ECONOMETRICS

[Econ 3061]

Madda Walabu University

College of Business and Economics
Department of Economics

Genemo fitala (MSc.)

genemo.fitala@mwu.edu.et
 2

CHAPTER ONE

INTRODUCTION
 CHAPTER OUTLINES

1.1. DEFINITION AND SCOPE OF ECONOMETRICS

1.2. MODELS: ECONOMIC MODELS AND ECONOMETRIC MODELS

1.3. METHODOLOGY OF ECONOMETRICS

1.4. THE SOURCES, TYPES AND NATURE OF DATA

3
 1.1. Definition and scope of 4
econometrics

 The economic theories we learn in various economics courses suggest many

relationships among economic variables.

 Forinstance, in microeconomics we learn demand and supply models in

which the quantities demanded and supplied of a good depend on its price.

 Inmacroeconomics, we study ‘investment function’ to explain the amount

of aggregate investment in the economy as the rate of interest changes;
and ‘consumption function’ that relates aggregate consumption to the level
of aggregate disposable income.
Cont’d 5

 Each of such specifications involves a relationship among economic

variables.

 As a field of economics and Business, we may be interested in questions

such as: If one variable changes in a certain magnitude, by how much will
another variable change?

 Also, given that we know the value of one variable; can we forecast or
predict the corresponding value of another?

 The purpose of studying the relationships among economic variables and

attempting to answer questions of the type raised here, is to help us
understood the real economic world we live in.
Cont’d 3
 However, economic theories have to be checked against data obtained from
the real world.

 If empirical data verify the relationship proposed by economic theory, we

accept the theory as valid. If the theory is incompatible with the
observed behavior, we either reject the theory or in the light of the
empirical evidence of the data, modify the theory.

 To provide a better understanding of economic relationships and a better

guidance for economic policy making we also need to know the quantitative
relationships between the different economic variables.

 The field of knowledge which helps us to carryout such an evaluation of

economic theories in empirical terms is econometrics.
Cont’d 3

WHAT IS ECONOMETRICS?

 Literally interpreted, econometrics means “economic measurement”,

but the scope of econometrics is much broader as described by
leading econometricians.

 Various econometricians used different ways of wordings to define

econometrics.

 But if we distill the fundamental features/concepts of all the

definitions, we may obtain the following definition.
Cont’d 3

 “Econometrics is the science which integrates economic theory, economic

statistics, and mathematical economics to investigate the empirical support
of the general schematic law established by economic theory.

 It is a special type of economic analysis and research in which the general

economic theories, formulated in mathematical terms, is combined with
empirical measurements of economic phenomena.

 Starting from the relationships of economic theory, we express them in

mathematical terms so that they can be measured.

 We then use specific methods, called econometric methods in order to obtain

numerical estimates of the coefficients of the economic relationships”.
Cont’d 3

 Measurement is an important aspect of econometrics. However, the

scope of econometrics is much broader than measurement.

 The “metric” part of the word econometrics signifies ‘measurement’,

and hence econometrics is basically concerned with measuring of
economic relationships.

 In short, econometrics may be considered as the integration of

economics, mathematics, and statistics for the purpose of providing
numerical values for the parameters of economic relationships and
verifying economic theories.
 1.1 Econometrics & Other Disciplines of 3
Economics

A. Economic theory states a qualitative relationship between the

explanatory & explained variable using Cetrus Peribus assumptions.

Ex.1. Consumption depends up on current income (Yt) & previous income (Yt-1) of
an individual other things being constant. This theory does not give any insight how
current income & previous income will affect consumption by giving numerical
values.

B. Mathematical Economics: It explains the economic theory in the

equation or mathematical forms. Or mathematical economics
explain the theory of economics in to mathematical relationship
between variables.
Cont’d 3

 We can explain the above theoretical relationship in mathematical form

as follows.
𝐶𝑡 = 𝑎 + 𝑏1𝑌𝑡 + 𝑏2𝑌𝑡 − 1 −−−−−−− −(1.1)
Where
Ct.: consumption expenditure
Yt: current income
Yt-1: previous income

 Again this mathematical relation does not capture other factors that
affect consumption expenditure.
Cont’d 3

 Then mathematical economics explain the exact relationship between

the dependent variable (Ct) & the independent variables (Yt &Yt-1) by
ignoring other variables that affects consumption expenditure.

C. Economic Statistics:- It is a descriptive aspects of economic theory. i.e.

by collecting, processing and presenting economic data in the form
of table & charts.

 Though Economic statistics provides numerical data like mean, median -

standard deviation etc. but it does not make reliable the relationship
between the economic variables.
Cont’d 3
D. Mathematical statistics:- This is based up on the probability theory,
which are developed on the basis of controlled experiments.

 This statistical method can be applied in economic relationships because

such experiment can not be designed for economic phenomena.

 This probability theory applied for very few cases in economics such
as Agricultural or industrial experimentations.

 In all of the above methods they completely ignore the other factors that will
affect the economic relationship but econometrics by developing a method
for dealing with the random term that will affect the economic relation ships
differentiate itself from the remaining.
Cont’d 3

𝑪𝒕 = 𝒂 + 𝒃𝟏𝒀𝒕 + 𝒃𝟐𝒀𝒕 − 𝟏 + 𝑼𝒕 −−−−−−−− −(𝟏. 𝟐)

 All variables have the same meaning as equation (1.1) except Ut .

 Ut: means the random term which represents all other factors that will affect
consumption expenditure.

 These factors may be many such as, invention of new product, wealth, wind-
fall gain/loss, migration, tradition, etc. are affecting consumption expenditure.

 Then econometrics by considering other factors (represented by Ui) will find

numerical values for coefficients of the variable that will explain the
relationship to verifying economic theories.
 1.4 Methodology of econometrics 15

 Econometric research is concerned with the measurement of the

parameters of economic relationships and with the predication of the
values of economic variables.

 Starting with the postulated theoretical relationships among economic

variables, econometric research or inquiry generally proceeds along the
following lines/stages.
1. Specification the model
2. Estimation of the model
3. Evaluation of the estimates
4. Forecasting or prediction
Cont’d
16

1. Specification of the model

 In this step the econometrician has to express the relationships between
economic variables in mathematical form. This step involves the
determination of three important tasks:

i. the dependent and independent (explanatory) variables which will be

included in the model,

ii. the a priori theoretical expectations about the size and sign of the
parameters of the function.

iii. the mathematical form of the model (number of equations, specific

form of the equations, etc.)
Cont’d 17

 Note: The specification of the econometric model will be based on

economic theory and on any available information related to the
phenomena under investigation.

 Thus, specification of the econometric model presupposes knowledge of

economic theory and familiarity with the particular phenomenon being
studied.

 Specification of the model is the most important and the most

difficult stage of any econometric research.

 It is often the weakest point of most econometric, applications.

Cont’d 18

 In this stage there exists enormous degree of likelihood of committing

errors or incorrectly specifying the model.

 Some of the common reasons for incorrect specification of the

econometric models are:

1. the imperfections, looseness of statements in economic theories.

2. the limitation of our knowledge of the factors which are operative in

any particular case.

3. the formidable obstacles presented by data requirements in the

estimation of large models
Cont’d 19

 The most common errors of specification are:

a. Omissions of some important variables from the function.

b. The omissions of some equations (for example, in

simultaneous equations model).

c. The mistaken mathematical form of the functions.

Cont’d
20
2. Estimation of the model
 This is purely a technical stage which requires knowledge of the various
econometric methods, their assumptions and the economic implications
for the estimates of the parameters.
 This stage includes the following activities:
a. Gathering of the data on the variables included in the model.
b. Examination of the identification conditions of the function
(especially for simultaneous equations models).
c. Examination of the aggregations problems involved in the variables
of the function.
Cont’d
21

d. Examination of the degree of correlation between the explanatory

variables (i.e. examination of the problem of multicollinearity).

e. Choice of appropriate economic techniques for estimation, i.e. to

decide a specific econometric method to be applied in estimation;
such as, OLS, MLM, Logit, and Probit.

Example
 Note that the statistical technique of regression analysis is the main tool used
to obtain the estimates.

 Using this technique, we obtain the following estimates of 𝜷𝟏 and 𝜷𝟐, namely,
−299.5913 and 0.7218.
Cont’d
22
Thus, the estimated consumption function is:

Ŷ𝒕 = −299.5913 + 0.7218X𝒕−−−−−−−(1.3)

The hat on the Y indicates that it is an estimate.

The estimated consumption function (regression
line) is shown in the following fig.

As Figure shows, the regression line fits the data

quite well in that the data points are very close to
the regression line.

The slope coefficient (the MPC) is about 0.72,

suggesting that an increase in real income of one
dollar led, on average, to an increase of about
72 cents in real consumption expenditure.
Cont’d 23

We say on average because the relationship

between consumption and income is inexact;
as is clear from Figure, not all the data
points lie exactly on the regression line.

In simple terms we can say that, according

to our data, the average, or mean,
consumption expenditure went up by about
72 cents for a dollar’s increase in real
income.
Cont’d
24
3. Evaluation of the estimates
 This stage consists of deciding whether the estimates of the
parameters are theoretically meaningful and statistically satisfactory.

 This stage enables the econometrician to evaluate the results of

calculations and determine the reliability of the results.

 For this purpose we use various criteria which may be classified into
three groups:

i. Economic a priori criteria: These criteria are determined by economic

theory and refer to the size and sign of the parameters of economic
relationships.
Cont’d 25

ii. Statistical criteria (first-order tests): determined by

statistical theory and aim at the evaluation of the
statistical reliability of the estimates of the parameters
of the model.
 Correlation coefficient test,
 standard error test,
 t-test,
 F-test, and
 R2-test are some of the most commonly used statistical tests
Cont’d 26
iii. Econometric criteria (second-order tests): These are set by the theory
of econometrics and aim at the investigation of whether the assumptions
of the econometric method employed are satisfied or not in any
particular case.

 The econometric criteria serve as a second order test (as test of the
statistical tests) i.e. they determine the reliability of the statistical
criteria;

 they help us establish whether the estimates have the desirable properties
of unbiasedness, consistency etc.

 Econometric criteria aim at the detection of the violation or validity of the

assumptions of the various econometric techniques.
Cont’d 27
4) Forecasting or prediction:
 Forecasting is one of the aims of econometric research. However, before
using an estimated model for forecasting by some way or another the
predictive power of the model need to be evaluated.

 It is possible that the model may be economically meaningful and

statistically and econometrically correct for the sample period for which
the model has been estimated; yet it may not be suitable for forecasting
due to various factors (reasons).

 Therefore, this stage involves the investigation of the stability of the

estimates and their sensitivity to changes in the size of the sample.
Cont’d 28
 If the chosen model does not refute the hypothesis or theory under
consideration, we may use it to predict the future value(s) of the dependent,
or forecast, variable Y on the basis of the known or expected future
value(s) of the explanatory, or predictor, variable X.

 To illustrate, suppose we want to predict the mean consumption expenditure

for 2006.

 The GDP value for 2006 was 11319.4 billion dollars. Putting this GDP figure on
the right-hand side of Eq. (1.3), we obtain:
Ŷ𝒕 = −299.5913 + 0.7218X𝒕

Ŷ2006 = −299.5913 + 0.7218 (11319.4) = 7870.7516,

or about 7870 billion dollars.

Cont’d 29
 Thus, given the value of the GDP, the mean, or average, forecast consumption
expenditure is about 7870 billion dollars. The actual value of the consumption
expenditure reported in 2006 was 8044 billion dollars.

 The estimated model Eq. (1.3) thus underpredicted the actual consumption
expenditure by about 174 billion dollars. We could say the forecast error is
about 174 billion dollars, which is about 1.5 percent of the actual GDP value for
2006.

 When we fully discuss the linear regression model in subsequent chapters, we

will try to find out if such an error is “small” or “large.”

 But what is important for now is to note that such forecast errors are
inevitable given the statistical nature of our analysis.
 5. Use of the Model for Control or Policy Purposes 30

 Suppose further the government believes that consumer expenditure of

about 8750 (billions of 2000 dollars) will keep the unemployment rate at its
current level of about 4.2% (early 2006). What level of income will guarantee
the target amount of consumption expenditure?

 If the regression results given in Eq. (1.3) seem reasonable, simple arithmetic
will show that 8750 = −299.5913 + 0.7218(GDP2006), X = 12537, approximately.

 That is, an income level of about 12537 (billion) dollars, given an MPC of about
0.72, will produce an expenditure of about 8750 billion dollars.

 As these calculations suggest, an estimated model may be used for control, or

policy, purposes. By appropriate fiscal &monetary policy mix, the government can
manipulate the control variable X to produce the desired level of the target variable Y.
1.5 Desirable properties of an Econometric Model 31
 An econometric model is a model whose parameters have been estimated
with some appropriate econometric technique.

 The ‘goodness’ of an econometric model is judged customarily according to

the following desirable properties.

1) Theoretical plausibility. The model should be compatible with the

postulates of economic theory. It must describe adequately the
economic phenomena to which it relates.

2) Explanatory ability. The model should be able to explain the

observations of he actual world. It must be consistent with the
observed behavior of the economic variables whose relationship it
determines.
Cont’d 32

3) Accuracy of the estimates of the parameters. The estimates of the

coefficients should be accurate in the sense that they should
approximate as best as possible the true parameters of he structural
model. The estimates should if possible possess the desirable properties
of unbiasedness, consistency and efficiency.

4) Forecasting ability. The model should produce satisfactory predictions of

future values of he dependent (endogenous) variables.

5) Simplicity. The model should represent the economic relationships with

maximum simplicity. The fewer the equations and the simpler their
mathematical form, the better the model is considered.
 1.6. Goals of Econometrics 33

Three main goals of Econometrics are identified:

i. Analysis i.e. testing economic theory

ii. Policy making i.e. Obtaining numerical estimates of the coefficients

of economic relationships for policy simulations.

iii. Forecasting i.e. using the numerical estimates of the coefficients in

order to forecast the future values of economic magnitudes.
 Terminology and Notation 34

 Before we proceed to a formal analysis of regression theory, let us deal

briefly on the matter of terminology and notation.
 Dependent variable and explanatory variable are described variously.
 1.7. The Sources, Types and 35
Nature of Data

 The success of any econometric analysis ultimately depends

on the availability of the appropriate data.

 It is therefore essential that we spend some time

discussing the nature, sources, and limitations of the data
that one may encounter in empirical analysis.
 1.7.1 Types of Data 36

 Three types of data may be available for empirical analysis: time series,
cross-section, and pooled (i.e., combination of time series &cross-section)

i. Time Series Data

 A time series is a set of observations on the values that a variable

takes at different times.
 Such data may be collected at regular time intervals, such as daily (e.g.,
stock prices, weather reports), weekly (e.g., money supply figures), monthly
(e.g., the unemployment rate, the Consumer Price Index [CPI]), quarterly
(e.g., GDP), annually (e.g., government budgets), quinquennially, that is, every
5 years (e.g., the census of manufactures), or decennially, that is, every 10
years (e.g., the census of population).
 Example of time series dataset: 37
Observation Year Month Exchange rate Interest rate
1 1990 1 1.32 7.35
2 1990 2 1.30 7.30
3 1990 3 1.29 7.32
. . . . .
. . . . .
. . . . .
191 2005 11 1.11 4.26
192 2005 12 1.10 4.31
Cont’d 38
ii. Cross-Section Data

 Cross-section data are data on one or more variables collected at the same
point in time.

 These data give information on the variables concerning individual agents

(consumers or producers) at a given point of time.

 The data is collected at single time-period or takes a snap shot approach to

social world.

 Each observation is a new individual, firm, etc. with information at a point

in time. If the data is not a random sample, we have a sample-selection
problem.
 Example of cross-section data 39
Observation Wage Education Experience Sex Marital status

1 3.10 11 2 1 0
2 3.24 12 22 1 1
3 3.00 11 2 0 0
. . . . . .
. . . . . .
. . . . . .
499 11.56 16 5 0 1
500 3.50 14 5 1 0
Cont’d 40
iii. Pooled Data

 In pooled, or combined, data are elements of both time series and cross-
section data.

 These are repeated surveys of a single (cross-section) or more than one

time sample in different periods of time.

 It is more powerful especially with respect to social changes.

 They record the behavior of the same set of individual microeconomic

units over time.

 Examples : Interviewing and collecting the data from the same people in
1991, 1995, 1999 etc. and observe the change.
Example of panel dataset: 150 cities over 2 years 41

Observation City Year Murders Population Police

1 1 1999 5 350,000 440
2 1 2000 8 359,200 471
3 2 1999 2 64.300 75
4 2 2000 1 65,100 75
. . . . . .
. . . . . .
299 150 1999 25 543,000 520
300 150 2000 32 546,200 493
 1.7.2 Source of Data 42
There are two types of data source:

a) Primary Data

 Data collected by the investigator directly from the source. Example:

observing signs, measure characteristics, record symptoms and
interview respondents, etc.

b) Secondary Data

 Data gathered or compiled from published and unpublished sources or

files. Example: Hospital records, vital statistics and registers, etc.
 1.8. Measurement Scales 43

 The variables that we will generally encounter fall into four

broad categories:

 ratio scale,

 interval scale,

 ordinal scale, and

 nominal scale.
Cont’d 44
1. Ratio Scale

 For a variable X, taking two values, X1 and X2, the ratio X1/X2 and the
distance (X2 − X1) are meaningful quantities.

 Also, there is a natural ordering (ascending or descending) of the values

along the scale. Therefore, comparisons such as X2 ≤ X1 or X2 ≥ X1 are
meaningful.

 Most economic variables belong to this category. Thus, it is meaningful to ask

how big this year’s GDP is compared with the previous year’s GDP.

 Personal income, measured in dollars, is a ratio variable; someone earning

$100,000 is making twice as much as another person earning $50,000.
 Cont’d 45
2. Interval Scale
 An interval scale variable satisfies the last two properties of the ratio scale
variable but not the first.

 Thus, the distance between two time periods, say (2000–1995) is meaningful,
but not the ratio of two time periods (2000/1995).

 Interval scales can have an arbitrary zero, but it is not possible to determine
for them what may be called an absolute zero or the unique origin.

 The primary limitation of the interval scale is the lack of a true zero; it
does not have the capacity to measure the complete absence of a trait or
characteristic.
Cont’d 46

 The Fahrenheit scale is an example of an interval scale and shows

similarities in what one can and cannot do with it.

 One can say that an increase in temperature from 30° to 40° involves the
same increase in temperature as an increase from 60° to 70°, but one
cannot say that the temperature of 60° is twice as warm as the
temperature of 30° because both numbers are dependent on the fact
that the zero on the scale is set arbitrarily at the temperature of the
freezing point of water.

 The ratio of the two temperatures, 30° and 60°, means nothing because
zero is an arbitrary point.
 Cont’d 47
3. Ordinal Scale
 The lowest level of the ordered scale that is commonly used is the ordinal scale.

 The ordinal scale places events in order, but there is no attempt to make the
intervals of the scale equal in terms of some rule.

 A variable belongs to this category only if it satisfies the third property of the
ratio scale (i.e., natural ordering).

 Examples are grading systems (A, B, C grades) or income class (upper, middle,
lower).

 For these variables the ordering exists but the distances between the
categories cannot be quantified.
 Cont’d
48

4. Nominal Scale
 Nominal scale are commonly used to refer to data that can only be classified
into categories.

 The lowest level of data measurement is nominal level data. Numbers

representing nominal data can be used only to classify or categorize.

 Variables in this category have none of the features of the ratio scale
variables.

 Variables such as gender (male, female) and marital status (married,

unmarried, divorced, separated) simply denote categories.
END OF CHAPTER ONE

THANK YOU!

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