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LECTURE / DISCUSSION

Simultaneous Equations

Regression Analysis Tutorial 229

Simultaneous Equations

Example 1

Gas

consumption

OLS estimate

. .

. true

. . .

. .

. . .

. .

. .

. . .

Thermostat

. setting

thermostat setting, thermostat setting is

correlated with g .

Regression Analysis Tutorial 230

Example 2

MOU ' % (price) % (Nemply) % g

Price ' % (MOU) % (region dum.) % µ

MOU

OLS

.

.

.

.

.

.

. . .

.

. true

. Price

Demand

price, price is correlated with g .

Regression Analysis Tutorial 231

Example 3

Demand: Q = " + $P + g

Supply: P = 8 + 2Q + µ

Regression Analysis Tutorial 232

M ' % P % N % g

P ' % M % R % µ

Endogenous: M, P

Exogenous: R, N

exogenous variables.

M = a + bR + cN + e

P = d + fR + gN + u

Get M̂ , P̂

explanatory variables M and P with predicted

values M̂ and P̂ .

M ' % P̂ % N % g(

P ' % M̂ % R % µ (

Regression Analysis Tutorial 233

Or apply IV directly.

Regress M = " + $P + 2N + g

with instruments N and R

and P = 8 + NM + 0R + µ

with instruments N and R .

TSP commands:

2sls(inst = (c,n,r)) p c,m,r ;

or

inst m c,p,n invr c,n,r ;

inst p c,m,r invr c,n,r ;

Regression Analysis Tutorial 234

Reduced-Form Equation

M = " + $P + 2N + g

P = 8 + NM + 0R + µ

Reduced-form

equations: endogenous variables expressed as a

function of exogenous variables.

M ' % ( % M % R % µ) % N % g

M ' % % M % R % N % µ % g

(1 & )M ' % % R % N % µ % g

% µ % g

M ' % R % N %

1& 1& 1& 1&

| | | |

| | | |

M= a + bR + cN + e

Regression Analysis Tutorial 235

Similarly,

% g % µ

P ' % R % N %

1& 1& 1& 1&

| | | |

| | | |

P= d + fR + gN + u

Regression Analysis Tutorial 236

2SLS. Structural equations are estimated in second

step of 2SLS.

because exogenous variables are uncorrelated with

errors.

parameters and the structural parameters.

For example:

c '

1&

Regression Analysis Tutorial 237

an exogenous variable.

M = " + $P + 2N + g

P = 8 + NM + 0R + µ

N rises by 1 unit:

M increases by 2

P increases by N2

M increases by $[N2]

P increases by N[$N2] = $N22

M increases by $[$N22] = $2N22

P increases by N[$2N22] = $2N32

M increases by $[$2N32] = $3N32

.

.

.

Total effect on M

4

% % ( ) 2

% ( ) 3

% ... ' j ( )t

t'0

'

1&

Regression Analysis Tutorial 238

Total effect on P

% 2

% 2 3

' % ( ) % ( )2

4

' j( )t '

t'0 1&

Regression Analysis Tutorial 239

reduced-form parameters.

% %

a ' d '

1& 1&

b ' f '

1& 1&

c ' g '

1& 1&

b g

' ' etc.

f c

Regression Analysis Tutorial 240

Example:

if â ' 4 d̂ ' 8

b̂ ' 3 f̂ ' 2

ĉ ' 7 ĝ ' 3.5

ˆ ' 1.5 ˆ ' 0.50

ˆ ' 1.75 ˆ ' 0.50

Regression Analysis Tutorial 241

M ' % P % N % I % g

P ' % M % R % µ

7 structural parameters

Reduced-form equations:

M = a + bN + cI + dR + e

P = f + gN + hI + RR + u

8 reduced-form parameters

reduced form parameters.

Regression Analysis Tutorial 242

M ' % P % g

P ' % M % R % µ

5 structural parameters

Reduced-form equations

M = a + bR + e

P = c + dR + u

4 reduced-form parameters

solutions.

Regression Analysis Tutorial 243

P̂ ' ĉ % d̂R

Step 2: M ' % P̂ % g

P ' % M̂ % R % µ

' % â % b̂R % R % µ

' ( % â) % ( b̂ % )R % µ

Regression Analysis Tutorial 244

Identification

Just identified NRFP = NSP 2SLS = ILS

Over identified NRFP > NSP 2SLS

Under identified NRFP < NSP Cannot estimate

NSP: Number of structural parameters.

Regression Analysis Tutorial 245

Efficiency

between errors. So, 2SLS is not efficient.

M ' % P % N % g

P ' % M % R % µ

g, µ correlated

probably also high and hence M is higher than predicted

from P and N only.

Regression Analysis Tutorial 246

and µ̂ .

included as explanatory variables.

M ' % P̂ % N % µ̂ % g((

P ' % M̂ % R % ĝ % µ ((

information for explaining M and ĝ provides

information for explaining P . Including this

information makes the estimates better.

Regression Analysis Tutorial 247

Special Case:

Seemingly Unrelated Equations

Yn ' % X n % gn

Wn ' % Sn % µ n

But: gn and µn are correlated.

Wn = temperature in Monterey.

equations are the same as the structural equations.

Get residuals ĝ n and µ̂ n .

explanatory variables:

(

Yn ' % Xn % µ̂ n % gn

(

Wn ' % S n % ĝ n % µ n

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