An Instrumental Variable Approach to Dynamic Models

Abstract

We present a new class of methods for identification and inference in dynamic
models with serially correlated unobservables, which typically imply that state variables
are econometrically endogenous. In the context of Industrial Organization, these state
variables often reflect econometrically endogenous market structure. We propose the
use of Generalized Instrument Variables methods to identify those dynamic policy
functions that are consistent with instrumental variable (IV) restrictions. Extending
popular “two-step” methods, these policy functions then identify a set of structural
parameters that are consistent with the dynamic model, the IV restrictions and the
data. We provide computed illustrations to both single-agent and oligopoly examples.
We also present a simple empirical analysis that, among other things, supports the
counterfactual study of an environmental policy entailing an increase in sunk costs.