ECON320321-ECONOMETRICS

lecture 01

Introduction to Econometrics

M. Rashika Sanjeewani.
BBA (B. Economics), MSc ( B.statistics)
 WHAT IS ECONOMETRICS
• Econometrics consists of the application of
mathematical statistics to economic data to
lend empirical support to the models
constructed by mathematical economics and
to obtain numerical results.
• Econometrics may be defined as the
quantitative analysis of actual economic
phenomena based on the concurrent
development of theory and observation,
related by appropriate methods of inference.

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What is Econometrics?

Econometrics
Economics

Statistics Mathematics

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 WHY ECONOMETRICS HAS A
SEPARATE DISCIPLINE?
• Economic theory makes statements or
hypotheses that are mostly qualitative in
nature.
Eg:- microeconomics theory states that,
other things remaining the same, a
reduction in the price of a commodity is
expected to increase the quantity
demanded of a commodity.
• Thus, economic theory postulates a
negative or inverse relationship between 4
WHY ECONOMETRICS HAS A SEPARATE
DISCIPLINE? (count…
• 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 the econometrician to provide
such numerical estimates.
• Stated differently, econometrics gives
empirical content to most economic theory.
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WHY ECONOMETRICS HAS A SEPARATE
DISCIPLINE? (count…
• The main concern of mathematical economics is
to express economic theory in mathematical
form without regard to measurability or
empirical verification of the theory.

• Econometrics, are mainly interested in the

empirical verification of economic theories.

• The econometrician often uses the mathematical

equations proposed by the mathematical
economist but puts these equations in such a
form that they lend themselves to empirical
testing.
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WHY ECONOMETRICS HAS A SEPARATE
DISCIPLINE? (count…
• Economic statistics is mainly concerned with
collecting, processing, and presenting economic
data in the form of charts and tables. These are the
job of the economic statistician
• 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.

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 METHODOLOGY OF
ECONOMETRICS
• How do econometricians proceed in their
analysis of an economic problem?
• Traditional econometric methodology proceeds
1. Statement of theory or hypothesis.
2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric, model
4. Collecting 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.
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 METHODOLOGY OF ECONOMETRICS
(count…..)
1. Statement of Theory or Hypothesis
• Keynes states that on average, consumers increase their
consumption as their income increases, but not as much
as the increase in their income (MPC < 1).

2. Specification of the Mathematical Model of

Consumption
Development
Y = β0+ β1X 0 < β1 < 1

Y = consumption expenditure and (dependent variable)

X = income, (independent, or explanatory variable)
β0 = the intercept
β1 = the slope coefficient

• The slope coefficient β1 measures the MPC.

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• Geometrically,

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3. Specification of the Econometric Model of
Consumption
• The relationships between economic variables are
generally inexact. In addition to income, other
variables affect consumption expenditure. For
example, 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, equation is modified as follows:

Y = β0 + β1X + u

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The disturbance, or error, term (u)

• where u, known as the disturbance, or error,

term, is a random (stochastic) 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.

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 METHODOLOGY OF ECONOMETRICS
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• Y = β0 + β1X + u is an example of a linear regression
model, i.e., it hypothesizes that Y is linearly related to X,
but that the relationship between the two is not exact; it is
subject to individual variation. The econometric model
above can be depicted as follow,

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4. Obtaining Data
• To obtain the numerical values of β1 and β2, we need data. Look at
Table below which relate to the personal consumption expenditure
(PCE) and the gross domestic product (GDP). The data are in “real”
terms.

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The data are plotted in Figure I.3

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5. Estimation of the Econometric Model
Regression analysis is the main tool used to obtain the
estimates. Using this technique and the data given
in Table . we obtain the following estimates of β0 and
β1, namely, −184.08 and 0.7064. Thus, the estimated
consumption function is:

Yˆ = −184.08 + 0.7064Xi

• The estimated regression line is shown in Figure The

regression line fits the data quite well. The slope
coefficient (i.e., the MPC) was about 0.70, an
increase in real income of 1 dollar led, on average, to
an increase of about 70 cents in real consumption.
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 METHODOLOGY OF ECONOMETRICS
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6. Test statement or Hypothesis.
• That is to find out whether the estimates
obtained in, are in accord with the expectations
of the theory that is being tested.
• Keynes expected the MPC to be positive but less
than 1. In our example we found the MPC to be
about 0.70.
• Such confirmation or refutation of economic
theories on the basis of sample evidence is based
on a branch of statistical theory known as
statistical inference (hypothesis testing).
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7. Forecasting or Prediction
• To illustrate, suppose we want to predict the mean
consumption expenditure for 1997. The GDP value for
1997 was 7269.8 billion dollars consumption would be:

Yˆ1997 = −184.0779 + 0.7064 (7269.8) = 4951

• The actual value of the consumption expenditure

reported in 1997 was 4913.5 billion dollars. The
estimated model thus over-predicted the actual
consumption expenditure by about 37.82 billion dollars.
We could say the forecast error is about 37.8 billion
dollars, which is about 0.76 percent of the actual GDP
value for 1997.

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 METHODOLOGY OF ECONOMETRICS
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• Suppose that, as a result of the proposed policy
change, investment expenditure increases. What
will be the effect on the economy?

• As macroeconomic theory shows, the change in

income following, a dollar’s worth of change in
investment expenditure is given by the income
multiplier M, which is defined as:

M = 1/(1 − MPC)

• The multiplier is about M = 3.33. That is, an increase

(decrease) of a dollar in investment will eventually lead
to more than a threefold increase (decrease) in
income; note that it takes time for the multiplier to
work.
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 METHODOLOGY OF ECONOMETRICS
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8. Use of the Model for Control or Policy Purposes
• Suppose further the government believes that consumer
expenditure of about 4900 will keep the unemployment rate
at its current level of about 4.2%. What level of income will
guarantee the target amount of consumption expenditure?

4900 = −184.0779 + 0.7064X

• An estimated model may be used for control, 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.

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Summarizes the anatomy of classical
econometric modeling

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 Types of econometrics

• It can be divided in to two categories as

follow,
1. Theoretical econometrics

2. Applied Econometrics

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 The role of the computer

• Some regression packages which have

most of the econometrics techniques are,

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 Types of Data
• Data are often discussed in terms of
variables, where a variable is:
Any characteristic that varies from one
member of a population to another.
• A simple example is height in centimeters,
which varies from person to person.

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• There are two basic types of variables:
numerical and categorical variables.

• Numerical Variables: variables to which a

number is assigned as a quantitative
value.

• Categorical Variables: variables defined

by the classes or categories into which an
individual member falls.

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 Types of Numerical variables
• Discrete: Reflects a number obtained by
counting—no decimal.
• Continuous: Reflects a measurement; the number
of decimal places depends on the precision of the
measuring device.
• Ratio scale: Order and distance implied.
Differences can
be compared; has a true zero. Ratios can be
compared.
Examples: Height, weight, blood pressure
• Interval scale: Order and distance implied.
Differences
can be compared; no true zero. Intervals cannot be
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compared.
 Categorical Variables
Defined by the classes or categories into which
an individual member falls.

• Nominal Scale: Name only--Gender,

hair color, ethnicity

• Ordinal Scale: Nominal categories with

an implied order--Low, medium, high.

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 Parametric and Non Parametric
Techniques
• Parametric Techniques
– Assumed that population is normally
distributed.
– Have continuous data

o Pearson correlation
o Independent sample t- test
o Paired sample t- test
o One way ANOVA

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• Non –parametric tech,
– Assume that population is not normally
distributed.
– Categorical data are applied

o Spearmen correlation
o Chi-squar analysis
o Mann-whitney U test
o Kruskal wallis test.
o Wilcoxon Rank test

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 Parameters Vs Statistics
• The measurement which are calculated
with regard to the population are called
parameters.

• Measurements with regards to samples

are called Statistics.

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 Estimation
• Making statements about a population by
examining sample results/ inferencing
population parameters using sample
statistics.
Sample statistics Population parameters
(known) Inference
(unknown, but can
be estimated from
sample evidence)

Sample Population
Size of the sample

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 Method of sampling
• There are two types of sampling methods,
1. Random/probability Sampling
techniques

2. Non- Random /non probability Sampling

Techniques.
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 Normal Distribution and Standard
Distribution
Normal Distribution
• It is the most important family of continuous
probability distribution in statistics which is
widely applicable in all field.
• The distribution is defined by two parameters
namely,

• The normal distribution is known as the

Gaussian Distribution and is denoted by,

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 Characteristics of normal distribution
• Frequency curve is symmetric
• It has bell shaped
• Two tails are very close to X axis but not
tangent.
• Mean, mode and medium will be equal.
• It has s function, (PDF):

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 Standard normal distribution
• In general all normal random variables are
converted to standard normal.
• It can be shown that,

• The distribution function of a general

normal distribution is given by,

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 Confidence & Significance
• Population parameter will exist in a range
according to some probability.
• That region is called confidence level.
upper and lower boundaries are called as
confidence limits. The probability is called
confidence co-efficient.
• The balance pert is called as significant
level.

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 Intervals and Level of Confidence
Sampling Distribution of the Mean

/2 1−  /2
x
Intervals μx = μ
extend from x1
σ x2 100(1-)%
x−z of intervals
n
to constructed
σ contain μ;
x+z
n 100()% do
Confidence not.
Intervals
Critical Points & Values
• The value this separate confidence level
from the significant level is called as
critical value.
• The values are obtained from the standard
tables. Such as

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 Critical Value /Finding z/2
• Consider a 95% confidence interval:

1 −  = .95

α α
= .025 = .025
2 2

Z units: z = -1.96 0 z = 1.96

Lower Upper
X units: Confidence Confidence
Limit Limit

➢ Find z.025 = 1.96 from the standard normal

distribution table
Critical Values:
Confidence Level Confidence coefficient Critical value

80%
90%
95%
98%
99%
 Degree of Freedom (df)
• the degrees of freedom are used to define the
number of independent quantities that can be
assigned to a statistical distribution.
• This number typically refers to a positive whole
number that indicates the lack of restrictions on
a person's ability to calculate missing factors
from statistical problems.
df for one sample :

df for 2 samples :

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