INTRODUCTION

DEBRE BERHAN UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS

Solomon Estifanos

MARCH, 2022
DEBRE BERHAN, ETHIOPIA
Outline

Introduction

✓ Definition and Scope of Econometrics

✓ Economic Models and Econometric Models

✓ Methodology of Econometrics

✓ The Sources, Types and Nature of Data

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Definition and Scope of Econometrics

 The economic theories we learn in various economics courses suggest

many relationships among economic variables.

For instance;
 In microeconomics we learn demand and supply models in which
quantities demanded and supplied of a good depend on its price.
 In macroeconomics, we study
✓ Investment function - to explain the amount of aggregate
investment in the economy as the rate of interest changes.
✓ Consumption function - that relates aggregate consumption to the
level of aggregate disposable income etc.
✓ Financial performance function – to explain the factors affecting
financial performance of a given entity.
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Definition Con’t . . .

 Each of such specifications involves a relationship among

economic variables. As economists, we may be interested in

questions such as:
 If one variable changes in a certain magnitude, by how much will

another variable change?

 Also, given that we know the value of one variable; can we

forecast or predict the corresponding value of another?

 The purpose of studying the relationships among economic

variables and attempting to answer questions of the type raised

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here, we need a tool known as econometrics.
Definition Con’t . . .

Thus, Econometrics is defined as;

 A science which deals with the measurements of economic relationship.

 A social science in which tools of economics theory, mathematics, and

statistical inference are applied to the analysis of economic phenomena.

 A science which integrates economic theory, economic statistics, and

mathematical economics to investigate the empirical support of the
general schematic law established by economic theory.

 It is considered as the integration of economics, mathematics, and

statistics for the purpose of providing numerical values for the
parameters of economic relationships and verifying economic theories.

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Econometrics Vs. Mathematical Economics
Mathematical Economics and
Economic Theory Econometrics
There is no essential difference between mathematical  Although econometrics presupposes, the
economics and economic theory. economic relationships to be expressed in
▪ Both state the same relationships, while mathematical forms, it does not assume
exact or deterministic relationship.
economic theory use verbal exposition,
 Econometrics assumes random
mathematical economics uses mathematical
relationships among economic variables.
symbols.
Thus, take into account random
▪ Both express economic relationships in an exact disturbances which relate deviations from
or deterministic form. exact behavioral patterns suggested by
▪ Neither of them allows for random elements economic theory and mathematical
which might affect the relationship and make it economics.
 Econometric methods provide numerical
stochastic.
values of the coefficients of economic
▪ Both of them do not provide numerical values for
relationships.
6 the coefficients of economic relationships.
Econometrics Vs. Statistics
 Econometrics differs from both mathematical statistics and economic statistics.

Economic statistics
✓ It is mainly a descriptive aspect of economics.
✓ It does not provide explanations of the development of the various variables.
✓ It does not provide measurements to coefficients of economic relationships.

Mathematical (or inferential) statistics

✓ It deals with the method of measurement which are developed on the basis
of controlled experiments.

 But the nature of relationships among economic variables are stochastic or

random. Yet the fundamental ideas of inferential statistics are applicable in
econometrics, but they must be adapted to the problem economic life. The
adjustment consists primarily in specifying the stochastic (random) elements that
are supposed to operate in the real world and enter into the determination of the
observed data.
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Economic Models Vs. Econometric Models
 Economic Models: Economic model is an organized set of relationships that
describes the functioning of an economic entity under a set of simplifying
assumptions. All economic reasoning is ultimately based on models. Economic
models consist of the following three basic structural elements.
 A set of variables
 A list of fundamental relationships and
 A number of strategic coefficients
 Econometric Models: besides the above structural elements they contain a random
element.
Example: Economic theory postulates that the demand for a commodity (Q) depends on its
price (P), on the prices of other related commodities (𝑃𝑟 ), on consumers’ income (Y) and on
tastes (T).
Economic Model: 𝑸 = 𝒃𝟎 + 𝒃𝟏 𝑷 + 𝒃𝟐 𝑷𝒓 + 𝒃𝟑 𝒀 + 𝒃𝟒 𝑻
Econometric Model: 𝑸 = 𝒃𝟎 + 𝒃𝟏 𝑷 + 𝒃𝟐 𝑷𝒓 + 𝒃𝟑 𝒀 + 𝒃𝟒 𝑻 + 𝑼
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Where u stands for random factors which affect the quantity demanded.
Methodology of Econometrics

 Econometric research or inquiry generally proceeds along the

following lines/stages.
1) Specification/Formulation of the model
2) Estimation of the model
3) Evaluation of the estimates
4) Evaluation of he forecasting power of the estimated model

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1. Specification/Formulation of the Model

 In this step the target is to express the relationships between economic variables
in mathematical form. This step involves three important tasks:
i) Dependent and independent variables which will be included in the model.
ii) Priori theoretical expectations about the size and sign of the parameters of the function.
iii) The mathematical form of the model (number of equations, specific functional form of the
equations (linear or non-linear), etc.)

 Specification of the econometric model presupposes knowledge of economic

theory and familiarity with the particular phenomenon being studied.

 Specification of the model is the most important and the most difficult stage of
any econometric research. The most common errors of specification are:
a) Omissions of some important variables from the function.
b) The omissions of some equations (for example, in simultaneous equations model).
c) The mistaken mathematical form of the functions.
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2. Estimation of the Model

 This is purely a technical stage which requires knowledge of the various

econometric methods, their assumptions and the economic implications for the
estimates of the parameters. This stage includes the following activities.
a) Gathering of the data on the variables included in the model.
b) Examination of the identification conditions of the function (especially for
simultaneous equations models).
c) Checking for existence of any problems in the data such as aggregations
problems.
d) Examination of the degree of correlation between the explanatory variables
(i.e. examination of the problem of multicollinearity).
e) Choice of appropriate economic techniques for estimation, i.e. to decide a
specific econometric method to be applied in estimation; such as, OLS,
MLM, Logit, Probit, Fixed effect, random effects and so on.
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3. Evaluation of the Estimates
 This stage consists of deciding whether the estimates of the parameters are
theoretically meaningful and statistically satisfactory.
 This stage enables the econometrician to evaluate the results of calculations and
determine the reliability of the results. For this purpose we use various criteria
which may be classified into three groups:
i. Economic a priori criteria - determined by economic theory and refer to the size and sign of
the parameters of economic relationships.
ii. Statistical criteria (first-order tests) - determined by statistical theory and aim at the
evaluation of the statistical reliability of the estimates of the parameters of the model.
Example: Correlation coefficient test, standard error test, t-test, F-test, and R2-test are some
of the most commonly used statistical tests.
iii. Econometric criteria (second-order tests) - aimed at the investigation of whether the
assumptions of the econometric method employed are satisfied or not in any particular case.
The econometric criteria serve to check the reliability of the statistical criteria. Econometric
criteria aim at the detection of the violation or validity of the assumptions of the various
econometric techniques. Example: linearity test, normality test, heteroscedasticity test,
12 autocorrelation test, multicollinearity test, omitted variable test
4. Evaluation of the Forecasting Power of the Model

 It is possible that the model may be economically meaningful and

statistically and econometrically correct for the sample period for which
the model has been estimated; yet it may not be suitable for forecasting
due to various factors (reasons).

 This stage involves;

 Investigating the stability of the estimates and their sensitivity to
changes in the size of the sample.
 Checking whether the estimated function performs adequately
outside the sample of data. i.e. we must test an extra sample
performance the model.
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 Goals of Econometrics

Three main goals of Econometrics;

a) Analysis i.e. testing economic theory. Example: Say’s Law

b) Policy Making i.e. Obtaining numerical estimates of the

coefficients of economic relationships for policy simulations.

c) Forecasting i.e. using the numerical estimates of the

coefficients in order to forecast the future values of economic

magnitudes.

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Nature of Data
Data can be categorized by its nature as;
o Cross-sectional data: data which is collected from different individuals
or entities at a given point of time. It has only space dimension.
𝒀𝒊 = 𝜷𝟎 + 𝜷𝟏 𝑿𝟏𝒊 + 𝜷𝟐 𝑿𝟐𝒊 +. . . +𝜷𝒎 𝑿𝒎𝒊 + 𝑼𝒊

o Times series data: data which is collected from specific individual or

entity over a period of time. It has only time dimension.
𝒀𝒕 = 𝜷𝟎 + 𝜷𝟏 𝑿𝟏𝒕 + 𝜷𝟐 𝑿𝟐𝒕 +. . . +𝜷𝒎 𝑿𝒎𝒕 + 𝑼𝒕
o Panel or longitudinal data: data which is collected from different
individuals or entities over a period of time. It has both space and time
dimensions.
𝒀𝒊𝒕 = 𝜷𝟎 + 𝜷𝟏 𝑿𝟏𝒊𝒕 + 𝜷𝟐 𝑿𝟐𝒊𝒕 +. . . +𝜷𝒎 𝑿𝒎𝒊𝒕 + 𝑼𝒊𝒕

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