ACT 671: Econometrics-I By

Professor Dr. Mudassir Uddin

M.Sc. (Karachi) M.Phil. (Karachi) M.Sc. (Oxford) PhD (Aberdeen)

Syllabus: Applied 617: Econometrics-I

a)

Basic concept of Econometrics. General Linear Statistical Models. Least Squares Maximum Likelihood Method of estimation. Point and interval estimation. Statistical properties of estimation. Prediction and degree of explanation. Restricted Maximum Likelihood Estimation. Non-linear Regression Model: Nonlinear least squares and non-linear maximum likelihood estimation. Functional Form: Box-Cox transformation. Estimation of Cobb-Douglas and CES production functions. Newton- Raphson Algorithm.

b)

c)

Statistical Model Selection: Model specification. Some variable selection rules; R-square, Cp, AIC, SC and unconditional mean squared error criteria.
Dummy variables and varying parameters models: Use of dummy variables in estimation. Testing for a change in the location vector.

d)

Text Book:
Wooldridge, J.M. (2002). Introductory Econometrics, (2nd Edition) MIT Press

Reference Books:
Damodar N. Gujrati (2003) Basic Econometrics. McGraw-Hill. (.)Greene, W.H. (2003) Econometrics Analysis. (5th Edition), Pearson Education, Inc. Maddala, G.C. (2002) Introduction to Econometrics, (3rd Edition), Wiley

What is Econometrics?
The word Econo means Economic Activity and Metrics means measurements. The statistical and applied field that attempts to test Economic Theory using real world data. Thus Econometrics is the unification of economic theory, mathematical economics and statistical methods. It is the branch of economics that applies statistical methods to the empirical study of economic theories and relationships.

Econometrics concerned with the emperical estimation of economic relationships. Its foundations are based on probability and mathematical statistics and it goes beyond the conventional statistical methods. Thus, econometrics is the application of statistical and mathematical methods in the field of economics to test and quantify economic theories and the solutions to economic problems

Econometrics
Econometrics = economic measurement Used to:

Estimate the magnitude of quantitative relationships among economic variables Test economic hypotheses Forecast future outcomes

Definitions of Econometrics
study of the methods and procedures that can be used to determine numerical values for economic relationships --- Johnson et. al. quantitative analysis of actual economic phenomena based on the concurrent development of theory and observation, related by appropriate methods of inference ---Samuelson, et. al.

aims at a conjunction of economic theory and actual measurements, using the theory and techniques of statistical inference as a bridge pier
blends economic theory, statistics, mathematics, and research philosophy to measure economic relationships ---Johnson et. al. what econometricians do
---Haavelmo

---Goldberger

Econometrics applies mathematical and statistical methods to analyze data related to economic models. For example, a theory may hypothesize that a person with more education will on average earn more income than person with less education holding everything else equal. Econometric estimates can estimate the magnitude and statistical significance of the relation. Econometrics can be used to draw quantitative generalizations. These include testing or refining a theory, describing the relation of past variables, and forecasting future variables. . Hashem, M. Pesaren (1987)

Econometrics as a Process
Mathematics Economic Theory Deterministic Economic Model Statistical Theory Computing Estimates & Inferences Data Statistical Model

Conclusions

Why study Econometrics?

Rare in economics (and many other areas without labs!) to have experimental data Need to use non experimental, or observational, data to make inferences Important to be able to apply economic theory to real world data

Objectives of Econometrics
Structural Analysis Quantitative measurements of economic relationships. Forecasting Prediction of quantitative values of economic variables. Policy Evaluation Selection of suitable policy among various alternates.

Understanding Economic Relationships Stock Index

Govt. budget

money supply short term treasury bills

inflation

trade deficit unemployment

Discount Rate by Govt.

power of labor unions

capital gains tax

crime rate rent control laws

Economic Decisions
To use information effectively:
economic theory economic data

economic decisions

Econometrics helps us to combine economic theory and economic data.

demand, qd, for an individual commodity:

qd = f( p, pc, ps, i )
p = own price; pc = price of complements; ps = price of substitutes; i = income

demand

supply, qs, of an individual commodity:

qs = f( p, pc, pf )

supply

p = own price; pc = price of competitive products; ps = price of substitutes; pf = price of factor inputs

Types of Model

A model is an idealized description of a real life problem or situation

Model
Mathematical Model

Statistical Model

Econometrics Model

Mathematical Model
It is a description of idealized relationship between mathematical variables in a real life situation. The model describes exact relationships, deterministic and reversible. Example: Here, both variables X and Y are free Y= +X from errors Use: In biological sciences, social sciences etc. Limited Scope in economics. Brief historical development

Statistical Model
A statistical model is based on the observation. It is representation of exact relationship between measurable characteristics in a real life situation. The model describes averages relationship. Neither the model is deterministic nor reversible. Also, the relationship is not exact. Example: Y = + X + e E[Y/X] = + X
Response Variables Explanatory Variables

Y: is subject to errors X: is free from errors

Use: Brief historical development

Econometric Model
It is appropriate representation of relationship between measurable economic variables in a real life situation. e.g. Production theory, demand theory, financial theory, etc. The model describes an approximate relationship, indeterminist and not reversible. Example: Yt= +Xt
Demand Function

Price Income

State Yt and Xt will be subject to errors Yt = Endogenous Variables Xt = Exogenous Variables Use: Brief historical description

Economic Model vs. Statistical Model

Adding a random error and functional form converts an economic model into a statistical model, which gives a basis for statistical inference and economic prediction.

Methodology of Econometrics
Three basic steps are properly combined to achieve the above stated objectives. 1. Specification to economic phenomenon (Econometric Model) 2. Observation of economic phenomenon (Economic Data) 3. Application of statistical and econometric methods

Methodology of Econometrics
Econometrics relies heavily on one particular statistical method which is regression analysis. Exposition of regression analysis is the logical beginning of econometrics.

Types of Data Cross Sectional

Cross-sectional data is a random sample
Each observation is a new individual, firm, etc. with information at a point in time

If the data is not a random sample, we have a sample-selection problem

Types of Data Panel or Longitudinal

Can pool random cross sections and treat similar to a normal cross section. Will just need to account for time differences.
Can follow the same random individual observations over time known as panel data or longitudinal data

Types of Data Time Series

Time series data has a separate observation for each time period e.g. stock prices Since not a random sample, different problems to consider
Trends and seasonality will be important

The Question of Causality

Simply establishing a relationship between variables is rarely sufficient Want to the effect to be considered causal If weve truly controlled for enough other variables, then the estimated ceteris paribus effect can often be considered to be causal Can be difficult to establish causality

Example: Returns to Education

A model of human capital investment implies getting more education should lead to higher earnings In the simplest case, this implies an equation like

Earnings 0 1education u

Example: (continued)
The estimate of 1, is the return to education, but can it be considered causal? While the error term, u, includes other factors affecting earnings, want to control for as much as possible Some things are still unobserved, which can be problematic

The Practice of Econometrics

Uncertainty regarding an outcome. Relationships suggested by economic theory. Assumptions and hypotheses to be specified. Sampling process including functional form. Obtaining data for the analysis. Estimation rule with good statistical properties. Fit and test model using software package. Analyze and evaluate implications of the results. Problems suggest approaches for further research.