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The document discusses simultaneous equations systems, structural equations, and the issues of simultaneous equation bias in econometric modeling. It explains the importance of using techniques like Two-Stage Least Squares (2SLS) to obtain consistent parameter estimates and outlines the conditions for identifying equations in a model. Additionally, it highlights the advantages of 2SLS over Indirect Least Squares (ILS) and the necessity of checking order and rank conditions for model identification.

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11 views13 pages

1 Merwo

The document discusses simultaneous equations systems, structural equations, and the issues of simultaneous equation bias in econometric modeling. It explains the importance of using techniques like Two-Stage Least Squares (2SLS) to obtain consistent parameter estimates and outlines the conditions for identifying equations in a model. Additionally, it highlights the advantages of 2SLS over Indirect Least Squares (ILS) and the necessity of checking order and rank conditions for model identification.

Uploaded by

amanueco21
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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1.

▎A) Simultaneous Equations System or Model

A simultaneous equations system or model refers to a set of equations in which multiple variables are
interdependent, meaning that the value of one variable affects the value of another, and vice versa. This
type of model is commonly used in economics and social sciences to represent complex relationships
where various factors influence each other simultaneously.

For example, in an economic model, supply and demand can be represented as simultaneous equations,
where the quantity supplied depends on price, and the quantity demanded also depends on price. The
solution to this system provides the equilibrium price and quantity.

▎B) Structural Equation

A structural equation is an equation that represents a specific relationship between variables based on
theoretical foundations. It reflects the underlying structure of a model, capturing causal relationships
among endogenous (dependent) and exogenous (independent) variables.

In structural equation modeling (SEM), these equations are often used to test hypotheses about
relationships between observed and latent variables. Structural equations can incorporate both direct
and indirect effects, allowing researchers to explore complex interdependencies.

▎C) Simultaneous Equation Bias Reduced Form of Equations

1. Simultaneous Equation Bias:

• This bias arises when estimating parameters in a system of simultaneous equations using ordinary
least squares (OLS) regression. Because the dependent variable in one equation may be correlated with
the error term in another equation, OLS estimates can be biased and inconsistent.

• For instance, if you try to estimate demand for a product using price as an independent variable, but
price is also influenced by demand (as it is determined by market equilibrium), then the OLS estimates
will not accurately reflect the true relationship.
2. Reduced Form of Equations:

• The reduced form of an equation refers to a transformation of a simultaneous equations system into
a single equation that expresses each endogenous variable solely in terms of exogenous variables
(independent variables).

• In this form, all endogenous variables are expressed as functions of only exogenous variables,
eliminating the direct interdependencies among them. This approach allows for consistent estimation of
parameters because it avoids the simultaneous equation bias.

• For example, if you have a system of supply and demand equations, the reduced form would express
quantity demanded and quantity supplied as functions of prices and other exogenous factors without
directly linking them to each othe

2.a) We need this simultaneous equation model


because both the demand and supply sides of the
market are determined by multiple factors, and they
are interdependent. By using a simultaneous equation
model, we can account for the interdependencies
between the demand and supply equations and
estimate the parameters of each equation more
accurately.

b) The estimation of demand and supply functions by


OLS can give biased and inconsistent parameter
estimates because the error terms in both equations
may be correlated. When the error terms are
correlated, the OLS estimators are no longer unbiased
and consistent. This is known as the simultaneous
equations bias. To obtain consistent, we need to use
techniques such as the Two-Stage Least Squares (2SLS)
or the Three-Stage Least Squares (3SLS) to account for
the interdependencies between the equations.

3.a) To determine if the demand and supply functions


are exactly identified, overidentified, or
underidentified, we need to compare the number of
structural parameters with the number of equations.

In this case, we have two equations (demand and


supply) and three structural parameters for each (α₁, α₂,
β₁, β₂). Since the number of structural parameters is
equal to the number of equations, the model is exactly
identified.
b) The reduced form equations represent the
relationships between the endogenous variables and
the exogenous variables in the system. To find the
reduced form equations, we need to solve the system of
equations for the endogenous variable Qt.

Demand: Qt = α₀ + α₁P₁ + α₂Yt + U₁


Supply: Qt = β₀ + β₁P₁ + β₂T₂ + U₂

By solving these equations simultaneously, we get the


reduced form equation:

Qt = (α₀ + β₀)/2 + (α₁ + β₁)/2 * P₁ + (α₂ + β₂)/2 * T₂ + (U₁ +


U₂)/2

c) The structural parameters are the coefficients that


represent the relationships between the endogenous
and exogenous variables in the system. To derive the
formula for the structural parameters, we need to solve
the system of equations for the structural parameters.

From the demand function, we can solve for α₁:

α₁ = (Qt - α₀ - α₂Yt - U₁)/P₁

From the supply function, we can solve for β₂:

β₂ = (Qt - β₀ - β₁P₁ - U₂)/T₂

Therefore, the formula for the structural parameters is:


α₁ = (Qt - α₀ - α₂Yt - U₁)/P₁
β₂ = (Qt - β₀ - β₁P₁ - U₂)/T₂
4.a) Indirect least squares (ILS) and two-stage least
squares (2SLS) are estimation techniques used in
econometrics when dealing with endogeneity
issues in regression models. They are typically
used when there is a need to account for the
correlation between the independent variables
and the error term in the regression equation.

b) The shortcoming of using indirect least squares


is that it assumes a specific form for the
relationship between the independent variables
and the error term. This assumption may not
always hold true in real-world scenarios, leading to
potential biases in the estimation results.
Additionally, ILS may not provide the most
efficient estimates compared to other estimation
techniques.
c) The advantage of 2SLS over ILS is that it does not
rely on any specific form for the relationship
between the independent variables and the error
term. Instead, it uses a two-stage approach where
the first stage involves regressing the independent
variables on the error term, and the second stage
involves regressing the dependent variable on the
transformed independent variables. This approach
allows for more flexibility and robustness in
capturing the underlying relationships in the data.
Additionally, 2SLS can provide more efficient
estimates compared to ILS, especially when there
are multiple endogenous variables involved.

5.To determine the identification of


each equation in the model, we need to
check the order and rank conditions.
1. **Order Condition:**
The order condition states that the
number of endogenous variables must
be equal to or greater than the number
of exogenous variables in each
equation. In this case, each equation
has three endogenous variables (Y1, Y2,
Y3) and one exogenous variable (X1, X2,
X3). Therefore, the order condition is
satisfied for each equation.

2. **Rank Condition:**
The rank condition requires that the
matrix of coefficients for the
endogenous variables in each equation
has full rank. This means that the
matrix should have a rank equal to the
number of endogenous variables.

Let's examine the matrices of


coefficients for each equation:

For the first equation:


$Y1 = 4Y2 - 3X1 + U1$

The matrix of coefficients for the


endogenous variables is:
$\begin{bmatrix}
0 & 4 & 0 \\
0 & 0 & -3 \\
0 & 0 & 0 \\
\end{bmatrix}$

The rank of this matrix is 2, which is less


than the number of endogenous
variables (3). Therefore, the first
equation does not satisfy the rank
condition.

For the second equation:


$Y2 - 2Y3 + 2X3 + U2$
The matrix of coefficients for the
endogenous variables is:
$\begin{bmatrix}
0 & 1 & 0 \\
-2 & 0 & 2 \\
0 & 0 & 0 \\
\end{bmatrix}$

The rank of this matrix is 2, which is less


than the number of endogenous
variables (3). Therefore, the second
equation does not satisfy the rank
condition.
For the third equation:
$Y3 = 2Y1 - 3Y2 + X2 + X3 + U3$

The matrix of coefficients for the


endogenous variables is:
$\begin{bmatrix}
2 & -3 & 0 \\
0 & 0 & 1 \\
0 & 0 & 0 \\
\end{bmatrix}$

The rank of this matrix is 2, which is less


than the number of endogenous
variables (3). Therefore, the third
equation does not satisfy the rank
condition.

In summary, none of the equations in


the model satisfy the rank condition.
This indicates that the model is not
identified, and we cannot uniquely
determine the values of the
endogenous variables based on the
given equations.

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