CHAPTER 1: INTRODUCTION
1.1. Definition and Scopes of Econometrics
What is Econometrics?
Literally interpreted, econometrics means “economic measurement.” So econometrics
deals with the measurement of economic relationships. 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 (e.g., elasticity,
propensities, and marginal values) and verifying economic theories.
The most important characteristics of economic relationships is that they contain a
random element, which, however ignored by economic theory and mathematical
economics which postulate exact relationships between the varies economic magnitudes.
Econometrics has developed methods for dealing with random component of economic
relationships.
So, Econometrics is the application of statistical and mathematical methods to the
analysis of economic data, with the purpose of giving empirical content to economic
theories and then verifying or refuting them. Bridging the gap between theory and policy
analysis requires acquiring the practice of applying the concepts, theories and methods of
Economics to policy analysis.
Why a Separate Discipline?
As the preceding definitions suggest, econometrics is an amalgam of economic theory,
mathematical economics, economic statistics, and mathematical statistics but it is
completely distinct from each one of these branches of science for the following reasons.
Economic theory makes statements that are mostly qualitative in nature, while
econometrics gives empirical content to most economic theory
The main concern of Mathematical economics is to express economic theory in
mathematical form without empirical verification of the theory, while
econometrics is mainly interested in the later
Economic Statistics is mainly concerned with collecting, processing and
presenting economic data. It does not being concerned with using the collected
data to test economic theories
Mathematical statistics provides many of tools for economic studies, but
econometrics supplies the later with many special methods of quantitative
analysis based on economic data
1.2. Goals of econometrics
There are three main goals of econometrics:
(1) Analysis, i.e. testing of econometric theory
(2) Policy making, i.e. supplying numerical estimates of the coefficients of economic
relationships, which may be then used for decision making
(3) Forecasting, i.e. using the numerical estimates of the coefficients in order to
forecast the future values of the economic magnitudes. Of course, these goals are
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not mutually exclusive. Successful econometric applications should include some
combinations of all three aims.
1.3. METHODOLOGY OF ECONOMETRICS
Applied econometric research is concerned with the measurement of the parameters of
economic relationships and with the prediction (by means of these parameters) of the
values of economic variables. In any econometric research one may distinguish four
stages.
Stage A: Specification of the model
The first, and most important, step the econometrician has to take in attempting the study
of any relationship between variables is to express these relationship in mathematical
form, that is to specify the model, with which the economic phenomenon will be explored
empirically. This is called the specification of the model or formulation of the maintained
hypothesis. It involves the determination of:
(1) The dependent and the explanatory variables which will be included in the
model;
(2) A priori theoretical expectation about the sign and size of the parameters of
the function. These a priori definitions will be the theoretical criteria on the basis
of which the results of the estimation of the model will be evaluated;
(3) The mathematical form of the model (number of equations, linear or non-
linear form of these equations, etc).
The specification of the econometric model will be based on econometric theory and on
any available information relating to the phenomenon being studied. Thus the
specification of the model presupposes knowledge of econometric theory as well as
familiarity with the particular phenomenon being studied.
The number of variables to be included in the model depends on the nature of the
phenomenon being studied and the purpose of the research. Usually we introduce
explicitly in the function only the most important (four or five) explanatory variables.
The influence of less important factors is taken into account by the introduction in the
model of a random variable, usually denoted by u. The values of this random variable
cannot be actually observed like the values of the other explanatory variables. We thus
have to guess at the pattern of the values of u by making some plausible assumptions
about their distribution. The statement of the assumptions about the random variable is
part of the specification of the model.
Thus the number of variables to be initially included in the model depends on the nature
of the economic phenomenon being studied, while the number of variables which will
finally be retained in the model depends on whether the parameter estimates related to the
variables pass the economic, statistical and econometric criteria, which we will discuss
later.
In most economic theory does not explicitly state the mathematical form of economic
relationships. It is often helpful to plot the actual data on two-dimensional diagrams,
taking two variables at a time (the dependent and each one of the explanatory variables in
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turn). In most cases the examinations of such scatter diagrams throws some light on the
form of the function and helps in deciding upon the choices of the mathematical form of
the relationship connecting the economic variables.
Stage B: Estimation of the model
After the model has been specified (formulated) the econometrician proceed with its
estimation, in other words, he must obtain numerical estimates of the coefficients of the
model. The estimation of the model is a purely technical stage which requires knowledge
of the various econometric methods, their assumptions and the economic implications of
the parameters.
The stage of estimation includes the following steps
(1) Gathering of statistical observations (data) on the variables included in the model
(2) Examination of the identification conditions of the function in which we are
interested
Identification is the procedure by which we attempt to establish that the coefficients
which we shall estimate by the application of some appropriate econometric technique
are actually the true coefficients of the functions in which we are interested.
(3) Examination of the aggregation problems involved in the variables of the function
Aggregation problems arise from the fact that we use aggregative variables in our
functions. Such aggregative variables may involve: aggregation over individuals,
aggregation over commodities, aggregation over time periods, and spatial aggregation.
The above sources of aggregation create various complications which may impart some
‘aggregation bias’ in the estimates of the coefficients.
(4) Examination of the degree of correlation between the explanatory variables, that
is, examination of the degree of multicollinearity
Most economic variables are correlated, in the sense that they tend to change
simultaneously during the various phases of economic activity. If, however, the degree of
collinearity is high, the results (measurements) obtained from economic applications may
be seriously impaired and their use may be greatly misleading, because in these
conditions it may not be computationally possible to separate the influence of each one
explanatory variable.
(5) Choice of the appropriate econometric technique
The coefficients of economic relationships may be estimated by various methods which
may be classified in two main groups:
(i) Single-equation techniques. These are techniques which are applied to one
equation at a time.
(ii) Simultaneous- equation techniques. These are techniques which are applied to all
the equations of a system at once, and give estimates of the coefficients of all the
functions simultaneously.
Stage C: Evaluation of estimates
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After the estimation of the model, the evaluation of the results of the calculations will
come (that is the determination of the reliability of these results). For this purpose we use
various criteria we use various criteria which may be classified into three groups.
Firstly, economic a priori criteria, which are determined by economic theory.
Secondly, statistical criteria, determined by statistical theory.
Thirdly, econometric criteria, determined by econometric theory.
Economic a priori criteria
These are determined by the principles of economic theory and refer to the sign and the
size of the parameters of economic relationships.
The coefficients of economic models are the ‘constants’ of economic theory: elasticities,
marginal values, multipliers, propensities, etc.
Economic theory defines the signs of these coefficients and their magnitude.
If the estimates of the parameters turn up with signs or size not conforming to economic
theory, they should be rejected, unless there is good reason to believe that in the
particular instance the principle of economic theory does not hold.
Statistical criteria: first-order tests
These are determined by statistical theory and aim at the evaluation of the statistical
reliability of the estimates of the parameters of the model. The most widely used
Statistical criteria are the correlation coefficient and the standard deviation (or standard
error) of the estimates.
It should be noted that the statistical criteria are secondary only to the a priori theoretical
criteria. The estimates of the parameters should be rejected in general if they happen to
have the wrong sign (or size) even though the correlation coefficient is high, or the
standard errors suggest that the estimates are statistically significant. In such cases the
parameters, though statistically satisfactory, are theoretically implausible, that is to say
they make no sense on the basis of the a priori theoretical-economic criteria.
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 tests (as tests of the statistical
tests); in other words they determine the reliability of the statistical criteria.
The evaluation of the results obtained from the estimation of the model, is a very
complex procedure. The econometrician must use all the above criteria, economic,
statistical and econometric, before he can accept or reject the estimates.
D. Evaluation of the forecasting power of the estimated model
The final stage of any econometric research is concerned with the evaluation of the
forecasting validity of the model. Estimates are useful because they help in decision-
making. A model, after the estimation of its parameters, can be used in forecasting the
values of economic variables.
The econometrician must ascertain how good the forecasts are expected to be in other
words he must test the forecasting power of the model. It is conceivably possible that the
model is economically meaningful and statistically and econometrically correct for the
sample period for which the model has been estimated, yet it may very well not be
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suitable for forecasting due, for example, to rapid change in the structural parameters of
the relationship in the real world.
Therefore, the final stage of any applied econometric research is the investigation of the
stability of the estimates, their sensitivity to changes in the size of the sample. One way
of establishing the forecasting power of a model is to use the estimates of the model for a
period not included in the sample.
The estimated value (forecast value) is compared with the actual (realized) magnitude of
the relevant dependent variable. Usually there will be a difference between the actual and
the forecast value of the variable, which is tested with the aim of establishing whether it
is (statistically) significant. If after conducting the relevant test of significance, we find
that the difference between the realized value of the dependent variable and that
estimated from the model is statistically significant, we conclude that the forecasting
power of the model, its extra – sample performance, is poor.
Another way of establishing the stability of the estimates and the performance of the
model outside the sample of data from which it has been estimated, is to re-estimate the
function with an expanded sample, that is a sample including additional observations.
The original estimates will normally differ from the new estimates. The difference is
tested for statistical significance with appropriate methods.
Reasons for a model‟s poor forecasting performance
a) The values of the explanatory variables used in the forecast may not be accurate
b) The estimates of the coefficients 's may be poor, due to deficiencies of the sample
data.
c) The estimates are good‟ for the period of the sample, but the structural background
conditions of the model may have changed from the period that was used as the basis for
the estimation of the model, and therefore, the old estimates are not „good‟ for
forecasting. The whole model needs re-estimation before it can be used for prediction.
How do econometricians proceed in their analysis of an economic problem? That is, what
is their methodology? Broadly speaking, traditional or classical econometric
methodology proceeds along 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
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:
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Keynes stated: “Consumption increases as income increases, but not as much as the
increase in income”. It means that “The marginal propensity to consume (MPC) for a unit
change in income is greater than zero but less than unit”
(2) Specification of the mathematical model of the theory
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:
Y = β1 + β2X; 0 < β2 < 1 ------------------------------------------------- (1.3.1)
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. 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 Eq. (1.3.1) 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, Eq. (1.3.1),
consumption (expenditure) is the dependent variable and income is the explanatory
variable.
(3) Specification of the econometric model of the theory
The purely mathematical model of the consumption function given in Eq. (1.3.1) is of
limited interest to the econometrician, for it assumes that there is an exact or
deterministic relationship between consumption and income. But relationships between
economic variables are generally inexact. For example, in the above example, in addition
to income, other variables affect consumption expenditure. Such as, 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 (1.3.1) as follows:
Y = β1 + β2X + u ---------------------------------------------------------------- (1.3.2)
Where u, known as the disturbance, or error term, is a random (stochastic) variable.
The disturbance term u may well represent all those factors that affect consumption but
are not taken into account explicitly.
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Equation (1.3.2) 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.
(4) Obtaining Data
Types of Data Required For Economic Analysis
The success of any econometric analysis ultimately depends on the availability of the
appropriate data. Three types of data may be available for empirical analysis: time series,
cross-section, and pooled (i.e., combination of time series and crosssection) data.
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).
Cross-Section Data Cross-section data are data on one or more variables collected at the
same point in time.
Pooled Data In pooled, or combined, data are elements of both time series and cross-
section data.
To estimate the econometric model given in (1.3.2), that is, to obtain the numerical values
of β1 and β2, we need data. Have a look at the data given in the table below!
Table 1.1
Year X Y
1980 2447.1 3776.3
1981 2476.9 3843.1
1982 2503.7 3760.3
1983 2619.4 3906.6
1984 2746.1 4148.5
1985 2865.8 4279.8
1986 2969.1 4404.5
1987 3052.2 4539.9
1988 3162.4 4718.6
1989 3223.3 4838.0
1990 3260.4 4877.5
1991 3240.8 4821.0
Y= Personal consumption expenditure and
X= Gross Domestic Product both in Billion US Dollars
(5) Estimating the Econometric Model
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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 1.1, we obtain the
following estimates of β1 and β2, namely, - 231.8 and 0.7194. Thus, the estimated
consumption function is:
Y = - 231.8 + 0.7194Xi -------------------------------------------------------------------- (1.3.3)
The hat on the Y indicates that it is an estimate. MPC was about 0.72 and it means that for
the sample period when real income increases by 1 USD, led (on average) real
consumption expenditure increases of about 72%.
Note: A hat symbol (^) above one variable will signify an estimator of the relevant
population value
(6) Hypothesis Testing
Are the estimates accords with the expectations of the theory that is being tested?
Is MPC < 1 statistically? If so, it may support Keynes’ theory. Confirmation or refutation
of economic theories based on sample evidence is object of Statistical Inference
(hypothesis testing).
(7) Forecasting or Prediction
With given future value(s) of X, what is the future value(s) of Y?
If GDP=$6000Bill in 1994, what is the forecasted consumption expenditure?
Y^= - 231.8+0.7196(6000) = 4084.6Bill
(8) Using model for control or policy purposes
Suppose we have the estimated consumption function given in (1.3.3). Suppose further
the government believes that consumer expenditure of about 4000 will keep the
unemployment rate at its current level of about 4.2 percent. What level of income will
guarantee the target amount of consumption expenditure?
Y=4000= -231.8+0.7194 X Þ X ~ 5882
Give MPC = 0.72, an income of $5882 Bill will produce an expenditure of $4000 Bill.
By fiscal and monetary policy, Government can manipulate the control variable X to get
the desired level of target variable Y.
1.4. Types or Elements 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.
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, one of the methods
used extensively in econometrics is 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.
Econometric methods may be classified in to two groups: (1) single-equation techniques,
which are methods that are applied to one relationship at a time; and simultaneous-
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equation techniques, which are methods applied to all the relationships of a model
simultaneously.
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, etc.