INTRODUCTION TO ECONOMETRICS II
ECO 306
NOUN
130
5.1.2.0 OBJECTIVE
The main objective of this unit is to demonstrate to the students that in practice most economic relationships interact with others in a system of simultaneous equations and when this is the case the application of OLS to a single relationship in isolation yields biased estimates.
5.1.3.0 MAIN CONTENTS
5.1.3.1 Simultaneous Equations Models Structural and Reduced Form
Equations As explained earlier in other modules, measurement error is not the only probable cause why the fourth Gauss–Markov condition may not be satisfied. Simultaneous equations bias is another. To illustrate this suppose there is an investigation on the determinants of price inflation and wage inflation. For ease, it would be better to start with a very simple model that supposes that p, the annual rate of growth of prices, is related to w, the annual rate of growth of wages, it being assumed that increases in wage costs force prices upwards That is
…[5.01] Here, w is related to pand U, the rate of unemployment, workers protecting their real wages by demanding increases in wages as prices rise, but their ability to do so being the weaker, the higher the rate of unemployment (
). Which is stated as
…[5.02] where,
are disturbance terms Clearly, this simultaneous equations model involves a certain amount ofcomplexity:wdetermines p in the first equation [5.01], and in turn,p helps to determine w in the second [5.02]. For better clarity in resolving this complexity, we need to make a distinction between endogenousand exogenous variables. Endogenous variables are variables whose values are determined by the interaction of the relationships in the model. Exogenous ones are those whose values are determined
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