1.

What is the application of simultaneous equations models in economic

theory?

A Simultaneous Equation Model (SEM) is a model in the form of a set of linear

simultaneous equations. Where introductory regression analysis introduces models
with a single equation (e.g. simple linear regression), SEM models have two or
more equations. In a single-equation model, changes in the response variable (Y)
happen because of changes in the explanatory variable (X); in an SEM model,
other Y variables are among the explanatory variables in each SEM equation. The
system is jointly determined by the equations in the system; In other words, the
system exhibits some type of simultaneity or “back and forth” causation between
the X and Y variables.

Examples of simultaneous equation.

a. Goods market equilibrium

b. Market equilibrium for substitute and complementary goods.
c. Revenue and cost function
d. National income model
2. Identify the use of panel data over cross sectional observation and time
series data.
What are the advantages of panel data over cross-section or time series data?
1. Since panel data relate to individuals, regions, states, countries, etc., over time, there is bound to be
heterogeneity in these units. The techniques of panel data estimation can take such heterogeneity explicitly
into account by allowing for individual-specific variables, as we shall show shortly. We use the term individual
in a generic sense to include micro-units such as individuals, regions, states, and countries.
2. By combining time series and cross-section observations, panel data give ―more informative data, more
variability, less collinearity among variables, more degrees of freedom and more efficiency.‖
3. By studying the repeated cross section of observations, panel data are better suited to study the dynamics
of change. Spells of unemployment, job turnover, and labor mobility are better studied with panel data.
4. Panel data can better detect and measure effects that simply cannot be observed in pure crosssection or
pure time series data. For example, the effects of innate ability on earnings can be better studied if we include
individual fixed effect, which cannot be captured by either crosssection or time series data. In short, panel
data can enrich empirical analysis in ways that may not be possible if we use only cross-section or time series
data

5. What is simultaneous Equation model

 A system describing the joint dependence of variables is called a system of simultaneous
equation or simultaneous equations model. The number of equations in such models is
equal to the number of jointly dependent or endogenous variables involved in the
phenomenon under analysis.

8.Structural models .

A structural model describes the complete structure of the relationships among the
economic variables. Structural equations of the model may be expressed in terms of
endogenous variables, exogenous variables and disturbances (random variables). The
parameters of structural model express the direct effect of each explanatory variable on
the dependent variable. Variables not appearing in any function explicitly may have an
indirect effect and is taken into account by the simultaneous solution of the system. For
instance, a change in consumption affects the investment indirectly and is not
considered in the consumption function. The effect of consumption on investment
cannot be measured directly by any structural parameter, but is measured indirectly by
considering the system as a whole.

Example: The following simple Keynesian model of income determination can be

considered as a structural model.

-------------------------------------------------------------- (3)

-------------------------------------------------------------- (4)

For and

Where: C = consumption expenditure

Z = non-consumption expenditure

Y = national income

C and Y are endogenous variables while Z is exogenous variable

3. Reduced form of the model .

The reduced form of a structural model is the model in which the endogenous variables are
expressed a function of the predetermined variables and the error term only.
Illustration: Find the reduced form of the above structural model. Since C and Y are endogenous variables and
only Z is the exogenous variables, we have to express C and Y in terms of Z. To do this substitute Y=C+Z into
equation (3)

-------------------------------------------------------------- (5)
Substituting again (5) into (4) we get;

---------------(6)
Equation (5) and (6) are called the reduced form of the structural model of the above. We can write this more
formally as:
Structural form equations Reduced form equations
Parameters of the reduced form measure the total effect (direct and indirect) of a change in exogenous
variables on the endogenous variable. For instance, in the above reduced form
4

equation (5),
measures the total effect of a unit change in the non-consumption expenditure
on consumption. This total effect is β, the direct effect, times , the indirect effect.
The reduced form equations can be obtained in two ways: 1) To express the endogenous variables directly as a
function of the predetermined variables. 2) To solve the structural system of endogenous variables in terms of
the predetermined variables, the structural parameters, and the disturbance terms.
Consider the following simple model for a closed economy.
--------------------------------------------------------- (i)
----------------------------------------------- (ii)
------------------------------------------------------- (iii) This model has three equations in three endogenous
variables ( , , and ) and two predetermined variables ( , and ).
To obtain the reduced form of this model, we may use two methods (direct method and solving the structural
model method).
4. Recursive models.
A model is called recursive if its structural equations can be ordered in such a way that the first
equation includes only the predetermined variables in the right hand side; the second equation
contains predetermined variables and the first endogenous variable (of the first equation) in the
right hand side and so on. The special feature of recursive model is that its equations may be
estimated, one at a time, by OLS without simultaneous equations bias

10.Three distinct problem of simultaneous Equation model

Simultaneous equation models create three distinct problems. These are:
1. Mathematical completeness of the model: any model is said to be (mathematically) complete
only when it possesses as many independent equations as endogenous variables. In other words if we happen
to know values of disturbance terms, exogenous variables and structural parameters, then all the endogenous
variables are uniquely determined.
2. Identification of each equation of the model: Many times it so happens that a given set of
values of disturbance terms and exogenous variables yield the same values of different endogenous variables
included in the model. It is because the equations are observationally indistinguishable, what is needed is that
the parameters of each equation in the system should be uniquely determined. Hence, certain tests are
required to examine the identification of each equation before its estimation.
3. Statistical estimation of each equation of the model : Since application of OLS yield biased
and inconsistent estimates, different statistical techniques are to be developed to estimate the structural
parameters.
9. Some of the most common simultaneous methods of estimation are :
i) .The indirect least square method (ILS)
ii). the two-stage least square method (2SLS)
iii). the three-stage least square method (3SLS)
IV). Limited information maximum likelihood method (LIML)
v) .The instrumental variable method (IV)
vi). the mixed estimation method;
vii) .The full information maximum likelihood method (FIML)
Of the three problems, we are going to discuss the second problem (the identification problem) in the
following section.
7. What is the method of estimation which is used to avoid the simultaneous
equation bias?
The bias arising from application of such procedure of estimation which treats each equation of the
simultaneous equations model is known as simultaneity bias or simultaneous equation bias. To avoid this bias
we will use other methods of estimation, such as,
I. Indirect Least Square (ILS),
II. Two Stage Least Square (2SLS),
III. Three Stage Least Square (3SLS),
IV. Maximum Likelihood Methods &
V. The Method of Instrumental Variable (VI)
6. Endogenous and exogenous variables
In simultaneous equation models variables are classified as endogenous and exogenous.

Endogenous variables are variables that are determined by the economic model (within the system) and
exogenous variables are those determined from outside.

Exogenous variables are also called predetermined.

Predetermined groups can be divided into two categories which are considered in general as exogenous
variables. These are: current and lagged exogenous and lagged endogenous. For instance; Xt and Xt−1 depict
the current and lagged exogenous variables and Yt−1 depicts lagged endogenous variable. This is on the
assumption that X’s symbolize the exogenous variables and Y’s symbolize the endogenous variables. Thus, Xt,
Xt−1 and Yt−1 are regarded as predetermined (exogenous) variables.
Since the exogenous variables are predetermined, they are supposed to be independent of the error terms in
the model.
Consider the demand and supply functions.
 -------------------------------------------------------------- (1)
-------------------------------------------------------------- (2) Where: Q = quantity, Y = income, P = price, R = Rainfalls, U1
&U2 are error terms.
Here P and Q are endogenous variables and Y and R are exogenous variables.
17. Why Panel Data?
What are the advantages of panel data over cross-section or time series data?
1. Since panel data relate to individuals, regions, states, countries, etc., over time, there is bound to be
heterogeneity in these units. The techniques of panel data estimation can take such heterogeneity explicitly
into account by allowing for individual-specific variables, as we shall show shortly. We use the term individual
in a generic sense to include micro-units such as individuals, regions, states, and countries.
2. By combining time series and cross-section observations, panel data give ―more informative data, more
variability, less col linearity among variables, more degrees of freedom and more efficiency.
3. By studying the repeated cross section of observations, panel data are better suited to study the dynamics
of change. Spells of unemployment, job turnover, and labor mobility are better studied with panel data. 4.
Panel data can better detect and measure effects that simply cannot be observed in pure cross section or pure
time series data. For example, the effects of innate ability on earnings can be better studied if we include
individual fixed effect, which cannot be captured by either cross section or time series data. In short, panel
data can enrich empirical analysis in ways that may not be possible if we use only cross-section or time series
data
14. What is the difference between balanced and unbalanced panel?
It is assumed that there are a maximum of N cross sectional units or observations and a maximum of T time
periods. If each cross-sectional unit has the same number of time series observations, then such a panel (data)
is called a balanced panel. In the present example we have a balanced panel, as each region in the sample has
20 observations. If the number of observations differs among panel members, we call such a panel an
unbalanced panel.