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Applied Econometrics CHAPTER 1 (Autosaved)

Econometrics applies statistical methods to economic data to empirically test economic theories. The methodology of econometrics involves: (1) stating an economic theory or hypothesis mathematically, (2) specifying an econometric model, (3) collecting data, (4) estimating model parameters, (5) hypothesis testing, and (6) using the model to forecast or evaluate policies. The document outlines this process using the example of estimating the marginal propensity to consume from consumption and income data to test Keynesian consumption theory.

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Mintayto Tebeka
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235 views19 pages

Applied Econometrics CHAPTER 1 (Autosaved)

Econometrics applies statistical methods to economic data to empirically test economic theories. The methodology of econometrics involves: (1) stating an economic theory or hypothesis mathematically, (2) specifying an econometric model, (3) collecting data, (4) estimating model parameters, (5) hypothesis testing, and (6) using the model to forecast or evaluate policies. The document outlines this process using the example of estimating the marginal propensity to consume from consumption and income data to test Keynesian consumption theory.

Uploaded by

Mintayto Tebeka
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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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1

APPLIED
ECONOMETRICS FOR
ACCOUNTING AND
FINANCE

Chapter 1: Introduction

to Econometrics
Outlines

• Definition and Scope of Econometrics


• The purpose and applications of Econometrics
• Methodology of Econometrics
• Econometric models
• The link between statistics and econometrics
• The kinds of problems handled by
econometrics
ANDUALEM BEGASHAW 2
Definition and Scope of
Econometrics
 Econometrics is the application of statistical and
mathematical methods to the analysis of economic data
with a purpose of giving empirical content to
economic theories and verifying or refuting them.

 More specifically, it is concerned with the use of


statistical methods to attach numerical values to the
parameters of economic models and also with the use
of these models for prediction.
ANDUALEM BEGASHAW 3
Why Econometrics is a Separate
Discipline?
Theor Empirical
y verification of
economic
theory.
mathematical
Econometrics
economics

statistic
s
ANDUALEM BEGASHAW 4
Methodology of
econometrics
Statement Specification of the
Specification of the
of theory mathematical model
econometric,
or of the Theory
model
hypothesis

Estimation of the
Collecting the parameters of the Hypothesis
data econometric testing
model

Forecasting or Using the model for


prediction policy purposes

ANDUALEM BEGASHAW 5
Methodology …
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


(single- equation model)

Y = β1 + β2X 0 < β2 < 1

Y = consumption expenditure and (dependent


variable) X = income, (independent, or explanatory
variable) β1 = the intercept
β2 = the slope coefficient
 The slope coefficient β2 measures the MPC.
ANDUALEM BEGASHAW 6
Cont.…
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, is


modified as follows:
Y = β1 + β 2 X + 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.

ANDUALEM BEGASHAW 7
Cont.…
Y = β1 + β 2 X + 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.

ANDUALEM BEGASHAW 8
Cont.…
4. Obtaining Data
 To obtain the numerical values of β1 and β2, we
need data. personal consumption expenditure (PCE)
and GDP product (GDP).The .

ANDUALEM BEGASHAW 9
Cont.…
The data are plotted in the following
Figure

ANDUALEM BEGASHAW 10
Cont.…
 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 β1 and β2, namely, −184.08 and 0.7064.
 Thus, the estimated consumption function is:

𝒀 = −𝟏𝟖𝟒. 𝟎𝟖 + 𝟎. 𝟕𝟎𝟔𝑿𝒊

 The estimated regression line is shown in the following 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.
ANDUALEM BEGASHAW 11
ANDUALEM BEGASHAW 12
Cont.…
6. Hypothesis Testing
 That is to find out whether the estimates obtained in, Eq. 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. But before we accept
this finding as confirmation of Keynesian consumption theory, we must
enquire whether this estimate is sufficiently below unity. In other words, is
0.70 statistically less than 1? If it is, it may support Keynes’ theory.
 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).

ANDUALEM BEGASHAW 13
Cont.…
7. Forecasting or Prediction
• 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) = 4951.3
• 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.
• Now suppose the government decides to propose a reduction in
the income tax. What will be the effect of such a policy on income
and thereby on consumption expenditure and ultimately on
ANDUALEM BEGASHAW 14
Cont.…
 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.
 The critical value in this computation is MPC.Thus, a quantitative estimate of
MPC provides valuable information for policy purposes. Knowing MPC, one can
predict the future course of income, consumption expenditure, and employment
following a change in the government’s fiscal policies.
ANDUALEM BEGASHAW 15
8. Use of the Model for Control or Policy
Purposes
 Suppose we have the estimated consumption function. 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?
 If the regression results seem reasonable, simple arithmetic will show
that: 4900 = −184.0779 + 0.7064X

 which gives X = 7197, approximately.That is, an income level of about 7197


(billion) dollars, given an MPC of about 0.70, will produce an expenditure of
about 4900 billion dollars.
 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.

ANDUALEM BEGASHAW 16
In
General
The aims of econometrics are:
a) Formulation of econometric models, that is,
formulation of economic models in an empirically
testable form (specification aspect).
b) Estimation and testing of these models with
observed data (inference aspect).
c) Use of these models for prediction and policy
purpose.

ANDUALEM BEGASHAW 17
Summarizes the anatomy of classical econometric
modeling.

ANDUALEM BEGASHAW 18
T h a n k You

ANDUALEM BEGASHAW 19

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