Instrument Strength in IV Estimation and Inference: A Guide to Theory and Practice

Michael Keane () and Timothy Neal
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Michael Keane: School of Economics

No 2022-07, Discussion Papers from School of Economics, The University of New South Wales

Abstract: 2SLS has poor properties if instruments are exogenous but weak. But how strong must instruments be for 2SLS estimates and test statistics to exhibit acceptable properties? A common standard is a first-stage F ≥ 10. This is adequate to ensure two- tailed t-tests have small size distortions. But other problems persist: In particular, we show 2SLS standard errors tend to be artificially small in samples where the estimate is most contaminated by the OLS bias. Hence, if the bias is positive, the t-test has little power to detect true negative effects, and inflated power to find positive effects. This phenomenon, which we call a “power asymmetry,†persists even if first-stage F is in the thousands. Robust tests like Anderson-Rubin perform better, and should be used in lieu of the t-test even with strong instruments. We also show how 2SLS test statistics typically suffer from very low power when first-stage F is near 10, leading us to suggest a higher standard of instrument strength in empirical practice.

Keywords: Instrumental variables; weak instruments; 2SLS; endogeneity; F-test; size distortion; Anderson-Rubin test; likelihood ratio test; LIML; GMM; Fuller; JIVE (search for similar items in EconPapers)
JEL-codes: C12 C26 C36 (search for similar items in EconPapers)
Pages: 44 pages
Date: 2022-11
New Economics Papers: this item is included in nep-ecm and nep-ets
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Journal Article: Instrument strength in IV estimation and inference: A guide to theory and practice (2023)
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