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4.8 Instrumental Variables

Instrumental Instrumental VariablesA major complication that is emphasized in microeconometrics is the possibility ofinconsistent parameter estimation due to endogenous regressors. Then regressionestimates measure only the magnitude of association, rather than the magnitudeand direction of causation which is needed for policy Instrumental Variables estimator provides a way to nonetheless obtain con-sistent parameter estimates. This method, widely used in econometrics and rarelyused elsewhere, is conceptually dif cult and easily provide a lengthy expository treatment that de nes an Instrumental variableand explains how the Instrumental Variables method works in a simple Inconsistency of OLSC onsider the scalar regression model with dependent variableyand single regres-sorx.

What are the consequences of this correlation between x and u? Now higher levels of x have two effects on y. From (4.43) there is both a direct effect via x and an indirect effect via u effecting x which in turn effects y. The goal of regression is to estimate only the rst effect, yielding an estimate of . The OLS

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