Bootstrap and Higher-Order Expansion Validity When Instruments May Be Weak

Abstract

It is well-known that size-adjustments based on Edgeworth expansions for the t-statistic perform poorly when instruments are weakly correlated with the endogenous explanatory variable. This paper shows, however, that the lack of Edgeworth expansions and bootstrap validity are not tied to the weak instrument framework, but instead depends on which test statistic is examined. In particular, Edgeworth expansions are valid for the score and conditional likelihood ratio approaches, even when the instruments are uncorrelated with the endogenous explanatory variable. Furthermore, there is a belief that the bootstrap method fails when instruments are weak, since it replaces parameters with inconsistent estimators. Contrary to this notion, we provide a theoretical proof that guarantees the validity of the bootstrap for the score test, as well as the validity of the conditional bootstrap for many conditional tests. Monte Carlo simulations show that the bootstrap actually decreases size distortions in both cases.