CFDP 1872

Non-linearity Induced Weak Instrumentation


Publication Date: September 2012

Pages: 38


In regressions involving integrable functions we examine the limit properties of IV estimators that utilise integrable transformations of lagged regressors as instruments. The regressors can be either I(0) or nearly integrated (NI) processes. We show that this kind of nonlinearity in the regression function can significantly affect the relevance of the instruments. In particular, such instruments become weak when the signal of the regressor is strong, as it is in the NI case. Instruments based on integrable functions of lagged NI regressors display long range dependence and so remain relevant even at long lags, continuing to contribute to variance reduction in IV estimation. However, simulations show that OLS is generally superior to IV estimation in terms of MSE, even in the presence of endogeneity. Estimation precision is also reduced when the regressor is nonstationary.


Instrumental variables, Integrable function, Integrated process, Invariance principle, Local time, Mixed normality, Stationarity, Nonlinear cointegration, Unit roots, Weak Instruments

JEL Classification Codes: C22, C32

See CFP: 1404