EED 401: ECONOMETRICS
• COURSE OUTLINE
Meaning and purpose of econometrics
Methodology of econometric research
Correlation analysis and single equation models;
simple linear & multiple linear regression
models
Functional forms of the regression model
Special models in regression analysis; dummy
variables, RTO.
COURSE OUTLINE CONT’D
Problems of single equation models;
autocorrelation, heteroscedasticity,
multicolinearity, errors in variables
Simultaneous equation models and estimation
Qualitative choice models
Time series analysis
SOME REFRENCES
• A. KOUTSOYIANNIS (2003). THEORY OF
ECONOMETRICS. 2ND EDITION. PELGRAVE
• JEFFREY M. WOOLDRIDGE. INTRODUCTORY
ECONOMICS- A MODERN APPROACH
• DAMODAR N. GUJIRATI. BASIC ECONOMETRICS.
FOURTH EDITION.
• ETC, ETC.
WHAT IS ECONOMETRICS?
• The word ‘econometrics’ is derived from two
Greek words, oikovoμia (economy), and
μetpov (measure)
• Definition: the social science in which the
tools of economic theory, mathematics and
statistical inference are applied to the analysis
of economic phenomena (Arthur Goldburger,
1964).
WHAT IS ECONOMETRICS? CONT’D
• Thus, econometrics is an amalgam of
economics, mathematics and statistics
• The uniqueness of econometrics lies in the
inclusion of a random element in models
ILLUSTRATION (economic model of crime)
• Based on economic reasoning (theory) time
spent on criminal activity by an individual will
depend on, hourly ‘criminal wage’ ( x1 ),
x1
WHAT IS ECONOMETRICS? CONT’D
•
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•
x
Hourly wage in legal employment,
2
Income other than from crime or employment,
Probability of getting caught, x4
Probability of being convicted if caught, x5
Expected sentence if convicted,
x6
Age, x
7
x3
WHAT IS ECONOMETRICS? CONT’D
• The above depicts an exact relationship ie the
time spent on crime is completely dependent
on 7 factors
• This is stated mathematically as:
• Or
y  f ( x1, x2 , x3 , x4 , x5 , x6 , x7 )
y  b0  b1x1  b2 x2  b3 x3  b4 x4  b5 x5  b6 x6  b7 x7
WHAT IS ECONOMETRICS? CONT’D
• This still leaves us with a deterministic
relationship
• But there are other factors that influence
crime apart from the 7. eg. health, vengeance,
religion, etc.
• Econometrics introduces a random factor
(stochastic term) which takes care of these
‘other’ factors
Econometric representation of the
crime model
y  f ( x1 , x2 , x3 , x4 , x5 , x6 , x7 , u)
y  b0  b1x1  b2 x2  b3 x3  b4 x4  b5 x5  b6 x6  b7 x7  u
Econometric representation of the
crime model CONT’D.
• U is the random factor encapsulating all other
random factors that affect time spent on
crime
• PROCEDURE FOR TESTING ECONOMIC THEORY
Reading assignment
• Establish the superiority of econometrics to
mathematical economics and statistics
Branches of econometrics
• Two main branches:
-Theoretical econometrics –dev’t. of appropriate
methods for the measurement of economic
relationships
-Applied econometrics: application of econometrics
to specific fields of economic theory ( demand,
supply, investment, production) for the analysis
of economic phenomena and forecasting
economic behaviour
Purpose of econometrics
• Policy-making: Provide numerical values for
the parameters of economic relationships
(elasticities, propensities, marginal values) for
decision making
• Analysis: Empirical verification of economic
laws/theories
• Forecasting: determining future values of
economic magnitudes based on numerical
estimates
METHODOLOGY OF ECONOMETRIC
RESEARCH
Generally, econometric research involves 4
stages:
1. Formulation of the maintained hypothesis:
ie. The specification of the model
2.Testing of maintained hypothesis: estimation
of the model by appropriate econometric
method
3. Evaluation of estimates: decide on the basis
of certain criteria whether the estimates are
satisfactory & reliable.
METHODOLOGY OF ECONOMETRIC
RESEARCH CONT’D.
4. Testing the forecasting validity of the model
1&3 are the most important for any
econometric research. Require strong
knowledge in the functioning of economic
systems
2&4 are technical & require a deep
understanding of econometrics
Formulation of the maintained
hypothesis
• It involves determining
1. Dependent and explanatory variables
2. The a priori theoretical expectations about
the signs & the size of the parameters of the
function to form the basis for the evaluation
of the model
3. The mathematical form of the model: single
vs. simultaneous equation; linear vs.
nonlinear functional forms
Reasons for incorrect specification of
economic models
1. Looseness/ imperfection of statements in
economic theories
2. Limitation of our knowledge about factors
which are operative in a particular situation
3. Problems associated with large data
requirements of large models. Errors of
specification- omission of variables,
equations, & wrong mathematical form of
functions
2. Estimation of the model
The estimation process involves the ff. Stages:
1. Gathering data-: cross-sectional, time series &
panel data
2. Examination of the identification condition of
the function
3. Examination of the aggregation problems of
the function (aggregation over individuals,
commodities, time,& space)
4. Examination of the degree of correlation
among the explanatory variables
5. Choice of the appropriate econometric
technique:i. Single equation techniques:- Classical Least
Squares (CLS) OR ordinary Least Squares(OLS)
method, Indirect Least Squares (ILS) or reducedform technique, 2SLS, Limited information
maximum likelihood method,etc.
ii. Simultaneous equation techniques:- 3SLS, FIML
3. Evaluation of estimates
Are the parameters theoretically meaningful and
statistically satisfactory?
We use 3 criteria for the evaluation;
1. Economic ‘a priori’ criteria: are the
parameters of the correct signs and the right
size?
2. Statistical criteria: first-order tests- usually
by using the correlation coefficient & the
standard deviation (error)
3. Econometric criteria: second-order test (test
of the statistical tests). This may involve tests
of consistency, efficiency, unbiasedness,
assumptions, identification, etc.
4. Evaluation of the Forecasting Power
of the Model
• Forecasting is one of the major objectives of
econometrics.
• Given data on personal consumption (Y) and GDP
(X) from 1982-1996 in billions of dollars the
estimated consumption function is given by:
Y  -184.08  0.7064Xi
• We can forecast the mean consumption
expenditure for 1997 given GDP=7269.8 billion dollars
as
Y1997  -184.0779  0.7064(7269.8)
 4951.309 billion dollars
• Actual consumption for 1997 was 4913.3 billion
dollars
• Forecast error is 37.81 billion dollars
• Question is: is the error large or small?
Properties of econometric models
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Econometric models are judged based on
Theoretical plausibility
Explanatory ability
Accuracy of the estimates of the parameters
Predictive power
simplicity
GOD BLESS YOU!