Beykent University

Department of Economics
Econometrics I
Do.Dr. zgr mer Ersin

PART 1:
Introduction, Basic Definitions
and Concepts
23.09.2017

Source:
Stock and Watson, Introduction to Econometrics,
3rd Edition.
Extra Material::Gujarati, Basic Econometrics, 4.Ed.
 RESEARCH AREAS IN ECONOMETRICS

To develop methods to analyze economic relationships

To test economic theory and hypothesis tests

To evaluate economic policies and
their relevant applications
Estimation and forecasting
collection of nonexperimental or observational data

and corresponding analyses.

2
 What is Econometrics?

Econometrics can be simple stated as economic

measurement

With its broad meaning, econometrics is stated as: To

analyze an economic phenomenon, econometrics is a
social science that benefits from tools of mathematical
and statistical inference*

Read Stock and Watson, Chapter 4.

* Arthur S. Goldberger, Economic Theory, John Wiley & Sons New

York 1964, p.1.
3
 Econometric Methodology (Classical
Approach)

1. Economic Theory and/or putting forth an hypothesis

2. Determination of mathematical model with respect to the
theory
3. Determination of the econometric model
4. collection of data (data types will be discussed later on)
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecast and prediction
8. Usage of models for political needs
Source: Gujarati, p. 3.)
 1. PUTTING FORTH A THEORY (OR
EVALUATING THEORY)
We will evaluate an econometric model application
for Keynesian consumption function. Keynes
discusses a psychological law regarding consumption
and income. Accordingly, as a person faces
increases in income, they also increase their
consumption. However, increases in consumption
lag behind the increases in income. Further, people
increase their consumption with certain lags *

* John Maynard Keynes, The General Theory of Employment, Interest and

Money, Harcourt Brace Jovanovich, New York, 1936, p. 96.
 2. Definition of an Econometric Model:
Keynesian Model
Keynes states a positive relationship between
consumption and income. However, the mathematical
form is not stated. In economics, we define the
Keynesian consumption function as follows:

Y 1 2X 0 2 1
Y: Consumption (Dependent variable)
X: Income (Independent variable, also called
explanatory variable)
1 and 2 are parameters. They are also called intercept
and slope, respectively.
Econ 102 Review: The Keynesian Theory of Consumption

With a straight line consumption curve, we can

use the following equation to describe the curve:
C = a + bY

An Aggregate
Consumption Function

The aggregate
consumption function
shows the level of
aggregate consumption at
each level of aggregate
income.
The upward slope
indicates that higher
levels of income lead to
higher levels of
consumption spending.
7 of 39
The Keynesian Theory of Consumption

marginal propensity to consume (MPC) That

fraction of a change in income that is consumed,
or spent.

C
marginal propensity to consume slope of consumption function
Y

aggregate saving (S) The part of aggregate

income that is not consumed.

SYC

8 of 39
The Keynesian Theory of Consumption

marginal propensity to consume (MPC) That

fraction of a change in income that is consumed,
or spent.

C
marginal propensity to consume slope of consumption function
Y

aggregate saving (S) The part of aggregate

income that is not consumed.

SYC

9 of 39
In the mathematical model, the slope
parameter is called the marginal propensity to
consume (MPC).

Y 1 2X 0 2 1
 3. Defining the Econometric Model of
Consumption
Mathematical models are deterministic. The changes between
variables are determined without any errors or deviations.
However, in social sciences, we observe stochastic relations
between variables.

Y 1 2X u

u: is called the residual,

(also as: the disturbance term)
 4. Data Collection

TUIK www.tuik.gov.tr
TCMB www.tcmb.gov.tr
DPT www.dpt.gov.tr
DTM www.dtm.gov.tr
OECD www.oecd.org
Eurostat www.eurostat.org
World Bank www.worldbank.org
IMF www.imf.org
5. Estimation of an Econometric Model
8,000

7,000

6,000

T KET IM

5,000

4,000

3,000

2,000

1,000
2,000 4,000 6,000 8,000 10,000 12,000

GELIR

Yt - 299.5913 0.7218 * X t

Tablo I-1
 6. Hypothesis Tests
By accepting that the estimated parameters are good
approximations of the theoretical parameters, we have to define a
method of measurement or criteria to evaluate the fit of
parameters.
We face several questions:
In reality and according to the data at hand, can we accept that mpc was below 1 as
Keynes stated?
Is mpc below 1?
Is mpc different than zero? If this is the case, what can we say about the Keynesian
model?
We can test if mpc is below 1.
We can follow statistical inference methods.
Now, its your turn. What are the hypotheses that we should write down? Is it a t test?
 7. Prediction
Predict the average consumption for the year 2006.
GDP in the year 2006 is 11319.4 billion dollars. By plugging this value, we
obtain the following result:

Y2006 - 299.5913 0.7218 * (11319.4)
7870.7516
In reality, in the year 2006, the average consumption is 7870.7516 billion
dollars. The predicted value is 174 billion dollars below the actual consumption.
These types of errors will be discussed later on.
 8. Using the Model for Political Decisions
By using the Keynesian consumption equation we
estimated, we can evaluate the multiplier in Turkish
economy.

8750 -299.5913 0.7218*GDP2006

GDP2006=12537. By multiplying GDP with 0.72, we

obtain the value above.
What about the multiplier? What is the impact of a 100
billion dollar increase of investments on the economy.
 A Note on Economic and Econometric
Models:
Methodology we follow:
A three stage approach (Box and Jenkins, 1986)
1. Modelling : By starting from an economic model, develop
the econometric model.
2. Estimation: Estimation stands for calculation of the
model parameters. An estimation method we follow is OLS
(Ordinary least squares)
3. Evaluation: Evaluation of the model. Diagnostics tests.
Changing the model if necessary. If accepted, use the model
for a policy tool.
 Data Types
In empirical studies, there are three different types
of data:
Time series data,
Cross-section data,
Panel data.
 Examples for data types:

1) cross-sectional data:
ndividuals, families, firms, cities, industries
Countries etc. for a specific time.

2) time series data :

For equal time intervals, time series data has
Observed values for specific economic data.
Macroeconomic data types are mostly included here.
GDP, inflation rate, CPI, interest rate, ISE100 etc.

8
 Time series data:

Time series data consists of a variable with changing

values with respect to time.
Examples include: Daily data,
Weekly data,
Quarterly data,
Annually data.
As we move from annually data to quarterly,
weeky, hourly, or even ten minutes interval data,
we say that, the frequency of data increases
Cross-sectional data: Wages

9
Time series data: min wage, u, gnp

10
 GSMH

12,000

10,000

8,000

6,000

4,000

2,000
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
 0
10000
20000
30000
40000
50000
60000
70000
80000
11-02-87
21-04-1988
19-10-1988
2447712
2447596
23-03-1990
26-09-1990
20-03-1991
23-09-1991
16-03-1992
2448936
2449203
2449270
2449415
31-08-1994
17-02-1995
18-08-1995
2450298
2450335
2450571
2450577
27-01-1998
29-07-1998
27-01-1999
27-07-1999
2451606
2451552
IMKB

29-01-2001
26-07-2001
24-01-2002
18-07-2002
13-01-2003
2452951
2453250
2453194
2453431
27-06-2005
19-12-2005
15-06-2006
ISE100 Index, Daily.

2453960
2454197
26-11-2007
22-05-2008
14-11-2008
14-05-2009
2454994
2455261
26-10-2010
25-04-2011
Sample Period: 11.02.1987-25.04.2011

IMKB
 Cross sectional data: Cross section data consists of
variables taking different values with respect to
different observations in a given time. This means,
we do not have time dimension for this type of
data.
Example: Car sales in 1990 in USA in different
states.
Weight and height data of economics students in
Beykent University this semester.

Tablo 1-1
 Panel data: A data type having both time and cross
section dimensions. If we record the car sales
volume for different states in America not only for
1990, but keep recording for 1990-2011 period, we
have larger amount of observations in our sample.
 An Economic Model
Example 1: An Economic Model of Crime
y = f(x1,x2,x3,x4,x5,x6,x7)

y = time spent for committing crime (hours)

x1 = earnings with respect to the time spent for crime
x2 = hourly wages earned in legal jobs
x3 = income left for the leisure time
x4 = Probability of getting cought
x5 = the probability of receiving a sentence after being caught
x6 = expected punisment after the sentence
x7 = age
5
An Example for Economic and Econometric Models:

Ekonomic Model: Training and Wages

wage: hourly wage rate

exper: experience in the job market
training: time spent on training for the job related tasks

Ekonometric Model: Linear specification

6
Econometric Model

u: error term, disturbance term, the total amount of effect of the variables not included in
the model.

0, 1, 2, 3 : parameters that show the degree of the relation, the strength of the
relation, sign of the relation between the explanatory variables and the dependent
variable.

7
 POOLED CROSS SECTIONAL DATA
Data set has both cross-sectional and time
series characteristics. Example:
Cross sectional data for 10 years
Here, the sampling is gathered so that each
Cross sectional sample doesnt have the
identical units (different families, different firms
etc).

12
Pooled cross sections

13
 PANEL DATA (LONGITUDINAL DATA)

Same units (same families, individuals, firms, etc)

are analyzed. This is the difference from the previous
(pooled c.s.) data type.
Ex: Each year, I go to the same families and do the
household survey. Lets say, same 1000 families.
I do this for 10 years. How many obs. will I have in
the end?

14
PANEL DATA

15
 Causality and Ceteris Paribus
n Econometrics
The reason of economic modelling is to put forth the
Relationship between one variable with the other.
This relationship can be considered as causality. But does not
show causality necessarily. It is better to put this as multiple correlation
Ceteris paribus: holding others constant.
Consider the demand function. By holding tastes, income
wealth, prices of other goods constant, we say:
Ceteris paribus, if price increases by one unit, the demand
for chocolates decrease by 0.5 unit.

16
Economics 102 Review:
Government Purchases (G), Net Taxes (T), and Disposable
Income (Yd)

When government enters the picture, the

aggregate income identity gets cut into three
pieces:
Yd Y T
Yd C S
Y T C S
Y C S T
And aggregate expenditure (AE) equals:

AE C I G
36 of 63
Fiscal Policy at Work: Multiplier Effects
The Government Spending Multiplier

1
government spending multiplier
MPS

government spending multiplier The ratio of

the
change in the equilibrium level of output to a
change in government spending.

37 of 63
Planned Investment and the Interest Rate
Planned Aggregate Expenditure and the Interest Rate

FIGURE 27.2 The Effect of an Interest Rate Increase on Planned

An increase in
Aggregate the interest rate from 3 percent to 6 percent lowers planned aggregate
Expenditure
expenditure and thus reduces equilibrium income from Y0 to Y1. 38 of 57
 An EXAMPLE:
Macroeconomic Variables in Japan
I collected the data from OECD.
Characteristics of the data are:
Quarterly. Time series. Sample: :
1981.Q1-2003.Q3
First, we use EXCEL to analyze and make
certain adjustments:
 Figure 1: Consumption and GDP in Japan, Yearly
Growth Rates
What can we say about the path followed by the two
0.08
variables?
0.06

0.04

0.02
gr_cons
gr_gdp
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93

-0.02

-0.04

-0.06
Model 1. What can we say about the
Consumption Regression in Japan?
 Figure 2: Now, we expand our model. We have GDP,
Investments, Government Expenditures, Consumption in
Japan. 1981.Q3-2003.Q3 (All variables are quarterly. All
variables are given as yearly growth rates)
.20

.15

.10

.05

.00

-.05

-.10

-.15

-.20
82 84 86 88 90 92 94 96 98 00 02

GR_GOV GR_INV
GR_GDP GR_CONS
 Model 2: GDP Model
We have Investments, Government Expenditures,
Consumption in Japan.
By using these variables, how can we predict the GDP?

Note that, we can write the economic model as:

Y=C+I+G
Is this a closed economy or an open economy?
Allright. How can we write down the econometric model?
(Hint: Write them with betas and a disturbance term in the
end of the equation)
Note that the variables we have are
time series data:
GR_GOV GR_INV
.08 .2

.06
.1

.04
.0
.02

-.1
.00

-.02 -.2
82 84 86 88 90 92 94 96 98 00 02 82 84 86 88 90 92 94 96 98 00 02

GR_GDP GR_CONS
.08 .08

.06 .06

.04
.04
.02
.02
.00
.00
-.02

-.02 -.04

-.04 -.06
82 84 86 88 90 92 94 96 98 00 02 82 84 86 88 90 92 94 96 98 00 02
Model is estimated with E-views 5.0
package program:
 Example Questions
By looking at the model estimated in the previous slide for Japan, answer
the following questions.
a. Write down the economic and the econometric model.
b. Test the hypothesis that the parameter of GR_INV is no different than zero at 5% significance
level. Interpret your result.
c. Calculate 99% confidence interval for the parameter of GR_GOV is no different than zero at 5%
significance level. Interpret your result.
d. In the econometric model, comment: What is the impact of a 1% increase in the investment
growth rate on the GDP growth rate.
e. If the government expenditure growth rate increases by 1% this year, what is the impact on GDP
growth rate?
f. Assume that the Consumption growth rate increases by 1%. What is the impact on the GDP
growth rate?
g. predict the GDP growth rate by assuming that investment growt rate is 5%, C growth rate is %5,
G growth rate is 5%.
h. Assume that G growth rate is recorded as -20% whereas, other variables grew at the rates given
in part (g). Now, solve question E again. Predict the new GDP growth rate.
i. Are there any missing variable or variables in the model you evaluated? Accordingly, what type
of changes are required on both the Economic and the Econometric Models?
j. Investigate: What is the R-square? In the model, R-square is calculated as 0.94. What does this
mean?
The same model is now estimated for Turkey for the
period of 1999Q1-2011Q3. Estimation results are
given below. Solve the same questions for the model
estimated for Turkey.
The figure below shows the two variables, d4cons
and d4y; which are the yearly growth rates of
consumption and income. Note the positive
correlation between the two variables.
.6

.5

.4

.3

.2

.1

.0

-.1
98 99 00 01 02 03 04 05 06 07 08 09 10 11

D4CONS D4Y
The figure below shows the two variables, d4inv and
d4y; which are the yearly growth rates of investment
and income. Note the positive correlation between
the two variables.
.6

.5

.4

.3

.2

.1

.0

-.1

-.2

-.3
98 99 00 01 02 03 04 05 06 07 08 09 10 11

D4INV D4Y