University of Wisconsin–Madison Spring 2018, ECON 710

Department of Economics M. Sølvsten, J. Freyberger

Problems for Linear IV Regression

• Problems 1–5 are designed to give you insights about basic IV estimation.

• Problems 1–5 are also good practice for the midterm.

• Problems 6 and 7 are designed to give you experience with implementation of

some of the inference methods discussed in lecture. They also provide some
insights about the issues of weak and many instruments.

• Problems 6 and 7 are due at the beginning of lecture 6 (February 12).

1. (Rational Expectations Model): For an observed sample of T observations (yt , xt ) ∈

R2 , suppose that

yt = E[xt | (ys , xs )t−1

s=1 ]β0 + vt

xt = E[xt | (ys , xs )t−1

s=1 ] + ηt (t = 1, . . . , T )

where (vt , ηt ) are i.i.d. with E[k(vt , ηt )k2 ] < ∞ and E[(vt , ηt )] = 0.

Context: yt could be investment and xt could be sales of a given company, both

in period t. Then we have that investment in period t reacts to the company’s
expected sales for period t where the expectation takes into account the past
sales and investments (ys , xs )t−1
s=1 . However, the researcher does not observe the

expectation function, but observes the realized sales which are expected sales plus
noise.

(a) In the model

yt = xt β0 + εt .

Determine what εt is. Determine whether xt is endogenous, i.e., is E[εt |

xt ] = 0?

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University of Wisconsin–Madison Spring 2018, ECON 710
Department of Economics M. Sølvsten, J. Freyberger

(b) Does the assumptions imply exogeneity of xt−1 or yt−1 ? What about xt+1
or yt+1 ? What about xt−2 or yt−2 ?

Suppose that E[x2t ] < ∞ and E[xt−1 xt ] 6= 0.

(c) Are any of the exogenous instruments in (b) also relevant?

2. (Linear Regression Model): For an observed random sample of n observations

(yi , xi ) ∈ R2 , suppose that

y i = xi β 0 + εi (i = 1, . . . , n)

where E[εi | xi ] = 0 and E[ε2i | xi ] = σ 2 .

(a) Is zi = x2i an exogenous instrument for xi ?

(b) What assumption makes zi = x2i a relevant instrument for xi ?

Pn −1 Pn
You may use that the IV estimator β̂IV = ( i=1 zi xi ) i=1 zi yi satisfies,

√  σ 2 E[zi2 ]
!

d
n β̂IV − β0 →− N 0,
E[zi xi ]2

for exogenous and relevant instruments.

(c) Compare the two IV estimators that use respectively zi = xi and zi = x2i
as instruments (asuming that zi = x2i is relevant). Is one estimator always
(weakly) more efficient than the other? What happens if xi is constant
across i?

3. (Indirect Least Squares) For an observed random sample of n observations (yi , xi , zi ) ∈

R3 , consider

yi = xi β0 + εi

xi = zi π0 + ui (i = 1, . . . , n) (1)

where E[(εi , ui ) | zi ] = 0 and E[zi2 ]π0 6= 0.

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University of Wisconsin–Madison Spring 2018, ECON 710
Department of Economics M. Sølvsten, J. Freyberger

(a) Write

yi = γ0 zi + vi (2)

where γ0 and vi are functions of β0 , π0 , εi and ui .

(b) What is the value of γ0 /π0 ? Is E[vi | zi ] = 0?

(c) Let π̂ and γ̂ be OLS estimators applied to (1) and (2). Show that the IV
estimator applied to the simultaneous model is equal to γ̂/π̂.

4. (Method of Moments Estimator) For an observed random sample of n observa-

tions (yi , xi , zi ) ∈ R3 , suppose that

yi = α0 + xi β0 + εi

with E[εi | zi ] = 0.

(a) Show that C(zi , xi ) 6= 0 is equivalent to relevance of (1, zi )0 as an instrument

for (1, xi )0 .
C(zi ,yi )
(b) Show that β0 = C(zi ,xi )
when C(zi , xi ) 6= 0.

(c) Show that the IV estimator of α0 , β0 using (1, zi )0 as an instrument for

(1, xi )0 has its second entry equal to
1 Pn
Ĉ(zi , yi ) n i=1 (zi − z̄)(yi − ȳ)
β̂ = = 1 Pn .
Ĉ(zi , xi ) n i=1 (zi − z̄)(xi − x̄)

5. (Included Exogenous Regressors) For an observed random sample of n observa-

tions (yi , xi , zi , wi0 ) ∈ R3+m , suppose that

yi = xi β0 + wi0 γ0 + εi

with E[εi | zi , wi ] = 0.
P −1 P
Let δ̂ = n
i=1 wi wi0 n
i=1 wi zi be the OLS estimator in the regression model

zi = wi0 δ0 + νi ,

and define zi⊥ = zi − wi0 δ̂.

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University of Wisconsin–Madison Spring 2018, ECON 710
Department of Economics M. Sølvsten, J. Freyberger

(a) Is zi⊥ an exogenous instrument in the sense that E[εi | zi ] = 0?

Consider the IV regressor that uses zi⊥ as an instrument, but ignores wi :

1 Pn ⊥
n i=1 zi yi
β̃IV = .
zi⊥ xi

(b) Show that

1 Pn ⊥
n i=1 zi εi
β̃IV = β0 +
zi⊥ xi

Consider the IV regressor that uses (zi , wi0 ) as an instrument for (xi , wi0 ):
  −1  
1
n
X  zi xi zi wi0  1 n
X z y
 i i
β̂IV =  .
n i=1 w x w w0 n i=1 w y
  
i i i i i i

(c) (Hard) Show that the first entry of β̂IV is equal to β̃IV .

Hint: You may need to rely on block-wise inversion of matrices (equivalently

the proof of the Frisch–Waugh–Lovell theorem)

6. (Weak Instruments) For an observed random sample of n = 250 observations

(yi , xi , zi ) ∈ R3 , consider

y i = xi β 0 + εi

xi = zi π0 + ui (i = 1, . . . , n)
√
where β0 = 0, π0 = 1/ n, and
    
 εi    1 .7 0
    
ui  ∼ N 0, .7 1 0 .
    
    
    
zi 0 0 1

(a) In large samples the first-stage F -statistic has approximate expectation of

π02 nE[zi2 ]
1+ .
σu2
What is this value? What is the probability limit of β̂OLS ?

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University of Wisconsin–Madison Spring 2018, ECON 710
Department of Economics M. Sølvsten, J. Freyberger

(b) In a statistical software of your choice, generate data from the above model
and calculate the following five statistics (defined in lectures 3 and 4):
 √     
β̂OLS , β̂IV , F̂ , 1  √nβ̂IV
   
 > 1.96  ^
, 1 AR(0) > 1.96 .
V̂

HC

(c) Repeat (b) 10000 times and report the simulated median of each the first
two statistics and the simulated mean of the last three statistics. Relate
your findings to the model and theory presented in class.

Hint: The Canvas course site contains some incomplete R-code that can be used
to perform the simulations.

7. (Many (Weak) Instruments) For an observed random sample of n = 250 obser-

vations (yi , xi , zi0 ) ∈ R1+1+` , consider

y i = xi β 0 + εi

xi = zi0 π0 + ui (i = 1, . . . , n)

√
where ` = 15, β0 = 0, π0 = (1, . . . , 1)0 / n, and
    
 εi    1 .7 0 
    
ui  ∼ N 0, .7 1 0.
    
    
    
zi 0 0 I`

(a) In large samples the first-stage F -statistic is close to

nE[(zi0 π0 )2 ]
1+ ,
`σu2

What is this value? What is the probability limit of β̂OLS and β̂2SLS under
many (weak) instruments (lecture 5)?

(b) In a statistical software of your choice, generate data from the above model
and calculate the following five statistics (defined in lecture 5):
 √  
 nβ̂
β̂OLS , β̂2SLS , β̂JIV E , F̂ , 1  √

 2SLS  > 1.96 .
V̂

HC

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University of Wisconsin–Madison Spring 2018, ECON 710
Department of Economics M. Sølvsten, J. Freyberger

(c) Repeat (b) 10000 times and report the simulated median of each the first
three statistics and the simulated mean of each of the last two statistics.
Relate your findings to the model and theory presented in class.

0
zi π̂(i) −Pii xi
Hint: In calculating β̂JIV E , you can use that zi0 π̂(i) = 1−Pii
where Pii =
P −1
zi0 n 0
i=1 zi zi zi .

Your written answer to problems 6 and 7 must contain two files: (1) a pdf file
that contains your code and potentially the output, and (2) a pdf file that contains
your findings and discussion (maximum length of the second file is two pages).