University of Agricultural Sciences and Veterinary Medicine Cluj-Napoca

- Agribusiness MSc -

Lecture 1.

Introduction

Course: Econometrics
Instructor: Diana Dumitras

Fall 2013
What is econometrics?

- does not exist a generally accepted answer

- literally, it means “economic measurement”, but measurement is an

important part of econometrics

- the answers vary:

= “econometrics is what econometrician do” (Goldberg, 1989)

= “ the study of the application of statistical methods to the

analysis of economic phenomena” (G. Tintner, 1953)

= “quantitative analysis of actual economic phenomena”

(P.A. Samuelson, 1954)

= “empirical determination of economic laws” (H.Theil, 1971)

What is econometrics?

Econometricians wear many different hats:

1. Economists
- utilize economic theory to improve their empirical analyses of
the problem they address

2. Mathematicians
- formulate economic theory in ways that make it appropriate for
statistical testing

3. Accountants
- are concerned with the problem of finding and collecting
economic data
- relate theoretical economic variables to observable ones
What is econometrics?

4. Applied statisticians
- spend hours with the computer trying to estimate economic
relationships or predict economic events

5. Theoretical statisticians
- apply their skills to the development of statistical techniques
appropriate to the empirical problems characterizing the
science of economics
What are the functions of
econometrics ?
1. To test economic theories or hypotheses
- ex. Is consumption directly related to income?
Is the quantity demanded of a commodity inversely related
to its price?

2. To estimate coefficients of economic relationships

- ex. A manager needs to know if a price reduction increases or
reduces the total sales revenues of the firm and, if so, by how
much.

3. To forecast / predict future values

- ex. Forecasting of the rate of inflation – useful for government
to take appropriate corrective action
Why a separate discipline?

 Ex. Microeconomic theory

- states that a reduction in the price of a commodity is expected to
increase the quantity demanded of that commodity, the other
things remaining constant

- it postulates a negative or inverse relationship btw. price and

quantity demanded

- does not tell how much the quantity will go up or down as a

certain change in price = does not provide numerical measure of
this relationship
Why a separate discipline?

 Ex. Mathematics
- express economic theory in mathematical form (equations)
- express an exact or deterministic functional relationship
- does not empirically verifies the theory

 Ex. Statistics
- collects, processes and presents economic data (charts, tables)
- provides the raw data
- does not test economic theory
Methodology of econometrics

Steps in traditional econometric methodology:

1. Statement of theory or hypothesis

2. Specification of the mathematical model of the theory
3. Specification of the statistical or econometric model
4. Obtaining the data
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purposes
Ex: The Keynesian theory of consumption
1. Statement of theory or hypothesis

Keynes (1936):
- stated that “men [women] are disposed, as a rule and on average,
to increase their consumption as their income increases,
but not as much as the increase in their income”

- postulated: 0 < MPC < 1

(MPC = marginal propensity to consume

= the rate of change of consumption for a unit change in income)
 2. Specification of the mathematical
model of consumption
- Keynes did not specify the precise form of the
functional relationship btw. consumption and income

- can use the functional form (consumption function):

Y = β1 + β2 X 0 < β2 < 1

Y
Y = consumption expenditure
X = income
β1 = intercept coefficient
β2=MPC β2 = slope coefficient (MPC)
1

β1 - the consumption is linearly

related to income
X
3. Specification of the econometric
model of consumption

Y = β1 + β2 X + u (linear regression model)

Y = consumption expenditure
X= income
β1= intercept coefficient
Y β2= slope coefficient
u = error term (disturbance)
- is a random variable
- represent the factors
excluded from the model,
u but which may affect Y

X
The main parts of an econometric model :

Y = β 1 + β 2X + u

Dependent variable Independent / explanatory variable

- ex. consumption - ex. income
 4. Obtaining data
- collect data & plot the data

Data on Y (Personal Consumption Expenditure) and

X (Gross Domestic Product) in billions $
Year Y X
1 3081.5 4620.3 PCE in relation with GDP

2 3240.6 4803.7
5000
3 3407.6 5140.1
4 3566.5 5323.5
4500
5 3708.7 5487.7 PCE(y)

6 3822.3 5649.5
4000
7 3972.7 5865.2
8 4064.6 6062
3500
9 4132.2 6136.3
10 4105.8 6079.4
3000
11 4219.8 6244.4 4000 5000 6000 7000
12 4343.6 6389.6
GDP(x)
13 4486 6610.7
14 4595.3 6742.1
15 4714.1 6928.4
 5. Estimation of Econometric Model
- to estimate = to obtain the numerical values of the parameters (β1,β2)

- use statistical technique of regression analysis

- the estimated consumption function (i.e. regression line):

Ŷ = -184.08 + 0.7064Xi

PCE in relation with GDP

5000

- the regression line 4500

PCE(y)

fits the data quite well 4000

3500

3000
4000 5000 6000 7000
GDP(x)
 How to interpret the results?

Ŷ = -184.08 + 0.7064 Xi

- the slope coefficient (MPC) = 0.70

- for the sample period, an increase in real income of 1 dollar led,

on average, to an increase of about 70 cents in real consumption
expenditure
PCE in relation with GDP

(or) 5000

4500
- the average (mean) consumption
PCE(y)

4000
expenditure went up by about
70 cents for a dollar’s increase 3500

in real income 3000

4000 5000 6000 7000
GDP(x)
 6. Hypothesis testing

= statistical inference

- assume that the fitted model is a good approximation of reality

- task: to develop a criteria to find out whether the estimates are in

accord with expectations of the theory

- Keynes expected: 0 < MPC < 1

- we found: MPC = 0.70 but is it statistically less than 1 ?

- If it is, it may support Keynes’ theory

 7. Forecasting or Prediction
If the hypothesis is accepted :
- may predict the future value(s) of the dependent variable Y
(forecast) on the basis of known or expected future value(s)
of the explanatory variable X (predictor)

Ex. We want to predict mean consumption expenditure for the following

year, knowing that GDPYear16 = 7269.8 billion $

Ŷ = -184.08 + 0.7064 Xi

ŶYear16 = -184.0779 + 0.7064 (7269.8) = 4951.3167

- the forecast consumption expenditure is about 4951 billion $

- the actual value reported was: 4913.5 billion $ forecast error

 8. Use of the model for control or policy purposes

Ex: Suppose the government believes that consumer expenditure of

4900 bill$ will keep unemployment rate at 4.2%.

What level of income will guarantee the target amount of

consumption expenditure?

- Recall:
Ŷ = -184.08 + 0.7064 Xi
- Solve for X:
4900 = -184.0779 + 0.7064X
X = 7197 bill$

 an income level of 7197 bill$ will produce an expenditure of

about 4900 bill$ (given an MPC of 0.70)
Believe me or not …

“Econometrics is fun !“

(Judge et al. 1988)