Simultaneous Equation System
Simultaneous Equation System
However, in many situation there is a two is a two way (or simultaneous) flow of influence
among economic variables, that is on economic variables affects another economic variables and
is in turn affected by it (them).
Thus in regression of money on the rate of interest the single equation methodology
assumes implicitly that the rate of interest is fixed and times to find out the response of money
demanded to the changes in the level of the interest rate. But if the rate of interest depends on
the demand for money, we need to consider two equations, one relating to and another
relating to . And this leads us to consider simultaneous equation models.
Exogenous Variable:
In simultaneous equation models, the variables that are truly no-stochastic or can be so regarded
are called the exogenous or predetermine variables.
What happens if the parameters of each equation are estimated by OLS, disregarding
other equations in the simultaneous equation system?
One of the crucial assumptions of the method of OLS is that the explanatory variables are
either non-stochastic or if stochastic (random), are distributed independently of the stochastic
disturbance term. If neither of these condions is met, then OLS estimators of simultaneous
equation models are not only biased but also inconsistent.
Here OLS cannot be applied to estimate the parameters unless it can be shown that the stochastic
explanatory variable is distributed independent of and similarly the stochastic
explanatory variable in is distributed independently of . In this situation, OLS method
leads to inconsistent estimate.
Assumptions:
Simultaneous Equation Model~2 of 4
Since is positive, the covariance between and is bound to be different from zero. So that
and are correlated, which violates the assumption of the classical linear regression model
that the disturbances are independent or at least uncorrelated with the explanatory variables.
Now we get from
An estimator is said to be consistent if its probability lilmit (or ) is equal to its true
(population) value. By applying the rules of to we get,
Simultaneous Equation Model~3 of 4
Simultaneous Equation Model~4 of 4