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Department of Economics

Room TO104

Course Components:

Econometrics means “economic measurement”. The scope of

econometrics is much broader, as can be seen from the following

definitions:

“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” (Gerhard

1968).

“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” (Goldberger

1964).

“Econometrics is concerned with the empirical determination of

economic laws” (Theil 1971).

WHAT IS ECONOMETRICS?

The subject deserves to be studied in its own right for the following reasons:

Economic theory makes statements or hypotheses that are mostly qualitative

in nature (the law of demand), the law does not provide any numerical

measure of the relationship. This is the job of the econometrician.

The main concern of mathematical economics is to express economic theory

in mathematical form without regard to measurability or empirical

verification of the theory. Econometrics is mainly interested in the empirical

verification of economic theory.

Economic statistics is mainly concerned with collecting, processing, and

presenting economic data in the form of charts and tables. It does not go any

further. The one who does that is the econometrician.

WHY ECONOMETRICS IS A

SEPARATE DISCIPLINE?

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. Collecting the data

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.

To illustrate the preceding steps, let us consider the well-known Keynesian theory

of consumption.

METHODOLOGY OF

ECONOMETRICS

1. Statement of Theory or Hypothesis

Keynes states that on average, consumers increase their consumption as their

income increases, but not as much as the increase in their income (MPC < 1).

equation model)

Y = β1 + β2X 0 < β2 < 1 (I.3.1)

X = income, (independent, or explanatory variable)

β1 = the intercept

β2 = the slope coefficient

Geometrically,

3. Specification of the Econometric Model of Consumption

The relationships between economic variables are generally inexact. 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.

modified as follows:

Y = β1 + β2X + u (I.3.2)

that has well-defined probabilistic properties. The disturbance term u may well

represent all those factors that affect consumption but are not taken into account

explicitly.

(I.3.2) is an example of a linear regression model, i.e., it hypothesizes that Y is

linearly related to X, but that the relationship between the two is not exact; it is

subject to individual variation. The econometric model of (I.3.2) can be depicted

as shown in Figure I.2.

4. Obtaining Data

To obtain the numerical values of β1 and β2, we need data. Look at Table I.1, which

relate to the personal consumption expenditure (PCE) and the gross domestic product

(GDP). The data are in “real” terms.

The data are plotted in Figure I.3

5. Estimation of the Econometric Model

Regression analysis is the main tool used to obtain the estimates. Using this

technique and the data given in Table I.1, we obtain the following estimates of β1

and β2, namely, −184.08 and 0.7064. Thus, the estimated consumption function is:

The estimated regression line is shown in Figure I.3. The regression line fits the

data quite well. The slope coefficient (i.e., the MPC) was about 0.70, an increase in

real income of 1 dollar led, on average, to an increase of about 70 cents in real

consumption.

6. Hypothesis Testing

That is to find out whether the estimates obtained in, Eq. (I.3.3) are in accord with

the expectations of the theory that is being tested. Keynes expected the MPC to be

positive but less than 1. In our example we found the MPC to be about 0.70. But

before we accept this finding as confirmation of Keynesian consumption theory, we

must enquire whether this estimate is sufficiently below unity. In other words, 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).

7. Forecasting or Prediction

To illustrate, suppose we want to predict the mean consumption expenditure for

1997. The GDP value for 1997 was 7269.8 billion dollars consumption would be:

The actual value of the consumption expenditure reported in 1997 was 4913.5

billion dollars. The estimated model (I.3.3) thus over-predicted the actual

consumption expenditure by about 37.82 billion dollars. We could say the forecast

error is about 37.8 billion dollars, which is about 0.76 percent of the actual GDP

value for 1997.

Now suppose the government decides to propose a reduction in the income tax.

What will be the effect of such a policy on income and thereby on consumption

expenditure and ultimately on employment?

Suppose that, as a result of the proposed policy change, investment expenditure

increases. What will be the effect on the economy? As macroeconomic theory shows,

the change in income following, a dollar’s worth of change in investment

expenditure is given by the income multiplier M, which is defined as:

investment will eventually lead to more than a threefold increase (decrease) in

income; note that it takes time for the multiplier to work.

The critical value in this computation is MPC. Thus, a quantitative estimate of MPC

provides valuable information for policy purposes. Knowing MPC, one can predict

the future course of income, consumption expenditure, and employment following a

change in the government’s fiscal policies.

Suppose we have the estimated consumption function given in (I.3.3). Suppose further

the government believes that consumer expenditure of about 4900 will keep the

unemployment rate at its current level of about 4.2%. What level of income will

guarantee the target amount of consumption expenditure?

If the regression results given in (I.3.3) seem reasonable, simple arithmetic will show

that:

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.

POLICY PURPOSES

Kinds of data

Time Series: A time series is a sequence of

observations which are ordered in time

Cross-section: is a type data collected by observing

many subjects (such as individuals, firms, countries,

or regions) at the same point of time, or without

regard to differences in time.

Panel: Data on an economic variable that include

both multiple economic units and multiple time

periods

Time Series Graph:

The Baltic Dry Index

Scatter Diagram:

Changes in GDP and Unemployment

12 Estonia

Increase in Unemployment Rate June 09 - May

Latvia

10 Lithuania

Spain

8

Ireland

6

08

Turkey USA

4 Sweden

Hungary Denmark

Finland Euro AreaRepublic

Czech

UK France Poland

2 Japan Belgium Greece

Norway

Italy

Germany Austria

New Zealand

Netherlands

0

-20 -15 -10 -5 0 5

-2

Latest Year-on-Year Change in GDP

Combined Time Series:

Timing of the Recession USA

Combined Time Series:

Timing of the Recession UK

Introduction to Probability:

What is a Random Variable?

with certainty before it occurs

The toss of a coin

The outcome of a soccer match

What is a Probability Distribution?

It describes the probabilities associated with

random variables

range of the random variable

Heads and tails

1, 2, 3, 4, 5, and 6

Notation

X, Y – random variables

A, B, Xi, Yi - possible values of random variables

SX – the set of all possible values of X

P(X) – the probability that X occurs

Or P(X=Xi) – the probability that X takes the

particular value Xi

Basic Rules of Probability

SX

0 < P(X) < 1

P(Sx) = 1

X not X

P(not X) = 1 – P(X)

0 < P(XY) < 1

P(SXY) = 1

Probability distribution of throw of a die

X P(X)

1 1/6

2 1/6

3 1/6

4 1/6

5 1/6

6 1/6

Total 1

Mutually Exclusive Events

Two events that cannot occur together

P(X and Y) = 0

P(X or Y) = P(X) + P(Y)

P(X=3) or (X=6) in throw of a die = ?

X Y

Non-Mutually Exclusive Events

P(X or Y) = P(X) + P(Y) – P(X and Y)

The general addition rule for probabilities

X X and Y Y

Joint probability distributions

The values that go on the inside portion of the table are the

intersections or "and"s of each pair of events). "Marginal" is

another word for totals -- it's called marginal because they

appear in the margins.

Y 0.00 0.20 0.20

Not Y 0.70 0.10 0.80

Marginal 0.70 0.30 1.00

Conditional Probability

Is the probability of Y occurring affected by the

probability of X occurring?

as: P(Y|X)

Conditional probability very important

for finance

the money supply?

yesterday’s price?

Independent Events

Two events are independent if the occurrence of

one does not influence the occurrence of the other

P(Y|X) = P(Y)

Probability Rules

Prob(X and Y) = P(X)*P(Y)

if X and Y independent

Combined Events - Counting Rule

outcomes, then the number of possible outcomes

for the joint event XY is nX * nY

or more possible outcomes

N = nX * nY * nz ….

Example of Combined Event: Stock Classifications

3 . . . .

Short-term

growth 2 . . . .

1 . . . .

1 2 3 4

Long-term growth

long-term growth is equally likely

What is the probability that sum of short-

term and long-term growth assessments = 5?

3 . . . .

Short-term

growth 2 . . . .

1 . . . .

1 2 3 4

Long-term growth

Answer = 3/12

Discrete and continuous random variables

What if we flipped a fair coin two times? What are the possible

outcomes and what is the probability of each?

They are used to model physical characteristics such as time,

length, position, etc. if we let X denote the height (in meters) of a

randomly selected maple tree, then X is a continuous random

variable

Probability Density Function and Cumulative

Distribution Functions

between any two points is the probability that the

random variable falls between these points.

The cumulative distribution function shows the

probability that an outcome less than a selected value

occurs.

The pdf and cdf contain the same information – they

just present it differently.

Cumulative Distribution Function

Cumulative Distribution Function

1.2

0.8

0.6

0.4

0.2

0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Probability Density Function

Density Function

0.25

0.2

0.15

0.1

0.05

0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Reading for Lecture 1

S&W Chapter 1

Section 1.2, 1.3,

S&W Chapter 2

Section 2.1

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