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A New Paradigm: A Joint Test of Structural and Correlation Parameters in Instrumental Variables Regression When Perfect Exogeneity is Violated

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  • Caner, Mehmet
  • Morrill, Melinda

Abstract

The instrumental variables strategy is commonly employed in empirical research. For correct inference using this econometric technique, the instruments must be perfectly exogenous and relevant. In fact, the standard t-ratio test statistic used in this context yields unreliable and often inaccurate results even when there is only a slight violation of the exclusion restriction. It is crucial to realize that to make reliable inferences on the structural parameters we need to know the true correlation between the structural error and the instruments. The main innovation in this paper is to identify an appropriate test in this context: a joint null hypothesis of the structural parameters with the correlation between the instruments and the structural error term. Since correlation cannot be estimated, we propose a test statistic involving a grid search over correlation values. To address inference under violations of exogeneity, significant contributions have been made in the recent literature by assuming some degree of non-exogeneity. We introduce a new approach by deriving a modified t-statistic that corrects for the bias associated with non-exogeneity of the instrument. A key advantage of our approach over that of the previous literature is that we do not need to make any assumptions about the degree of violation of exogeneity either as possible values or prior distributions. In particular, our method is not a form of sensitivity analysis. Since our modified test statistic is continuous and monotonic in correlation it is easy to conduct inference by a simple grid search. Even though the joint null may seem to be limiting in interpreting rejection, we can still make accurate inferences on the structural parameters because of a feature of the grid search over correlation values. The procedure for calculating the modified coefficients and statistics is illustrated with two empirical examples.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 16790.

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Date of creation: 14 Aug 2009
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Handle: RePEc:pra:mprapa:16790

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Keywords: Violation of exogeneity; Instrumental variables regression: Joint test;

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  1. Richard A. Ashley., 2006. "Assessing the Credibility of Instrumental Variables Inference With Imperfect Instruments Via Sensitivity Analysis," Working Papers, Virginia Polytechnic Institute and State University, Department of Economics e06-9, Virginia Polytechnic Institute and State University, Department of Economics.
  2. Costas Meghir & Mårten Palme, 1999. "Assessing the effect of schooling on earnings using a social experiment," IFS Working Papers, Institute for Fiscal Studies W99/10, Institute for Fiscal Studies.
  3. repec:wyi:wpaper:001990 is not listed on IDEAS
  4. Aviv Nevo & Adam M. Rosen, 2008. "Identification with Imperfect Instruments," NBER Working Papers, National Bureau of Economic Research, Inc 14434, National Bureau of Economic Research, Inc.
  5. Richard Ashley, 2009. "Assessing the credibility of instrumental variables inference with imperfect instruments via sensitivity analysis," Journal of Applied Econometrics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 24(2), pages 325-337, 03.
  6. Mehmet Caner, 2006. "Near Exogeneity and Weak Identification in Generlized Empirical Likelihood estimators : Fixed and Many Moment Asymptotics," Working Papers, University of Pittsburgh, Department of Economics 212, University of Pittsburgh, Department of Economics, revised Jan 2006.
  7. Berkowitz, Daniel & Caner, Mehmet & Fang, Ying, 2012. "The validity of instruments revisited," Journal of Econometrics, Elsevier, Elsevier, vol. 166(2), pages 255-266.
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