Instrumental variables estimation

Summary

Instrumental variables estimation recovers the coefficients of a linear model when some regressors are correlated with the error term, a situation called endogeneity. Endogeneity arises from omitted variables, simultaneous equations or measurement error, and it makes ordinary least squares inconsistent. An instrument is a variable that is correlated with the endogenous regressor but uncorrelated with the error. It isolates the part of the regressor's variation that is free of the confounding. Two-stage least squares is the standard instrumental variables estimator, and it is a special case of the generalized method of moments.