Econometric Analysis for Business

Management
Topic I
Introduction to
Econometrics

.
0
 Applied Econometrics 4th edition

What is Econometrics?

Econometrics means measurement (metrics in greek) in

economics.
Literal meaning is “measurement in economics”.
▪ Econometrics = use of statistical methods to analyze economic data

▪ Econometricians typically analyze nonexperimental data

The importance of applied work in economics is increasing

constantly.

.
1
 What is Econometrics?
▪ Everything you learned about micro and macro still applies here!

▪ The importance of applied work in economics is increasing

constantly.

.
2
 Microeconomic theory states that, other things remaining the same, a
reduction in the price of a commodity is expected to increase the
quantity demanded of that commodity.

Thus, economic theory postulates a negative or inverse relationship

between the price and quantity demanded of a commodity.

.
3
 Goals of Econometric Analysis
▪ Typical goals of econometric analysis:
▶ Estimating relationships between economic variables.

▶ Testing economic theories and hypotheses.

▶ Forecasting economic variables

▶ Evaluating and implementing business and govt. policy.

.
4
 Examples of problems
▶ Modelling long-term relationships among prices and interest rates.

▶ Examining the effect of inflation in unemployment rates.

▶ Examining the effect of disposable income on consumption.

▶ Determining the factors that affect GDP per capita growth.

▶ Forecasting the correlation among the returns and the stock indices of two
countries

.
5
 Applied Econometrics 4th edition

Examples of problems
▪ Determining the factors that affect GDP per capita growth

▪ Testing the validity of the CAPM and APT theories

▪ Forecasting the correlation between the returns and the stock indices of two
countries.

▪ Testing whether financial markets are weak-form informationally efficient.

▪ Measuring and forecasting the volatility of bond returns.

▪ Forecasting the correlation between the returns to the stock indices of two
countries.

.
6
 Applied Econometrics 4th edition
Examples of problems

▪ Explaining the determinants of bond credit ratings used by the ratings agencies.

▪ Modelling long-term relationships between prices and exchange rates

▪ Determining the optimal hedge ratio for a spot position in oil.

▪ Testing technical trading rules to determine which makes the most money.

▪ Testing the hypothesis that earnings or dividend announcements have no effect on stock prices.

▪ Testing whether spot or futures markets react more rapidly to news.

.
7
 Steps in Econometric Analysis

.
8
 Statement of theory or hypothesis

.
9
 Specification of the mathematical model of the theory

.
10
.
11
 if we were to obtain data on consumption
expenditure and disposable (i.e., aftertax) income of a
sample of, say, 500 American families and plot these
data on a graph paper with consumption expenditure
on the vertical axis and disposable income on the
horizontal axis

.
12
.
13
 we would not expect all 500 observations to lie exactly on the straight line

because, in addition to income, other variables affect consumption expenditure.

For example, size of family, ages of the members in the family, family religion, etc., are
likely to exert some influence on consumption.

.
14
 Specification of the statistical, or econometric, model

.
15
 Obtaining Data

.
16
 Estimation of the Econometric Model

.
17
 Hypothesis Testing

• Keynes expected the MPC to be positive but less than 1.

• In our example we found the MPC to be about 0.70.

• 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).

.
18
 Forecasting or Prediction

.
19
 suppose we want to predict the mean consumption
expenditure
for 1997.

The GDP value for 1997 was 7269.8 billion dollars

.
20
 Use of the Model for Control or Policy Purposes

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?

.
21
 ▪ Economic models
▪ A model is a simplified representation of a real-world process.
It should be representative in the sense that it should contain
the salient features of the phenomena under study.

▪ In general, one of the objectives in modeling is to have a

simple model to explain a complex phenomenon. Such an
objective may sometimes lead to oversimplified model and
sometimes the assumptions made are unrealistic.

.
22
 ▪ In practice, generally all the variables which the experimenter thinks are relevant to explain the

phenomenon are included in the model. Rest of the variables are dumped in a basket called

“disturbances” where the disturbances are random variables. This is the main difference between

the economic modeling and econometric modeling. An economic model is a set of assumptions

that describes the behavior of an economy, or more general, a phenomenon.

▪ This is also the main difference between the mathematical modeling and statistical modeling.

The mathematical modeling is exact in nature whereas the statistical modeling contains a

stochastic term also.

.
23
 ▪ An econometric model consists of
- a set of equations describing the behavior. These
equations are derived from the economic model and have two
parts – observed variables and disturbances.
- a statement about the errors in the observed values of
variables.
- a specification of the probability distribution of
disturbances.

.
24
 ▪ Economic model of crime (Becker (1968))

▪ Derives equation for criminal activity based on utility maximization

Hours spent in
criminal activities

Age
„Wage“ of cri-
minal activities Probability of Expected
Wage for legal
Other Probability of conviction if sentence
employment
income getting caught caught

▪ Functional form of relationship not specified

▪ Equation could have been postulated without economic modeling

.
25
 Theoretical econometrics

▪ The theoretical econometrics includes the development of appropriate methods

for the measurement of economic relationships which are not meant for controlled
experiments conducted inside the laboratories.

▪ The econometric methods are generally developed for the analysis of

non-experimental data.

.
26
 Applied econometrics

▪ The applied econometrics includes the application of econometric methods to

specific branches of econometric theory and problems like demand, supply,
production, investment, consumption etc.

▪ The applied econometrics involves the application of the tools of econometric

theory for the analysis of economic phenomenon and forecasting the economic
behaviour.

.
27
 Economic Data

.
28
 Economic Data
▪ Econometric analysis requires data.

▪ There are several different kinds of economic data sets:

▪ Cross-sectional data
▪ Time series data
▪ Pooled cross sections
▪ Panel/Longitudinal data
▪ Econometric methods depend on the nature of the data used.
▪ Use of inappropriate methods may lead to misleading results.

.
29
 Cross-Sectional Data
▪ These may include samples of individuals, households, firms, cities,
states, countries, or other units of interest at a given point of time or in a
given period.

▪ Cross-sectional observations are more or less independent.

▪ An example is pure random sampling from a population.

▪ Sometimes pure random sampling is violated, for example, people

refuse to respond in surveys, or sampling may be characterized by
clustering.

▪ Cross-sectional data is typically encountered in applied 30

.
 Cross-Sectional Data

Cross-sectional data set on wages and other characteristics

obsno wage educ exper female married

1 3.10 11 2 1 0
2 3.24 12 22 1 1
3 3.00 11 2 0 0
4 6.00 8 44 0 1
5 5.30 12 7 0 1
. . . . . .
. . . . . .
. . . . . .
525 11.56 16 5 0 1
526 3.50 14 5 1 0

.
31
 Cross-Sectional Data

Cross-sectional data on growth rates and country characteristics

obsno country gpcrgdp govcons60 second60

1 Argentina 0.89 9 32
2 Austria 3.32 16 50
3 Belgium 2.56 13 69
4 Bolivia 1.24 18 12
. . . . .
. . . . .
. . . . .
61 Zimbabwe 2.30 17 6

.
32
 Cross Sectional Data
▪ Examples of Problems that Could be Tackled Using a
Cross-Sectional Regression
- The relationship between company size and the return to
investing in its shares
- The relationship between a country’s GDP level and the
probability that the government will default on its sovereign debt.

.
33
34

Time series data

▪ This includes observations of a variable or several variables over time.

▪ E.g., stock prices, money supply, consumer price index, GDP,

automobile sales, and so on.

▪ Time series observations are typically serially correlated.

▪ Ordering of observations conveys important information.

▪ Data frequency - daily, weekly, monthly, quarterly, annually, and so on.

▪ Typical features of time series include trends and seasonality.

▪ Typical applications include applied macroeconomics and finance.

.
34
 Time series data

Time series data on min. wage, unemployment, and related data for Puerto
Rico

obsno year avgmin avgcov prunemp prgnp

1 1950 0.20 20.1 15.4 878.7
2 1951 0.21 20.7 16.0 925.0
3 1952 0.23 22.6 14.8 1015.9
. . . . . .
. . . . . .
. . . . . .
37 1986 3.35 58.1 18.9 4281.6
38 1987 3.35 58.2 16.8 4496.7

.
35
 Time series data

▪ Examples of Problems that Could be Tackled Using a Time

Series Regression
- How the value of a country’s stock index has varied with that
country’s macroeconomic fundamentals.
- How the value of a company’s stock price has varied when it
announced the value of its dividend payment.
- The effect on a country’s currency of an increase in its interest
rate

.
36
37

Pooled cross sections

▪ Two or more cross sections are combined in one data set.

▪ Cross sections are drawn independently of each other.
▪ Pooled cross sections are often used to evaluate policy changes.
▪ Example:
▪ Evaluating effect of change in property taxes on house prices.
▪ Random sample of house prices for the year 1993.
▪ A new random sample of house prices for the year 1995.

.
37
 Pooled cross sections

Pooled cross sections on two years of housing prices

obsno year hprice proptax sqrft bdrms bthrms

1 1993 85,500 42 1600 3 2
2 1993 67,300 36 1440 3 2
3 1993 134,000 38 2000 4 2
. . . . . . .
. . . . . . .
. . . . . . .
250 1993 243,600 41 2600 4 3
251 1995 65,000 16 1250 2 1
252 1995 182,400 20 2200 4 2
253 1995 97,500 15 1540 3 2
. . . . . . .
. . . . . . .
. . . . . . .
520 1995 57,200 16 1100 2 1

.
38
39

Panel or Longitudinal Data

▪ The same cross-sectional units are followed over time.

▪ Panel data have a cross-sectional and a time series dimension.
▪ Panel data can be used to account for time-invariant
unobservables.
▪ Panel data can be used to model lagged responses.
▪ Example:
▪ City crime statistics; each city is observed in two years.
▪ Time-invariant unobserved city characteristics may be modeled.
▪ Effect of police on crime rates may exhibit time lag.

.
39
 Economic Data

Two-year panel data set on city crime statistics

obsno city year murders population unem police

1 1 1986 5 350,000 8.7 440
2 1 1990 8 359,200 7.2 471
3 2 1986 2 64,300 5.4 75
4 2 1990 1 65,100 5.5 75
. . . . . . .
. . . . . . .
. . . . . . .
297 149 1986 10 260,700 9.6 286
298 149 1990 6 245,000 9.8 334
299 150 1986 25 543,000 4.3 520
300 150 1990 32 546,200 5.2 493

40
.
40
 Applied Econometrics 4th edition

The Structure of Economic Data - Notation

▪ Time series: Yt, t=1990, 1991, …, 2012
▪ Cross-Sectional: Yi, i=1, 2, 3, …, 40
▪ Panel Data: Yit, i and t defined as above.

▪ It is common to denote each observation by the letter t and the

total number of observations by T for time series data, and to
denote each observation by the letter i and the total number of
observations by N for cross-sectional data.

.
41
 Applied Econometrics 4th edition

Basic Data Handling

▪ Looking at raw data
▪ Graphical Analysis
▪ Summary Statistics
▪ Components of a Time Series
▪ Indices and Base Dates
▪ Data Transformations

.
42
 Applied Econometrics 4th edition

Basic Data Handling - Looking at raw data

▪ Before getting into the statistical and econometric tools, a

preliminary analysis is extremely important
▪ “Get the feel” of your data
▪ Look at the numbers on a spreadsheet. Note number of series/end
and start dates, range of values etc.
▪ Outliers, discontinuities, structural breaks etc.

.
43
 Applied Econometrics 4th edition

Basic Data Handling – Graphical Analysis

▪ Graphs facilitate the inspection process
▪ See the “big picture”
▪ Histograms: give an indication of the distribution of a variable
▪ Scatter plots: give combinations of values from two series for
the purpose of determining their relationship (if any)
▪ Line Graphs: facilitate the comparisons of series
▪ Bar Charts: good for comparisons
▪ Pie Charts: good for percentages/portions

.
44
 Applied Econometrics 4th edition
Basic Data Handling – Histograms

• Histograms: give an indication of the distribution of a variable

.
45
 Applied Econometrics 4th edition
Basic Data Handling – Scatter Plots

• Scatter Plots: give combinations

of values from two series for the
purpose of determining their
relationship (if any)
▪ Eviews command (open the
two series together in a
group and choose
View/Graph/Scatter)

.
46
 Applied Econometrics 4th edition
Basic Data Handling–Line Graphs

Line Graphs: facilitate

the comparisons of series

Command in Eviews:
Plot X Y

.
47
 Applied Econometrics
Basic Data Handling–Bar Charts 4th edition

Bar Charts: facilitate

the comparisons of
series

Command in Eviews:
View/Graph/Bar

.
48
 Applied Econometrics 4th edition
Basic Data Handling–Pie Charts

Pie Charts: Good for

proportions

Command in Eviews:
View/Graph/Pie

.
49
 Applied Econometrics 4th edition
Basic Data Handling – Summary Statistics

• Summary statistics provide a more precise idea of the distribution

of a variable (mean, variance, st. dev. etc)
• For comparisons open the variables in a group.

.
50
 Applied Econometrics 4th edition

Basic Data Handling–Components of a Time Series

An economic or financial time series consists of up to four
components
1. Trend (smooth, long-term/consistent upward or downward
movement)
2. Cycle (rise and fall over periods longer than a year)
3. Seasonal (within year pattern seen in frequency data)
4. Irregular (random component, episodic – unpredictable but
identifiable – and residual – unpredictable and unidentifiable)

.
51
 Applied Econometrics 4th edition
Basic Data Handling–Components of a Time Series
An economic or financial time series consists of up to four components

.
52
 Applied Econometrics 4th edition

Basic Data Handling–Components of a Time Series

Seasonal (within year pattern seen in quarterly, monthly or weekly data)

.
53
 Applied Econometrics 4th edition

Basic Data Handling–Components of a Time Series

Trend (smooth, long-term/consistent upward or downward movement)

.
54
 Applied Econometrics 4th edition

Basic Data Handling–Components of a Time Series

Cycle (rise and fall over periods longer than a year)

.
55
 Applied Econometrics 4th edition

Basic Data Handling–Components of a Time Series

Irregular (random component, episodic – unpredictable but
identifiable – and residual – unpredictable and unidentifiable)

.
56
 Economic Data

▪ Causality and the notion of ceteris paribus

▪ Ceteris paribus: “other relevant factors being equal.”

▪ Most economic questions are ceteris paribus questions.
▪ It is important to define which causal effect one is interested
in.
▪ It is useful to describe how an experiment would have to be
designed to infer the causal effect in question.
.
57
 Basic Data Handling

▪ Looking at raw data – spreadsheet, outliers, discontinuous, structural

breaks

▪ Graphical Analysis – histograms, pie chart, bar charts, line graphs,

scatter plots

▪ Summary Statistics – mean, variance, st. dev. etc

▪ Components of a Time Series – trend, cycle, seasonal, irregular

▪ Indices and Base Dates – splicing indices and change the base date

▪ Data Transformations – growth rates, natural logs, difference (trend), 58

.
 Summary

.
59
 Summary

▶ Introduction to econometrics

▶ Goals of econometric analysis

▶ Steps/stages in econometric analysis

▶ Types of economic data

.
60
 Discussion and Queries

.
61
 Discussion and Queries

.
62