Sample Question #159 (econometrics)
What are instrumental variable regressions? When do you use them?
Instrumental variable (IV) estimation is a weird concept to those unfamiliar with it. Basically, instead of regressing the dependent variable on the original independent variables, we regress on a set of instrumental variables, which are simply some variables that are orthogonal to the error term in the original regression. (Confusing, isn’t it?) The reason for doing this is we may suspect that the original independent variables (regressors) are not orthogonal to the error term, but we still want to keep the original independent variable set for theoretical reasons (e.g., the original independent variables make "nice" factors). By using IV estimation, we can obtain consistent estimators for the original independent variables despite our suspicion that these original regressors are correlated with the error term.
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