Granular Instrumental Variables

We propose a new way to construct instruments in a broad class of economic environments. In the economies we study, a few large firms, industries or countries account for an important share of economic activity. As the idiosyncratic shocks from these large players affect aggregate outcomes, they are valid and often powerful instruments. We provide a methodology to extract idiosyncratic shocks from the data and create “granular instrumental variables” (GIVs), which are size-weighted sums of idiosyncratic shocks. These GIVs allow us to then estimate parameters of interest, including causal elasticities and multipliers. We illustrate the idea in a basic supply and demand framework. GIVs provide a novel approach to identify both supply and demand elasticities based on idiosyncratic shocks to either supply or demand. We then show how to extend the basic procedure to cover a range of empirically relevant situations. As an application, we measure how “sovereign yield shocks” transmit across countries in the Eurozone. We sketch how GIVs could be useful to estimate a host of other causal parameters in economics.