Applied Econometrics 3rd

edition
SIMPLE REGRESSION
1. Introduction to the Classical Linear Regression Model
2. The OLS Method of Estimation
3. The Overall Goodness of Fit
4. Hypothesis Testing
5. How to Estimate a Simple Regression in Eviews
6. Applications and Examples

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 Applied Econometrics 3rd
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Learning Objectives
• Compute the equation of a simple regression line from a
sample of data, and interpret the slope and intercept of the
equation.
• A full understanding of the simple OLS method of estimation
and discussion of the properties of estimated coefficients.
• Computation of a standard error of the estimate and
interpretation of its meaning and its use in Hypothesis Testing.
• Understanding and interpretation of the R2
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INTRODUCTION
• Regression analysis is the process of constructing a
mathematical model or function that can be used to
predict or determine one variable by another variable.
• Key issue here is direction of causation of the two
variables, or which variable depends on the other.
• Therefore we have two cases of variables
dependent variables (usually denoted by Y)
independent or explanatory (usually denoted by X)
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 Applied Econometrics 3rd
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REGRESSION MODELS
• Deterministic Regression Model: Y=b0+b1X
• Probabilistic Regression Model: Y= 0+ 1X+u

• b0 and b1 are population parameters

• 0 and 1 are estimated by sample statistics
b0 and b1

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 Applied Econometrics 3rd
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REGRESSION MODELS
Probabilistic Regression Model: Yt=a+ Xt+u

• Why probabilistic?

E(Yt)=a+ Xt
Yt=E(Yt) +ut
Yt=a+ Xt+u

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 Applied Econometrics 3rd
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REGRESSION MODELS
Why probabilistic?

1. Omission of explanatory variables

2. Aggregation of variables
3. Model specification
4. Functional misspecification
5. Measurement errors

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 Applied Econometrics 3rd
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THE SCATTER PLOT
X

300

250

200

150 X

100

50

0
0 20 40 60 80 100 120 140 160 180
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 Applied Econometrics 3rd
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Four Ways of Fitting a Line in the Data

• By eye
• Connecting the first with the last observation
• Take the average of the first two and the
average of the two last and connect
• Apply Ordinary Least Squares
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 Applied Econometrics 3rd
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THE SCATTER PLOT

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 Applied Econometrics 3rd
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EQUATION OF THE REGRESSION LINE

Yˆ  b0  b1 X
where : b0 = the sample intercept
b1 = the sample slope
Yˆ = the predicted value of Y
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 Applied Econometrics 3rd
edition
SLOPE AND INTERCEPT OF THE
REGRESSION LINE

  X  Y 
  X  X Y  Y   XY  nXY  XY 
n
b  
 X  X   X n X
2 2 2

1 2

X 2
 X
n

 Y  X
b Y b X  n b n
0 1 1

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 Applied Econometrics 3rd
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LEAST SQUARES ANALYSIS

SSXY    X  X Y  Y    XY 
  X  Y 
n

X  X
2
 X
SSXX   
2

2
X n
SSXY
b1  SSXX

 Y  X
b  Y b X  n b n
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 Applied Econometrics 3rd
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LEAST SQUARES ANALYSIS

Why OLS?
1. Elimination of the effect of the sign (positive and
negative residuals offset each other)
2. More weight is given to larger residuals and so we
work harder to reduce the very large errors
3. It chooses a method that follow some numerical and
statistical properties (remember unbiasedness,
efficiency etc)
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 Applied Econometrics 3rd
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ASSUMPTIONS OF THE LEAST SQUARES
ANALYSIS

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 Applied Econometrics 3rd
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PROPERTIES OF THE OLS ESTIMATORS
Linearity

Unbiasedness

Efficiency

BLUEness
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Consistency
 Applied Econometrics 3rd
edition
PROPERTIES OF THE OLS ESTIMATORS
• BLUE - What does the acronym stand for?

• “Estimator” - is an estimator of the true value of .

• “Linear” - is a linear estimator
• “Unbiased” - On average, the actual value of the and ’s will be equal to
the true values.
• “Best” - means that the OLS estimator has minimum variance among
the class of linear unbiased estimators. The Gauss-Markov
theorem proves that the OLS estimator is best.

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 Applied Econometrics 3rd
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EXAMPLE: THE KEYNESIAN
CONSUMPTION FUNCTION

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 Applied Econometrics 3rd
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EXAMPLE: THE KEYNESIAN
CONSUMPTION FUNCTION

C2=B2*A2
D2=B2*B2

A22=SUM(A2:A21)
B22=SUM(B2:B21)

and so on!

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 EXCEL CALCULATIONS
Applied Econometrics 3
rd

edition

b0=(C22-(A22*B22)/20)/(D22-
((B22ˆ2)/20))=0.601888903
b1=AVERAGE(A2:A21)-G2*AVERAGE(B2:B21)=15.116408

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 Applied Econometrics 3rd
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EXCEL CALCULATIONS (THE EASY WAY!)
• Step 1: go to the menu Tools/Data Analysis and choose the command
regression.
• Step 2: We are then asked to specify the Input Range, Output Range, and
a choice of including or not labels in the first row.
• Step 3: The Input Range is the columns that contain the data for Y and X
(i.e. we enter ‘$A$1:$B$21’ or simply select this area using the mouse).
• Step 4: The Output Range can be either a different sheet (not
recommended) or any empty cell in the current sheet (i.e. we might specify
cell F5).
• Step 5: Since we have chosen the labels in our selection we tick the box.
• Step 6: By clicking <OK> we obtain the display shown in Table 4.4.

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 Applied Econometrics 3rd
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EXCEL RESULTS

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 Applied Econometrics 3rd
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THE REGRESSION LINE
X
300

250

200

150
X
Linear (X)
100

50

0
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 Applied Econometrics 3rd
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REGRESSION IN EVIEWS (1) (1)

Step 1 Open EViews.

Step 2 Choose File/New/Workfile in order to create a new file.

Step 3 Choose Undated or Irregular and specify the number of

observations (in this case 20). A new window appears which
automatically contains a constant (c) and a residual (resid) series.

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 Applied Econometrics 3rd
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REGRESSION IN EVIEWS (2)
Step 4 In the command line type:
genr x=0 (press enter)
genr y=0 (press enter)
which creates two new series named x and y that contain zeros
for every observation.
Open x and y as a group by selecting them and double clicking
with the mouse.

Step 5 Either type the data in EViews or copy/paste the data

from Excel®. To edit the series press the edit +/− button. After
finishing
From withBanoediting the series press the edit +/− button again
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 Applied Econometrics 3rd
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REGRESSION IN EVIEWS (3)
Step 6 Once the data have been entered into Eviews, the
regression line (to obtain alpha and beta) may be estimated either
by typing:

ls y c x (press ‘enter’)

on the command line, or by clicking on Quick/Estimate Equation

and then writing your equation (i.e. y c x) in hte new window.

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 Applied Econometrics 3rd
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READING THE EVIEWS REGRESSION
OUTPUT

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 Applied Econometrics 3rd
edition
THE COEFFICIENT OF
DETERMINATION
The proportion of variability of the dependent
variable accounted for or explained by the
independent variable in a regression model.
It is called R2 and it takes values from 0-1.

TSS=ESS+RSS
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R2 = ESS/TSS or R2 = 1 – (RSS/TSS) 27
 Applied Econometrics 3rd
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THE COEFFICIENT OF
DETERMINATION
Problems associated with R2
1. Spurious regression problem
2. High correlation of Xt with another varible Zt
3. Correlation does not necessarily imply causality
4. Time Series vs Cross Sectional equations
5. Low R2 does not mean wrong choice of Xt
6. R2s from equation with different forms of Yt are
not comparable
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 Applied Econometrics 3rd
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HYPOTHESIS TESTS FOR THE SLOPE
OF THE REGRESSION MODEL

H 0:  1  0 t
b 1 1

S
H 1:  1  0
b

where: S 
S e
b
SS
H 0:  1  0
XX

SSE
Se 
H 1:  1  0
n2

SSXX  
2

  X
2

H 0:  1  0
X n
  the hypothesized slope
H 1:  1  0
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df  n  2 29
 Applied Econometrics 3rd
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HYPOTHESIS TESTS FOR THE SLOPE
OF THE REGRESSION MODEL

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 Applied Econometrics 3rd
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HYPOTHESIS TESTS FOR THE SLOPE
OF THE REGRESSION MODEL
We don’t like statistical Tables? – good!!!

We don’t need statistical Tables

A rule of thumb | t | > 2

The p-value approach (<0.05)

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