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Overcoming the Many Weak Instrument Problem Using Normalized Principal Components

In: Essays in Honor of Jerry Hausman

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  • Nicky Grant

Abstract

Principal component (PC) techniques are commonly used to improve the small sample properties of the linear instrumental variables (IV) estimator. Carrasco (2012) argue that PC type methods provide a natural ranking of instruments with which to reduce the size of the instrument set. This chapter shows how reducing the size of the instrument based on PC methods can lead to poor small sample properties of IV estimators. A new approach to ordering instruments termed ‘normalized principal components’ (NPCs) is introduced to overcome this problem. A simulation study shows the favourable small samples properties of IV estimators using NPC, methods to reduce the size of the instrument relative to PC. Using NPC we provide evidence that the IV setup in Angrist and Krueger (1992) may not suffer the weak instrument problem.

Suggested Citation

  • Nicky Grant, 2012. "Overcoming the Many Weak Instrument Problem Using Normalized Principal Components," Advances in Econometrics, in: Essays in Honor of Jerry Hausman, pages 107-147, Emerald Group Publishing Limited.
    • Handle: RePEc:eme:aecozz:s0731-9053(2012)0000029010
    DOI: 10.1108/S0731-9053(2012)0000029010
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