EED 401: ECONOMETRICS• COURSE OUTLINEMeaning and purpose of econometricsMethodology of econometric researchCorrelation analysis and single equation models;

simple linear & multiple linear regression models

Functional forms of the regression modelSpecial models in regression analysis; dummy

variables, RTO.

COURSE OUTLINE CONT’D

Problems of single equation models; autocorrelation, heteroscedasticity, multicolinearity, errors in variables

Simultaneous equation models and estimationQualitative choice modelsTime series analysis

SOME REFRENCES• A. KOUTSOYIANNIS (2003). THEORY OF

ECONOMETRICS. 2ND EDITION. PELGRAVE

• JEFFREY M. WOOLDRIDGE. INTRODUCTORY ECONOMICS- A MODERN APPROACH

• DAMODAR N. GUJIRATI. BASIC ECONOMETRICS. FOURTH EDITION.

• ETC, ETC.

WHAT IS ECONOMETRICS?

• The word ‘econometrics’ is derived from two Greek words, oikovoμia (economy), and μetpov (measure)

• Definition: the social science in which the tools of economic theory, mathematics and statistical inference are applied to the analysis of economic phenomena (Arthur Goldburger, 1964).

WHAT IS ECONOMETRICS? CONT’D

• Thus, econometrics is an amalgam of economics, mathematics and statistics

• The uniqueness of econometrics lies in the inclusion of a random element in models

ILLUSTRATION (economic model of crime)• Based on economic reasoning (theory) time

spent on criminal activity by an individual will depend on, hourly ‘criminal wage’ ( ),

1x

1x

WHAT IS ECONOMETRICS? CONT’D

• Hourly wage in legal employment,• Income other than from crime or employment,• Probability of getting caught, • Probability of being convicted if caught,• Expected sentence if convicted,• Age,

2x3x

4x5x

6x7x

WHAT IS ECONOMETRICS? CONT’D

• The above depicts an exact relationship ie the time spent on crime is completely dependent on 7 factors

• This is stated mathematically as:

• Or ),,,,,,( 7654321 xxxxxxxfy

776655443322110 xbxbxbxbxbxbxbby

WHAT IS ECONOMETRICS? CONT’D

• This still leaves us with a deterministic relationship

• But there are other factors that influence crime apart from the 7. eg. health, vengeance, religion, etc.

• Econometrics introduces a random factor (stochastic term) which takes care of these ‘other’ factors

Econometric representation of the crime model

),,,,,,,( 7654321 uxxxxxxxfy

uxbxbxbxbxbxbxbby 776655443322110

Econometric representation of the crime model CONT’D.

• U is the random factor encapsulating all other random factors that affect time spent on crime

• PROCEDURE FOR TESTING ECONOMIC THEORY

Reading assignment

• Establish the superiority of econometrics to mathematical economics and statistics

Branches of econometrics

• Two main branches: -Theoretical econometrics –dev’t. of appropriate

methods for the measurement of economic relationships

-Applied econometrics: application of econometrics to specific fields of economic theory ( demand, supply, investment, production) for the analysis of economic phenomena and forecasting economic behaviour

Purpose of econometrics

• Policy-making: Provide numerical values for the parameters of economic relationships (elasticities, propensities, marginal values) for decision making

• Analysis: Empirical verification of economic laws/theories

• Forecasting: determining future values of economic magnitudes based on numerical estimates

METHODOLOGY OF ECONOMETRIC RESEARCH

Generally, econometric research involves 4 stages:

1. Formulation of the maintained hypothesis: ie. The specification of the model

2.Testing of maintained hypothesis: estimation of the model by appropriate econometric method

3. Evaluation of estimates: decide on the basis of certain criteria whether the estimates are satisfactory & reliable.

METHODOLOGY OF ECONOMETRIC RESEARCH CONT’D.

4. Testing the forecasting validity of the model 1&3 are the most important for any

econometric research. Require strong knowledge in the functioning of economic systems

2&4 are technical & require a deep understanding of econometrics

Formulation of the maintained hypothesis

• It involves determining1.Dependent and explanatory variables2.The a priori theoretical expectations about

the signs & the size of the parameters of the function to form the basis for the evaluation of the model

3.The mathematical form of the model: single vs. simultaneous equation; linear vs. nonlinear functional forms

Reasons for incorrect specification of economic models

1. Looseness/ imperfection of statements in economic theories

2. Limitation of our knowledge about factors which are operative in a particular situation

3. Problems associated with large data requirements of large models. Errors of specification- omission of variables, equations, & wrong mathematical form of functions

2. Estimation of the model

The estimation process involves the ff. Stages:1. Gathering data-: cross-sectional, time series &

panel data2. Examination of the identification condition of the

function3. Examination of the aggregation problems of the

function (aggregation over individuals, commodities, time,& space)

4. Examination of the degree of correlation among the explanatory variables

5. Choice of the appropriate econometric technique:-

i. Single equation techniques:- Classical Least Squares (CLS) OR ordinary Least Squares(OLS) method, Indirect Least Squares (ILS) or reduced-form technique, 2SLS, Limited information maximum likelihood method,etc.

ii. Simultaneous equation techniques:- 3SLS, FIML

3. Evaluation of estimates

Are the parameters theoretically meaningful and statistically satisfactory?

We use 3 criteria for the evaluation;1.Economic ‘a priori’ criteria: are the

parameters of the correct signs and the right size?

2.Statistical criteria: first-order tests- usually by using the correlation coefficient & the standard deviation (error)

3. Econometric criteria: second-order test (test of the statistical tests). This may involve tests of consistency, efficiency, unbiasedness, assumptions, identification, etc.

4. Evaluation of the Forecasting Power of the Model

• Forecasting is one of the major objectives of econometrics.

• Given data on personal consumption (Y) and GDP (X) from 1982-1996 in billions of dollars the estimated consumption function is given by:

• We can forecast the mean consumption expenditure for 1997 given GDP=7269.8 billion dollars

as

0.7064X -184.08Y i

• Actual consumption for 1997 was 4913.3 billion dollars

• Forecast error is 37.81 billion dollars• Question is: is the error large or small?

dollarsbillion 4951.309

9.8)0.7064(726 -184.0779Y1997

Properties of econometric models

• Econometric models are judged based on• Theoretical plausibility• Explanatory ability• Accuracy of the estimates of the parameters• Predictive power• simplicity

GOD BLESS YOU!