Optimal Instrument Selection using Bayesian Model Averaging for Model Implied Instrumental Variable Two Stage Least Squares Estimators

Abstract: Model-Implied Instrumental Variable Two-Stage Least Squares (MIIV-2SLS) is a limited information, equation-by-equation, non-iterative estimator for latent variable models. Associated with this estimator are equation specific tests of model misspecification. One issue with equation specific tests is that they lack specificity, in that they indicate that some instruments are problematic without revealing which specific ones. Instruments that are poor predictors of their target variables (weak instruments) is a second potential problem. We propose a novel extension to detect instrument specific tests of misspecification and weak instruments. We term this the Model-Implied Instrumental Variable Two-Stage Bayesian Model Averaging (MIIV-2SBMA) estimator. We evaluate the performance of MIIV-2SBMA against MIIV-2SLS in a simulation study and show that it has comparable performance in terms of parameter estimation. Additionally, our instrument specific overidentification tests developed within the MIIV-2SBMA framework show increased power to detect specific problematic and weak instruments. Finally, we demonstrate MIIV-2SBMA using an empirical example.