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CHAPTER
1
THE NATURE
AND SCOPE
OF ECONOMETRICS

Research in economics, finance, management, marketing, and related disci-

plines is becoming increasingly quantitative. Beginning students in these fields
are encouraged, if not required, to take a course or two in econometricsa field
of study that has become quite popular. This chapter gives the beginner an
overview of what econometrics is all about.

1.1 WHAT IS ECONOMETRICS?

Simply stated, econometrics means economic measurement. Although quan-
titative measurement of economic concepts such as the gross domestic prod-
uct (GDP), unemployment, inflation, imports, and exports is very important,
the scope of econometrics is much broader, as can be seen from the following
definitions:
Econometrics may be defined as the social science in which the tools of economic the-
ory, mathematics, and statistical inference are applied to the analysis of economic
phenomena.1

Econometrics, the result of a certain outlook on the role of economics, consists of the
application of mathematical statistics to economic data to lend empirical support to
the models constructed by mathematical economics and to obtain numerical results.2

1
Arthur S. Goldberger, Econometric Theory, Wiley, New York, 1964, p. 1.
2
P. A. Samuelson, T. C. Koopmans, and J. R. N. Stone, Report of the Evaluative Committee for
Econometrica, Econometrica, vol. 22, no. 2, April 1954, pp. 141146.

1
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2 CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS

1.2 WHY STUDY ECONOMETRICS?

As the preceding definitions suggest, econometrics makes use of economic the-
ory, mathematical economics, economic statistics (i.e., economic data), and
mathematical statistics. Yet, it is a subject that deserves to be studied in its own
right for the following reasons.
Economic theory makes statements or hypotheses that are mostly qualitative
in nature. For example, microeconomic theory states that, other things remain-
ing the same (the famous ceteris paribus clause of economics), an increase in the
price of a commodity is expected to decrease the quantity demanded of that
commodity. Thus, economic theory postulates a negative or inverse relation-
ship between the price and quantity demanded of a commoditythis is the
widely known law of downward-sloping demand or simply the law of demand.
But the theory itself does not provide any numerical measure of the strength of
the relationship between the two; that is, it does not tell by how much the quan-
tity demanded will go up or down as a result of a certain change in the price of
the commodity. It is the econometricians job to provide such numerical esti-
mates. Econometrics gives empirical (i.e., based on observation or experiment)
content to most economic theory. If we find in a study or experiment that when
the price of a unit increases by a dollar the quantity demanded goes down by,
say, 100 units, we have not only confirmed the law of demand, but in the
process we have also provided a numerical estimate of the relationship between
the two variablesprice and quantity.
The main concern of mathematical economics is to express economic theory
in mathematical form or equations (or models) without regard to measurability
or empirical verification of the theory. Econometrics, as noted earlier, is primar-
ily interested in the empirical verification of economic theory. As we will show
shortly, the econometrician often uses mathematical models proposed by the
mathematical economist but puts these models in forms that lend themselves to
empirical testing.
Economic statistics is mainly concerned with collecting, processing, and pre-
senting economic data in the form of charts, diagrams, and tables. This is the
economic statisticians job. He or she collects data on the GDP, employment, un-
employment, prices, etc. These data constitute the raw data for econometric
work. But the economic statistician does not go any further because he or she is
not primarily concerned with using the collected data to test economic theories.
Although mathematical statistics provides many of the tools employed in the
trade, the econometrician often needs special methods because of the unique
nature of most economic data, namely, that the data are not usually generated
as the result of a controlled experiment. The econometrician, like the meteorol-
ogist, generally depends on data that cannot be controlled directly. Thus, data
on consumption, income, investments, savings, prices, etc., which are collected
by public and private agencies, are nonexperimental in nature. The econometri-
cian takes these data as given. This creates special problems not normally dealt
with in mathematical statistics. Moreover, such data are likely to contain errors
of measurement, of either omission or commission, and the econometrician
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CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS 3

may be called upon to develop special methods of analysis to deal with such
errors of measurement.
For students majoring in economics and business there is a pragmatic reason
for studying econometrics. After graduation, in their employment, they may be
called upon to forecast sales, interest rates, and money supply or to estimate de-
mand and supply functions or price elasticities for products. Quite often, econo-
mists appear as expert witnesses before federal and state regulatory agencies on
behalf of their clients or the public at large. Thus, an economist appearing before
a state regulatory commission that controls prices of gas and electricity may be re-
quired to assess the impact of a proposed price increase on the quantity de-
manded of electricity before the commission will approve the price increase. In
situations like this the economist may need to develop a demand function for
electricity for this purpose. Such a demand function may enable the economist to
estimate the price elasticity of demand, that is, the percentage change in the quan-
tity demanded for a percentage change in the price. Knowledge of econometrics
is very helpful in estimating such demand functions.
It is fair to say that econometrics has become an integral part of training in
economics and business.

1.3 THE METHODOLOGY OF ECONOMETRICS

How does one actually do an econometric study? Broadly speaking, economet-
ric analysis proceeds along the following lines.
1. Creating a statement of theory or hypothesis.
2. Collecting data.
3. Specifying the mathematical model of theory.
4. Specifying the statistical, or econometric, model of theory.
5. Estimating the parameters of the chosen econometric model.
6. Checking for model adequacy: Model specification testing.
7. Testing the hypothesis derived from the model.
8. Using the model for prediction or forecasting.
To illustrate the methodology, consider this question: Do economic condi-
tions affect peoples decisions to enter the labor force, that is, their willingness
to work? As a measure of economic conditions, suppose we use the unemploy-
ment rate (UNR), and as a measure of labor force participation we use the labor
force participation rate (LFPR). Data on UNR and LFPR are regularly published
by the government. So to answer the question we proceed as follows.

Creating a Statement of Theory or Hypothesis

The starting point is to find out what economic theory has to say on the subject
you want to study. In labor economics, there are two rival hypotheses about the
effect of economic conditions on peoples willingness to work. The discouraged-
worker hypothesis (effect) states that when economic conditions worsen, as
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4 CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS

reflected in a higher unemployment rate, many unemployed workers give up

hope of finding a job and drop out of the labor force. On the other hand, the
added-worker hypothesis (effect) maintains that when economic conditions
worsen, many secondary workers who are not currently in the labor market
(e.g., mothers with children) may decide to join the labor force if the main
breadwinner in the family loses his or her job. Even if the jobs these secondary
workers get are low paying, the earnings will make up some of the loss in in-
come suffered by the primary breadwinner.
Whether, on balance, the labor force participation rate will increase or decrease
will depend on the relative strengths of the added-worker and discouraged-
worker effects. If the added-worker effect dominates, LFPR will increase even
when the unemployment rate is high. Contrarily, if the discouraged-worker effect
dominates, LFPR will decrease. How do we find this out? This now becomes our
empirical question.

Collecting Data
For empirical purposes, therefore, we need quantitative information on the two
variables. There are three types of data that are generally available for empirical
analysis.
1. Time series.
2. Cross-sectional.
3. Pooled (a combination of time series and cross-sectional).
Times series data are collected over a period of time, such as the data on
GDP, employment, unemployment, money supply, or government deficits.
Such data may be collected at regular intervalsdaily (e.g., stock prices),
weekly (e.g., money supply), monthly (e.g., the unemployment rate), quarterly
(e.g., GDP), or annually (e.g., government budget). These data may be quanti-
tative in nature (e.g., prices, income, money supply) or qualitative (e.g., male or
female, employed or unemployed, married or unmarried, white or black). As
we will show, qualitative variables, also called dummy or categorical variables,
can be every bit as important as quantitative variables.
Cross-sectional data are data on one or more variables collected at one point
in time, such as the census of population conducted by the U.S. Census Bureau
every 10 years (the most recent was on April 1, 2000); the surveys of consumer
expenditures conducted by the University of Michigan; and the opinion polls
such as those conducted by Gallup, Harris, and other polling organizations.
In pooled data we have elements of both time series and cross-sectional data.
For example, if we collect data on the unemployment rate for 10 countries for a
period of 20 years, the data will constitute an example of pooled datadata on
the unemployment rate for each country for the 20-year period will form time se-
ries data, whereas data on the unemployment rate for the 10 countries for any
single year will be cross-sectional data. In pooled data we will have 200
observations20 annual observations for each of the 10 countries.
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CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS 5

There is a special type of pooled data, panel data, also called longitudinal or
micropanel data, in which the same cross-sectional unit, say, a family or firm, is
surveyed over time. For example, the U.S. Department of Commerce conducts
a census of housing at periodic intervals. At each periodic survey the same
household (or the people living at the same address) is interviewed to find out
if there has been any change in the housing and financial conditions of that
household since the last survey. The panel data that result from repeatedly in-
terviewing the same household at periodic intervals provide very useful infor-
mation on the dynamics of household behavior.

Sources of Data A word is in order regarding data sources. The success

of any econometric study hinges on the quality, as well as the quantity, of
data. Fortunately, the Internet has opened up a veritable wealth of data. In
Appendix 1A we give addresses of several Web sites that have all kinds of mi-
croeconomic and macroeconomic data. Students should be familiar with such
sources of data, as well as how to access or download them. Of course, these
data are continually updated so the reader may find the latest available data.
For our analysis, we obtained the time series data shown in Table 1-1. This
table gives data on the civilian labor force participation rate (CLFPR) and the
civilian unemployment rate (CUNR), defined as the number of civilians unem-
ployed as a percentage of the civilian labor force, for the United States for the
period 19802007.3
Unlike physical sciences, most data collected in economics (e.g., GDP, money
supply, Dow Jones index, car sales) are nonexperimental in that the data-
collecting agency (e.g., government) may not have any direct control over the
data. Thus, the data on labor force participation and unemployment are based on
the information provided to the government by participants in the labor market.
In a sense, the government is a passive collector of these data and may not be
aware of the added- or discouraged-worker hypotheses, or any other hypothesis,
for that matter. Therefore, the collected data may be the result of several factors
affecting the labor force participation decision made by the individual person.
That is, the same data may be compatible with more than one theory.

Specifying the Mathematical Model of Labor Force Participation

To see how CLFPR behaves in relation to CUNR, the first thing we should do is
plot the data for these variables in a scatter diagram, or scattergram, as shown
in Figure 1-1.
The scattergram shows that CLFPR and CUNR are inversely related, perhaps
suggesting that, on balance, the discouraged-worker effect is stronger than the
added-worker effect.4 As a first approximation, we can draw a straight line

3
We consider here only the aggregate CLFPR and CUNR, but data are available by age, sex, and
ethnic composition.
4
On this, see Shelly Lundberg, The Added Worker Effect, Journal of Labor Economics, vol. 3,
January 1985, pp. 1137.
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6 CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS

TABLE 1-1 U.S. CIVILIAN LABOR FORCE PARTICIPATION RATE

(CLFPR), CIVILIAN UNEMPLOYMENT RATE (CUNR),
AND REAL AVERAGE HOURLY EARNINGS (AHE82)*
FOR THE YEARS 19802007

Year CLFPR (%) CUNR (%) AHE82 ($)

1980 63.8 7.1 8.00

1981 63.9 7.6 7.89
1982 64.0 9.7 7.87
1983 64.0 9.6 7.96
1984 64.4 7.5 7.96
1985 64.8 7.2 7.92
1986 65.3 7.0 7.97
1987 65.6 6.2 7.87
1988 65.9 5.5 7.82
1989 66.5 5.3 7.75
1990 66.5 5.6 7.66
1991 66.2 6.8 7.59
1992 66.4 7.5 7.55
1993 66.3 6.9 7.54
1994 66.6 6.1 7.54
1995 66.6 5.6 7.54
1996 66.8 5.4 7.57
1997 67.1 4.9 7.69
1998 67.1 4.5 7.89
1999 67.1 4.2 8.01
2000 67.1 4.0 8.04
2001 66.8 4.7 8.12
2002 66.6 5.8 8.25
2003 66.2 6.0 8.28
2004 66.0 5.5 8.24
2005 66.0 5.1 8.18
2006 66.2 4.6 8.24
2007 66.0 4.6 8.32

*AHE82 represents average hourly earnings in 1982 dollars.

Source: Economic Report of the President, 2008, CLFPR from
Table B-40, CUNR from Table B-43, and AHE82 from Table B-47.

through the scatter points and write the relationship between CLFPR and
CUNR by the following simple mathematical model:
CLFPR = B1 + B2 CUNR (1.1)
Equation (1.1) states that CLFPR is linearly related to CUNR. B1 and B2 are known
as the parameters of the linear function.5 B1 is also known as the intercept; it

5
Broadly speaking, a parameter is an unknown quantity that may vary over a certain set of val-
ues. In statistics a probability distribution function (PDF) of a random variable is often character-
ized by its parameters, such as its mean and variance. This topic is discussed in greater detail in
Appendixes A and B.
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CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS 7

Fitted Line Plot

67.5

67.0

66.5

CLFPR (%)
66.0

65.5

65.0

64.5

64.0

63.5
3.5 4.5 5.5 6.5 7.5 8.5 9.5 10.5
CUNR (%)
FIGURE 1-1 Regression plot for civilian labor force participation
rate (%) and civilian unemployment rate (%)

gives the value of CLFPR when CUNR is zero.6 B2 is known as the slope. The
slope measures the rate of change in CLFPR for a unit change in CUNR, or more gen-
erally, the rate of change in the value of the variable on the left-hand side of the
equation for a unit change in the value of the variable on the right-hand side.
The slope coefficient B2 can be positive (if the added-worker effect dominates
the discouraged-worker effect) or negative (if the discouraged-worker effect
dominates the added-worker effect). Figure 1-1 suggests that in the present case
it is negative.

Specifying the Statistical, or Econometric,

Model of Labor Force Participation
The purely mathematical model of the relationship between CLFPR and CUNR
given in Eq. (1.1), although of prime interest to the mathematical economist, is
of limited appeal to the econometrician, for such a model assumes an exact, or
deterministic, relationship between the two variables; that is, for a given CUNR,
there is a unique value of CLFPR. In reality, one rarely finds such neat relation-
ships between economic variables. Most often, the relationships are inexact, or
statistical, in nature.
This is seen clearly from the scattergram given in Figure 1-1. Although the two
variables are inversely related, the relationship between them is not perfectly or
exactly linear, for if we draw a straight line through the 28 data points, not all the
data points will lie exactly on that straight line. Recall that to draw a straight line
we need only two points.7 Why dont the 28 data points lie exactly on the straight

6
In Chapter 2 we give a more precise interpretation of the intercept in the context of regression
analysis.
7
We even tried to fit a parabola to the scatter points given in Fig. 1-1, but the results were not
materially different from the linear specification.
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8 CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS

line specified by the mathematical model, Eq. (1.1)? Remember that our data on
labor force and unemployment are nonexperimentally collected. Therefore, as
noted earlier, besides the added- and discouraged-worker hypotheses, there
may be other forces affecting labor force participation decisions. As a result, the
observed relationship between CLFPR and CUNR is likely to be imprecise.
Let us allow for the influence of all other variables affecting CLFPR in a
catchall variable u and write Eq. (1.2) as follows:

CLFPR = B1 + B2CUNR + u (1.2)

where u represents the random error term, or simply the error term.8 We let u
represent all those forces (besides CUNR) that affect CLFPR but are not explic-
itly introduced in the model, as well as purely random forces. As we will see in
Part II, the error term distinguishes econometrics from purely mathematical
economics.
Equation (1.2) is an example of a statistical, or empirical or econometric, model.
More precisely, it is an example of what is known as a linear regression model,
which is a prime subject of this book. In such a model, the variable appearing on
the left-hand side of the equation is called the dependent variable, and the vari-
able on the right-hand side is called the independent, or explanatory, variable.
In linear regression analysis our primary objective is to explain the behavior of
one variable (the dependent variable) in relation to the behavior of one or more
other variables (the explanatory variables), allowing for the fact that the rela-
tionship between them is inexact.
Notice that the econometric model, Eq. (1.2), is derived from the mathemati-
cal model, Eq. (1.1), which shows that mathematical economics and economet-
rics are mutually complementary disciplines. This is clearly reflected in the
definition of econometrics given at the outset.
Before proceeding further, a warning regarding causation is in order. In the
regression model, Eq. (1.2), we have stated that CLFPR is the dependent vari-
able and CUNR is the independent, or explanatory, variable. Does that mean
that the two variables are causally related; that is, is CUNR the cause and CLFPR
the effect? In other words, does regression imply causation? Not necessarily. As
Kendall and Stuart note, A statistical relationship, however strong and how-
ever suggestive, can never establish causal connection: our ideas of causation
must come from outside statistics, ultimately from some theory or other.9 In
our example, it is up to economic theory (e.g., the discouraged-worker hypoth-
esis) to establish the cause-and-effect relationship, if any, between the depen-
dent and explanatory variables. If causality cannot be established, it is better to
call the relationship, Eq. (1.2), a predictive relationship: Given CUNR, can we pre-
dict CLFPR?

8
Instatistical lingo, the random error term is known as the stochastic error term.
9
M. G. Kendall and A. Stuart, The Advanced Theory of Statistics, Charles Griffin Publishers, New
York, 1961, vol. 2, Chap. 26, p. 279.
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CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS 9

Estimating the Parameters of the Chosen Econometric Model

Given the data on CLFPR and CUNR, such as that in Table 1-1, how do we esti-
mate the parameters of the model, Eq. (1.2), namely, B1 and B2? That is, how do
we find the numerical values (i.e., estimates) of these parameters? This will be
the focus of our attention in Part II, where we develop the appropriate methods
of computation, especially the method of ordinary least squares (OLS). Using OLS
and the data given in Table 1-1, we obtained the following results:

CLFPR = 69.4620 - 0.5814CUNR (1.3)

Note that we have put the symbol on CLFPR (read as CLFPR hat) to remind
us that Eq. (1.3) is an estimate of Eq. (1.2). The estimated regression line is shown
in Figure 1-1, along with the actual data points.
As Eq. (1.3) shows, the estimated value of B1 is L 69.5 and that of B2 is L 0.58,
where the symbol L means approximately. Thus, if the unemployment rate
goes up by one unit (i.e., one percentage point), ceteris paribus, CLFPR is ex-
pected to decrease on the average by about 0.58 percentage points; that is, as eco-
nomic conditions worsen, on average, there is a net decrease in the labor force
participation rate of about 0.58 percentage points, perhaps suggesting that the
discouraged-worker effect dominates. We say on the average because the
presence of the error term u, as noted earlier, is likely to make the relationship
somewhat imprecise. This is vividly seen in Figure 1-1 where the points not on
the estimated regression line are the actual participation rates and the (vertical)
distance between them and the points on the regression line are the estimated
us. As we will see in Chapter 2, the estimated us are called residuals. In short,
the estimated regression line, Eq. (1.3), gives the relationship between average
CLFPR and CUNR; that is, on average how CLFPR responds to a unit change in
CUNR. The value of about 69.5 suggests that the average value of CLFPR will
be about 69.5 percent if the CUNR is zero; that is, about 69.5 percent of the civil-
ian working-age population will participate in the labor force if there is full
employment (i.e., zero unemployment).10

Checking for Model Adequacy: Model Specification Testing

How adequate is our model, Eq. (1.3)? It is true that a person will take into account
labor market conditions as measured by, say, the unemployment rate before
entering the labor market. For example, in 1982 (a recession year) the civilian un-
employment rate was about 9.7 percent. Compared to that, in 2001 it was only
4.7 percent. Aperson is more likely to be discouraged from entering the labor mar-
ket when the unemployment rate is more than 9 percent than when it is 5 percent.
But there are other factors that also enter into labor force participation decisions.
For example, hourly wages, or earnings, prevailing in the labor market also will

10
This is, however, a mechanical interpretation of the intercept. We will see in Chapter 2 how to
interpret the intercept term meaningfully in a given context.
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10 CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS

be an important decision variable. In the short run at least, a higher wage may at-
tract more workers to the labor market, other things remaining the same (ceteris
paribus). To see its importance, in Table 1-1 we have also given data on real average
hourly earnings (AHE82), where real earnings are measured in 1982 dollars. To
take into account the influence of AHE82, we now consider the following model:

CLFPR = B1 + B2CUNR + B3AHE82 + u (1.4)

Equation (1.4) is an example of a multiple linear regression model, in contrast to

Eq. (1.2), which is an example of a simple (two-variable or bivariate) linear regression
model. In the two-variable model there is a single explanatory variable, whereas
in a multiple regression there are several, or multiple, explanatory variables.
Notice that in the multiple regression, Eq. (1.4), we also have included the error
term, u, for no matter how many explanatory variables one introduces in the
model, one cannot fully explain the behavior of the dependent variable. How
many variables one introduces in the multiple regression is a decision that the
researcher will have to make in a given situation. Of course, the underlying eco-
nomic theory will often tell what these variables might be. However, keep in
mind the warning given earlier that regression does not mean causation; the
relevant theory must determine whether one or more explanatory variables are
causally related to the dependent variable.
How do we estimate the parameters of the multiple regression, Eq. (1.4)? We
cover this topic in Chapter 4, after we discuss the two-variable model in
Chapters 2 and 3. We consider the two-variable case first because it is the build-
ing block of the multiple regression model. As we shall see in Chapter 4, the
multiple regression model is in many ways a straightforward extension of the
two-variable model.
For our illustrative example, the empirical counterpart of Eq. (1.4) is as fol-
lows (these results are based on OLS):

CLFPR = 81.2267 - 0.6384CUNR - 1.4449AHE82 (1.5)

These results are interesting because both the slope coefficients are negative.
The negative coefficient of CUNR suggests that, ceteris paribus (i.e., holding the
influence of AHE82 constant), a one-percentage-point increase in the unem-
ployment rate leads, on average, to about a 0.64-percentage-point decrease in
CLFPR, perhaps once again supporting the discouraged-worker hypothesis. On
the other hand, holding the influence of CUNR constant, an increase in real
average hourly earnings of one dollar, on average, leads to about a 1.44 percentage-
point decline in CLFPR.11 Does the negative coefficient for AHE82 make eco-
nomic sense? Would one not expect a positive coefficientthe higher the hourly

11
As we will discuss in Chapter 4, the coefficients of CUNR and AHE82 given in Eq. (1.5) are
known as partial regression coefficients. In that chapter we will discuss the precise meaning of partial
regression coefficients.
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CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS 11

earnings, the higher the attraction of the labor market? However, one could
justify the negative coefficient by recalling the twin concepts of microeconomics,
namely, the income effect and the substitution effect.12
Which model do we choose, Eq. (1.3) or Eq. (1.5)? Since Eq. (1.5) encompasses
Eq. (1.3) and since it adds an additional dimension (earnings) to the analysis, we
may choose Eq. (1.5). After all, Eq. (1.2) was based implicitly on the assumption
that variables other than the unemployment rate were held constant. But where
do we stop? For example, labor force participation may also depend on family
wealth, number of children under age 6 (this is especially critical for married
women thinking of joining the labor market), availability of day-care centers for
young children, religious beliefs, availability of welfare benefits, unemploy-
ment insurance, and so on. Even if data on these variables are available, we may
not want to introduce them all in the model because the purpose of developing
an econometric model is not to capture total reality, but just its salient features.
If we decide to include every conceivable variable in the regression model, the
model will be so unwieldy that it will be of little practical use. The model ulti-
mately chosen should be a reasonably good replica of the underlying reality. In
Chapter 7, we will discuss this question further and find out how one can go
about developing a model.

Testing the Hypothesis Derived from the Model

Having finally settled on a model, we may want to perform hypothesis testing.
That is, we may want to find out whether the estimated model makes economic
sense and whether the results obtained conform with the underlying economic
theory. For example, the discouraged-worker hypothesis postulates a negative
relationship between labor force participation and the unemployment rate. Is this
hypothesis borne out by our results? Our statistical results seem to be in confor-
mity with this hypothesis because the estimated coefficient of CUNR is negative.
However, hypothesis testing can be complicated. In our illustrative example,
suppose someone told us that in a prior study the coefficient of CUNR was
found to be about 1. Are our results in agreement? If we rely on the model,
Eq. (1.3), we might get one answer; but if we rely on Eq. (1.5), we might get another
answer. How do we resolve this question? Although we will develop the neces-
sary tools to answer such questions, we should keep in mind that the answer to a
particular hypothesis may depend on the model we finally choose.
The point worth remembering is that in regression analysis we may be inter-
ested not only in estimating the parameters of the regression model but also in
testing certain hypotheses suggested by economic theory and/or prior empiri-
cal experience.

12
Consult any standard textbook on microeconomics. One intuitive justification of this result is
as follows. Suppose both spouses are in the labor force and the earnings of one spouse rise substan-
tially. This may prompt the other spouse to withdraw from the labor force without substantially
affecting the family income.
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12 CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS

Using the Model for Prediction or Forecasting

Having gone through this multistage procedure, you can legitimately ask the
question: What do we do with the estimated model, such as Eq. (1.5)? Quite nat-
urally, we would like to use it for prediction, or forecasting. For instance, sup-
pose we have 2008 data on the CUNR and AHE82. Assume these values are 6.0
and 10, respectively. If we put these values in Eq. (1.5), we obtain 62.9473 per-
cent as the predicted value of CLFPR for 2008. That is, if the unemployment
rate in 2008 were 6.0 percent and the real hourly earnings were $10, the civilian
labor force participation rate for 2008 would be about 63 percent. Of course,
when data on CLFPR for 2008 actually become available, we can compare the
predicted value with the actual value. The discrepancy between the two will
represent the prediction error. Naturally, we would like to keep the prediction
error as small as possible. Whether this is always possible is a question that we
will answer in Chapters 2 and 3.
Let us now summarize the steps involved in econometric analysis.

Step Example

1. Statement of theory The added-/discouraged-worker hypothesis

2. Collection of data Table 1-1
3. Mathematical model of theory: CLFPR = B1 + B2CUNR
4. Econometric model of theory: CLFPR = B1 + B2CUNR + u
5. Parameter estimation: CLFPR = 69.462 - 0.5814CUNR
6. Model adequacy check: CLFPR = 81.3 - 0.638CUNR - 1.445AHE82
7. Hypothesis test: B2 0 or B2 0
8. Prediction: What is CLFPR, given values of CUNR and AHE82?

Although we examined econometric methodology using an example from

labor economics, we should point out that a similar procedure can be employed
to analyze quantitative relationships between variables in any field of knowl-
edge. As a matter of fact, regression analysis has been used in politics, interna-
tional relations, psychology, sociology, meteorology, and many other disciplines.

1.4 THE ROAD AHEAD

Now that we have provided a glimpse of the nature and scope of econometrics,
let us see what lies ahead. The book is divided into four parts.
Appendixes A, B, C, and D review the basics of probability and statistics for the
benefit of those readers whose knowledge of statistics has become rusty. The
reader should have some previous background in introductory statistics.
Part I introduces the reader to the bread-and-butter tool of econometrics,
namely, the classical linear regression model (CLRM). A thorough understanding
of CLRM is a must in order to follow research in the general areas of economics
and business.
Part II considers the practical aspects of regression analysis and discusses a
variety of problems that the practitioner will have to tackle when one or more
assumptions of the CLRM do not hold.
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Part III discusses two comparatively advanced topicssimultaneous equa-

tion regression models and time series econometrics.
This book keeps the needs of the beginner in mind. The discussion of most top-
ics is straightforward and unencumbered with mathematical proofs, derivations,
etc.13 We firmly believe that the apparently forbidding subject of econometrics
can be taught to beginners in such a way that they can see the value of the subject
without getting bogged down in mathematical and statistical minutiae. The
student should keep in mind that an introductory econometrics course is just like
the introductory statistics course he or she has already taken. As in statistics,
econometrics is primarily about estimation and hypothesis testing. What is dif-
ferent, and generally much more interesting and useful, is that the parameters
being estimated or tested are not just means and variances, but relationships be-
tween variables, which is what much of economics and other social sciences is all
about.
A final word: The availability of comparatively inexpensive computer soft-
ware packages has now made econometrics readily accessible to beginners. In
this book we will largely use four software packages: EViews, Excel, STATA,
and MINITAB. These packages are readily available and widely used. Once stu-
dents get used to using such packages, they will soon realize that learning
econometrics is really great fun, and they will have a better appreciation of the
much maligned dismal science of economics.

KEY TERMS AND CONCEPTS

The key terms and concepts introduced in this chapter are

Econometrics Random error term (error term)

Mathematical economics Linear regression model:
Discouraged-worker hypothesis dependent variable
(effect) independent (or explanatory)
Added-worker hypothesis (effect) variable
Time series data Causation
a) quantitative Parameter estimates
b) qualitative Hypothesis testing
Cross-sectional data Prediction (forecasting)
Pooled data
Panel (or longitudinal or micropanel
data)
Scatter diagram (scattergram)
a) parameters
b) intercept
c) slope

13
Some of the proofs and derivations are presented in our Basic Econometrics, 5th ed., McGraw-
Hill, New York, 2009.
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14 CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS

QUESTIONS
1.1. Suppose a local government decides to increase the tax rate on residential prop-
erties under its jurisdiction. What will be the effect of this on the prices of resi-
dential houses? Follow the eight-step procedure discussed in the text to answer
this question.
1.2. How do you perceive the role of econometrics in decision making in business
and economics?
1.3. Suppose you are an economic adviser to the Chairman of the Federal Reserve
Board (the Fed), and he asks you whether it is advisable to increase the money
supply to bolster the economy. What factors would you take into account in
your advice? How would you use econometrics in your advice?
1.4. To reduce the dependence on foreign oil supplies, the government is thinking
of increasing the federal taxes on gasoline. Suppose the Ford Motor Company
has hired you to assess the impact of the tax increase on the demand for its cars.
How would you go about advising the company?
1.5. Suppose the president of the United States is thinking of imposing tariffs on im-
ported steel to protect the interests of the domestic steel industry. As an economic
adviser to the president, what would be your recommendations? How would you
set up an econometric study to assess the consequences of imposing the tariff?

PROBLEMS
1.6. Table 1-2 gives data on the Consumer Price Index (CPI), S&P 500 stock index,
and three-month Treasury bill rate for the United States for the years 19802007.
a. Plot these data with time on the horizontal axis and the three variables
on the vertical axis. If you prefer, you may use a separate figure for each variable.
b. What relationships do you expect to find between the CPI and the S&P index
and between the CPI and the three-month Treasury bill rate? Why?
c. For each variable, eyeball a regression line from the scattergram.

TABLE 1-2 CONSUMER PRICE INDEX (CPI, 19821984 = 100), STANDARD AND POORS COMPOSITE
INDEX (S&P 500, 19411943 = 100), AND THREE-MONTH TREASURY BILL RATE (3-m T BILL, %)

Year CPI S&P 500 3-m T bill Year CPI S&P 500 3-m T bill

1980 82.4 118.78 12.00 1994 148.2 460.42 4.29

1981 90.9 128.05 14.00 1995 152.4 541.72 5.51
1982 96.5 119.71 11.00 1996 156.9 670.50 5.02
1983 99.6 160.41 8.63 1997 160.5 873.43 5.07
1984 103.9 160.46 9.58 1998 163.0 1,085.50 4.81
1985 107.6 186.84 7.48 1999 166.6 1,327.33 4.66
1986 109.6 236.34 5.98 2000 172.2 1,427.22 5.85
1987 113.6 286.83 5.82 2001 177.1 1,194.18 3.45
1988 118.3 265.79 6.69 2002 179.9 993.94 1.62
1989 124.0 322.84 8.12 2003 184.0 965.23 1.02
1990 130.7 334.59 7.51 2004 188.9 1,130.65 1.38
1991 136.2 376.18 5.42 2005 195.3 1,207.23 3.16
1992 140.3 415.74 3.45 2006 201.6 1,310.46 4.73
1993 144.5 451.41 3.02 2007 207.3 1,477.19 4.41

Source: Economic Report of the President, 2008, Tables B-60, B-95, B-96, and B-74, respectively.
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TABLE 1-3 U.K. POUND / $ EXCHANGE RATE BETWEEN U.K. POUND

AND U.S. DOLLAR AND THE CPI IN THE UNITED STATES
AND THE U.K., 19852007

Period /$ CPI U.S. CPI U.K.

1985 1.2974 107.6 111.1

1986 1.4677 109.6 114.9
1987 1.6398 113.6 119.7
1988 1.7813 118.3 125.6
1989 1.6382 124.0 135.4
1990 1.7841 130.7 148.2
1991 1.7674 136.2 156.9
1992 1.7663 140.3 162.7
1993 1.5016 144.5 165.3
1994 1.5319 148.2 169.3
1995 1.5785 152.4 175.2
1996 1.5607 156.9 179.4
1997 1.6376 160.5 185.1
1998 1.6573 163.0 191.4
1999 1.6172 166.6 194.3
2000 1.5156 172.2 200.1
2001 1.4396 177.1 203.6
2002 1.5025 179.9 207.0
2003 1.6347 184.0 213.0
2004 1.8330 188.9 219.4
2005 1.8204 195.3 225.6
2006 1.8434 201.6 232.8
2007 2.0020 207.3 242.7

Source: Economic Report of the President, 2008. U.K. Pound/ $

from Table B-110; CPI (19821984 = 100) from Table B-108.

1.7. Table 1-3 gives you data on the exchange rate between the U.K. pound and the
U.S. dollar (number of U.K. pounds per U.S. dollar) as well as the consumer
price indexes in the two countries for the period 19852007.
a. Plot the exchange rate (ER) and the two consumer price indexes against time,
measured in years.
b. Divide the U.S. CPI by the U.K. CPI and call it the relative price ratio (RPR).
c. Plot ER against RPR.
d. Visually sketch a regression line through the scatterpoints.
1.8. Table 1-4 on the textbook Web site contains data on 1247 cars from 2008.14 Is
there a strong relationship between a cars MPG (miles per gallon) and the
number of cylinders it has?
a. Create a scatterplot of the combined MPG for the vehicles based on the num-
ber of cylinders.
b. Sketch a straight line that seems to fit the data.
c. What type of relationship is indicated by the plot?

14
Data were collected from the United States Department of Energy Web site at http://www.
fueleconomy.gov/.
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APPENDIX 1A: Economic Data

on the World Wide Web15
Economic Statistics Briefing Room: An excellent source of data on output, income,
employment, unemployment, earnings, production and business activity, prices
and money, credits and security markets, and international statistics.
http://www.whitehouse.gov/fsbr/esbr.htm
Federal Reserve System Beige Book: Gives a summary of current economic con-
ditions by the Federal Reserve District. There are 12 Federal Reserve Districts.
www.federalreserve.gov/FOMC/BeigeBook/2008
National Bureau of Economic Research (NBER) Home Page: This highly regarded
private economic research institute has extensive data on asset prices, labor,
productivity, money supply, business cycle indicators, etc. NBER has many
links to other Web sites.
http://www.nber.org
Panel Study: Provides data on longitudinal survey of representative sample of
U.S. individuals and families. These data have been collected annually since 1968.
http://www.umich.edu/~psid
The Federal Web Locator: Provides information on almost every sector of the
federal government; has international links.
www.lib.auburn.edu/madd/docs/fedloc.html
WebEC:WWW Resources in Economics: A most comprehensive library of eco-
nomic facts and figures.
www.helsinki.fi/WebEc
American Stock Exchange: Information on some 700 companies listed on the
second largest stock market.
http://www.amex.com/
Bureau of Economic Analysis (BEA) Home Page: This agency of the U.S.
Department of Commerce, which publishes the Survey of Current Business, is an
excellent source of data on all kinds of economic activities.
www.bea.gov
Business Cycle Indicators: You will find data on about 256 economic time series.
http://www.globalexposure.com/bci.html
CIA Publication: You will find the World Fact Book (annual).
www.cia.gov/library/publications
Energy Information Administration (Department of Energy [DOE]): Economic
information and data on each fuel category.
http://www.eia.doe.gov/
FRED Database: Federal Reserve Bank of St. Louis publishes historical eco-
nomic and social data, which include interest rates, monetary and business
indicators, exchange rates, etc.
http://www.stls.frb.org/fred/
15
It should be noted that this list is by no means exhaustive. The sources listed here are up-
dated continually. The best way to get information on the Internet is to search using a key word (e.g.,
unemployment rate). Dont be surprised if you get a plethora of information on the topic you search.
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International Trade Administration: Offers many Web links to trade statistics,

cross-country programs, etc.
http://www.ita.doc.gov/
STAT-USA Databases: The National Trade Data Bank provides the most com-
prehensive source of international trade data and export promotion informa-
tion. It also contains extensive data on demographic, political, and socioeco-
nomic conditions for several countries.
http://www.stat-usa.gov/
Bureau of Labor Statistics: The home page contains data related to various as-
pects of employment, unemployment, and earnings and provides links to other
statistical Web sites.
http://stats.bls.gov
U.S. Census Bureau Home Page: Prime source of social, demographic, and
economic data on income, employment, income distribution, and poverty.
http://www.census.gov/
General Social Survey: Annual personal interview survey data on U.S. house-
holds that began in 1972. More than 35,000 have responded to some 2500 different
questions covering a variety of data.
www.norc.org/GCS+Website
Institute for Research on Poverty: Data collected by nonpartisan and nonprofit
university-based research center on a variety of questions relating to poverty
and social inequality.
http://www.ssc.wisc.edu/irp/
Social Security Administration: The official Web site of the Social Security
Administration with a variety of data.
http://www.ssa.gov
Federal Deposit Insurance Corporation, Bank Data and Statistics:
http://www.fdic.gov/bank/statistical/
Federal Reserve Board, Economic Research and Data:
http://www.federalreserve.gov/econresdata
U.S. Census Bureau, Home Page:
http://www.census.gov
U.S. Department of Energy, Energy Information Administration:
www.eia.doe.gov/overview_hd.html
U.S. Department of Health and Human Services, National Center for Health
Statistics:
http://www.cdc.gov/nchs
U.S. Department of Housing and Urban Development, Data Sets:
http://www.huduser.org/datasets/pdrdatas.html
U.S. Department of Labor, Bureau of Labor Statistics:
http://www.bls.gov
U.S. Department of Transportation, TranStats:
http://www.transtats.bts.gov
U.S. Department of the Treasury, Internal Revenue Service, Tax Statistics:
http://www.irs.gov/taxstats
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18 CHAPTER ONE: THE NATURE AND SCOPE OF ECONOMETRICS

Rockefeller Institute of Government, State and Local Fiscal Data:

www.rockinst.org/research/sl_finance
American Economic Association, Resources for Economists:
http://www.rfe.org
American Statistical Association, Business and Economic Statistics:
www.amstat.org/publications/jbes
American Statistical Association, Statistics in Sports:
http://www.amstat.org/sections/sis/
European Central Bank, Statistics:
http://www.ecb.int/stats
World Bank, Data and Statistics:
http://www.worldbank.org/data
International Monetary Fund, Statistical Topics:
http://www.imf.org/external/np/sta/
Penn World Tables:
http://pwt.econ.upenn.edu
Current Population Survey:
http://www.bls.census.gov/cps/
Consumer Expenditure Survey:
http://www.bls.gov/cex/
Survey of Consumer Finances:
http://www.federalreserve.gov/pubs/oss/
City and County Data Book:
http://www.census.gov/statab/www/ccdb.html
Panel Study of Income Dynamics:
http://psidonline.isr.umich.edu
National Longitudinal Surveys:
http://www.bls.gov/nls/
National Association of Home Builders, Economic and Housing Data:
http://www.nahb.org/page.aspx/category/sectionID=113
National Science Foundation, Division of Science Resources Statistics:
http://www.nsf.gov/sbe/srs/
Economic Report of the President:
http://www.gpoaccess.gov/eop/
Various Economic Data Sets:
http://www.economy.com/freelunch/
The Economist Market Indicators:
http://www.economist.com/markets/indicators
Statistical Resources on the Military:
http://www.lib.umich.edu/govdocs/stmil.html
World Economic Indicators:
http://devdata.worldbank.org/
Economic Time Series Data:
http://www.economagic.com/