Econometrics II Problem Set 2 Solutions
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Powered by AIMoment conditions are key in determining the probability limits of both IV and OLS estimators as they specify the relationships assumed in expected value terms between the instruments and residuals. For IV estimators, satisfying the moment conditions ensures consistency and unbiasedness by stipulating that the instruments are uncorrelated with the error term. In contrast, violating these conditions leads to biased OLS probability limits when regressor and errors are correlated. These conditions define the asymptotic properties and efficacy of the respective estimation techniques .
The Durbin-Wu-Hausman test is used to detect endogeneity in econometric models. It assesses whether differences between OLS and IV estimators are statistically significant. A significant test result suggests that the OLS estimator is inconsistent and that variables assumed to be exogenous are in fact endogenous, guiding the choice of IV over OLS. Conversely, non-significance indicates endogeneity is not a significant concern, allowing OLS use. This test provides critical insights into the appropriateness of model specifications .
Comparing the standard errors of IV and OLS estimates often shows that IV estimates have larger standard errors due to the variability in using an instrument. This larger error range reflects less precise estimations. If the standard errors overlap significantly with those of the OLS, it suggests the presence of biases or weaknesses in the instruments used, underscoring issues like weak instruments or the endogeneity not adequately controlled .
Estimating the return to education using OLS might lead to biased results if education is endogenous, potentially due to omitted variable bias like ability. The use of father's education as an instrumental variable can address this endogeneity, as it might correlate with the individual's education level but not directly with the error term in the wage equation (e.g., unobserved ability), thus providing an unbiased estimate of the returns to education when the instrument is valid .
IV estimation is preferred over OLS when the potential asymptotic bias from OLS is greater due to correlation between the regressors and the error term. This situation arises when there's reasonable correlation between the instrument and the endogenous regressor, and the instrument is uncorrelated with the error term. However, IV estimator's inconsistency can be large if the correlation between the instrument and the regressor is weak, which can exacerbate the effect of any correlation between the instrument and the error term .
The overidentifying restrictions test, also known as the Sargan or Hansen test, is used to assess the validity of instruments in an econometric model. It checks whether the instruments are uncorrelated with the error term by evaluating the model's fit. A failure to reject the null hypothesis indicates that the instruments are valid, implying they do not fit the data too closely compared to the number of instruments used, providing confidence in their exogeneity. Rejection suggests potential invalidity due to correlation with the error term, necessitating reevaluation of instruments .
When ρ=0.9, the correlation between et and et-1 is high because the effect of the lagged error term carries over strongly to the next time period. The correlation between et and et-4 will be lower than between et and et-1, but still noticeable due to the persistence induced by ρ. The variance of et will be larger as a high value of ρ implies a greater buildup of variance over time through the influence of past errors. Conversely, when ρ=0.4, the correlation between successive terms and variance are both lower, reflecting the reduced influence of past values on the current value .
When classical measurement error is present in the explanatory variable, it induces a negative correlation between the error term and the observed explanatory variable if β1>0. This correlation results in the OLS estimator of β1 being biased and inconsistent, as the OLS assumption that the error term is uncorrelated with the explanatory variables is violated .
An instrumental variable z is considered in regression to resolve endogeneity issues arising from correlation between x and u. IV is used because z is presumed to be correlated with x but uncorrelated with the error term u, providing a consistent estimator for the coefficients. However, if the correlation between z and x is weak, it can lead to large standard errors in the estimation and potential asymptotic bias, diminishing the reliability of the inference made from IV estimation .
If xt and xt-1 are correlated, it implies the presence of autocorrelation in the series, which often occurs with measurement errors that do not completely account for temporal dependencies between observations. This correlation suggests potential inefficiencies or biases in standard OLS estimation. Recognizing this correlation can guide model adjustments, such as using a dynamic model specification or correction techniques like robust standard errors, to obtain consistent and efficient parameter estimates .