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 an alternative solution to this problem based on modelling the interaction between the endogenous Tobin’s q and the error term in th...

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Bibliographic Details
Published inJournal of the Royal Statistical Society. Series A, Statistics in society Vol. 181; no. 3; pp. 689 - 716
Main Authors Galvao, Antonio F., Montes–Rojas, Gabriel, Olmo, Jose, Song, Suyong
Format Journal Article
LanguageEnglish
Published Oxford Wiley 01.06.2018
Oxford University Press
Subjects
Asymptotic properties
Bias
Cash flow
Companies
Corporate governance
Demand
Economic models
Endogeneity
Endogenous
Investment
Investment equation
Investments
Measurement
Measurement errors
Original Articles
Regression analysis
Regression models
Tobin's q
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Summary: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 an alternative 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 US firms reveals a larger effect of Tobin’s q on firms’ investment demand than that obtained by 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.
ISSN:0964-1998
1467-985X
DOI:10.1111/rssa.12313