Chapter 1

METHODOLOGY OF ECONOMETRICS
 Introduction

 Economic theories suggest many relationships among

economic variables. For instance,
 In microeconomics we learn
• demand and supply models.
 In macroeconomics, we study :
 ‘investment function’
 ‘Consumption function’
 Each of such specifications involves a relationship among
economic variables.
 Introduction cont’ed
 As economists, 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 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.
•However, economic theories that postulate the relationships
between economic variables 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.
 Introduction cont’ed
• 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.
 Having said the background statement in our attempt for
defining ‘ECONOMETRICS’, we may now formally
define what econometrics is.
 WHAT IS ECONOMETRICS?
• The term ‘Econometrics’ is formed from two word of Greek
origin “oikovoia” (economy) and “uetpu” (measures).
 Literally, Econometrics means “economic measurement”.

 but the scope of econometrics is much broader as

described by leading econometricians.

• In short, Econometrics can be considered as the integration

of economics, mathematics and statistics for the purpose of :
 providing numerical values for the parameters of economic
variables and
 verifying economic theories.
• Econometrics may be defined as a social science
in which the tools of Economic theory, Mathematics,
and Statistical inference are applied to the analysis of
economic phenomena” (Goldberger1964).
 TYPES OF ECONOMETRICS:

ECONOMETRICS

THEORITICAL APPLIED

CLASSICAL BAYESIAN CLASSICAL BAYESIAN

Theoretical Econometrics: -
• is concerned with the development of appropriate methods for
measuring economic relationships specified by models.
• One of the methods used extensively in this course is least
squares.
 TE 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.

Applied Econometrics: -
 In applied econometrics we use the tools of theoretical
econometrics to study some special fields of economics and
business, such as the production function, investment function,
demand and supply functions, etc.
 WHY ECONOMTRICS IS A SEPARATE DISCIPLNE?
• Economic theory makes statements or hypotheses that are
mostly qualitative in nature (the law of demand), it does not
provide any numerical measures of the relationships.
 This job is done by the ‘Econometricians’.

• The main concern of mathematical economics is to express

economic theory in mathematical form without regard to
measurability or empirical measure of the theory.
 Econometrics is mainly interested in the empirical
verification of economic theory/model.
• Economic statistics is mainly concerned with collecting,
processing and presenting economic data in the form of charts
and tables.
 It does not go any further. The one who does it is the
econometricians.
 Goals of Econometrics

• Three main goals of Econometrics are identified:

i) Analysis
 i.e. testing economic theory

ii) Forecasting
i.e. using the numerical estimates of the coefficients in
order to forecast the future values of economic
magnitudes.
iii) Policy making
 i.e. Using numerical estimates of the coefficients of
economic relationships for policy simulations.
 METHODOLOGY OF ECONOMETRICS

• Broadly speaking econometrics methodology proceeds

along the following lines:
1. Statement of Economic theory or hypothesis.
2. Specification of the mathematical model of the theory.
3. Specification of the statistical or econometrics models.
4. Collecting the Data.
5. Estimations of the parameters of the econometric model.
6. Hypothesis testing.
7. Forecasting or Predictions.
8. Using the model for control or policy purposes.
[Link] of Economic Theory or Hypothesis:

• Statement of a theory is a definite or clear expression of

the theory.
• For exp.-Keynes postulated that :
 on average, consumers increase their consumption as their
income increases, but not as much as the increase in their
income.
 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:

• The second step is to express the relationship in mathematical

form, that is to specify the model , with which economic
phenomena will be explored empirically.
Y=β1 +β2X (0 <β <1)

Y= consumption expenditure (dependent variable)

X= income (independent or explanatory variable)
β1= the intercept coefficient

β2= the slope coefficient

• This equation, which states that consumption is linearly

related to income , is an example of mathematical model of
the relationship b/w consumption and income, that is called the
consumption function.
• The slope coefficient β2 measures the MPC.
Geometrically:
 3. Specification of the Econometrics model:
• The relationships between economic variables are
generally inexact.
 Here in addition to income, other variables affect
consumption expenditure.
 For example - size of family, Age structure, Religion,
Income distribution, traditions, psychological and
sociological factors etc, are likely to exert some influence
on consumption.
• To allow for the inexact relationships between economic
variable, the consumption function is modified as follows:
Y=β1+β2X+u
 Cont...
• Where u, known as the disturbance, or error term is a
random variable that has well defined probabilistic
properties.
This disturbance term u may well represent all those
factors that affect consumption but are not taken into
account
• The econometrics consumption hypothesizes that the
dependent variable is linearly related to the explanatory
variable but that relationship between the two is not
exact; it is subject to individual variations.
The economic model of the consumption function can be
depicted as shown in the following figure.
 4. Obtaining Data
 To estimate the econometric model or to obtain the
numerical values of β1 and β2 the data used may be of
various types:
A. Time series: Time series data give information about the
numerical values of variables from period to period.
B. Cross-section data: These data give information on the
variables concerning individual agents(consumers and
producers) at a given point of time.
 For exp.- A cross-section sample of various family budgets
not only tells about expenditure pattern but also family
income, family composition, and other demographic, social
or financial characteristics.
Cont..
C. Panel data: These are repeated surveys of a single sample
(cross-section) in different period of times.
 They record the behaviour of the same set of
individual micro economic units over time.
D. Engineering data: These data give information about the
technical requirements of the methods of production
employed for producing a certain commodity.
 These are collected from the producers of the
commodity and are used in the studies of production
(production function, input-output relationships, etc.
E. Data constructed by the econometricians: Dummy variables
 In many cases some factors affecting the dependent variable
cannot be measured in any of the above conventional data,
because they are qualitative factors. For exp.- profession ,
religion, sex are the factors affecting consumption of particular
items like bread, meat, cosmetics etc.
 Such variables can be approximated by the introduction of
function of ‘Dummy Variable’. For exp:- if we study the
demand for bread with cross section data, the factor sex could
be represented by dummy variable, which might be assigned
the value of:
• One when individual is a Male.
• Zero when the consumer is a Female.
 In this case the coefficient of the dummy variable will be
positive if in the real world females consume less bread.
5. Estimation of the parameters of the econometric model:
• After obtaining the data, next step is to estimate the
parameters of the given function (here consumption
function)
• The numerical estimates of the parameters give
empirical content to the consumption function.
• For this we try to estimate the model on the basis of
collected data using appropriate tools and techniques.
• The main tool used to obtain the estimates is the
statistical tool of ‘Regression analysis’ such as, OLS,
MLM, Logit, and Probit.
– Now that we have the data, our next task is to
estimate the parameters of the consumption
function. the statistical technique of regression
analysis is the main tool used to obtain the
estimates. E.g.
Y_hat= −184.08 + 0.7064Xi

– 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.
 6. Hypothesis Testing/Evaluation of the estimates and the model:

• This stage enables the econometrician to evaluate the results

of calculations and determine the reliability of the results.
• The evaluation consist of deciding whether the estimates of
the parameters are theoretically meaningful and
statistically satisfactory.
• 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.
ii. 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.
 Correlation coefficient test, standard error test, t-test, F-test, and
R2-test are some of the most commonly used statistical tests.
iii. Econometric criteria (second-order tests):
 aim at the detection of the violation or validity of the
assumptions of the various econometric techniques.
 They serve as a 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 BLUE.
• 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 are in accord with
the expectations of the theory that is being tested.

• 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. 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).
 HYPOTHESIS TESTING (Evaluation of
the forecasting power of the model)
Cont..
If the model fit well If model does not fit
to the Data. well to the Data

Use the model for Again specify the

economic theory,
prediction or mathematical and
forecasting econometrics model.

Use the predicted or Recollect the fresh data

forecasted value for for calculating variables
policy formation specified in the models.
 7. FORCASTING OR PREDICTION
• Forecasting is one of the aims of econometric research.

• 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 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, we obtain:
Y_ hat1997 = −184.0779 + 0.7064 (7269.8)
= 4951.3167
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 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.
 8. USE OF THE MODEL FOR CONTROL OR POLICY
PURPOSE

• On the basis of the calculations, an estimated

model can/may be used for control or policy
purposes.
• By appropriate fiscal or monetary policy mix, the
government can manipulate the control variable X
to produce the desired level of the target variable
Y.
• Suppose we have the estimated consumption function given above. Suppose further
the government believes that consumer expenditure of about 4900 (billions of 1992
dollars) will keep the unemployment rate at its current level of about 4.2 percent
(early 2000).

• What level of income will guarantee the target amount of consumption expenditure?

• If the regression results given above seem reasonable, simple arithmetic will show
that
4900 = −184.0779 + 0.7064X

• which gives X = 7197, approximately. That is, an income 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.
 Economic Empirical Study

Economic Theory; Past Experience, studies

C = f(Inc) ==>
Formulating a model: Cause - effect Ct = 1 + 2Inct + ut

Gathering data: Statistics monthly, quarterly, yearly data

Estimating the model: Simple OLS method or other advances

H0: 2>0,
Testing the hypothesis: If not true
positive relationship or not

Interpreting the results:

Forecasting Policy implication and decisions