Wollo University, College of Business and Economics, Department of Economics

Chapter One: Introduction

1.1 Definition and Scope of Econometrics
By its literal meaning econometrics means “Economic Measurement” Econometrics can be
defined as the social science in which the economic phenomenon is measured and analyzed
through the application of economic theory, mathematics and statistical methods. Although
measurement is an important part of econometrics, the scope of econometrics is much
broader, as can be explained as follow:
 It helps to estimate economic relationship and to test economic theories based on the
development of statistical methods
 It helps to predict the future economic trends by examining the economic data
 It helps to evaluate and implement government and business policies
 As its most common application, econometric used to forecast important macro
economic variables such as interest rate, inflation and GDP.
 It can also be used in economic areas that have nothing to do with macro-economic
forecasting, for example, analyzing the effect of political campaign expenditures on
voting out comes.

1.2 Purpose and Application of Econometrics

The main purpose of studying econometrics is for achieving three major goals:
1. Describing economic reality: it allows as to put numbers in equations that previously
contained only abstract symbols.
2. Testing hypothesis about economic and business theory: It allows us to test theories
with qualitative evidence. Tests would be undertaken to check whether the estimated
values of the coefficients are confirmed or refuted with the existing economic theories.
3. Forecasting future economic and business activities: Based on the post trends, the
future economic situation might be forecasted particularly using a time series data.
Business leader and policy makers are used to make decision about the future by
taking the post trends as a good guide to the future. Since shocks cannot be predicted,
the penalty to being wrong in forecasting future economic activities becomes high.

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Wollo University, College of Business and Economics, Department of Economics

With regard to the application of econometrics, econometrics may be divided into two
broad categories: theoretical econometrics and applied econometrics. Theoretical
econometrics is concerned with the development of appropriate methods for measuring
economic relationships specified by econometric models. In this aspect, econometrics
leans heavily on mathematical statistics. For example, one of the methods used
extensively in this book is least squares. Theoretical econometrics must spell out the
assumptions of this method, its properties, and what happens to these properties when one
or more of the assumptions of the method are not fulfilled.

In applied econometrics we use the tools of theoretical econometrics to study some special
fields of economics and business, such as the production function, investment function,
demand and supply functions, portfolio theory, etc. Thus econometrics is employed not
only by economics and business students but also by students and researchers in several
other disciplines, such as politics, international relations, agriculture, and health sciences.
Students in these disciplines will find the expanded discussion of several topics very
useful.

1.3 Econometric Models Vs Mathematical and Statistical Models

Econometrics Vs Economic Theory and Mathematical Economics
Economic theory makes statements or hypotheses that are mostly quantitative in nature. For
example, microeconomic theory states that, other things remained the same a reduction in
the price of a commodity is expected to increase the quantity demand of that commodity.
Thus, economic theory postulates a negative or an inverse relationship between the price
and quantity demand of the commodity but does not provide any numerical measure of the
relationship between the two. That is, it does not tell us how much the quantity demand will
be changed as a result of certain change in the price. It is rather issue of econometrics to
provide such numerical estimates. So econometric gives empirical contents to economic
theories.

In addition, the main concern of mathematical economics is to express economic theory in

mathematical of equations form without regard to measurability of empirical verification of

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Wollo University, College of Business and Economics, Department of Economics

the theory. But econometrics mainly concerned on such empirical verification of the theory.
Econometricians often use the mathematical equations proposed by mathematical
economists but converts these equations into econometric equations so as to make ready for
empirical testing.

Econometrics Vs Economic Statistics and Mathematical Statistics

Economic statistics is mainly concerned with collecting, processing, and presenting
economic data in the form of charts and tables. For example, an economic statistician may
collect data on GDP, employment, price etc but does not go further in using the collected
data to test economic theories. Instead, it is the job of an econometrician to use the raw data
to test the economic theories.

Indeed, mathematical statistics provide many tools to analyze the data. However,
econometrics concerned with the unique nature and structure of the data and thus provides
special methods or techniques to analyze the data based on the nature & structure of the
data. Generally, econometrics is an amalgam of economic theory, mathematical economics,
economic statistics and mathematical statistics.

1.4 Problems Handled by Econometrics and the Methodology

As clearly indicated in the previous sections econometrics is applied to various disciplines.
Mainly it is used in economics and business to solve the practical problems of the business
environment in particular and the overall real world phenomenon in general. In this respect,
econometrics is used to estimate, analyze and forecast the economic variables (such as
national output or GDP, inflation, unemployment, interest rate, exchange rate and balance
of payment-trade balance and net capital flow) and thus to find solutions for the problems
related with these macroeconomic issues. In general, in applied econometrics we use the
tools of theoretical econometrics to study some special fields of economics and business,
such as the production function, investment function, demand and supply functions,
portfolio theory, capital asset pricing, returns on assets etc.

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Wollo University, College of Business and Economics, Department of Economics

Regarding the methodology of econometrics the method for the analysis of a given
economic problem is the main concern of econometrics. Here we deal about the traditional
or classical methodology which still dominates empirical research in economics and other
social and behavioral sciences. This methodology will be discussed under the following
step wise procedures:
1. Economic theory
2. Specification of mathematical model
3. Specification of econometric model
4. Obtaining the data
5. Estimation of econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purpose

1. Economic Theory
It is a statement of theory of hypothesis that is developed in a certain economic
phenomenon, to illustrate this and the preceding steps let’s consider the well know
Keynesian theory of consumption, that is, individuals consumption increases as their
income increases, but not as much as the increase in their income. In other words, the
marginal propensity to consume (MPC) the rate of change in consumption for a unit change
in income lies between zero & one.

2. Specification of Mathematical Model

Although Keynes postulates a positive relationship between consumption and income, he
did not specify the precise form of the functional relationship between the two therefore, a
mathematical economist may suggest the following mathematical model of consumption
function.
Y=1+2 0<2<1
Where: Y= consumption expenditure/dependent variable; X= income/independent variable
or explanatory Variable; 1+2= parameters of the model which refers to intercept & slope
coefficients respectively.

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 Wollo University, College of Business and Economics, Department of Economics

The slope  2 measures MPC. The above mathematical equation, which states the
consumption function is linearly related to income, is termed as a consumption function in
economics. Since such model has only one equation it is called single equation model.
However, of it has more than one equation, it is called multiple-equation model. The
graphical representation of the mathematical model looks like:

Y=1+2
Consumption
Expenditure

0
0 Income
Fig. 1.1 Keynesian Consumption function

3. Specification of Econometrics Model

Unlike the mathematical model, the econometric model assumes that the relationship
between consumption and income is not exact or deterministic. For example, if we obtain
data on consumption and disposable income of some families, we would not expect all
observations to lie exactly on the straight line of a graph. So that the relationship between
consumption and income is inexact, because in addition to income other variables such as
family size, age of family members and family religion affect consumption.

To allow for the inexact relationship between the two variables the mathematical model is
modified and thus turned to econometric model by introducing the disturbance or error
term, U, which is a random or stochastic variable that well represents all those factors
affecting consumption but not taken into account explicitly.
Y=1+2+U
This equation is an econometric model specifically a linear regression model the model can
also be represented graphically as:

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Wollo University, College of Business and Economics, Department of Economics

. . . Y= 1+ 2+U

. . . .
Consumption
Expenditure

. . .

0
Income
Fig. 1.2 Econometric model of consumption Function

4. Obtaining Data
In order to estimate the parameters of the econometric model, that is, the numerical values
of 1 & 2, we need to have data on consumption and income.

5. Estimation of the Econometric Model

Once we have the data, we are in a position to estimate the parameters of the econometric
model. That is, finding out the numerical values of 1 &  2 and hence the estimated
econometric model or empirical content of the consumption function. Using the statistical
technique of regression analysis and the data the parameters will be estimated. Say the
estimates are obtained as: 1=-184.08 and  2=0.7064, then the estimated econometric model
particularly the estimated consumption function, Ŷ, is:
Ŷ= -184.08+0.7064Xi
From the estimated function the slope coefficient (i.e, the MPC) of 0.70 is interpreted as an
increase in income of one dollar, on average, increases the consumption expenditure about
by 0.70 cents. Since the relationship between income & consumption is inexact we use the
term “on average”.

6. Hypothesis Testing
In this step we need to check whether the estimates obtained are in accord with the
expectation of the theory that is being tested. Although the estimated obtained (i.e, MPC =
0.70) is confirmed with the Keynes theory that MPC lies between zero one we need to still
check whether this confirmation is not a chance of occurrence or peculiarity of a particular
data we have used. In other words, is 0.70 statistically less than one? If so, we proved that
the estimated value confirmed with the theory.
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Wollo University, College of Business and Economics, Department of Economics

Such confirmation of the estimates with the theory using statistical method is known as
statistical inference or hypothesis testing.

7. Forecasting or Prediction
If the chosen model does not refute the hypothesis or theory under consideration, we use it
to predict the dependent or forecast variable Y on the basis of expected future value of the
explanatory or predictor variable X. For example, if the expected GDP or income value for
2017 was 7269.8 billion dollars, the estimated consumption in 2017 will be:
Ŷ2017 = -184.0779+0.7064(7269.8)
= 4951.3167
8. Use of the Model for Control or Policy Purposes
In addition to using the model for forecasting or prediction purpose, the government can
further use the model for control or policy purposes through the appropriate fiscal &
monetary policy mix. To this regard, the desired level of the target variable Y can be
produced by manipulating the control variable X. For example, if the government believes
that consumes expenditure of about 4900 billion dollars will keep the unemployment rate its
current level of about 4.2%, the income should be manipulated at about 7197 billion dollar
to produce the target amount of consumption expenditure.
i.e, 4900= -184.0779=7064X
X= 5084.0779/07064
X= 7197.1658

1.5 Concepts of Regression

Regression analysis is a statistical technique that attempts to explain the dependency of one
variable, the dependent variable, on one or more other variables, the independent or
explanatory variables through the qualification of a single equation.
Y=  0  1 X 1  u

The main goal of the regression analysis is to obtain the possible estimates of the
coefficients and thus to predicate the estimated value of the dependent variable based on the
known or fixed values the independent variables.

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Wollo University, College of Business and Economics, Department of Economics

The dependent variable is a variable that is being predicted or estimated where as the
independent variables are used as predictor and basis for estimation.

Regression Versus Causation

Although the regression analysis deals with the dependency of one variable on the other
variable, it does not necessarily imply causation. In other words, as a statistical relationship
regression will simply explain the relationship between variables but not establish causal
connection. Instead, causation comes from outside statistics, ultimately from theories.

For example, the regression analysis on the two variables rainfall and crop yield only tells
us that crop yield depends on rainfall. But the fact that we treat crop yield as dependent on
rainfall is no due to statistical analysis rather it is due to some theoretical & factual
considerations. That is, the statistical relationship between crop yield & rainfall is
regression analysis where as the fact that changes in rainfall causes the crop yield to change
is causation. Note that the statistical relationship in itself cannot logically imply causation.

Regression Versus Correlation

In regression analysis, as already noted, it is concerned to deal the dependency of one
variable on the other variable which helps to estimate the average values of one variable on
the basis of the fixed values of the other variables. Thus, the dependent variable is assumed
to be random or stochastic while the explanatory variables are assumed to be fixed values.
In correlation analysis, however the primary objective is to measure the strength or degree
of linear association between two variables. In correlation analysis there is no distinction
between the dependent & explanatory variables, it merely measures the association between
variables.

For example, given the two variables lung concern & smoking, the regression analysis deals
about the dependency of lung cancer on smoking in which how the effects on lung cancer is
estimated based on a fixed value of smoking. On the other hand, the correlation analysis
simply deals about measuring the degree of association between the lung cancer and
smoking without making separation between dependent (Or estimated) and explanatory (Or
predictor) variables. That is, correlation between lung cancer & smoking is the same as that
between smoking and lung cancer.

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