Granular Instrumental Variables

82 Pages Posted: 15 Apr 2019

See all articles by Xavier Gabaix

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Ralph S. J. Koijen

University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: April 9, 2019

Abstract

In many settings, there is a dearth of instruments, which hampers economists’ ability to investigate causal relations. We propose a quite general way to construct instruments: “granular instrumental variables” (GIVs). In the economies we study, a few large firms or countries account for a large share of economic activity. As they are large, their idiosyncratic shocks affect aggregate outcomes. This makes those idiosyncratic shocks valid instruments for aggregate shocks. We provide a methodology to extract idiosyncratic shocks from the data, this way creating GIVs. Those 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 supply and demand elasticities, based on idiosyncratic shocks to supply or demand. We then show how the procedure can be adapted to handle many enrichments. We provide initial illustrations of the procedure with two applications. First, we measure how shocks to domestic banks causally affect sovereign yields. We document how negative shocks to Italian banks adversely affect Italian government bond yields, and vice-versa. This gives the first causal measure of the “doom loop” between banks and sovereign yields. Second, we estimate short-term supply and demand elasticities in the oil market. Our estimates match well 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, particularly in aggregate macro-finance contexts where instruments are usually very rare.

Suggested Citation

Gabaix, Xavier and Koijen, Ralph S. J., Granular Instrumental Variables (April 9, 2019). Available at SSRN: https://ssrn.com/abstract=3368612 or http://dx.doi.org/10.2139/ssrn.3368612

Xavier Gabaix

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Ralph S. J. Koijen (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/ralph.koijen/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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