Practice of Lagging Variables To Avoid Simultaneity

Feb 3rd, 2012
Studypool Tutor
University of Kent, Canterbury and Medway
Course: finance
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A common practice in applied econometrics work consists of replacing a (suspected) simultaneously-determined explanatory variable with its lagged value. This note demonstrates that this practice does not enable one to escape simultaneity bias. I show through both theory and simulations the infeasibility of identifying structural parameters of the DGP when the relationship between X and Y is characterized by simultaneity. Further, I demonstrate that it is straightforward to generate examples where the researcher is likely to conclude that the effect of X on Y is opposite in sign to its true value, and to find that the associated, wrong-signed coefficient is statistically significant a majority of the time.

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