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A Gentle Introduction to Instrumental Variables

Instrumental variable (IV) methods are widely used in economics for estimating regression models where the right hand side variables are correlated with the error terms. Such correlation arises in a number of circumstances: simultaneous equation models, the use of proxy variables, and omitted regressors being common examples. In this tutorial, I compare ordinary least squares (OLS) and IV methods. Comparison of the distribution of the OLS and IV estimators will be intuitive rather than formal. I then give several empirical examples from the econometric literature to illustrate how to find and use instruments.