What are instrumental variables in econometrics?

An instrumental variable (sometimes called an “instrument” variable) is a third variable, Z, used in regression analysis when you have endogenous variables—variables that are influenced by other variables in the model. In other words, you use it to account for unexpected behavior between variables.

How do you identify a good instrumental variable?

The three main conditions that define an instrumental variable are: (i) Z has a casual effect on X, (ii) Z affects the outcome variable Y only through X (Z does not have a direct influence on Y which is referred to as the exclusion restriction), and (iii) There is no confounding for the effect of Z on Y.

What are instruments in econometrics?

An instrument is a variable that does not itself belong in the explanatory equation but is correlated with the endogenous explanatory variables, conditionally on the value of other covariates.

How do you select instrument variables?

You certainly can choose candidate instruments “through theoretical considerations or evidence found in past research”. Then a simple check is to compute their linear correlation with the suspected endogenous variable, and their linear correlation with the dependent variable.

What is an instrumental variable example?

An example of instrumental variables is when wages and education jointly depend on ability which is not directly observable, but we can use available test scores to proxy for ability.

Can an instrumental variable be a dummy variable?

The Instrumental Variable (IV) method is a standard econometric approach to address endogeneity issues (for example, when an explanatory variable is correlated with the error term). Many instruments rely on cross-sectional variation produced by a dummy variable, which is discretized from a continuous variable.

What is identification econometrics?

Identification, in econometrics, is a problem which tells whether structural parameters can be obtained or not from reduced form parameters. Cite. 1 Recommendation.

Can you have two instrumental variables?

Empirical researchers often combine multiple instrumental variables (IVs) for a single treatment using two-stage least squares (2SLS). We apply these results to an empirical analysis of the returns to college with multiple instruments.

How do instrumental variables work?

The idea behind instrumental variables is that the changes in treatment that are caused by the instrument are unconfounded (since changes in the instrument will change the treatment but not the outcome or confounders) and can thus be used to estimate the treatment effect (among those individuals who are influenced by …

Can a dummy be an instrumental variable?

What is linear probability model in econometrics?

A linear probability model (LPM) is a regression model where the outcome variable is a binary variable, and one or more explanatory variables are used to predict the outcome. Explanatory variables can themselves be binary, or be continuous.

How does instrumental variable work?