Question

Details the properties that the instruments must satisfy for the IV estimator to be appropriate.

Answer 1

Instrumental Variables (IV) is a method of estimation that is widely used in many economic applications when correlation between the explanatory variables and the error term is suspected - for example, due to omitted variables, measurement error, or other sources of simultaneity bias.

Predicted values are formed by projecting xi on a set of instrumental variables or instruments, which are required to have two important properties:

1. It is related to the explanatory variable(s) xi (informative): It ensures that the predicted values are related to xi.
2. It is uncorrelated with the errors ui (valid): It ensures that the predicted values are uncorrelated with ui.