On the Validity and Refinement of the Use of Rainfall as Instrument for Transitory Income
Given that rainfall is externally provided by nature and that it is also correlated with rural income, rainfall shocks seem to be the perfect instrument, as adopted in a popular interpretation of Paxson (1992). However, there are two problems with this reinterpretation: weak instruments and first-stage misspecification. After finding that rainfall is weakly correlated with income, I use Moreira's (2003) pivotal statistics to retest the hypothesis that the propensity to save out of transitory income is one, but still cannot reject the null. Later I find that there are previously untested assumptions on the income equation, and in fact the data indicate that they are invalid. In a new specification the propensity is found to be less than unity.
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