Tests based on t-statistics for IV regression with weak instruments

Abstract

This paper considers tests of the parameter of an endogenous variable in an instrumental variables regression model. The focus is on one-sided conditional t-tests. Theoretical and numerical work shows that the conditional 2SLS and Fuller t-tests perform well even when instruments are weakly correlated with the endogenous variable. When the population F-statistic is as small as two, their power is reasonably close to the power envelopes for similar and non-similar tests which are invariant to rotation transformations of the instruments. This finding is surprising considering the bad performance of two-sided conditional t-tests found in Andrews et al. (2007). We show these tests have bad power because the conditional null distributions of t-statistics are asymmetric when instruments are weak. Taking this asymmetry into account, we propose two-sided tests based on t-statistics. These novel tests are approximately unbiased and can perform as well as the conditional likelihood ratio (CLR) test. (C) 2014 Elsevier B.V. All rights reserved.