October 1, 2006
This paper analyses the use of factor analysis for instrumental variable estimation when the number of instruments tends to infinity. We consider cases where the unobserved factors are the optimal instruments but also cases where the factors are not necessarily the optimal instruments but can provide a summary of a large set of instruments. Further, the situation where many weak instruments exist is also considered in the context of factor models. Theoretical results, simulation experiments and empirical applications highlight the relevance and simplicity of Factor-GMM estimation.
J.E.L classification codes: C32, C51, E52
Keywords:Factor models, Principal components, Instrumental variables, GMM, Weak instruments, DSGE models