Chapter One: Introduction: 1.1 Definition and Scope of Econometrics
Chapter One: Introduction: 1.1 Definition and Scope of Econometrics
With regard to the application of econometrics, econometrics may be divided into two
broad categories: theoretical econometrics and applied econometrics. Theoretical
econometrics is concerned with the development of appropriate methods for measuring
economic relationships specified by econometric models. In this aspect, econometrics
leans heavily on mathematical statistics. For example, one of the methods used
extensively in this book 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
fields of economics and business, such as the production function, investment function,
demand and supply functions, portfolio theory, etc. Thus econometrics is employed not
only by economics and business students but also by students and researchers in several
other disciplines, such as politics, international relations, agriculture, and health sciences.
Students in these disciplines will find the expanded discussion of several topics very
useful.
the theory. But econometrics mainly concerned on such empirical verification of the theory.
Econometricians often use the mathematical equations proposed by mathematical
economists but converts these equations into econometric equations so as to make ready for
empirical testing.
Indeed, mathematical statistics provide many tools to analyze the data. However,
econometrics concerned with the unique nature and structure of the data and thus provides
special methods or techniques to analyze the data based on the nature & structure of the
data. Generally, econometrics is an amalgam of economic theory, mathematical economics,
economic statistics and mathematical statistics.
Regarding the methodology of econometrics the method for the analysis of a given
economic problem is the main concern of econometrics. Here we deal about the traditional
or classical methodology which still dominates empirical research in economics and other
social and behavioral sciences. This methodology will be discussed under the following
step wise procedures:
1. Economic theory
2. Specification of mathematical model
3. Specification of econometric model
4. Obtaining the data
5. Estimation of econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purpose
1. Economic Theory
It is a statement of theory of hypothesis that is developed in a certain economic
phenomenon, to illustrate this and the preceding steps let’s consider the well know
Keynesian theory of consumption, that is, individuals consumption increases as their
income increases, but not as much as the increase in their income. In other words, the
marginal propensity to consume (MPC) the rate of change in consumption for a unit change
in income lies between zero & one.
The slope 2 measures MPC. The above mathematical equation, which states the
consumption function is linearly related to income, is termed as a consumption function in
economics. Since such model has only one equation it is called single equation model.
However, of it has more than one equation, it is called multiple-equation model. The
graphical representation of the mathematical model looks like:
Y=1+2
Consumption
Expenditure
0
0 Income
Fig. 1.1 Keynesian Consumption function
To allow for the inexact relationship between the two variables the mathematical model is
modified and thus turned to econometric model by introducing the disturbance or error
term, U, which is a random or stochastic variable that well represents all those factors
affecting consumption but not taken into account explicitly.
Y=1+2+U
This equation is an econometric model specifically a linear regression model the model can
also be represented graphically as:
. . . .
Consumption
Expenditure
. . .
0
Income
Fig. 1.2 Econometric model of consumption Function
4. Obtaining Data
In order to estimate the parameters of the econometric model, that is, the numerical values
of 1 & 2, we need to have data on consumption and income.
6. Hypothesis Testing
In this step we need to check whether the estimates obtained are in accord with the
expectation of the theory that is being tested. Although the estimated obtained (i.e, MPC =
0.70) is confirmed with the Keynes theory that MPC lies between zero one we need to still
check whether this confirmation is not a chance of occurrence or peculiarity of a particular
data we have used. In other words, is 0.70 statistically less than one? If so, we proved that
the estimated value confirmed with the theory.
Econometrics Lecture Notes; 2013 By Addisu M. 6
Wollo University, College of Business and Economics, Department of Economics
Such confirmation of the estimates with the theory using statistical method is known as
statistical inference or hypothesis testing.
7. Forecasting or Prediction
If the chosen model does not refute the hypothesis or theory under consideration, we use it
to predict the dependent or forecast variable Y on the basis of expected future value of the
explanatory or predictor variable X. For example, if the expected GDP or income value for
2017 was 7269.8 billion dollars, the estimated consumption in 2017 will be:
Ŷ2017 = -184.0779+0.7064(7269.8)
= 4951.3167
8. Use of the Model for Control or Policy Purposes
In addition to using the model for forecasting or prediction purpose, the government can
further use the model for control or policy purposes through the appropriate fiscal &
monetary policy mix. To this regard, the desired level of the target variable Y can be
produced by manipulating the control variable X. For example, if the government believes
that consumes expenditure of about 4900 billion dollars will keep the unemployment rate its
current level of about 4.2%, the income should be manipulated at about 7197 billion dollar
to produce the target amount of consumption expenditure.
i.e, 4900= -184.0779=7064X
X= 5084.0779/07064
X= 7197.1658
The main goal of the regression analysis is to obtain the possible estimates of the
coefficients and thus to predicate the estimated value of the dependent variable based on the
known or fixed values the independent variables.
The dependent variable is a variable that is being predicted or estimated where as the
independent variables are used as predictor and basis for estimation.
For example, the regression analysis on the two variables rainfall and crop yield only tells
us that crop yield depends on rainfall. But the fact that we treat crop yield as dependent on
rainfall is no due to statistical analysis rather it is due to some theoretical & factual
considerations. That is, the statistical relationship between crop yield & rainfall is
regression analysis where as the fact that changes in rainfall causes the crop yield to change
is causation. Note that the statistical relationship in itself cannot logically imply causation.
For example, given the two variables lung concern & smoking, the regression analysis deals
about the dependency of lung cancer on smoking in which how the effects on lung cancer is
estimated based on a fixed value of smoking. On the other hand, the correlation analysis
simply deals about measuring the degree of association between the lung cancer and
smoking without making separation between dependent (Or estimated) and explanatory (Or
predictor) variables. That is, correlation between lung cancer & smoking is the same as that
between smoking and lung cancer.