ECONOMETRICS

Applications with EViews

Abdul Waheed
Econometrics: Applications with EViews by Abdul Waheed 1
Chapter 1: Introduction

Learning Outcomes
1. Know about the field of econometrics.
2. Understand the methodology of econometrics.
3. Know how to specify an econometric model.
4. Know how to evaluate the econometric model.
5. Conduct forecasting or prediction based on an econometric model.
6. Get an introduction to the Econometric Views (EViews) software.

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Chapter 1: Introduction to Econometrics

Introduction to Econometrics
The field of Econometrics may be considered the integration of
Economics, Mathematics, and Statistics.

The purpose of this integration is to verify economic theories.

For example, the production theory state that the output is a function of
labor and capital. Now, first, we need to verify this theory.

Then, we want to know what is the effect of one unit increase in labor
or capital on output. For this, we need to express this relationship in
mathematical form.
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Chapter 1: Introduction to Econometrics

Then, we use specific methods, which are called econometric

methods, to obtain numerical estimates of the coefficient of
economic relationship.

Once we get the coefficient of labor and capital, we will be able

to know, by how much output will change, if we change labor or
capital by one unit.

The methodology of econometrics is explained in detail in the

next section.

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Chapter 1: Introduction to Econometrics

Methodology of Econometrics
In economic theory, claims or hypotheses are made. For example,
the supply theory postulates a positive effect of price on the
quantity supplied, holding all other factors constant. However,
the theory does not provide any numerical measure of the
relationship between price and quantity supplied.

The main concern of mathematical economics is to express the

theory or hypothesis in mathematical form, without regard to
empirical verification of the theory or hypothesis.

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Chapter 1: Introduction to Econometrics
An economic statistician is mainly concerned with the collection of
data, processing of the data, presenting the data in the form of tables,
charts, and diagrams, and detecting some relationships. An economic
statistician is mainly concerned with the descriptive aspect of economic
relationships.

The econometrician will state economic theory or hypothesis, make an

econometric model, collect the data, estimate the parameters of the
model, and then finally verify the model, and suggest some policy
implications. Thus, the primary objective of econometricians is to test
the economic theory, use the estimated model for forecasting, and
provide guidelines to policymakers for decision-making.

Quantitative Research Methods by Abdul 6

Waheed
Chapter 1: Introduction to Econometrics
The traditional econometric methodology proceeds along the following
steps:

1. Statement of theory or hypothesis.

2. Specification of the mathematical model.
3. Specification of the econometric model.
4. Collection of data on the variables of the model.
5. Estimation of the parameters of the econometric model.
6. Evaluation of the econometric model.
7. Forecasting based on an econometric model.
8. Policy implications and simulations based on the econometric model.
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Chapter 1: Introduction to Econometrics
1. Statement of Theory or Hypothesis
The first step in any econometric research is to select an economic
theory or hypothesis. In the literature, there are many economic
theories or hypotheses. The researcher attempts to test those theories or
hypotheses. For example, consider the following economic theory.

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Chapter 1: Introduction to Econometrics
The supply is defined as the amount of a good or service that
producers are willing and able to provide at a given price in each time
period.

The supply is influenced by several factors such as the price of that

good or service, the number of suppliers in the market, prices of the
resources used in the production process, government policies (for
example tax or subsidy policy), improvement in technology, the
expectation of the suppliers, the price of the related good or service, and
availability of inputs.

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Chapter 1: Introduction to Econometrics

The law of supply states that there is a positive effect of price on

the quantity supplied, holding all other factors constant.

This means, as the price increases, the quantity supplied of the

good of service also increases if we keep all other factors
constant.

Once the theory or hypothesis is selected from economic

literature, the next step would be to specify the mathematical
model.

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Chapter 1: Introduction to Econometrics

2. Specification of the Mathematical Model

The second step is to specify a mathematical model for
the economic theory or hypothesis.

(1.1) Y = f(X)

Where,
Y = dependent variable
X = independent or explanatory variable
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Chapter 1: Introduction to Econometrics

Considering the above example of supply theory, we

can state the mathematical model in functional form as
follows.

(1.2)

Where WSUPPLY is the supply of wheat in matric tons and

SPWHEAT is the support Price of wheat in rupees per kilogram.

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Chapter 1: Introduction to Econometrics

The mathematical model in parametric form can be

stated as follows:

(1.3) Yi = β0 + β1Xi

Where:
β0 = the intercept parameter
β1 = the slope parameter
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Chapter 1: Introduction to Econometrics
The wheat Supply-Price model can be stated as:

(1.4)

The above model (1.4) is a linear mathematical model

or economic model in parametric form.

The parameters β0 and β1 are unknown and have to be

estimated. The above equation has the exact relationship
between supply and price, which in reality does not
exist.
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Chapter 1: Introduction to Econometrics

3. Specification of the Econometric Model

The relationships between economic variables are generally inexact. In
addition to price, other variables affect supply as discussed in Step 1.
To allow for the inexact relationships between economic variables,
(1.3) is modified as follows:

(1.5) Y = β 0 + β1 X + u

The supply-price model can be stated as:

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Chapter 1: Introduction to Econometrics

Where u is known as the disturbance, or error term, which is a random

or stochastic variable that has well-defined properties.

All the factors that have an impact on supply but aren't explicitly taken
into consideration in the model could very well be represented by the
disturbance term, u.

The econometrician also decides in this stage regarding a priori

theoretical expectations for the sign and size of the model's parameter.
For the above-mentioned supply model, β1 is expected to be positive,
that is β1 > 0.

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Chapter 1: Introduction to Econometrics

4. Collection of Data
The collection of data is the branch of statistics, which is known
as descriptive statistics.

The econometrician has to decide what type of data will be

collected for the study. The data can be time series, cross-
sectional, or panel data.

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Chapter 1: Introduction to Econometrics

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Chapter 1: Introduction to Econometrics

Sometimes the data of the same variable is not available, the

econometrician may use the proxy for that variable.

For example, the proxy for the openness variable is the sum of export
and export as a ratio of gross domestic product.

There are some cases when we have to use a qualitative variable in the
econometric model. In such a case, we need to code the data to make it
quantitative.

The econometrician also uses a dummy variable in the model. This

variable takes the value of one and zero, where one shows the presence
of an attribute and zero is for otherwise.
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Chapter 1: Introduction to Econometrics
5. Estimation of the Econometric Model
As the econometric model has been specified and data have been
collected, the econometrician will proceed with its estimations.

In the estimation, the econometrician obtains the numerical

values of the parameters β0 and β1.

This is a very technical stage that requires knowledge of the

various econometric method and their assumptions.

The choice of the appropriate econometric technique is very

important at this stage.
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Chapter 1: Introduction to Econometrics

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Chapter 1: Introduction to Econometrics

Thus, the estimated wheat supply model is as follows:

(1.7) (

The slope coefficient shows that when the price increases by $1 per 40
KG, the production of wheat will increase by 0.05 million tons kg. The
value of the intercept is 8.95, which means that when the support price
of wheat is zero, (SPWHEAT=0), the production of wheat (WSUPPLY)
is 8.95 million tons kg.

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Chapter 1: Introduction to Econometrics

6. Evaluation of the Econometric Model

At this stage, the econometrician checks the reliability of the
result of the estimated econometric model.

In this evaluation, it is decided whether the estimates of the

parameters are theoretically meaningful and statistically
satisfactory or not.

For example, the estimate obtained in (1.7) can be evaluated with the
expectation of the law of supply. If the sign of the estimate of β1 is
positive, then it is theoretically meaningful.

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Chapter 1: Introduction to Econometrics

To test whether the estimates are statistically

satisfactory, we need to perform a hypothesis test.

Hypothesis testing is the branch of statistics which is

known as inferential statistics.

Some tests are used to check the overall significance of

the model and to trace the econometric problem in the
model. All these will be discussed in different chapters
of the book.
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Chapter 1: Introduction to Econometrics

7. Forecasting based on Econometric Model

The main objective of any econometric research is to obtain a
good fit model of the economic relationship and to use it for the
prediction or forecasting of the dependent variable.

For this, first, we need to assess the prediction power of the

model. Sometimes, the estimated model is economically
meaningful and statically satisfactory but may not be suitable for
forecasting.

Different tests are available to evaluate the forecast ability of the

estimated model.
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Chapter 1: Introduction to Econometrics
To briefly explain the forecasting, consider the estimated econometric
model (1.7), which can be used for forecasting wheat production
(WSUPPLY) based on the support price of wheat (SPWHEAT).

(1.8)
(1.9)

The actual value of wheat production for 1995 is 17.00 million tons kg.
The estimated model (I.7) thus over-predicted the actual production of
wheat by 0.2 million tons kg.

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Chapter 1: Introduction to Econometrics

We could say that the forecast error is about 0.2 million

tons kg, which is about 1.18 percent of the actual value
of wheat production in 1995.

This difference can be tested for significance by various

methods. If it is found significant, the econometrician
tries to find out the sources of the forecast error, and
then improve the model.

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Chapter 1: Introduction to Econometrics
8. Policy Implications and Simulations
The estimated econometric model can be used for policy implications
or simulation.

The policy implication of the estimated wheat model is that the effect
of the support price of wheat is positive on the production of wheat.

So, if policymakers want to increase the production of wheat, they must

increase the support price of wheat.

The policy simulations can be performed with the estimated model in

the way that if policymakers increase the support price of wheat by
10% in 1994 then by how much the production of wheat will increase
in 1995 and subsequent years?
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Chapter 1: Introduction to Econometrics
Furthermore, suppose the farmers are using fertilizer and the
government wants to give some subsidy to the wheat farmers on
fertilizer.

Now the question is what would be the effect of this subsidy policy on
the production of wheat? Suppose this subsidy increases the use of
fertilizer and consequently the production of wheat. Then, the
government may adopt the policy of subsidy.

Thus, with appropriate economic policies, the government can achieve

the desired level of wheat production.

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Chapter 1: Introduction to Econometrics
Econometric Analysis with EViews
Many econometric analyses are very time-consuming without the use of
statistical computer software. Several computer software can be used to get
results for econometric analysis, such as MICROTSP, EXCEL, EViews, SPSS,
SAS, STATA, etc.

The EViews is a simple and interactive econometric computer package, which

can be used to get the results of various econometric analyses, that use time
series, cross-sectional or panel data. It is a user-friendly software because of
its interactive features like a window, button, and menus.

The EViews software is used to get the results of various econometric

analyses. The data files are available on http://waheedku.com that can be used
to replicate the results which are reported in different chapters of the book.
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Chapter 1: Introduction to Econometrics

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 End of the Chapter

Statistical Analysis in Business and Economics by Abdul Waheed 32