The Covariance Transformation and the Instrumental Variables Estimator of the Fixed Effects Model.

The covariance transformation is a useful and often necessary procedure to estimate the fixed effects model. When some explanatory variables are contemporaneously correlated with the disturbance term, the slope coefficients can be consistently estimated by an instrumental variables estimator. This paper describes how to use the covariance transformation to compute the instrumental variables estimator as a two-stage-least-squares estimator. Discussions of the relative asymptotic efficiency of alternative sets of instrumental variables and how to construct a consistent estimator of the asymptotic covariance matrix of the instrumental variables estimator are also provided. Copyright 1991 by Blackwell Publishing Ltd