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
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
This is the end of the preview.
Sign up
to
access the rest of the document.
 Winter '07
 SandraBlack
 Regression Analysis, zi, instrumental variables regression

Click to edit the document details