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On solving endogeneity with invalid instruments: an application to investment equations

On solving endogeneity with invalid instruments: an application to investment equations
On solving endogeneity with invalid instruments: an application to investment equations
Regression models relating investment demand with firms' Tobin's q and cash flow are fraught with measurement errors which, in turn, cause endogeneity bias. We propose a solution to this problem based on modelling the interaction between the endogenous Tobin's q and the error term in the investment equation as a function of lagged values of Tobin's q. We then study the identification conditions and asymptotic properties of the resulting estimator. Our analysis of a panel of U.S. firms reveals a larger effect of Tobin's q on firms' investment demand than that obtained using available estimators in the literature. Moreover, the estimates highlight the importance of cash flow. We find mixed evidence on the relationship between investment demand and firms' cash flow with respect to different measures of financial constraints. Nevertheless, this evidence is more supportive of the view that firms' cash
flows have a weaker correlation to investment demand when financial conditions tighten.
0964-1998
689-716
Galvao, Antonio F.
6f2af55a-e340-404e-a787-cb2f90c87ebd
Montes-Rojas, Gabriel
69548d5d-9e1f-4f6c-8453-6c2675b8dc21
Olmo, Jose
706f68c8-f991-4959-8245-6657a591056e
Song, Suyong
1cb81583-42ca-450f-b9b2-65cdcaed66df
Galvao, Antonio F.
6f2af55a-e340-404e-a787-cb2f90c87ebd
Montes-Rojas, Gabriel
69548d5d-9e1f-4f6c-8453-6c2675b8dc21
Olmo, Jose
706f68c8-f991-4959-8245-6657a591056e
Song, Suyong
1cb81583-42ca-450f-b9b2-65cdcaed66df

Galvao, Antonio F., Montes-Rojas, Gabriel, Olmo, Jose and Song, Suyong (2018) On solving endogeneity with invalid instruments: an application to investment equations. Journal of the Royal Statistical Society: Series A (Statistics in Society), 181 (3), 689-716. (doi:10.1111/rssa.12313).

Record type: Article

Abstract

Regression models relating investment demand with firms' Tobin's q and cash flow are fraught with measurement errors which, in turn, cause endogeneity bias. We propose a solution to this problem based on modelling the interaction between the endogenous Tobin's q and the error term in the investment equation as a function of lagged values of Tobin's q. We then study the identification conditions and asymptotic properties of the resulting estimator. Our analysis of a panel of U.S. firms reveals a larger effect of Tobin's q on firms' investment demand than that obtained using available estimators in the literature. Moreover, the estimates highlight the importance of cash flow. We find mixed evidence on the relationship between investment demand and firms' cash flow with respect to different measures of financial constraints. Nevertheless, this evidence is more supportive of the view that firms' cash
flows have a weaker correlation to investment demand when financial conditions tighten.

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Accepted/In Press date: 20 July 2017
e-pub ahead of print date: 6 September 2017
Published date: June 2018

Identifiers

Local EPrints ID: 413888
URI: http://eprints.soton.ac.uk/id/eprint/413888
ISSN: 0964-1998
PURE UUID: 19d71ac7-164b-4921-965a-fca85f02279b
ORCID for Jose Olmo: ORCID iD orcid.org/0000-0002-0437-7812

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Date deposited: 08 Sep 2017 16:30
Last modified: 07 Oct 2020 05:00

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