Africa Beza College

Econometrics for Finance

Chapter One
Definition, Scope & Types of Econometrics
 What is econometrics?
1.1 Introduction
Definition: Econometrics deals with the measurement of economic relationships.
relationships.
Econometrics is a combination of economic theory, mathematical economics and statistics, but it is completely distinct from each one
of these three branches of science. The relationships and differences among these sciences are pointed out below.

A. Economic theory makes statements or hypotheses that are mostly qualitative in nature
Ex. Microeconomic theory states that, other things remaining the same, a reduction in the price of a commodity is expected to
increase the quantity demanded of that commodity. But the theory itself does not provide any numerical measure of the relationship
between the two: that is it does not tell by how much the quantity will go up or down as a result of a certain change in the price of
the commodity. It is the job of econometrician to provide such numerical statements.

B. Mathematical economics: the main concern of Mathematical economics is to express economic theory in mathematical
form (equations) without regard to measurability or empirical verification of the theory. Both economic theory and mathematical
economics state the same relationships. Economic theory uses verbal exposition but mathematical economics employs mathematical
symbolism. Neither of them allows for random elements which might affect the relationship and make it stochastic. Furthermore,
they do not provide numerical values for the coefficients of the relationships.

Although econometrics presupposes the expression of economic relationships in mathematical form, like mathematical economics it
does not assume that economic relationships are exact (deterministic).
It assumes that relationships are not exact
Econometric methods are designed to take in to account random disturbances which create deviations from the exact behavioral
patterns suggested by economic theory and mathematical economics.
Econometrics provides numerical values of the coefficients of economic phenomena.

C. Economic Statistics is mainly concerned with collecting, processing, and presenting economic data in the form of charts
and tables. It is mainly a descriptive aspect of economics. It does not provide explanations of the development of the various
variables and it does not provide measurement of the parameters of economic relationships.
The econometrician often needs special methods since the data are not generated as the result of a controlled experiment. This creates
special problems not normally dealt with in mathematical statistics. Moreover, such data are likely to contain errors of
measurement, and the econometrician may be called up on to develop special methods of analysis to deal with such errors of
measurement.

Note: To conclude econometrics is an amalgam of economic theory, mathematical economics, economic statistics, and
mathematical statistics. Yet, it is a subject that deserves to be studied in its own right for the above mentioned reasons.

1.2 Goals of Econometrics

Three main goals of econometrics
1. Analysis: - Testing Economic Theory
Economists formulated the basic principles of the functioning of the economic system using verbal exposition and applying a
deductive procedure. Economic theories thus developed in an abstract level were not tested against economic reality. Econometrics
aims primarily at the verification of economic theories.

2. Policy-Making
In many cases we apply the various econometric techniques in order to obtain reliable estimates of the individual coefficients of the
economic relationships from which we may evaluate elasticities or other parameters of economic theory (multipliers, technical
coefficients of production, marginal costs, marginal revenues, etc.) The knowledge of the numerical value of these coefficients is very
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 Africa Beza College
Econometrics for Finance
important for the decisions of firms as well as for the formulation of the economic policy of the government. It helps to compare the
effects of alternative policy decisions.

3. Forecasting
In formulating policy decisions it is essential to be able to forecast the value of the economic magnitudes. Such forecasts will enable
the policy-maker to judge whether it is necessary to take any measures in order to influence the relevant economic variables.

1.3 TYPES OF ECONOMETRICS

Econometrics may be divided in to two broad categories

1. Theoretical Econometrics
2. Applied Econometrics

1. Theoretical Econometrics is concerned with the development of appropriate methods for measuring economic relationships
specified by econometric models. In this aspect, econometrics tends heavily on mathematical statistics. For example, one of the
tools that are used extensively is the method of least squares. It is the concern of theoretical econometrics to 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.

2. In Applied Econometrics we use the tools of theoretical econometrics to study some special field(s) of economics, such as the
production function, consumption function, investment function, demand and supply functions, etc. Applied econometrics
includes the applications of econometric methods to specific branches of economic theory. It involves the application of the tools of
theoretical econometrics for the analysis of economic phenomena and forecasting economic behavior.

1.4 Methodology of Econometrics

In any econometric research we may distinguish four stages:
A. Specification of the model
The first, and the most important, step the econometrician has to take in attempting the study of any relationship between
variables is to express this relationship in mathematical form, that is to specify the model, with which the economic phenomenon
will be explored empirically. This is called the specification of the model or formulation of the maintained hypothesis. It involves
the determination of:

i. The dependent and explanatory variables which will be included in the model. The econometrician should be able to make a
list of the variables that might influence the dependent variable.
 General economic theories,
 Previous studies in any particular field and
 Information about individual condition in a particular case, and the actual behavior of the economic agents may indicate the
general factors that affect the dependent variable.
 The a priori theoretical expectations about the sign and the size of the parameters of the function. These a priori definitions will
be the theoretical criteria on the basis of which the results of the estimation of the model will be evaluated
 Economic theory
 Other applied research

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 Africa Beza College
Econometrics for Finance
 Information about possible special features of the phenomena being studied will contain suggestions about
the sign and size of the parameters.
Example: Consider the following simple consumption function:
C = 0 + 1Y+ U
Where: C = Consumption function
Y = level of income
In this function the coefficient 1 is the marginal propensity to consume (MPC) and should be positive with a value less than unity
(0<1<1). The constant intercept, o of the function is expected to be positive. This is because when income is zero, consumption
will assume a positive value; people will spend past savings, will borrow or find other means for covering their needs.

ii. The mathematical form of the model (number of equations liner or non-linear form of these equations, etc).
The specification of the econometric model will be based on economic theory and on any available information relating to the
phenomenon being studied. The econometrics must know the general laws of economic theory, and furthermore must gather any
other information relevant to the particular characteristics of the relationship as well as all studies already published on the subject
by other research workers.

The most common errors of specification are:

 The omission of some variables from the functions
 The omission of some equations
 The mistaken mathematical form of the functions.

B. Estimation of the Model

Having specified the econometric model, the next task of the econometrician is to obtain estimates (numerical values) of the
parameters of the model from the data available; consider the Keynesian consumption function.

C = o + 1Y+ U
Where: C is consumption
Y is income
If 1 = 0.8.
0.8. This value provides a numerical estimate of the marginal propensity to consume (MPC). If also supports Keynes’
hypothesis that MPC is less than 1.

The stage of estimation includes the following steps.

 Gathering of statistical observations (data) on the variables included in the model
 Examination of the identification conditions of the function in which we are interested.
 Examination of the aggregation problems involved in the variables of the function.
 Examination of the degree of correlation between the explanatory variables.
 Choice of the appropriate econometric technique for the estimation of the function and critical examination of the assumptions
of the chosen technique and of their economic implications for the estimates of the coefficients.

C. Evaluation of Estimates
After the estimation of the model the econometrician must proceed with the evaluation of the results of the calculations that is with
the determination of the reliability of these results. The evaluation consists of deciding whether the estimates of the parameters are
theoretically meaningful and statistically satisfactory. Various criteria may be used.

 Economic a prior criteria: – These are determined by the principles of economic theory and refer to the sign and the size of the
parameters of economic relationships. In econometric jargon we say that economic theory imposes restrictions on the signs and
values of the parameters of economic relationships.
 Statistical criteria: – These are determined by statistical theory and aim at the evaluation of the statistical reliability of the
estimates of the parameters of the model. The most widely used statistical criteria are the correlation coefficient and the
standard deviation (or the standard error) of the estimates. These concepts will be discussed in the subsequent units. Note
that the statistical criteria are secondary only to the a priori theoretical criteria. The estimates of the parameters should be
rejected in general if they happen to have the wrong sign or size even though the pass the statistical criteria.
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 Africa Beza College
Econometrics for Finance
 Econometric criteria: – are determined by econometric theory. It aims at the investigation of whether the assumptions of the
econometric method employed are satisfied or not in any particular case. When the assumptions of an econometric technique are
not satisfied it is customary to re-specify the model.

D.Evaluation
D.Evaluation of the forecasting power of the estimated model
The final stage of any econometric research is concerned with the evaluation of the forecasting validity of the model. Estimates are
useful because they help in decision-making. A model, after the estimation of its parameters, can be used in forecasting the values of
economic variables. The econometrician must ascertain how good the forecasts are expected to be in other words they must test the
forecasting power of the model. It is conceivably possible that the model is economically meaningful and statistically and
econometrically correct for the sample period for which the model has been estimated, yet it may very well not be suitable for
forecasting due, for example, to rapid change in the structural parameters of the relationship in the real world.

Therefore, the final stage of any applied econometric research is the investigation of the stability of the estimates, their sensitivity to
changes in the size of the sample. One way of establishing the forecasting power of a model is to use the estimates of the model for a
period not included in the sample. The estimated value (forecast value) is compared with the actual (realized) magnitude of the
relevant dependent variable. Usually there will be a difference between the actual and the forecast value of the variable, which is
tested with the aim of establishing whether it is (statistically) significant. If after conducting the relevant test of significance, we
find that the difference between the realized value of the dependent variable and that estimated from the model is statistically
significant, we conclude that the forecasting power of the model, its extra – sample performance, is poor.

Another way of establishing the stability of the estimates and the performance of the model outside the sample of data, from which it
has been estimated, is to re-estimate the function with an expanded sample that is a sample including additional observations. The
original estimates will normally differ from the new estimates. The difference is tested for statistical significance with appropriate
methods.

Reasons for a model’s poor forecasting performance

a) The values of the explanatory variables used in the forecast may not be accurate
b) The estimates of the coefficients (’s) may be poor, due to deficiencies of the sample data.
c) The estimates are ‘good’ for the period of the sample, but the structural background conditions of the model may have changed
from the period that was used as the basis for the estimation of the model, and therefore the old estimates are not ‘good’ for
forecasting. The whole model needs re-estimation before it can be used for prediction.
Example, Suppose that we estimate the demand function for a given commodity with a single equation model using time-series
data for the period 1950 – 68 as follows

= 100 + 5Yt – 30Pt

This equation is then used for ‘forecasting’ the demand of the commodity in the year 1970, a period outside the sample data.
Given Y1970 = 1000 and P1970 = 5

= 100 + 5(1000) – 30(5) = 4, 950 units.units.

If the actual demand for this commodity in 1970 is 4, 500 there is a difference of 450 between the estimated from the model and the
actual market demand for the product. The difference can be tested for significance by various methods. If it is found significant, we
try to find out what are the sources of the error in the forecast, in order to improve the forecasting power of our model.

1.5 The Nature and Sources of Data for Econometric Analysis

The success of any econometric analysis ultimately depends on the availability of the appropriate data. Let us first discuss the types
of data and then we will see the sources and limitations of the data.

1.5.1 Types of Data

There are three types of data
a) Time series data
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Econometrics for Finance
This is a set of observations on the values that a variable takes at different times. Such data may be collected at regular time
intervals: daily, weekly, monthly, quarterly, annually etc.

Example: Data on stock prices, unemployment rate, GDP etc

Data may be qualitative or quantitative
Qualitative data
data are sometimes called dummy variables or categorical variable. These are variables that cannot be quantified.
Example: male or female, married or unmarried, religion, etc
Quantitative data are data that can be quantified, example: income, prices, money etc.
b) Cross-Section data
These data give information on the variables concerning individual agents (consumers or producers) at a given point of time.
Example:
 The census of population conducted by CSA.
 survey of consumer expenditure conducted by Addis Ababa university
Note that due to heterogeneity, cross- sectional data have their own problems.

c) Pooled Data
These are repeated surveys of a single (cross-section) sample in different periods of time. They record the behavior of the same set of
individual microeconomic units over time. There are elements of both time series and cross sectional data.

The panel or longitudinal data also called micro panel data is a special type of pooled data in which the same cross-sectional unit is
surveyed over time.

1.5.2 The Sources of Data

A governmental agency, an international agency, a private organization or an individual may collect the data used in empirical
analysis.

Example. Governmental in Ethiopia: - MEDAC, MOF, CSA, NBE

International agencies: - International Monetary Fund (IMF), World Bank (WB)
The individual (researcher) himself may collect data through interviews or using questionnaire.
In the social sciences the data that one generally obtains is non-experimental in nature; that is not subject to the control of the
researcher. For example, data on GNP, unemployment, stock prices etc are not directly under the control of the investigator. This
often creates special problems for the researcher in pinning down the exact cause or causes affecting a particular situation.

Limitations
Although there is plenty of data available for economic research, the quality of the data is often not that good. Reasons are:
 Since most social science data are not experimental in nature, there is the possibility of observational errors.
 Errors of measurement arising from approximations and round offs.
 In questionnaire type surveys, there is the problem of non-response
 Respondents may not answer all the questions correctly
 Sampling methods used in obtaining data
 Economic data is generally available at a highly aggregate level. For example most macro data like GNP, unemployment,
inflation etc are available for the economy as a whole.

 Because of confidentiality, certain data can be published only in highly aggregate form For example; data on individual tax,
production, employment etc at firm level are usually available in aggregate form.

Because of all these and many other problems, the researcher should always keep in mind that the results of research are only as good
as the quality of the data. Therefore, the results of the research may be unsatisfactory due to the poor quality of the available data
(may not be due to wrong model)

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