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Instrumental variables regressions with honestly uncertain exclusion restrictions

  • Kraay, Aart

The validity of instrumental variables (IV) regression models depends crucially on fundamentally untestable exclusion restrictions. Typically exclusion restrictions are assumed to hold exactly in the relevant population, yet in many empirical applications there are reasonable prior grounds to doubt their literal truth. In this paper I show how to incorporate prior uncertainty about the validity of the exclusion restriction into linear IV models, and explore the consequences for inference. In particular I provide a mapping from prior uncertainty about the exclusion restriction into increased uncertainty about parameters of interest. Moderate prior uncertainty about exclusion restrictions can lead to a substantial loss of precision in estimates of structural parameters. This loss of precision is relatively more important in situations where IV estimates appear to be more precise, for example in larger samples or with stronger instruments. The author illustrates these points using several prominent recent empirical papers that use linear IV models.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 4632.

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Date of creation: 01 May 2008
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Handle: RePEc:wbk:wbrwps:4632
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  1. Hoogerheide, Lennart & Kleibergen, Frank & van Dijk, Herman K., 2007. "Natural conjugate priors for the instrumental variables regression model applied to the Angrist-Krueger data," Journal of Econometrics, Elsevier, vol. 138(1), pages 63-103, May.
  2. Small, Dylan S., 2007. "Sensitivity Analysis for Instrumental Variables Regression With Overidentifying Restrictions," Journal of the American Statistical Association, American Statistical Association, vol. 102, pages 1049-1058, September.
  3. Michael P. Murray, 2006. "Avoiding Invalid Instruments and Coping with Weak Instruments," Journal of Economic Perspectives, American Economic Association, vol. 20(4), pages 111-132, Fall.
  4. Daron Acemoglu & Simon Johnson & James A. Robinson, 2001. "The Colonial Origins of Comparative Development: An Empirical Investigation," American Economic Review, American Economic Association, vol. 91(5), pages 1369-1401, December.
  5. Francisco Rodriguez & Dani Rodrik, 2001. "Trade Policy and Economic Growth: A Skeptic's Guide to the Cross-National Evidence," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 261-338 National Bureau of Economic Research, Inc.
  6. Daniel Berkowitz & Mehmet Caner & Ying Fang, 2006. "Are "Nearly Exogenous" Instruments Reliable?," Working Papers 219, University of Pittsburgh, Department of Economics, revised Jan 2006.
  7. Rajan, Raghuram G & Zingales, Luigi, 1998. "Financial Dependence and Growth," American Economic Review, American Economic Association, vol. 88(3), pages 559-86, June.
  8. Poirier, Dale J., 1998. "Revising Beliefs In Nonidentified Models," Econometric Theory, Cambridge University Press, vol. 14(04), pages 483-509, August.
  9. Edward L. Glaeser & Rafael La Porta & Florencio Lopez-de-Silane & Andrei Shleifer, 2004. "Do Institutions Cause Growth?," NBER Working Papers 10568, National Bureau of Economic Research, Inc.
  10. David H. Romer & Jeffrey A. Frankel, 1999. "Does Trade Cause Growth?," American Economic Review, American Economic Association, vol. 89(3), pages 379-399, June.
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