Econometrics I For

Economics
CHAPTER ONE

1. INTRODUCTION
Definition and scope of econometrics
The economic theories we learn in various economics courses suggest many
relationships among economic variables. For instance, in microeconomics we learn
demand and supply models in which the quantities demanded and supplied of a good
depend on its price. In macroeconomics, we study ‘investment function’ to explain the
amount of aggregate investment in the economy as the rate of interest changes; and
‘consumption function’ that relates aggregate consumption to the level of aggregate
disposable income.
Each of such specifications involves a relationship among economic variables. 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 that we
know 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. 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. To
provide a better understanding of economic relationships and a better guidance for
economic policy making we also need to know the quantitative relationships between
the different economic variables. We obtain these quantitative measurements taken
from the real world. The field of knowledge which helps us to carry out such an
evaluation of economic theories in empirical terms is econometrics.

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WHAT IS ECONOMETRICS?
Economics
Literally interpreted, econometrics means “economic measurement”, but the scope of
econometrics is much broader as described by leading econometricians. Various
econometricians used different ways of wordings to define econometrics. But if we
distill the fundamental features/concepts of all the definitions, we may obtain the
following definition.
“Econometrics is the science which integrates economic theory, economic statistics,
and mathematical economics to investigate the empirical support of the general
schematic law established by economic theory. It is a special type of economic analysis
and research in which the general economic theories, formulated in mathematical
terms, is combined with empirical measurements of economic phenomena. Starting
from the relationships of economic theory, we express them in mathematical terms so
that they can be measured. We then use specific methods, called econometric methods
in order to obtain numerical estimates of the coefficients of the economic
relationships.”
Measurement is an important aspect of econometrics. However, the scope of
econometrics is much broader than measurement. As D.Intriligator rightly stated the
“metric” part of the word econometrics signifies ‘measurement’, and hence
econometrics is basically concerned with measuring of economic relationships.

In short, 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 and verifying economic theories.
Econometrics vs. mathematical economics
Mathematical economics states economic theory in terms of mathematical symbols.
There is no essential difference between mathematical economics and economic
theory. Both state the same relationships, but while economic theory use verbal
exposition, mathematical symbols. Both express economic relationships in an exact or
deterministic form. Neither mathematical economics nor economic theory allows for
random elements which might affect the relationship and make it stochastic.
Furthermore, they do not provide numerical values for the coefficients of economic
relationships.

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Economics
Econometrics differs from mathematical economics in that, although econometrics
presupposes, the economic relationships to be expressed in mathematical forms, it does
not assume exact or deterministic relationship. Econometrics assumes random
relationships among economic variables. Econometric methods are designed to take
into account random disturbances which relate deviations from exact behavioral
patterns suggested by economic theory and mathematical economics. Furthermore,
econometric methods provide numerical values of the coefficients of economic
relationships.
Econometrics vs. statistics
Econometrics differs from both mathematical statistics and economic statistics. An
economic statistician gathers empirical data, records them, tabulates them or charts
them, and attempts to describe the pattern in their development over time and perhaps
detect some relationship between various economic magnitudes. Economic statistics is
mainly a descriptive aspect of economics. It does not provide explanations of the
development of the various variables and it does not provide measurements the
coefficients of economic relationships.

Mathematical (or inferential) statistics deals with the method of measurement which
are developed on the basis of controlled experiments. But statistical methods of
measurement are not appropriate for a number of economic relationships because for
most economic relationships controlled or carefully planned experiments cannot be
designed due to the fact that the nature of relationships among economic variables are
stochastic or random. Yet the fundamental ideas of inferential statistics are applicable
in econometrics, but they must be adapted to the problem economic life. Econometric
methods are adjusted so that they may become appropriate for the measurement of
economic relationships which are stochastic. The adjustment consists primarily in
specifying the stochastic (random) elements that are supposed to operate in the real
world and enter into the determination of the observed data.

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Economics
Economic models vs. econometric models
i) Economic models:
Any economic theory is an observation from the real world. For one reason, the
immense complexity of the real world economy makes it impossible for us to
understand all interrelationships at once. Another reason is that all the
interrelationships are not equally important as such for the understanding of the
economic phenomenon under study. The sensible procedure is therefore, to pick up the
important factors and relationships relevant to our problem and to focus our attention
on these alone. Such a deliberately simplified analytical framework is called on
economic model. It is an organized set of relationships that describes the functioning of
an economic entity under a set of simplifying assumptions. All economic reasoning is
ultimately based on models. Economic models consist of the following three basic
structural elements.
1. A set of variables
2. A list of fundamental relationships and
3. A number of strategic coefficients

ii) Econometric models:

The most important characteristic of economic relationships is that they contain a
random element which is ignored by mathematical economic models which postulate
exact relationships between economic variables.
Example: Economic theory postulates that the demand for a commodity depends on its
price, on the prices of other related commodities, on consumers’ income and on tastes.
This is an exact relationship which can be written mathematically as:
Q = b0 + b1 P + b2 P0 + b3Y + b4t

The above demand equation is exact. However, many more factors may affect
demand. In econometrics the influence of these ‘other’ factors is taken into account by
the introduction into the economic relationships of random variable. In our example,
the demand function studied with the tools of econometrics would be of the stochastic
form:
Q = b0 + b1 P + b2 P0 + b3Y + b4t + u

where u stands for the random factors which affect the quantity demanded.
Methodology of econometrics
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Economics
Econometric research is concerned with the measurement of the parameters of
economic relationships and with the predication of the values of economic variables.
The relationships of economic theory which can be measured with econometric
techniques are relationships in which some variables are postulated as causes of the
variation of other variables. Starting with the postulated theoretical relationships
among economic variables, econometric research or inquiry generally proceeds along
the following lines/stages.
1. Specification the model
2. Estimation of the model
3. Evaluation of the estimates
4. Evaluation of The forecasting power of the estimated model
1. Specification of the model
In this step the econometrician has to express the relationships between economic
variables in mathematical form. This step involves the determination of three
important tasks:
i) The dependent and independent (explanatory) variables which will be
included in the model.
ii) The a priori theoretical expectations about the size and sign of the
parameters of the function.
iii) The mathematical form of the model (number of equations, specific
form of the equations, etc.)

Note: The specification of the econometric model will be based on economic theory
and on any available information related to the phenomena under investigation. Thus,
specification of the econometric model presupposes knowledge of economic theory and
familiarity with the particular phenomenon being studied.

Specification of the model is the most important and the most difficult stage of any
econometric research. It is often the weakest point of most econometric applications.
In this stage there exists enormous degree of likelihood of committing errors or
incorrectly specifying the model. Some of the common reasons for incorrect
specification of the econometric models are:
1. The imperfections, looseness of statements in economic theories.

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2. The limitation of our knowledge of the factors which are operative in any
particular case.
3. The formidable obstacles presented by data requirements in the estimation of
large models.
The most common errors of specification are:
a. Omissions of some important variables from the function.
b. The omissions of some equations (for example, in simultaneous equations
model).
c. The mistaken mathematical form of the functions.

2. Estimation of the model

This is purely a technical stage which requires knowledge of the various econometric
methods, their assumptions and the economic implications for the estimates of the
parameters. This stage includes the following activities.
a. Gathering of the data on the variables included in the model.
b. Examination of the identification conditions of the function (especially for
simultaneous equations models).
c. Examination of the aggregations problems involved in the variables of the
function.
d. Examination of the degree of correlation between the explanatory variables (i.e.
examination of the problem of multicollinearity).
e. Choice of appropriate economic techniques for estimation, i.e. to decide a
specific econometric method to be applied in estimation; such as, OLS, MLM,
Logit, and Probit.

3. Evaluation of the estimates

This stage consists of deciding whether the estimates of the parameters are
theoretically meaningful and statistically satisfactory. This stage enables the
econometrician to evaluate the results of calculations and determine the reliability of
the results. 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.

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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 R 2-
test are some of the most commonly used statistical tests.
iii. 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 test (as 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 un-biasedness, consistency
etc. Econometric criteria aim at the detection of the violation or validity of the
assumptions of the various econometric techniques.
4) Evaluation of the forecasting power of the model:
Forecasting is one of the aims of econometric research. However, before using an
estimated model for forecasting by some way or another the predictive power of the
model. It is possible that the model may be economically meaningful and statistically
and econometrically correct for the sample period for which the model has been
estimated; yet it may not be suitable for forecasting due to various factors (reasons).
Therefore, this stage involves the investigation of the stability of the estimates and their
sensitivity to changes in the size of the sample. Consequently, we must establish whether
the estimated function performs adequately outside the sample of data. i.e. we must test
an extra sample performance the model.
Desirable properties of an econometric model
An econometric model is a model whose parameters have been estimated with some
appropriate econometric technique. The ‘goodness’ of an econometric model is judged
customarily according to the following desirable properties.

1. Theoretical plausibility. The model should be compatible with the postulates of

economic theory. It must describe adequately the economic phenomena to which it
relates.
2. Explanatory ability. The model should be able to explain the observations of the
actual world. It must be consistent with the observed behaviour of the economic
variables whose relationship it determines.
3. Accuracy of the estimates of the parameters. The estimates of the coefficients should
be accurate in the sense that they should approximate as best as possible the true

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parameters of the structural model. The estimates should if possible possess the
desirable properties of un-biasedness, consistency and efficiency.
4. Forecasting ability. The model should produce satisfactory predictions of future
values of the dependent (endogenous) variables.
5. Simplicity. The model should represent the economic relationships with maximum
simplicity. The fewer the equations and the simpler their mathematical form, the better
the model is considered, ceteris paribus (that is to say provided that the other desirable
properties are not affected by the simplifications of the model).
Goals of Econometrics
Three main goals of Econometrics are identified:
i) Analysis i.e. testing economic theory
ii) Policy making i.e. Obtaining numerical estimates of the coefficients of
economic relationships for policy simulations.
iii) Forecasting i.e. using the numerical estimates of the coefficients in order to
forecast the future values of economic magnitudes.
1.8. Types of data
Various types of data is used in the estimation of the model.
1. Time series data
Time series data give information about the numerical values of variables from period to
period and are collected over time. For example, the data during the years 1990-2010 for
monthly income constitutes a time series data.
2. Cross section data
The cross section data give information on the variables concerning individual agents (e.g.,
consumers or produces) at a given point of time. For example, a cross section of sample of
consumers is a sample of family budgets showing expenditures on various commodities by
each family, as well as information on family income, family composition and other
demographic, social or financial characteristics
3. Panel data:
The panel data are the data from repeated survey of a single (cross-section) sample in
different periods of time.