The Reduced Form as an Empirical Tool: A Cautionary Tale from the Financial Veil
The reduced-form empirical strategy has been used for more than 30 years to test the Modigliani-Miller model of corporate financial structure. Curiously, the early tests almost always accepted the model, whereas subsequent tests almost always reject it. This paper considers the limitations of the reduced-form strategy that led to the early, spurious results, and demonstrates why an empirical strategy that is not closely tied to an under-lying economic theory of behavior will usually yield estimates that are too imprecise or too unreliable to form a basis for policy.
Suggested citation: Craig, Ben R., and Christopher Richardson. “The Reduced Form as an Empirical Tool: A Cautionary Tale from the Financial Veil,” Federal Reserve Bank of Cleveland, Economic Review, vol. 32, no. 1, pp. 16-25, 03.01.1996.