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Econo Metri

The document provides an introduction to econometrics, defining it as the application of mathematical statistics to economic data for empirical support of economic theories. It outlines the traditional methodology of econometrics, which includes hypothesis formulation, model specification, data collection, parameter estimation, hypothesis testing, forecasting, and policy application. Additionally, it distinguishes between theoretical and applied econometrics, emphasizing the importance of mathematical statistics in the field.

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14 views21 pages

Econo Metri

The document provides an introduction to econometrics, defining it as the application of mathematical statistics to economic data for empirical support of economic theories. It outlines the traditional methodology of econometrics, which includes hypothesis formulation, model specification, data collection, parameter estimation, hypothesis testing, forecasting, and policy application. Additionally, it distinguishes between theoretical and applied econometrics, emphasizing the importance of mathematical statistics in the field.

Uploaded by

newaybeyene5
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© © All Rights Reserved
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Introduction to Econometrics

Gadisa M.
Introduction
• What is econometrics?
– Literally interpreted, econometrics means “economic
measurement.” Although measurement is an important part of
econometrics, the scope of econometrics is much broader, as can
be seen from the following quotations:

– 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.

– . . . econometrics may be defined as the quantitative analysis of


actual economic phenomena based on the concurrent
development of theory and observation, related by appropriate
methods of inference.
Introduction
– Econometrics may be defined as the social science in which the tools
of economic theory, mathematics, and statistical inference are
applied to the analysis of economic phenomena.

– Econometrics is concerned with the empirical determination of


economic laws

• The art of the econometrician consists in finding the set of


assumptions that are both sufficiently specific and sufficiently
realistic to allow him to take the best possible advantage of the
data available to him.

• The method of econometric research aims, essentially, at a


conjunction of economic theory and actual measurements, using
the theory and technique of statistical inference as a bridge pier.
METHODOLOGY OF ECONOMETRICS

• How do econometricians proceed in their analysis of an


economic problem? That is, what is their methodology?

• Although there are several schools of thought on econometric


methodology, we present here the traditional or classical
methodology, which still dominates empirical research in
economics and other social and behavioral sciences.

• Broadly speaking, traditional econometric methodology


proceeds along the following lines:

1. Statement of theory or hypothesis.


2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric, model
4. Obtaining the data
Methodology..
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purposes.

1. Statement of Theory or Hypothesis


– Keynes postulated that the marginal propensity to
consume (MPC), the rate of change of consumption for a
unit (say, a dollar) change in income, is greater than zero
but less than 1.

– Theory of demand is an other example, ‘there is an inverse


relationship between the price of a commodity and its
quantity demanded, citrus paribus’.
Methodology…

2. Specification of the Mathematical Model (of


Consumption)
– a mathematical economist might suggest the following
form of the Keynesian consumption function:
Y = β1 + β2X, 0 < β2 < 1

– where Y = consumption expenditure and X = income, and


where β1 and β2 , known as the parameters of the model,
1 2

are, respectively, the intercept and slope coefficients.

– The slope coefficient β2 measures the MPC (marginal


2

propensity to consume). Graphically presented on the next


slide.
Methodology…
3. Specification of the Econometric Model (of Consumption)

– The purely mathematical model of the consumption function given in the


above equation is of limited interest to the econometrician, for it assumes
that there is an exact or deterministic relationship between consumption and
income.

– But relationships between economic variables are generally inexact.

– To allow for the inexact relationships between economic variables, the


econometrician would modify the deterministic consumption function as
follows:

Y = β1 + β2X + u

where u, known as the disturbance, or error, term, is a random (stochastic)


variable that has well-defined probabilistic properties.
Methodology…
– The disturbance term u may well represent all those factors that
affect consumption but are not taken into account explicitly.

– The above equation is an example of an econometric model.

• More technically, it is an example of a linear regression


model, which is one of the major concerns of this course.

• The econometric consumption function hypothesizes that the


dependent variable Y (consumption) is linearly related to the
explanatory variable X (income)

• but that the relationship between the two is not exact; it is


subject to individual variation.
Methodology…
4. Obtaining Data
– To estimate the econometric model given, to obtain the numerical
values of β1 and β2, we need data.
– See the data in the table on the previous slide, used for illustration .

5. Estimation of the Econometric Model


– Now that we have the data, our next task is to estimate the
parameters of the consumption function. the statistical technique
of regression analysis is the main tool used to obtain the
estimates. E.g.
Y_hat= −184.08 + 0.7064Xi

– suggesting that for the sample period an increase in real income of


1 dollar led, on average, to an increase of about 70 cents in real
consumption expenditure.
Methodology…
6. Hypothesis Testing
• Assuming that the fitted model is a reasonably good
approximation of reality, we have to develop suitable criteria
to find out whether the estimates obtained are in accord with
the expectations of the theory that is being tested.

• As noted earlier, Keynes expected the MPC to be positive but


less than 1. In our example we found the MPC to be about
0.70. Is 0.70 statistically less than 1? If it is, it may support
Keynes’ theory.

• 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).
Methodology…
7. Forecasting or Prediction

• If the chosen model does not refute the hypothesis or theory under
consideration, we may use it to predict the future value(s) of the
dependent, or forecast, variable Y on the basis of known or expected
future value(s) of the explanatory, or predictor, variable X.

• To illustrate, suppose we want to predict the mean consumption


expenditure for 1997. The GDP value for 1997 was 7269.8 billion
dollars.

• Putting this GDP figure on the right-hand side, we obtain:

Y_ hat1997 = −184.0779 + 0.7064 (7269.8)


= 4951.3167
or about 4951 billion dollars.
Methodology…
• Thus, given the value of the GDP, the mean, or average,
forecast consumption expenditure is about 4951 billion
dollars.

• The actual value of the consumption expenditure reported


in 1997 was 4913.5 billion dollars.

• The estimated model thus over predicted the actual


consumption expenditure by about 37.82 billion dollars.

• We could say the forecast error is about 37.82 billion


dollars, which is about 0.76 percent of the actual GDP
value for 1997.
Methodology
8. Use of the Model for Control or Policy Purposes
• Suppose we have the estimated consumption function given above. 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?

• If the regression results given above seem reasonable, simple arithmetic will show that
4900 = −184.0779 + 0.7064X

• which gives X = 7197, approximately. That is, an income level of about 7197 (billion)
dollars, given an MPC of about 0.70, will produce an expenditure of about 4900 billion
dollars.

• As these calculations suggest, an estimated model may be used for control, or policy,
purposes. By appropriate fiscal and monetary policy mix, the government can
manipulate the control variable X to produce the desired level of the target variable Y.
Summary
TYPES OF ECONOMETRICS
• Econometrics may be divided into two broad categories:
– theoretical econometrics and
– applied econometrics.

• In each category, one can approach the subject in


– the classical or
– Bayesian tradition.

• The emphasis here is on the classical approach. For the Bayesian


approach, you may consult other references.

• Theoretical econometrics is concerned with the development of


appropriate methods for measuring economic relationships
specified by econometric models.
Pictorial presentation
Types of econometrics…
• Econometrics leans heavily on mathematical statistics.

• For example, one of the methods used extensively in this course is least
squares.

• Theoretical econometrics must spell out the assumptions of this


method, its properties, and what happens to these properties when one
or more of the assumptions of the method are not fulfilled.

• In applied econometrics we use the tools of theoretical econometrics


to study some special field(s) of economics and business, such as

– the production function,


– investment function,
– demand and supply functions,
– portfolio theory, etc.
Thank you!

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