Econ 302.
Econometrics
Bilkent University
Department of Economics
Taskin
Lab Exercise 12 (Endogeneity and IV estimation)
INSTRUMENTAL VARIABLES
In growth equation, the pace of output growth is perceived as the result of
economic and noneconomic factors in the country. One such exercise examines the
role of “institutions” on output growth.
The paper written by Daron Acemoglu, Simon Johnson and James Robinson “The
Colonial Origins of Comparative Development: An Empirical Investigation”,
published in the American Economic Review, December 2001, vol. 91,
pp1369-1401, examines the role of ‘property rights’ in the output growth. The
presence of secure property rights will create an advantage in creating faster capital
accumulation and output growth.
However, a simple regression of GDP per capita on a measure of property
rights(institutions) may suffer from endogeneity problem or reverse causation of
higher income also ‘causing’ better and stronger property rights (institutions) in
the economy. Hence simple OLS will create a biased and inconsistent estimates.
The estimating equation is;
Logyi = m + a Ri + X'i g + ei
Where the variable of interest is the R and the coefficient is a .
OLS estimations
1. Conduct an OLS estimate. What are the properties of the estimate? How do you interpret
the coefficients? You may also use control variables such as Latitude.
2. Plot y and R.
3. What is the correlation between the residual of this regression and R variable.
The paper makes use of the Instrumental Variable estimation technique and found
one variable strongly correlated with property rights (institutions) but independent
of the error in the equation because of no intertemporal correlation. (Not related in
the same time period). This variable is “settler mortality” (logmort) (for the
countries which has colonization period in their history.
Settler mortality is seen as a predictor of good institutions, hence property rights
because high death rates in the first settlers forced the colonizers to establish good
institution in the countries from which they want to extract resources. The good
institutions then imply good institutions now.
4. Conduct an 2SLS estimation where you are using the Logmort as an instrument for R.
You can reproduce the same results in Table 4 in columns (1) and (2). If you use the 2SLS
command the EVIEWS,
If you use the 2SLS command the EVIEWS should produce the same results, with
some probability of minor difference resulting from difference in algorithms.
This estimation technique is essentially a two stage estimation:
Stage 1. Looks and finds out the common element of the explanatory variable (R in
this case) and the variable that will be used as an instrument (logmort in this case).
Stage 2. At this stage the fitted (filtered part of the explanatory variable which is R̂)
is used as the independent variable
How to deal with the possible endogeneity problem,
Output growth has an impact on institutional development. What variables might be an
instrument for R, protection of property rights. Logmort
Hence, the log of mortality rates in the early colonies can be used as an instrument for R,
protection of property rights today.
5. To see the instrument relevance let’s plot the relationship between R and log M.
6. a)Estimate the relationship and see what variation of R does the log M explains.
Compute the fitted value of Rhat( R̂) in this equation. (First stage of the 2SLS)
b) Estimate the relationship between growth rate and fitted value of R, (Rhat). This is
the second stage of the 2SLS
If you use the 2SLS command the EVIEWS should produce the same coefficient results,
with some probability of minor difference resulting from difference in algorithms
Daron Acemoglu’s web site provides data for 64 ex-colonies:
Variables:
Counryn: countryname
Shortnam: country abbreviaion
Lgdp: log of GDP per capita in 1995
Logmort: log of settler mortality
Latitude: absolute latitude of capital
Prot (R) : measure of protection of property rights
Euro: proportion of population of European descent in 1975
The paper examines the relevance of the mortality rate as a good instrument in following 3
steps:
Theoretically it is expected that present institutions are functions of past institutions and
hence,
Ri = lR + bRCi + X'i g R + uR where C is the past institutions.
Furthermore past institutions depend on measure of early settlements S with the following
function:
Ci = lC + bCSi + X'i g C + uC ,
Early settlements are functions of mortality rate of the early colonies, log of M, with the
following function;
Si = lS + bS log Mi + X'i g S + uS
Hence, the log of mortality rates in the early colonies can be used as an instrument for R,
protection of property rights today.