Chapter 2: causal and noncausal models

Advanced Econometrics 1
topics
structural models
exogeneity
causality
Simultaneous Equation Model
Potential Outcome Model
structural models
suppose we want to model jointly the G variables contained in
y
0
= (y
1
, ..., y
G
}
jointly means that we allow for interdependencies between
elements in y
additionally we have K explanatory variables z
0
= (z
1
, ..., z
K
}
which we do not model explicitly
structural model (for observation i ) can be written as
g(y
i
, z
i
, u
i
j0} = 0 (2.1)
where u is an error term and 0 a vector of structural
parameters
g(y
i
, z
i
, u
i
j0} = 0 (2.1)
main objective of structural model is statistical inference
about 0
main assumption is a priori ordening of variables in cause (z)
and eect (y) relationships
y and z are labeled endogenous and exogenous variables
respectively
exogeneity of z implies that we dont need to model z
explicitly
g(y
i
, z
i
, u
i
j0} = 0 (2.1)
object of interest are structural or deep parameters 0
expressing y as function of z (and u) leads to reduced form
y
i
= f (z
i
, u
i
j} (2.2)
reduced form parameters are functions of 0
typically reduced form parameters have no causal
interpretation
exogeneity
set of variables W = |Y Z| with joint density f
J
(Wjc}
c = (c
1
, c
2
} and suppose c
1
parameter of interest
we can always write joint density as product of conditional
and marginal densities, i.e.
f
J
(Wjc} = f
C
(YjZ, c
1
} f
M
(Zjc
2
} (2.6)
Z exogenous with respect to c
1
when c
1
is functionally
independent of c
2
in case of exogeneity marginal model can be omitted from
analysis
conditional model alone is sucient for making inference on
c
1
exogeneity of a variable implies that we do not have to model
that variable explicitly
in time series analysis we further distinguish various types of
exogeneity:
weak exogeneity
Granger noncausality
strong exogeneity
weak exogeneity
f
J
(Wjc} = f
C
(YjZ, c
1
} f
M
(Zjc
2
} (2.6)
suppose parameter of interest is now ` = h(c} and not c
1
Z is weakly exogenous for ` if:
` = h(c
1
}, hence ` does only depend on c
1
c
1
and c
2
are variation free, i.e. (c
1
, c
2
} 2 4
1
4
2
under weak exogeneity no information is lost by considering
only conditional model f
C
(YjZ, c
1
} for conducting inference
on `
example
consider bivariate dynamic model:
y
t
= ,
1
z
t
,
2
y
t1
u
1t
z
t
=
1
y
t1

2
z
t1
u
2t
with (u
1t
, u
2t
}
0
IIN(0, 2}
endogeneity problem if o
12
6= 0
u
1t
= `u
2t
-
t
with

12

22
= ` and o
2
"
= o
11


2
12

22
hence, we have
y
t
= ,
1
z
t
,
2
y
t1
`u
2t
-
t
= (,
1
`}z
t
(,
2
`
1
}y
t1
`
2
z
t1
-
t
= c
1
z
t
c
2
y
t1
c
3
z
t1
-
t
y
t
= c
1
z
t
c
2
y
t1
c
3
z
t1
-
t
z
t
=
1
y
t1

2
z
t1
u
2t
with
(-
t
jz
t
, y
t1
, z
t1
} N(0, o
2
"
}
(u
2t
jy
t1
, z
t1
} N(0, o
22
}
conditional model is
(y
t
jz
t
, y
t1
, z
t1
} N(c
1
z
t
c
2
y
t1
c
3
z
t1
, o
2
"
}
marginal model is
(z
t
jy
t1
, z
t1
} N(
1
y
t1

2
z
t1
, o
22
}
c
1
= (c
1
, c
2
, c
3
, o
2
"
} and c
2
= (
1
,
2
, o
22
} are parameters of
conditional and marginal models respectively
we have
c
1
= ,
1
`, c
2
= ,
2
`
1
, c
3
= `
2
although
1
and
2
appear in the denitions of c
2
and c
3
, still
c
1
and c
2
are variation free
hence z
t
is weakly exogenous for c
1
structural parameters ,
1
and ,
2
are
,
1
= c
1
`, ,
2
= c
2
`
1
, ` =
c
3

2
as they cannot be determined solely from c
1
= (c
1
, c
2
, c
3
, o
2
"
},
z
t
is not weakly exogenous for ,
1
and ,
2
however, imposing o
12
= 0 (hence ` = 0) we get that
,
1
= c
1
and ,
2
= c
2
, hence z
t
is weakly exogenous for those
parameters too
nally, strong exogeneity occurs in this model when we in
addition impose
1
= 0 (which in this example equals
Granger-noncausality)
causality
structural models attempt to model causal relationships
between economic variables
interpretation of structural parameters as causal eects,
however, can be still problematic
ideally we need some sort of exogeneity to interpret structural
parameters as causal
linear Simultaneous Equations Model
g(y
i
, z
i
, u
i
j0} = 0 (2.1)
linear SEM is structural model with g a linear function
G equations
y
0
i
B z
0
i
= u
i
(2.10)
each column of B and contain parameters for specic
equation
structural parameters (previously labeled 0) are elements of B
(G G) and (K G)
structural equations:
behavioral
identity/equilibrium condition
variables:
endogenous: determined within SEM
exogenous: predetermined or determined outside SEM
form:
structural: based on economic theory
reduced: solution in terms of exogenous variables and error
terms
structural and reduced forms are
YB Z = U (2.11)
Y = Z(B
1
} UB
1
= ZR V (2.12)
reduced form can be estimated by OLS and used for
prediction of Y based on Z
structural form can be used for making causal statements
however, it cannot be estimated by OLS because simultaneous
equations bias occurs
example
consider structural model
y
1i
=
1
,
1
y
2i
u
1i
y
2i
= y
1i
z
1i
where 0 < ,
1
< 1
possible economic interpretation: y
1
consumption, y
2
income,
z
1
investments
,
1
is marginal propensity to consume
reduced form is
y
1i
=

1
1 ,
1

,
1
1 ,
1
z
1i

1
1 ,
1
u
1i
y
2i
=

1
1 ,
1

1
1 ,
1
z
1i

1
1 ,
1
u
1i
we have (N 2) data matrices
Y =

y
1
y
2

, Z =

i z
1

, U =

u
1
0

parameter matices are
B =

1 1
,
1
1

, =

1
0
0 1

reduced form is
Y = ZR V
R =
1
1 ,
1

1

1
,
1
1

, V =
1
1 ,
1

u
1
u
1

y
1i
=
1
,
1
y
2i
u
1i
y
2i
= y
1i
z
1i
OLS estimator of ,
1
equals
`
,
1
=
P
N
i =1
(y
2i
y
2
}(y
1i
y
1
}
P
N
i =1
(y
2i
y
2
}
2
= ,
1

1
N1
P
N
i =1
(y
2i
y
2
}u
1i
1
N1
P
N
i =1
(y
2i
y
2
}
2
`
,
1
is biased and inconsistent estimator of ,
1
because
Cov (y
2i
, u
1i
} 6= 0 (simultaneous equations bias)
using law of large numbers (Appendix A.3) it can be shown
that
plim
1
N 1
N
X
i =1
(y
2i
y
2
}u
1i
= Cov (y
2i
, u
1i
}
=
1
1 ,
1
Var (u
1i
}
plim
1
N 1
N
X
i =1
(y
2i
y
2
}
2
= Var (y
2i
}
=
Var (z
1i
} Var (u
1i
}
(1 ,
1
}
2
hence, the probability limit of the OLS estimator is
plim
`
,
1
= ,
1
(1 ,
1
}
Var (u
1i
}
Var (z
1i
} Var (u
1i
}
for ,
1
< 1 we have that plim
`
,
1
,
1
we can use z
1
as instrumental variable for y
2
to achieve
consistent estimation
instrumental variables (IV) estimator of ,
1
is
`
,
1
=
P
N
i =1
(z
1i
z
1
}(y
1i
y
1
}
P
N
i =1
(z
1i
z
1
}(y
2i
y
2
}
= ,
1

1
N1
P
N
i =1
(z
1i
z
1
}u
1i
1
N1
P
N
i =1
(z
1i
z
1
}(y
2i
y
2
}
because
plim
1
N 1
N
X
i =1
(z
1i
z
1
}u
1i
= 0
IV estimator is consistent
y
1i
=
1
,
1
y
2i
u
1i
y
2i
= y
1i
z
1i
causal interpretation of ,
1
as marginal propensity to consume
is somewhat problematic
income y
2
is endogenous, hence jointly determined with
consumption y
1
from reduced form we see that
0y
1
0y
2
=
@y
1
@z
1
@y
2
@z
1
hence, ,
1
is ratio of marginal responses of y
1
and y
2
on z
1
identication
YB Z = U (2.11)
Y = ZR V (2.12)
OLS estimator of structural form is inconsistent
OLS estimator of reduced form is consistent
identication: can we go back from reduced form parameters
to structural form parameters?
three possibilities:
unidentied
exactly identied
overidentied
consistent estimation of structural parameters feasible only for
(exact of over) identied models
YB Z = U (2.11)
Y = ZR V (2.12)
B = G G, = K G, 2 = G G, R = K G, D = G G
structural form has
G
2
KG
1
2
G(G 1} KG
1
2
G(G 1} = G
2
excess parameters
solution is to impose restrictions:
normalization
exclusion
other (identities, other linear restrictions, covariance
restrictions)
without additional parameter restrictions observationally
equivalent structures may exist
equivalent structures have identical reduced forms
suppose there exists nonsingular G G matrix H such that
YBH ZH = UH
reduced form is
Y = Z(H(BH}
1
} UH(BH}
1
= ZR V
which is identical to that of original structure (B, , 2)
identication can be checked equation by equation
necessary for identication is order condition: number of
excluded exogenous variables from equation j must at least
equal number of included endogenous variables in equation j
sucient is rank condition: consider the set of variables
excluded from equation j ; the matrix of coecients for these
variables in the other equations must have full row rank
in two-equation SEM rank condition is easy to verify: at least
one exogenous variable excluded from rst equation must
have nonzero coecient in second equation (and vice versa
for identication of second equation)
example: two-equation SEM
y
1
= ,
12
y
2

11
z
1

12
z
2

13
z
3

14
z
4
u
1
y
2
= ,
21
y
1

21
z
1

21
z
2
u
2
order condition for rst equation not satised: 0 excluded
exogenous variables and 1 included endogenous variable (y
2
)
order condition for second equation satised: 2 excluded
exogenous variables (z
3
and z
4
) and 1 included endogenous
variable (y
1
)
rank condition for second equation: either
13
6= 0 or
14
6= 0
(or both)
one degree of overidentication
example: exact identication
y
1i
=
1
,
1
y
2i
u
1i
y
2i
= y
1i
z
1i
second equation is identity, hence automatically identied
order condition for rst equation satised: 1 excluded
exogenous variable (z
1
) and 1 included endogenous variable
(y
2
)
reduced form for rst equation is
y
1i
=

1
1 ,
1

,
1
1 ,
1
z
1i

1
1 ,
1
u
1i
=
11

12
z
1i
v
1i
exact identication: unique solutions for
1
and ,
1
(given
11
and
12
) are

1
=

11
1
12
, ,
1
=

12
1
12
verifying order and especially rank conditions can be tedious,
especially in a large SEM
simpler alternative: think of identication in terms of the
possibility for IV estimation
structural equation is identied if and only if there exists a
consistent IV estimator for the parameters in the equation
in other words, if there are sucient instruments (order
condition) for the endogenous regressors that are correlated
(rank condition) with these variables
further remarks
SEM can be extended to nonlinear settings (Section 2.4.3)
in applied research it is nowadays common to focus on one
equation only; typically specication of a full SEM is avoided
(Section 2.6)
we distinguish full- versus limited-information structural
models; IV methods are example of limited-information
approach
in order to understand application of IV methods, however, it
is useful to think of instrumental variables arising from
exclusion restrictions within SEM