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Chapter One

Econometrics is the application of statistical methods and mathematical models to economic data in order to test economic theories and hypotheses. It combines economic theory, statistics, and mathematics. Econometric models are used to estimate relationships between economic variables and make predictions using real-world data. Econometricians first develop an economic theory or hypothesis, then build an econometric model to test the theory using statistical techniques like regression analysis on collected data. The goals of econometrics are to analyze economic theories, inform policymaking, and enable forecasting. Econometric data can come from various sources and be in different forms, including time series, cross-sectional, panel, pooled, and censored/truncated data.

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167 views5 pages

Chapter One

Econometrics is the application of statistical methods and mathematical models to economic data in order to test economic theories and hypotheses. It combines economic theory, statistics, and mathematics. Econometric models are used to estimate relationships between economic variables and make predictions using real-world data. Econometricians first develop an economic theory or hypothesis, then build an econometric model to test the theory using statistical techniques like regression analysis on collected data. The goals of econometrics are to analyze economic theories, inform policymaking, and enable forecasting. Econometric data can come from various sources and be in different forms, including time series, cross-sectional, panel, pooled, and censored/truncated data.

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Habtamu Bore
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER ONE: INTRODUCTION TO ECONOMETRICS

1.1 Definition and Scope of Econometrics

 Econometrics is the application of statistical methods and mathematical models to economic data in
order to provide empirical evidence for economic theories, test hypotheses, and make predictions about
economic phenomena.
 Econometrics is a quantitative discipline that combines economic theory, statistical analysis, and
mathematical modeling to study and understand the relationships between economic variables and make
informed decisions based on data-driven evidence.
 It is the intersection of economics, statistics, and mathematics, where statistical techniques are applied to
economic data to estimate and quantify the relationships between economic variables and to analyze
economic phenomena.
 It is the field of study that bridges the gap between economic theory and real-world data, using statistical
tools to analyze and interpret the complex interactions and dynamics of economic systems.
 It is the discipline that employs statistical methods to extract meaningful insights from economic data,
enabling economists to make informed policy recommendations, evaluate the effectiveness of
interventions, and gain a deeper understanding of economic behavior.

Why a Separate Discipline?


 Economic theory: is a simplified representation of economic reality as the world.
 Economic theory makes statements that are mostly qualitative in nature. E.g demand theory.
 Economic theory uses verbal exposition while econometrics gives empirical content to most
economic theory. Therefore econometrics is a field of study which used to evaluate and verify
economic theories in empirical terms.
 Mathematical Economics: express economic theory in mathematical form without empirical
verification of the theory, (use mathematical symbols).
 While econometrics is mainly interested in the empirical verification of the theory.
 Economic Statistics is mainly concerned with collecting, processing and presenting economic
data. It does not being concerned with using the collected data to test economic theories.
 Mathematical statistics provides many of tools for economic studies, but econometrics supplies
the economic studies with many special methods of quantitative analysis based on economic data.
 In short both mathematical economics and economic theory express economic relationships
in an exact or deterministic form. Neither mathematical economics nor economic theory
allows for random elements which might affect the relationship and make it stochastic.
Econometrics Lecture Note By Tamirat M. (MA) 1|Page
Furthermore, they do not provide numerical values for the coefficients of economic
relationships.
 However, Econometrics differs from other discipline in that; it does not assume exact or
deterministic relationship.
 Furthermore, econometric methods provide numerical values of the coefficients of
economic relationships.
In general Econometrics:
 use economic theories, mathematical economics and economic statistics empirical
measure presuppose economic relationship can be deterministic and random provide
empirical value of the coefficient of the relationship can be used to infer relationship among
variables.

1.2 Economic Model Vs Econometrics Model

1. Economic Model: An economic model is a simplified representation of real-world economic


relationships and phenomena. It is a theoretical framework that economists use to analyze and
understand how various factors interact and influence economic outcomes. Economic models are often
based on assumptions and mathematical or statistical techniques to describe economic behavior. They can
be used to study a wide range of economic issues, such as supply and demand, market equilibrium,
production and consumption decisions, economic growth, and more. Economic models are primarily
focused on theory and understanding the underlying economic mechanisms.

2. Econometric Model: Econometrics is a branch of economics that combines economic theory,


mathematics, and statistical methods to analyze and quantify economic relationships. Econometric models
are used to estimate and test economic theories and hypotheses using real-world data. These models
involve the application of statistical techniques to data to estimate the relationships between various
economic variables. Econometric models can be used for forecasting, policy analysis, and evaluating the
impact of specific interventions or events on the economy. They are more empirical in nature, as they rely
on data and statistical analysis to make predictions and draw conclusions.

In summary, an economic model is a theoretical framework used to understand economic phenomena


and relationships, while an econometric model is a statistical model that uses data to estimate and test
economic theories. Economic models are more focused on theory and understanding, while econometric
models are more empirical and data-driven. However, there is often an overlap between the two, as
econometric models are often based on economic theories and assumptions.

Econometrics Lecture Note By Tamirat M. (MA) 2|Page


1.3 Methodology of Econometrics

How do Econometricians proceed in their analysis of an economic problem?


1) Economic Theory/ Statement of theory/Hypothesis – formulating research question
2) Mathematical Model of Theory (e.g Y=A*K^a*L^(1-a), Y=C+G+I+NX)
3) Econometric Model of Theory

In a linear regression model, the relationship between a dependent variable (Y) and one or more
independent variables (X₁, X₂, ..., Xₙ) is expressed as:

Y = β₀ + β₁X₁ + β₂X₂ + ... + βₙXₙ + ε where:

- Y is the dependent variable (also known as the response variable or the endogenous variable).

- X₁, X₂, ..., Xₙ are the independent variables (also known as explanatory variables, predictors, or
regressors).

- β₀, β₁, β₂, ..., βₙ are the coefficients (also known as the regression coefficients or parameters) that
represent the relationship between the dependent variable and independent variables.

- ε is the error term (also known as the residual or disturbance), representing the unobserved factors that
affect the dependent variable but are not captured by the independent variables.

The coefficients β₀, β₁, β₂, ..., βₙ are estimated using statistical techniques such as ordinary least squares
(OLS) estimation.
4) Data collection
5) Estimation of Econometric Model
6) Hypothesis Testing
7) Forecasting or Prediction
8) Using the Model for control or policy purposes

Goals of Econometrics
Three main goals of Econometrics are:
a. Analysis i.e. testing economic theory

b. Policy making i.e. Obtaining numerical estimates of the coefficients of economic relationships for policy
simulations.

Econometrics Lecture Note By Tamirat M. (MA) 3|Page


c. Forecasting i.e. using the numerical estimates of the coefficients in order to forecast the future values of
economic magnitudes.

1.4. The Source and Type of Econometric Data


 Why need to study types of data?
 Applications of econometric model differ depend on data.
A. sources of data
 The data used in empirical analysis may be collected by a governmental agency, an international agency
(e.g., (IMF), a private organization or an individual.
Household (utility, consumption, saving etc.)
firms( production , profit, costs, etc)
government( government expenditure, public finance, etc) things like commodities Export and import.

B. Types of Data
 Cross-Sectional Data
 Time Series Data
 Pooled Data
 Panel Data

1. Time series data: Time series data consists of observations collected over time at regular intervals.
It is commonly used in econometrics to analyze and forecast economic variables such as GDP, inflation
rates, stock prices, and interest rates. Time series data often exhibits temporal dependencies, such as
trends, seasonality, and autocorrelation.

2. Cross-sectional data: Cross-sectional data refers to data collected at a specific point in time for
multiple individuals, firms, or other units of analysis. It provides information about different entities at a
particular time and is commonly used to study relationships between variables, such as the impact of
education on income by comparing individuals with different levels of education.

3. Panel data: Panel data, also known as longitudinal data or panel series, combines elements of both
time series and cross-sectional data. It involves observations on multiple individuals, firms, or other units
of analysis over time. Panel data allows for the examination of both the cross-sectional and temporal
dimensions of the data, enabling researchers to analyze individual and time-specific effects.

Econometrics Lecture Note By Tamirat M. (MA) 4|Page


4. Pooled data: Pooled data refers to combining data from different sources or time periods into a single
dataset. It is often used when the individual datasets are similar in nature and can be merged to increase
the sample size and improve statistical efficiency.

5. Censored or truncated data: Censored or truncated data arises when the values of a variable are
partially or completely unobserved due to some limitations or restrictions. Censored data occurs when the
variable is observed up to a certain threshold, while truncated data occurs when observations are missing
beyond a certain point. Special econometric techniques, such as Tobit models or Heckman selection
models, are often employed to handle censored or truncated data.

Review questions
 How would you define econometrics?
 How does it differ from mathematical economics and statistics?
 Describe the main steps involved in any econometrics research.
 Differentiate between economic and econometric model.
 What are the goals of econometrics?
 Differentiate types of econometrics data

Econometrics Lecture Note By Tamirat M. (MA) 5|Page

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