WPS4632
Policy ReseaRch WoRking PaPeR 4632
Instrumental Variables Regressions
with Honestly Uncertain Exclusion
Restrictions
Aart Kraay
The World Bank
Development Research Group
Macroeconomics and Growth Team
May 2008
Policy ReseaRch WoRking PaPeR 4632
Abstract
The validity of instrumental variable regression models uncertainty about the exclusion restriction into increased
depends crucially on fundamentally untestable exclusion uncertainty about parameters of interest. Moderate prior
restrictions. Typically exclusion restrictions are assumed uncertainty about exclusion restrictions can lead to a
to hold exactly in the relevant population, yet in many substantial loss of precision in estimates of structural
empirical applications there are reasonable prior grounds parameters. This loss of precision is relatively more
to doubt their literal truth. This paper shows how to important in situations where instrumental variable
incorporate prior uncertainty about the validity of the estimates appear to be more precise, for example in larger
exclusion restriction into linear instrumental variable samples or with stronger instruments. These points are
models, and explores the consequences for inference. illustrated using several prominent recent empirical
In particular the paper provides a mapping from prior papers that use linear instrumental variable models.
This paper--a product of the Growth and the Macroeconomics Team, Development Research Group--is part of a larger
effort in the department to develop tools for the analysis of development issues. Policy Research Working Papers are also
posted on the Web at http://econ.worldbank.org. The author may be contacted at akraay@worldbank.org.
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
Produced by the Research Support Team
Instrumental Variables Regressions
with Honestly Uncertain Exclusion Restrictions
Aart Kraay
The World Bank
_____________________________
1818 H Street NW, Washington DC, 20433, akraay@worldbank.org. I would like to thank Daron
Acemoglu, Laura Chioda, Frank Kleibergen, Dale Poirier and Luis Serven for helpful comments.
The opinions expressed here are the author's and do not reflect the official views of the World
Bank, its Executive Directors, or the countries they represent.
"The whole problem with the world is that fools and fanatics are always so certain of
themselves, but wiser people are so full of doubts"
Bertrand Russell
The validity of the widely-used linear instrumental variable (IV) regression model
depends crucially on the exclusion restriction that the error term in the structural
equation of interest is orthogonal to the instrument. In virtually all applied empirical work
this identifying assumption is imposed as if it held exactly in the relevant population. But
in the vast majority of empirical studies using non-experimental data, it is hard to be
certain that the exclusion restriction is literally true as it is fundamentally untestable.1
Recognizing this, careful empirical papers devote considerable effort to selecting clever
instruments and arguing for the plausibility of the relevant exclusion restrictions. But
despite the best efforts of the authors, readers (and authors) of these papers may in
many cases legitimately entertain doubts about the extent to which the exclusion
restriction holds.
In this paper I consider the implications of replacing the standard identifying
assumption that the exclusion restriction is literally true with a weaker one: that there is
prior uncertainty over the correlation between the instrument and the error term,
captured by a well-specified prior distribution centered on zero. The standard and stark
prior assumption is that this distribution is degenerate with all of the probability mass
concentrated at zero, so that the exclusion restriction holds with probability one in the
population of interest. In most applications however a more honest, or at least more
modest, prior assumption is that there is some possibility that the exclusion restriction
fails, even if our best guess is that it is true.
I then explore the consequences for inferences about the structural parameters
of interest of such prior uncertainty about the validity of the exclusion restriction. I find
that even modest prior uncertainty about the validity of the exclusion restriction can lead
to a substantial loss of precision in the IV estimator. Somewhat surprisingly, this loss of
precision is relatively more important in situations in which the usual IV estimator would
1Murray (2006) poetically refers to this as the "cloud of uncertainty that hovers over instrumental
variable estimation".
1
otherwise appear to be more precise, for example, when the sample size is large or the
instrument is particularly strong. The intuition for this is straightforward. If I am willing to
entertain doubts about the literal validity of the exclusion restriction, having a stronger
instrument or having a larger sample size cannot reduce my uncertainty about the
exclusion restriction, as the data are fundamentally uninformative about its validity.
Since prior uncertainty about the exclusion restriction is unaffected by sample size or the
strength of the instrument, while the variance of the IV estimator declines with sample
size and the strength of the instrument for the usual reasons, the effects of prior
uncertainty about the exclusion restriction become relatively more important in
circumstances where the IV estimator would otherwise appear to be more precise.
In this paper I rely on the Bayesian approach to inference. With its explicit
treatment of prior beliefs about parameters of interest, it provides a natural framework for
considering prior uncertainty about the exclusion restriction. I use recently-developed
techniques from the literature on Bayesian analysis of linear IV models, and extend them
to allow for prior uncertainty over the validity of the exclusion restriction. However, to
keep the results as familiar as possible (and hopefully as useful as possible) to non-
Bayesian readers, I confine myself to particular cases that mimic standard frequentist
results as closely as possible.
The broader goal of this paper is to provide a practical tool for producers and
users of linear IV regression results who are willing to entertain doubts about the validity
of their exclusion restrictions. Too often discussions of empirical papers that use IV
regressions have an absolutist character to them. The author of the paper feels
compelled to assert that the exclusion restriction relevant to his or her instrument and
application is categorically true, and the skeptical reader, or seminar participant, or
referee, is left in an uncomfortable "take it or leave it" position. One possibility is to
wholeheartedly accept the author's untestable assertions regarding the literal truth of the
exclusion restriction, and with them the results of the paper. The stark opposite
possibility is to reject the literal truth of the exclusion restriction, and with it the results of
the paper.
The results in this paper provide a modest but useful step away from such
"foolish and fanatical" behaviour that the quote from Bertrand Russell reminds us of. For
2
example, using the results in this paper, the producers and consumers of a particular IV
regression can readily agree on how much prior uncertainty about the validity of the
exclusion restriction would be consistent with the author's results remaining significant at
conventional levels. In some circumstances results might be quite robust to substantial
prior uncertainty about the exclusion restriction, in which case the author and skeptical
reader might agree that the author's conclusions are statistically significant even if they
do not agree on the likelihood that the exclusion restriction is in fact true. In other
circumstances, even a little bit of prior uncertainty about the exclusion restriction might
be enough to overturn the significance of the author's results, in which case the reader
who is skeptical about the validity of the exclusion restriction would be justified in
rejecting the conclusions of the paper. The contribution of this paper is to provide an
explicit tool to enable such robustness checks for uncertainty about the exclusion
restriction.
I illustrate these results using three prominent studies that use linear IV
regressions. Rajan and Zingales (1998) study the relationship between financial
development and growth, using measures of legal origins and institutional quality as
instruments for financial development. Frankel and Romer (1999) study the effects of
trade on levels of development across countries, using the geographically-determined
component of trade as an instrument. Finally, Acemoglu, Johnson and Robinson (2001)
study the effects of institutional quality on development in a sample of former colonies,
using historical settler mortality rates in the 18th and 19th centuries as instruments. In
all three cases, reasonable readers might entertain some doubts as to the literal validity
of the exclusion restriction. I show how to adjust the standard errors in core
specifications from these papers to reflect varying degrees of uncertainty about the
exclusion restriction. For the first two papers I find that moderate uncertainty about the
exclusion restriction is sufficient to call into question whether the findings are indeed
significant at conventional levels, while the findings of the third paper appear to be more
robust to all but extreme prior uncertainty about the exclusion restriction.
Most theoretical and empirical work using the linear IV regression model
proceeds from the assumption that the exclusion restriction holds exactly in the relevant
population. One notable recent exception, closely related to this paper, is Hahn and
Hausman (2006). They study the asymptotic properties of OLS and IV estimators when
3
there are known "small" violations of the exclusion restriction. In particular, they allow
for a known correlation between the instrument and the error term, and in order to obtain
asymptotic results they assume that this correlation shrinks with the square root of the
sample size. Since the violation of the exclusion restriction is "local" in this particular
sense, they find no effects on the asymptotic variance of the IV estimator. They then go
on to compare the asymptotic mean squared error of the OLS and IV estimators, and
show that IV dominates OLS according to this criteria unless violations of the exclusion
restriction are strong. My approach and results differ importantly in two respects. First, I
do not assume that the strength of violations of the exclusion restriction declines with
sample size. While this assumption is analytically convenient when deriving asymptotic
properties of estimators, it is not very intuitive. Since in general the data are
uninformative about exclusion restrictions, it is unclear why we should think that
concerns about the validity of the exclusion restriction are diminished in larger samples.
Second, I explicitly incorporate uncertainty about the exclusion restriction, by assuming
that there is a well-specified prior distribution over the correlation between the instrument
and the error term. In contrast Hahn and Hausman (2006) treat violations of the
exclusion restriction as a certain but unknown parameter to be chosen by the
econometrician.2 The uncertainty about the exclusion restriction that I emphasize is
central to my results, as this uncertainty is responsible for the increased posterior
uncertainty about parameters of interest. Closely related to their paper is Berkowitz,
Caner and Fang (2008) who assume the same 'local' violation of the exclusion
restriction, and demonstrate that standard test statistics in the IV regression model tend
to over-reject the null hypothesis.
The results in this paper are also closely related to (although developed
independently of) those in Conley, Hansen, and Rossi (2007). They study linear IV
regression models in which there are potentially failures of the exclusion restriction
(which they refer to as "plausible exogeneity"). They propose a number of strategies for
investigating the robustness of inference in the presence of potentially invalid
instruments, including a fully-Bayesian approach like the one taken here. While very
similar in approach, this paper complements theirs in three respects. First, I focus on
2A similar approach of considering the sensitivity of coefficient estimates and tests of
overidentifying restrictions to parametric violations of the exclusion restriction is taken by Small
(2007).
4
special cases in which analytic or near-analytic results on the effects of prior uncertainty
about the exclusion restriction are available, which helps to develop some key insights.
In contrast, their paper uses numerical methods to construct and sample from the
posterior distribution of the parameters of interest. Second, I characterize how the
consequences for inference of prior uncertainty about the exclusion restriction depend
on the characteristics of the observed sample. This can provide guidance to applied
researches as to whether such prior uncertainty is likely to matter significantly in
particular samples. Finally, I provide several macroeconomic cross-country applications
of this approach that complement the more microeconomic examples in their paper.
The rest of the paper proceeds as follows. In order to develop intuitions based
on analytic results, I begin in Section 2 with the simplest possible example of a bivariate
OLS regression. This is of course a particular case of IV in which the regressor serves
as its own instrument. I consider the consequences of introducing prior uncertainty
about the correlation between the regressor and the error term for inference about the
slope coefficient. In this simple case I can analytically characterize the effect of prior
uncertainty of the precision of the OLS estimator. In Section 3 I turn to the IV regression
model, focusing on the particular case of a just-identified specification with a single
endogenous regressor. The same insights and analytic results from the OLS case apply
to the OLS estimates of the reduced-form of the IV regression model. Although I am no
longer able to analytically characterize the effect of prior uncertainty on the precision of
the IV estimator of the structural slope coefficient of interest, it is straightforward to
characterize it numerically and show how it depends on the characteristics of alternative
realized samples. Section 4 of the paper applies these results to three empirical
applications. Section 5 offers concluding remarks and discusses potential extensions of
the results.
5
2. The Ordinary Least Squares Case
I begin by showing how to incorporate prior uncertainty about the exclusion
restriction in the simplest possible case: a linear OLS regression. It is helpful to begin
with this simple case by way of introduction. In the next section of the paper we will see
how these results extend in a very straightforward way to linear IV regression models.
2.1 Basic Setup and the Likelihood Function
Consider the following bivariate linear regression:
(1) yi = xi +i
The regressor x is normalized to have zero mean and unit standard deviation. Assume
further that the regressor and the error term are jointly normally distributed:
(2) xii ~ N 0, 0 2
1
The key assumption here is that I allow for the possibility that the error term is correlated
with the regressor, i.e. might be different from zero. In the case of OLS this is the
relevant failure of the exclusion restriction. In the next section when I discuss the IV
case, I will assume that an instrumental variable z is available for x, but might be invalid
in the sense that the instrument is correlated with the error term .
The distribution of the error term conditional on x is:
(3) i| xi ~ N xi , 2 1-2
( ( ))
Note of course that when 0, the usual conditional independence assumption
E i| xi = 0 that is normally used to justify OLS does not hold.
[ ]
6
Let y and X denote the Tx1 vectors of data on y and x in a sample of size T, and
note that the normalization of x implies that X'X=T. Also let = T-1X'y denote the OLS
^
estimator of the slope coefficient, and let s2 = y - X y - X /(T -1) be the OLS
( ^ )( ^)
estimator of the variance of the error term. Finally, define 2 1- 2 . With this
( )
notation the likelihood function can be written as:
2
1- 2
(4) L( y,X;,,) -T2 exp- 1 (T -1)s2 + -^ -
2 /T
2.2 The Prior Distribution
In Bayesian analysis, the parameters of the model, in this case , , and , are
treated as random variables. The analyst begins by specifying a prior probability
distribution over these parameters, reflecting any prior information that might be
available. This prior distribution for the parameters is then multiplied with the likelihood
function, which is simply the distribution of the observed data conditional on the
parameters. Using Bayes' Rule this delivers the posterior distribution of the model
parameters conditional on the observed data sample. Inferences about the parameters
of interest are based on this posterior distribution. In many applications, choosing an
appropriately uninformative or diffuse prior distribution for the parameters results in a
posterior distribution that is closely analogous to the usual frequentist results. In the
case of a simple OLS regression where =0 with certainty, an example of such a diffuse
prior distribution is to assume that and ln() are independently and uniformly
distributed, which implies that their joint prior distribution is proportional to 1/. In this
case, a well-known textbook Bayesian result is that the marginal posterior distribution for
is a Student-t distribution with mean equal to the OLS slope estimate and variance
equal to the estimated variance of the OLS slope. As a result, a standard frequentist 95
7
percent confidence interval would be analogous to the range from the 2.5th percentile to
97.5th percentile of the posterior distribution for .
In order to retain this link with standard frequentist results, I will maintain this
diffuse prior assumption for and . My main interest is in specifying a non-degenerate
prior distribution for the correlation between the regressor and the error term, . Note
that in the standard case there is a drastic asymmetry between prior beliefs about and
the other parameters of the model. In particular, prior beliefs about are usually
assumed to be highly informative in the sense that the prior probability distribution for
is degenerate with all the probability mass at zero, while prior beliefs about and are
assumed to be diffuse or totally uninformative. My objective is to relax this asymmetry
by allowing for some prior uncertainty about the exclusion restriction. In particular, I
assume the prior distribution for is proportional to 1- 2
( ) over the support (-1,1),
where is a parameter that governs prior confidence as to the validity of the identifying
assumption. In particular, when =0 we have a uniform prior over (-1,1). As increases
the prior becomes more concentrated around zero, and in the limit we approach the
standard assumption that =0 with probability one. Figure 1 plots this prior distribution
for alternative values of . The top panel of Table 1 reports the 5th and 95th percentiles
of the distribution for alternative values of . For example, setting =500 corresponds to
the rather strong prior belief that there is a 90 percent probability that is between -0.05
and 0.05, and only a 10 percent probability that it is further away from zero.
A natural extension is to allow the prior distribution for to have a non-zero
mean, in order to encompass prior beliefs that there might be systematic violations of
the exclusion restriction. Although this is straightforward to do, I do not pursue this
option here as it adds little in the way of additional conceptual insights. For example, if
our prior is that the mean of is positive, then there will be a corresponding downward
adjustment in the mean of posterior distribution for the slope coefficient. Moreover, the
adjustments to the variance of the posterior distribution due to uncertainty about the
exclusion restriction will be the same as what we have in the case where has a zero
mean, and these adjustments to the variance are of primary interest here.
8
Assuming further that the prior distribution for is independent of the prior distribution for
the other two parameters, we have the following joint prior distribution for the three
parameters of the model:
(5) g(,,) -1 1- 2 ( )
2.3 The Posterior Distribution
The posterior density is proportional to the product of the likelihood and the prior
density, i.e. from applying Bayes' Rule. Multiplying these two distributions and
performing some standard rearrangements gives:
2
f(,, | y,X) (/ T)-2 exp- 1 1 -^ - 1- 2
2 /T
(6)
-T2 exp-
+1
2
1 (T -1)s2 (1-2 )
The first line is proportional to a normal distribution for conditional on and , with
mean -^ and variance /T . When =0, this is the very standard
1- 2
Bayesian result for the linear regression model with a diffuse prior. In particular, when
=0, the posterior conditional distribution of is normal and is centered on the OLS
estimate . When is different from zero, the mean of the conditional posterior
^
distribution for needs to be adjusted to reflect this failure of the exclusion restriction. If
the correlation between the regressor and the error term is positive (negative), then
9
intuitively, the posterior mean needs to be adjusted downwards (upwards) from the OLS
slope estimator.
The second line is the joint posterior distribution of and . It consists of the
product of an inverted gamma distribution for and the posterior distribution for .3 The
posterior distribution for is also standard, and intuitively has a mean equal to the OLS
standard error estimator (times a small degress of freedom correction), i.e.
E =
[ ] (T -3)
(T -1) s2 .
The only novel part of Equation (6) is the posterior distribution for , which is
identical to the prior distribution. This is what Poirier (1998) refers to as a situation in
which the data are marginally uninformative about the unidentified parameter . This in
turn is a consequence of our prior assumption that is independent of the other
parameters of the model.4 Although the data are uninformative about , since we have
now explicitly incorporated uncertainty about the exclusion restriction, we can explicitly
average over this uncertainty when performing inference about the slope coefficient of
interest, . In particular, we know that the marginal posterior distribution of will reflect
our uncertainty about the exclusion restriction. We turn to this next.
2.3 Inference About With an Uncertain Exclusion Restriction
Inferences about are based on its marginal posterior distribution, which is
obtained by integrating and out of the joint posterior distribution of all three
3A random variable x follows an inverted gamma distribution, x~IG(,) if its pdf is:
f(x;,) = ()- x-( +1) exp- 2
x1 . Setting x=2, = T -1, = and
2 s2 (T -1)
disregarding the unimportant constant of proportionality gives the result in the text.
4If by contrast the prior distribution allowed for some dependence between the unidentified
parameter and the identified ones, then the posterior distribution for would no longer be
identical to the prior. Intuitively, if the unidentified and identified parameters are a priori
dependent, then the data will through this channel be informative about the unidentified
parameters.
10
parameters. This integration does not appear to be tractable analytically.5 However,
given the conditional structure of the posterior distribution, it is straightforward to
compute the mean and variance of the marginal posterior distribution of by repeated
application of the law of iterated expectations. In particular, for the posterior mean we
find:
(7) E = ^ - sB(T)E
[ ] = ^
1-2
where B(T) ((T -2)/2) T2-1
((T -1)/2) 1 as T becomes large, and we have used the
fact that E = B(T)s .
[ ]
Note that the last expectation is with respect to the marginal posterior distribution
of . When is identically equal to zero, we have the usual result that the mean of the
posterior distribution of is the OLS slope estimate. However, when there is prior (and
thus also posterior) uncertainty about , we have an additional term reflecting this
uncertainty. This term involves the expectation (with respect to the posterior density for
) of . When the prior (and posterior) are symmetric around =0, this term is
1- 2
unsurprisingly zero in expectation. If we are agnostic as to whether the correlation
between the error term and x is positive or negative, on average this does not affect the
posterior mean of . Of course for other priors (and posteriors) not symmetric around
zero this would not be the case, and the posterior mean of would have to be adjusted
accordingly.
The posterior unconditional variance is more interesting, and can also be found
by repeated application of iterated expectations:
5 When =0, standard results show that integrating out of the joint posterior distribution results
in a marginal t-distribution for . However this convenient standard result does not go through
when differs from zero.
11
(8) V = s2 T + E1-
[ ] 1 2 T -
2 T 1
-3
Disregarding the small degrees of freedom correction (T -1)/(T - 3) , the first term is
just the standard OLS estimator of the variance of , which is
^ s2
. The second term is
T
a correction to the variance estimator coming from the fact that there is uncertainty about
the conditional mean of coming from our uncertainty about . In fact, the second term
is recognizeable as the variance of the adjustment to the conditional mean that we saw
above.
This correction to the posterior variance of is quantitatively very important
because it does not decline with the sample size T. The reason for this is
straightforward -- since the data are uninformative about the correlation between the
regressor and the error term, having a larger sample cannot reduce our uncertainty
about this parameter.
The bottom panel of Table 1 gives a sense of the quantitative importance of this
1/2
adjustment to the posterior variance. Define 1+ T E
2
1- as the ratio of the
2
standard deviation of the posterior distribution of in the case where there is prior
uncertainty about , to the same standard deviation in the standard case where is
identically equal to zero. This ratio captures the inflation of the posterior standard
deviation due to uncertainty about . This ratio can be large, particularly in cases where
the sample size is large and/or when there is greater prior uncertainty about . For
example, for the case where =100, so that 90 percent of the prior probability mass for
lies between -0.12 and 0.12, the posterior standard deviation is 22 percent higher in a
sample size of 100, but 87 percent higher when the sample size is 500, and 245 percent
larger in a sample of size 1000. Moving to the left in the table to cases with greater prior
uncertainty about results in even greater inflation of the posterior standard deviation.
12
In summary, in this section I have shown how to incorporate prior uncertainty
about the relevant exclusion restriction in a very simple OLS example. The main insight
from this section is that even modest doses of prior uncertainty about the exclusion
restriction can substantially magnify the variance of the posterior distribution of .
Moreover, this effect is greater the larger is the sample size, as the intrinsic uncertainty
about the exclusion restriction becomes relatively more important. The results of this
section will be helpful in developing results for the IV case in the following section, and
the key insight regarding the role of sample size will generalize naturally.
13
3 The Instrumental Variables Case
I now extend the results of the previous section to the case of the linear IV
regression model in which there is prior uncertainty about the validity of the exclusion
restriction. In this section I show that this type of uncertainty magnifies the posterior
variance of the slope coefficients in the reduced-form version of the model, and this in
turn makes the unconditional posterior distribution of the structural slope coefficient of
interest more dispersed. I also show how this increase in dispersion depends on the
characteristics of the observed sample.
3.1 Basic Setup
To keep things as simple as possible I focus on the particular case where the
dependent variable y is a linear function of a single potentially endogenous regressor, x,
and a single instrument z is available for x. The structural form of the model is:
yi = xi +i
(9) xi = zi + vi
The main parameter of interest is , which captures the structural relationship between y
and x. The parameter captures the relationship between the instrument z and the
endogenous variable x.
For convenience I assume that, like the endogenous regressor x, the instrument
z has also been normalized to have a zero mean and unit standard deviation. I assume
further that the two error terms and the instrument are jointly normally distributed:
i 0 2
(10) vi 2vv 0
zi ~ N 0 , 0 1
where 2 and 2v are the variances of the two error terms, and and are the
correlations of with v, and with z, respectively.
14
The standard assumption used to identify the linear IV model is that the
correlation between the instrument z and the error term is identically equal to zero.
This is the exclusion restriction which stipulates that the only channel through which the
instrument z affects the dependent variable y is through the endogenous variable x.
When the exclusion restriction holds, it is possible to separate the the regressor x into (i)
an endogenous component, v, that has a potentially nonzero correlation with the error
term, and (ii) an exogenous component ·z that is uncorrelated with the error term when
=0. This latter exogenous source of variation in x can then be used to identify the slope
coefficient . In fact, this is precisely the intuition behind two-stage least squares (2SLS)
estimation. In the first stage, the endogenous variable is regressed on the instrument x.
The fitted values from this first-stage regression are used as a proxy for the exogenous
component of x in the second-stage regression.
When the exclusion restriction fails to hold, the instrumental variables estimator
of is biased with a bias equal to . This bias is larger (in absolute value) the
larger is the correlation between the instrument and the error term, and the weaker is the
correlation between the instrument and the endogenous variable x, i.e. the smaller is .
Standard practice is to impose the identifying assumption and proceed as if it
were literally true. This approach is appealing because it ensures -- albeit purely by
assumption -- that the IV estimator will be consistent for . But in most empirical
applications using non-experimental data, it is impossible to be sure that the exclusion
restriction in fact holds, as it is fundamentally untestable.
Bayesian analysis of the linear IV model is most conveniently based on the
reduced form of the model in Equation (9). The reduced form is obtained by substituting
the second equation into the first:
yi = zi +ui
(11) xi = zi + vi
15
where ui i + vi and . This latter identity allows us to retrieve the slope
parameter of interest, , from the coefficients of the reduced-form model. This is
precisely the principle of indirect least squares. In particular, in the just-identified case I
consider here, the 2SLS estimator of is the ratio of the OLS estimators of and from
the two equations of the reduced form.
The distributional assumptions for the structural form of the model imply the
following distribution for the reduced form errors and the instrument:
ui 0 u 2 u v u
(12) vi 2v 0
zi ~ N 0 ,
0 1
where:
u = 2 + 2v +22v
2
= +v
(13) 2 + 2v +22v
=
2 + 2v +22v
Note that the correlation between the reduced form error u and the instrument z is the
counterpart of the correlation between the structural form error and the instrument z.
When the exclusion restriction holds exactly, ==0, and we have the standard linear IV
regression model. In the next section of the paper I show how to replace this exact
exclusion restriction with something weaker: a non-degenerate prior probability
distribution over the correlation between the instrument and the error term.
The distribution of the reduced-form errors u and v conditional on the instrument
is:
16
(14) ui 2
vi zi ~ N
u zi
0 , u (1-2) u v 2v
This in turn implies the following distribution for y and x conditional on the instrument:
(15) yxii zi ~ N
( +u)zi ,
zi u (1-2) 2vv
2
u
Let Y denote the Tx2 matrix with the T observations on (yi,xi) as rows; let Z denote the
Tx1 vector containing the T observations on zi; and recall that Z has been normalized
such that Z'Z=T. Let denote the variance-covariance matrix of (yi,xi) conditional on zi.
Define the 1x2 matrix G : and let G : = Z'Z
( ) ^ (^ ) ( )
^ -1Z'Y denote the matrix of
OLS estimates of the reduced-form slope coefficients and
S Y - ZG Y - ZG /(T -1) as the estimated variance-covariance matrix of the
( ^ )( ^ )
residuals from the OLS estimation of the reduced-form slopes. The multivariate
generalization of the likelihood function in Equation (4) is:6
L(Y,X,Z;G,,)= -TM / 2 -T /2
(16) exp- tr-1(T -1)S+ T G- G- u :0) G- G- u :0)
1 ( (^ ( ))( (^ ( ))
2
3.2 Bayesian Analysis of the IV Regression Model
When the exclusion restriction holds exactly, i.e. ==0, the reduced-form model
in Equation (11) becomes a standard multivariate linear regression model, in this
particular case with two equations in which the dependent variable y and the
endogenous regressor x are both regressed on the instrument z. Bayesian analysis of
6See for example Zellner (1973), Equation 8.6 or Poirier (1996), Equation 10.3.12.
17
the linear IV model builds on well-established textbook results for Bayesian analysis of
the multivariate regression model (for textbook treatments of the latter see Zellner
(1971), Ch. 8 and Poirier (1996), Ch. 10). In particular, the multivariate regression
model admits a natural conjugate prior, meaning that the prior and posterior distributions
have the same analytic form. Moreover, there are analytic results providing the mapping
from the parameters of the prior distribution to the parameters of the posterior
distribution, which make transparent how the observed data is used to update prior
beliefs.
Hoogerheide, Kleibergen and Van Dijk (2008) extend these tools to analysis of
the linear IV regression model. Their key insight is that, since there is a one-to-one
mapping between the structural and the reduced-form parameters, the familiar prior and
posterior distributions for the reduced form parameters in the multivariate regression
model induce well-behaved prior and posterior distributions over the structural
parameters. They analytically characterize these distributions for the structural
parameters for a number of particular cases, and provide an application to the Angrist-
Krueger data. I follow their approach, but with a further extension to allow for prior
uncertainty over the validity of the exclusion restriction.
3.3 The Prior Distribution
I begin by specifying the same prior distribution over the correlation between the
reduced-form error and the instrument, , that was used in the previous section of the
paper, i.e. g 1- 2
( ) ( ) over the support (-1,1) where is a parameter that governs
the strength of the prior belief that this correlation is zero. For the remaining parameters,
I make the standard multivariate analog of the diffuse prior assumptions for these
parameters in the OLS case. In particular, define 11 = (1- 2 )u , 2
12 = (1-2)-1 , and 22 = 2v , so that =
/2 11 12 11 22 , and let the prior
22
distribution for the elements of be -3/2. This prior corresponds to the Jeffrey's prior
for the multivariate regression model when =0. And, as in the OLS case, this choice of
prior distribution ensures that the Bayesian results mimic the frequentist ones for the
18
case where =0. In this case, the posterior distribution for the reduced-form slopes is a
multivariate Student-t distribution centered in the OLS slope estimates. With the further
assumption that the prior distribution of the reduced-form slopes is uniform and
independent of the other parameters, we have the following joint prior distribution:
(17) g(G,, ) -3 1- 2 /2 ( )
Before proceeding, it is useful to characterize the prior distribution that this
implies for the correlation between the structural disturbance and the instrument, .
Since = u , the prior distribution of will in general
u -2 uv / +( /)22v
2
depend on the entire joint prior distribution of all of the structural parameters. However,
since the prior distribution of the remaining parameters is chosen to be uninformative, it
is straightfoward to verify numerically that the distribution of has the same shape and
percentiles as the distribution of .7 As a result, we can use the percentiles reported in
Table 1 for the prior distribution of in the OLS case to interpret the prior distributions of
and in the IV case.
3.4 The Posterior Distribution
The posterior distribution for the parameters of interest is proportional to the
product of the likelihood function and the prior, i.e. from applying Bayes' Rule.
Multiplying these two distributions and rearranging gives:
7It is straightforward although tedious to compute the Jacobian of the mapping from the structural
parameters to the reduced-form parameters, and use this to write down the joint prior distribution
of all the structural-form parameters. It does not however appear to be tractable to extract
analytically from this the implied marginal distribution of . This is why I instead characterize this
distribution numerically.
19
L(G,,|Y,X,Z)
: 0
-1/2 ^ 11 -1 ^ 11
(18) exp- G-G-
1
2 1- 2 : 0 G - G -
T 1- 2
-(T-2)/2exp- tr -1S(T -1) 1-2
1 { )
2 } (
This expression is just the multivariate generalization of Equation (6). The first line is
proportional to a normal distribution for the matrix of reduced-form slopes, G, conditional
on and , with mean ^ - 11 : ^ and variance-covariance matrix
. When
1- 2 T
=0, we again retrieve the standard Bayesian result for the multivariate linear regression
model with a diffuse prior for the reduced-form of the IV regression. In particular, when
=0, the posterior conditional distribution of the reduced-form slopes is normal and is
centered on their OLS estimates. However, when is different from zero, the mean of
the conditional posterior distribution for needs to be adjusted to reflect this failure of the
exclusion restriction, which induces a correlation between the regressor and the error
term in the first structural equation. If the correlation between the regressor and the
error term is positive (negative), then intuitively, the posterior mean needs to be adjusted
downwards (upwards) from the OLS slope estimator. In contrast, no adjustment is
required for the conditional mean of , since by assumption the error term in the second
structural equation is orthogonal to the instrument.
The second line is the joint posterior distribution of and , and is again
precisely analogous to the OLS case. It consists of the product of an inverted Wishart
distribution for and the posterior distribution for . The posterior inverted Wishart
distribution for is the multivariate generalization of the inverted gamma distribution for
in the OLS case, and again it is intuitively centered on the OLS variance estimator, i.e.
E =
[ ] T -1 S .
T - 3
20
As in the OLS case, the only novel part of Equation (6) is the posterior
distribution for , which once again is identical to the prior distribution. As before, the
prior and the posterior are identical because the data are marginally uninformative about
this parameter given the prior independence between and the other parameters of the
model. However, since we have explicitly incorporated uncertainty about the exclusion
restriction, we can explicitly average over this uncertainty when performing inference
about the slope coefficients of interest.
3.4 Inference with an Uncertain Exclusion Restriction
As in the OLS case, we want to base inferences about on its marginal posterior
distribution, which is obtained by integrating all of the other parameters out of the joint
posterior distribution. Again, this is unfortunately not tractable analytically and needs to
be done numerically. However, we can obtain some useful insights by first studying how
the distribution of the reduced-form slopes is affected by prior uncertainty about the
exclusion restriction.
We begin by using the law of iterated expectations to compute the unconditional
posterior mean and variance of the reduced-form slopes:
(19) E : = ^ - sB(T)E
[ ] ( : ^)
: ^ = ^
1-2
and
(20) V : =
[ ] s11 1/ T +E 2 /(1- 2)
2( [ ])
s222 /T T - 3
s12 /T T -1
s12 / T
These expressions are just the multivariate generalizations of Equations (6) and (7) in
the OLS case, and the intuitions for them are identical. Since the prior (and posterior)
distribution for has zero mean, the expectation in Equation (19) is equal to zero and so
the unconditional posterior mean for the reduced-form slopes is equal to their OLS
21
estimates. The effects on the posterior variance are substantively more interesting. As
before, we see that the posterior variance of increases due to uncertainty about the
exclusion restriction. In fact, the posterior variance of is identical to the OLS case. It
consists of the usual component that declines with sample size, s11 / T , as well as an
2
adjustment capturing the variance of the adjustment to the sample mean due to
uncertainty about the exclusion restriction, s11 E 2 /(1- 2 ) . The key point once again
2 [ ]
is that this adjustment does not decline with sample size, and so uncertainty about the
exclusion restriction has proportionately larger effects on the posterior variance of the
reduced-form slope coefficient when the sample size is large. In contrast, there is no
change in the posterior variance of the slope coefficient from the first-stage regression,
, as the exclusion restriction is not relevant to the estimation of this slope parameter.
This adjustment to the posterior variance of the reduced-form coefficient will
also be reflected in the distribution of the structural form coefficients. In particular, since
=/, and since uncertainty about the exclusion restriction expands the posterior
variance of alone, we would expect to see a similar increase in the dispersion of the
posterior distribution of as well. I characterize this effect by sampling from the
posterior distribution of . In fact, since the posterior distribution of conditional on
and is a Cauchy-like ratio of correlated normal random variables, it is not even clear
that moments of the unconditional posterior distribution of exist.
In general, the effects of prior uncertainty about the exclusion restriction on the
posterior distribution of the structural slope coefficient of interest will be sample-
dependent. This is because the posterior distribution in Equation (18) depends on the
observed sample through the OLS estimates of the reduced form slopes and residual
variances, ^ , , and S. In order to give a sense of how the effects of prior uncertainty
^
about the exclusion restriction might vary in different observed samples, I present some
simple illustrative calculations for alternative hypothetical observed samples. I begin by
innocuously assuming that the observed data on y and x are scaled to have mean zero
and variance one, as is z. The observed sample can therefore be characterized by three
sample correlations, Ryx, Ryz, and Rxz, and the observed reduced-form slopes and
residual variances can be expressed in terms of these correlations as:
22
(21) (^:^)=(R )
yz:Rxz and S = 1-R2yz Rxy -Rzy Rxz
1-R2xz
For each hypothetical sample summarized by a combination of assumptions on the three
sample correlations, I sample from the posterior distribution of , for a range of values
for the parameter governing prior uncertainty about the exclusion restriction, , and for
different values of the sample size, T. I take 10,000 draws from the posterior distribution
of in each case, and compute the 2.5th and 97.5th percentiles of the distribution. This
is analogous to a standard frequentist 95 percent confidence interval for the IV estimate
of the slope coefficient.
The results of this exercise are summarized in Table 2. Each row of the table
corresponds to a set of assumptions on the observed sample correlations and the
sample size. These assumptions are spelled out in the left-most columns, in italics. In
each row I also report the 2.5th and 97.5th percentiles of the posterior distribution for
in the standard case where there is no uncertainty about the exclusion restriction, i.e.
when ==0. This serves as a benchmark. The right-most columns correspond to
various assumption about , corresponding to varying degrees of prior certainty about
the exclusion restriction. I consider the same range of values as in Table 1, and for
reference at the top of the table I report the 5th and 95th percentiles of the prior
distribution of (and ) that these imply. Each cell entry reports the length of the
interval from the 2.5th to the 97.5th percentile of the posterior distribution of ,
expressed as a ratio to the length of this same interval when ==0, i.e. relative to the
standard case.
Not surprisingly, all of the entries in Table 2 are greater than one, reflecting the
fact that prior uncertainty about the exclusion restriction increases the dispersion of the
posterior distribution of . This increase in posterior uncertainty regarding is of course
higher the greater is prior uncertainty regarding the exclusion restriction. Consider for
example when all three sample correlations are equal to 0.5 and the sample size is
equal to 100. When =10, corresponding to significant uncertainty about the exclusion
restriction, the 95 percent confidence interval for is 2.14 times larger than the
23
benchmark case where ==0 by assumption. However, as increases this
magnification of posterior uncertainty is smaller, and when =500 the confidence
intervals are just 1.03 times larger than the benchmark case.
Unsurprisingly, Table 2 also confirms that in all cases the magnification of
posterior uncertainty is greater the larger is the sample size. For example, when all
three sample correlations are equal to 0.5 and the sample size is equal to 100, the
confidence interval for is inflated by a factor of 2.14 when T=100, but it is inflated by a
factor of 4.45 when T=500. The reason for this is the same as in Section 2 in the OLS
case. There we saw that the correction to the posterior variance of to capture
uncertainty about the exclusion restriction does not decline with sample size, and so its
effect on posterior uncertainty is proportionately greater the larger is the sample size.
The more interesting insight from Table 2 is that the magnification of posterior
uncertainty about also depends on the moments of the observed sample in a very
intuitive way. Consider the first panel of Table 2, where I vary the strength of the first-
stage sample correlation between the instrument and the endogenous variable, Rxz,
holding constant the other two correlations.8 In the standard case where ==0 by
assumption, the confidence intervals of course shrink as the strength of the first-stage
relationship increases. However, the magnification of the posterior variance increases
as the strength of the first-stage relationship increases. The intuition for this is
analogous to the intuition for the effects of sample size. A larger sample size, and also a
stronger first-stage relationship between the instrument and the endogenous variable
permit more precise inferences about . However, a larger sample size and a stronger
first-stage regression cannot reduce our intrinsic uncertainty about the validity of the
exclusion restriction, and so the adjustment to the posterior variance to account for this
is proportionately greater. Of course this does not mean that uncertainty about the
8 In these examples I have chosen hypothetical samples in which we are unlikely to encounter
well-known weak-instrument pathologies. In fact, the minimum correlation of 0.3 between the
endogenous variable and the instrument in this table is deliberately chosen to ensure that the
first-stage F-statistic is almost 10 in the smallest sample of size T=100 that I consider, and is
greater than 10 in all other cases. This corresponds to the rule of thumb proposed by Staiger
and Stock (1997) for distinguishing between weak and strong instruments. These weak-
instrument pathologies pose no particular difficulties for Bayesian analysis that bases inference
on the entire posterior distribution of . However, with weak instruments the Bayesian highest
posterior density intervals I focus would no longer necessarily be symmetric around the mode of
the posterior distribution.
24
exclusion restriction is less important in an absolute sense in small samples or with weak
instruments -- only that its effects on posterior uncertainty are smaller relative to other
sources of posterior imprecision about the parameters of interest.
The same insight holds in the second and third panels of Table 2. In the second
panel, I vary the strength of the observed sample correlation between the dependent
variable and the instrument, Ryz. Since I am holding constant the other two correlations
in this panel, larger values of Ryz correspond to greater endogeneity problems, and
hence less precise IV estimates of the structural slope coefficient in the benchmark
case where ==0 by assumption. Since varying the extent of the endogeneity problem
does not affect the intrinsic uncertainty about the exclusion restriction, I find that the
magnification of the confidence interval declines as Ryz increases. A similar effect
occurs in the third panel, where I vary the strength of the observed correlation between y
and x. Since I am holding the other two correlations constant, higher values of Rxy imply
a more precisely-estimated structural relationship between these two variables.
However, once again this does not affect intrinsic prior (and posterior) uncertainty about
the exclusion restriction, and so the magnification of the confidence intervals increases
as Rxy increases.
In summary, we have seen that prior uncertainty about the exclusion restriction
can substantially increase posterior uncertainty about the key structural slope coefficient
of interest, . The magnitude of this inflation of posterior uncertainty depends of course
depends on the degree of prior uncertainty about the exclusion restriction. But it also
depends on the characteristics of the observed sample in a very intuitive way. Holding
other things constant, a greater sample size, a stronger first-stage relationship between
the instrument and the endogenous variable, a stronger structural correlation between
dependent variable and the endogenous variable, and a weaker reduced-form
correlation between the endogenous variable and the instrument all imply a more
precise IV estimator, absent any prior uncertainty about the exclusion restriction.
However, since none of these factors help to reduce prior (or posterior) uncertainty
about the exclusion restriction, this uncertainty becomes relatively more important.
25
4. Empirical Applications
I next demonstrate the quantitative importance for inference of prior uncertainty
about exclusion restrictions in three well-known empirical studies that use linear
instrumental variables models. Acemoglu, Johnson and Robinson (2001, hereafter AJR)
study the causal effects of institutions on economic development. Using a sample of 64
former colonies, they regress the logarithm of GDP per capita on a measure of property
rights protection. They propose using historical data on mortality rates experienced by
settlers during the colonial period as a novel instrument for institutional quality. AJR
argue that in areas where settlers experienced high mortality rates, colonial powers had
few incentives to set up institutions that protect property rights and provide a foundation
for subsequent economic activity. In a simple bivariate specification there are a number
of obvious concerns regarding the validity of the exclusion restriction that settler mortality
rates matter for development only through their effects on institutional quality. Historical
settler mortality rates might be correlated with the tropical location and intrinsic disease
burden of a country, and these factors may matter directly for modern development.
AJR seek to address such concerns in their paper through the addition of various control
variables to capture these effects. For example, we will show results using one of their
core specifications in which they control for latitude to capture such locational effects
(Table 4, Column 2 in AJR). And in the paper they also present a wide range results
with direct controls for location and the disease burden.9
Nevertheless, a reader of AJR might reasonably entertain some doubts as to
whether the exclusion restriction holds exactly even in these extended specifications.
There are many potential correlates of settler mortality rates that might in turn be
correlated with development outcomes. For example, Glaeser et. al. (2004) argue that
low settler mortality rates may have operated through investments in human capital
rather than institutions to protect property rights. Here we do not take any stand as to
9 Ideally I would like to use one of AJR's specifications with a more complete set of control
variables to illustrate the effects of uncertainty about exclusion restrictions. However, in many of
their specifications with more control variables, their instruments are much weaker, and I do not
want to conflate my point about uncertainty regarding exclusion restrictions with the well-known
concerns with weak instruments. For example, in Columns (7) and (8) of Table 4, AJR introduce
continent dummies, and continent dummies together with latitude. In these specifications, I find
first-stage F-statistics on the excluded instrument of 6.83 and 3.97, well below the Staiger and
Stock (1997) rule of thumb of 10. This suggests that the settler mortality instrument does not
have sufficiently strong explanatory power within geographic regions.
26
which of these potential failures of the exclusion restriction is the right one. Rather we
simply argue that reasonable people might question whether the exclusion restriction
holds exactly, and might entertain some probability that it is not in fact true.
My second example is Frankel and Romer (1999, hereafter FR), who study the
relationship between trade openness and development in a large cross-section of
countries. They regress log GDP per capita on trade as a share of GDP. To address
concerns about potential reverse causation and omitted variables, they propose a novel
instrument based on the geographical determinants of bilateral trade. In particular, they
estimate a regression of bilateral trade between country pairs on the distance between
the countries in the pair, their size measured by log population and log area, and a
dummy variable indicating whether either country in the pair is landlocked. They then
use the fitted values from this bilateral trade regression to come up with a constructed
trade share for each country that reflects only these geographical determinants of trade.
They then use this as an instrument for trade. In their core specification, they also
control directly for country size, as measured by log population and log land area, to
control for the problem that large countries tend to trade less and these size variables
also enter in the bilateral trade equation. There are however various reasons why the
necessary exclusion restriction (that the geographically-determined component of trade
matters for development only through its effects on overall trade) may not hold exactly.
For example, Rodriguéz and Rodrik (2000) discuss various channels through which the
geographical variables in the FR bilateral trade regression might have direct effects on
per capita incomes.
My third example comes from Rajan and Zingales (1998, hereafter RZ), who
study the relationship between financial development and growth. In contrast with the
previous two papers that exploit purely cross-country variation, this paper uses a novel
identification strategy that exploits within-country cross-industry differences in
manufacturing growth rates. They construct a measure of the dependence of different
manufacturing sectors on financial services, and then ask whether industries that are
more financially-dependent grow faster in countries where financial development is
greater. In particular, they estimate regressions of the growth rate of industry i in country
j on a set of country dummies, a set of industry dummies, the initial size of the industry,
and an interaction of the financial dependence of the sector with the level of financial
27
development in the country. In a number of specifications, RZ instrument for this final
interaction term with variables capturing the legal origins of the country and a measure
of institutional quality, all interacted with a measure of financial development. In
particular, I will focus on the specification in Table 4, column 6 of RZ, where the relevant
measure of financial dependence is an index of accounting standards recording the
types of information provided in annual reports of publicly-traded corporations in a cross-
section of countries.
This third example differs from the previous ones in two key respects. First,
because RZ rely on the within-country variation in sectoral growth rates, potential
violations of the exclusion restriction are less obvious than in the previous two cases. In
RZ, the requirement is that the instruments be orthogonal to the country- and industry-
specific component of growth, since the regressions contain country and industry
dummies. Thus for example, concerns about the exclusion restriction are not that
countries with faster growth adopt better accounting standards, but rather that countries
with a relatively faster growth in financially-dependent industries would adopt better
accounting standards. Nevertheless there might be residual concerns about the validity
of the exclusion restriction in this case. The second difference is that RZ use multiple
instruments, while the results I show above apply to the case of a single instrument. To
make the RZ results fit into the framework of this paper, I choose just one of their
instruments and first reproduce the RZ results in this just-identified case. For this
purpose I choose their index of efficiency and integrity of the legal system, produced by
a commercial risk rating agency, as the one instrument of choice. Doing so gives a
result that is of comparable significance to the RZ core result, although the magnitude of
the estimated coefficient becomes somewhat larger than what RZ report.10
I use datasets provided by the authors to reproduce their results. In each of the
three examples, I first project the dependent variable, the regressor of interest, and the
instrument on all the remaining control variables that these authors treat as exogenous,
so that I can identify these residuals as y, x, and z in the discussion above. I also
normalize the variance of z to be equal to one, consistent with the discussion above. I
10An alternative is to use just their dummy variable for Scandinavian legal origins as an
instrument, which generates results that are quite similar to those reported by RZ. Conversely,
using either dummies for British or French legal origins alone as an instrument does not deliver
significant IV estimates of the coefficient on the interaction variable of interest.
28
then take 10,000 draws from the posterior distribution of , for alternative values of
corresponding to varying degrees of prior uncertainty about the exclusion restriction. I
then compute the 2.5th, 50th and 97.5th percentiles of this distribution.
Table 3 summarizes the results, with three panels corresponding to the three
examples. In each panel in the first column I report the sample size and my replication
of the relevant IV slope coefficient and standard error from each paper. In the columns
of the table I provide summary statistics on the posterior distribution for the slope
coefficient, for varying degrees of prior uncertainty about the exclusion restriction. In
addition, Figure 2 plots the posterior densities for the slope coefficient for selected
values of . Unsurprisingly, in all three panels of this figure we clearly see how the
posterior distribution of the slope coefficient becomes more dispersed as uncertainty
about the exclusion restriction increases.
This increase in posterior dispersion is quantified in the table, which reports the
2.5th, 50th, and 97.5th percentiles of the posterior distribution of the structural slope
coefficient for each of the three papers. To read this table, it is useful to begin with the
last column which reports these percentiles for the limiting case where tends to infinity
and thus the prior distribution imposes =0 with certainty. This corresponds to the
standard Bayesian IV estimates in which there is no uncertainty regarding the exclusion
restriction. Because of my choice of diffuse priors for all of the parameters other than ,
when =0 these Bayesian results mimic the classical ones quite closely, with these
percentiles quite similar to the 95 percent confidence intervals reported in the first
column. This is particularly so for RZ, while for FR and AJR the posterior distribution of
the slope is somewhat longer right tail, with the result that the 97.5th percentiles are a bit
higher than the upper bounds of the classical confidence intervals. This is also apparent
in Figure 2, where the thin solid line plots a normal distribution with mean and standard
deviation corresponding to the classical IV slope coefficient estimate and estimated
standard error. For RZ this normal distribution coincides almost perfectly with the
posterior distribution for the slope when =0, while there are some small discrepancies
for the other two papers.
Moving from right to left in Table 3 illustrates the effects of greater prior
uncertainty about the exclusion restriction. In each of the three panels, I summarize this
29
increase in the dispersion of the posterior distribution by reporting the length of the
interval from the 2.5th percentile to the 97.5th percentile, relative to the length of the
same interval when =0 with certainty. These intervals expand substantially as
uncertainty about the exclusion restriction increases. For example, for FR in the middle
panel, this interval is 2.8 times as wide when =10, while for RZ in the bottom panel it is
7.26 times as wide. This greater proportional effect on posterior uncertainty about the
structural slope is consistent with what we saw in the artificial samples in Table 2, as RZ
have a larger sample size and a stronger instrument than do FR. In contrast, for AJR
with their smaller sample, the increase in posterior dispersion is smaller.
Table 2 also can be used to determine how great prior uncertainty about the
exclusion restriction needs to be in order for the interval from the 2.5th percentile to the
97.5th percentile of the posterior distribution of to include zero. In the case of AJR,
their particular specification that we report is most robust to uncertainty about the
exclusion restriction. Even when =5, so that there is a great deal of prior uncertainty,
with 90 percent of the prior probability mass for (and ) between -0.46 and 0.46, the
2.5th percentile of the posterior distribution of the slope is greater than zero. This is not
however the case for FR and RZ. Moving from =200 to =100, the 2.5th percentile of
the posterior distribution of the slope falls below zero. This in turn means that if the prior
distribution of (and ) is such that more than 10 percent of the prior probability mass
falls outside the interval of about (-0.1,0.1), then the Bayesian analog of the 95 percent
confidence interval includes zero.
30
5. Extensions and Conclusions
The validity of the IV estimator depends crucially on the validity of fundamentally
untestable exclusion restrictions. Typically these exclusion restrictions are assumed to
hold exactly in the relevant population. However, in many empirical examples it is
reasonable to doubt their validity. In this paper I have shown how to explicitly
incorporate prior uncertainty about the exclusion restriction into the linear IV regression
model. This prior uncertainty about the exclusion restriction leads to greater posterior
uncertainty about parameters of interest, in some cases quite substantially so. This
enables straightforward checks of the robustness of inferences about structural
parameters to varying degrees of prior uncertainty about the exclusion restriction.
There are at least two natural extensions of the results presented here. The first
I have already discussed: allowing the prior distribution for the correlation between the
instrument and the error term to have a non-zero mean. This would encompass not only
prior uncertainty about the validity of the exclusion restriction, but also prior beliefs about
the direction of likely violations of the exclusion restriction. For example, one might
specify a prior distribution for that is a translation of a beta distribution, i.e.
( +1)/2 ~ Beta(1,1) . With appropriate choices of the prior parameters 1 and 2, a
prior such as this can capture prior beliefs regarding both the mean and the variance of
. Since there is no updating of the prior distribution of , we will have the same
posterior distribution, and we can simply (numerically) integrate over this distribution to
arrive at the marginal posterior distribution for the slope coefficients of interest. This will
have predictable effects on the results presented here: the posterior mean of the
distribution of the structural slope coefficients will need to be adjusted to reflect the non-
zero prior and posterior mean for the distribution of , since the expectation in Equation
(19) will no longer be zero. While this extension may be practically useful in many
situations where there might be obvious potential directions for violations of the
exclusion restriction, conceptually this adds little in the way of additional insights.
The second is to consider the case of multiple instruments and multiple
endogenous variables. In this paper, I have focused on the case of a single endogenous
variable and a single instrument in order to keep the results as transparent as possible.
Moving to the case of multiple endogenous variables and potential overidentification also
31
poses no particular conceptual problems, although it does pose two modest practical
difficulties. First, when there are multiple instruments, we need to elicit a prior
distribution over the correlation between each of the instruments and the structural error
term, rather than just a simple univariate prior over a single parameter that I have used
here. In practice, it may be difficult to flexibly specify such a prior in a way that captures
differing degrees of certainty about the exclusion restriction for each instrument.
Second, in the case of overidentification, the mapping from the reduced-form parameters
to the structural parameters is more complex, and therefore it is more difficult to simulate
the prior and posterior distribution of the structural parameters that is implied by the prior
and posterior distribution over the reduced-form parameters. Hoogerheide, Kleibergen
and Van Dijk (2007) provide further details on this case.
32
References
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Berkowtiz, Daniel, Mehmet Caner and Ying Fang (2008). "Are 'Nearly Exogenous'
Instruments Reliable?". Economics Letters. (article in press).
Conley, Tim, Christian Hansen and Peter E. Rossi (2007). "Plausibly Exogenous".
Manuscript. Graduate School of Business, University of Chicago.
Frankel, Jeffrey A. and David Romer (1999). "Does Trade Cause Growth?" The
American Economic Review, (June) 379-399.
Glaeser, Edward, Rafael Laporta, Florencio Lopez-de-Silanes, and Andrei Shleifer
(2004). "Do Institutions Cause Growth?". Journal of Economic Growth.
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Murray, Michael (2006). "Avoiding Invalid Instruments and Coping with Weak
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Poirier, Dale J. (1998). "Revising Beliefs in Nonidentified Models". Econometric Theory.
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Small, Dylan (2007). "Sensitivity Analysis for Instrumental Variables Regression With
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33
Table 1: Inference in the OLS Case
Value of Prior Parameter
5 10 100 200 500 1000
90% Prior Probability of Between:
Lower -0.46 -0.34 -0.12 -0.08 -0.05 -0.04
Upper 0.46 0.34 0.12 0.08 0.05 0.04
Inflation of Posterior Standard Deviation of When T=:
100 3.32 2.45 1.22 1.12 1.05 1.02
200 4.58 3.32 1.41 1.22 1.10 1.05
500 7.14 5.10 1.87 1.50 1.22 1.12
1000 10.05 7.14 2.45 1.87 1.41 1.22
34
Table 2: Inference in the IV Case
Value of Prior Parameter
5 10 100 200 500
90 percent of prior probability between:
Lower -0.46 -0.34 -0.12 -0.08 -0.05
Upper 0.46 0.34 0.12 0.08 0.05
Assumptions on Observed Sample Width of 95% Confidence Interval for
Indicated Value of
(Relative to Width when =0)
Vary Strength of First-Stage CORR(x,z)
Rxy= 0.5 Ryz= 0.5 Rxz= 0.3
95% CI for (1.00, 4.02) T=100 1.85 1.49 1.05 1.05 1.04
95% CI for (1.32, 2.20) T=500 4.44 3.16 1.41 1.26 1.11
Rxy= 0.5 Ryz= 0.5 Rxz= 0.5
95% CI for (0.65, 1.52) T=100 2.95 2.14 1.17 1.10 1.03
95% CI for (0.84, 1.19) T=500 6.42 4.45 1.72 1.42 1.17
Rxy= 0.5 Ryz= 0.5 Rxz= 0.7
95% CI for (0.47, 0.99) T=100 3.28 2.41 1.22 1.13 1.05
95% CI for (0.61, 0.83) T=500 7.19 5.00 1.86 1.48 1.23
Vary Strength of Reduced Form CORR(y,z)
Rxy= 0.5 Ryz= 0.3 Rxz= 0.5
95% CI for (0.24, 0.99) T=100 3.71 2.64 1.24 1.11 1.05
95% CI for (0.45, 0.76) T=500 8.09 5.75 2.01 1.60 1.29
Rxy= 0.5 Ryz= 0.5 Rxz= 0.5
95% CI for (0.65, 1.52) T=100 2.95 2.14 1.17 1.10 1.03
95% CI for (0.84, 1.19) T=500 6.42 4.45 1.72 1.42 1.17
Rxy= 0.5 Ryz= 0.7 Rxz= 0.5
95% CI for (1.01, 2.11) T=100 2.02 1.57 1.07 1.06 1.05
95% CI for (1.21, 1.65) T=500 4.17 3.13 1.33 1.21 1.09
Vary Strength of Structural CORR(y,x)
Rxy= 0.3 Ryz= 0.5 Rxz= 0.5
95% CI for (0.60, 1.63) T=100 2.57 1.92 1.12 1.06 1.02
95% CI for (0.81, 1.23) T=500 5.34 3.70 1.53 1.31 1.13
Rxy= 0.5 Ryz= 0.5 Rxz= 0.5
95% CI for (0.65, 1.52) T=100 2.95 2.14 1.17 1.10 1.03
95% CI for (0.84, 1.19) T=500 6.42 4.45 1.72 1.42 1.17
Rxy= 0.7 Ryz= 0.5 Rxz= 0.5
95% CI for (0.72, 1.39) T=100 3.65 2.70 1.28 1.16 1.07
95% CI for (0.87, 1.15) T=500 8.14 5.73 2.03 1.64 1.28
35
Table 3: Empirical Examples
Value of Prior Parameter
5 10 100 200 500
90% Prior Probability of Between:
Lower -0.46 -0.34 -0.12 -0.08 -0.05 0.00
Upper 0.46 0.34 0.12 0.08 0.05 0.00
Acemoglu-Johnson-Robinson (2001)
(Table 4, Column 2)
T=64
IV Slope = 0.96
IV Standard Error = 0.21
95% C.I. = (0.53, 1.39)
Posterior Distribution for Slope
2.5th Percentile 0.08 0.32 0.61 0.63 0.63 0.65
Mode 0.95 0.96 0.96 0.96 0.96 0.96
97.5th Percentile 2.31 2.06 1.80 1.81 1.76 1.75
Increase in P025-P975 range 2.02 1.57 1.08 1.07 1.02 1.00
Frankel-Romer (1999)
(Table 3, Column 2)
T=150
IV Slope = 1.97
IV Standard Error = 0.91
95% C.I. = (0.18, 3.76)
Posterior Distribution for Slope
2.5th Percentile -5.62 -3.61 -0.28 0.01 0.14 0.31
Mode 1.98 1.95 1.97 1.98 1.96 1.96
97.5th Percentile 10.73 8.66 5.37 5.04 4.83 4.69
Increase in P025-P975 range 3.73 2.80 1.29 1.15 1.07 1.00
Rajan-Zingales (1998)
(Table 4, Column 6)
T=1067
IV Slope = 0.31
IV Standard Error = 0.08
95% C.I. = (0.16, 0.46)
Posterior Distribution for Slope
2.5th Percentile -1.27 -0.82 -0.06 0.02 0.10 0.16
Mode 0.30 0.31 0.31 0.31 0.31 0.31
97.5th Percentile 1.85 1.41 0.70 0.60 0.53 0.47
Increase in P025-P975 range 10.14 7.26 2.45 1.90 1.40 1.00
36
Figure 1: The Prior Distribution for , OLS Case
14
12
10 eta=0
eta=5
8 eta=10
eta=100
6
eta=500
4
2
0
-1 -0.5 0 0.5 1
Correlation between x and
37
Figure 2: Posterior Distribution for Structural Slopes
2.5
eta=10
Acemoglu, 2 eta=100
Johnson and phi=0
Robinson (2001)1.5 normal
1
0.5
0
-1 -0.5 0 0.5 1 1.5 2 2.5 3
0.5
0.45
eta=10
0.4
Frankel and eta=100
0.35
Romer (1999) phi=0
0.3
normal
0.25
0.2
0.15
0.1
0.05
0
-6 -4 -2 0 2 4 6 8 10
6
5 eta=10
Rajan and eta=100
Zingales (1998) 4 phi=0
normal
3
2
1
0
-1.5 -1 -0.5 0 0.5 1 1.5
38
39