You want to study the impact of credit conditions on firms’ profits using a sample of 10,000 firms for which you observe their profits and the credit conditions under which they operate (1.e. the maximum pre-approved loan size and the interest rate at which they access credit) You estimate the following model: Profits; = Bo + B. Interest; + B, LoanSize: + & a) Explain why this regression likely suffers from reverse causality. Explain how this problem affects the OL S estimation. b) Explain why this regression likely suffers from omitted variable bias. Explain how this problem affects the OLS estimation c) Suppose that the variables Profits, Interest and LoanSize are observed for 5 consecutive years for each of the 10.000 firms. Explain how you can estimate a Fixed Effect model. Write the equation you would estimate and discuss if this strategy can solve the issues from parts a) and b). d) A bank decides to offer low interest rate loans to any firm registered in postcodes ending in odd numbers (eg. 124 31). Explain how you can use this fact to construct an instrumental variable for the endogenous variable Interest, and what are the conditions that your instrumental variable must satisfy.
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