Granular Instrumental Variables

Abstract

We propose a new way to construct instruments in a broad class of economic environments. In the economies we study, a few large firms, industries or countries account for an 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 data and create "granular instrumental variables" (GIVs), which are size-weighted sums of idiosyncratic shocks. GIVs allow us to then estimate parameters of interest. As an application, we measure how "sovereign yield shocks" transmit across countries in the Eurozone.