Introductory Econometrics - A Modern Approach - ch15.pptVIP

Economics 20 - Prof. Anderson Why Use Instrumental Variables? Instrumental Variables (IV) estimation is used when your model has endogenous x’s That is, whenever Cov(x,u) ≠ 0 Thus, IV can be used to address the problem of omitted variable bias Additionally, IV can be used to solve the classic errors-in-variables problem What Is an Instrumental Variable? In order for a variable, z, to serve as a valid instrument for x, the following must be true The instrument must be exogenous That is, Cov(z,u) = 0 The instrument must be correlated with the endogenous variable x That is, Cov(z,x) ≠