Lecture 13 - LECTURE 13 INSTRUMENTAL VARIABLES REGRESSION...

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LECTURE 13: INSTRUMENTAL VARIABLES REGRESSION Two important threats to internal validity are: Omitted variable bias from a variable that is correlated with X but is unobserved, so cannot be included in the regression; Simultaneous causality bias (X causes Y, Y causes X); Instrumental variables regression can eliminate bias when E( ε |X) 0 – using an instrumental variable, Z . IV REGRESSION WITH ONE REGRESSOR AND ONE INSTRUMENT Y i = β 0 + β 1 X i + ε i IV regression breaks X into two parts: a part that might be correlated with ε , and a part that is not. By isolating the part that is not correlated with ε , it is possible to estimate β 1 . This is done using an instrumental variable , Z i , which is uncorrelated with ε i . The instrumental variable detects movements in X i that are uncorrelated with ε i , and uses these to estimate β i . TERMINOLOGY: ENDOENEITY AND EXOGENEITY An endogenous variable is one that is correlated with ε An exogenous variable is one that is uncorrelated with ε
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