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Given that,

w=β0+β1p+β3U+ww
p=αw+α1w+α2M+wp
where,
p= the annual rate of price infation in Ghana,
W=the rate of annual wage infation in Chana;
M= money supply (controlled by the central bank)
U= the rate of unemployment in GhanR.
In addition, α1>0;α2>0iβ1>0iβ2<0;up and un are white nolse.
a) Explain why the OLS estimator would yield inconsistent estimates for α1 and P1. (4 mnrks)
b) Use the order condition to establish the identification status of each equation and determine which estimation method is suitable for the estimation of the structural parameters. ( 6 marlcs)
c) Suppose the wage price inflation equation is modified by adding the explanatory variable, X, defined as the rate of growth of productivity which is assumed to be exogenous. The modified wage equation is: w=β0+β1p+β2U+X+uw What happens to the identification status of the two equations? Would you still use the estimation method you used in part (b) above? Explain your answer. (6 marks)
d) Instead of using two-stage least squares (TSLS) a researcher decides to use the instrumental variables (IV) method to obtain consistent estimate for β1. Which exogenous variables in the model can be used as valid instruments? ( 6 marks)
e) Use your answer in part (d) above to Write down the normal equations to be use to estimate β1. (2 marks)
f) Use your answer in part (e) above to obtain the instrumental variable estimate for all three slope parameters in the modified wage equation in part (c) abov

User CZFox
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Answer:

a) The OLS estimator would yield inconsistent estimates for α1 and β1 because these coefficients have a zero in them. This means they cannot be identified from the linear regression and therefore any value could be chosen arbitrarily. In other words, there is no unique solution to these coefficients when estimated using OLS. As a result, the OLS estimators for α1 and β1 may not be very meaningful or reliable.

b) The order conditions for both equations are satisfied if p and U are exogenous. Therefore, the identification status of the first equation is ID(1,1) while the second equation has perfect overlap or ID(1,1). Estimation methods such as OLS or Two Stage Least Squares (TSLS) are appropriate for the estimation of the structural parameters in this case.

c) When the wage equation is modified to include the additional explanatory variable X, the identification status changes to underidentified. Specifically, the new system becomes underindentified because the third column of the augmented regression matrix collapses onto the third column of the original matrix. Because of this, the estimates for the structural parameters become biased and standard inference procedures based on OLS or TSLS may lead to invalid inferences. The same applies even when using IV approach. This problem can occur when there is multicollinearity between the endogenous and exogenous variables.

d) Valid instruments must meet several criteria, including being exogenous relative to the structural errors, having a positive coefficient on the endogenous variable, and being correlated with the endogenous variable. In this context, some possible candidates for instruments include X and W. For example, if X represents productivity shocks, it should be correlated with the error term in the wage equation but uncorrelated with the error terms in the price inflation equation. Similarly, if W represents real wages, it should be correlated with the error terms in the wage equation

e) Using the instruments W and X along with Z, the normal equations to estimate β1 using the instrumental variables (IV) method are given by:

[Z'Z]−1Z'[X'w'-I']=0

This equation requires solving for the parameter vector β1, where X'w'-I' is the reduced form of the wage equation, [Z'Z] is the reduced form matrix of the instruments, and Z'[X'w'-I'] is the reduced form vector of the instrumental variables.

f) To obtain the instrumental variable estimate for all three slope parameters in the modified wage equation, one needs to fit the following two stage least squares (TSLS) models:

First stage:

lnw=β0+β1p+β2U+beta3X+u

Second stage:

lnp=α0+α1lnw+α2M+v

The instruments for the first stage are the reduced form of lnw: X'lnw'-I', and the instruments for the second stage are the reduced form of lnp: [-1,-1,-1,0][lnp-lnw*],[X'lnp-lnw*]. Solving the first stage TSLS model yields consistent estimates for the structural parameters β0, β1, β2, and β3. Then, plugging the TSLS estimates into the second stage TSLS model yields an estimate for α0 and α1. Finally, plugging the estimated α0 and α1 together with the estimated parameters from the first stage back into the original wage and price inflation equations gives us the final estimates for all the slope parameters.

Overall, when using the instrumental variable method, it is crucial to carefully select valid instruments to avoid problems like endogeneity bias in the estimations. Additionally, correct specification of the economic model, proper data handling, and careful consideration of assumptions are necessary steps towards obtaining accurate results in applied economics.

User Kashif Khan
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