Exercise – SIMULTANEOUS EQUATIONS MODELS

August 2021
1. Explain the meaning of each of the following terms:
(a) Endogenous variables.
An endogenous variable is a variable in a statistical model that's changed
or determined by its relationship with other variables within the model. In
other words, an endogenous variable is synonymous with a dependent
variable, meaning it correlates with other factors within the system being
studied. Therefore, its values may be determined by other variables.

(b) Exogenous variables.

Endogenous variables are the opposite of exogenous variables, which are
independent variables or outside forces. Exogenous variables can have an
impact on endogenous factors, however.

(c) Structural equations.

Structural equations specify, by means of a set of linear equations, how a
set of variables are related to each other in terms of cause and effect.

(d) Reduced – form equations.

The reduced form of a set of structural equations, is the form produced by
solving for each dependent variable such that the resulting equations
express the endogenous variables as functions of the exogenous variables. 

(e) Order condition for identification.

The Rule is a as follows;

Let g be the number of endogenous variables in the system

k the total number of variables (endogenous and exogenous) missing from
the equation under consideration.

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 Then:
If k = g – 1, the equation is exactly identified.
If k > g – 1, the equation is over-identified.
If k < g – 1, the equation is under-identified.

(f) Rank condition for identification.

The Rule is a as follows;

Delete the particular row.

Pick up the columns corresponding to the elements that have zero in that
row.
If from this array of columns, we can find rows and columns that are not
all zeros, then the equation is identified. Otherwise, not.
If there is one such column (or row), delete that column (or row).

(g) Indirect least squares.

A method for estimating the structural parameters of a single equation in
a simultaneous equations model. It involves estimating the parameters of
the system in the reduced form using ordinary least squares and solving
for the structural parameters in terms of the reduced form parameters.

(h) Two-stage least squares.

Two-Stage least squares
technique that is used in
technique is the extension
dependent variable’s error
variables.
(2SLS) regression analysis is a statistical
the analysis of structural equations.  This
of the OLS method.  It is used when the
terms are correlated with the independent

(i) Instrumental variable methods.

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 An instrumental variable (sometimes called an “instrument” variable) is a
third variable, Z, used in regression analysis when you have endogenous
variables—variables that are influenced by other variables in the model. In
other words, you use it to account for unexpected behavior between
variables.
Using an instrumental variable to identify the hidden (unobserved)
correlation allows you to see the true correlation between the explanatory
variable and response variable, Y.

(j) Normalization.
The issue of normalization arises whenever two different values of
unknown parameters imply the identical economic model. A
normalization does not just imply a rule for selecting which point, among
equivalent ones, to call the maximum likelihood estimator (MLE). It also
governs the topography of the set of points that go into a small-sample
confidence interval associated with that MLE.

2. Explain concisely what is meant by “the identification problem” in the context of

the linear simultaneous equation model.

The identification problem is a deductive, logical issue that must be solved

before estimating an economic model.
In demand and supply model, the equilibrium point belongs to both curves, and
many presumptive curves can be drawn through such a point.
We need prior information on the slopes, intercepts and error terms to identify
the true from the presumptive demand and supply curves.

3. Consider the three-equation model

y 1 = β 13 y 3 + γ 12 x 2 + u1

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 y 2 = β 21 y 1 + β 23 y 3 + γ 21 x 1 + γ 22 x 2 + u2
y 3 = γ 33 x3 + u3

where y 1 , y 2 , and y 3 are endogenous and x 1 , x 2 , and x 3 are

exogenous. Discuss the identification of each of the equations of the model, based
on the order and rank conditions.
Now suppose that you want to estimate the first equation by two – stage least
squares, but you have only an ordinary least squares program available. Explain

carefully, step by step, how you would estimate

β 13 , γ 12 , and var( u1 ) .

Done

4. The structure of a model with four endogenous and three exogenous variables is
as follows (1 indicates presence and 0 absence of the variable in the equation):

1 0 1 1 1 0 0
1 1 1 0 0 1 1
0 0 1 0 1 0 0
1 0 1 1 0 1 0
Which of the four equations are identified?

Let’s say the four endogenous variables are

y1 , y2 , y3 , y4 and three

exogenous variables are

z 1 , z 2 , z 3 . i.e.

Y1 Y2 Y3 Y4 Z1 Z2 Z3

1 0 1 1 1 0 0

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 1 1 1 0 0 1 1

0 0 1 0 1 0 0

1 0 1 1 0 1 0

To check the rank condition for the equations, we delete the row and pick
up the columns corresponding to the missing variables we get,

Equation 1 – Not Identified

1 1 1
0 0 0
0 1 0

Equation 2 – Identified

1 1
0 1
1 0

Equation 3 – Identified

1 0 1 0 0
1 1 0 1 1
1 0 1 1 0

Equation 4 – Identified

0 1 0
1 0 1
0 1 0

Therefore, equations 2,3 and 4 are identified.

5. Consider the model

Q= β 0 + β 1 P w + β 2 Y + u Demand function
Q= α 0 + α 1 P w + α 2 S + u Supply function

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Estimate this model by 2SLS, Instrumental Variable, and indirect least squares
methods using the data in Table 6.5.1 (transform all variables to logs). Would
you get different results using the three methods?
How would you choose the appropriate normalization?

(with respect to Q or Pw )? Does normalization matter in this model?

Pending

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