CHAPTER -1

1. INTRODUCTION TO ECONOMETRICS
1.1. DEFINITION AND SCOPE
1.1.1. What is Econometrics?

Literally interpreted, econometrics means “economic measurement.” Although measurement

is an important part of econometrics, the scope of econometrics is much broader, as can be
seen from the following quotations:
Econometrics, the result of a certain outlook on the role of economics, consists of
the application of mathematical statistics to economic data to lend empirical support to the
models constructed by mathematical economics and to obtain numerical results.
Econometrics may be defined as the quantitative analysis of actual economic phenomena
based on the concurrent development of theory and observation, related by appropriate
methods of inference.
Econometrics may be defined as the social science in which the tools of economic
theory, mathematics, and statistical inference are applied to the analysis of economic
phenomena. Econometrics is concerned with the empirical determination of economic
laws.
The art of the econometrician consists in finding the set of assumptions that are
both sufficiently specific and sufficiently realistic to allow him to take the best
possible advantage of the data available to him.
Econometricians . . . are a positive help in trying to dispel the poor public image
of economics (quantitative or otherwise) as a subject in which empty boxes are
opened by assuming the existence of can-openers to reveal contents which any
ten economists will interpret in 11 ways.
The method of econometric research aims, essentially, at a conjunction of economic theory
and actual measurements, using the theory and technique of statistical inference as a bridge
pier.
1.2. WHY A SEPARATE DISCIPLINE?

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As the preceding definitions suggest, econometrics is an amalgam of economic theory,
mathematical economics, economic statistics, and mathematical statistics. Yet the subject
deserves to be studied in its own for the following reasons.
Economic theory makes statements or hypotheses that are mostly qualitative in nature.
For example, microeconomic theory states that, other things remaining the same, a
reduction in the price of a commodity is expected to increase the quantity demanded of
that commodity. Thus, economic theory postulates a negative or inverse relationship
Between the price and quantity demanded of a commodity. But the theory itself does not
provide any numerical measure of the relationship between the two; that is, it
does not tell by how much the quantity will go up or down as a result of a
certain change in the price of the commodity. It is the job of the econometrician to
provide such numerical estimates. Stated differently, econometrics gives empirical
content to most economic theory.

The main concern of mathematical economics is to express economic

theory in mathematical form (equations) without regard to measurability or
empirical verification of the theory. Econometrics, as noted previously, is
mainly interested in the empirical verification of economic theory. As we
shall see, the econometrician often uses the mathematical equations proposed by the
mathematical economist but puts these equations in such a
form that they lend themselves to empirical testing. And this conversion of
mathematical into econometric equations requires a great deal of ingenuity
and practical skill.

Economic statistics is mainly concerned with collecting, processing, and

presenting economic data in the form of charts and tables. These are the jobs of the
economic statistician. It is he or she who is primarily responsible
for collecting data on gross national product (GNP), employment, unemployment, prices,
etc. The data thus collected constitute the raw data for
econometric work. But the economic statistician does not go any further,
not being concerned with using the collected data to test economic theories.

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 Of course, one who does that becomes an econometrician.
Although mathematical statistics provides many tools used in the trade,
the econometrician often needs special methods in view of the unique nature of most
economic data, namely, that the data are not generated as the
result of a controlled experiment. The econometrician, like the meteorologist, generally
depends on data that cannot be controlled directly.
In econometrics the modeler is often faced with observational as opposed to
experimental data. This has two important implications for empirical modeling
in econometrics. First, the modeler is required to master very different skills
than those needed for analyzing experimental data. . . . Second, the separation
of the data collector and the data analyst requires the modeler to familiarize
himself/herself thoroughly with the nature and structure of data in question.
1.3. Goals of Econometrics
The principal purposes of econometrics are structural analysis, forecasting, and policy
evaluation. Any econometric study may have one or more of these purposes. These are
the products of econometrics.
1. Structural analysis: is the use of estimated econometric model for the quantitative
measurement of economic relationships. It also facilitates the comparison of rival
theories proposed for the same phenomena. It may be considered as the means of
understanding real world phenomena by quantitatively measuring, testing and
validating economic relationships.
2. Forecasting: is the use of estimated econometric models in order to predict
quantitative values of variables outside the sample data actually observed.
3. Policy evaluation: We use estimated values to choose among alternative economic
policies.
1.4. TYPES OF ECONOMETRICS
Econometrics may be divided into two broad categories: theoretical econometrics and applied
econometrics. In each category, one can approach the subject in the classical or Bayesian
tradition.

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Theoretical econometrics is concerned with the development of appropriate methods for
measuring economic relationships specified by econometric models. In this aspect, econometrics
leans heavily on mathematical statistics. For example, least squares.
Theoretical econometrics must spell out the assumptions of
this method, its properties, and what happens to these properties when one
or more of the assumptions of the method are not fulfilled.
In applied econometrics we use the tools of theoretical econometrics to
study some special field(s) of economics and business, such as the production function,
investment function, demand and supply functions, portfolio
theory, etc.

1.5. METHODOLOGY OF ECONOMETRICS

How do econometricians proceed in their analysis of an economic problem?
That is, what is their methodology? Although there are several schools of
thought on econometric methodology, we present here the traditional or
classical methodology, which still dominates empirical research in economics and other
social and behavioral sciences. Broadly speaking, traditional econometric methodology
proceeds the following lines;
1. Statement of theory or hypothesis.
2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric, model

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4. Obtaining the data
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purposes.
To illustrate the preceding steps, let us consider the well-known Keynesian
theory of consumption.
1. Statement of Theory or Hypothesis

Keynes stated:

The fundamental psychological law . . . is that men [women] are disposed, as a

rule and on average, to increase their consumption as their income increases, but
not as much as the increase in their income.
In short, Keynes postulated that the marginal propensity to consume
(MPC), the rate of change of consumption for a unit (say, a dollar) change
in income, is greater than zero but less than 1.

2. Specification of the Mathematical Model of Consumption

Although Keynes postulated a positive relationship between consumption

and income, he did not specify the precise form of the functional relationship between
the two. For simplicity, a mathematical economist might suggest the following form
of the Keynesian consumption function:

Where Y = consumption expenditure and X = income, and where β1 and β2,

known as the parameters of the model, are, respectively, the intercept and slope
coefficients.

The slope coefficient β2 measures the MPC. Geometrically, in above equation is as

shown in Figure below.

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This equation, which states that consumption is linearly related to income, is an
example of a mathematical model of the relationship between consumption and
income that is called the consumption function in economics. A model is simply a
set of mathematical equations, If the model has only one equation, as in the preceding
example, it is called
a single-equation model, whereas if it has more than one equation, it is
known as a multiple-equation model.
In above equation the variable appearing on the left side of the equality sign
is called the dependent variable and the variable(s) on the right side are
called the independent, or explanatory, variable(s). Thus, in the Keynesian
consumption function, equation, consumption (expenditure) is the dependent variable
and income is the explanatory variable

3. Specification of the Econometric Model of Consumption

The purely mathematical model of the consumption function is of limited interest to

the econometrician, for it assumes that
there is an exact or deterministic relationship between consumption and

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 income. But relationships between economic variables are generally inexact.
Thus, if we were to obtain data on consumption expenditure and disposable
(i.e., aftertax) income of a sample of, say, 500 American families and plot
these data on a graph paper with consumption expenditure on the vertical
axis and disposable income on the horizontal axis, we would not expect all
500 observations to lie exactly on the straight line of in below equation because, in
addition to income, other variables affect consumption expenditure. For example, size
of family, ages of the members in the family, family religion, etc.,
are likely to exert some influence on consumption.
To allow for the inexact relationships between economic variables, the
econometrician would modify the deterministic consumption function) as follows:

Where, u, known as the disturbance, or error, term, is a random (stochastic) variable

That has well-defined probabilistic properties. The disturbance
term u may well represent all those factors that affect consumption but are
not taken into account explicitly, in above equation is an example of an econometric
model. More technically, it is an example of a linear regression model, The
econometric consumption function hypothesizes that the dependent variable Y
(consumption) is linearly related to the explanatory variable X (income) but that the
relationship between the two is not exact; it is subject to individual variation. The
econometric model of the consumption function can be depicted as shown in Figure
below

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.
4. Obtaining Data

To estimate the econometric model given in given in model specification, that is, to
Obtain the numerical values of β1 and β2. We will discuss this concept in depth in
chapter three.

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The Y variable in this table is the aggregate (for the economy as a whole) personal
consumption expenditure (PCE) and the X variable is gross domestic product (GDP), a
measureof aggregate income, both measured in billions of 1992 dollars. Therefore,
the data are in “real” terms; that is, they are measured in constant (1992)
prices.

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5. Estimation of the Econometric Model

Now that we have the data, our next task is to estimate the parameters of
the consumption function. The numerical estimates of the parameters give
empirical content to the consumption function. The actual mechanics of estimating
the parameters will be discussed in Chapter 3. For now, note that
the statistical technique of regression analysis is the main tool used to
obtain the estimates. Using this technique and the data given in Table I.1,
we obtain the following estimates of β1 and β2, namely, −184.08 and 0.7064.
Thus, the estimated consumption function is:

The hat on the Y indicates that it is an estimate.11 the estimated consumption function
(i.e., regression line).
As Figure I.3 shows, the regression line fits the data quite well in that the
data points are very close to the regression line. From this figure we see that
for the period 1982–1996 the slope coefficient (i.e., the MPC) was about
0.70, suggesting that for the sample period an increase in real income of
1 dollar led, on average, to an increase of about 70 cents in real consumption
expenditure. We say on average because the relationship between consumption and
income is inexact; as is clear from Figure I.3; 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 70 cents for a dollar’s increase in real income.
6. Hypothesis Testing

Assuming that the fitted model is a reasonably good approximation of

reality, we have to develop suitable criteria to find out whether the estimates obtained
in, say, Eq. (I.3.3) are in accord with the expectations of the
theory that is being tested. According to “positive” economists like Milton
Friedman, a theory or hypothesis that is not verifiable by appeal to empirical evidence

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 may not be admissible as a part of scientific enquiry.13
As noted earlier, Keynes expected the MPC to be positive but less than 1.
In our example we found the MPC to be about 0.70. But before we accept
this finding as confirmation of Keynesian consumption theory, we must enquire
whether this estimate is sufficiently below unity to convince us that
this is not a chance occurrence or peculiarity of the particular data we have
used. In other words, is 0.70 statistically less than 1? If it is, it may support
Keynes’ theory such confirmation or refutation of economic theories on the basis of
sample evidence is based on a branch of statistical theory known as statistical
inference (hypothesis testing). Throughout this book we shall see
how this inference process is actually conducted.
7. Forecasting or Prediction

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 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 1997.
The GDP value for 1997 was 7269.8 billion dollars. Putting this GDP figure on the
right-hand side of (I.3.3), we obtain:

or about 4951 billion dollars. Thus, given the value of the GDP, the mean,
or average, forecast consumption expenditure is about 4951 billion dollars. The actual
value of the consumption expenditure reported in 1997 was
4913.5 billion dollars. The estimated model (I.3.3) thus over predicted
the actual consumption expenditure by about 37.82 billion dollars. We
could say the forecast error is about 37.82 billion dollars, which is about
0.76 percent of the actual GDP value for 1997. 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

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 that such forecast errors are inevitable given the statistical nature of our
analysis.

There is another use of the estimated model (I.3.3). Suppose the President decides to
propose a reduction in the income tax. What will be the effect of such a policy on
income and thereby on consumption expenditure
and ultimately on employment?

Suppose that, as a result of the proposed policy change, investment expenditure

increases. What will be the effect on the economy? As macroeconomic theory shows,
the change in income following, say, a dollar’s worth of
change in investment expenditure is given by the income multiplier M,
which is defined as

If we use the MPC of 0.70 obtained in (I.3.3), this multiplier becomes about
M = 3.33. That is, an increase (decrease) of a dollar in investment will eventually lead
to more than a threefold increase (decrease) in income; note that
it takes time for the multiplier to work.

The critical value in this computation is MPC, for the multiplier depends
on it. And this estimate of the MPC can be obtained from regression models
such as (I.3.3). Thus, a quantitative estimate of MPC provides valuable information
for policy purposes. Knowing MPC, one can predict the future
course of income, consumption expenditure, and employment following a
change in the government’s fiscal policies.
8. Use of the Model for Control or Policy Purposes
Suppose we have the estimated consumption function given in estimated in above.
Suppose further the government believes that consumer expenditure of
about 4900 (billions of 1992 dollars) will keep the unemployment rate at its current

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 level of about 4.2 percent (early 2000). What level of income will
guarantee the target amount of consumption expenditure?

Which, gives X = 7197, approximately. That is, incomes level of about

7197 (billion) dollars, given an MPC of about 0.70, will produce an expenditure of
about 4900 billion dollars. As these calculations suggest, an estimated model may be
used for control, or policy, purposes. By appropriate fiscal and monetary policy mix,
the government can manipulate the control variable X to produce the desired
level of the target variable Y.
1.6. TYPES OF ECONOMETRICS DATA
2. Experimental
3. non-experimental data
4. Qualitative
5. quantitative data
6. Cross section data
7. Time series data
8. Pooled cross- sections
9. A panel data or longitudinal data
Cross sectional data: Cross-section data are data on one or more variables collected at the same
point in time, such as the census of population conducted by the Census Bureau every 10 years
(the latest being in year 1997), the surveys of consumer expenditures conducted by the
University of Jimma.
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).
Pooled data: In pooled, or combined, data are elements of both time series and cross-section
data.

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A Panel or Longitudinal: This is a special type of pooled data in which the same cross-
sectional unit (say, a family or a firm) is surveyed over time. For example, the U.S. Department
of Commerce carries out a census of housing at periodic intervals. At each periodic survey the
same household (or the people living at the same address) is interviewed to find out if there has
been any change in the housing and financial conditions of that household since the last survey.
1.7. ELEMENTS OF ECONOMETRICS
2. Econometric inputs:
 Economic Theory
 Mathematics
 Statistical Theory
 Data
 Computers (CPU power)
 Interpretation
3. Econometric outputs:
 Estimation – Measurement
 Inference - Hypothesis testing
 Forecasting – Prediction
 Evaluation

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