Chapter three

An Introduction to Simultaneous Equation models

3.1. Introduction
In all the previous chapters discussed so far, we have been focusing exclusively with the
problems and estimations of a single equation regression models. In such models, a
dependent variable is expressed as a linear function of one or more explanatory variables.
The cause-and-effect relationship in such models between the dependent and
independent variable is unidirectional. That is, the explanatory variables are the cause and
the independent variable is the effect. But there are situations where such one-way or
unidirectional causation in the function is not meaningful. This occurs if, for instance, Y
(dependent variable) is not only function of X’s (explanatory variables) but also all or
some of the X’s are, in turn, determined by Y. There is, therefore, a two-way flow of
influence between Y and (some of) the X’s which in turn makes the distinction between
dependent and independent variables a little doubtful. Under such circumstances, we
need to consider more than one regression equations; one for each interdependent variable
to understand the multi-flow of influence among the variables. This is precisely what is
done in simultaneous equation models.
A system describing the joint dependence of variables is called a system of simultaneous
equation or simultaneous equations model. The number of equations in such models is
equal to the number of jointly dependent or endogenous variables involved in the
phenomenon under analysis. Unlike the single equation models, in simultaneous
equation models it is not usually possible (possible only under specific assumptions) to
estimate a single equation of the model without considering the information provided by
other equation of the system. If one applies OLS to estimate the parameters of each
equation disregarding other equations of the model, the estimates so obtained are not only
biased but also inconsistent; i.e. even if the sample size increases indefinitely, the estimators
do not converge to their true values. The bias arising from application of such procedure
of estimation which treats each equation of the simultaneous equations model as though
it were a single model is known as simultaneity bias or simultaneous equation bias.
Example: At the macro level, aggregate consumption expenditure depends on aggregate
disposable income; aggregate disposable income depends upon the national income and
taxes imposed by the government; national income depends on aggregate consumption
expenditure of the economy.
What happens to the parameters of such relationship if we estimate by applying OLS to
each equation without considering the information provided by the other equations in
the system? The application of OLS to estimate the parameters of economic relationships
presupposes the classical assumptions discussed in chapter two of Econometrics I. One
of the crucial assumptions of the OLS is that the explanatory variables and the
disturbance term is independent i.e. the disturbance term is exogenous (E[XiUi] = 0). As
a result, the linear model could be interpreted as describing the conditional expectation
of the dependent variable (Y) given a set of explanatory variables. In the simultaneous
equation models, such independence of explanatory variables and disturbance term is
violated i.e. E[XiUi]  0. If this assumption is violated, the OLS estimator is biased and
inconsistent. To show simultaneity bias, let’s consider the following simple simultaneous
equation model.
𝑌 = 𝛼0 + 𝛼1 𝑋 + 𝑈
}………………………………………… (1)
𝑋 = 𝛽0 + 𝛽1 𝑌 + 𝛽2 𝑍 + 𝑉
Suppose that the following assumptions hold.
𝛦(𝑈) = 0, 𝛦(𝑈𝑖 𝑈𝑗 ) = 0,
𝛦(𝑉) = 0 𝛦(𝑉𝑖 𝑉𝑗 ) = 0, 𝑎𝑙𝑠𝑜
𝛦(𝑈 2 ) = 𝜎𝑢2 ,
𝛦(𝑈𝑖𝑉𝑖) = 0
𝛦(𝑉 2 ) = 𝜎𝑢2
where X and Y are endogenous variables and Z is an exogenous variable.
The reduced form of X of the above model is obtained by substituting Y in equation of X.
𝑋 = 𝛽0 + 𝛽1 (𝛼0 + 𝛼1 𝑋 + 𝑈) + 𝛽2 𝑍 + 𝑉
𝛽0 +𝛼0 𝛽1 𝛽 𝛽 𝑈+𝑉
𝑋= + (1−𝛼2 𝛽 ) 𝑍 + (1−𝛼
1
)…………………………... (2)
1−𝛼1 𝛽1 1 1 1 𝛽1

Applying OLS to the first equation of the above structural model will result in biased
estimator because𝑐𝑜𝑣( 𝑋𝑖 𝑈𝑖 ) = 𝛦(𝑋𝑖 𝑈𝑗 ) ≠ 0. Now, let’s proof whether this expression.
𝑐𝑜𝑣( 𝑋𝑈) = 𝛦[{𝑋 − 𝛦(𝑋)}{𝑈 − 𝛦(𝑈)}]
= 𝛦[{𝑋 − 𝛦(𝑋)}𝑈]…. since 𝛦(𝑈) = 0
𝛽0 + 𝛼0 𝛽1 𝛽2 𝛽1 𝑈 + 𝑉 𝛽0 + 𝛼0 𝛽1 𝛽2
= 𝛦 [{ +( )𝑍 + ( )− −( ) 𝑍}] 𝑈
1 − 𝛼1 𝛽1 1 − 𝛼1 𝛽1 1 − 𝛼1 𝛽1 1 − 𝛼1 𝛽1 1 − 𝛼1 𝛽1
𝑈
= 𝛦 [{ (𝛽 − 𝛼0 𝛽1 + 𝛽2 𝑍 + 𝛽1 𝑈 + 𝑉 − 𝛽0 + 𝛽1 𝛼0 − 𝛽2 𝑍)}]
1 − 𝛼1 𝛽1 0
𝑈
= 𝛦 [{ (𝛽 𝑈 + 𝑉)}]
1 − 𝛼1 𝛽1 1
1
=( ) 𝛦(𝛽1 𝑈 2 + 𝑈𝑉)
1 − 𝛼1 𝛽1
𝛽 𝛽 𝜎𝑢2
= (1−𝛼1 𝛽 ) 𝛦(𝑈 2 ) = 1−𝛼1 ≠ 0 , since E(UV) = 0………………………….3
1 1 1 𝛽1
That is, covariance between X and U is not zero. As a consequence, if OLS is applied to
each equation of the model separately the coefficients will turn out to be biased. Now,
let’s examine how the non-zero co-variance of the error term and the explanatory variable
will lead to biasness in OLS estimates of the parameters.
If we apply OLS to the first equation of the above structural equation 𝑌 = 𝛼0 + 𝛼1 𝑋 + 𝑈,
we obtain
𝛴𝑥𝑦 𝛴𝑥(𝑌−𝑌̄) 𝛴𝑥𝑌 𝑌̄𝛴𝑥
𝛼̂1 = 𝛴𝑥 2 = = 𝛴𝑥 2 ; (since 𝛴𝑥 2 is zero)
𝛴𝑥 2
𝛴𝑥(𝛼0 +𝛼1 𝑋+𝑈) 𝛼0 𝛴𝑥 𝛴𝑥𝑈 𝛴𝑥𝑈
= = + 𝛼1 𝛴𝑥 2 + 𝛴𝑥 2
𝛴𝑥 2 𝛴𝑥 2
𝛴𝑥𝑋
But, we know that 𝛴𝑥 = 0and 𝛴𝑥 2 = 1, hence
𝛴𝑥𝑈
𝛼̂ = 𝛼1 + 𝛴𝑥 2 ………………………………………………………….4
𝛴𝑥𝑈
Taking the expected values on both sides; 𝛦(𝛼̂) = 𝛼1 + 𝛦 ( 𝛴𝑥 2 )

Since, we have proved that 𝛦(𝛴𝑋𝑈) ≠ 0; 𝛦(𝛼̂) ≠ 𝛼, that is 𝛼̂1 will be biased by the amount
𝜮𝒙𝒖
equivalent to 𝜮𝒙𝟐 .

3.2. Definitions of Some Concepts

 Endogenous variables are variables that are determined by the economic model
(within the system).
 Exogenous variables are those determined outside the model. Exogenous variables
are also called predetermined and divided into: current and lagged exogenous and lagged
endogenous variables. For instance;𝑌𝑡 = 𝛽0 + β1 𝑌𝑡−1 + β2 𝑋𝑡 + β3 𝑋𝑡−1 + 𝑈 in this
example 𝑋𝑡 𝑎𝑛𝑑 𝑋𝑡−1 are the current and lagged exogenous variables and 𝑌𝑡−1 is lagged
endogenous variable. Thus, 𝑋𝑡 , 𝑋𝑡−1 and 𝑌𝑡−1 are predetermined (exogenous) variables
and they are independent of the disturbance terms.
Consider the demand and supply functions.
𝑄 𝑑 = 𝛽0 + 𝛽1 𝑃 + 𝛽2 𝑌 + 𝑈1
𝑄 𝑠 = 𝛼0 + 𝛼1 𝑃 + 𝛼2 𝑅 + 𝑈2
where: Q=quantity, Y=income, P=price, R=Rainfalls, 𝑈1 &𝑈2 are error terms.
Here P and Q are endogenous variables and Y and R are exogenous variables.
 A structural model describes the complete structure of the relationships among the
economic variables. Structural model is expressed in terms of endogenous variables,
exogenous variables and disturbances (random variables). The parameters of structural
model express the direct effect of each explanatory variable on the dependent variable.
 Variables not appearing in any function explicitly may have an indirect effect and is
considered by the simultaneous solution of the system. For instance, a change in
consumption affects the investment indirectly and is not considered in the
consumption function. The effect of consumption on investment cannot be measured
directly by any structural parameter, but is measured indirectly by considering the
system as a whole.
Example: The following simple Keynesian model of income determination can be
considered as a structural model.
𝐶 = 𝛼 + 𝛽𝑌 + 𝑈 for  >0 and 0<<1
𝑌 =𝐶+𝑍
where: C=consumption expenditure
Z=non-consumption expenditure
Y=national income
C and Y are endogenous variables while Z is exogenous variable.
 The reduced form of a structural model is the model in which the endogenous
variables are expressed a function of the predetermined variables and the error term
only i.e. (Yt = f (Yt-i, Xt, Xt-i, Ut) or Y = f (predetermined, error term only).
Illustration: Find the reduced form of the above structural model.
Since C and Y are endogenous variables and only Z is the exogenous variables, we have
to express C and Y in terms of Z. To do this substitute Y=C+Z into equation (16).
𝐶 = 𝛼 + 𝛽(𝐶 + 𝑍) + U
𝐶 = 𝛼 + 𝛽𝐶 + 𝛽𝑍 + 𝑈
𝐶 − 𝛽𝐶 = 𝛼 + 𝛽𝑍 + 𝑈
𝐶(1 − 𝛽) = 𝛼 + 𝛽𝑍 + 𝑈
𝛼 𝛽 𝑈
𝐶 = 1−𝛽 + (1−𝛽) 𝑍 + 1−𝛽 ………………. reduced form of consumption

Substituting reduced form of consumption into income equation we will get;

𝛼 1 𝑈
𝑌 = 1−𝛽 + (1−𝛽) 𝑍 + 1−𝛽 ………………......reduced form of income
Parameters of the reduced form measure the total effect (direct and indirect) of a change in
exogenous variables on the endogenous variable. For instance, in the above reduced form
𝛽
of consumption, (1−𝛽) measures the total effect of a unit change in the non-consumption
1
expenditure on consumption. This total effect is 𝛽, the direct effect, times (1−𝛽) ,the
indirect effect.
The reduced form equations can be obtained in two ways:
1) To express the endogenous variables directly as a function of the predetermined
variables (direct method).
2) To solve the structural system of endogenous variables in terms of the
predetermined variables, the structural parameters, and the disturbance terms.
Consider the following simple model for a closed economy.
Ct = a1Yt + U1 ---------------------------------------------------------(i)
It = b1Yt + b2Yt-1 + U2-----------------------------------------------(ii)
Yt = Ct +It + Gt-------------------------------------------------------(iii)
This model has three equations in three endogenous variables (Ct, It, and Yt) and two
predetermined variables (Gt, andYt-1). To obtain the reduced form of this model, we may
use two methods (direct method and solving the structural model method).
Direct Method: Express the three endogenous variables (Ct , It , and Yt ) as functions of the
two predetermined variables (Gt, andYt-1) directly using ’s as the parameters of the
reduced form model as follows.
Ct = 11Yt-1 + 12Gt + V1 ------------------------------------(iv)
It, =21Yt-1 + 22Gt +V2 -------------------------------------(v)
Yt =31Yt-1 + 32Gt + V3 ---------------------------(vi)
Note: 11, 12, 21, 22, 31, and 32 are reduced form parameters. By solving the structural
system of endogenous variables in terms of predetermined variables, structural
parameters and disturbances, the expressions for the reduced parameters can be obtained
easily. For instance, the third structural equation (iii) can be expressed in reduced form
as follows: Yt = b2/ (1-a1-b1) Yt-1 + 1/(1-a1-b1) Gt + (U1 +U2)/ (1-a1-b1). This equation is
obtained by simply substituting structural equations (i) and (ii) in (iii). From this
expression: 31 = b2/ (1-a1-b1) and 32 = b2/ (1-a1-b1)
3.3. Problems of simultaneous equation models
Simultaneous equation models create three distinct problems. These are:
1. Mathematical completeness of the model: any model is said to be mathematically
complete only when it possesses as many independent equations as endogenous
variables. In other words, if we happen to know values of disturbance terms,
exogenous variables and structural parameters, then all the endogenous variables
are uniquely determined.
2. Identification of each equation of the model: Many times, a given set of values of
disturbance terms and exogenous variables yield the same values of different
endogenous variables included in the model because the equations are
observationally indistinguishable, what is needed is that the parameters of each
equation in the system should be uniquely determined. Hence, certain tests are
required to examine the identification of each equation before its estimation.
3. Statistical estimation of each equation of the model: Since application of OLS
yield biased and inconsistent estimates, different statistical techniques are to be
developed to estimate the structural parameters. Some of the most common
simultaneous methods1 of estimation are:
i) The indirect least square method (ILS)
ii) The two-stage least square method(2SLS)
iii) The instrumental variable method (IV)
iv) The three-stage least square method(3SLS)
v) Limited information maximum likelihood method (LIML)
vi) The mixed estimation method; and
vii) The full information maximum likelihood method (FIML)
Of the three problems, we are going to discuss the identification problem and Statistical
estimation the model in the following section.
3.4. The identification problem
In simultaneous equation models, the Problem of identification is a problem of model
formulation; it does not concern with the estimation of the model. The estimation of the
model depends up on the empirical data and the form of the model. If the model is not

1
The first three methods of estimation are to be discussed in this course and the others are beyond the scope of this
introductory course.
in the proper statistical form, it may turn out that the parameters may not uniquely
estimated even though adequate and relevant data are available. In a language of
econometrics, a model is said to be identified only when it is in unique statistical form to enable
us to obtain unique estimates of its parameters from the sample data. To illustrate the problem
identification, let’s consider a simplified wage-price model.
W =  + P + E + U --------------------------------------(i)
𝑃 = 𝜆 + 𝜇𝑊 + 𝑉 ------------------------------------------------(ii)
where W and Pare percentage rates of wage and price inflation respectively, E is a
measure of excess demand in the labor market while U and V are disturbances, E is
assumed to be exogenously determined. If E is assumed to be exogenously determined,
then (i) and (ii) represent two equations determining two endogenous variables: W and
P. Let’s explain the problem of identification with help of these two equations of a
simultaneous equation model.
Let’s use equation (ii) to express ‘W’ in terms of P:
−𝜆 1 𝑉
𝑊= + 𝜇 𝑃 − 𝜇 -------------------------------------------------(iii)
𝜇

Now, suppose A and B are any two constants. Let’s multiply equation (i) by A, multiply
equation (ii) by B and then add the two equations. This gives
𝜆 𝐵 𝐵
(𝐴 + 𝐵)𝑊 = 𝐴𝛼 − 𝐵 𝜇 + (𝐴𝛽 + 𝜇 ) 𝑃 + 𝐴ϒ𝐸 + 𝐴𝑈 − 𝜇 𝑉 or
𝐵𝜆 𝐵 𝐵
𝐴𝛼− 𝐴𝛽+ 𝐴ϒ 𝐴𝑈−( )𝑉
𝜇 𝜇
𝑊= 𝑉
+ ( 𝐴+𝐵 ) 𝑃 + (𝐴+𝐵) 𝐸 + -------------------(iv)
𝐴+𝐵 𝐴+𝐵

Equation (iv) is what is known as a linear combination of (i) and (ii). The point about
equation (iv) is that it is of the same statistical form as the wage equation (i). That is, it
has the form:
W = constant + (constant)P + (constant)E + disturbance
Moreover, since A and B can take any values we like, this implies that our wage price
model generates an infinite number of equations such as (iv), which are all statistically
indistinguishable from the wage equation (i). Hence, if we apply OLS or any other technique
to data on W, P and E in an attempt to estimate the wage equation, we can’t know whether
we are actually estimating (i) rather than one of the infinite number of possibilities given
by (iv). Equation (i) is said to be unidentified, and consequently there is now no way in
which unbiased or even consistent estimators of its parameters may be obtained.
Notice that, in contrast, price equation (ii) cannot be confused with the linear combination
(iv), because it is a relationship involving W and P only and does not, like (iv), contain
the variable E. The price equation (ii) is therefore said to be identified, and in principle it
is possible to obtain consistent estimates of its parameters. A function (an equation)
belonging to a system of simultaneous equations is identified if it has a unique statistical form, i.e.
if there is no other equation in the system, or formed by algebraic manipulations of the other
equations of the system, contains the same variables as the function(equation) in question.
Identification problems do not just arise only on two equation-models. Using the above
procedure, we can check identification problems easily if we have two or three equations
in a given simultaneous equation model. However, for ‘n’ equations simultaneous
equation model, such a procedure is very cumbersome. In general, for any number of
equations in a given simultaneous equation, we have two conditions that need to be
satisfied to say that the model is in general identified or not. In the following section we
will see the formal conditions for identification.
1. The order condition for identification
This condition is based on a counting rule of the variables included and excluded from
the particular equation. It is a necessary but not sufficient condition for the identification
of an equation. The order condition may be stated as follows.
For an equation to be identified the total number of variables (endogenous and exogenous) excluded
from it must be equal to or greater than the number of endogenous variables in the model less one.
Given that in a complete model the number of endogenous variables is equal to the number of
equations of the model, the order condition for identification is sometimes stated in the following
equivalent form. For an equation to be identified the total number of variables excluded from it but
included in other equations must be at least as great as the number of equations of the system less
one.
Let: G = total number of equations (= total number of endogenous variables)
K= number of total variables in the model (endogenous and predetermined)
M= number of variables, endogenous and exogenous, included in a particular
equation.
Then the order condition for identification may be symbolically expressed as:
(𝐾 − 𝑀) ≥ (𝐺 − 1)
𝑒𝑥𝑐𝑙𝑢𝑑𝑒𝑑
[ ] ≥ [𝑡𝑜𝑡𝑎𝑙𝑛𝑢𝑚𝑏𝑒𝑟𝑜𝑓𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑖𝑛𝑠 − 1]
𝑣𝑎𝑟 𝑖 𝑎𝑏𝑙𝑒
For example, if a system contains 10 equations with 15 variables, ten endogenous and five
exogenous, an equation containing 11 variables is not identified, while another
containing 5 variables is identified.
a. For the first equation we have
𝐺 = 10, 𝐾 = 15, 𝑀 = 11
Order condition:
(𝐾 − 𝑀) ≥ (𝐺 − 1)
(15 − 11) < (10 − 1); that is, the order condition is not satisfied.
b. For the second equation we have
𝐺 = 10, 𝐾 = 15, 𝑀=5
order condition:
(𝐾 − 𝑀) ≥ (𝐺 − 1)
(15 − 5) < (10 − 1) ; that is, the order condition is satisfied.
The order condition for identification is necessary for a relation to be identified, but it is
not sufficient, that is, it may be fulfilled in any particular equation and yet the relation
may not be identified.
2. The rank condition for identification
The rank condition states that: in a system of G equations any particular equation is
identified if and only if it is possible to construct at least one non-zero determinant of
order (G-1) from the coefficients of the variables excluded from that particular equation
but contained in the other equations of the model. The practical steps for tracing the
identifiability of an equation of a structural model may be outlined as follows.
Firstly. Write the parameters of all the equations of the model in a separate table, noting
that the parameter of a variable excluded from an equation is equal to zero.
For example, let a structural model be:
𝑦1 = 3𝑦2 − 2𝑥1 + 𝑥2 + 𝑢1
𝑦2 = 𝑦3 + 𝑥3 + 𝑢2
𝑦3 = 𝑦1 − 𝑦2 − 2𝑥3 + 𝑢3
where the y’s are the endogenous variables and the x’s are the predetermined variables.
This model may be rewritten in the form
−𝑦1 + 3𝑦2 + 0𝑦3 − 2𝑥1 + 𝑥2 + 0𝑥3 + 𝑢1 = 0
0𝑦1 − 𝑦2 + 𝑦3 + 0𝑥1 + 0𝑥2 + 𝑥3 + 𝑢2 = 0
𝑦1 − 𝑦2 − 𝑦3 + 0𝑥1 + 0𝑥2 − 2𝑥3 + 𝑢3 = 0
Ignoring the random disturbance, the table of the parameters of the model is as follows:

Variables
Equations 𝑌1 𝑌2 𝑌3 𝑋1 𝑋2 𝑋3
1st equation -1 3 0 -2 1 0
2nd equation 0 -1 1 0 0 1
3rd equation 1 -1 -1 0 0 -2
Secondly. Strike out the row of coefficients of the equation which is being examined for
identification. For example, if we want to examine the identifiability of the second
equation of the model we strike out the second row of the table of coefficients.
Thirdly. Strike out the columns in which a non-zero coefficient of the equation being
examined appears. By deleting columns in which a non-zero coefficient of the equation
being examined we are left with the coefficients of variables not included in the particular
equation, but contained in the other equations of the model. For example, if we are
examining for identification the second equation of the system, we will strike out the
second, third and the sixth columns of the above table, thus obtaining the following
tables.
Table of structural parameters Table of parameters of excluded variables
𝒀𝟏 𝒀𝟐 𝒀𝟑 𝑿𝟏 𝑿𝟐 𝑿𝟑 𝒀𝟑 𝑿𝟏 𝑿𝟐
  
1st -1 3 0 -2 1 0 -1 -2 1
→2nd 0 -1 1 0 0 1
3rd 1 -1 -1 0 0 -2 1 0 0
Fourthly. Form the determinant(s) of order (G-1) and examine their value. If at least one
of these determinants is non-zero, the equation is identified. If all the determinants of
order (G-1) are zero, the equation is under-identified.
In the above example of exploration of the identifiability of the second structural equation
we have three determinants of order (G-1)=3-1=2. They are:
−1 − 2 −2 1 −1 1
𝛥1 = | | ≠ 0𝛥2 = | | = 0𝛥3 = | |≠0
1 0 0 0 1 0
(the symbol 𝛥stands for ‘determinant’) We see that we can form two non-zero
determinants of order G-1=3-1=2; hence the second equation of our system is identified.
Fifthly. To see whether the equation is exactly identified or overidentified we use the order
condition (𝐾 − 𝑀) ≥ (𝐺 − 1). With this criterion, if the equality sign is satisfied, that is if
(𝐾 − 𝑀) = (𝐺 − 1), the equation is exactly identified. If the inequality sign holds, that is,
if (𝐾 − 𝑀) < (𝐺 − 1), the equation is overidentified.
 In the case of the second equation we have:
G=3 K=6 M=3
And the counting rule (𝐾 − 𝑀) ≥ (𝐺 − 1) gives
(6-3)>(3-1)
Therefore, the second equation of the model is overidentified.
Example 1. Assume the following simple version of the Keynesian model of income
determination.
Consumption function: 𝐶𝑡 = 𝑎0 + 𝑎1 𝑌𝑡 − 𝑎2 𝑇𝑡 + 𝑢
Investment function: 𝐼𝑡 = 𝑏0 + 𝑏1 𝑌𝑡−1 + 𝑢
Taxation function: 𝑇𝑡 = 𝑐0 + 𝑐1 𝑌𝑡 + 𝑤
Definition: 𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡 + 𝐺𝑡
This model is mathematically complete in the sense that it contains as many equations as
endogenous variables. There are four endogenous variables, C,I,T,Y, and two
predetermined variables, lagged income (𝑌𝑡−1 ) and government expenditure (G).
A. The first equation (consumption function) is not identified
1. Order condition: (𝐾 − 𝑀) ≥ (𝐺 − 1)
There are six variables in the model (K=6) and four equations (G=4). The consumption
function contains three variables (M=3).
(K-M)=3 and (G-1)=3
Thus (K-M)=(G-1), which shows that the order condition for identification is satisfied.
2. Rank condition
The table of structural coefficients is as follows
Variables
Equations 𝐶 𝑌 𝑇 𝐼 𝑌𝑡−1 𝐺
1st equation -1 𝑎1 𝑎2 0 0 0
2nd equation 0 0 0 -1 𝑏1 0
3rd equation 0 𝑐1 -1 0 0 0
4th equation 1 -1 0 1 0 1
We strike out the first row and the three first columns of the table and thus obtain the
table of coefficients of excluded variables.

Complete table of Table of coefficients of

structural parameters excluded variables
 -1 𝒂𝟏 𝒂𝟐 0 0 0
0 0 0 -1 𝒃𝟏 0 -1 𝒃𝟏 0
0 𝒄𝟏 -1 0 0 0 0 0 0
1 -1 0 1 0 1 -1 0 0
We evaluate the determinant of this table. Clearly the value of this determinant is zero,
since the second row contains only zeros. Consequently, we cannot form any nonzero
determinant of order 3(=G-1). The rank condition is violated. Hence, we conclude that
the consumption function is not identified, despite the satisfaction of the order criterion.
B. The investment function is overidentified
1. Order condition
The investment function includes two variables. Hence
K-M = 6-2
Clearly (K-M) > (G-1), given that G-1=3. The order condition is fulfilled.
2. Rank condition
Deleting the second row and the fourth and fifth columns of the structural coefficients
table we obtain .
Complete table of structural Table of coefficients of
Parameters excluded variables

-1 𝒂𝟏 𝒂𝟐 0 0 0
0 0 0 -1 𝒃𝟏 0 -1 0
𝒂𝟏 𝒂𝟐
0
0 𝒄𝟏 -1 0 0 0 𝒄𝟏 -1 0
-1 0 -1
1 0 1 1 -1 0 1
The value of the first 3x3 determinant of the parameters of excluded variables is
𝑐 −1 0−1 0𝑐
𝛥1 = −1 | 1 | − 𝑎1 | | + 𝑎2 | 1 | = 1 + 𝑎1 − 𝑎2 𝑐1 ≠ 0
−10 10 1−1
(provided 𝑎1 − 𝑎2 𝑐1 ≠ −1)
The rank condition is satisfied since we can construct at least one non-zero determinant
of order 3=(G-1).
Applying the counting rule (𝐾 − 𝑀) ≥ (𝐺 − 1) we see that the inequality sign holds: 4>3;
hence the investment function is overidentified.