| Summary: | In this paper, we use the instrument variable (IV) method with a two-stage least squares (2SLS) estimator to explore the impact of exogenous income changes on happiness. Our study is based on the German post-reunification period from 1991 to 1995, when East German income levels, by no means of productivity increase, were set to catch-up to that of their West German industrial counterparts. Using West German sectoral income as an instrument for East German income, we resolved the problem of reverse causation and eliminated the effects of both time-variant and time-invariant unobserved characteristics that were correlated with income and happiness. Our results show that exogenous increases in income did have a positive and significant effect on happiness in East Germany. This impact was greater than what was found in other studies on income and happiness, thereby suggesting that the actual effect of income on happiness has been suppressed in these studies.
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