BIN: 408: Econometrics and

Business Forecasting
• Reference:
1. Basic Econometrics (5th ed.)
-Damodar N. Gujarat
-Dawn C. Prter
2. Econometrics by Example
- Damodar Gujarat
3. Introductory Econometrics A modern Approach (6th ed.)
-Jeffrey M. Wooldridge
4. Introductory Econometrics for Finance (3rd ed.)
-Chris Brooks
Topic 1: Econometrics
some basic idea

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WHAT IS ECONOMETRICS?
Definition 1: econometrics = econo + metrics
• economics vs. econometrics
economics: focus on “how” and “why”
econometrics: focus on “how much” and “why how much”
example:
• economist: “If the government increases beverage excise
tax, consumers will cut down on their beverage
consumption.”
• econometrician: “If the government increases beverage
excise tax by 20%, consumers will reduce their beverage
consumption by 1%.”
econometrics is absolutely vital in applying economic theories
in practice
WHAT IS ECONOMETRICS?
Definition 2: econometrics = statistics for economists
• “application of mathematical statistics to economic data to lend
empirical support to models constructed by mathematical economics
and to obtain numerical estimates.” (Samuelson et al., Econometrica,
1954)
• “Econometrics is concerned with the empirical determination of
economic laws” (Theil 1971).
• Allows for the fact we don’t have data on all possible influences by
including an error term
• “application of mathematics and statistical methods to the analysis
of economic data.“ (www.wikipedia.org)

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Why use econometrics? Cont….

 It allows us to analyse a large amount of information in a

systematic way

• Suppose we have data on the price of ice cream and the

quantity of ice cream eaten and we are interested in how
consumer demand responds to changes in price
• We could look at what happened to ice cream sales every
time the price changed
• But if there are lots of observations this could take a long
time- and if we only look at one or two instances our
conclusions could be unrepresentative
• Regression analysis can handle millions of observations
easily
Why use econometrics? Cont….

 Can give more meaningful results than simple statistics

• We could look at the average price of ice cream and the

average quantity eaten in a large dataset very easily
• Knowing that a 5% price increase leads to a 1% reduction
in demand could be much more helpful than simply
knowing the average level of each
Why use econometrics? Cont….

 Controls for effect of more than one variable

• We could use our data to make a chart, showing how

quantity is related to price
• However there may be many other factors affecting
quantity demanded that obscure this relationship (e.g.
more ice cream in the summer)
• Econometrics can control for these other factors, allowing
us to focus on the relationship we are interested in
 What Is Econometrics About?
• In economics we express our ideas about relationships
between economic variables using the mathematical concept
of a function.

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 What Is Econometrics About?

• It is not enough to know that certain economic variables are

interrelated, or even the direction of the relationship. In addition,
we must understand the magnitudes involved; That is, how much a
change in one variable affects another.

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METHODOLOGY OF ECONOMETRICS
• 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.

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 METHODOLOGY OF ECONOMETRICS. Cont……

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).

2. Specification of the Mathematical Model of Consumption (single-

equation model)
Y = β1 + β2X 0 < β2 < 1 (I.3.1)

Y = consumption expenditure and (dependent variable)

X = income, (independent, or explanatory variable)
β1 = the intercept
β2 = the slope coefficient

• The slope coefficient β2 measures the MPC.

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METHODOLOGY OF ECONOMETRICS. Cont……

• Geometrically,

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METHODOLOGY OF ECONOMETRICS. Cont……

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.

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METHODOLOGY OF ECONOMETRICS. Cont……

• To allow for the inexact relationships between economic

variables, (I.3.1) is modified as follows:

• Y = β1 + β2X + u (I.3.2)

• where u, known as the disturbance, or error, term, is a

random (stochastic) variable 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.

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 METHODOLOGY OF ECONOMETRICS. Cont……
• (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.

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 METHODOLOGY OF ECONOMETRICS. Cont……
4. Obtaining Data
• To obtain the numerical values of β1 and β2, we need data. Look at
Table 1.1, which relate to the personal consumption expenditure
(PCE) and the gross domestic product (GDP). The data are in “real”
terms.

Table: 1.1

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METHODOLOGY OF ECONOMETRICS. Cont……

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 1.1, we obtain the
following estimates of β1 and β2, namely, −184.08 and 0.7064.
Thus, the estimated consumption function is:

• Yˆ = −184.08 + 0.7064Xi (I.3.3)

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METHODOLOGY OF ECONOMETRICS. Cont……

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METHODOLOGY OF ECONOMETRICS. Cont……

• Yˆ = −184.08 + 0.7064Xi (I.3.3)

• 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.

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 METHODOLOGY OF ECONOMETRICS. Cont……

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.

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METHODOLOGY OF ECONOMETRICS. Cont……

• 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).

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METHODOLOGY OF ECONOMETRICS. Cont……

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:
Yˆ1997 = −184.0779 + 0.7064 (7269.8) = 4951.3 (I.3.4)
• 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?
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Figure I.4 summarizes the anatomy of classical
econometric modeling

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Economic Data Types

1. Data may be collected at various levels of aggregation:

• micro—data collected on individual economic decision-

making units such as individuals, households, and firms.

• macro—data resulting from a pooling or aggregating over

individuals, house-holds, or firms at the local, state, or
national levels.

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Economic Data Types. Cont….

2. Data may also represent a flow or a stock:

• flow—outcome measures over a period of time, such as

the consumption of gasoline during the last quarter of
2010.

• stock—outcome measured at a particular point in time,

such as the quantity of crude oil held by Exxon in its U.S.

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Economic Data Types. Cont….

3. Data may be quantitative or qualitative:

• quantitative—outcomes such as prices or income that

may be expressed as numbers or some transformation of
them, such as real prices or per capita income.

• qualitative—outcomes that are of an ‘‘either-or’’

situation.

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Types of data

• Time series
• Cross-sectional
• Penal data

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