(Answered) Consider the model yt alpha beta1 x1t beta2 x2t beta3

Economics

Consider the model Yt = α + β1 X1t + β2 X2t + β3 Yt-1 + vt

Suppose Yt-1 and vt are correlated. To remove the correlation, suppose we use the following instrumental variable approach: First regress Yt on X1t and X2t and obtain the estimated Yˆt from this regression. Then regress Yt = α + β1 X1t + β2 X2t + β3 Yˆt-1 + vt

where Yˆt-1 are estimated from the ?rst-stage regression.

a. How does this procedure remove the correlation between Yt-1 and vt in the original model?

b. What are the advantages of the recommended procedure over the Liviatan approach?

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