CHAPTER ONE

1.1 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 the 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; and ‘consumption
function’ that relates aggregate consumption to the level of aggregate disposable income.

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 here, is to help us understood the real economic world
we live in.
However, economic theories that postulate the relationships between economic variables
have to be checked against data obtained from the real world. If empirical data verify the
relationship proposed by economic theory, we accept the theory as valid. If the theory is
incompatible with the observed behavior, we either reject the theory or in the light of the
empirical evidence of the data, modify the theory. To provide a better understanding of
economic relationships and a better guidance for economic policy making we also need
to know the quantitative relationships between the different economic variables. We
obtain these quantitative measurements taken from the real world. The field of
knowledge which helps us to carry out such an evaluation of economic theories in
empirical terms is econometrics.
WHAT IS ECONOMETRICS?
Literally interpreted, econometrics means “economic measurement”, but the scope of
econometrics is much broader as described by leading econometricians. Various
econometricians used different ways of wordings to define econometrics. But if we distill
the fundamental features/concepts of all the definitions, we may obtain the following
definition.
“Econometrics is the 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 a special type of economic analysis and
research in which the general economic theories, formulated in mathematical terms, is
combined with empirical measurements of economic phenomena. Starting from the
relationships of economic theory, we express them in mathematical terms so that they can
be measured. We then use specific methods, called econometric methods in order to
obtain numerical estimates of the coefficients of the economic relationships.”
Measurement is an important aspect of econometrics. However, the scope of
econometrics is much broader than measurement. As D.Intriligator rightly stated the
“metric” part of the word econometrics signifies ‘measurement’, and hence econometrics
is basically concerned with measuring of economic relationships. In short, econometrics
may be 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.

1.2 Econometrics vs. mathematical economics

Mathematical economics states economic theory in terms of mathematical symbols.
There is no essential difference between mathematical economics and economic theory.
Both state the same relationships, but while economic theory use verbal exposition,
mathematical symbols. Both 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. Furthermore, they do not
provide numerical values for the coefficients of economic relationships.

Econometrics differs from mathematical economics in that, although econometrics

presupposes, the economic relationships to be expressed in mathematical forms, it does
not assume exact or deterministic relationship. Econometrics assumes random
relationships among economic variables. Econometric methods are designed to take into
account random disturbances which relate deviations from exact behavioral patterns
suggested by economic theory and mathematical economics.

1.3 Econometrics vs. statistics

Econometrics differs from both mathematical statistics and economic statistics. An
economic statistician gathers empirical data, records them, tabulates them or charts them,
and attempts to describe the pattern in their development over time and perhaps detect
some relationship between various economic magnitudes. Economic statistics is mainly a
descriptive aspect of economics. It does not provide explanations of the development of
the various variables and it does not provide measurements the coefficients of economic
relationships.

Mathematical (or inferential) statistics deals with the method of measurement which are
developed on the basis of controlled experiments. But statistical methods of
measurement are not appropriate for a number of economic relationships because for
most economic relationships controlled or carefully planned experiments cannot be
designed due to the fact that 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.
1.4 Economic models vs. econometric models
i) Economic models:
Any economic theory is an observation from the real world. For one reason, the immense
complexity of the real world economy makes it impossible for us to understand all
interrelationships at once. Another reason is that all the interrelationships are not equally
important as such for the understanding of the economic phenomenon under study. The
sensible procedure is therefore, to pick up the important factors and relationships relevant
to our problem and to focus our attention on these alone. Such a deliberately simplified
analytical framework is called on economic model. It is an organized set of relationships
that describes the functioning of an economic entity under a set of simplifying
assumptions.
ii) Econometric models:
The most important characteristic of economic relationships is that they contain a random
element which is ignored by mathematical economic models which postulate exact
relationships between economic variables.
1.5 Methodology of econometrics
Econometric research is concerned with the measurement of the parameters of economic
relationships and with the predication of the values of economic variables. The
relationships of economic theory which can be measured with econometric techniques are
relationships in which some variables are postulated as causes of the variation of other
variables. Starting with the postulated theoretical relationships among economic
variables, econometric research or inquiry generally proceeds along the following
lines/stages.
1. Specification the model
2. Estimation of the model
3. Evaluation of the estimates
4. Evaluation of the forecasting power of the estimated model
1. Specification of the model
In this step the econometrician has to express the relationships between economic
variables in mathematical form. This step involves the determination of three important
tasks:
i) The dependent and independent (explanatory) variables which will be included in
the model.
ii) The a 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 form of the
equations, etc.)
Note: The specification of the econometric model will be based on economic theory and
on any available information related to the phenomena under investigation. Thus,
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. It is often the weakest point of most econometric applications. In
this stage there exists enormous degree of likelihood of committing errors or incorrectly
specifying the model. Some of the common reasons for incorrect specification of the
econometric models are:
1. The imperfections, looseness of statements in economic theories.
2. The limitation of our knowledge of the factors which are operative in any
particular case.
3. The formidable obstacles presented by data requirements in the estimation of
large models.
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.

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. Examination of the aggregations problems involved in the variables of the
function.
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, and
Probit.
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: These criteria are determined by economic theory and
refer to the size and sign of the parameters of economic relationships.
ii. Statistical criteria (first-order tests): These are determined by statistical theory
and aim at the evaluation of the statistical reliability of the estimates of the
parameters of the model. 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):
These are set by the theory of econometrics and aim at the investigation of whether the
assumptions of the econometric method employed are satisfied or not in any particular
case. The econometric criteria serve as a second order test (as test of the statistical tests)
i.e. they determine the reliability of the statistical criteria; they help us establish whether
the estimates have the desirable properties of biasedness, consistency etc. Econometric
criteria aim at the detection of the violation or validity of the assumptions of the various
econometric techniques.
4) Evaluation of the forecasting power of the model:
Forecasting is one of the aims of econometric research. However, before using an
estimated model for forecasting by some way or another the predictive 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).
Therefore, this stage involves the investigation of the stability of the estimates and their
sensitivity to changes in the size of the sample. Consequently, we must establish whether
the estimated function performs adequately outside the sample of data. i.e. we must test
an extra sample performance the model.

1.6 Desirable properties of an econometric model

An econometric model is a model whose parameters have been estimated with some
appropriate econometric technique. The ‘goodness’ of an econometric model is judged
customarily according to the following desirable properties.
1. Theoretical plausibility. The model should be compatible with the postulates of
economic theory. It must describe adequately the economic phenomena to which
it relates.
2. Explanatory ability. The model should be able to explain the observations of he
actual world. It must be consistent with the observed behavior of the economic
variables whose relationship it determines.
3. Accuracy of the estimates of the parameters. The estimates of the coefficients should
be accurate in the sense that they should approximate as best as possible the true
parameters of the structural model. The estimates should if possible possess the
desirable properties of biasedness, consistency and efficiency.
4. Forecasting ability. The model should produce satisfactory predictions of future
values of he dependent (endogenous) variables.
5. Simplicity. The model should represent the economic relationships with maximum
simplicity. The fewer the equations and the simpler their mathematical form, the
better the model is considered, ceteris paribus (that is to say provided that the other
desirable properties are not affected by the simplifications of the model).
1.7 Goals of Econometrics
Three main goals of Econometrics are identified:
i) Analysis i.e. testing economic theory
ii) Policy making i.e. Obtaining numerical estimates of the coefficients of economic
relationships for policy simulations.
iii) Forecasting i.e. using the numerical estimates of the coefficients in order to
forecast the future values of economic magnitudes.
 CHAPTER TWO
THE CLASSICAL REGRESSION ANALYSIS
[The Simple Linear Regression Model]
Economic theories are mainly concerned with the relationships among various economic
variables. These relationships, when phrased in mathematical terms, can predict the effect
of one variable on another. The functional relationships of these variables define the
dependence of one variable upon the other variable (s) in the specific form. The specific
functional forms may be linear, quadratic, logarithmic, exponential, hyperbolic, or any
other form. A simple linear regression model, i.e. a relationship between two variables
related in a linear form. i.e. stochastic and non-stochastic, among which we shall be
using the former in econometric analysis.
2.1. Stochastic and Non-stochastic Relationships
A relationship between X and Y, characterized as Y = f(X) is said to be deterministic or
non-stochastic if for each value of the independent variable (X) there is one and only one
corresponding value of dependent variable (Y). On the other hand, a relationship
between X and Y is said to be stochastic if for a particular value of X there is a whole
probabilistic distribution of values of Y. In such a case, for any given value of X, the
dependent variable Y assumes some specific value only with some probability.
The derivation of the observation from non-stochastic the line may be attributed to
several factors.
a. Omission of variables from the function
b. Random behavior of human beings
c. Imperfect specification of the mathematical form of the model
d. Error of aggregation
e. Error of measurement
In order to take into account the above sources of errors we introduce in econometric
functions a random variable which is usually denoted by the letter ‘u’ or ‘ ’ and is called
error term or random disturbance or stochastic term of the function, so called be cause u
is supposed to ‘disturb’ the exact linear relationship which is assumed to exist between X
and Y. By introducing this random variable in the function the model is rendered
stochastic of the form:
 ……………………………………………………….(2.2)
Thus a stochastic model is a model in which the dependent variable is not only
determined by the explanatory variable(s) included in the model but also by others which
are not included in the model.
2.2. Simple Linear Regression model.
The above stochastic relationship (2.2) with one explanatory variable is called simple
linear regression model.
The true relationship which connects the variables involved is split into two parts:
A part represented by a line and a part represented by the random term ‘u’.

The scatter of observations represents the true relationship between Y and X. The line
represents the exact part of the relationship and the deviation of the observation from the
line represents the random component of the relationship. Were it not for the errors in the
model, we would observe all the points on the line corresponding to
. However because of the random disturbance, we observe
corresponding to . These points diverge from the
regression line by .

The first component in the bracket is the part of Y explained by the changes in X and the
second is the part of Y not explained by X, that is to say the change in Y is due to the
random influence of .
2.2.1 Assumptions of the Classical Linear Stochastic Regression Model.
The classical made important assumptions in their analysis of regression .The most
important of these assumptions are discussed below.
1. The model is linear in parameters.
The classical assumed that the model should be linear in the parameters regardless of
whether the explanatory and the dependent variables are linear or not. This is because if
the parameters are non-linear it is difficult to estimate them since their value is not known
but you are given with the data of the dependent and independent variable.
2. Ui is a random real variable
This means that the value which u may assume in any one period depends on chance; it
may be positive, negative or zero. Every value has a certain probability of being assumed
by u in any particular instance.
3. The mean value of the random variable(U) in any particular period is zero
This means that for each value of x, the random variable(u) may assume various
values, some greater than zero and some smaller than zero, but if we considered all
the possible and negative values of u, for any given value of X, they would have on
average value equal to zero. In other words the positive and negative values of u
cancel each other. Mathematically,
4. The variance of the random variable(U) is constant in each period (The
assumption of homoscedasticity)
For all values of X, the u’s will show the same dispersion around their mean. This
constant variance is called homoscedasticity assumption and the constant variance itself
is called homoscedastic variance.
5. .The random variable (U) has a normal distribution
This means the values of u (for each x) have a bell shaped symmetrical distribution about
their zero mean and constant variance , i.e.


6. The random terms of different observations are independent. (The

assumption of no autocorrelation)
This means the value which the random term assumed in one period does not depend on
the value which it assumed in any other period.
7. The are a set of fixed values in the hypothetical process of repeated
sampling which underlies the linear regression model.
This means that, in taking large number of samples on Y and X, the values are the
same in all samples, but the values do differ from sample to sample, and so of course
do the values of .
8. The random variable (U) is independent of the explanatory variables.
This means there is no correlation between the random variable and the explanatory
variable.
9. The explanatory variables are measured without error
U absorbs the influence of omitted variables and possibly errors of measurement in the
y’s. i.e., we will assume that the regressors are error free, while y values may or may not
include errors of measurement.
2.2.2 Methods of estimation
Specifying the model and stating its underlying assumptions are the first stage of any
econometric application. The next step is the estimation of the numerical values of the
parameters of economic relationships. The parameters of the simple linear regression
model can be estimated by various methods. Three of the most commonly used methods
are:
1. Ordinary least square method (OLS)
2. Maximum likelihood method (MLM)
3. Method of moments (MM)
But, here we will deal with the OLS and the MLM methods of estimation.
2.2.2.1 The ordinary least square (OLS) method
The model is called the true relationship between Y and X because Y
and X represent their respective population value, and are called the true
parameters since they are estimated from the population value of Y and X But it is
difficult to obtain the population value of Y and X because of technical or economic
reasons. So we are forced to take the sample value of Y and X. The parameters estimated
from the sample value of Y and X are called the estimators of the true parameters
and are symbolized as .
The model , is called estimated relationship between Y and X since
are estimated from the sample of Y and X and represents the sample
counterpart of the population random disturbance .
Estimation of by least square method (OLS) or classical least square (CLS)
involves finding values for the estimates which will minimize the sum of
square of the squared residuals ( ).

From the estimated relationship , we obtain:

……………………………(2.3)

……………………….(2.4)
To find the values of that minimize this sum, we have to partially differentiate
with respect to and set the partial derivatives equal to zero.
1.

Rearranging this expression we will get: ……(2.6)

If you divide (2.9) by ‘n’ and rearrange, we get

2.

Note: . Hence it is possible to rewrite as and .

It follows that;
and

……………………………………….(2.10)
Equations are called the Normal Equations. After certain step we get:
 2
= ( )

………………….(2.11)

Equation (2.11) can be rewritten in somewhat different way and arrived final steps are :-

Now, denoting as , and as we get;

……………………………………… (2.12)

The expression in (2.12) to estimate the parameter coefficient is termed is the formula in
deviation form.
2.2.2.2 Estimation of a function with zero intercept
Suppose it is desired to fit the line , subject to the restriction To
estimate , the problem is put in a form of restricted minimization problem and then
Lagrange method is applied.

We minimize:

Subject to:
The composite function then becomes
where is a Lagrange multiplier.
We minimize the function with respect to

Substituting (iii) in (ii) and rearranging we obtain:

 ……………………………………..(2.13)

This formula involves the actual values (observations) of the variables and not their
deviation forms, as in the case of unrestricted value of .

2.2.2.3. Statistical Properties of Least Square Estimators

There are various econometric methods with which we may obtain the estimates of the
parameters of economic relationships. We would like to an estimate to be as close as the
value of the true population parameters i.e. to vary within only a small range around the
true parameter. How are we to choose among the different econometric methods, the one
that gives ‘good’ estimates? We need some criteria for judging the ‘goodness’ of an
estimate.
‘Closeness’ of the estimate to the population parameter is measured by the mean and
variance or standard deviation of the sampling distribution of the estimates of the
different econometric methods. We assume the usual process of repeated sampling i.e. we
assume that we get a very large number of samples each of size ‘n’; we compute the
estimates ’s from each sample, and for each econometric method and we form their
distribution. We next compare the mean (expected value) and the variances of these
distributions and we choose among the alternative estimates the one whose distribution is
concentrated as close as possible around the population parameter.
PROPERTIES OF OLS ESTIMATORS
The ideal or optimum properties that the OLS estimates possess may be summarized by
well known theorem known as the Gauss-Markov Theorem.
Statement of the theorem: “Given the assumptions of the classical linear regression
model, the OLS estimators, in the class of linear and unbiased estimators, have the
minimum variance, i.e. the OLS estimators are BLUE.
According to the theorem, under the basic assumptions of the classical linear regression
model, the least squares estimators are linear, unbiased and have minimum variance (i.e.
are best of all linear unbiased estimators). Sometimes the theorem referred as the BLUE
theorem i.e. Best, Linear, and Unbiased Estimator. An estimator is called BLUE if:
 a. Linear: a linear function of the random variable, such as, the dependent
variable Y.
b. Unbiased: its average or expected value is equal to the true population
parameter.
c. Minimum variance: It has a minimum variance in the class of linear and
unbiased estimators. An unbiased estimator with the least variance is known
as an efficient estimator.
According to the Gauss-Markov theorem, the OLS estimators possess all the BLUE
properties. The detailed proof of these properties are presented below
The variance of the random variable (Ui)
Dear student! You may observe that the variances of the OLS estimates involve ,
which is the population variance of the random disturbance term. But it is difficult to
obtain the population data of the disturbance term because of technical and economic
reasons. Hence it is difficult to compute ; this implies that variances of OLS estimates
are also difficult to compute. But we can compute these variances if we take the unbiased
estimate of which is computed from the sample value of the disturbance term e i
from the expression:

…………………………………..2.14

2.2.2.4. Statistical test of Significance of the OLS Estimators

(First Order tests)
After the estimation of the parameters and the determination of the least square
regression line, we need to know how ‘good’ is the fit of this line to the sample
observation of Y and X, that is to say we need to measure the dispersion of observations
around the regression line. This knowledge is essential because the closer the
observation to the line, the better the goodness of fit, i.e. the better is the explanation of
the variations of Y by the changes in the explanatory variables.
We divide the available criteria into three groups: the theoretical a priori criteria, the
statistical criteria, and the econometric criteria. Under this section, our focus is on
statistical criteria (first order tests). The two most commonly used first order tests in
econometric analysis are:
1) The coefficient of determination (the square of the correlation coefficient i.e. R 2).
This test is used for judging the explanatory power of the independent variable(s).
2) The standard error tests of the estimators. This test is used for judging the statistical
reliability of the estimates of the regression coefficients.

TESTS OF THE ‘GOODNESS OF FIT’ WITH R2

R2 shows the percentage of total variation of the dependent variable that can be explained
by the changes in the explanatory variable(s) included in the model
Interpretation of R2
Suppose , this means that the regression line gives a good fit to the observed data
since this line explains 90% of the total variation of the Y value around their mean. The
remaining 10% of the total variation in Y is unaccounted for by the regression line and is
attributed to the factors included in the disturbance variable
2. TESTING THE SIGNIFICANCE OF OLS PARAMETERS
To test the significance of the OLS parameter estimators we need the following:
 Variance of the parameter estimators
 Unbiased estimator of
 The assumption of normality of the distribution of error term.
i) Standard error test ii) Student’s t-test iii) Confidence interval
All of these testing procedures reach on the same conclusion. Let us now see these testing
methods one by one.
i) Standard error test
This test helps us decide whether the estimates are significantly different from
zero, i.e. whether the sample from which they have been estimated might have come
from a population whose true parameters are zero. .
Formally we test the null hypothesis
against the alternative hypothesis
The standard error test may be outlined as follows.
First: Compute standard error of the parameters.
Second: compare the standard errors with the numerical values of .
Decision rule:
 If , accept the null hypothesis and reject the alternative hypothesis.

We conclude that is statistically insignificant.

 If , reject the null hypothesis and accept the alternative hypothesis.

We conclude that is statistically significant.

The acceptance or rejection of the null hypothesis has definite economic meaning.
Namely, the acceptance of the null hypothesis (the slope parameter is zero) implies
that the explanatory variable to which this estimate relates does not in fact influence the
dependent variable Y and should not be included in the function, since the conducted test
provided evidence that changes in X leave Y unaffected. In other words acceptance of H 0
implies that the relationship between Y and X is in fact , i.e. there is no
relationship between X and Y.
ii) Student’s t-test
Like the standard error test, this test is also important to test the significance of the
parameters. From your statistics, any variable X can be transformed into t using the
general formula:
To undertake the above test we follow the following steps.
Step 1: Compute t*, which is called the computed value of t, by taking the value of in
the null hypothesis. In our case , then t* becomes:

Step 2: Choose level of significance. Level of significance is the probability of making

‘wrong’ decision, i.e. the probability of rejecting the hypothesis when it is actually true or
the probability of committing a type I error. It is customary in econometric research to
choose the 5% or the 1% level of significance. This means that in making our decision
we allow (tolerate) five times out of a hundred to be ‘wrong’ i.e. reject the hypothesis
when it is actually true.
Step 3: Check whether there is one tail test or two tail test. If the inequality sign in the
alternative hypothesis is , then it implies a two tail test and divide the chosen level of
significance by two; decide the critical rejoin or critical value of t called t c. But if the
inequality sign is either > or < then it indicates one tail test and there is no need to divide
the chosen level of significance by two to obtain the critical value from the t-table.
Step 4: Obtain critical value of t, called tc at and n-2 degree of freedom for two tail test.
Step 5: Compare t* (the computed value of t) and tc (critical value of t)
 If t*> tc , reject H0 and accept H1. The conclusion is is statistically significant.
 If t*< tc , accept H0 and reject H1. The conclusion is is statistically
insignificant.
iii) Confidence interval
Rejection of the null hypothesis doesn’t mean that our estimate is the correct
estimate of the true population parameter . It simply means that our estimate
comes from a sample drawn from a population whose parameter is different from zero.
In order to define how close the estimate to the true parameter, we must construct
confidence interval for the true parameter, in other words we must establish limiting
values around the estimate with in which the true parameter is expected to lie within a
certain “degree of confidence”. In this respect we say that with a given probability the
population parameter will be with in the defined confidence interval (confidence limits).

We choose a probability in advance and refer to it as confidence level (interval

coefficient). It is customarily in econometrics to choose the 95% confidence level. This
means that in repeated sampling the confidence limits, computed from the sample, would
include the true population parameter in 95% of the cases. In the other 5% of the cases
the population parameter will fall outside the confidence interval.
In a two-tail test at  level of significance, the probability of obtaining the specific t-
value either –tc or tc is at n-2 degree of freedom.

; Where is the critical value of t at confidence interval

and n-2 degree of freedom.