What is Econometrics?

Econometrics is the quantitative application of statistical and mathematical models using data to
develop theories or test existing hypotheses in economics, and for forecasting future trends from
historical data. It subjects real-world data to statistical trials and then compares and contrasts the
results against the theory or theories being tested. Depending on if you are interested in testing
an existing theory or using existing data to develop a new hypothesis based on those
observations, econometrics can be subdivided into two major categories: theoretical and applied.
Those who routinely engage in this practice are commonly known as econometricians.

Econometrics is the use of statistical techniques to understand economic issues and test theories.
Without evidence, economic theories are abstract and might have no bearing on reality (even if
they are completely rigorous). Econometrics is a set of tools we can use to confront theory with
real-world data.

The goal of an applied econometric study might be to test a hypothesis – for example, to
determine how much of the ‘gender pay gap’ can be explained by differences in education and
experience. Alternatively, a study could estimate a key parameter, such as the price elasticity of
demand for oil. Or econometric techniques could be used to generate forecasts, like the Bank of
England uses to determine the level that the base interest rate should be set each month.

Fast Facts

 Econometrics is the quantitative application of statistical and mathematical models using

data to develop theories or test existing hypotheses in economics,
 Econometrics relies on techniques such as regression models and null hypothesis testing.
 Econometrics can also be used to try to forecast future economic or financial trends.

The Basics Of Econometrics

Econometrics analyzes data using statistical methods in order to test or develop economic theory.
These methods rely on statistical inferences to quantify and analyze economic theories by
leveraging tools such as frequency distributions, probability and probability distributions,
statistical inference, correlation analysis, simple and multiple regression analysis, simultaneous
equations models and time series methods.

Econometrics was pioneered by Lawrence Klein, Ragnar Frisch and Simon Kuznets. All three
won the Nobel Prize in economics in 1971 for their contributions. Today, it is used regularly
among academics as well as practitioners such as Wall Street traders and analysts.

An example of the application of econometrics is to study the income effect using observable
data. An economist may hypothesize that as a person increases his income, his spending will also
increase. If the data show that such an association is present, a regression analysis can then be
conducted to understand the strength of the relationship between income and consumption and
whether or not that relationship is statistically significant - that is, it appears to be unlikely that it
is due to chance alone.

The Methodology of Econometrics

The first step to econometric methodology is to obtain and analyze a set of data and define a
specific hypothesis that explains the nature and shape of the set. This data may be, for example,
the historical prices for a stock index, observations collected from a survey of consumer
finances, or unemployment and inflation rates in different countries. If you are interested in the
relationship between the annual price change of the S&P 500 and the unemployment rate, you'd
collect both sets of data. Here, you want to test the idea that higher unemployment leads to lower
stock market prices. Stock market price is therefore your dependent variable and the
unemployment rate is the independent or explanatory variable. The most common relationship is
linear, meaning that any change in the explanatory variable will have a positive correlated with
the dependent variable, in which case a simple regression model is often used to explore this
relationship, which amounts to generating a best fit line between the two sets of data and then
testing to see how far each data point is, on average, from that line.

Note that you can have several explanatory variables in your analysis, for example changes to
GDP and inflation in addition to unemployment in explaining stock market prices. When more
than one explanatory variable is used, it is referred to as multiple linear regression - a model that
is the most commonly used tool in econometrics.

Several different regression models exist that are optimized depending on the nature of the data
being analyzed and the type of question being asked. The most common example is the ordinary
least-squares (OLS) regression, which can be conducted on several types of cross-sectional or
time-series data. If you're interested in a binary (yes-no) outcome - for instance, how likely you
are to be fired from a job (yes, you get fired, or no, you do not) based on your productivity - you
can use a logistic regression or a probit model. Today, there are hundreds of models that an
econometrician has at his disposal.

Econometrics is now conducted using statistical analysis software packages designed for these
purposes, such as STATA, SPSS, or R. These software packages can also easily test for
statistical significance to provide support that the empirical results produced by these models are
not merely the result of chance. R-squared, t-tests, p-values, and null-hypothesis testing are all
methods used by econometricians to evaluate the validity of their model results.

Limitations Of Econometrics
Econometrics is sometimes criticized for relying too heavily on the interpretation of raw data
without linking it to established economic theory or looking for causal mechanisms. It is crucial
that the findings revealed in the data are able to be adequately explained by a theory, even if that
means developing your own theory of the underlying processes.

Regression analysis also does not prove causation, and just because two data sets show an
association, it may be spurious: for example, drowning deaths in swimming pools increase with
GDP. Does a growing economy cause people to drown? Of course not, but perhaps more people
buy pools when the economy is booming. Econometrics is largely concerned with correlation
analysis; and remember, correlation does not equal causation.

The following are the various econometrics models

1. Linear Regression
2. Panel Data Models
3. Probit and Logit Models
4. Bivariate Probit and Logit Models
5. Multinomial Probit and Logit Models
6. Ordered Probit and Logit Models
 7. Limited Dependent Variable Models
8. Count Data Models
9. Survival Analysis
10. Spatial Econometrics
11. Quantile Regression
12. Propensity Score Matching
13. Principal Component Analysis
14. Instrumental Variables
15. Seemingly Unrelated Regressions
16. Time Series ARIMA Models

Linear Regression
Linear regression is the starting point of econometric analysis. The linear regression model has a
dependent variable that is a continuous variable, while the independent variables can take any
form (continuous, discrete, or indicator variables). A simple linear regression model has only
one independent variable, while a multiple linear regression model has two or more independent
variables. The linear regression is typically estimated using OLS (ordinary least squares).
Examples include studying the effect of education on income; or the effect of recession on stock
returns.
Linear regression model: topics covered
Linear regression model
Coefficients and marginal effects

Reasons for including error term in regression model

An error term is a variable in a statistical or mathematical model, which is created when
the model does not fully represent the actual relationship between the independent variables and
the dependent variables. ... The error term is also known as the residual, disturbance, or
remainder term.

An error term is a variable in a statistical or mathematical model, which is created when the
model does not fully represent the actual relationship between the independent variables and the
dependent variables. ... The error term is also known as the residual, disturbance, or
remainder term.

Observational error (or measurement error) is the difference between a measured value of a
quantity and its true value. In statistics, an error is not a "mistake". Variability is an inherent
part of the results of measurements and of the measurement process.

Generally errors are classified into three types: systematic errors, random errorsand blunders.
Gross errors are caused by mistake in using instruments or meters,
calculating measurement and recording data results.Aug 20, 2014

Why do we include a disturbance term in a regression model? Disturbance is another name for
prediction error. Regression models rarely predict most of the variance in the dependent variable.
Consider this example:

Dependent variable = heart rate (HR)

Predictors (X variables) including age, body weight, stress

The error term would tell us about the components of scores that cannot be predicted by
the variables in the equation, that is, other factors not included in the analysis that predict heart
rate such as medication use, anxiety, meditation, smoking, family history and so forth
(potentially this could include dozens of variables).

Prediction error = effects of predictors not included in the regression equation + random
variance (inherent unpredictability) + “free will” (if you believe in that).

For some outcome variables, inherent randomness (unpredictability or indeterminism) is a source

of prediction error.

If the dependent variable is a behavior measure (such as frequency of helping), another possible
“cause” is “free will” (although some scientists would say there is no such thing as free will).
Failure to cooperate and do as expected is a problem in human research and can be a problem
even in animal studies,

What Is an Error Term?

An error term is a residual variable produced by a statistical or mathematical model, which is
created when the model does not fully represent the actual relationship between the independent
variables and the dependent variables. As a result of this incomplete relationship, the error term
is the amount at which the equation may differ during empirical analysis.

The error term is also known as the residual, disturbance, or remainder term and is variously
represented in models by the letters e, ε, or u.

An Example Formula Wherein an Error Term Applies Is

An error term essentially means that the model is not completely accurate and results in differing
results during real-world applications. For example, assume there is a multiple linear
regression function that takes the following form:

Regression Formula. Investopedia

Where:

 Y = dependent variable
 a, ß = constants
 X, ρ = independent variables
 Ɛ = error term

When the actual Y differs from the expected or predicted Y in the model during an empirical
test, then the error term does not equal 0, which means there are other factors that influence Y.

Understanding Error Terms

An error term represents the margin of error within a statistical model; it refers to the sum of the
deviations within the regression line, which provides an explanation for the difference between
the results of the model and actual observed results. The regression line is used as a point of
analysis when attempting to determine the correlation between one independent variable and one
dependent variable.

What Do Error Terms Tell Us?

Within a linear regression model tracking a stock’s price over time, the error term is the
difference between the expected price at a particular time and the price that was actually
observed. In instances where the price is exactly what was anticipated at a particular time, the
price will fall on the trend line and the error term will be zero.

Points that do not fall directly on the trend line exhibit the fact that the dependent variable, in this
case, the price, is influenced by more than just the independent variable, representing the passage
of time. The error term stands for any influence being exerted on the price variable, such as
changes in market sentiment.

The two data points with the greatest distance from the trend line should be an equal distance
from the trend line, representing the largest margin of error.

If a model is heteroskedastic, a common problem in interpreting statistical models correctly, it

refers to a condition in which the variance of the error term in a regression model varies widely.

Key Takeaways

 An error term appears in a statistical model, like a regression model, to indicate the
uncertainty in the model.
 The error term is a residual variable that accounts for a lack of perfect goodness of fit.
 Heteroskedastic refers to a condition in which the variance of the residual term, or error
term, in a regression model varies widely.

Linear Regression, Error Term, and Stock Analysis

Linear regression is a form of analysis that relates to current trends experienced by a particular
security or index by providing a relationship between a dependent and independent variable,
such as the price of a security and the passage of time, resulting in a trend line that can be used as
a predictive model.

A linear regression exhibits less delay than that experienced with a moving average, as the line is
fit to the data points instead of based on the averages within the data. This allows the line to
change more quickly and dramatically than a line based on numerical averaging of the available
data points.

The Difference between Error Terms and Residuals

Although the error term and residual are often used synonymously, there is an important formal
difference. An error term is generally unobservable and a residual is observable and calculable,
making it much easier to quantify and visualize. In effect, while an error term represents the way
observed data differs from the actual population, a residual represents the way observed data
differs from sample population data.
econometrics is the application of statistical methods to economic data in order to
give empirical content to economic relationships.[1]More precisely, it is "the
quantitative analysis of actual economic phenomena based on the concurrent
development of theory and observation, related by appropriate methods of
inference".[2] An introductory economics textbook describes econometrics as
allowing economists "to sift through mountains of data to extract simple
relationships".[3] The first known use of the term "econometrics" (in cognate form)
was by Polish economist Paweł Ciompa in 1910.[4] Jan Tinbergen is considered by
many to be one of the founding fathers of econometrics.[5][6][7] Ragnar Frisch is
credited with coining the term in the sense in which it is used today.[8]
A basic tool for econometrics is the multiple linear
[9]
regression model. Econometric theory uses statistical theory and mathematical
statistics to evaluate and develop econometric methods.[10][11] Econometricians try
to find estimators that have desirable statistical properties
including unbiasedness, efficiency, and consistency. Applied econometrics uses
theoretical econometrics and real-world datafor assessing economic theories,
developing econometric models, analysing economic history, and forecasting.