Optimal Invariant Similar Tests for Instrumental Variables Regression

83 Pages Posted: 23 Aug 2004 Last revised: 27 Oct 2024

See all articles by Donald W. K. Andrews

Donald W. K. Andrews

Yale University - Cowles Foundation

Marcelo J. Moreira

Getulio Vargas Foundation (FGV) - FGV/EPGE Escola Brasileira de Economia e Finanças

James H. Stock

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Harvard University - Harvard Kennedy School (HKS)

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Date Written: August 2004

Abstract

This paper considers tests of the parameter on endogenous variables in an instrumental variables regression model. The focus is on determining tests that have certain optimal power properties. We start by considering a model with normally distributed errors and known error covariance matrix. We consider tests that are similar and satisfy a natural rotational invariance condition. We determine tests that maximize weighted average power (WAP) for arbitrary weight functions among invariant similar tests. Such tests include point optimal (PO) invariant similar tests. The results yield the power envelope for invariant similar tests. This allows one to assess and compare the power properties of existing tests, such as the Anderson-Rubin, Lagrange multiplier (LM), and conditional likelihood ratio (CLR) tests, and new optimal WAP and PO invariant similar tests. We find that the CLR test is quite close to being uniformly most powerful invariant among a class of two-sided tests. A new unconditional test, P*, also is found to have this property. For one-sided alternatives, no test achieves the invariant power envelope, but a new test. the one-sided CLR test. is found to be fairly close. The finite sample results of the paper are extended to the case of unknown error covariance matrix and possibly non-normal errors via weak instrument asymptotics. Strong instrument asymptotic results also are provided because we seek tests that perform well under both weak and

Suggested Citation

Andrews, Donald W. K. and Moreira, Marcelo J. and Stock, James H., Optimal Invariant Similar Tests for Instrumental Variables Regression (August 2004). NBER Working Paper No. t0299, Available at SSRN: https://ssrn.com/abstract=579203

Donald W. K. Andrews

Yale University - Cowles Foundation ( email )

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Marcelo J. Moreira (Contact Author)

Getulio Vargas Foundation (FGV) - FGV/EPGE Escola Brasileira de Economia e Finanças ( email )

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James H. Stock

Harvard University - Department of Economics ( email )

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