Friday, May 11, 2012

Avoiding Invalid Instruments and Coping with Weak Instruments

Useful advice for when trying to implement IV.

Avoiding Invalid Instruments and Coping with Weak Instruments
Michael P. Murray
Journal of Economic Perspectives—Volume 20, Number 4—Fall 2006—Pages 111–132

Archimedes said, “Give me the place to stand, and a lever long enough, and I will move the Earth” (Hirsch, Kett, and Trefil, 2002, p. 476). Economists have their own powerful lever: the instrumental variable estimator. The instrumental variable estimator can avoid the bias that ordinary least squares suffers when an explanatory variable in a regression is correlated with the regression’s disturbance term. But, like Archimedes’ lever, instrumental variable estimation requires both a valid instrument on which to stand and an instrument that isn’t too short (or “too weak”). This paper briefly reviews instrumental variable estimation, discusses classic strategies for avoiding invalid instruments (instruments themselves correlated with the regression’s disturbances), and describes recently developed strategies for coping with weak instruments (instruments only weakly correlated with the offending explanator).

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