Econometric Analysis of Cross Section and Panel Data- Wooldridge, J. (2002) 4 The Single-Equation Linear Model and OLS Estimation 4.1 Overview of the Single-Equation Linear Model kGoldberger (1972) defines a structural model as one representing a causal relationship, as opposed to a relationship that simply captures statistical associations. The error term u can consist of a variety of things, including omitted variables and measurement error. The parameters b j hopefully correspond to the parameters of interest, that is, the parameters in an underlying structural model. kAn explanatory variable x j is said to be endogenous in equation (4.1) if it is correlated with u. You should not rely too much on the meaning of µµendogenous¶¶ from other branches of economics. In traditional usage, a variable is endogenous ifit is determined within the context of a model. The usage in econometrics, while related to traditional definitions, is used broadly to describe any situation where an explanatory variable is correlated with the disturbance. If x j is uncorrelated with u, then xj is said to be exogenous in equation. kIn applied econometrics, endogeneity usually arises in one of three ways: Omitted Variables Measurement ErrorSimultaneity The distinctions among the three possible forms of endogeneity are not always sharp. In fact, an equation can have more than one source of endogeneity.For an illuminating discussion of the three kinds of endogeneity as they arise in a particular field, see Deaton¶s (1995) survey chapter on econometric issues in development economics. kAs with Assumption OLS.1, Assumption OLS.2 is an assumption about the population. Since E (x¶x) is a symmetric KxK matrix, Assumption OLS.2 is equivalent to assuming that E (x¶x) is positive definite. Since x1 1»4 1, Assumption OLS.2 is also equivalent to saying that the (population) variance matrix of the K-1 nonconstant elements in x is nonsingular. This is a standard assumption, which
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8/6/2019 Eco No Metric Analysis of Cross Section and Panel Data
Econometric Analysis of Cross Section and Panel Data-Wooldridge, J. (2002)
4 The Single-Equation Linear Model and OLS Estimation
4.1 Overview of the Single-Equation Linear Model
k Goldberger (1972) defines a structural model as one representing a causal
relationship, as opposed to a relationship that simply captures statistical
associations. The error term u can consist of a variety of things, including omitted
variables and measurement error. The parameters b j hopefully correspond to the
parameters of interest, that is, the parameters in an underlying structural model.
k An explanatory variable x j is said to be endogenous in equation (4.1) if it iscorrelated with u. You should not rely too much on the meaning of µµendogenous¶¶
from other branches of economics. In traditional usage, a variable is endogenous if
it is determined within the context of a model. The usage in econometrics, while
related to traditional definitions, is used broadly to describe any situation where an
explanatory variable is correlated with the disturbance. If x j is uncorrelated with u,
then xj is said to be exogenous in equation.
k In applied econometrics, endogeneity usually arises in one of three ways:
Omitted Variables
Measurement Error
Simultaneity
The distinctions among the three possible forms of endogeneity are not always
sharp. In fact, an equation can have more than one source of endogeneity.For an
illuminating discussion of the three kinds of endogeneity as they arise in a
particular field, see Deaton¶s (1995) survey chapter on econometric issues in
development economics.
k As with Assumption OLS.1, Assumption OLS.2 is an assumption about the
population. Since E (x¶x) is a symmetric KxK matrix, Assumption OLS.2 is
equivalent to assuming that E (x¶x) is positive definite. Since x1 1»4 1, Assumption
OLS.2 is also equivalent to saying that the (population) variance matrix of the K-1
nonconstant elements in x is nonsingular. This is a standard assumption, which
8/6/2019 Eco No Metric Analysis of Cross Section and Panel Data
of equation (5.1) generally results in inconsistent estimators of all the b jif Cov (xK ,
u) .
² The method of instrumental variables (IV) provides a general solution to the
problem of an endogenous explanatory variable. To use the IV approach with xK endogenous, we need an observable variable, z1, not in equation (5.1) that satisfies
two conditions. First, z1 must be uncorrelated with u:Cov (z1, u) . Second, z1 is
correlated with xK( ).
Equation (5.4)
² The linear projection in equation (5.4) is called a reduced form equation for the
endogenous explanatory variable xK . In the context of single-equation linear
models, a reduced form always involves writing an endogenous variable as a linear
projectiononto all exogenous variables.
² From the structural equation (5.1) and the reduced form for xK , we obtain a
reduced form for y by plugging equation (5.4) into equation (5.1) and rearranging:
Equation (5.6)
² Estimates of the reduced form parameters are sometimes of interest in their own
right, but estimating the structural parameters is generally more useful.
² Two-stage least squares (2SLS) estimator is the most efficient IV estimator.To
illustrate the method of 2SLS, define the vector of exogenous variables again by
. Out of all possible linear
combinations of z that can be used as an instrument for xK , the method of 2SLS
chooses that which is most highly correlated with xK . If xK were exogenous, then
this choice would imply that the best instrument for xK is simply itself. Ruling this
case out, the linear combination of z most highly correlated with xK is given by the
linear projection of xK
on z. Write the reduced form for xK
as
is uncorrelated with u. In fact, xK is often interpreted as the part of xK that is
8/6/2019 Eco No Metric Analysis of Cross Section and Panel Data
uncorrelated with u. If xK is endogenous, it is because r K is correlated with u.If we
could observe xK , we would use it as an instrument for xK in equation (5.1)and use
the IV estimator from the previous subsection. Since the d j and y j are population
parameters, xK is not a usable instrument. However, as long as we make
thestandard assumption that there are no exact linear dependencies among theexogenous variables, we can consistently estimate the parameters in equation
(5.14) byOLS. The sample analogues of the xfor each observation i are simply
the OLS iK fitted values:
² Now, for each observation i, define the vector i=
1,2« N. Using as the instruments for xi gives the IV estimator
² Part b is the crucial rank condition for identification. In a precise sense it means
that z is sufficiently linearly related to x so that rank E (z¶x) has full column rank.
² Necessary for the rank condition is the order condition, L � K. In other words, we
must have at least as many instruments as we have explanatory variables. If we do
not have as many instruments as right-hand-side variables, then b is not identified.
However, L � K is no guarantee that 2SLS.2b holds: the elements of z might not
be appropriately correlated with the elements of x.
6Additional Single-Equation Topics
8/6/2019 Eco No Metric Analysis of Cross Section and Panel Data