Sunday, June 25, 2017

Instrumental Variables & the Frisch-Waugh-Lovell Theorem

The so-called Frisch-Waugh-Lovell (FWL) Theorem is a standard result that we meet in pretty much any introductory grad. course in econometrics.

The theorem is so-named because (i) in the very fist volume of Econometrica Frisch and Waugh (1933) established it in the particular context of "de-trending" time-series data; and (ii) Lovell (1963) demonstrated that the same result establishes the equivalence of "seasonally adjusting" time-series data (in a particular way), and including seasonal dummy variables in an OLS regression model. (Also, see Lovell, 2008.)

We'll take a look at the statement of the FWL Theorem in a moment. First, though, it's important to note that it's purely an algebraic/geometric result. Although it arises in the context of regression analysis, it has no statistical content, per se.

What's not generally recognized, however, is that the FWL Theorem doesn't rely on the geometry of OLS. In fact, it relies on the geometry of the Instrumental Variables (IV) estimator - of which OLS is a special case, of course. (OLS is just IV in the just-identified case, with the regressors being used as their own instruments.)

Implicitly, this was shown in an old paper of mine (Giles, 1984) where I extended Lovell's analysis to the context of IV estimation. However, in that paper I didn't spell out the generality of the FWL-IV result.

Let's take a look at all of this.