ECONOMENTRICS (ECN3311)

Lecture 1

John Musantu
 Definition

What is Econometrics?

❑ Literal meaning is "measurements in economics"

❑ A set of statistical techniques to evaluate quantitat

ive relationships using empirical data

❑ Useful in context of both economics and beyond

 Motivation
Econometrics is widely applied in academia, public, pr
ivate sectors and many other organisations
Application in several areas, including:
❑ Testing empirical validity of hypotheses
❑ Evaluating policy
❑ Prediction and forecasting
 The Approach
Conventional approach to econometric analysis:
❑ Theory and hypothesis formulation
❑ Empirical model
❑ Choice of data and estimation method
❑ Estimation
❑ Evaluation
❑ Inference and hypothesis testing
 Approach Cont’
Researchers/Econometricians often have a variety of research
questions. Most of these research questions have policy
implication, but most of the theory doesn’t quantify the
causal effects, hence, we turn to Econometrics.
Example of relationships:
❑ What is the price elasticity of cigarettes?
❑ What is the effect of reducing class size on student
achievement?
❑ What is the effect on earnings of a year of education?
❑ What is the effect on output growth of a 1 percentage
point increase in interest rates by the central bank?
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 Controlled experiments

❑ The focus of this course is the use of statistical

and econometric methods to quantify causal
effects.
❑ Ideally, we would like to conduct a controlled
experiment with cigarette prices, class size,
returns to education, central bank interest rates,
etc.
❑ But most of the time, we cannot do so and must
use observational (non-experimental) data.
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 Observational studies
❑ Observational studies pose major
challenges: e.g. consider the estimation
of returns to education…
❑ Confounding effects (omitted factors)
❑ Simultaneous causality
❑ “Correlation does not necessarily imply
causation”
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 Course Objective
You will…
❑ learn methods for estimating causal effects using
observational data;
❑ learn some tools that can be used for other
purposes, for example forecasting using time series
data;
❑learn to do analysis and evaluate the work of other
econometric applications.

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 Stages of
applied
econometric
research

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 Types of data
❑ Cross-sectional data
❑ Time-series data
❑ Panel data

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Populations, Samples, Estimators and
Estimates
Populations:
❑ Total collection of all objects or people to be studied
Samples:
❑ Selection of some items from population
Estimators:
❑ Formulae to calculate regression coefficients
Estimates:
❑ Actual numerical values of coefficients calculated from
sample using estimator

❖ Examples will be made in the next part of the lecture

 The Simple Regression Model
Y X
❑ We begin our study with an
extensively investigation of Dependent Independent
the estimation of a linear variable variable
relationship between two Explained Explanatory
variables, Yi and Xi, of the variable variable
form: Predictand / Predictor
Predicted
Regressand Regressor
Outcome Covariate
for Response Stimulus
Controlled Control
variable variable

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 The Population Regression Function (PRF)
❑ Imagine we wish to find the relationship between father’s height
and son’s height.
❑ Imagine we had data on ALL the world’s father’s and son’s heights.
❑ Then we can get the Population Regression Function!

son's height i =  +  (father' s height ) i + ui

❑But we can’t observe the heights of ALL fathers and

sons in the world throughout time.
❑So we have to do with a sample!

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 Pearson’s sample
❑The following
scatter diagram
shows the
heights of 1,078
fathers and their
full-grown sons,
in England, circa
1900.
❑There is one dot
for each father-
son pair.

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 So how can we draw a line?
❑Using the
ordinary least
squares (OLS)
method, we can
get the sample
regression line:

son's height i = ˆ + ˆ (father's height )i

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 Idea of OLS

❑ Given

❑ The idea is to find α

and β (that draws a
line) which
minimizes the sum
of the residuals’
squared.

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Econometric Modelling
Interpretation of Parameters
Fitted Values and Residuals

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 Part 3: Classical Linear Regression
Note: Basic matrix algebra needed on this se
ction
Econometric Modelling:
Vector Representation
Econometric Modelling: Vector Repres
entation continue
Econometric Modelling: Matrix Rep
resentation
Note No.
of
columns
in X and
rows in β
match
Assumption 1: Linearity
Assumption 2: Linear Independence
Assumption 3: Strict Exogeneity
Assumption 4: Spherical Disturbances
Assumption 4: Spherical Disturbances
(Homoscedasticity)
Spherical Disturbances (Non-auto
correlation)
Assumption 5: Normality
 Derivations of OLS

Home exercise:
❑ Derive the parameters
Hint: Minimize the sum of squared residuals, use partial
differentiation and chain rule.

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