Slide 1

• We wish to estimate some specification

• However one of the regressors is endogenous

• That is one of the regressors is correlated with the error term

• Thus our coefficient estimate on the endogenous variable will be biased and
inconsistent

• What can we do about this?

Slide 2

• We can use an instrument variable approach

• That is we need to find a variable which satisfies two conditions

• Firstly it must be uncorrelated with the error term

• Secondly it must be correlated with the endogenous regressor

• This will yield us consistent estimates.

• Although the estimates will still be biased, the bias will be reduced

Slide 3

• What does the IV estimation approach actually estimate?

• It gives us the local average treatment effect

• That is we get the estimate for the people who are induced by the instrument
to receive the treatment

• This relies on the monotonicity assumption

• This means there are no defiers

• I.e. people who don’t get the treatment because of the instrument

• The LATE does not yield the average effect for everyone who gets the
treatment or for the whole population
 • Potentially problematic?

• However they are of some use to policymakers

Slide 4

• There are other potential problems with the IV estimation approach besides
the monotonicity assumption.

• Weak instruments can cause IV estimation to be more biased than OLS with
an endogenous regressor.

• Refer to plims’ on slides

Slide 5

• There are 3 IV estimation methods we will wish to explore

• Firstly 2SLS

• With this method estimate the endogenous variable as a function of your

instrument(s) in the first stage

• Then in the second stage, estimate the original specification with the
estimate from the first stage replacing the endogenous regressor

• This will yield us consistent estimates of all our coefficients

• One issue is that we do not get efficient estimates

• It is not the BLUE according to the Gauss-Markov Theorem if we have

heteroskedasticity

Slide 6

• Method 2 is two-step generalized method of moments

• This amends the problem of inefficiency

• With this method, in the first stage estimate the specification using 2SLS

• In the second stage we use the variance-covariance matrix and weight the
observations similar to a generalized least squares approach
 • In practice one should bootstrap the standard errors as they are typically
underestimated

Slide 7

• Our final approach would use an Arellano-Bond estimator

• With our first two methods we may struggle to find suitable instruments

• The AB estimator is useful in this scenario

• Firstly take first-differences to eliminate any individual fixed effects

• Under the assumption that there is no serial correlation and we have strict
exogeneity, we can use lags of the regressors and dependent variables as
instruments.