GMM = generalized method of moments
IV = instrumental variables
2SLS = Two stage least squares
OLS = ordinary least squares
I keep seeing talk of 'moment conditions' or 'moment equations', but don't exactly understand the context.
Consider a very standard regression model:
$$y_i = \beta x_i + u_i $$
where $u_i$ is an error term, and suppose all the classic linear regression assumptions hold.
If I relax the exogeneity assumption,i.e., $\mathbb{E}(u|x) \neq 0$ (also side question: Why does this imply that $\mathbb{E}(u_i x_i)\neq0$?), then using OLS here will produce biased estimates right?
Is $\mathbb{E}(u_i | x_i)=0$ the 'moment condition' in OLS? Is it $\mathbb{E}(u_i x_i) =0$ ?
My second question is whether GMM, 2SLS, and IV are specifically distinct from one another.
My book says that when we have $K$ endogeneous regressors and $K$ instruments (exactly identified) we use IV.
In the case of being over-identified, and we have $J>K$ IVs, we use GMM.
What about for the under-identified case?
Finally, What's the best way to distinguish between these different methods?
For instance, what is the difference in using GMM in an over-identified case vs trying to use IV in that case?
Thanks for any help.
Best Answer
The moment condition is $$ \mathbb{E}[u_i x_i] = 0 = \mathbb{E}[(y_i - \beta x_i)x_i]. $$ This is also called an orthogonality condition. It is used as a method of moments estimator by using the sample version, $$ (y-X \beta)X = 0, $$ and you solve for $\beta$ to get $$ \hat{\beta} = (X'X)^{-1} X'y, $$ the same as the OLS estimator.
Second question: GMM is the generalized method of moments. The standard method of moments is to pick sample moments that converge in probability to the true moment. For example, the sample mean is a method of moments estimator of the population mean by a weak law of large numbers. In GMM, the model can be non-linear, so that you have a population model $$ \mathbb{E}[g(X,\mu)] =0 $$ and are trying to pick $\mu$ to get the sample version to fit: $$ \dfrac{1}{N}\sum_{i=1}^N g(x_i,\mu) =0. $$
Instrumental variables is a tool for solving endogeneity or omitted variables bias or measurement error problems. In the linear framework, you have \begin{eqnarray} x = \pi' Z + \eta \\ y = \beta' x + \varepsilon \end{eqnarray} with $cov(\eta, \varepsilon) \neq 0$, OLS is biased. It is an independent concept of GMM, although you can use a GMM-IV framework to estimate models, which is nice because it gives a J-test of overidentification (which shows up later in your question). IV uses a different orthogonality condition, $$ (y-\beta X) Z =0 $$ where $Z$ are the instruments, and the IV estimator is $$ \hat{\beta} = (X'Z)^{-1}Z'y. $$ 2SLS is a way of getting the IV estimator with the least pain possible. You run OLS of $X$ on $Z$ to get $\hat{X}$, then regress $y$ on $\hat{X}$ instead of $X$ to get an unbiased estimate of $\hat{\beta}$. It is not GMM, just another way to do IV, although they are asymptotically (maybe even numerically?) equivalent.
If your model is under-identified, you don't have enough variables to solve the orthogonality condition. There are an infinite number of possible $\hat{\beta}$'s that solve whatever you are looking at. Don't do this, or look into the LASSO.
There is a category error in your last question. GMM is a method of finding and proving properties of estimators, like maximum likelihood. IV is a framework for estimating systems that violate the independence assumptions of OLS. The tests come out of the frameworks.
It sounds like you are reading Hayashi's book before you are ready. Try Greene or Kennedy, or Mostly Harmless Econometrics to get a background on this stuff.