Granular Instrumental Variables

Abstract

In many settings, economists have few instruments with which to investigate causal relations. We propose a general way to construct new instruments: “granular instrumental variables” (GIVs). In the economies we study, a few large firms, industries or countries account for a important share of economic activity. As the idiosyncratic shocks from these large players affect aggregate outcomes, they are valid and often powerful instruments. We provide a methodology to extract idiosyncratic shocks from the data in order to create GIVs, which are size-weighted sums of idiosyncratic shocks. These GIVs allow us to then estimate parameters of interest, including causal elasticities.

We first illustrate the idea in a basic supply and demand framework: we achieve a novel identification of both supply and demand elasticities, based on idiosyncratic shocks to either supply or demand. We then show how the procedure can be enriched to work in many situations. We provide illustrations of the procedure with two applications. First, we measure how “sovereign yield shocks” spill over to other countries in the Eurozone. Second, we estimate short-term supply and demand elasticities in the oil market. Our estimates match existing estimates that use much more complex and labor-intensive (e.g., narrative) methods. We sketch how GIVs could be useful to estimate a host of other causal parameters in economics.