ
[C is unbounded] ≥ 1 −α. (5.14)
PROOF. See Dufour (1997).
Corollary 5.2 If C does not satisfy the property given in the previous theorem, its size must be zero.
This will be the case, in particular, for any Wald-type confidence interval, obtained by assuming
that
t
´
θ
2
=
´
θ
2
−θ
2
´ σ
θ
2
approx
∼ N(0, 1) , (5.15)
which yields confidence intervals of the form
´
θ
2
− c´ σ
θ
2
≤ θ
2

´
θ
2
+ c´ σ
θ
2
, where P[|N(0, 1)| >
c] ≤ α. By the above corollary, this type of interval has level zero, irrespective of the critical value
c used:
inf
θ
P
θ
_
´
θ
2
−c´ σ
θ
2
≤ θ
2

´
θ
2
+c´ σ
θ
2
_
= 0 . (5.16)
17
In such situations, the notion of standard error loses its usual meaning and does not constitute a valid
basis for building confidence intervals. In SEM, for example, this applies to standard confidence
intervals based on 2SLS estimators and their asymptotic “standard errors”.
Correspondingly, if we wish to test an hypothesis of form H
0
: θ
2
= θ
0
2
, the size of any test of
the form
¸
¸
¸t
´
θ
2

0
2
)
¸
¸
¸ =
¸
¸
¸
¸
¸
´
θ
2
−θ
0
2
´ σ
θ
2
¸
¸
¸
¸
¸
> c(α) (5.17)
will deviate arbitrarily fromits nominal size. No unique large-sample distribution for t
´
θ
2
can provide
valid tests and confidence intervals based on the asymptotic distribution of t
´
θ
2
. From a statistical
viewpoint, this means that t
´
θ
2
is not a pivotal function for the model considered. More generally,
this type of problem affect the validity of all Wald-type methods, which are based on comparing
parameter estimates with their estimated covariance matrix.
By contrast, in models of the form (5.1) - (5.5), the distribution of the LR statistics for most
hypotheses on model parameters can be bounded and cannot move arbitrarily: likelihood ratios are
boundedly pivotal functions and provide a valid basis for testing and confidence set construction
[see Dufour (1997)].
The central conclusion here is: tests and confidence sets on the parameters of a structural model
should be based on proper pivots.
6. Approaches to weak instrument problems
What should be the features of a satisfactory solution to the problem of making inference in struc-
tural models? We shall emphasize here four properties: (1) the method should be based on proper
pivotal functions (ideally, a finite-sample pivot); (2) robustness to the presence of weak instruments;
(3) robustness to excluded instruments; (4) robustness to the formulation of the model for the ex-
planatory endogenous variables Y (which is desirable in many practical situations).
In the light of these criteria, we shall first discuss the Anderson-Rubin procedure, which in our
view is the reference method for dealing with weak instruments in the context of standard SEM,
second the projection technique which provides a general way of making a wide spectrum of tests
and confidence sets, and thirdly several recent proposals aimed at improving and extending the AR
procedure.
6.1. Anderson-Rubin statistic
A solution to testing in the presence of weak instruments has been available for more than 50
years [Anderson and Rubin (1949)] and is now center stage again [Dufour (1997), Staiger and
Stock (1997)]. Interestingly, the AR method can be viewed as an alternative way of exploiting
“instruments” for inference on a structural model, although it pre-dates the introduction of 2SLS
methods in SEM [Theil (1953), Basmann (1957)], which later became the most widely used method
for estimating linear structural equations models.
12
The basic problem considered consists in testing
12
The basic ideas for using instrumental variables for inference on structural relationships appear to go back to Working
(1927) and Wright (1928). For an interesting discussion of the origin of IVmethods in econometrics, see Stock and Trebbi
18
the hypothesis
H
0

0
) : β = β
0
(6.1)
in model (5.1) - (5.4). In order to do that, we consider an auxiliary regression obtained by subtracting
Y β
0
from both sides of (5.1) and expanding the right-hand side in terms of the instruments. This
yields the regression
y −Y β
0
= X
1
θ
1
+X
2
θ
2
+ε (6.2)
where θ
1
= γ +Π
1
(β −β
0
), θ
2
= Π
2
(β −β
0
) and ε = u+V (β −β
0
) . Under the null hypothesis
H
0

0
), this equation reduces to
y −Y β
0
= X
1
θ
1
+ε , (6.3)
so we can test H
0

0
) by testing H

0

0
) : θ
2
= 0, in the auxiliary regression (6.2). This yields the
following F-statistic — the Anderson-Rubin statistic — which follows a Fisher distribution under
the null hypothesis:
AR(β
0
) =
[SS
0

0
) −SS
1

0
)]/k
2
SS
1

0
)/(T −k)
∼ F(k
2
, T −k) (6.4)
where SS
0

0
) = (y −Y β
0
)

M(X
1
)(y −Y β
0
) and SS
1

0
) = (y −Y β
0
)

M(X)(y −Y β
0
); for
any full-rank matrix A, we denote P(A) = A(A

A)
−1
A

and M(A) = I− P(A). What plays the
crucial role here is the fact that we have instruments (X
2
) that can be related to Y but are excluded
from the structural equation. To draw inference on the structural parameter β, we “hang” on the
variables in X
2
: if we add X
2
to the constrained structural equation (6.3), its coefficient should be
zero. For these reasons, we shall call the variables in X
2
auxiliary instruments.
Since the latter statistic is a proper pivot, it can be used to build confidence sets for β :
C
β
(α) = {β
0
: AR(β
0
) ≤ F
α
(k
2
, T −k)} (6.5)
where F
α
(k
2
, T − k) is the critical value for a test with level α based on the F(k
2
, T − k) distri-
bution. When there is only one endogenous explanatory variable (G = 1), this set has an explicit
solution involving a quadratic inequation, i.e.
C
β
(α) = {β
0
: aβ
2
0
+bβ
0
+c ≤ 0} (6.6)
where a = Y

HY, H ≡ M(X
1
) − M(X) [1 +k
2
F
α
(k
2
, T −k)/(T −k)] , b = −2Y

Hy, and
c = y

Hy . The set C
β
(α) may easily be determined by finding the roots of the quadratic polynomial
in equation (6.6); see Dufour and Jasiak (2001) and Zivot, Startz, and Nelson (1998) for details.
When G > 1, the set C
β
(α) is not in general an ellipsoid, but it remains fairly manageable
by using the theory of quadrics [Dufour and Taamouti (2000)]. When the model is correct and its
parameters are well identified by the instruments used, C
β
(α) is a closed bounded set close to an
ellipsoid. In other cases, it can be unbounded or empty. Unbounded sets are highly likely when
the model is not identified, so they point to lack of identification. Empty confidence sets can occur
(with a non-zero probability) when we have more instruments than parameters in the structural
(2003).
19
equation (5.1), i.e. the model is overidentified. An empty confidence set means that no value of
the parameter vector β is judged to be compatible with the available data, which indicates that the
model is misspecified. So the procedure provides as an interesting byproduct a specification test.
13
It is also easy to see that the above procedure remains valid even if the extended reduced form
(5.6) is the correct model for Y. In other words, we can leave out a subset of the instruments (X
3
)
and use only X
2
: the level of the procedure will not be affected. Indeed, this will also hold if
Y is determined by the general — possibly nonlinear — model (5.7). The procedure is robust to
excluded instruments as well as to the specification of the model for Y. The power of the test may
be affected by the choice of X
2
, but its level is not. Since it is quite rare an investigator can be sure
relevant instruments have not been left out, this is an important practical consideration.
The AR procedure can be extended easily to deal with linear hypotheses which involve γ as
well. For example, to test an hypothesis of the form
H
0

0
, γ
0
) : β = β
0
and γ = γ
0
, (6.7)
we can consider the transformed model
y −Y β
0
−X
1
γ
0
= X
1
θ
1
+X
2
θ
2
+ε . (6.8)
Since, under H
0

0
, γ
0
),
y −Y β
0
−X
1
γ
0
= ε , (6.9)
we can test H
0

0
, γ
0
) by testing H

0

0
, γ
0
) : θ
1
= 0 and θ
2
= 0 in the auxiliary regression (6.8);
see Maddala (1974). Tests for more general restrictions of the form
H
0

0
, ν
0
) : β = β
0
and Rγ = ν
0
, (6.10)
where R is a r ×K fixed full-rank matrix, are discussed in Dufour and Jasiak (2001).
The AR procedure thus enjoys several remarkable features. Namely, it is: (1) pivotal in finite
samples; (2) robust to weak instruments; (3) robust to excluded instruments; (4) robust to the spec-
ification of the model for Y (which can be nonlinear with an unknown form); further, (5) the AR
method provides asymptotically “valid” tests and confidence sets under quite weak distributional
assumptions (basically, the assumptions that cover the usual asymptotic properties of linear regres-
sion); and (6) it can be extended easily to test restrictions and build confidence sets which also
involve the coefficients of the exogenous variables, such as H
0

0
, ν
0
) in (6.10).
But the method also has its drawbacks. The main ones are: (1) the tests and confidence sets
obtained in this way apply only to the full vector β [or (β

, γ

)

]; what can we do, if β has more than
one element? (2) power may be low if too many instruments are added (X
2
has too many variables)
to perform the test, especially if the instruments are irrelevant; (3) error normality assumption is
restrictive and we may wish to consider other distributional assumptions; (4) the structural equations
are assumed to be linear. We will now discuss a number of methods which have been proposed in
order to circumvent these drawbacks.
13
For further discussion of this point, see Kleibergen (2002b).
20
6.2. Projections and inference on parameter subsets
Suppose now that β [or (β

, γ

)

] has more than one component. The fact that a procedure with a
finite-sample theory has been obtained for “joint hypotheses” of the form H
0

0
) [or H
0

0
, γ
0
)]
is not due to chance: since the distribution of the data is determined by the full parameter vector,
there is no reason in general why one should be able to decide on the value of a component of
β independently of the others. Such a separation is feasible only in special situations, e.g. in the
classical linear model (without exact multicollinearity). Lack of identification is precisely a situation
where the value of a parameter may be determined only after various restrictions (e.g., the values
of other parameters) have been imposed. So parametric nonseparability arises here, and inference
should start from a simultaneous approach. If the data generating process corresponds to a model
where parameters are well identified, precise inferences on individual coefficients may be feasible.
This raises the question how one can move from a joint inference on β to its components.
A general approach to this problem consists in using a projection technique. If
P[β ∈ C
β
(α)] ≥ 1 −α, (6.11)
then, for any function g(β),
P
_
g(β) ∈ g [C
β
(α)]
¸
≥ 1 −α. (6.12)
If g(β) is a component of β or (more generally) a linear transformation g(β) = w

β, the confidence
set for a linear combination of the parameters, say w

β takes the usual form [w

˜
β−ˆ σz
α
, w

˜
β+ˆ σz
α
]
with
˜
β a k-class type estimator of β; see Dufour and Taamouti (2000).
14
Another interesting feature comes from the fact that the confidence sets obtained in this way are
simultaneous in the sense of Scheffé. More precisely, if {g
a
(β) : a ∈ A} is a set of functions of β,
then
P
_
g
a
(β) ∈ g [C
β
(α)] for all a ∈ A
¸
≥ 1 −α. (6.13)
If these confidence intervals are used to test different hypotheses, an unlimited number of hypotheses
can be tested without losing control of the overall level.
6.3. Alternatives to the AR procedure
In view of improving the power of AR procedures, a number of alternative methods have been
recently suggested. We will now discuss several of them.
a. Generalized auxiliary regression A general approach to the problem of testing H
0

0
) con-
sists in replacing X
2
in the auxiliary regression
y −Y β
0
= X
1
θ
1
+X
2
θ
2
+ε (6.14)
14
g [C
β
(α)] takes the form of a bounded confidence interval as soon as the confidence set g [C
β
(α)] is unbounded.
For further discussion of projection methods, the reader may consult Dufour (1990, 1997), Campbell and Dufour (1997),
Abdelkhalek and Dufour (1998), Dufour, Hallin, and Mizera (1998), Dufour and Kiviet (1998), and Dufour and Jasiak
(2001).
21
by an alternative set of auxiliary instruments, say Z of dimension T ×
¯
k
2
. In other words, we
consider the generalized auxiliary regression
y −Y β
0
= X
1
θ
1
+Z
¯
θ
2
+ε (6.15)
where
¯
θ
2
= 0 under H
0

0
). So we can test H
0

0
) by testing
¯
θ
2
= 0 in (6.15). Then the problem
consists in selecting Z so that the level can be controlled and power may be improved with respect
to the AR auxiliary regression (6.14). For example, it is easy to see that the power of the AR test
could become low if a large set of auxiliary instruments is used, especially if the latter are weak.
So several alternative procedures can be generated by reducing the number of auxiliary instruments
(the number of columns in Z).
At the outset, we should note that, if (5.8) were the correct model and Π = [Π
1
, Π
2
] were
known, then an optimal choice from the viewpoint of power consists in choosing Z = X
2
Π
2
;
see Dufour and Taamouti (2001b). The practical problem, of course, is that Π
2
is unknown. This
suggests that we replace X
2
Π
2
by an estimate, such as
Z = X
2
˜
Π
2
(6.16)
where
˜
Π
2
is an estimate of the reduced-form coefficient Π
2
in (5.2). The problem then consists in
choosing
˜
Π. For that purpose, it is tempting to use the least squares estimator
ˆ
Π = (X

X)
−1
X

Y.
However,
ˆ
Π and ε are not independent and we continue to face a simultaneity problem with messy
distributional consequences. Ideally, we would like to select an estimate
˜
Π
2
which is independent
of ε.
b. Split-sample optimal auxiliary instruments If we can assume that the error vectors
(u
t
, V

t
)

, t = 1, . . . , T, are independent, this approach to estimating Π may be feasible by using
a split-sample technique: a fraction of the sample is used to obtain
˜
Π and the rest to estimate the
auxiliary regression (6.15) with Z = X
2
˜
Π
2
. Under such circumstances, by conditioning on
˜
Π, we
can easily see that the standard F test for
¯
θ
2
= 0 is valid. Further, this procedure is robust to weak
instruments, excluded instruments as well as the specification of the model for Y [i.e., under the
general assumptions (5.6) or (5.7)], as long as the independence between
˜
Π and ε can be main-
tained. Of course, using a split-sample may involve a loss of the effective number of observations
and there will be a trade-off between the efficiency gain from using a smaller number of auxiliary
instruments and the observations that are “sacrificed” to get
˜
Π. Better results tend to be obtained by
using a relatively small fraction of the sample to obtain
˜
Π — 10% for example — and the rest for
the main equation. For further details on this procedure, the reader may consult Dufour and Jasiak
(2001) and Kleibergen (2002a).
15
A number of alternative procedures can be cast in the framework of equation (6.15).
c. LM-type GMM-based statistic If we take Z = Z
WZ
with
Z
WZ
= P[M(X
1
)X
2
]Y = P[M(X
1
)X
2
]M(X
1
)Y = [M(X
1
)X
2
]
ˆ
Π
2
, (6.17)
15
Split-sample techniques often lead to important distributional simplifications; for further discussion of this type of
method, see Angrist and Krueger (1995) and Dufour and Torrès (1998, 2000).
22
ˆ
Π
2
= [X

2
M(X
1
)X
2
]
−1
X

2
M(X
1
)Y , (6.18)
the F-statistic [say, F
GMM

0
)] for
¯
θ
2
= 0 is a monotonic transformation of the LM-type statistic
LM
GMM

0
) proposed by Wang and Zivot (1998). Namely,
F
GMM

0
) =
_
T −k
1
−G
GT
_
LM
GMM

0
)
1 −(1/T)LM
GMM

0
)
(6.19)
where ν
1
= T −k
1
−G and
LM
GMM

0
) =
(y −Y β
0
)

P[Z
WZ
](y −Y β
0
)
(y −Y β
0
)

M(X
1
)(y −Y β
0
)/T
. (6.20)
Note that
ˆ
Π
2
above is the ordinary least squares (OLS) estimator of Π
2
from the multivariate re-
gression (5.2), so that F
GMM

0
) can be obtained by computing the F-statistic for θ

2
= 0 in the
regression
y −Y β
0
= X
1
θ

1
+ (X
2
ˆ
Π
2


2
+u. (6.21)
When k
2
≥ G, the statistic F
GMM

0
) can also be obtained by testing θ
∗∗
2
= 0 in the auxiliary
regression
y −Y β
0
= X
1
θ
∗∗
1
+
ˆ
Y θ
∗∗
2
+u (6.22)
where
ˆ
Y = X
ˆ
Π. It is also interesting to note that the OLS estimates of θ
∗∗
1
and θ
∗∗
2
, obtained by
fitting the latter equation, are identical to the 2SLS estimates of θ
∗∗
1
and θ
∗∗
2
in the equation
y −Y β
0
= X
1
θ
∗∗
1
+Y θ
∗∗
2
+u. (6.23)
The LM
GMM
test may thus be interpreted as an approximation to the optimal test based on re-
placing the optimal auxiliary instrument X
2
Π
2
by X
2
ˆ
Π
2
. The statistic LM
GMM

0
) is also nu-
merically identical to the corresponding LR-type and Wald-type tests, based on the same GMM
estimator (in this case, the 2SLS estimator of β).
As mentioned above, the distribution of this statistic will be affected by the fact that X
2
ˆ
Π
2
and
u are not independent. In particular, it is influenced by the presence of weak instruments. But
Wang and Zivot (1998) showed that the distribution of LM
GMM

0
) is bounded by the χ
2
(k
2
)
asymptotically. When k
2
= G (usually deemed the “just-identified” case, although the model may
be under-identified in that case), we see easily [from (6.21)] that F
GMM

0
) is (almost surely)
identical with the AR statistic, i.e.
F
GMM

0
) = AR(β
0
) if k
2
= G, (6.24)
so that F
GMM

0
) follows an exact F(G, T −k) distribution, while for k
2
> G,
GF
GMM

0
) ≤
_
T −k
1
−G
T −k
1
−k
2
_
k
2
AR(β
0
) , (6.25)
so that the distribution of LM
GMM

0
) can be bounded in finite samples by the distribution of a
23
monotonic transformation of a F(k
2
, T −k) variable [which, for T large, is very close to the χ
2
(k
2
)
distribution]. But, for T reasonably large, AR(β
0
) will always reject when F
GMM

0
) rejects (at a
given level), so the power of the AR test is uniformly superior to that of the LM
GMM
bound test.
16
d. Kleibergen’s K test If we take Z = Z
K
with
Z
K
= P(X)
_
Y −(y −Y β
0
)
s
uV

0
)
s
uu

0
)
_
= X
˜
Π(β
0
) ≡
˜
Y (β
0
) , (6.26)
˜
Π(β
0
) =
ˆ
Π − ˆ π(β
0
)
s
εV

0
)
s
εε

0
)
,
ˆ
Π = (X

X)
−1
X

Y , (6.27)
ˆ π(β
0
) = (X

X)
−1
X

(y −Y β
0
) , s
uV

0
) =
1
T −k
(y −Y β
0
)

M(X)Y , (6.28)
s
uu

0
) =
(y −Y β
0
)

M(X)(y −Y β
0
)
T −k
, (6.29)
we obtain a statistic, which reduces to the one proposed by Kleibergen (2002a) for k
1
= 0. More
precisely, with k
1
= 0, the F-statistic F
K

0
) for
¯
θ
2
= 0 is equal to Kleibergen’s statistic K(β
0
)
divided by G :
F
K

0
) = K(β
0
)/G. (6.30)
This procedure tries to correct the simultaneity problem associated with the use of
ˆ
Y in
the LM
GMM
statistic by “purging” it from its correlation with u [by subtracting the term
ˆ π(β
0
)s
εV

0
)/s
εε

0
) in Z
K
] . In other words, F
K

0
) and K(β
0
) ≡ GF
K

0
) can be obtained
by testing
¯
θ
2
= 0 in the regression
y −Y β
0
= X
1
θ
1
+
˜
Y (β
0
)
¯
θ
2
+u (6.31)
where the fitted values
ˆ
Y , which appear in the auxiliary regression (6.22) for the LM
GMM
test, have
been replaced by
˜
Y (β
0
) =
ˆ
Y −Xˆ π(β
0
)s
εV

0
)/s
εε

0
), which are closer to being orthogonal with
u.
If k
2
= G, we have F
K

0
) = AR(β
0
) ∼ F(G, T − k), while in the other cases (k
2
≥ G),
we can see easily that the bound for F
GMM

0
) in (6.25) also applies to F
K

0
) :
GF
K

0
) ≤
_
T −k
1
−G
T −k
1
−k
2
_
k
2
AR(β
0
) , (6.32)
Kleibergen (2002a) did not supply a finite-sample distributional theory but showed (assuming
k
1
= 0) that K(β
0
) follows a χ
2
(G) distribution asymptotically under H
0

0
), irrespective of
the presence of weak instruments. This entails that the K(β
0
) test will have power higher than
the one of LM
GMM
test [based on the χ
2
(k
2
) bound], at least in the neighborhood of the null
hypothesis, although not necessarily far away from the null hypothesis.
It is also interesting to note that the inequality (6.32) indicates that the distribution of K(β
0
) ≡
16
The χ
2
(k
2
) bound also follows in a straightforward way from (6.25). Note that Wang and Zivot (1998) do not provide
the auxiliary regression interpretation (6.21) - (6.22) of their statistics. For details, see Dufour and Taamouti (2001b).
24
GF
K

0
) can be bounded in finite samples by a [k
2
(T −k
1
−G)/(T −k)]F(k
2
, T −k) distribution.
However, because of the stochastic dominance of AR(β
0
), there would be no advantage in using
the bound to get critical values for K(β
0
), for the AR test would then have better power.
In view of the fact that the above procedure is based on estimating the mean of XΠ (using
X
ˆ
Π) and the covariances between the errors in the reduced form for Y and u [using s
εV

0
)], it
can become quite unreliable in the presence of excluded instruments.
e. Likelihood ratio test The likelihood ratio (LR) statistic for β = β
0
was also studied by Wang
and Zivot (1998). The LR test statistic in this case takes the form:
LR
LIML
= T
_
ln
_
κ(β
0
)
_
−ln
_
κ(
ˆ
β
LIML
)

(6.33)
where
ˆ
β
LIML
is the limited information maximum likelihood estimator (LIML) of β and
κ(β) =
(y −Y β)

M(X
1
)(y −Y β)
(y −Y β)

M(X)(y −Y β)
. (6.34)
Like LM
GMM
, the distribution of LR
LIML
depends on unknown nuisance parameters under
H
0

0
), but its asymptotic distribution is χ
2
(k
2
) when k
2
= G and bounded by the χ
2
(k
2
) dis-
tribution in the other cases [a result in accordance with the general LR distributional bound given in
Dufour (1997)]. This bound can also be easily derived from the following inequality:
LR
LIML

_
T
T −k
_
k
2
AR(β
0
) , (6.35)
so that the distribution of LR
LIML
is bounded in finite samples by the distribution of a [Tk
2
/(T −
k)]F(k
2
, T − k) variable; for details, see Dufour and Khalaf (2000). For T reasonably large, this
entails that the AR(β
0
) test will have power higher than the one of LR
LIML
test [based on the
χ
2
(k
2
) bound], at least in the neighborhood of the null hypothesis. So the power of the AR test is
uniformly superior to the one of the LR
LIML
bound test. Because the LR test depends heavily on
the specification of the model for Y , it is not robust to excluded instruments.
f. Conditional tests A promising approach was recently proposed by Moreira (2003a). His sug-
gestion consists in conditioning upon an appropriately selected portion of the sufficient statistics for
a gaussian SEM. On assuming that the covariance matrix of the errors is known, the corresponding
conditional distribution of various test statistics for H
0

0
) does not involve nuisance parameters.
The conditional distribution is typically not standard but may be established by simulation. Such
an approach may lead to power gains. On the other hand, the assumption that error covariances
are known is rather implausible, and the extension of the method to the case where the error co-
variance matrix is unknown is obtained at the expense of using a large-sample approximation. Like
Kleibergen’s procedure, this method yields an asymptotically similar test. For further discussion,
see Moreira and Poi (2001) and Moreira (2003b).
g. Instrument selection procedures Systematic search methods for identifying relevant instru-
ments and excluding unimportant instruments have been discussed by several authors; see Hall,
25
Rudebusch, and Wilcox (1996), Hall and Peixe (2000), Dufour and Taamouti (2001a), and Donald
and Newey (2001). In this setup, the power of AR-type tests depends on a function of model param-
eters called the concentration coefficient. One way to approach instrument selection is to maximize
the concentration coefficient towards maximizing test power. Robustness to instrument exclusion
is very handy in this context. For further discussion, the reader may consult Dufour and Taamouti
(2001a).
To summarize, in special situations, alternatives to the AR procedure may allow some power
gains with respect to the AR test with an unreduced set of instruments. They themselves may have
some important drawbacks. In particular, (1) only an asymptotic distributional theory is supplied,
(2) the statistics used are not pivotal in finite samples, although Kleibergen’s and Moreira’s statistics
are asymptotically pivotal, (3) they are not robust to instrument exclusion or to the formulation of
the model for the explanatory endogenous variables. It is also of interest to note that finite-sample
versions of several of these asymptotic tests may be obtained by using split-sample methods.
All the problems and techniques discussed above relate to sampling-based statistical methods.
SEM can also be analyzed through a Bayesian approach, which can alleviate the indeterminacies
associated with identification via the introduction of a prior distribution on the parameter space.
Bayesian inferences always depend on the choice of prior distribution (a property viewed as undesir-
able in the sampling approach), but this dependence becomes especially strong when identification
problems are present [see Gleser and Hwang (1987)]. This paper only aims at discussing prob-
lems and solutions which arise within the sampling framework, and it is beyond its scope to debate
the advantages and disadvantages of Bayesian methods under weak identification. For additional
discussion on this issue, see Kleibergen and Zivot (2003) and Sims (2001).
7. Extensions
We will discuss succinctly some extensions of the above results to multivariate setups (where several
structural equations may be involved), models with non-Gaussian errors, and nonlinear models.
7.1. Multivariate regression, simulation-based inference and nonnormal errors
Another approach to inference on a linear structural equation model is based on observing that the
structural model (5.1) - (5.4) can be put in the form of a multivariate linear regression (MLR):
¯
Y = XB +U (7.1)
where
¯
Y = [y, Y ], B = [π, Π], U = [u, V ] = [
˜
U
1
, . . . ,
˜
U
T
]

, π = [π

1
, π

2
]

, Π = [Π

1
, Π

2
]

,
π
1
= Π
1
β+γ and π
2
= Π
2
β.
17
This model is linear except for the nonlinear restriction π
2
= Π
2
β.
Let us now make the assumption that the errors in the different equations for each observation,
˜
U
t
,
satisfy the property:
˜
U
t
= JW
t
, t = 1, . . . , T , (7.2)
17
Most of this section is based on Dufour and Khalaf (2000, 2001, 2002).
26
where the vector w = vec(W
1
, . . . , W
n
) has a known distribution and J is an unknown nonsin-
gular matrix (which enters into the covariance matrix Σ of the error vectors
˜
U
t
). This distributional
assumption is, in a way, more restrictive than the one made in section 5.1 — because of the assump-
tion on V — and in another way, less restrictive, because the distribution of u is not taken to be
necessarily N
_
0, σ
2
u
I
T
¸
.
Consider now an hypothesis of the form
H
0
: RBC = D (7.3)
where R, C and D are fixed matrices. This is called a uniform linear (UL) hypothesis; for example,
the hypothesis β = β
0
tested by the AR test can be written in this form [see Dufour and Khalaf
(2000)]. The corresponding gaussian LR statistic is
LR(H
0
) = T ln(|
ˆ
Σ
0
|/|
ˆ
Σ|) (7.4)
where
ˆ
Σ =
ˆ
U

ˆ
U/T and
ˆ
Σ
0
=
ˆ
U

0
ˆ
U
0
/T are respectively the unrestricted and restricted estimates of
the error covariance matrix. The AR test can also be obtained as a monotonic transformation of a
statistic of the form LR(H
0
). An important feature of LR(H
0
) in this case is that its distribution
under H
0
does not involve nuisance parameters and may be easily simulated (it is a pivot); see
Dufour and Khalaf (2002). In particular, its distribution is completely invariant to the unknown
J matrix (or the error covariance matrix). In such a case, even though this distribution may be
complicated, we can use Monte Carlo test techniques — a form of parametric bootstrap — to obtain
exact test procedures.
18
Multivariate extensions of AR tests, which impose restrictions on several
structural equations, can be obtained in this way. Further, this approach allows one to consider any
(possibly non-gaussian) distribution on w.
More generally, it is of interest to note that the LR statistic for about any hypothesis on B can
be bounded by a LR statistic for an appropriately selected UL hypothesis: setting b = vec(B) and
H
0
: Rb ∈ ∆
0
(7.5)
where R an arbitrary q × k(G + 1) matrix and ∆
0
is an arbitrary subset of R
q
, the distribution of
the corresponding LR statistic can be bounded by the LR statistic for a UL hypothesis (which is
pivotal). This covers as special cases all restrictions on the coefficients of SEM (as long as they are
written in the MLR form). To avoid the use of such bounds (which may be quite conservative), it is
also possible to use maximized Monte Carlo tests [Dufour (2002)].
All the above procedures are valid for parametric models that specify the error distribution up to
an unknown linear transformation (the J matrix) which allows an unknown covariance matrix. It is
easy to see that these (including the exact procedures discussed in section 6) yield “asymptotically
valid” procedures under much weaker assumptions than those used to obtain finite-sample results.
However, in view of the discussion in section 4, the pitfalls and limitations of such arguments should
be remembered: there is no substitute for a provably exact procedure.
If we aim at getting tests and confidence sets for nonparametric versions of the SEM (where the
18
For further discussion of Monte Carlo test methods, see Dufour and Khalaf (2001) and Dufour (2002).
27
error distribution involves an infinite set of nuisance parameters), this may be achievable by looking
at distribution-free procedures based on permutations, ranks or signs. There is very little work on
this topic in the SEM. For an interesting first look, however, the reader should look at an interesting
recent paper by Bekker (2002).
7.2. Nonlinear models
It is relatively difficult to characterize identification and study its consequences in nonlinear struc-
tural models. But problems similar to those noted for linear SEM do arise. Nonlinear structural
models typically take the form:
f
t
(y
t
, x
t
, θ) = u
t
, E
θ
[u
t
| Z
t
] = 0 , t, . . . , T, (7.6)
where f
t
(·) is a vector of possibly nonlinear relationships, y
t
is a vector endogenous variables, x
t
is
a vector of exogenous variables, θ is vector of unknown parameters, Z
t
is a vector of conditioning
variables (or instruments) — usually with a number of additional distributional assumptions — and
E
θ
[ · ] refers to the expected value under a distribution with parameter value θ. In such models, θ
can be viewed as identifiable if there is only one value of θ [say, θ =
¯
θ] that satisfies (7.6), and we
have weak identification (or weak instruments) when the expected values E¯
θ
[f
t
(y
t
, x
t
, θ) | Z
t
] = 0 ,
t, . . . , T, are “weakly sensitive” to the value of θ.
Research on weak identification in nonlinear models remains scarce. Nonlinearity makes it dif-
ficult to construct finite-sample procedures even in models where identification difficulties do not
occur. So it is not surprising that work in this area has been mostly based on large-sample approx-
imations. Stock and Wright (2000) studied the asymptotic distributions of GMM-based estimators
and test statistics under conditions of weak identification (and weak “high level” asymptotic distri-
butional assumptions). While GMM estimators of θ have nonstandard asymptotic distributions, the
objective function minimized by the GMM procedure follows an asymptotic distribution which is
unaffected by the presence of weak instruments: it is asymptotically pivotal. So tests and confidence
sets based on the objective function can be asymptotically valid irrespective of the presence of weak
instruments. These results are achieved for the full parameter vector θ, i.e. for hypotheses of the
form θ = θ
0
and the corresponding joint confidence sets. This is not surprising: parametric non-
separability arises here for two reasons, model nonlinearity and the possibility of non-identification.
Of course, once a joint confidence set for θ has been built, inference on individual parameters can
be drawn via projection methods. Other contributions in this area include papers by Kleibergen
(2001a, 2003), who proposed an extension of the K(β
0
) test, and Wright (2003, 2002) proposed
tests of underidentification and identification.
In view the discussion in section 4, the fact that all these methods are based on large-sample ap-
proximations without a finite-sample theory remains a concern. However, a first attempt at deriving
finite-sample procedures is available in Dufour and Taamouti (2001b). Under parametric assump-
tions on the errors, the hypothesis θ = θ
0
is tested by testing γ = 0 in an auxiliary regression of the
form:
f
t
(y
t
, x
t
, θ
0
) = z
t

0
, θ
1
)γ +ε
t
, t, . . . , T, (7.7)
28
where the z
t

0
, θ
1
) are instruments in a way that maximizes power against a reference alternative
(point-optimal instruments). One gets in this way point-optimal tests [see King (1988) and Dufour
and King (1991)]. Inference on nonlinear regressions are also covered by this setup. As in the case
of linear SEM, sample-split techniques may be exploited to approximate optimal instruments, and
projection methods can be used to draw inference on subvectors of θ.
8. Conclusion
By way of conclusion, we will summarize the main points made in this paper.
1. There are basic pitfalls and limitations faced in developing inference procedures in economet-
rics. If we are not careful, we can easily be led into ill-defined problems and find ourselves:
(a) trying to test a non-testable hypothesis, such as an hypothesis on a moment in the context
of an insufficiently restrictive nonparametric model, or an hypothesis (e.g., a unit root
hypothesis) on a dynamic model while allowing a dynamic structure with an unlimited
(not necessarily infinite) number of parameters;
(b) trying to solve an inference problem using a technique that cannot deliver a solution
because of the very structure of the technique, as in (i) testing an hypothesis on a mean
(or median) under heteroskedasticity of unknown form, via standard least-square-based
“heteroskedasticity-robust” standard errors, or (ii) building a confidence interval for a
parameter which is not identifiable in a structural model, via the usual technique based
on standard errors. In particular, this type of difficulty arises for Wald-type statistics in
the presence of weak instruments (or weakly identified models)
2. In many econometric problems (such as, inference on structural models), several of the intu-
itions derived from the linear regression model and standard asymptotic theory can easily be
misleading.
(a) Standard errors do not constitute a valid way of assessing parameter uncertainty and
building confidence intervals.
(b) In many models, such as structural models where parameters may be underidentified,
individual parameters in statistical models are not generally meaningful, but parameter
vectors can be (at least in parametric models). We called this phenomenon parametric
nonseparability. As a result, restrictions on individual coefficients may not be testable,
while restrictions on the whole parameter vector are. This feature should play a central
role in designing methods for dealing with weakly identified models.
3. The above difficulties underscore the pitfalls of large-sample approximations, which are typ-
ically based on pointwise (rather than uniform) convergence results and may be arbitrarily
inaccurate in finite samples.
29
4. Concerning solutions to such problems, and more specifically in the context of weakly iden-
tified models, we have emphasized the following points.
(a) In accordance with basic statistical theory, one should always look for pivots as the
fundamental ingredient for building tests and confidence sets.
(b) Pivots are not generally available for individual parameters, but they can be obtained in
a much wider set of cases for appropriately selected vectors of parameters.
(c) Given a pivot for a parameter vector, we can construct valid tests and confidence sets
for the parameter vector.
(d) Inference on individual coefficients may then be derived through projection methods.
5. In the specific example of SEM, the following general remarks are in our view important.
(a) Besides being pivotal, the AR statistic enjoys several remarkable robustness properties,
such as robustness to the presence of weak instruments, to excluded instruments or to
the specification of a model for the endogenous explanatory variables.
(b) It is possible to improve the power of AR-type procedures (especially by reducing the
number of instruments), but power improvements may come at the expense of using a
possibly unreliable large-sample approximation or losing robustness (such as robustness
to excluded instruments). As usual, there is a trade-off between power (which is typi-
cally increased by considering more restrictive models) and robustness (which involves
considering a wider hypothesis).
(c) Trying to adapt and improve AR-type procedures (without ever forgetting basic statisti-
cal principles) constitutes the most promising avenue for dealing with weak instruments.
30
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39

ABSTRACT

We discuss statistical inference problems associated with identification and testability in econometrics, and we emphasize the common nature of the two issues. After reviewing the relevant statistical notions, we consider in turn inference in nonparametric models and recent developments on weakly identified models (or weak instruments). We point out that many hypotheses, for which test procedures are commonly proposed, are not testable at all, while some frequently used econometric methods are fundamentally inappropriate for the models considered. Such situations lead to ill-defined statistical problems and are often associated with a misguided use of asymptotic distributional results. Concerning nonparametric hypotheses, we discuss three basic problems for which such difficulties occur: (1) testing a mean (or a moment) under (too) weak distributional assumptions; (2) inference under heteroskedasticity of unknown form; (3) inference in dynamic models with an unlimited number of parameters. Concerning weakly identified models, we stress that valid inference should be based on proper pivotal functions — a condition not satisfied by standard Waldtype methods based on standard errors — and we discuss recent developments in this field, mainly from the viewpoint of building valid tests and confidence sets. The techniques discussed include alternative proposed statistics, bounds, projection, split-sampling, conditioning, Monte Carlo tests. The possibility of deriving a finite-sample distributional theory, robustness to the presence of weak instruments, and robustness to the specification of a model for endogenous explanatory variables are stressed as important criteria assessing alternative procedures. Key-words : hypothesis testing; confidence set; confidence interval; identification; testability; asymptotic theory; exact inference; pivotal function; nonparametric model; Bahadur-Savage; heteroskedasticity; serial dependence; unit root; simultaneous equations; structural model; instrumental variable; weak instrument; weak identification; simultaneous inference; projection; split-sample; conditional test; Monte Carlo test; bootstrap. JEL classification numbers: C1, C12, C14, C15, C3, C5.

i

RÉSUMÉ

Nous analysons les problèmes d’inférence associés à l’identification et à la testabilité en économétrie, en soulignant la similarité entre les deux questions. Après une courte revue des notions statistiques requises, nous étudions tour à tour l’inférence dans les modèles non-paramétriques ainsi que les résultats récents sur les modèles structurels faiblement identifiés (ou les instruments faibles). Nous remarquons que beaucoup d’hypothèses, pour lesquelles des tests sont régulièrement proposés, ne sont pas en fait testables, tandis que plusieurs méthodes économétriques fréquemment utilisées sont fondamentalement inappropriées pour les modèles considérés. De telles situations conduisent à des problèmes statistiques mal posés et sont souvent associées à un emploi mal avisé de résultats distributionnels asymptotiques. Concernant les hypothèses non-paramétriques, nous analysons trois problèmes de base pour lesquels de telles difficultés apparaissent: (1) tester une hypothèse sur un moment avec des restrictions trop faibles sur la forme de la distribution; (2) l’inférence avec hétéroscédasticité de forme non spécifiée; (3) l’inférence dans les modèles dynamiques avec un nombre illimité de paramètres. Concernant les modèles faiblement identifiés, nous insistons sur l’importance d’utiliser des fonctions pivotales — une condition qui n’est pas satisfaite par les méthodes usuelles de type Wald basées sur l’emploi d’écart-types — et nous passons en revue les développements récents dans ce domaine, en mettant l’accent sur la construction de test et régions de confiance valides. Les techniques considérées comprennent les différentes statistiques proposées, l’emploi de bornes, la subdivision d’échantillon, les techniques de projection, le conditionnement et les tests de Monte Carlo. Parmi les critères utilisés pour évaluer les procédures, nous insistons sur la possibilité de fournir une théorie distributionnelle à distance finie, sur la robustesse par rapport à la présence d’instruments faibles ainsi que sur la robustesse par rapport la spécification d’un modèle pour les variables explicatives endogènes du modèle. Mots clés : test d’hypothèse; région de confiance; intervalle de confiance; identification; testabilité; théorie asymptotique; inférence exacte; fonction pivotale; modèle non-paramétrique; BahadurSavage; hétéroscédasticité; dépendance sérielle; racine unitaire; équations simultanées; modèle structurel; variable instrumentale; instrument faible; inférence simultanée; projection; subdivision d’échantillon; test conditionnel; test de Monte Carlo; bootstrap. Classification JEL: : C1, C12, C14, C15, C3, C5.

ii

Contents
List of Propositions and Theorems 1. 2. 3. Introduction Models Statistical notions 3.1. Hypotheses . . . . . . . . . . . . 3.2. Test level and size . . . . . . . . . 3.3. Confidence sets and pivots . . . . 3.4. Testability and identification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii 1 4 5 5 7 8 9 9 9 12 13 14 15 16 17 18 18 21 21 26 26 28 29

4.

Testability, nonparametric models and asymptotic methods 4.1. Procedures robust to nonnormality . . . . . . . . . . . . . . . . . . . . . . . . 4.2. Procedures robust to heteroskedasticity of unknown form . . . . . . . . . . . . . 4.3. Procedures robust to autocorrelation of arbitrary form . . . . . . . . . . . . . . Structural models and weak instruments 5.1. Standard simultaneous equations model . . . . . . . . . . . . . . . . . . . . . . 5.2. Statistical problems associated with weak instruments . . . . . . . . . . . . . . 5.3. Characterization of valid tests and confidence sets . . . . . . . . . . . . . . . . Approaches to weak instrument problems 6.1. Anderson-Rubin statistic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2. Projections and inference on parameter subsets . . . . . . . . . . . . . . . . . . 6.3. Alternatives to the AR procedure . . . . . . . . . . . . . . . . . . . . . . . . . Extensions 7.1. Multivariate regression, simulation-based inference and nonnormal errors . . . . 7.2. Nonlinear models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion

5.

6.

7.

8.

List of Propositions and Theorems
4.1 4.2 4.4 Theorem : Mean non-testability in nonparametric models . . . . . . . . . . . . . . Theorem : Characterization of heteroskedasticity robust tests . . . . . . . . . . . . . Theorem : Unit root non-testability in nonparametric models . . . . . . . . . . . . . 10 12 13

iii

and more specifically on weak instruments in the context of structural models [e. So it is not surprising that SEM were introduced and most often employed in the analysis of economic data. such as unit roots and unidentified (or weakly identified) models. GARCH-types processes. the literature on nonparametric testability sheds light on various econometric problems and their solutions.1. An important component of this work is the development of procedures for testing hypotheses (or models).1 In particular. a view widely held by both scientists and philosophers is that testability or the formulation of testable hypotheses constitutes a central feature of scientific activity — a view we share. at least. this paper also considers questions associated with the development of reliable inference procedures in econometrics. Introduction The main objective of econometrics is to supply methods for analyzing economic data. Further. results (from mathematical statistics and econometrics) on testability in nonparametric models.g. We will find it useful to bring together two separate streams of literature: namely. Last year. 1 . (2) new models: multivariate time series models. asymptotic distributions based on “weak regularity conditions”. Markov chain Monte Carlo techniques. (5) methods based on weak distributional assumptions: nonparametric methods.. as a way of getting more reliable tests and confidence sets. such as: (1) new fields of applications linked to the availability of new data. raising among various issues the possibility of observational equivalence between alternative parameter values (non-identification) and the use of instrumental variables (IV). Specifically. (4) methods based on simulation: bootstrap. and assessing alternative theories. it is not clear a discipline should be viewed as scientific if it does not lead to empirically testable hypotheses. on the same occasion. the only coherent — or. qualitative variables. more specialized. the only well developed — set of methods are those supplied by statistical and econometric theory. micro-data. we mean a set of possible data distributions such that a distribution [e. Further. the finite-sample 1 By a nonparametric model (or hypothesis). both in microeconomics and macroeconomics.g.. (6) discovery of various nonregular problems which require nonstandard distributional theories. and the recent econometric research on weak instruments. To date. But our exposition will be. specifically bootstrapping. Indeed. in a way. we shall focus on general statistical issues raised by identification in econometric models. panels. Over the last 25 years. building models. indirect inference. But this requirement leaves open the question of formulating operational procedures for testing models and theories. MacKinnon (2002) discussed the use of simulation-based inference methods in econometrics. (3) a greater ability to estimate nonlinear models which require an important computational capacity. the “true” distribution] cannot be singled out by fixing a finite number of parameter values. In view of the importance of the issue. financial data. The problems involved are difficult. Simultaneous equations models (SEM) are related in a natural way to the concept of equilibrium postulated by economic theory. econometric research has led to important developments in many areas. and in another way. more general — and critical. simultaneous equations models (SEM)]. we shall emphasize that identification problems arise in both literatures and have similar consequences for econometric methodology. With the exception of mathematics. Methods for estimating and testing such models constitute a hallmark of econometric theory and represent one of its most remarkable achievements.

Specifically. because it underscores the pitfalls in using large-sample approximations. second. the topic of SEM was dormant until a few years ago. • identification involves the possibility of distinguishing different parameter values on the basis of the corresponding data distributions. no reasonable test can be produced. while • testability refers to the possibility of designing procedures that can discriminate between subsets of parameter values. and Baker (1993. In particular. the reader may consult Rothenberg (1971). despite a lot of loose ends (often hidden by asymptotic distributional theory). Merckens.5 In nonparametric models. this is typically interpreted by stating that the postulated distribution of the data — as a function of the parameter vector (the likelihood function) — can be the same for different values of the parameter vector. as well as the importance of going back to basic statistical theory when developing econometric methods. so inference is typically based on large-sample approximations.. This will be discussed in greater detail below. Roughly speaking.. The exogeneity requirement has been well known from the very beginning of IV methods. an instrument should have two basic properties: first. functionals of distribution functions). It returned to center stage with the discovery of so-called weak instruments. 2003). The second one was also known from the theory of identification. A parameter (or a parameter vector) in a model is not identified when it is not possible to distinguish between alternative values of the parameter. 3 2 2 . Choi and Phillips (1992).g. 4 For general expositions of the theory of identification in econometrics and statistics. Early papers which called attention to the problem include: Nelson and Startz (1990a. we mean here a test that both satisfies a level constraint and may have power superior to the level when the tested hypothesis (the null hypothesis) does not hold. 1995). Weak instruments lead to poor performance of standard econometric procedures and cases where they have pernicious effects may be difficult to detect. it should be independent (or. and Bound. but its practical importance was not well appreciated and often hidden from attention by lists of instruments relegated to footnotes (if not simply absent) in research papers. Hsiao (1983). it should be correlated with the included endogenous explanatory variables for which it is supposed to serve as an instrument (relevance). weakly correlated with endogenous explanatory variables). Prakasa Rao (1992).2 IV methods have become a routine part of econometric analysis and.e. Maddala and Jeong (1992). In parametric models. quite generally.3 Interest in the problem also goes far beyond IV regressions and SEM.4 An important consequence of this sort of situation is a statistical impossibility: we cannot design a data-based procedure for distinguishing between equivalent parameter values (unless additional information is introduced). see Phillips (1983) and Taylor (1983). 5 By a reasonable test. uncorrelated) with the disturbance term in the equation of interest (exogeneity). and Wansbeek (1994) and Manski (1995. identification is more difficult to characterize because a likelihood function (involving a finite number of parameters) is not available and parameters are often introduced through more abstract techniques (e. Buse (1992). Jaeger. 1990b). For reviews. at least. which can be interpreted as instruments with little relevance (i.distributional theory of estimators and test statistics is very complex. Bekker. Fisher (1976). But the central problem is the same: can we distinguish between alternative values of the parameter? So. an identification problem can be viewed as a special form of non-testability.

3 . we review the inferential issues linked to the possible presence of weak instruments in structural models. many models and hypotheses are formulated in ways that make them fundamentally nontestable. (b) testing an hypothesis about a mean (or a median) with heteroskedasticity of unknown form.. the following points will be stressed: 1. a problem of non-testability can be viewed as a form of non-identification. while quantiles are. some parameters tend to be non-testable (badly identified) in nonparametric models while others are not. the following points will be emphasized: 1. these phenomena underscore parametric nonseparability problems: statements about a given parameter (often interpreted as the parameter of interest) are not empirically meaningful without supplying information about other parameters (often called nuisance parameters). 3. 2.d. by reducing the number of parameters).g.Alternatively. and conversely identification problems can be eliminated by transforming the parameter space (e.g. medians). in particular. especially in nonparametric setups.g. in accordance with basic statistical theory. this tends to be the case in nonparametric setups. from this viewpoint. such as: (a) testing an hypothesis about a mean when the observations are independent and identically distributed (i. Furthermore. but hypotheses that set both the parameter of interest and some nuisance parameters may well be testable in such circumstances.i. it is well known that one can create a non-identified model by introducing redundant parameters.. variances) while it does not for quantiles (e. inappropriate choices of parameter representations. we will review the associated problems and proposed solutions. moments are not a good way of representing the properties of distributions in nonparametric setups. under nonparametric assumptions. one should always look for pivots as the fundamental ingredient for building tests and confidence sets. These problems are closely related. 5. with an emphasis on finite-sample properties and the development of tests and confidence sets which are robust to the presence of weak instruments. regarding the issue of testability. such difficulties arise in basic apparently well-defined problems. we pursue two main objectives: first. such approximations are arbitrarily bad in finite samples. this principle appears to be especially important when identification problems are present. In this paper. Problems of non-identification are associated with bad parameterizations. second. it is fundamentally misleading because.. More precisely. to the extent that asymptotic distributional theory is viewed as a way of producing statistical methods which are valid under “weak” distributional assumptions. . (or underidentification). so that the development of appropriate inference procedures should start from a joint approach. In particular. in particular. We will see below that the same remark applies quite generally to non-testability problems. 4. we analyze the statistical problems associated with non-identification within the broader context of testability. non-testability easily occurs for moments (e. Concerning weak instruments. means. (c) testing the unit root hypothesis on an autoregressive model whose order can be arbitrarily large.

2. we refer the reader to the excellent survey recently published by Stock. such as: (a) robustness to weak instruments. We conclude in section 8. weak instrument problems underscore in a striking way the limitations of large-sample arguments for deriving and evaluating inference procedures. especially in improving power. In section 4.2. 7. while extensions to nonlinear or nonGaussian models are considered in Section 7. 5. The paper is organized as follows. so that proper pivots may easily involve many more parameters than the parameter of interest. 4. Wright. or asymptotic theory in this context. furthermore. we will not discuss in any detail results on estimation. various extensions and improvements over the AR method are possible. it satisfies all the invariance properties listed above. a fairly complete set of inference procedures that allow one to produce tests and confidence sets for all model parameters can be obtained through projection techniques. and we cannot provide here a complete review. so that it may reasonably be viewed as a fundamental building block for developing reliable inference procedures in the presence of weak instruments. (b) robustness to instrument exclusion. In section 5. In particular. AR) constitutes one of the (very rare) truly pivotal functions proposed for SEM. An hypothesis should have two basic features. parametric nonseparability arises in striking ways when some parameters may not be identified. 3. Models The purpose of econometric analysis is to develop mathematical representations of data. which we call models or hypotheses (models subject to restrictions). we study testability problems in nonparametric models. if not misleading. In the next two sections. we review succinctly some basic notions concerning models (section 2) and statistical theory (section 3). however. we examine a number of possible solutions in the context of linear SEM. (c) robustness to the specification of the model for the endogenous explanatory variables in the equation(s) of interest. very few informative pivotal functions have been proposed in the context of simultaneous equations models. and Yogo (2002). we review the statistical difficulties associated with weak instruments. For that purpose. it is important to note that these often come at the expense of using large-sample approximations or giving up robustness. important additional criteria for evaluating procedures in such contexts include various forms of invariance (or robustness). which are important for our discussion. this also indicates that the common distinction between parameters of interest and nuisance parameters can be quite arbitrary. 8. 4 . 6. the detection of weak instruments. In section 6. The literature on weak instruments is growing rapidly. the early statistic proposed by Anderson and Rubin (1949.

consequently. Xn ) 6 (3. note the information criterion is emphasized by an influential view in philosophy of science which stresses falsifiability as a criterion for the scientific character of a theory [Popper (1968)]. compatibility with observed data is most easily satisfied by vague models which impose few restrictions. . they are logically unfalsifiable: in contrast with deterministic models. be informative.1) For further discussion on the issues discussed in this section. Such models are unverifiable: as with any theory that makes an indefinite number of predictions. Given these facts. The more restrictive a model is. Deterministic models . void of empirical content. It must be compatible with available data. such as Lehmann (1986). Statistical notions In this section. A non-restrictive hypothesis says nothing and. 3. most models used in econometrics are stochastic. Moreover. 5 . the information criterion suggests the use of parsimonious models that usually take the form of parametric models based on strong assumptions. and the more interesting it is. It must restrict the expected behavior of observations. Accordingly. the more informative it is. we would like it to be true. . Hypotheses Consider an observational experiment whose result can be represented by a vector of observations X(n) = (X1 . it is clear any criterion for assessing whether an hypothesis is acceptable must involve a conventional aspect. in contrast. . Models can be classified as being either deterministic or stochastic. the reader may consult Dufour (2000). However.1. 2. 2. which claim to make arbitrarily precise predictions.1. derived from the Neyman-Pearson approach and described in standard textbooks. The general outlook follows modern statistical testing theory. we review succinctly basic statistical notions which are essential for understanding the rest of our discussion.6 3. are highly falsifiable but always inconsistent with observed data. The purpose of hypothesis testing theory is to supply a coherent framework for accepting or rejecting probabilistic hypotheses. . ideally. vague models may take the form of parametric models with a large number of free parameters or nonparametric models which involve an infinite set of free parameters and thus allow for weak assumptions. these two criteria are not always compatible: 1. It is a probabilistic adaptation of the falsification principle. does not teach us anything: it is empirically empty. we can never be sure that the model will not be put in jeopardy by new data. a probabilistic model is usually logically compatible with all possible observation vectors.

Otherwise.4) where F0 is a distribution function with a specific form. we call θ1 the parameter of interest. and let ¯ ¯ F (x) = F (x1 . H0 is unacceptable ⇐⇒ (∀F ∈ H0 ) F is unacceptable .g. A model is parametric if the distribution of the data is specified up to a finite number of (scalar) parameters. . xn ) = P[X1 ≤ x1 . .). etc. and θ2 a nuisance parameter: the parameter of interest is set by H0 but the nuisance parameter remains unknown. kurtosis. if F0 (x | θ) represents a Gaussian distribution with mean µ and variance σ 2 [e. 1 We usually abbreviate this as: H0 : θ1 = θ0 . equivalently.where Xi takes real values. (3. .8) 6 .. Such functions are also called functionals. Then we can say that: H0 is acceptable ⇐⇒ (∃F ∈ H0 ) F is acceptable or. An hypothesis H0 on X (n) is an assertion ¯ H0 : F ∈ H 0 . quartiles. xn ). θ2 ).5) where H0 is a subset of Fn . where x = (x1 . 1 (3.2) be its distribution. or several distributions (composite hypothesis). corresponding to a Gaussian law]. . H0 may be interpreted as follows: there is at least one distribution in H0 that can be viewed as a representation compatible with the observed “behavior” of X (n) . . (3. the set of all possible distributions Fn . Xn ≤ xn ] (3. . θ2 ) and θ1 = θ0 } . H0 often takes the following form: H0 ≡ {F (·) : F (x) = F0 (x | θ1 .).9) (3.6) (3.7) In such a case. we prefer to represent distributions in terms of parameters. (3. . There are two ways of introducing parameters in a model. we have θ = (µ. . . The set H0 may contain: a single distribution (simple hypothesis). The second approach is to define a family of distribution functions which are indexed by a parameter vector θ : F (x) = F0 (x | θ) (3.3) Examples of such parameters include: the moments of a distribution (mean. In particular. etc. The first is to define a function from a space of probability distributions to a vector in some Euclidean space: θ : Fn −→ Rp . . . For example. We denote by Fn the set of possible distribution ¯ functions on Rn [F ∈ Fn ]. its quantiles (median. For various reasons. . σ 2 ). it is nonparametric. variance. if we can write θ = (θ1 .

do not reject H0 if Sn (X1 . . for F ∈ H0 ) define the power function of the test. As the set H0 gets larger. the less restrictive an hypothesis is.7 / Power describes the ability of a test to detect a “false” hypothesis. the power function can be defined as the function: P (F ) = PF [Rejecting H0 ] for F ∈ H1 \ H0 . the more restricted will be the corresponding test procedure. . It usually takes the form: reject H0 if Sn (X1 . In a framework such as the one in (3. . the one with the highest power against a given alternative distribution F ∈ H0 is deemed preferable (at least. the test procedure must satisfy a bigger set of constraints: the larger is the set of distributions compatible with a null hypothesis. equivalently.2.10) (3. we have an ill-defined test problem. we typically like to have a test with the highest possible power against “alternatives of interest”. . Probabilities of rejecting H0 for distributions outside H0 (i. The test has level α iff PF [Rejecting H0 ] ≤ α for all F ∈ H0 or. (3. θ2 ) More formally. c(α. where we distinguish between a parameter of interest θ1 and a nuisance parameter θ2 . In other words. If the latter is specified. in the sense that no procedure which has some power can satisfy the level constraint: H0 is non-testable. It is easy to understand that imposing a large set of restrictions on a test procedure may reduce its power against specific alternatives. Xn ) ≤ c . Alternative tests are typically assessed by comparing their powers: between two tests with the same level.13) H0 is testable if we can find a finite number c that satisfies the level restriction.e. 3. Sometimes. under this / particular alternative). θ2 ) that satisfies the level constraint (3.11).6). But.11) (3. The test has size α if F ∈H0 sup PF [Rejecting H0 ] = α . F ∈H0 (3. . the stronger are the restrictions on the test procedure. in which case it should satisfy the level constraint for F ∈ H0 . 7 7 . . Test level and size A test for H0 is a rule by which one decides to reject or accept the hypothesis (or to view it as incompatible with the data). .12) sup PF [Rejecting H0 ] ≤ α . Among tests with the same level. . where H1 is an appropriate subset of the set of all possible distributions Fn . this is typically due to heavy dependence of the distribution of Sn on the nuisance parameter θ2 . There may be a point where the restrictions are no longer implementable. where PF [ · ] is the function (probability measure) giving the probability of an event when the data distribution function is F.It is important to note here that showing that H0 is unacceptable requires one to show that all distributions in H0 are incompatible with the observed data. in ill-defined problems.. we may be able to find a (finite) critical value c = c(α. In such a case. Xn ) > c . it is also defined on the set H1 ∪ H0 .

. . t(β i ) = n(β i − β i )/ˆ β ] σˆ i=1 Xi /n and sX = n i=1 i 8 . . For example.e. is called the size of the confidence set.θ2 C]. . . even if this is the case. . θ0 ) may 1 2 be perfectly testable.18) (3. . X1 . . Xn ) whose distribution does not depend on unknown parameters (nuisance parameters). . is not testable. Xn ) is boundedly pivotal if its distribution function may depend on θ but is bounded over the parameter space [see Dufour (1997)].14) and if we can build a different test Sn (θ0 . the function Sn (θ1 .15) 1 1 1 If we have θ1 . . By contrast. θ2 ) does allow one to interpret the values taken by the test statistic Sn (nonseparability). θ0 ) . n(Xn − µ) is not a pivot because its distribution depends on σ. if X1 . θ2 ) = ∞ . X1 .e. When we have a pivotal function (or a boundedly pivotal function). Besides.19) ¯ (Xi − Xn )/(n − 1). . it is a pivot. X1 . More generally. . follows a Student t(n − 1) distribution √ ¯ which does not depend on the unknown values of µ and σ. In practice. . θ2 3. the distribution does not depend on θ2 . . σ 2 ]. . . we can 1 1 determine the set of values that can be viewed as compatible with the data according to the tests considered: C = θ0 : Sn (θ0 . confidence regions (or confidence intervals) were made possible by the discovery of pivotal functions (or pivots): a pivot for θ1 is a function Sn (θ1 . i. . . 1 (3. we can find a point c such that: P[Sn (θ1 . X1 . θ2 ) = (θ0 .e. . The set C covers the “true” parameter value θ1 with probability at least 1 − α.16) (3. hence. this does not imply that an hypothesis that would fix both θ1 and θ2 . sup c(α.17) inf P[θ1 ∈ C] ≥ 1 − α . Xn ) ≤ c(θ0 ) . so that it is not possible to find a useful (finite) critical value for testing H0 . the hypothesis H0 : (θ1 . Xn ) for each possible value of θ0 . More generally. i. (3. i. . the t-statistic √ ¯ tn (µ) = n(Xn − µ)/sX ¯ where Xn = n i. The minimal probability of covering the true value of θ1 . Xn ∼ N [µ. inf P[θ1 ∈ θ 1 . . (3. in particular. Confidence sets and pivots If we consider an hypothesis of the form H0 (θ0 ) : θ1 = θ0 1 1 (3. . Xn ) ≥ c] ≤ α .d. C is a confidence set with level 1 − α for θ1 . ∀θ1 .3. But only a complete specification of the vector (θ1 . .i. the t statistics for individual coefficients [say. in the classical linear model √ ˆ with several regressors.θ2 PF Rejecting H0 (θ0 ) ≤ α 1 for all F ∈ H(F0 . . X1 .depends heavily on θ2 .

design a procedure for deciding whether θ = θ1 or θ = θ2 . an empirically empty hypothesis. (3) testing the unit root hypothesis on an autoregressive model whose order can be arbitrarily large.1. 4. the proposed statistic cannot be pivotal for the model considered: its distribution varies too much under the null hypothesis to determine a finite critical point satisfying the level restriction (3.4. Maasoumi (1992) and Pötscher (2002).constitute pivots because their distributions do not depend on unknown nuisance parameters. 3. Second. If an hypothesis is non-testable. the values of the other regression coefficients disappear from the distribution. its equality to zero.18). In the next section. First. Testability and identification When formulating and trying to solve test problems. A parameter θ is identifiable iff θ(F1 ) = θ(F2 ) =⇒ F1 = F2 . we have a non-testable hypothesis. we examine several cases where this happens. there is no valid test that satisfies reasonable properties [such as depending upon the data]: in such a case. Testability. The values of θ are testable. for example. so that we may expect to be able to “tell” the difference by looking at the data. a parametric transformation g(θ) is identifiable iff g[θ(F1 )] = g[θ(F2 )] =⇒ F1 = F2 . (3. Tests on regression coefficients in linear regressions Further discussion on the issues discussed in this section is available in Dufour (2001). but turn out to be ill-defined when we look at them more carefully. in principle. we are not able to design a reasonable procedure for deciding whether it holds (without the introduction of additional data or information). these definitions mean that different values of the parameter imply different distributions of the data. we can.21) Intuitively. This is certainly the case when a unique distribution is associated with each parameter value [for example. nonparametric models and asymptotic methods We will now discuss three examples of test problems that look perfectly well defined and sensible at first sight.i.8 4. two types of basic difficulties can arise.20) For θ1 = θ2 . in particular.d. 8 9 . but this may not be the case when a parameter covers several distributions. (2) testing an hypothesis about a mean (or a median) with heteroskedasticity of unknown form. Procedures robust to nonnormality One of the most basic problems in econometrics and statistics consists in testing an hypothesis about a mean. we may use the Neyman-Pearson likelihood ratio test to make the decision]. These include: (1) testing an hypothesis about a mean when the observations are independent and identically distributed (i. More generally. (3.). This difficulty is closely related to the concept of identification in econometrics. For rrelated discussions. see also Horowitz (2001).

for any µ1 = µ0 . however. . Indeed. Further. Xn are i. If the simplest versions of the problem have no reasonable solution. Here. The set of possible data distributions (or data generating processes) compatible with this hypothesis. Further [by (4. if there is at least one value µ1 = µ0 such that PFn Rejecting H0 (µ0 ) ≥ α for at least one Fn ∈ H(µ1 ) .e. more generally. The normality assumption. if a test has level α for testing H0 (µ0 ).e. .5) (4.d.d.6) (4. . . H(µ0 ) = {Distribution functions Fn ∈ Fn such that H0 (µ0 ) is satisfied} . such as H0 (µ0 ) : X1 . P ROOF . If a test has level α for (4. for all µ1 = µ0 .i. the situation will not improve when we consider more complex versions (as done routinely in econometrics). . . if “by luck” the power of the test gets as high as the level. Here H0 (µ0 ) is a nonparametric hypothesis because the distribution of the data cannot be completely specified by fixing a finite number of parameters.05) in such a problem can be run 10 (4.3) PFn [Rejecting H0 (µ0 )] ≤ α for all Fn ∈ H(µ0 ) .i. So it is tempting to consider a weaker (less restrictive) version of this null hypothesis. on parameters of models which are estimated by the generalized method of moments (GMM) can be viewed as extensions of this fundamental problem.1 M EAN H0 (µ0 ). PFn Rejecting H0 (µ0 ) = α for all Fn ∈ H(µ) . the probability of rejecting H0 (µ0 ) should not exceed the level irrespective how far the “true” mean is from µ0 . i. the restrictions imposed by the level constraint are so strong that the test cannot have power exceeding its level: it should be insensitive to cases where the null hypothesis does not hold! An optimal test (say. (4. at level .TESTABILITY IN NONPARAMETRIC MODELS . PFn [Rejecting H0 (µ0 )] ≤ α for all Fn ∈ H(µ1 ) . we would like to test the hypothesis that the observations have mean µ0 . i.1) In other words.4) NON . In other words [by (4.4)].2) is much larger here than in the Gaussian case and imposes very strong restrictions on the test.d.or. then the probability of rejecting should be uniformly equal to the level α. then. is often considered to be too “strong”. the set H(µ0 ) is so large that the following property must hold.6)]. under the general assumption that X1 . Xn are i.. The problem of testing an hypothesis about a mean has a very well known and neat solution when the observations are independent and identically (i. .i. then. . (4.) distributed according to a normal distribution: we can use a t test. observations with E(X1 ) = µ0 . See Bahadur and Savage (1956). Theorem 4. .

a structural equation (as in SEM).. The above theorem also implies that tests based on the “asymptotic distribution” of the usual t statistic for µ = µ0 [tn (µ0 ) defined in (3. models of the form H0 (θ0 ) are typically estimated and tested through a variant of the generalized method of moments (GMM). A way to interpret what happens here is through the distinction between pointwise convergence and uniform convergence. Examples include: 1. for each value of γ. p H0 (µp ) : X1 . the test has level 0. . Xn are i. Then. observations such that Var(Xt ) = σ 2 . T . usually with weaker assumptions on the distribution 11 . most hypotheses on the coefficients of a regression (linear or nonlinear).e. (2) using a random number generator. . Suppose. Clearly.05 pointwise (for each γ).d. 2. .05 . hypotheses about various moments of Xt : H0 (σ 2 ) : X1 . γ>0 (4. .d.e.10) Pn (γ) converges to a level of 0. θ0 ) = ut . . for all n .95)e−|γ|n where γ = 0. .as follows: (1) ignore the data. produce a realization of a variable U according to a uniform distribution on the interval (0.i. where u1 . Many other hypotheses lead to similar difficulties. It is also easy to see that a similar result will hold if we add various nonparametric restrictions on the distribution. t = 1 . 1). .i. . (4.05. (3) reject H0 if U ≤ . . In econometrics. procedures based on the asymptotic distribution of a test statistic have size that deviate arbitrarily from their nominal size. In other words. so that the probability of rejection is arbitrarily close to one for γ sufficiently close to zero (for all sample sizes n).d.8) lim Pn (γ) = 0. U ∼ U (0. that the probability of rejecting H0 (µ0 ) when it is true depends on a single nuisance parameter γ in the following way: Pn (γ) ≡ Pγ |tn (µ0 )| > c = 0. Xn are i.05 + (0. this is not an interesting procedure. or a more general estimating function [Godambe (1960)]: H0 (θ0 ) : gt (Zt . uT are i. but the convergence is not uniform.19)] has size one under H0 (µ0 ) : sup Fn ∈H(µ0 ) PFn |tn (µ0 )| > c = 1 (4. n→∞ (4. . . . to simplify. . . i. i.9) but the size of the test is one for all sample sizes: sup Pn (γ) = 1 . . 1). such as a finite variance assumption. observations such that E(Xt ) = µp .i. .7) for any finite critical value c.05 asymptotically.

. More generally. . . P ROOF . . . . In such a case. It is important to observe that the above discussion does not imply that all nonparametric hypotheses are non testable.’s such that Med(Xt ) = m0 . . . Newey and McFadden (1994) and Hall (1999). In the present case. Equivalently. To see this. . Xn are independent random variables (4. then it must satisfy the condition P[ Rejecting H0 | |X1 |. see Hansen (1982).10) and Lehmann and Stein (1949). . namely: H0 : X1 .5 H0 (m0 ) : X1 . T . observations such that P Xt ≤ Qp0 = p .5 H0 (m0 ) can be easily tested with a sign test [see Pratt and Gibbons (1981. .2. though quantiles are. Moments are not empirically meaningful functionals in nonparametric models (unless strong distributional assumptions are added). But it is not widely appreciated that this involves very strong restrictions on the procedures that can satisfy this requirement. In other words. . 4.12) . the problem of non-testability could be eliminated by choosing another measure of central tendency.11) each with a distribution symmetric about zero.i.of u1 . . Procedures robust to heteroskedasticity of unknown form Another common problem in econometrics consists in developing methods which remain valid in making inference on regression coefficients when the variances of the observations are not identical (heteroskedasticity). continuous r. its level must be equal to α conditional on the absolute values of the observations (which amounts to considering 12 TESTS . H0 states that the joint distribution Fn of the observations belongs to the (huge) set H0 = {Fn ∈ Fn : Fn satisfies H0 } : H0 allows heteroskedasticity of unknown form. . .v.i. . See Pratt and Gibbons (1981. |Xn | ] ≤ α under H0 . . . it follows from the above discussion that they constitute pseudo-solutions of ill-defined problems. Xn are i. t = 1 . If a test has (4. a valid test with level α must be a sign test — or. . consider the problem which consists in testing whether n observations are independent with common zero median.2 C HARACTERIZATION OF HETEROSKEDASTICITY ROBUST level α for H0 . where 0 < α < 1. Newey and West (1987a).d. . more precisely. we have the following theorem. . 0. . . Xn are i. To the extent that GMM methods are viewed as a way to allow for “weak assumptions”. T . . In particular. t = 1 . Section 5. . this may go as far as looking for tests which are “robust to heteroskedasticity of unknown form”. . such as a median: 0. uT . hypotheses on the quantiles of the distribution of observations in random sample remain testable nonparametrically: p H0 (Qp0 ) : X1 . . Chapter 2)]. Theorem 4. .d.

(4. and Hendry (1993). Procedures robust to autocorrelation of arbitrary form As a third illustration.i. i. Dolado.4 U NIT ˜ α for H0 . t = 1 . (4. i. i. i.e. ˜ H0 : Xt = β 0 + p k=1 p λk Xt−k + ut . and Maddala and Kim (1998).15) or. Most so-called “heteroskedasticity robust procedures” based on “corrected” standard errors [see White (1980). n . For examples of size distortions. . . more precisely. t = 1 . . the reader may consult: Banerjee. Davidson and MacKinnon (1993. see Dufour (1981) and Campbell and Dufour (1995. If a test has level (4. the condition (4. ˜ PFn [Rejecting H0 ] ≤ α P ROOF . For reviews of this huge literature. for all 0 < α < 1.14) where p is not bounded a priori.d. Galbraith. Newey and West (1987b). let us now examine the problem of testing the unit root hypothesis in the context of an autoregressive model whose order is infinite or is not bounded by a prespecified maximal order: p Xt = β 0 + k=1 λk Xt−k + ut .12) and consequently have size one.d. sup PFn [Rejecting H0 ] = 1 . if a test procedure does not satisfy (4. Cushing and McGarvey (1999)] do not satisfy condition (4.3.16) k=1 About this problem. Chapter 16). Theorem 4. From this. then its true size is one irrespective of its nominal size.TESTABILITY IN NONPARAMETRIC MODELS . λk = 1 and ut ∼ N [0 . This type of problem has attracted a lot of attention in recent years.17) (4.9 4. the following remarkable property follows.3 If.13) Fn ∈H0 In other words. Stock (1994). we can show the following theorem and corollary.12) is not satisfied. for some p ≥ 0 . Tanaka (1996). .i. .e. . n . . 10 9 13 . σ 2 ] . 1997). . ut ∼ N [0 . then the size of the test is equal to one. See Cochrane (1991) and Blough (1992).12) for all levels 0 < α < 1. Corollary 4.a test based on the signs of the observations).18) ˜ PFn [Rejecting H0 ] ≤ α ˜ for all Fn satisfying H0 . σ 2 ] .10 We wish to test: p ˜ H0 : k=1 λk = 1 (4. (4. for all Fn . then ROOT NON .

the reader may consult Sims (1971a. Nankervis. For further discussion of this topic. 2002c). Jaeger. Gleser and Hwang (1987). Faust (1996. Chao and Swanson (2001. 1990b). and Zivot (2001).i. 2003). and Yogo (2002)]. Rudebusch. Hall and Peixe (2000).19) λk = 1 and ut ∼ N [0 . Hillier (1990). 2003b). Nelson. 1989). the condition (4. 2001b. and Savin (1994).16). Kleibergen and Zivot (2003). Buse (1992). Phillips (1987). The order of the autoregressive process is an essential part of the hypothesis: it is not possible to separate inference on the unit root hypothesis from inference on the order of the process. .18) is not satisfied. Stock. .. Bound. Consequently. Hall. the true size under the hypothesis H0 is equal to one. Moreira (2001.e. Staiger and Stock (1997). 1999) and Pötscher (2002). Bekker (2002). Wang and Zivot (1998). for all 0 < α < 1.g. Dufour and Taamouti (2000. Startz. (4. Maddala and Jeong (1992). Nelson and Startz (1990a. 14 . 2002a. 2003a. then the size of the test is equal to one. The literature on this topic is now considerable. n . 2001).11 In this section. Dufour (1997). the null hypothesis is simply too “large” (unrestricted) to allow testing from a finite data set. Koschat (1987). and Wilcox (1996). Wright. i. Phillips (1989). Wright (2003. ˜ sup PFn [Rejecting H0 ] = 1 Fn ∈H0 ˜ where H0 is the set of all data distributions Fn that satisfy H0 . Hahn. 2003). McManus. a numerical upper bound on the order) and the sum of the coefficients: for example. Stock and Yogo (2002. Zivot. and Nelson (2003). t = 1 . and Kuersteiner (2001). Kleibergen (2001b. 11 See Sargan (1983). 1971b). Hausman. Similar difficulties will also occur for most other hypotheses on the coefficients of (4. Imbens and Manski (2003).Corollary 4. Hahn and Hausman (2002a. i. Angrist and Krueger (1995). To get a testable hypothesis. Dufour and Jasiak (1993. Startz. Perron (2003). Phillips and Perron (1988)] are affected by these ˜ problems: irrespective of the nominal level of the test. 5. all procedures that claim to offer corrections for very general forms of serial dependence [e. and Nelson (1998). 2003).e. 2002b. 2002b. . and Zivot. As in the mean problem. 1995).. it is essential to fix jointly the order of the AR process (i. Shea (1997). . Choi and Phillips (1992). 2001a.5 If. 1985. Blough (1992). and Baker (1993. Phillips (1984. Moreira and Poi (2001).d. Stock and Wright (2000). 2001a). we shall examine these issues in the context of SEM. Bekker and Kleibergen (2001). σ 2 ] . Startz. we could consider the following null hypothesis where the order of the autoregressive process is equal to 12: H0 (12) : Xt = β 0 + 12 k=1 12 k=1 λk Xt−k + ut . 2002). Structural models and weak instruments Several authors in the past have noted that usual asymptotic approximations are not valid or lead to very inaccurate results when parameters of interest are close to regions where these parameters are no longer identifiable.

Below.4) (5. Π1 and Π2 are k1 ×G and k2 ×G matrices of unknown coefficients. . We view this situation as important because. (5.1. . . the vectors V1 .4) may be interpreted as the strict exogeneity of X with respect to u.5. X2 . u ∼ N 0.6) where X3 is a T × k3 matrix of explanatory variables (not necessarily strictly exogenous). we could also assume that Y obeys a general nonlinear model of the form: Y = g(X1 . X3 . VT need not follow a Gaussian distribution and may be heteroskedastic. . β and γ are G × 1 and k1 × 1 vectors of unknown coefficients. . Even more generally.2) can be rewritten in reduced form as: y = X1 π 1 + X2 π 2 + v .2) where y and Y are T × 1 and T × G matrices of endogenous variables. The model presented in (5. . . Note that the distribution of V is not otherwise restricted.8) (5.5) (5. we shall use the following assumptions on the distribution of u : u and X are independent. we shall also consider the situation where the reduced-form equation for Y includes a third set of instruments X3 which are not used in the estimation: Y = X1 Π1 + X2 Π2 + X3 Π3 + V (5. . Y = X1 Π1 + X2 Π2 + V . Further.(5. . Finally. . X3 may be unobservable. Standard simultaneous equations model Let us consider the standard simultaneous equations model: y = Y β + X1 γ + u . in practice. in particular. VT ] is a T × G matrix of reducedform disturbances. uT ) is a T × 1 vector of structural disturbances. X2 ] is a full-column rank T × k matrix (5.3) where k = k1 + k2 . u = (u1 . .9) 15 . V. . Y = X1 Π1 + X2 Π2 + V . it is quite rare that one can consider all the relevant instruments that could be used. σ 2 IT u . X1 and X2 are T × k1 and T × k2 matrices of exogenous variables.1) .1) (5. (5. and V = [V1 .7) where g(·) is a possibly unspecified nonlinear function and Π is an unknown parameter matrix. Π) (5. (5. X = [X1 . to get a finite-sample distributional theory for the test statistics. in particular.

Choi and Phillips (1992). When identification conditions are not satisfied. The necessary and sufficient condition for identification is the well-known rank condition for the identification of β : β is identifiable iff rank(Π2 ) = G . Wang and Zivot (1998). Weak instruments are notorious for causing serious statistical difficulties on several fronts: (1) parameter estimation. Phillips (1989). Stock and Wright (2000)]. (5. Theoretical results show that the distributions of various estimators depend in a complicated way on unknown nuisance parameters.where π 1 = Π1 β + γ . 1. Phillips (1985). but reasonable characterizations include the condition that det(Π2 Π2 ) is “close to zero”. rank(Π2 ) = k2 with strong linear dependence between the rows (or columns) of Π2 ].. Jaeger. (3) hypothesis testing. 3. We now consider these problems in greater detail. Rothenberg (1984). Maddala and Jeong (1992).2. 5. (5. or that Π2 Π2 has one or several eigenvalues “close to zero”. weak-instrument (local to non-identification) asymptotics [Staiger and Stock (1997). With weak instruments. 16 . 3. There is no compelling definition of the notion of near-nonidentification. or Π2 is close to having deficient rank [i. (5. standard asymptotic theory for estimators and test statistics typically collapses.11) We have a weak instrument problem when either rank(Π2 ) < k2 (non-identification). Dufour (1997)]. The main conclusions of this research can be summarized as follows. and π 2 = Π2 β . empirical examples [Bound. (2) confidence interval construction. and Baker (1995)]. theoretical work on the exact distribution of two-stage least squares (2SLS) and other “consistent” structural estimators and test statistics [Phillips (1983). Work in this area includes: 1. Buse (1992). 2.10) is the crucial equation governing identification in this system: we need to be able to recover β from the values of the regression coefficients π 2 and Π2 . Nelson and Startz (1990a).e. Thus. 2. they are difficult to interpret. Hillier (1990).10) Suppose now that we are interested in making inference about β. v = u + V β . Statistical problems associated with weak instruments The problems associated with weak instruments were originally discovered through its consequences for estimation. Phillips (1984). Nelson and Startz (1990a).

This will be the case. these authors found that replacing the instruments used by Angrist and Krueger (1991) with randomly generated (totally irrelevant) instruments produced very similar point estimates and standard errors.. 1)| > c] ≤ α . QJE). 4. 1) . bimodal). By the above corollary.13) (5. 1 P ROOF . (5.14) Corollary 5. θ = ( θ1 . Wright. in particular. This result indicates that the original instruments were weak.. 5. (5. Using 329000 observations. A striking illustration of these problems appears in the reconsideration by Bound.(a) the 2SLS estimator becomes heavily biased [in the same direction as ordinary least squares (OLS)]. θ2 )] such that θ2 is no longer identified when θ1 takes a certain value. For a more complete discussion of estimation with weak instruments. where P[|N (0. See Dufour (1997). (5.12) 1 Theorem 5. Consider the general situation where we have two parameters θ1 and θ2 [i. (b) the distribution of the 2SLS estimator is quite far from the normal distribution (e.16) θ 17 . the reader may consult Stock. and Yogo (2002). Pθ [C is unbounded] ≥ 1 − α . and Baker (1995) of a study on returns to education by Angrist and Krueger (1991. if θ1 = θ0 . for any Wald-type confidence interval. obtained by assuming that tθ 2 = θ2 − θ2 σ θ2 approx ∼ N (0. irrespective of the critical value c used: inf Pθ θ2 − cσ θ2 ≤ θ2 ≤ θ2 + cσ θ2 = 0 .e. say θ1 = θ0 : 1 L(y | θ1 . this type of interval has level zero. its size must be zero.1 If θ2 is a parameter whose value is not bounded.3. θ2 ) ≡ L(y | θ0 ) . Characterization of valid tests and confidence sets Weak instruments also lead to very serious problems when one tries to perform tests or build confidence intervals on the parameters of the model.15) which yields confidence intervals of the form θ2 − cσ θ2 ≤ θ2 ≤ θ2 + cσ θ2 .2 If C does not satisfy the property given in the previous theorem. then the confidence region C with level 1 − α for θ2 must have the following property: Pθ [C is unbounded] > 0 and.g. (5. Jaeger.

second the projection technique which provides a general way of making a wide spectrum of tests and confidence sets. From a statistical viewpoint. 6. For an interesting discussion of the origin of IV methods in econometrics. a finite-sample pivot). if we wish to test an hypothesis of form H0 : θ2 = θ0 . By contrast.17) 2 σ θ2 will deviate arbitrarily from its nominal size. (3) robustness to excluded instruments. this type of problem affect the validity of all Wald-type methods.12 The basic problem considered consists in testing The basic ideas for using instrumental variables for inference on structural relationships appear to go back to Working (1927) and Wright (1928).In such situations. Interestingly. which are based on comparing parameter estimates with their estimated covariance matrix. Approaches to weak instrument problems What should be the features of a satisfactory solution to the problem of making inference in structural models? We shall emphasize here four properties: (1) the method should be based on proper pivotal functions (ideally.5). this applies to standard confidence intervals based on 2SLS estimators and their asymptotic “standard errors”. which in our view is the reference method for dealing with weak instruments in the context of standard SEM. the notion of standard error loses its usual meaning and does not constitute a valid basis for building confidence intervals. the size of any test of 2 the form θ2 − θ0 2 tθ2 (θ0 ) = > c(α) (5. see Stock and Trebbi 12 18 . although it pre-dates the introduction of 2SLS methods in SEM [Theil (1953). In the light of these criteria. No unique large-sample distribution for tθ2 can provide valid tests and confidence intervals based on the asymptotic distribution of tθ2 . In SEM. which later became the most widely used method for estimating linear structural equations models. More generally.1. in models of the form (5. (2) robustness to the presence of weak instruments. Staiger and Stock (1997)].1) . Correspondingly. 6. and thirdly several recent proposals aimed at improving and extending the AR procedure. the AR method can be viewed as an alternative way of exploiting “instruments” for inference on a structural model. for example. the distribution of the LR statistics for most hypotheses on model parameters can be bounded and cannot move arbitrarily: likelihood ratios are boundedly pivotal functions and provide a valid basis for testing and confidence set construction [see Dufour (1997)]. (4) robustness to the formulation of the model for the explanatory endogenous variables Y (which is desirable in many practical situations). Anderson-Rubin statistic A solution to testing in the presence of weak instruments has been available for more than 50 years [Anderson and Rubin (1949)] and is now center stage again [Dufour (1997). we shall first discuss the Anderson-Rubin procedure. Basmann (1957)]. The central conclusion here is: tests and confidence sets on the parameters of a structural model should be based on proper pivots. this means that tθ2 is not a pivotal function for the model considered.(5.

5) where Fα (k2 .1) . this equation reduces to y − Y β 0 = X1 θ 1 + ε . it can be used to build confidence sets for β : Cβ (α) = {β 0 : AR(β 0 ) ≤ Fα (k2 .2).4). and Nelson (1998) for details. Cβ (α) = {β 0 : aβ 2 + bβ 0 + c ≤ 0} 0 (6. The set Cβ (α) may easily be determined by finding the roots of the quadratic polynomial in equation (6.6) where a = Y HY. we “hang” on the variables in X2 : if we add X2 to the constrained structural equation (6. When there is only one endogenous explanatory variable (G = 1). this set has an explicit solution involving a quadratic inequation.4) where SS0 (β 0 ) = (y − Y β 0 ) M (X1 )(y − Y β 0 ) and SS1 (β 0 ) = (y − Y β 0 ) M (X)(y − Y β 0 ). and c = y Hy . so they point to lack of identification. This yields the following F-statistic — the Anderson-Rubin statistic — which follows a Fisher distribution under the null hypothesis: AR(β 0 ) = [SS0 (β 0 ) − SS1 (β 0 )]/k2 ∼ F (k2 .e. i.the hypothesis H0 (β 0 ) : β = β 0 (6.2) where θ1 = γ + Π1 (β − β 0 ). Unbounded sets are highly likely when the model is not identified. Since the latter statistic is a proper pivot. T − k)} (6. but it remains fairly manageable by using the theory of quadrics [Dufour and Taamouti (2000)]. we denote P (A) = A(A A)−1 A and M (A) = I− P (A). its coefficient should be zero.3) so we can test H0 (β 0 ) by testing H0 (β 0 ) : θ2 = 0. the set Cβ (α) is not in general an ellipsoid. Empty confidence sets can occur (with a non-zero probability) when we have more instruments than parameters in the structural (2003).6). H ≡ M (X1 ) − M (X) [1 + k2 Fα (k2 . T − k) is the critical value for a test with level α based on the F (k2 . Cβ (α) is a closed bounded set close to an ellipsoid. In order to do that. To draw inference on the structural parameter β.3). T − k) distribution. (6. When G > 1. θ2 = Π2 (β − β 0 ) and ε = u + V (β − β 0 ) . This yields the regression y − Y β 0 = X1 θ 1 + X2 θ 2 + ε (6. for any full-rank matrix A. In other cases. it can be unbounded or empty. Under the null hypothesis H0 (β 0 ). we shall call the variables in X2 auxiliary instruments. b = −2Y Hy. we consider an auxiliary regression obtained by subtracting Y β 0 from both sides of (5. 19 .1) and expanding the right-hand side in terms of the instruments. T − k) SS1 (β 0 )/(T − k) (6.(5.1) in model (5. What plays the crucial role here is the fact that we have instruments (X2 ) that can be related to Y but are excluded from the structural equation. T − k)/(T − k)] . Startz. When the model is correct and its parameters are well identified by the instruments used. see Dufour and Jasiak (2001) and Zivot. For these reasons. in the auxiliary regression (6.

the model is overidentified. For example. we can consider the transformed model y − Y β 0 − X1 γ 0 = X1 θ1 + X2 θ2 + ε . but its level is not. ν 0 ) : β = β 0 and Rγ = ν 0 . (6. what can we do. (5) the AR method provides asymptotically “valid” tests and confidence sets under quite weak distributional assumptions (basically. In other words. are discussed in Dufour and Jasiak (2001).10) (6. see Kleibergen (2002b). (3) error normality assumption is restrictive and we may wish to consider other distributional assumptions. Since.equation (5. i. So the procedure provides as an interesting byproduct a specification test. to test an hypothesis of the form H0 (β 0 . (6. Indeed. 13 For further discussion of this point.7).8) (6. But the method also has its drawbacks.6) is the correct model for Y. γ 0 ). if β has more than one element? (2) power may be low if too many instruments are added (X2 has too many variables) to perform the test. 20 . Namely. (2) robust to weak instruments. this will also hold if Y is determined by the general — possibly nonlinear — model (5. γ 0 ) : θ1 = 0 and θ2 = 0 in the auxiliary regression (6. such as H0 (β 0 . it is: (1) pivotal in finite samples. see Maddala (1974).9) we can test H0 (β 0 .8). γ ) ]. and (6) it can be extended easily to test restrictions and build confidence sets which also involve the coefficients of the exogenous variables. Tests for more general restrictions of the form H0 (β 0 . further. (4) the structural equations are assumed to be linear.10). especially if the instruments are irrelevant. under H0 (β 0 . ν 0 ) in (6. (4) robust to the specification of the model for Y (which can be nonlinear with an unknown form). The main ones are: (1) the tests and confidence sets obtained in this way apply only to the full vector β [or (β . the assumptions that cover the usual asymptotic properties of linear regression). The power of the test may be affected by the choice of X2 . this is an important practical consideration. which indicates that the model is misspecified. γ 0 ) : β = β 0 and γ = γ 0 . we can leave out a subset of the instruments (X3 ) and use only X2 : the level of the procedure will not be affected. γ 0 ) by testing H0 (β 0 . (3) robust to excluded instruments. y − Y β 0 − X1 γ 0 = ε . An empty confidence set means that no value of the parameter vector β is judged to be compatible with the available data. The procedure is robust to excluded instruments as well as to the specification of the model for Y. The AR procedure can be extended easily to deal with linear hypotheses which involve γ as well.7) where R is a r × K fixed full-rank matrix.1). The AR procedure thus enjoys several remarkable features.e. Since it is quite rare an investigator can be sure relevant instruments have not been left out. We will now discuss a number of methods which have been proposed in order to circumvent these drawbacks.13 It is also easy to see that the above procedure remains valid even if the extended reduced form (5.

So parametric nonseparability arises here. a number of alternative methods have been recently suggested.6. e. If the data generating process corresponds to a model where parameters are well identified. in the classical linear model (without exact multicollinearity). Alternatives to the AR procedure In view of improving the power of AR procedures. then.g. precise inferences on individual coefficients may be feasible. for any function g(β). Lack of identification is precisely a situation where the value of a parameter may be determined only after various restrictions (e. and Dufour and Jasiak (2001). (6. Generalized auxiliary regression A general approach to the problem of testing H0 (β 0 ) consists in replacing X2 in the auxiliary regression y − Y β 0 = X1 θ 1 + X2 θ 2 + ε (6.14) 14 g [Cβ (α)] takes the form of a bounded confidence interval as soon as the confidence set g [Cβ (α)] is unbounded. We will now discuss several of them. Such a separation is feasible only in special situations. P g(β) ∈ g [Cβ (α)] ≥ 1 − α .2. 21 . Projections and inference on parameter subsets Suppose now that β [or (β . the values of other parameters) have been imposed. and Mizera (1998). γ ) ] has more than one component. Abdelkhalek and Dufour (1998). w β + σ zα ] ˜ a k-class type estimator of β. (6. This raises the question how one can move from a joint inference on β to its components. Hallin.3. A general approach to this problem consists in using a projection technique.g. if {ga (β) : a ∈ A} is a set of functions of β. the confidence ˜ ˆ ˜ ˆ set for a linear combination of the parameters. there is no reason in general why one should be able to decide on the value of a component of β independently of the others.12) If g(β) is a component of β or (more generally) a linear transformation g(β) = w β. Dufour. More precisely. and inference should start from a simultaneous approach.. Dufour and Kiviet (1998).13) If these confidence intervals are used to test different hypotheses. see Dufour and Taamouti (2000). If P[β ∈ Cβ (α)] ≥ 1 − α . γ 0 )] is not due to chance: since the distribution of the data is determined by the full parameter vector. the reader may consult Dufour (1990. say w β takes the usual form [w β − σ zα . The fact that a procedure with a finite-sample theory has been obtained for “joint hypotheses” of the form H0 (β 0 ) [or H0 (β 0 .11) 6. an unlimited number of hypotheses can be tested without losing control of the overall level. 1997). Campbell and Dufour (1997). then P ga (β) ∈ g [Cβ (α)] for all a ∈ A ≥ 1 − α . (6. a.14 with β Another interesting feature comes from the fact that the confidence sets obtained in this way are simultaneous in the sense of Scheffé. For further discussion of projection methods.

Then the problem θ θ consists in selecting Z so that the level can be controlled and power may be improved with respect to the AR auxiliary regression (6. Better results tend to be obtained by ˜ — 10% for example — and the rest for using a relatively small fraction of the sample to obtain Π the main equation. c. it is tempting to use the least squares estimator Π = (X X)−1 X Y. (6..16) ˜ where Π2 is an estimate of the reduced-form coefficient Π2 in (5. b. this procedure is robust to weak can easily see that the standard F test for θ instruments. Π and ε are not independent and we continue to face a simultaneity problem with messy ˜ distributional consequences. the reader may consult Dufour and Jasiak (2001) and Kleibergen (2002a). For further details on this procedure.8) were the correct model and Π = [Π1 . . Ideally.14).17) 15 Split-sample techniques often lead to important distributional simplifications. Π2 ] were known. Further. under the ˜ general assumptions (5.15) where ¯2 = 0 under H0 (β 0 ). we should note that. of course. are independent. ˆ However. by conditioning on Π. this approach to estimating Π may be feasible by using ˜ a split-sample technique: a fraction of the sample is used to obtain Π and the rest to estimate the ˜ ˜ auxiliary regression (6. Of course. So several alternative procedures can be generated by reducing the number of auxiliary instruments (the number of columns in Z).¯ by an alternative set of auxiliary instruments.2). This suggests that we replace X2 Π2 by an estimate. 22 . then an optimal choice from the viewpoint of power consists in choosing Z = X2 Π2 . it is easy to see that the power of the AR test could become low if a large set of auxiliary instruments is used.e. Split-sample optimal auxiliary instruments If we can assume that the error vectors (ut . Vt ) . . we would like to select an estimate Π2 which is independent of ε. 2000). we consider the generalized auxiliary regression y − Y β 0 = X1 θ1 + Z ¯2 + ε θ (6. is that Π2 is unknown.7)]. In other words. using a split-sample may involve a loss of the effective number of observations and there will be a trade-off between the efficiency gain from using a smaller number of auxiliary ˜ instruments and the observations that are “sacrificed” to get Π.15) with Z = X2 Π2 . At the outset.15). For that purpose. For example. t = 1. for further discussion of this type of method. T.15 A number of alternative procedures can be cast in the framework of equation (6.15). such as ˜ Z = X2 Π2 (6. The practical problem. especially if the latter are weak. . excluded instruments as well as the specification of the model for Y [i.6) or (5. if (5. say Z of dimension T × k2 . see Dufour and Taamouti (2001b). we ¯2 = 0 is valid. The problem then consists in ˜ ˆ choosing Π. So we can test H0 (β 0 ) by testing ¯2 = 0 in (6. . Under such circumstances. as long as the independence between Π and ε can be maintained. see Angrist and Krueger (1995) and Dufour and Torrès (1998. LM-type GMM-based statistic If we take Z = ZW Z with ZW Z ˆ = P [M (X1 )X2 ]Y = P [M (X1 )X2 ]M (X1 )Y = [M (X1 )X2 ]Π2 .

21)] that FGM M (β 0 ) is (almost surely) identical with the AR statistic.ˆ Π2 = [X2 M (X1 )X2 ]−1 X2 M (X1 )Y . the distribution of this statistic will be affected by the fact that X2 Π2 and u are not independent. we see easily [from (6. (6.2). based on the same GMM estimator (in this case.24) so that the distribution of LMGM M (β 0 ) can be bounded in finite samples by the distribution of a 23 . FGM M (β 0 ) = where ν 1 = T − k1 − G and LMGM M (β 0 ) = (y − Y β 0 ) P [ZW Z ](y − Y β 0 ) . The statistic LMGM M (β 0 ) is also numerically identical to the corresponding LR-type and Wald-type tests. the 2SLS estimator of β).25) (6. obtained by 1 2 fitting the latter equation. FGM M (β 0 ) = AR(β 0 ) if k2 = G . (y − Y β 0 ) M (X1 )(y − Y β 0 )/T (6.e. T − k) distribution. (6. In particular. i. ˆ As mentioned above.22) 1 ˆ ˆ where Y = X Π. When k2 = G (usually deemed the “just-identified” case. (6. although the model may be under-identified in that case).21) 1 When k2 ≥ G. it is influenced by the presence of weak instruments. are identical to the 2SLS estimates of θ∗∗ and θ∗∗ in the equation 1 2 y − Y β 0 = X1 θ∗∗ + Y θ∗∗ + u . so that FGM M (β 0 ) can be obtained by computing the F-statistic for θ∗ = 0 in the 2 regression ˆ 2 y − Y β 0 = X1 θ∗ + (X2 Π2 )θ∗ + u . so that FGM M (β 0 ) follows an exact F (G. It is also interesting to note that the OLS estimates of θ∗∗ and θ∗∗ . Namely.18) the F-statistic [say. 1 2 (6. G FGM M (β 0 ) ≤ T − k1 − G T − k1 − k2 k2 AR(β 0 ) .20) T − k1 − G GT LMGM M (β 0 ) 1 − (1/T )LMGM M (β 0 ) (6. FGM M (β 0 )] for ¯2 = 0 is a monotonic transformation of the LM-type statistic θ LMGM M (β 0 ) proposed by Wang and Zivot (1998). But Wang and Zivot (1998) showed that the distribution of LMGM M (β 0 ) is bounded by the χ2 (k2 ) asymptotically.19) ˆ Note that Π2 above is the ordinary least squares (OLS) estimator of Π2 from the multivariate regression (5.23) The LMGM M test may thus be interpreted as an approximation to the optimal test based on reˆ placing the optimal auxiliary instrument X2 Π2 by X2 Π2 . while for k2 > G. the statistic FGM M (β 0 ) can also be obtained by testing θ∗∗ = 0 in the auxiliary 2 regression ˆ 2 y − Y β 0 = X1 θ∗∗ + Y θ∗∗ + u (6.

suu (β 0 ) = (y − Y β 0 ) M (X)(y − Y β 0 ) . although not necessarily far away from the null hypothesis. have ˜ ˆ been replaced by Y (β 0 ) = Y −X π (β 0 )sεV (β 0 )/sεε (β 0 ).25) also applies to FK (β 0 ) : G FK (β 0 ) ≤ T − k1 − G T − k1 − k2 k2 AR(β 0 ) .21) . which reduces to the one proposed by Kleibergen (2002a) for k1 = 0. while in the other cases (k2 ≥ G). AR(β 0 ) will always reject when FGM M (β 0 ) rejects (at a given level). irrespective of the presence of weak instruments. is very close to the χ2 (k2 ) distribution].monotonic transformation of a F (k2 . Kleibergen’s K test ZK If we take Z = ZK with suV (β 0 ) ˜ ˜ = X Π(β 0 ) ≡ Y (β 0 ) .22) of their statistics.27) (6. (6.32) indicates that the distribution of K(β 0 ) ≡ 16 The χ2 (k2 ) bound also follows in a straightforward way from (6. at least in the neighborhood of the null hypothesis. It is also interesting to note that the inequality (6. (6.32) Kleibergen (2002a) did not supply a finite-sample distributional theory but showed (assuming k1 = 0) that K(β 0 ) follows a χ2 (G) distribution asymptotically under H0 (β 0 ). T −k) variable [which. FK (β 0 ) and K(β 0 ) ≡ G FK (β 0 ) can be obtained ˆ by testing ¯2 = 0 in the regression θ ˜ y − Y β 0 = X1 θ1 + Y (β 0 )¯2 + u θ (6.25). T −k we obtain a statistic. This entails that the K(β 0 ) test will have power higher than the one of LMGM M test [based on the χ2 (k2 ) bound]. for T large.29) = P (X) Y − (y − Y β 0 ) sεV (β 0 ) ˜ ˆ ˆ Π(β 0 ) = Π − π (β 0 ) . Note that Wang and Zivot (1998) do not provide the auxiliary regression interpretation (6.30) ˆ This procedure tries to correct the simultaneity problem associated with the use of Y in the LMGM M statistic by “purging” it from its correlation with u [by subtracting the term π (β 0 )sεV (β 0 )/sεε (β 0 ) in ZK ] . which are closer to being orthogonal with ˆ u. the F-statistic FK (β 0 ) for ¯2 = 0 is equal to Kleibergen’s statistic K(β 0 ) θ divided by G : FK (β 0 ) = K(β 0 )/G .31) ˆ where the fitted values Y . for T reasonably large.28) (6. 24 . suu (β 0 ) ˆ Π = (X X)−1 X Y . But. we can see easily that the bound for FGM M (β 0 ) in (6.(6. suV (β 0 ) = 1 (y − Y β 0 ) M (X)Y .22) for the LMGM M test.16 d. sεε (β 0 ) π (β 0 ) ˆ = (X X)−1 X (y − Y β 0 ) . so the power of the AR test is uniformly superior to that of the LMGM M bound test. For details. see Dufour and Taamouti (2001b). More precisely. If k2 = G. In other words. T −k (6. with k1 = 0.26) (6. which appear in the auxiliary regression (6. we have FK (β 0 ) = AR(β 0 ) ∼ F (G. T − k).

34) (6. This bound can also be easily derived from the following inequality: LRLIM L ≤ T T −k k2 AR(β 0 ) . On the other hand. Conditional tests A promising approach was recently proposed by Moreira (2003a). 25 . for details. it X Π) can become quite unreliable in the presence of excluded instruments. T −k) distribution. (6. this entails that the AR(β 0 ) test will have power higher than the one of LRLIM L test [based on the χ2 (k2 ) bound]. g. Instrument selection procedures Systematic search methods for identifying relevant instruments and excluding unimportant instruments have been discussed by several authors. it is not robust to excluded instruments. His suggestion consists in conditioning upon an appropriately selected portion of the sufficient statistics for a gaussian SEM. However. On assuming that the covariance matrix of the errors is known. (y − Y β) M (X)(y − Y β) (6. Such an approach may lead to power gains.35) so that the distribution of LRLIM L is bounded in finite samples by the distribution of a [T k2 /(T − k)]F (k2 . So the power of the AR test is uniformly superior to the one of the LRLIM L bound test. For further discussion. f. T − k) variable. The LR test statistic in this case takes the form: ˆ LRLIM L = T ln κ(β 0 ) − ln κ(β LIM L ) ˆ where β LIM L is the limited information maximum likelihood estimator (LIML) of β and κ(β) = (y − Y β) M (X1 )(y − Y β) . because of the stochastic dominance of AR(β 0 ). the distribution of LRLIM L depends on unknown nuisance parameters under H0 (β 0 ). at least in the neighborhood of the null hypothesis. Likelihood ratio test The likelihood ratio (LR) statistic for β = β 0 was also studied by Wang and Zivot (1998). The conditional distribution is typically not standard but may be established by simulation. this method yields an asymptotically similar test. but its asymptotic distribution is χ2 (k2 ) when k2 = G and bounded by the χ2 (k2 ) distribution in the other cases [a result in accordance with the general LR distributional bound given in Dufour (1997)].33) Like LMGM M . the assumption that error covariances are known is rather implausible. see Moreira and Poi (2001) and Moreira (2003b). see Hall.G FK (β 0 ) can be bounded in finite samples by a [k2 (T −k1 −G)/(T −k)]F (k2 . In view of the fact that the above procedure is based on estimating the mean of XΠ (using ˆ and the covariances between the errors in the reduced form for Y and u [using sεV (β 0 )]. Because the LR test depends heavily on the specification of the model for Y . the corresponding conditional distribution of various test statistics for H0 (β 0 ) does not involve nuisance parameters. for the AR test would then have better power. there would be no advantage in using the bound to get critical values for K(β 0 ). e. Like Kleibergen’s procedure. see Dufour and Khalaf (2000). and the extension of the method to the case where the error covariance matrix is unknown is obtained at the expense of using a large-sample approximation. For T reasonably large.

1. π 1 = Π1 β +γ and π 2 = Π2 β. Π = [Π1 . π = [π 1 . . (1) only an asymptotic distributional theory is supplied. 17 This model is linear except for the nonlinear restriction π = Π β. t = 1. Π]. . 2002). U = [u. although Kleibergen’s and Moreira’s statistics are asymptotically pivotal.1) ¯ ˜ ˜ where Y = [y. . and nonlinear models. 7. in special situations. UT ] . alternatives to the AR procedure may allow some power gains with respect to the AR test with an unreduced set of instruments. 26 . and Wilcox (1996). V ] = [U1 . SEM can also be analyzed through a Bayesian approach. the reader may consult Dufour and Taamouti (2001a).4) can be put in the form of a multivariate linear regression (MLR): ¯ Y = XB + U (7. For additional discussion on this issue. π 2 ] . They themselves may have some important drawbacks. which can alleviate the indeterminacies associated with identification via the introduction of a prior distribution on the parameter space. (7. Π2 ] . Dufour and Taamouti (2001a). simulation-based inference and nonnormal errors Another approach to inference on a linear structural equation model is based on observing that the structural model (5. . .2) 17 Most of this section is based on Dufour and Khalaf (2000. see Kleibergen and Zivot (2003) and Sims (2001). . T . B = [π. .1) . (3) they are not robust to instrument exclusion or to the formulation of the model for the explanatory endogenous variables. For further discussion.Rudebusch. Robustness to instrument exclusion is very handy in this context. but this dependence becomes especially strong when identification problems are present [see Gleser and Hwang (1987)]. This paper only aims at discussing problems and solutions which arise within the sampling framework. One way to approach instrument selection is to maximize the concentration coefficient towards maximizing test power. and Donald and Newey (2001). satisfy the property: ˜ Ut = JWt . (2) the statistics used are not pivotal in finite samples. Multivariate regression. and it is beyond its scope to debate the advantages and disadvantages of Bayesian methods under weak identification. It is also of interest to note that finite-sample versions of several of these asymptotic tests may be obtained by using split-sample methods. . Bayesian inferences always depend on the choice of prior distribution (a property viewed as undesirable in the sampling approach). In particular. All the problems and techniques discussed above relate to sampling-based statistical methods. Hall and Peixe (2000). 2 2 ˜ Let us now make the assumption that the errors in the different equations for each observation. To summarize.(5. In this setup. 7. Extensions We will discuss succinctly some extensions of the above results to multivariate setups (where several structural equations may be involved). models with non-Gaussian errors. the power of AR-type tests depends on a function of model parameters called the concentration coefficient. Y ]. 2001. Ut .

where the vector w = vec(W1 . All the above procedures are valid for parametric models that specify the error distribution up to an unknown linear transformation (the J matrix) which allows an unknown covariance matrix. σ 2 IT . even though this distribution may be complicated. It is easy to see that these (including the exact procedures discussed in section 6) yield “asymptotically valid” procedures under much weaker assumptions than those used to obtain finite-sample results. its distribution is completely invariant to the unknown J matrix (or the error covariance matrix). the hypothesis β = β 0 tested by the AR test can be written in this form [see Dufour and Khalaf (2000)]. This is called a uniform linear (UL) hypothesis. see Dufour and Khalaf (2002). less restrictive. However. because the distribution of u is not taken to be necessarily N 0. this approach allows one to consider any (possibly non-gaussian) distribution on w. In particular. . the distribution of the corresponding LR statistic can be bounded by the LR statistic for a UL hypothesis (which is pivotal). can be obtained in this way. This distributional assumption is. Further. u Consider now an hypothesis of the form H0 : RBC = D (7. The AR test can also be obtained as a monotonic transformation of a statistic of the form LR(H0 ). More generally. 27 . . The corresponding gaussian LR statistic is ˆ ˆ LR(H0 ) = T ln(|Σ0 |/|Σ|) (7. . it is of interest to note that the LR statistic for about any hypothesis on B can be bounded by a LR statistic for an appropriately selected UL hypothesis: setting b = vec(B) and H0 : Rb ∈ ∆0 (7. it is also possible to use maximized Monte Carlo tests [Dufour (2002)]. An important feature of LR(H0 ) in this case is that its distribution under H0 does not involve nuisance parameters and may be easily simulated (it is a pivot). more restrictive than the one made in section 5.18 Multivariate extensions of AR tests. see Dufour and Khalaf (2001) and Dufour (2002). To avoid the use of such bounds (which may be quite conservative). which impose restrictions on several structural equations.4) ˆ ˆ ˆ ˆ ˆ ˆ where Σ = U U /T and Σ0 = U0 U0 /T are respectively the unrestricted and restricted estimates of the error covariance matrix. the pitfalls and limitations of such arguments should be remembered: there is no substitute for a provably exact procedure. . in view of the discussion in section 4.5) where R an arbitrary q × k(G + 1) matrix and ∆0 is an arbitrary subset of Rq . in a way. for example.1 — because of the assumption on V — and in another way. If we aim at getting tests and confidence sets for nonparametric versions of the SEM (where the 18 For further discussion of Monte Carlo test methods. Wn ) has a known distribution and J is an unknown nonsin˜ gular matrix (which enters into the covariance matrix Σ of the error vectors Ut ). This covers as special cases all restrictions on the coefficients of SEM (as long as they are written in the MLR form). In such a case.3) where R. C and D are fixed matrices. we can use Monte Carlo test techniques — a form of parametric bootstrap — to obtain exact test procedures.

. T. However. While GMM estimators of θ have nonstandard asymptotic distributions. . In such models. θ0 ) = zt (θ0 . θ can be viewed as identifiable if there is only one value of θ [say. Zt is a vector of conditioning variables (or instruments) — usually with a number of additional distributional assumptions — and Eθ [ · ] refers to the expected value under a distribution with parameter value θ. But problems similar to those noted for linear SEM do arise. a first attempt at deriving finite-sample procedures is available in Dufour and Taamouti (2001b). In view the discussion in section 4. θ = ¯ that satisfies (7. Under parametric assumptions on the errors.e. yt is a vector endogenous variables. . Nonlinear structural models typically take the form: ft (yt . this may be achievable by looking at distribution-free procedures based on permutations. This is not surprising: parametric nonseparability arises here for two reasons. (7. 2003). however.error distribution involves an infinite set of nuisance parameters). once a joint confidence set for θ has been built. i. . inference on individual parameters can be drawn via projection methods. . who proposed an extension of the K(β 0 ) test. are “weakly sensitive” to the value of θ. θ is vector of unknown parameters. There is very little work on this topic in the SEM. θ) | Zt ] = 0 . ranks or signs. the objective function minimized by the GMM procedure follows an asymptotic distribution which is unaffected by the presence of weak instruments: it is asymptotically pivotal.6) where ft (·) is a vector of possibly nonlinear relationships. For an interesting first look. θ1 )γ + εt . Eθ [ut | Zt ] = 0 .2. xt . T. Stock and Wright (2000) studied the asymptotic distributions of GMM-based estimators and test statistics under conditions of weak identification (and weak “high level” asymptotic distributional assumptions). Nonlinearity makes it difficult to construct finite-sample procedures even in models where identification difficulties do not occur. and we θ] have weak identification (or weak instruments) when the expected values E¯ [ft (yt . θ t. for hypotheses of the form θ = θ0 and the corresponding joint confidence sets. Other contributions in this area include papers by Kleibergen (2001a. . So it is not surprising that work in this area has been mostly based on large-sample approximations. . . the reader should look at an interesting recent paper by Bekker (2002). T. xt . . 2002) proposed tests of underidentification and identification. θ) = ut .6). . Of course. the hypothesis θ = θ0 is tested by testing γ = 0 in an auxiliary regression of the form: ft (yt . 7. . the fact that all these methods are based on large-sample approximations without a finite-sample theory remains a concern. model nonlinearity and the possibility of non-identification. xt . t. So tests and confidence sets based on the objective function can be asymptotically valid irrespective of the presence of weak instruments.7) 28 . Research on weak identification in nonlinear models remains scarce. xt is a vector of exogenous variables. and Wright (2003. . Nonlinear models It is relatively difficult to characterize identification and study its consequences in nonlinear structural models. (7. t. These results are achieved for the full parameter vector θ.

As in the case of linear SEM. The above difficulties underscore the pitfalls of large-sample approximations. Inference on nonlinear regressions are also covered by this setup. via standard least-square-based “heteroskedasticity-robust” standard errors.. but parameter vectors can be (at least in parametric models). individual parameters in statistical models are not generally meaningful.where the zt (θ0 . (b) In many models. we will summarize the main points made in this paper. (a) Standard errors do not constitute a valid way of assessing parameter uncertainty and building confidence intervals. which are typically based on pointwise (rather than uniform) convergence results and may be arbitrarily inaccurate in finite samples. There are basic pitfalls and limitations faced in developing inference procedures in econometrics. this type of difficulty arises for Wald-type statistics in the presence of weak instruments (or weakly identified models) 2. while restrictions on the whole parameter vector are. (b) trying to solve an inference problem using a technique that cannot deliver a solution because of the very structure of the technique. If we are not careful. 1.g. As a result. or (ii) building a confidence interval for a parameter which is not identifiable in a structural model. such as an hypothesis on a moment in the context of an insufficiently restrictive nonparametric model. via the usual technique based on standard errors. a unit root hypothesis) on a dynamic model while allowing a dynamic structure with an unlimited (not necessarily infinite) number of parameters. as in (i) testing an hypothesis on a mean (or median) under heteroskedasticity of unknown form. Conclusion By way of conclusion. 3. 29 . We called this phenomenon parametric nonseparability. and projection methods can be used to draw inference on subvectors of θ. several of the intuitions derived from the linear regression model and standard asymptotic theory can easily be misleading. One gets in this way point-optimal tests [see King (1988) and Dufour and King (1991)]. such as structural models where parameters may be underidentified. In many econometric problems (such as. θ1 ) are instruments in a way that maximizes power against a reference alternative (point-optimal instruments). In particular. restrictions on individual coefficients may not be testable. sample-split techniques may be exploited to approximate optimal instruments. we can easily be led into ill-defined problems and find ourselves: (a) trying to test a non-testable hypothesis. This feature should play a central role in designing methods for dealing with weakly identified models. inference on structural models). 8. or an hypothesis (e.

4. In the specific example of SEM. 30 . (c) Trying to adapt and improve AR-type procedures (without ever forgetting basic statistical principles) constitutes the most promising avenue for dealing with weak instruments. the following general remarks are in our view important. we can construct valid tests and confidence sets for the parameter vector. we have emphasized the following points. (b) It is possible to improve the power of AR-type procedures (especially by reducing the number of instruments). to excluded instruments or to the specification of a model for the endogenous explanatory variables. one should always look for pivots as the fundamental ingredient for building tests and confidence sets. but power improvements may come at the expense of using a possibly unreliable large-sample approximation or losing robustness (such as robustness to excluded instruments). (c) Given a pivot for a parameter vector. Concerning solutions to such problems. there is a trade-off between power (which is typically increased by considering more restrictive models) and robustness (which involves considering a wider hypothesis). but they can be obtained in a much wider set of cases for appropriately selected vectors of parameters. (d) Inference on individual coefficients may then be derived through projection methods. such as robustness to the presence of weak instruments. (b) Pivots are not generally available for individual parameters. (a) Besides being pivotal. As usual. 5. and more specifically in the context of weakly identified models. (a) In accordance with basic statistical theory. the AR statistic enjoys several remarkable robustness properties.

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