Chapter 10

Instrumental Variables Regression

Multiple Choice

1) Estimation of the IV regression model

a. requires exact identification.

b. allows only one endogenous regressor, which is typically correlated with the error
term.
c. requires exact identification or overidentification.
d. is only possible if the number of instruments is the same as the number of
regressors.

2) Two stage least squares is calculated as follows: in the first stage

a. Y is regressed on the exogenous variables only. The predicted value of Y is then

regressed on the instrumental variables.
b. the unknown coefficients in the reduced form equation are estimated by OLS, and
the predicted values are calculated. In the second stage, Y is regressed on these
predicted values and the other exogenous variables.
c. the exogenous variables are regressed on the instruments. The predicted value of
the exogenous variables is then used in the second stage, together with the
instruments, to predict the dependent variable.
d. the unknown coefficients in the reduced form equation are estimated by weighted
least squares, and the predicted values are calculated. In the second stage, Y is
regressed on these predicted values and the other exogenous variables.

3) The conditions for a valid instruments do not include the following:

a. each instrument must be uncorrelated with the error term.

b. each one of the instrumental variables must be normally distributed.
c. at least one of the instruments must enter the population regression of X on the
Z’s and the W’s.
d. perfect multicollinearity between the predicted endogenous variables and the
exogenous variables must be ruled out.

4) The IV regression assumptions include all of the following with the exception of

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 a. the error terms must be normally distributed.
b. E(ui|W1i,…, Wri) = 0.
c. the X’s, W’s, Z’s, and u all have nonzero, finite fourth moments.
d. (X1i,…, Xki, W1i,…,Wri, Z1i, … Zmi, Yi) are i.i.d. draws from their joint distribution.

5) The rule-of-thumb for checking for weak instruments is as follows: for the case of a
single endogenous regressor,

a. a first stage F must be statistically significant to indicate a strong instrument.

b. a first stage F > 1.96 indicates that the instruments are weak.
c. the t-statistic on each of the instruments must exceed at least 1.64.
d. a first stage F < 10 indicates that the instruments are weak.

6) The J-statistic

a. tells you if the instruments are exogenous.

b. provides you with a test of the hypothesis that the instruments are exogenous for
the case of exact identification.
c. is distributed χ m2 − k where m-k is the degree of overidentification.
d. is distributed χ m2 − k where m-k is the number of instruments minus the number of
regressors.

7) In the case of the simple regression model Yi = β0 + β1Xi + ui, i = 1,…, n, when X and u
are correlated, then

a. the OLS estimator is biased in small samples only.

b. OLS and TSLS produce the same estimate.
c. X is exogenous.
d. the OLS estimator is inconsistent.

8) The following will not cause correlation between X and u in the simple regression model:

a. simultaneous causality.
b. omitted variables.
c. irrelevance of the regressor.
d. errors in variables.

9) The distinction between endogenous and exogenous variables is

a. that exogenous variables are determined inside the model and endogenous

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 variables are determined outside the model.
b. dependent on the sample size: for n > 100, endogenous variables become
exogenous.
c. dependent on the distribution of the variables: when they are normally distributed,
they are exogenous; otherwise they are endogenous.
d. whether or not the variables are correlated with the error term.

10) The two conditions for a valid instrument are

a. corr(Zi, Xi) = 0 and corr(Zi, ui) ≠ 0.

b. corr(Zi, Xi) = 0 and corr(Zi, ui) = 0.
c. corr(Zi, Xi) ≠ 0 and corr(Zi, ui) = 0.
d. corr(Zi, Xi) ≠ 0 and corr(Zi, ui) ≠ 0.

11) Instrument relevance

a. means that the instrument is one of the determinants of the dependent variable.
b. is the same as instrument exogeneity.
c. means that some of the variance in the regressor is related to variation in the
instrument.
d. is not possible since X and u are correlated and Z and u are not correlated.

12) Consider a competitive market where the demand and the supply depend on the current
price of the good. Then fitting a line through the quantity-price outcomes will

a. give you an estimate of the demand curve.

b. estimate neither a demand curve nor a supply curve.
c. enable you to calculate the price elasticity of supply.
d. give you the exogenous part of the demand in the first stage of TSLS.

13) When there is a single instrument and single regressor, the TSLS estimator for the slope
can be calculated as follows

TSLS = sZY .
a. β 1
sZX
TSLS = s XY .
b. β 1
s X2
TSLS = sZX .
c. β 1
sZY

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 TSLS = sZY .
d. β 1
sZ2

14) The TSLS estimator is

a. consistent and has a normal distribution in large samples.

b. unbiased.
c. efficient in small samples.
d. F-distributed.

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15) The reduced form equation for X
a. regresses the endogenous variable X on the smallest possible subset of regressors.
b. relates the endogenous variable X to all the available exogenous variables, both
those included in the regression of interest and the instruments.
c. uses the predicted values of X from the first stage as a regressor in the original
equation.
d. uses smaller standard errors, such as homoskedasticity-only standard errors, for
inference.

16) When calculating the TSLS standard errors

a. you do not have to worry about heteroskedasticity, since it was eliminated in the
first stage.
b. you can use the standard errors reported by OLS estimation of the second stage
regression.
c. the critical values from the standard normal table should be adjusted for the
proper degrees of freedom.
d. you should use heteroskedasticity-robust standard errors.

17) Having more relevant instruments

a. is a problem because instead of being just identified, the regression now becomes
overidentified.
b. is like having a larger sample size in that the more information is available for use
in the IV regressions.
c. typically results in larger standard errors for the TSLS estimator.
d. is not as important for inference as having the same number of endogenous
variables as instruments.

18) Weak instruments are a problem because

a. the TSLS estimator may not be normally distributed, even in large samples.
b. they result in the instruments not being exogenous.
c. the TSLS estimator cannot be computed.
d. you cannot predict the endogenous variables any longer in the first stage.

19) (Requires Appendix Material) The relationship between the TSLS slope and the
corresponding population parameter is:

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 1 n _

∑
n i =1
( Z i − Z )ui
a. ( βˆ1TSLS − β1 ) = .
1 n _

∑ (Zi − Z )( X i − X )
n i =1
1 n _

n
∑ (Zi − Z )
b. ( βˆ1TSLS − β1 ) = n i =1 _ .
1
∑ i
n i =1
( Z − Z )( X i − X )

1 n _

n
∑ ( Z i − Z )ui
c. ( βˆ1TSLS − β1 ) = i =n1 _
.
1
∑ i
n i =1
( Z − Z ) 2

1 n
∑ ( X i − X )ui
n i =1
d. ( βˆ1TSLS − β1 ) = n _
.
1
∑ (Zi − Z )( X i − X )
n i =1

20) If the instruments are not exogenous,

a. you cannot perform the first stage of TSLS.

b. then, in order to conduct proper inference, it is essential that you use
heteroskedasticity-robust standard errors.
c. your model becomes overidentified.
d. then TSLS is inconsistent.

21) In the case of exact identification,

a. you can use the J-statistic in a test of overidentifying restrictions.

b. you cannot use TSLS for estimation purposes.
c. you must rely on your personal knowledge of the empirical problem at hand to
assess whether the instruments are exogenous.
d. OLS and TSLS yield the same estimate.

22) To calculate the J-statistic you regress the

a. squared values of the TSLS residuals on all exogenous variables and the
instruments. The statistic is then the number of observations times the regression
R2 .
b. TSLS residuals on all exogenous variables and the instruments. You then multiply

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 the homoskedasticity-only F-statistic from that regression by the number of
instruments.
c. OLS residuals from the reduced form on the instruments. The F-statistic from this
regression is the J-statistic.
d. TSLS residuals on all exogenous variables and the instruments. You then multiply
the heteroskedasticity-robust F-statistic from that regression by the number of
instruments.

23) (Requires Chapter 8) When using panel data and in the presence of endogenous
regressors ,

a. the TSLS does not exist.

b. you do not have to worry about the validity of instruments, since there are so
many fixed effects.
c. the OLS estimator is consistent.
d. application of the TSLS estimator is straightforward if you use two time periods
and difference the data.

24) In practice, the most difficult aspect of IV estimation is

a. finding instruments that are both relevant and exogenous.

b. that you have to use two stages in the estimation process.
c. calculating the J-statistic.
d. finding instruments that are exogenous. Relevant instruments are easy to find.

25) Consider a model with one endogenous regressor and two instruments. Then the J-
statistic will be large

a. if the number of observations is very large.

b. if the coefficients are very different when estimating the coefficients using one
instrument at a time.
c. if the TSLS estimates are very different from the OLS estimates.
d. when you use homoskedasticity-only standard errors.