Which of the following assumptions is required for two-stage least squares estim
ID: 3371038 • Letter: W
Question
Which of the following assumptions is required for two-stage least squares estimation method?
a.
There are perfect linear relationships among the instrumental variables.
b.
There is strong correlation between each instrumental variable and the error term.
c.
The conditional variance of the error term depends on an exogenous explanatory variable.
d.
The error term has zero mean.
a.
There are perfect linear relationships among the instrumental variables.
b.
There is strong correlation between each instrumental variable and the error term.
c.
The conditional variance of the error term depends on an exogenous explanatory variable.
d.
The error term has zero mean.
Explanation / Answer
Answer is option C. In ordinary least square method, we make an assumption that conditional variance of the error term is independent of the exogenous explanatory variable. When this assumption fails to hold, i.e., when they are dependent we go for two stae least square estimation method.
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