Gujarati: Basic Front Matter Introduction © The McGraw−Hill

Econometrics, Fourth Companies, 2004

Edition

INTRODUCTION 3

jobs of the economic statistician. It is he or she who is primarily responsible

for collecting data on gross national product (GNP), employment, unem-
ployment, prices, etc. The data thus collected constitute the raw data for
econometric work. But the economic statistician does not go any further,
not being concerned with using the collected data to test economic theories.
Of course, one who does that becomes an econometrician.
Although mathematical statistics provides many tools used in the trade,
the econometrician often needs special methods in view of the unique na-
ture of most economic data, namely, that the data are not generated as the
result of a controlled experiment. The econometrician, like the meteorolo-
gist, generally depends on data that cannot be controlled directly. As Spanos
correctly observes:
In econometrics the modeler is often faced with observational as opposed to
experimental data. This has two important implications for empirical modeling
in econometrics. First, the modeler is required to master very different skills
than those needed for analyzing experimental data. . . . Second, the separation
of the data collector and the data analyst requires the modeler to familiarize
himself/herself thoroughly with the nature and structure of data in question.8

I.3 METHODOLOGY OF ECONOMETRICS

How do econometricians proceed in their analysis of an economic problem?
That is, what is their methodology? Although there are several schools of
thought on econometric methodology, we present here the traditional or
classical methodology, which still dominates empirical research in eco-
nomics and other social and behavioral sciences.9
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. 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.
To illustrate the preceding steps, let us consider the well-known Keynesian
theory of consumption.

8
Aris Spanos, Probability Theory and Statistical Inference: Econometric Modeling with Obser-
vational Data, Cambridge University Press, United Kingdom, 1999, p. 21.
9
For an enlightening, if advanced, discussion on econometric methodology, see David F.
Hendry, Dynamic Econometrics, Oxford University Press, New York, 1995. See also Aris
Spanos, op. cit.
 Gujarati: Basic Front Matter Introduction © The McGraw−Hill
Econometrics, Fourth Companies, 2004
Edition

4 BASIC ECONOMETRICS

1. Statement of Theory or Hypothesis

Keynes stated:
The fundamental psychological law . . . is that men [women] are disposed, as a
rule and on average, to increase their consumption as their income increases, but
not as much as the increase in their income.10
In short, Keynes postulated that the marginal propensity to consume
(MPC), the rate of change of consumption for a unit (say, a dollar) change
in income, is greater than zero but less than 1.

2. Specification of the Mathematical Model of Consumption

Although Keynes postulated a positive relationship between consumption
and income, he did not specify the precise form of the functional relation-
ship between the two. For simplicity, a mathematical economist might sug-
gest the following form of the Keynesian consumption function:
Y = β1 + β2 X 0 < β2 < 1 (I.3.1)
where Y = consumption expenditure and X = income, and where β1 and β2 ,
known as the parameters of the model, are, respectively, the intercept and
slope coefficients.
The slope coefficient β2 measures the MPC. Geometrically, Eq. (I.3.1) is as
shown in Figure I.1. This equation, which states that consumption is lin-

Y
Consumption expenditure

β2 = MPC
1

β1

X
Income

FIGURE I.1 Keynesian consumption function.

10
John Maynard Keynes, The General Theory of Employment, Interest and Money, Harcourt
Brace Jovanovich, New York, 1936, p. 96.
Gujarati: Basic Front Matter Introduction © The McGraw−Hill
Econometrics, Fourth Companies, 2004
Edition

INTRODUCTION 5

early related to income, is an example of a mathematical model of the rela-

tionship between consumption and income that is called the consumption
function in economics. A model is simply a set of mathematical equations.
If the model has only one equation, as in the preceding example, it is called
a single-equation model, whereas if it has more than one equation, it is
known as a multiple-equation model (the latter will be considered later in
the book).
In Eq. (I.3.1) the variable appearing on the left side of the equality sign
is called the dependent variable and the variable(s) on the right side are
called the independent, or explanatory, variable(s). Thus, in the Keynesian
consumption function, Eq. (I.3.1), consumption (expenditure) is the depen-
dent variable and income is the explanatory variable.

3. Specification of the Econometric Model of Consumption

The purely mathematical model of the consumption function given in
Eq. (I.3.1) is of limited interest to the econometrician, for it assumes that
there is an exact or deterministic relationship between consumption and
income. But relationships between economic variables are generally inexact.
Thus, if we were to obtain data on consumption expenditure and disposable
(i.e., aftertax) income of a sample of, say, 500 American families and plot
these data on a graph paper with consumption expenditure on the vertical
axis and disposable income on the horizontal axis, we would not expect all
500 observations to lie exactly on the straight line of Eq. (I.3.1) because, in
addition to income, other variables affect consumption expenditure. For ex-
ample, size of family, ages of the members in the family, family religion, etc.,
are likely to exert some influence on consumption.
To allow for the inexact relationships between economic variables, the
econometrician would modify the deterministic consumption function
(I.3.1) as follows:

Y = β1 + β2 X + u (I.3.2)

where u, known as the disturbance, or error, term, is a random (stochas-

tic) 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.
Equation (I.3.2) is an example of an econometric model. More techni-
cally, it is an example of a linear regression model, which is the major
concern of this book. The econometric consumption function hypothesizes
that the dependent variable Y (consumption) is linearly related to the ex-
planatory variable X (income) but that the relationship between the two is
not exact; it is subject to individual variation.
The econometric model of the consumption function can be depicted as
shown in Figure I.2.
 Gujarati: Basic Front Matter Introduction © The McGraw−Hill
Econometrics, Fourth Companies, 2004
Edition

6 BASIC ECONOMETRICS

Consumption expenditure Y

X
Income

FIGURE I.2 Econometric model of the Keynesian consumption function.

4. Obtaining Data
To estimate the econometric model given in (I.3.2), that is, to obtain the
numerical values of β1 and β2 , we need data. Although we will have more to
say about the crucial importance of data for economic analysis in the next
chapter, for now let us look at the data given in Table I.1, which relate to

TABLE I.1 DATA ON Y (PERSONAL CONSUMPTION EXPENDITURE)

AND X (GROSS DOMESTIC PRODUCT, 1982–1996), BOTH
IN 1992 BILLIONS OF DOLLARS

Year Y X

1982 3081.5 4620.3

1983 3240.6 4803.7
1984 3407.6 5140.1
1985 3566.5 5323.5
1986 3708.7 5487.7
1987 3822.3 5649.5
1988 3972.7 5865.2
1989 4064.6 6062.0
1990 4132.2 6136.3
1991 4105.8 6079.4
1992 4219.8 6244.4
1993 4343.6 6389.6
1994 4486.0 6610.7
1995 4595.3 6742.1
1996 4714.1 6928.4

Source: Economic Report of the President, 1998, Table B–2, p. 282.

Gujarati: Basic Front Matter Introduction © The McGraw−Hill
Econometrics, Fourth Companies, 2004
Edition

INTRODUCTION 7

5000

4500
PCE (Y)

4000

3500

3000
4000 5000 6000 7000
GDP (X)

FIGURE I.3 Personal consumption expenditure (Y ) in relation to GDP (X ), 1982–1996, both in billions of 1992
dollars.

the U.S. economy for the period 1981–1996. The Y variable in this table is
the aggregate (for the economy as a whole) personal consumption expen-
diture (PCE) and the X variable is gross domestic product (GDP), a measure
of aggregate income, both measured in billions of 1992 dollars. Therefore,
the data are in “real” terms; that is, they are measured in constant (1992)
prices. The data are plotted in Figure I.3 (cf. Figure I.2). For the time being
neglect the line drawn in the figure.

5. Estimation of the Econometric Model

Now that we have the data, our next task is to estimate the parameters of
the consumption function. The numerical estimates of the parameters give
empirical content to the consumption function. The actual mechanics of es-
timating the parameters will be discussed in Chapter 3. For now, note that
the statistical technique of 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:

Ŷ = −184.08 + 0.7064Xi (I.3.3)

The hat on the Y indicates that it is an estimate.11 The estimated consump-

tion function (i.e., regression line) is shown in Figure I.3.
11
As a matter of convention, a hat over a variable or parameter indicates that it is an esti-
mated value.
 Gujarati: Basic Front Matter Introduction © The McGraw−Hill
Econometrics, Fourth Companies, 2004
Edition

8 BASIC ECONOMETRICS

As Figure I.3 shows, the regression line fits the data quite well in that the
data points are very close to the regression line. From this figure we see that
for the period 1982–1996 the slope coefficient (i.e., the MPC) was about
0.70, suggesting that for the sample period an increase in real income of
1 dollar led, on average, to an increase of about 70 cents in real consumption
expenditure.12 We say on average because the relationship between con-
sumption and income is inexact; as is clear from Figure I.3; not all the data
points lie exactly on the regression line. In simple terms we can say that, ac-
cording to our data, the average, or mean, consumption expenditure went up
by about 70 cents for a dollar’s increase in real income.

6. Hypothesis Testing
Assuming that the fitted model is a reasonably good approximation of
reality, we have to develop suitable criteria to find out whether the esti-
mates obtained in, say, Eq. (I.3.3) are in accord with the expectations of the
theory that is being tested. According to “positive” economists like Milton
Friedman, a theory or hypothesis that is not verifiable by appeal to empiri-
cal evidence may not be admissible as a part of scientific enquiry.13
As noted earlier, 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 en-
quire whether this estimate is sufficiently below unity to convince us that
this is not a chance occurrence or peculiarity of the particular data we have
used. 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 statis-
tical inference (hypothesis testing). Throughout this book we shall see
how this inference process is actually conducted.

7. Forecasting or Prediction
If the chosen model does not refute the hypothesis or theory under consid-
eration, we may use it to predict the future value(s) of the dependent, or
forecast, variable Y on the basis of known or expected future value(s) of the
explanatory, or predictor, variable X.
To illustrate, suppose we want to predict the mean consumption expen-
diture for 1997. The GDP value for 1997 was 7269.8 billion dollars.14 Putting
12
Do not worry now about how these values were obtained. As we show in Chap. 3, the
statistical method of least squares has produced these estimates. Also, for now do not worry
about the negative value of the intercept.
13
See Milton Friedman, “The Methodology of Positive Economics,” Essays in Positive Eco-
nomics, University of Chicago Press, Chicago, 1953.
14
Data on PCE and GDP were available for 1997 but we purposely left them out to illustrate
the topic discussed in this section. As we will discuss in subsequent chapters, it is a good idea
to save a portion of the data to find out how well the fitted model predicts the out-of-sample
observations.
Gujarati: Basic Front Matter Introduction © The McGraw−Hill
Econometrics, Fourth Companies, 2004
Edition

INTRODUCTION 9

this GDP figure on the right-hand side of (I.3.3), we obtain:

Ŷ1997 = −184.0779 + 0.7064 (7269.8)

(I.3.4)
= 4951.3167

or about 4951 billion dollars. Thus, given the value of the GDP, the mean,
or average, forecast consumption expenditure is about 4951 billion dol-
lars. The actual value of the consumption expenditure reported in 1997 was
4913.5 billion dollars. The estimated model (I.3.3) thus overpredicted
the actual consumption expenditure by about 37.82 billion dollars. We
could say the forecast error is about 37.82 billion dollars, which is about
0.76 percent of the actual GDP value for 1997. When we fully discuss the
linear regression model in subsequent chapters, we will try to find out if
such an error is “small” or “large.” But what is important for now is to note
that such forecast errors are inevitable given the statistical nature of our
analysis.
There is another use of the estimated model (I.3.3). Suppose the Presi-
dent decides to propose a reduction in the income tax. What will be the ef-
fect 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 ex-
penditure increases. What will be the effect on the economy? As macroeco-
nomic theory shows, the change in income following, say, a dollar’s worth of
change in investment expenditure is given by the income multiplier M,
which is defined as

1
M= (I.3.5)
1 − MPC

If we use the MPC of 0.70 obtained in (I.3.3), this multiplier becomes about
M = 3.33. That is, an increase (decrease) of a dollar in investment will even-
tually 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, for the multiplier depends
on it. And this estimate of the MPC can be obtained from regression models
such as (I.3.3). Thus, a quantitative estimate of MPC provides valuable in-
formation 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.

8. Use of the Model for Control or Policy Purposes

Suppose we have the estimated consumption function given in (I.3.3).
Suppose further the government believes that consumer expenditure of
about 4900 (billions of 1992 dollars) will keep the unemployment rate at its
 Gujarati: Basic Front Matter Introduction © The McGraw−Hill
Econometrics, Fourth Companies, 2004
Edition

10 BASIC ECONOMETRICS

Economic theory

Mathematical model of theory

Econometric model of theory

Data

Estimation of econometric model

Hypothesis testing

Forecasting or prediction

Using the model for

control or policy purposes
FIGURE I.4 Anatomy of econometric modeling.

current level of about 4.2 percent (early 2000). What level of income will
guarantee the target amount of consumption expenditure?
If the regression results given in (I.3.3) seem reasonable, simple arith-
metic will show that

4900 = −184.0779 + 0.7064X (I.3.6)

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 expendi-
ture of about 4900 billion dollars.
As these calculations suggest, an estimated model may be used for con-
trol, 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.
Figure I.4 summarizes the anatomy of classical econometric modeling.

Choosing among Competing Models

When a governmental agency (e.g., the U.S. Department of Commerce) col-
lects economic data, such as that shown in Table I.1, it does not necessarily
have any economic theory in mind. How then does one know that the data
really support the Keynesian theory of consumption? Is it because the
Keynesian consumption function (i.e., the regression line) shown in Fig-
ure I.3 is extremely close to the actual data points? Is it possible that an-