An instrumental variable is a variable that is correlated
A)with the endogenous right hand side variable but not correlated with the error term.
B)with the error term but not correlated with the endogenous right hand side variable.
C)with both the error term and the endogenous right hand side variable.
D)with both the endogenous right hand side variable and with another independent variable.

Question

Quizplus · Accepted Answer

An instrumental variable must be correlated with the endogenous right hand side variable, otherwise it cannot address endogeneity. However, it should not be correlated with the error term; otherwise, it would not be a valid instrument. Therefore, choice A is correct. Choices B and C are incorrect because an instrumental variable should not be correlated with the error term. Choice D is incorrect because an instrumental variable should not be correlated with another independent variable.

An Instrumental Variable Is a Variable That Is Correlated