Granular Instrumental Variables

Abstract

We propose a new way to construct instruments in a broad class of economic environments: “granular instrumental variables” (GIVs). In the economies we study, a few large firms, in- dustries or countries account for an important share of economic activity. As the idiosyncratic shocks from these large players affect aggregate outcomes, they are valid and often powerful instruments. We provide a methodology to extract idiosyncratic shocks from the data in order to create GIVs, which are size-weighted sums of idiosyncratic shocks. These GIVs allow us to then estimate parameters of interest, including causal elasticities and multipliers.We first illustrate the idea in a basic supply and demand framework: we achieve a novel identification of both supply and demand elasticities based on idiosyncratic shocks to either supply or demand. We then show how the procedure can be enriched to work in many sit- uations. We provide illustrations of the procedure with two applications. First, we measure how “sovereign yield shocks” transmit across countries in the Eurozone. Second, we estimate short-term supply and demand multipliers and elasticities in the oil market. Our estimates match existing ones that use more complex and labor-intensive (e.g., narrative) methods. We sketch how GIVs could be useful to estimate a host of other causal parameters in economics. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.