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Econ 5: Econometrics

UNIT 1
Introduction and Review

Ronie T. Lagat
Instructor
Email: [email protected]
Cell #: 09363236237

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Chapter 1: What is Econometrics?

History

It is in this building in Rotterdam, the Netherlands, at the Pieter de Hooghweg

where it all began. The world’s first academic program on econometrics was
launched in 1956. Initiated by Jan Tinbergen and Henri Theil, the Econometric
Institute was founded and the first students embarked on an econometrics bachelor
program, which bore many similarities with the one today. The library looked different
in those days, by the way.

Definition

Econometrics is the application of statistical and mathematical methods to analyse

economic theory with data by using different techniques of estimation and testing of
hypotheses relating to economic theories.1 It uses statistical methods for the
analysis of economic phenomena. Econometrics is by no means the same as
economic statistics or application of mathematics to economics. The unification of

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economic theory, mathematics and statistics constitutes what is called econometrics.

Economic theories are usually expressed in mathematical forms. Statistical methods
are adopted in explaining the economic phenomenon in stochastic form that
constitutes the econometric methods. Econometrics is used to estimate the values of
the parameters which are essentially the coefficients of mathematical equations
representing economic relationships. The econometric relationships can capture the
random behaviour of economic relationships which are not considered in theories in
economics. Econometrics differs from statistics. Statistical models describe the
methods of measurement which are developed on the basis of controlled
experiments. The econometric methods are generally developed for the analysis of
non-experimental data. Econometrics uses statistical methods to test the validity of
economic theories by introducing randomness in economic relationships. Thus,
econometrics basically attempts to specify the stochastic element in the model on
the basis of the real-world data. Econometrics has emerged as a separate discipline
because the straightforward application of statistical methods usually fails to answer
many economic questions.
Economic problems can rarely be studied in a fully controlled, experimental
environment. Real-world data are needed to infer economic regularities. Economic
research questions based on economic theory suggest the structure of an
appropriate econometric model for estimation with data to make some inference on
the research questions. Econometric analysis is of two types: theoretical
econometrics and applied econometrics. The theoretical econometrics deals with the
development of new methods appropriate for the measurement of economic
relationships. The applied econometrics, on the other hand, is the application of
econometric theory for the analysis
of economic phenomenon and forecasting the economic behaviour. The following is
a good example of how economic theory structures the statistical method to develop
an econometric model for empirical analysis of an economic problem. Human capital
theory states that workers with similar productive characteristics like education and
work experience should get the same wages. We can express this theoretical
proposition in terms of wage equation by taking wage as dependent variable and
workers’ characteristics as a vector of independent variables. By incorporating
statistical regularities, this wage regression equation forms an econometric model
that could be estimated with real-world data to test the validity of the human capital
theory. The estimation of econometric model also provides several economic
implications. One of the popular research areas in labour economics relates to
gender wage discrimination. An economic model based on human capital theory can
give some substance to this conjecture. To see whether there is discrimination, we
can
compare estimated wages of women and men that are similar with respect to these
characteristics. If the null hypothesis of gender discrimination is not rejected, then it
has serious implications for women participation in the labour market. A related issue
is the comparison of wages between groups over time or space. If gender wage
differential has narrowed over time, it seems to indicate that there has been an
improvement in the labour market outcome. Statistics is sceptical about labour
market participation. At the same time, however, it is not true that econometric
methods are designed only for the sake of creating ever more complicated tools. No,
the techniques are helpful in many situations: for example, when it comes to
forecasting economic variables like gross domestic product (GDP) growth, inflation,

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and unemployment or when it comes to policy evaluation where the merits of

educational programs and tax reform programs can be evaluated.

Another important research issue in human capital theory is return to education, the
effect of education on employment and wages. It is important to know the return to
schooling for taking decision on investment in schooling. Return to education is
defined as the wage increase per additional year of schooling. By using this
definition if we want to estimate return to schooling by using statistical method in a
straightforward way, we have to face a real problem. We can measure statistically
the return to education by randomly allocating different education levels to different
individuals and infer the effect on their earnings. But, the problem of measurement is
not straightforward like this when we use real-world data on actual education levels
and earnings. In reality, workers are heterogeneous in terms of their ability. Persons
with high ability earn more than persons with low ability at any given level of
education. If we compare return to education by ignoring the possible effects of
ability, we cannot explain the wage differences because of the inherent differences in
ability between the groups. In econometrics, we combine economic theory and
statistics to formulate and analyse an interesting economic question. Economic
theory, for example, provides different models of stock prices to test for stock market
efficiency. If stock markets are efficient, all available information determines properly
the movement of stock prices.
If stock market is inefficient arbitrage will appear in the market, and by exploiting it an
investor becomes rich. Econometrics is useful in finding out the effect of arbitrage
with the help of economic theory and appropriate statistical tools. Econometrics is
used not only in economics but also in other areas like engineering sciences,
biological sciences, medical sciences, geosciences and agricultural sciences.
Econometric methods are helpful in explaining the stochastic relationship in
mathematical form among variables.

Scope of Econometrics

Quantitative economics is a highly specialized field of study which is taught at the

post-graduation level. The courses related to this field are popular in India but it is
done by some of the best brains of the society. The study of quantitative economics
became all the more important as a result of the utilization of economics as a subject
that can analytically approach the problems and provide efficient solutions. The
subject is also known as econometrics as it deals with the study of complex
mathematical and statistical models which help in detailed study of concepts of
economics.

The growth and development of industries is always dependent on a few factors

such as resource utilization, maximization of revenue and similar factors. The subject
quantitative economics provide economic models required for the analysis of such
factors. The demand for experts in this field are huge across all the sectors some of
them being advisory bodies, multinational corporations, manufacturing units,
business conglomerates and so on.

The global competition has led to unending race where every enterprise wants to
become the market leader. This has led to the enhanced quality and services

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provided by organizations. The role of economic models in such a scenario becomes

all the more important. Econometrics is a highly important subject for research
purpose because it always leads to an efficient solution of an economic problem.

A number of esteemed institutes of the country offer courses on this subject. In a

developing economy like India, the role of econometrists becomes obligatory. The
experts in this field are the ones who bag the best jobs in the market. Not only in
India but the employment scope for the quantitative economics experts are huge
abroad also. http://entrance-exam.net/scope-of-econometrics/

Nature of Econometrics and Economic Data

Econometrics encompasses forecasting–not only the high-profile forecasts of

macroeconomic and financial variables, but also forecasts of demand for a product,
likely effects of a tax package, or the interaction between the demand for health
services and welfare reform. Why is econometrics separate from mathematical
statistics? Because most applications of statistics in economics and finance are
related to the use of non-experimental data, or observational data. The fundamental
techniques of statistics have been developed for use on experimental data: that
gathered from controlled experiments, where the design of the experiment and the
reliability of measurements from its outcomes are primary foci. In relying on
observational data, economists are more like astronomers, able to collect and
analyse increasingly complete measures on the world (or universe) around them, but
unable to influence the outcomes. This distinction is not absolute; some economic
policies are in the nature of experiments, and economists have been heavily involved
in both their design and implementation. A good example within the last five years is
the implementation of 1 The Economist U.S. v Microsoft). welfare reform, limiting
individuals’ tenure on the welfare rolls to five years of lifetime experience. Many
doubted that this would be successful in addressing the needs of those welfare
recipients who have low job skills; but the reforms have been surprisingly successful,
as a recent article in states, at raising the employment rate among this cohort.
Economists are also able to carefully examine the economic consequences of
massive regime changes in an economy, such as the transition from a planned
economy to a capitalist system in the former Soviet bloc. But fundamentally applied
econometricians observe the data, and use sophisticated techniques to evaluate
their meaning. We speak of this work as empirical analysis, or empirical research.
The first step is the careful formulation of the question of interest. This will often
involve the application or development of an economic model, which may be as
simple as noting that normal goods have negative price elasticity, or exceedingly
complex, involving a full-fledged description of many aspects of a set of interrelated
markets and the supply/demand relationships for the products traded (as would, for
instance, an econometric analysis of an antitrust issue, such as Economists are
often attacked for their imperialistic tendencies–applying economic logic to consider
such diverse topics as criminal behaviour, fertility, or environmental issues–but
where there is an economic dimension, the application of economic logic and
empirical research based on econometric practice may yield valuable insights.

The methodology of econometrics is not the study of particular econometric

techniques, but a meta-study of how econometrics contributes to economic science.

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As such it is part of the philosophy of science. The essay begins by reviewing the
salient points of the main approaches to the philosophy of science - particularly,
logical positivism, Popper's falsificationism, Lakatos methodology of scientific
research programs, and the semantic approach - and orients econometrics within
them. The principal methodological issues for econometrics are the application of
probability theory to economics and the mapping between economic theory and
probability models. Both are raised in Haavelmo's (1944) seminal essay. Using that
essay as a touchstone, the various recent approaches to econometrics are surveyed
- those of the Cowles Commission, the vector auto regression program, the LSE
approach, calibration, and a set of common, but heterogeneous approaches
encapsulated as the "textbook econometrics." Finally, the essay considers the light
shed by econometric methodology on the main epistemological and ontological
questions raised in the philosophy of science.

Types of Econometrics

1. Theoretical Econometrics

It is the study of the properties of existing statistical models and procedures for
finding out the unknown values in the model. In this we seek to develop new
statistical procedures that are valid despite the nature of economic data to change
itself simultaneously.

Theoretical econometrics relies heavily on the likes of mathematics, theoretical

statistics, and numerical quantities to prove that the new procedures have the ability
to draw correct inferences.

(Also check: Statistical Data Analysis)

The theoretical econometrics focuses on issues such as the general linear model,
simultaneous equations models, distributed lags and ancillary related topics. Most of
these problems were encountered while working on empirical research.

2. Applied Econometrics

It is the special use of econometric techniques to convert qualitative economic

statements into quantitative ones, unlike the theoretical approach. Because applied
econometricians acquire a closer experience with the data, they often face problems
regarding data attributes that point to errors with existing set of estimation
techniques and also alert their theoretical econometricians about the anomalies.

The applied econometrics deals with topics of production of goods and their
productivity, demand for labour, arbitrage pricing theory, demand for housing related
issues.

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For example, the econometrician might discover that the variance of the data (how
much individual values in a series differ from the overall average) is always rotating
and is never fixed over time.

Main tool of Econometrics

The main tool of econometrics is the linear multiple regression model, which helps in
estimating how a change in one of the explanatory variables affects the working of
the model, from the variable being explained to the changes occurring on the
dependent variable. In modern econometrics, many statistical tools have come to the
limelight, but simple linear regression is still the most routinely used starting point for
an analysis.

This step is necessary because a regression tends to estimate the marginal

impact of a specific explanatory variable after taking into account the variance
caused by the impact of the other explanatory variables to the model.

For example, the model may try to differentiate the effect of a 1 percentage point
increase in taxes on average household consumption expenditure, assuming other
consumption factors, such as pre-tax income, wealth, and interest rates to be static.

Stages of Econometrics

The methodology of econometrics is fairly straightforward.

Suggestion of theory

The first step is to suggest a theory or hypothesis, in order to start examining a

particular piece of data. The explanatory variables in the model are specified before-
hand, and the sign and/or magnitude of the relationship between every single
explanatory variable and the dependent variable are clearly established so as to not
cause any confusion.

At this stage, applied econometricians come into play and they rely heavily on
economic theory to successfully formulate a hypothesis out of the provided data.

(Suggested read: 7 Major Branches of Discrete Mathematics)

For example, a philosophy of international economics is that prices across open

borders go hand in hand after purchasing power parity is allowed. The empirical
relationship between domestic prices and foreign prices (adjusted for nominal
exchange rate scenarios) should always be positive, and they should try to maintain
parity at all times.

Specifying a Statistical model

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The second step is to specify a statistical model that captures the essence of the
theory. The economist tries to propose a unique relationship between the dependent
variable and the explanatory variables through the model.

By far the easiest approach is to assume linearity—meaning that any change in an

explanatory variable will always induce a similar change in the dependent variable. It
is certainly impossible to account for every little influence on the dependent variable;
hence a variable is added to the statistical model to nullify the external disturbances.

The role here of the new variable is to represent all the determinants of the
dependent variable that cannot be accounted for. Mostly caused by the complexity of
the data.

Simply to be consistent and make all conditions hold true for the statistical model,
economists usually assume that this ―error‖ term averages to zero and is
unpredictable.

(Recommended read: Types of statistical analysis)

Estimating variables

The third step is to estimate the unknown variables of the model using economic
data at disposal. It usually involves using an appropriate statistical procedure and an
econometric software package to carry out this process.

This is termed as the easiest part of the analysis thanks to easy availability of
abundant economic data and excellent econometric techniques and software. The
econometrics still relies on the principles of the famous GIGO (garbage in, garbage
out) style of computing.

Proof-reading

This is the fourth step and also the most important out of all. This step involves
asking the right questions to ourselves. For example,

Are the signs and the relationship of the estimated parameters that bridge the
dependent variable to the explanatory variables consistent with the predictions of the
economic theory?
If the estimated parameters do not make sense, how should the statistical model is
edited by an econometrician so as to yield appropriate results?
And does a more accurate estimate guarantee an economically significant model?

This step, in particular, tests the econometrician’s skill and expertise in the field.

Testing the hypothesis

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The main tool of the fourth stage is hypothesis testing, a statistical procedure in
which the researcher remarks regarding the true value of an economic parameter,
and a statistical test is carried out to finds out whether the estimated parameter is
synonymous with the particular hypothesis.

If it is not, the researcher must either reject the hypothesis or make changes in the
statistical model and start all over again.

If all four stages proceed successfully, the result is a model that can be used as a
tool to assess the empirical validity of an economic model.

The empirical model may also be used to predict the dependent variable, potentially
helping policymakers to make critical decisions about changes in monetary and/or
fiscal policy to keep the economy on an even platform.

Students of econometrics are often fascinated by the ability of linear multiple

regression to forecast economic relationships.

Three fundamentals of econometrics are worth remembering;

First, the quality of the parameter findings depends on the current working condition
of the economic model.
Second, if a relevant explanatory variable is excluded from the model, it is most
likely for parameter estimates to become unreliable and inaccurate.
Third, the parameter estimates have a very slim chance of being on similar lines
with the actual parameter values that are generated by the statistical data, even if
the econometrician identifies the process as the source of the original data.

Eventually the estimates are used because they will become precise as more data is
available and estimates are in accordance to the vastness of coverage.

Functions of Econometrics

Econometrics has basically three closely interrelated functions.

The first function of Econometrics is to test out economic theories or hypotheses

lay out by the coveted econometricians. For example, is consumption directly related
to income? Is the quantity demanded of a certain commodity inversely related to its
price?
The second function of Econometrics is to provide numerical estimates for the
variables of economic relationships. These are essential in decision making.
For instance, a government policy maker needs to have an accurate estimate of the
coefficient of the relationship between consumption and income in order to
understand the stimulating effect of a proposed tax reduction and make a sound
decision.
The third function of econometrics is to predict economic events. This, too, is
necessary in order for policy makers to take economically appropriate action if the
rate of unemployment or inflation is predicted to rise in the future.

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Conclusion

It is no secret that economics runs the world and with econometrics, new theories
are proved, new inferences are made and statistical models are rejected or
approved, every day.

Econometrics divides the world into infinite possibilities of forming new theories
which is complemented by the data that is provided to the econometricians.

Policy-makers find this data to be very insightful and depend on these inferences to
form very important policies and decisions.

Activity 1: ESSAY

Read the following questions and answer concisely and precisely.

1. Is Econometrics same as Statistics? Explain briefly.
2. What are the goals of econometrics?
3. Compare and contrast:
3.1. Mathematical Statistics vs. Economic Statistics
3.2. Mathematical Statistics vs. Econometrics
3.3. Economic Statistics vs. Econometrics
4. How different is economics is from econometrics?
5. What is Econometrics?
6. Differentiate theoretical and applied econometrics.
7. There 5 stages of Econometrics. Choose one and in your own words explain
its importance in the methodology of econometrics.

Your answer will be scored through this rubric:

Score Organization Style Content Ideas

The essay The essayThe content The essay is
contains stiff shows theappears clear and
Excellent (10 pts.) topic sentences absence of a sophisticated focused. The
and a controlled planned and contains work holds the
organization. organization. well-developed reader’s
ideas. attention.
The essay The essay The essay The essay is
contains a contains precise content appears mostly focused
Very Good (8 pts.) logical and and varied illustrative and and contains a
appropriate sentence balanced. few useful
organization. structures and details.
The writer uses word choices.
clear topic
sentences.
The essay The essay The essay The writer
contains a follows a limited contains begins the work
logical and but mostly unbalanced by defining the

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appropriate correct sentence content that topic. However,

Average (6 pts.) organization. structure. requires more the development
analysis. of ideas appears
general.

The essay has The essay The essay The author fails
Needs an inconsistent contains several contains a lot of to define the
Improvement (4 organization. awkward and research topic well, or the
pts.) unclear information writer focuses
sentences. without analysis on several
or commentary. issues.

Deadline of submission: March 14, 2022

References:
Das, Panchanan. Econometrics in Theory and Practice. Department of Economics. University of Calcutta.
Kolkata India. Springer Nature Singapore, Pte. Lmd. (2019).

Franses, Philip Hans. Enjoyable Econometrics. Cambridge University Press (2018).

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https://www.analyticssteps.com/blogs/what-econometrics-types-stages-and-functions

https://www.wise-geek.com/what-are-the-different-types-of-econometrics-theory.htm

https://scholar.harvard.edu/files/gracemccormack/files/econometricsnotes.pdf

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