Instrumental variable procedures are needed when some regressors are endogenous (correlated with the error term). The procedure for correcting this endogeneity problem involves finding instruments that are correlated with the endogenous regressors but uncorrelated with the error term. Then the two stage least squares procedure can be applied. An example of instrumental variables is when wages and education jointly depend on ability which is not directly observable, but we can use available test scores to proxy for ability.
Handouts, Programs, and Data
Instrumental variables: topics covered
The two stage least squares (2SLS) estimation procedure
Weak instrumental variables
Systems of equations (2SLS and 3SLS)