Lecture IV

By:

Amsalu B. (MSc.)

Lecturer, Department of Economics

Unity University

Email: [email protected]

Unity, Ethiopia
 4.1 Nature of Simultaneous Equation models
So far we have been discussed by focusing
exclusively on the problems and estimations of a
single equation regression models. In such models, a
dependent variable is expressed as a linear function
of one or more explanatory variables.
i.e, there was a single dependent variable Y and one
or more explanatory variables, X’s.
The cause-and-effect relationship in single equation
models between the dependent and independent
variable is unidirectional.
That is, the explanatory variables are the cause
and the independent variable is the effect.
But there are situations where such one-way or
unidirectional causation in the function is not
meaningful.
 4.1 Nature of Simultaneous Equation models
 This occurs if, for instance, Y (dependent variable)
is not only function of X’s (explanatory variables)
but also all or some of the X’s are, in turn,
determined by Y.
 There is, therefore, a two-way flow of influence
between Y and (some of) the X’s which in turn
makes the distinction between dependent and
independent variables a little doubtful.
 In simultaneous model there is more than one
equation –one for each of the mutually, or jointly,
dependent or endogenous variables.
 The number of equations in such models is equal to
the number of jointly dependent or endogenous
variables involved in the phenomenon under
analysis.
 4.1 Nature of Simultaneous Equation models
 Unlike the single equation models, in
simultaneous equation models it is not usually
possible (possible only under specific
assumptions) to estimate a single equation of
the model without taking into account the
information provided by other equation of the
system.
 If one applies OLS to estimate the parameters
of each equation disregarding other equations
of the model, the estimates so obtained are not
only biased but also inconsistent, i.e. even if the
sample size increases indefinitely, the
estimators do not converge to their true values.
 4.1 Nature of Simultaneous Equation models
 Example: the classic example of simultaneous
causality in economics is supply and demand.
 Both Prices and quantities adjust until supply
and demand are in equilibrium.
 A shock of demand or supply cause both
prices and quantities to move.
 As well known, the prices P of a commodity
and quantity Q sold are determined by the
intersection of the demand and supply curves
for that commodity.
 Look at the graph of dd and ss from class discussion
 4.2 Model specification

Thus, assuming for simplicity that the demand and

supply curves are linear and adding the stochastic
disturbance term U1 and U2, we may write the
empirical dd and ss function as:
Demand function:
 Qt   0  1 Pt   2Yt  U1t    1  0
d

 Supply function:
Qt   0  1 Pt   2Yt  U 2t    1  0
s

Equilibrium condition: Qt s  Qt d
 Where Qtd= quantity demand
 Qts=quantity supplied
 t=time;  0 , and 1 are the parameters
 4.2 Model specification
 B/C of simultaneous dependence between Q and P, then U1t and
Pt, and U2t and pt cannot be independent.
 If u1t in above equation changes b/c changes in other variables
affecting Qtd such as income, wealth and tastes), the demand
curve will shift upward if u1t is +ve and downward if u1t is –ve.
 Thus, shift in demand curve changes both P and Q.
 Similarly, a change in U2t b/c of weather, import or export
restrictions, etc; will shift the ss curves, again affect both P and Q.
 B/c of this simultaneous dependence b/c Q and P, u1t and Pt and
u2t and pt cannot be independent. Thus, a regression of Q and P
as in above equation would violate an important assumptions of
the classical linear regression model; namely the assumption of no
correlation b/n the explanatory variable(s) and the disturbance
term.
,

In simultaneous equation models variables are

classified as endogenous and exogenous.
 Endogenous variables: are variables that are
determined by the economic model (within the system)
and
Exogenous variables: are those determined from
outside of the system.
Exogenous variables are also called predetermined.
Since the exogenous variables are predetermined, they
are supposed to be independent of the error terms in
the model/ non stochastic.
are exogenous variables, lagged exogenous variables and
lagged endogenous variables. Predetermined variables are
non-stochastic and hence independent of the disturbance
terms. , X t , X t 1 and Yt 1 are regarded as predetermined
(exogenous) variables.
 4.3Definitions of Some Concepts

Structural models: A structural model

describes the complete structure of the
relationships among the economic variables.
 Structural equations of the model =
endogenous variables+ exogenous variables +
disturbances (random variables).
The parameters of structural model express
the direct effect of each explanatory variable
on the dependent variable.
The Variables not appearing in any function
explicitly may have an indirect effect and is taken into
account by the simultaneous solution of the system.
 4.3Definitions of Some Concepts

Reduced form of the model: The reduced form

of a structural model is the model in which the
endogenous variables are expressed a function
of the predetermined variables and the error
term only.
Example: We may write the empirical demand-
and-supply functions as
 4.3Definitions of Some Concepts
Example: The following simple Keynesian model of
income determination can be considered as a
structural model.
 =------------(1)
 ------------(2)

where: C=consumption expenditure; Z=non-

consumption expenditure ; Y=national income; C
and Y are endogenous variables while Z is
exogenous variable.
Find the reduced form of the above structural
model. Since C and Y are endogenous variables
and only Z is the exogenous variables, we have to
express C and Y in terms of Z.
 4.3Definitions of Some Concepts

To do this substitute Y=C+Z into equation (1).

 -------(3)
Substituting again (3) into (2) we get;
  1  U
 Y   Z  ----------(4)
1  1   1 

Equation (3) and (4) are called the reduced

form of the structural model of the above. We
can write this more formally as:
 4.3 Definitions of Some Concepts

 Parameters of the reduced form measure the total effect (direct and
indirect) of a change in exogenous variables on the endogenous
variable.
 For instance,  in the above reduced form equation(1),
  
  measures
 1   
the total effect of a unit change in the non-consumption expenditure
 1 
on consumption. This total effect is   , the direct effect, times
 1   
,the indirect effect.
 4.4 Inconsistency and Simultaneity Bias of OLS Estimators
 Biasedness:
 The two-way causation in a relationship leads to
violation of the important assumption of linear
regression model, i.e. one variable can be dependent
variable in one of the equation but becomes also
explanatory variable in the other equations of the
simultaneous-equation model.
 In this case E[XiUi] may be different from zero. To
show simultaneity bias, let’s consider the following
simple simultaneous equation model.
Y   0  1 X  U 

X   0   1Y   2 Z  V 
X  f (Y )
 Y  f (X ) this shows that the 2 way causation in a
relationship leads to violations of the important
assumptions linear regression model
 4.4 Inconsistency and Simultaneity Bias of OLS Estimators

 Suppose that the following assumptions hold,

(U )  0 , (V )  0
(U 2 )   u2 , (V 2 )   u2
(U iU j )  0 , (ViV j )  0, also (UiVi )  0;

where X and Y are endogenous variables and

Z is an exogenous variable.
The reduced form of X of the above model is
obtained by substituting Y in the equation of
X.
X   0  1 ( 0   1 X  U )   2 Z  V
 0   0 1   2   1U  V 
X     Z   
1   1 1  1   1 1   1   1 1 
 4.4 Inconsistency and Simultaneity Bias of OLS Estimators

 Applying OLS to the first equation of the

above structural model will result in biased
estimator because cov( X U )  ( X U )  0 . Now, let’s
i i i j

proof whether this expression.

 1  1 u2
  (U ) 
2
0
 1   1 1  1   1 1
 That is, covariance between X and U is not
zero. As a consequence, if OLS is applied to
each equation of the model separately the
coefficients will turn out to be biased.
 Now, let’s examine how the non-zero co-
variance of the error term and the
explanatory variable will lead to biasness in
OLS estimates of the parameters.
 4.4 Inconsistency and Simultaneity Bias of OLS Estimators

 Consistency Problems: An estimator is said to

be consistent if its probability limit is equal to
its population value.
 Inconsistent estimates
 2 2U
1  1  2
p lim(ˆ1 )  1 
u 2

ˆ 2  v 2 
1  1  
 X 2 

1  1  2  
 4.5 Solution to the Simultaneous Equations
 The obvious solution is to apply other methods of
estimation w/c gives better estimates of parameters.
 1. the reduced form method or indirect least
squares (ISLS)
 2. the method of instrumental variables
 3. two stage least squares (2SLS)
 4. limited information maximum likelihood (LIML)
 5. the mixed estimation
 6. Three stage least squares
 7. Full information maximum likelihood (FIML)
 4.5 Solution to the Simultaneous Equations
 N.B: 1-5---we can applied to one equation at a time,
and 6-7----the systems methods b/c they are applied to
all equations of the system simultaneously.
How to estimate the reduced form parameters?
 The estimates of the reduced from coefficients (π’s )
may be obtained in two ways.
1. Direct estimation of the reduced coefficients
by applying OLS.
2. Indirect estimation of the reduced form
coefficients.
 4.6 Direct estimation of the reduced form coefficients
 Direct Method: Express the three endogenous
variables(Ct , It , and Yt ) as functions of the
two predetermined variables (Gt, andYt-1)
directly using π’s as the parameters of the
reduced form model as follows.
Ct = π11Yt-1 + π12Gt + V1
It , =π21Yt-1 + π22Gt +V2
Yt =π31Yt-1 + π32Gt + V3
Note: π11 , π12 , π21 , π22 , π31 , and π32 are
reduced from parameters.
4.6 Direct estimation of the reduced form coefficients
 The reduced form π ’s may be estimated by
the method of least- squares –no restriction
(LSNR).
 This means we can apply OLS to reduced
form equation because we express all the
endogenous variables in terms of
exogenous variables.
 4.6 Direct estimation of the reduced form coefficients

 This method of obtaining the π 's is called least

squares no restriction (LSNR) because it doesn't take
into consideration any information on the structural
parameters.

 In this method what required is knowledge of the

predetermined variables appearing in the system not
about the coefficients of structural questions.
4.7 Indirect estimation of the reduced form coefficients
 It is known that there is a relationship
between the reduced form coefficients &
the structural parameters (explained in the
table).
 Therefore, to obtain values of coefficients
estimate the structural parameters by any
appropriate econometric techniques and
then substitutes these estimates in to the
system of parameters relationships to
obtain indirectly.
 This indirect method involved three steps.
 4.8 Indirect estimation of the reduced form coefficients
 1st step: Solve the system of endogenous variables so that each
equation contains only predetermined explanatory variables.
 2nd step: Obtain the estimates of the structural parameters by
any appropriate econometric method.
 3rd step: Substitute the estimates of β's and γ's in to the system
of parameters relations to find the estimates of the reduced form
coefficients.
 Advantage of indirect estimation of the reduced-form coefficients
 Though it is complicated, it has a very good importance.
 a) The derivation of parameters like, π's, β's & α's is more
efficient because in this way we take in to account all the
information incorporated in the structural model.
 b) Structural changes occur continuously overtime.
 4.9 Recursive models

 A model is called recursive if its structural

equations can be ordered in such a way that:
 the first equation includes only the predetermined
variables in the right hand side.
 the second equation contains predetermined variables and
the first endogenous variable (of the first equation) in the
right hand side and so on.
 The special feature of recursive model is that
its equations may be estimated, one at a time,
by OLS without simultaneous equations bias.
 4.9 Recursive models
 OLS is not applicable if there is interdependence
between the explanatory variables and the error term.
 In the simultaneous equation models, the endogenous
variables may depend on the error terms of the
model.
 Hence, the OLS technique is not appropriate for
estimation of an equation in a simulations equations
model.
 However, in a special type of simultaneous equations
model called Recursive, Triangular or Causal model,
the use of OLS procedure of estimation is appropriate.
 Consider the following three equation system to
understand the nature of such models:
 4.9 Recursive models
 Note that:

 In the above illustration, the X’s and Y’s are exogenous and
endogenous variables respectively.
 The disturbance terms follow the following assumptions.

 The above assumption is the most crucial

assumption that defines the recursive model.
 4.9 Recursive models
 If this does not hold, the above system is no
longer recursive and OLS is also no longer
valid.
 The first equation of the above system
contains only the exogenous variables on the
right hand side.
 Since by assumption, the exogenous variable is
independent of U1 , the first equation satisfies
the critical assumption of the OLS procedure.
 Hence, OLS can be applied straight forwardly
to this equation.
 4.9 Recursive models
 Let us build a hypothetical recursive model for
an agricultural commodity, say wheat.
 The production of wheat =Y1; , may be assumed
to depend on exogenous factors: X2 = climatic
conditions; and X3=last season’s price. The retail
price =Y2 may be assumed to be the function of
production level Y1= and exogenous factor X4=
disposable income.
 Finally, the price obtained by the producer = Y3
can be expressed in terms of the retail price; Y2
and exogenous factor; Xj= the cost of marketing
the producer.
 The relevant equations of the model may be
described as under:
 4.9 Recursive models

Y1  1   2 X 2   3 X 3  U1
Y2   4  1Y1   5 X 4  U 2
Y3   6   2Y2   7 X 5  U 3

 In the first equation, there are only exogenous

variables and are assumed to be independent of U1.
 In the second equation, the causal relation between
Y1and Y2 is in one direction.
 Also Y1 is independent of U2 and can be treated just
like exogenous variable.
 Similarly since Y2 is independent of U3 , OLS can be
applied to the third equation.
 Thus, we can rewrite the above equations as follows:
 4.9 Recursive models

Y1  1   2 X 2   3 X 3  U1
 1Y1  Y2   4   5 X 4  U 2
  2Y2  Y3   6   7 X 5  U 3
 We can again rewrite this in matrix form as
follows:

 The coefficient matrix of endogenous variables is

thus a triangular one; hence recursive models are
also called as triangular models.
 4.9 Problems of simultaneous equation models

 Simultaneous equation models create three distinct

problems. These are:
 Identification of each equation of the model
 Mathematical completeness of the model
 any model is said to be (mathematically)
complete only when it possesses as many
independent equations as endogenous variables.
 In other words if we happen to know values of
disturbance terms, exogenous variables and
structural parameters, then all the endogenous
variables are uniquely determined.
 Statistical estimation of each equation of the model
 4.10 The identification problem
Of the three problems, we are going to discuss the first
problem (the identification problem) in the following
section.
The identification problem
 In simultaneous equation models, the Problem of
identification is a problem of model formulation; it
does not concern with the estimation of the model.
 The estimation of the model depends up on the
empirical data and the form of the model.
 If the model is not in the proper statistical form, it may
turn out that the parameters may not uniquely
estimated even though adequate and relevant data are
available.
 In a language of econometrics, a model is said to be
identified only when it is in unique statistical form to
enable us to obtain unique estimates of its parameters
from the sample data.
 4.10 Identification Problem
The identical concept concerns with whether the
numerical estimates of structural equations can be
obtained from the estimated reduced form coefficients.
Look at a simple Keynesian model, to illustrate the
problem of identification (look at “Introduction to
Econometrics: theory and practice with Stata” by Tesfaye
E,)
An identification may be either exactly (fully or just
identified) or over identified or under identification.
A. Under identification (SEP>REP)
• It occurs when the parameters of structural equation is
higher than reduced form parameters.
• If the coefficients of the structural equations are greater
than the coefficients of the reduced form, then we can
say that the equation is under identified.
 Under identification (SEP>REP)
Example: look at f/wing demand and supply equations
Under identification (SEP>REP)
 Under identification (SEP>REP)
 Equation number 10.37 and 10.39 were the two reduced form
equations derived from the structural equations number 10.32
& 10.33.
 Now if you compare the number of structural equation
coefficients (α0, α1, β0 and β1) are four where as from the
structural equations we have only two coefficients (π0 and π1).
 The coefficients of reduced form contain the coefficients of the
structural equations i.e α0, α1, β1 and β2 are found in π0 and
π1.
 But how we can find the values of α0, α1, β1 and β2 from π0
and π1. It is an ambiguous question??
 Since it is not possible to find these values from π0andπ1 or
the coefficients of the structural equations are greater than
the coefficients of the reduced form then we can say that the
equation is under identified and we can not compute four
structured coefficients from two reduced coefficients.
 Why under identification is happened?
 The reason to have under identified function in
the previous demand and supply function was
that:
 The same variables P and Q are appearing in
both functions (only endogenous variables in
both equation)
 There is no additional information.
 Exact /Just/ Identification (SEP=REP)
 It occurs when structural coefficients are equal to
reduced form coefficients.
 Now let’s incorporate additional variable in the
demand function in order to solve the above problem.
Exact /Just/ Identification (SEP=REP)
Exact /Just/ Identification (SEP=REP)
Exact /Just/ Identification (SEP=REP)
 Exact /Just/ Identification (SEP=REP)
 But in case of the demand function α0, α1, and α2, is 3
structural coefficients but in reduced form of equation
the coefficients are two.
 Since in the demand function the coefficient of the
reduced form (10.45) is less than the coefficients of the
structural equation (10.40).
 We can concluded that the demand function is under
identified (π2,π3) are less than α0,α1,and α2).
 But in case of supply function π2,π3 are equal to β0 , β1
then it is just identified.
 In conclusion, we can say that the supply function is
identified but the demand function is not identified on the
basis of this one can say that the system as a whole is not
identified.
 Over identification (SEP<REP)
 It occurs when the coefficients (parameters) of
structural equation is less than the coefficients
(parameters) of reduced forms.
 Let’s modify the demand function by
incorporating wealth (R) and supply function by
incorporating the lagged price we will have the
following equation.
Over identification (SEP<REP)
 Over identification (SEP<REP)
 From equation number 10.47 and 10.48 we have seven
structural coefficients but in equation 10.49 and 10.45
we have eight reduced form coefficients.
 Since the coefficients of reduced form coefficients are
greater than the reduced form coefficients we can say
that the system as a whole is over identified.
 A function (an equation) belonging to a system of
simultaneous equations is identified if it has a unique
statistical form, i.e. if there is no other equation in the
system, or formed by algebraic manipulations of the
other equations of the system, contains the same
variables as the function(equation) in question.
 4.11 Formal Rules (Conditions) for Identification
 Identification problems do not just arise only on two
equation-models.
 Using the above procedure, we can check identification
problems easily if we have two or three equations in a
given simultaneous equation model.
 However, for ‘n’ equations simultaneous equation
model, such a procedure is very cumbersome.
 In general, for any number of equations in a given
simultaneous equation, we have two conditions that
need to be satisfied to say that the model is in general
identified or not.
 In the following section we will see the formal
conditions for identification.
 Formal Rules (Conditions) for Identification
 Actually the term ‘identification’ was originally used to
denote the possibility (or impossibility) of deducing the
values of the parameters of the structural relations from
a knowledge of the reduced form parameters.
 However, we think that the reduced form approach is
conceptually confusing and computationally more
difficult than the structural model approach, because it
requires the derivation of the reduced from first and then
examination of the values of the determinant formed
form some of the reduced form coefficients.
 The reduced form equation is time consuming process.
 The structural form approach is simpler and more useful.
 Thus, the so called order and rank conditions of
identification lighten the task by providing a systematic
way.
 Formal Rules (Conditions) for Identification
 There are two conditions which must be fulfilled for
an equation to be identified. These are:
 1. the order condition for identification
 2. the rank condition for identification
 The identification of a system means the
identification of each question.
 The parameters identification in any equations
means there is unique value for each parameter in
equations.
 Equation is under identified when its statistical
form is not unique/ When one or more of its
equation of the model are identified we can say that
the system as a whole is under identified.
 Formal Rules (Conditions) for Identification
 Equation identified: in this case a system is identified when all
the equations are identified.
 In identified system we can have two options:
 if an equation is under identified it is impossible to
estimate all its parameters using any econometric
techniques. However, if the equation is identified its
coefficients (parameters) can be statistically estimated.
 If the equation is exactly identified appropriate method
for estimation is the method of Indirect Least Square
(ILSM).
 If the equation is over identified, ILS will not give unique
estimates of the parameters b/c it will not yield unique
estimates of structural parameters.
 In this case we use various methods. These are:
 2SLS (Two Stages Least Squares) or
 MLM(Maximum Likely hood methods)
 A. The order condition for identification
 This condition is based on a counting rule of the variables
included and excluded from the particular equation.
 It is a necessary but not sufficient condition for the
identification of an equation.
 The order condition may be stated as follows.
 For an equation to be identified the total number of variables (endogenous
and exogenous) excluded from it must be equal to or greater than the
number of endogenous variables in the model less one.
Let, G = total number of equations (= total number of
endogenous variables)
K= number of total variables in the model (endogenous
and predetermined)
M= number of variables, endogenous and exogenous,
included in a particular equation/ in a specific equation.
 A. The order condition for identification
 Then the order condition for identification may be
symbolically expressed as:

 The guidelines is that:

 If (K-M)> (G-1); the equation is identified.
 If (K-M)= (G-1); the equation is just/exactly
identified.
 If (K-M)< (G-1); the equation is under identified.
 If (K-M)>(G-1); the equation is over identified.
 A. The order condition for identification
Example 1:
Qd  α  α1 P1  α2 I  U1    ( 1 )
Qs  β0  β1 P1  U 2        (2)

• Take the dd equation

• G= total number of equations/ total number of
endogenous variables=2
• K=total number of exogenous and endogenous
variables in equation (1), i.e., in demand equation=3
• The solution is that: (K-M)________(G-1)
• (3-3)____(2-1)=0<1, we conclude that the demand
equation is under identified.
 A. The order condition for identification
Take the ss equation
 Given: G=2; K=3; M=2;
 Solution:
 K-M-------------G-1
 (3-2)--------------(2-1)
 1=1 from these we can conclude that the
supply function is exactly identified.
Example 2: Given the structural model and
determine whether the equation are identified or
under identified.
 A. The order condition for identification
y1  3 y2  2 x1  x2  u1    1
y2  y3  x3  u 2        2
y3  y1  y2  2 x3  u3      3

• Take equation (1);

• Given; M (endogenous and exogenous variables) in this
specified equation is 4 (y1, y2, x1 and x2); K=6; G=3;
• (K-M)----------(G-1)
• 6-4-------------(3-1)
• 2=2-- this equation is identified and it is exactly
identified.
 A. The order condition for identification
• Take equation (2);
• Given; M (endogenous and exogenous variables)
in this specified equation is 3 (y2, y3, & x3);
K=6; G=3;
• (K-M)----------(G-1)
• 6-3-------------(3-1)
• 3>2-- this equation is identified and it is over
identified.
 A. The order condition for identification
• Take equation (3);
• Given; M (endogenous and exogenous variables) in
this specified equation is 4 (y3, y1, y2 and x3); K=6;
G=3;
• (K-M)----------(G-1)
• 6-4-------------(3-1)
• 2=2-- this equation is identified and it is exactly
identified.
 Example 3: if a system contains 10 equations with
15 variables, ten endogenous and five exogenous, an
equation containing 11 variables is not identified,
while another containing 5 variables is identified.
 A. The order condition for identification
 For 1st equation we have:
G=10; K=15; M=11;
Order condition:
 K-M> G-1
 15-11> 10-1
 4<9 that is the order condition is not
satisfied.
 For the 2nd equation we have:
 G=10; K=15; M=5
 Order condition:
 (K-M)> (G-1); 10>9-----the order conditions
satisfied.
 B. The rank condition for identification
 The rank condition states that: in a system of G
equations any particular equation is identified if
and only if it is possible to construct at least one
nonzero determinant of order (G-1) from the
coefficients of the variables excluded from that
particular equation but contained in the other
equations of the model.
 The practical steps for tracing the identifiablity of
an equation of a structural model may be outlined
as follows.
 Firstly, write the parameters of all the equations of
the model in a separate table, noting that the
parameter of a variable excluded from an equation
is equal to zero.
 B. The rank condition for identification

 Where y’s are the endogenous variables and

 x’s are the exogenous variables

 Ignoring the random disturbance the table of

the parameters of the model is as follows:
 B. The rank condition for identification

Secondly, Strike out the row of coefficients of the

equation which is being examined for identification.
For example, if we want to examine the
identifiability of the second equation of the model
we strike out the second row of the table of
coefficients.
 B. The rank condition for identification
 Thirdly, Strike out the columns in which a non-zero coefficient
of the equation being examined appears.
 Table of structural parameter

Equatio Y1 Y2 Y3 X1 X2 X3
ons

1st equ. -1 3 0 -2 1 0

2nd equ. 0 1 1 0 0 1

3rd equ. 1 1 1 0 0 2

 By deleting the relevant row and columns we are left with the
coefficients of variables not included in the particular
equation, but contained in the other equations of the model.
 For example, if we are examining for identification the second
equation of the system, we will strike out the second, third and
the sixth columns of the above table, thus obtaining the
following tables.
B. The rank condition for identification
 B. The rank condition for identification
 Fourthly, form the determinant(s) of order (G-1) and
examine their value.
 Guide line:
 If at least one of these determinants is non-zero, the
equation is identified.
 If all the determinants of order (G-1) are zero, the
equation is under identified.
 In the above example of exploration of the
identifiability of the second structural equation we have
three determinants of order (G-1)=3-1=2. They are:
B. The rank condition for identification
 B. The rank condition for identification
 The identification of a function is achieved by
assuming that some variables of the model have
zero coefficient in this equation, that is, we
assume that some variables do not directly affect
the dependent variable in this equation.
 This, however, is an assumption which can be
tested with the sample data.
 We will examine some tests of identifying
restrictions in a subsequent section.
 Some examples will illustrate the application of
the two formal conditions for identification.
 B. The rank condition for identification
Example:
 Estimation of Simultaneous Equations Models
 To estimate the simultaneous equation models we adopt two approaches.
 The first one is single equation method, also known as limited information method.
 In this single equation method we estimate each question in the system
individually.
 The second one is system methods also known as full information methods.
 In this case we estimate all equations in the model simultaneously.
 In practice system methods are not commonly used for variety of reasons rather,
single equation methods are often used.
 The major single equation methods applied in the estimation of simultaneous
equation methods are:
 1. Ordinary least squares (OLS)
 2. Indirect least squares (ILS)
 3. Two stage least squares (2SLS)
 1. Ordinary Least Squares

 We have seen that applying OLS on simultaneous equation

produce bias & inconsistent parameters.

 But there is one situation OLS can be applied appropriately even

in the context of simultaneous equation.
 1. Ordinary Least Squares
 In equation 10.51 the endogenous variables appear in the left & the exogenous
variables in the right hand side.

 Hence, OLS can apply straight forwardly to this question given all the assumptions of
OLS holds true.

 In equation 10.52 we can apply OLS provided that Y1 & U2 are uncorrelated.

 Again we can apply OLS to the last equation if both Y1 & Y2 are uncorrelated with
U3.

 In this recursive system OLS can be applied to each equation separately & we do not
face a simultaneous equation problem.

 The reason for this is that clear, because there is no interdependence among the
endogenous variables.

 Thus, Y1 affect Y2 influence Y3 without being influenced by Y3.

 In other words each equation exhibits a unilateral causal dependence.

 2. Indirect least square (ILS method)

 ILS is applicable only for just/exact identified equations [(K-M)

= (G-1)].

 The method of obtaining the estimates of the structural

coefficients using OLS of the reduced form coefficients is known
as the method of (ILS) indirect least squares & the estimates
obtained are known as the indirect least squares estimates.

 Indirect Least Square method involves the following Steps

 2. Indirect least square (ILS method)
 1st:We first obtain the reduced form equation from the structural
equations. i.e. explaining the endogenous variables as a function of
explanatory (exogenous variables) & a stochastic term.
 2nd: Apply OLS to the reduced- form equations individually. In
this case the exogenous variables are uncorrelated with the
stochastic term.
 3rd: we obtain estimates of the original structural coefficients
from the estimated reduced-form coefficients obtained in step two.
ILS derives from the fact that structural coefficients are obtained
indirectly from the OLS estimates of the reduced form
coefficients.
 3. Two-Stage Least Squares (2SLS) Method

 The 2SLS procedure is generally applicable for

estimation of over-identified equations as it
provides unique estimators.
 Two-Stage Least Squares (2SLS) Method
involves the following steps.
1st: Estimate the reduced Yˆ form equations by
OLS and obtain the predicted .
2nd: Replace Yˆ the right hand side endogenous
variables in the structural equations by the
corresponding and estimate them by OLS.
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