What is

econometrics

A short history
of
econometrics

Methodology Econometrics 242

of
econometrics Introduction

Charles Adams

University of the Western Cape

Semester 1, 2022

ECO242 Chapter 0: History and methodology 1/21

 Topics
What is
econometrics

A short history
of
econometrics

Methodology 1 What is econometrics

of
econometrics

2 A short history of econometrics

3 Methodology of econometrics

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 What is econometrics?
What is
econometrics

A short history
of
econometrics Literal meaning 1: Economic measurement
Methodology
of
Literal meaning 2: Finding a model to summarize reality
econometrics
Literal meaning 3: Quantitative analysis of actual economic phenomena
Involving the following:
Economic theory
Mathematics
Statistics
Data
Your computer (Excel/E-Views/Stata/SPSS/R/Python)

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 What is econometrics?
What is
econometrics

A short history
of
econometrics

Methodology
of
econometrics

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 A short history of econometrics
What is
econometrics

A short history
of
econometrics The early years:
Methodology
of
Developed as a separate discipline during the 1930s and 1940s
econometrics Early practitioners: Lawrence Klein and Jan Tinbergen
Early practical application constrained by lack of computing power
Cowles Commission methodology developed during 1950s and 1960s
Starting point: Classical Linear Regression Model; focus on error term assumptions
What to do if the assumptions don’t hold
Endogeneity; measurement error
Focus on fixing the regression results; underlying approach was not questioned

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 A short history of econometrics
What is
econometrics

A short history
The 1960s and 1970s: era of large The 1980s and 1990s: A rethink of
of
econometrics
macro-models. econometric theory and
Methodology e.g. Wharton model in US - 2000 methodology.
of
econometrics equations.
Problems with traditional
BER and Treasury models in RSA.
econometrics: spurious
Used for policy analysis and correlation/regression.
forecasting.
Solution: cointegration
Economic instability of the 1970s
discredited large econometric Lucas critique
models’ forecasting ability.
Solution; micro-foundations,
Similar criticism to economic
structural DSGE models.
methodology arose post GFC.
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 Methodology of econometrics
What is
econometrics

A short history
of
econometrics 1 Statement of theory or hypothesis.
Methodology
of
2 Specification of the mathematical model of the theory.
econometrics
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.

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 Methodology of econometrics: Step 1
What is
econometrics

A short history
of
econometrics

Methodology
of Statement of the theory or hypothesis
econometrics
When (X) increases, consumption (Y ) increases, but the latter increase is not
as much as the former.
That is, the marginal propensity to consume (M P C) is greater than 0 but
smaller than 1.

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 Methodology of econometrics: Step 2
What is
econometrics

A short history
of Mathematical model
econometrics

Methodology Consumption = f (income)

of
econometrics Consumption = β1 + β2 Income [In this case: 0 < β2 < 1]
Consumption is the dependent variable.
Income is the independent or explanatory variable.
β1 and β2 are model parameters.
β1 is the intercept parameter, and β2 is the slope parameter.
The mathematical model implies an exact (deterministic) relationship between
consumption and income.
This is clearly unrealistic.

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 Methodology of econometrics: Step 2
What is
econometrics

A short history
of
econometrics

Methodology
of
econometrics

Mathematical model

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 Methodology of econometrics: Step 3
What is
econometrics

A short history
Econometric model
of
econometrics Relationship between income (X) and consumption (Y ) likely to be inexact.
Methodology
of
Therefore, add an error term (u) to the mathematical model.
econometrics

Consumption = β1 + β2 Income + u

Consumption
\ = β̂1 + β̂2 Income
Residuals (û) = Consumption − Consumption
\
The error term is a random (stochastic) variable that represents factors that
affect consumption but are not taken into account explicitly.
Figure 1.2

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 Methodology of econometrics: Step 4
What is
econometrics

A short history
of
econometrics

Methodology
of
econometrics
Obtain data (usually from a sample)
Time-series (if looking at income vs. consumption in 1981-2000)
Cross-section (if examining income vs. consumption of 1000 employees in
Bellville in 2015)

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 Methodology of econometrics: Step 4
What is
econometrics

A short history
of
econometrics

Methodology
of
econometrics

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 Methodology of econometrics: Step 5
What is
econometrics

A short history
of
econometrics Estimation of the econometric model
Methodology
of Ordinary Least Squares (OLS)
econometrics
Derives estimates of the parameters by minimizing the sum of squared
residuals.
Example Consumption = β1 + β2 Income
Consumption
\ = −0.125 + 0.63Income
What do the parameter values, −0.125 and 0.63 mean?

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 Methodology of econometrics: Step 5
What is
econometrics

A short history
of
econometrics

Methodology
of
econometrics

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 Methodology of econometrics: Step 6
What is
econometrics

A short history
of Hypothesis testing
econometrics

Methodology
Is the (positive) relationship between income and consumption statistically
of significant?
econometrics
Moreover, is the estimated slope parameter statistically different from 1?
Statistical inference: Drawing conclusions about a population, based on a
sample of population
Sample regression line and parameters 6= Population regression line and
parameters
How good is the model?
Over-fitting, under-fitting, functional form, etc.

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 Methodology of econometrics: Step 7
What is
econometrics

A short history
of
econometrics

Methodology
of
Forecasting or prediction
econometrics
Predicting the future value of the dependent variable on the basis of the
known value of the independent variable.
Example Consumption
\ = −0.125 + 0.63Income
If GDP is R5 trillion in 2020, what will consumption expenditure be?

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 Methodology of econometrics: Step 8
What is
econometrics

A short history
of Use of model for control or policy purposes
econometrics

Methodology
If a certain level of Y is targeted, by how much should X be changed?
of
econometrics Example: Government wants to raise consumption expenditure to R2 trillion in
order to increase employment levels.

(2) = −0.125 + 0.63Income

Income = R3.373 trillion

GDP of R3.373 trillion required to raise consumption expenditure to R2
trillion.

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 Your econometrics road map
What is
econometrics Basic concepts (2nd year) Advanced (3rd year)
A short history
of Chapter 0: Introduction Chapter 7: Multivariate regression:
econometrics
Chapter 1: Nature of regression Estimation
Methodology
of
econometrics Appendix A: Review of stats Chapter 8: Multivariate regression:
Inference
Chapter 2: Bivariate model: basics
Chapter 9: Dummy variables in
Chapter 3: Problem of estimation
regression
Chapter 4: Classical Normal model
Chapter 10: Multicollinearity
Chapter 5: Bivariate model:
Chapter 11: Heteroscedasticity
Inference
Chapter 12: Autocorrelation
Chapter 6: Extensions of bivariate
model Chapter 13: Model specification and
testing
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What is
econometrics

A short history
of
econometrics

Methodology
of
econometrics

End!

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 Example of econometrics work being done today
What is
econometrics

A short history
of
econometrics

Methodology
of
econometrics

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