ECN 5121 Econometric Methods I

INTRODUCTION
ECN 5121 Econometric Methods I

Chapter Outlines
 What is Econometrics?
 Methodology of Econometrics
 Types of Econometrics
 Mathematical and Statistical Prerequisites
2
What is Econometrics?
 Literal definition: measurement in
economics.
 Working definition: the application of
statistical, mathematical and economic
theory/hypothesis to the analysis of
economic situation.
3
Why a Separate Discipline?
 Econometric is an amalgam of economic theory,
mathematical economics, economic statistics,
and mathematical statistics.
 Economy theory – statements or hypotheses that

are mostly qualitative in nature.
 Mathematical economics – express theory in
mathematical form (equation) without regard to
measurability or empirical verification of the theory.
 Economic statistics – concerned with collecting,
processing, and presenting economic data in the
form of charts and tables.
 Mathematical statistics – provides many tools
used in trade.
4
Why Study Econometrics?
 Theories do not provide the necessary
measure of strength of relationship -
numerical estimate of the relationship.
Example, Law of Demand.
 To provide empirical verification of
theories.
5
The Objective of Econometrics
 Formulation of econometric models.
 Empirical verification of theories and
hypothesis.
 Use the models for prediction, forecasting
and policy recommendation.
6
Methodology of Econometrics
 Traditional econometric methodology
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
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.
7
1. Statement of Theory or
Hypothesis
 Marginal propensity to consume (MPC).
 The rate of change of consumption for a
unit change in income, is greater than 0
but less than 1.
8
2. Specification of the Mathematical
Model of the Theory
 Keynesian consumption function:
Y = β 1 + β 2X 0 < β 2 < 1
 Linearly relationship between consumption
and income.
 Simply a set of mathematical equations.
 Represent an exact or deterministic
relationship between Y and X.
9
3. Specification of the Econometric
Model
 For econometrician, relationship between
economic variables are generally inexact.
 In addition to income, there are other variables
affect consumption expenditure.
 Deterministic consumption function modified:
Y = β1 + β2X + u
 u – disturbance or error term: a random
(stochastic) variable represent all those factors
that affect consumption but are not taken into
account explicitly.
10
4. Obtaining Data
 Data can be obtained through many sources:
 Government
 Non-government organizations
 Research organizations
 Individual researchers
 Internet (e.g. http://rfe.wustl.edu/Data/index.html,
http://www.bnm.gov.my/, http://www.imf.org)
 Data can be divided into three types: Cross
Sectional Data, Time Series Data and Panel
Data (Pooled Data).
11
5. Estimation of the Econometric
Model
 Regression analysis – numerical
estimated of the parameters:
Ŷt = -299.5913 + 0.7218Xt
 MPC = 0.72, increase in real income of
one dollar led, on average, to an increase
of about 72 cents in real consumption
expenditure.
12
6. Hypothesis Testing
 Confirmation or refutation of economic theories on
the basis of sample evidence based on a branch
of statistical theory known as statistical inference.
Y = β1 + β2X + u
Ŷt = -299.5913 + 0.7218Xt
 Autonomous consumption > 0
H0: β1 = 0 H1: β1 > 0
 0 < MPC < 1
H0: β2 = 0 H1: β2 > 0 or H2: β2 < 1
13
7. Forecasting or Prediction
 If the chosen model does not refute the
hypothesis or theory, we may use it to
predict the future value(s) of the
dependent variable
 values of the explanatory variable was known.
Ŷt = -299.5913 + 0.7218(7269)
14
8. Use of the Model for Control or
Policy Purposes
 An estimated model may be used for
control, or policy, purposes.
 Government can manipulate the control
variable X to produce the desired level of
the target variable Y.
e.g. fiscal policy or monetary policy.
15
Types of Econometrics
 Divided into 2 broad categories:
 Theoretical econometrics
 development of appropriate methods for measuring
economic relationships specified by econometric models.
 e.g. ordinary least squares (OLS), panel data models, vector
autoregressive (VAR) model, etc.
 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.
 Applied econometrics
 use the tools of theoretical econometrics to study some
special field(s) of economics and business.
 e.g. production function, investment function, demand and
supply functions, portfolio theory, etc. 16
Mathematical and Statistical
Prerequisites
 Basic concepts of statistical estimation
and hypothesis testing.
 A nodding acquaintance with notions of
differential calculus is desirable.
 Regression software packages: ET,
LIMDEP, SHAZAM, MICRO TSP,
MINITAB, EVIEWS, SAS, SPSS, STATA,
Microfit, PcGive.
17
Methodology Of Econometrics
• How does one actually undertake an econometric study?
i. Create a statement of theory or hypothesis (such as demand is
–ve price, +ve related to income)
ii. Collect data which is going to be used to test the
theory/hypothesis (data can be time series, cross sectional, or
a combination of the two)
iii. Specify the model or theory (such as Q = f(P, P0, Y)
iv. Estimation of the model and its parameters (such as Q = 0
-1P + 2P0 +3Y , and finding numerical values for 0, 1, 2, 3
v. Test the hypothesis derived from the model (such as is
demand price inelastic i.e. 1 = 1
vi. Use the model to gain a forecast
Stages of Applied Econometric Analysis
Economic theory
Econometric model Data
Model estimation
Specification testing and diagnostics
Is the model adequate?
No Yes
Test any hypothesis
Use for predictions and policy making

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INTRODUCTION

ECN 5121 Econometric Methods I

 Economy theory – statements or hypotheses that

1. Statement of theory or hypothesis.

Econometric model Data

Specification testing and diagnostics

Is the model adequate?

Test any hypothesis

Use for predictions and policy making

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