CH 1. The Nature of Econometrics and Economic Data

Econ 3044: Introduction to Econometrics
Chapter-1: The Nature of Econometrics and Economic

Data
Lemi Taye
Addis Ababa University

lemi.taye@aau.edu.et
March 25, 2021
Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 1 / 30

Definition and Scope of Econometrics
What is econometrics?
Econometrics = use of statistical methods to analyze economic data

Econometricians typically analyze nonexperimental data

Typical goals of econometric analysis
Estimating relationships between economic variables

Testing economic theories and hypotheses
Forecasting economic variables
Evaluating and implementing government and business policy

Steps in an econometric analysis
1 Economic model
2 Econometric model
Economic models
I Maybe micro- or macromodels
I Often use optimizing behaviour, equilibrium modeling, ...
I Establish relationships between economic variables
I Examples: demand equations, pricing equations, ...

Steps in an econometric analysis
An econometric model consists of a set of behavioral equations

derived from the economic model.
These equations involve some observed variables and some
“disturbances” (which are a catchall for all the variables considered
irrelevant for the purpose of this model).

Economic vs. Econometric Models
Example
Taking the simplest example of a demand model:
Q = b0 + b1 P + b2 P0 + b3 Y + b4 t
An econometric model would be of the stochastic form:
Q = b0 + b1 P + b2 P0 + b3 Y + b4 t + u
where u stands for the random factors which affect the quantity demanded.

Economic vs. Econometric Models
Example (Job Training and Worker productivity)

Basic economic understanding is sufficient for realizing that factors such as
education, experience, and training affect worker productivity. This simple
reasoning leads to a model such as
wage = f (educ, exper, training),
A complete econometric model might be
wage = β0 + β1 educ + β2 exper + β3 training + u,
where the term u contains factors such as “innate ability,” quality of

education, family background, and the myriad other factors that can
influence a person’s wage.

Methodology of Econometrics
Broadly speaking, traditional econometric methodology proceeds along

the following lines:
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.

To illustrate the preceding steps, let us consider the well-known

Keynesian theory of consumption.
1. Statement of theory or hypothesis

Keynes postulated that the marginal propensity to consume
(MPC),the rate of change of consumption for a unit (say, a dollar)
change in income, is greater than zero but less than 1.

2. Specification of the Mathematical Model of Consumption

For simplicity, a mathematical economist might suggest the following
form of the Keynesian consumption function:
Y = β1 + β2 X 0 < β2 < 1
where Y = consumption expenditure and X = income, and where β1

and β2 , known as the parameters of the model, are, respectively, the
intercept and slope coefficients.

3. Specification of the Econometric Model of Consumption

I The relationships between economic variables are generally inexact. In
addition to income, other variables affect consumption expenditure.
For example, size of family, ages of the members in the family, family
religion, etc., are likely to exert some influence on consumption.
I To allow for the inexact relationships between economic variables, the
mathematical equation is modified as follows:
Y = β1 + β2 X + u 0 < β2 < 1
where u is disturbance term or error term. It is a random or stochastic

variable.

4. Obtaining Data
I An econometric model requires data on all the variables in the model.
Figure: Data on Y (Personal Consumption Expenditure) and X (Gross

Domestic Product), both in Billions of Dollars

5. Estimation of the Econometric Model

I The actual mechanics of estimating the parameters will be discussed in
Chapter 2. For now, note that the statistical technique of regression
analysis is the main tool used to obtain the estimates.
I Using this technique and the data given in Table 1, we obtain the
following estimates of β1 and β2 , namely, 299.5913 and 0.7218. Thus,
the estimated consumption function is:
Ŷt = −299.5913 + 0.7218Xt

I The hat on the Y indicates that it is an estimate.

6. Hypothesis Testing
Are the estimates in accord with the expectations of the theory that is
being tested? Is M P C < 1 statistically?
7. Forecasting or Prediction
I With given future value(s) of X, what is the future value(s) of Y ?
I Example: if GDP=$6000Bill in 1994, what is the forecast consumption
expenditure?
Ŷ = −299.5913 + 0.7218(6000) ≈ 4031.21

8. Use of the Model for Control or Policy Purposes

I Suppose that the government believes that consumer expenditure of
about 8750 (billions of 2000 dollars) will keep the unemployment rate
at its current level of about 4.2 percent (early 2006). What level of
income will guarantee the target amount of consumption expenditure?
I If the regression results seem reasonable, simple arithmetic will show
that
8750 = −299.5913 + 0.7218(GDP2006 )
which gives X = 12537, approximately.
I That is, an income level of about 12537 (billion) dollars, given an
M P C of about 0.72, will produce an expenditure of about 8750 billion
dollars.
I By appropriate fiscal and monetary policy mix, the government can
manipulate the control variable X to produce the desired level of the
target variable Y .

Types of Data for Econometric Analysis
Data based on sources is classified in to primary and secondary.

Data types can also be classified as:
Non-experimental vs. experimental data
I Non-experimental data are obtained from observations of a system that
is not subject to experimental control, while experimental data are
obtained from controlled experiments in laboratory.
Qualitative versus quantitative data
I Data, as a matter of definition, is quantitative. Thus facts, which are
already expressed as numbers.
I There are also variables, which are qualitative by nature and variables
which show qualitative shifts over time or space.
I Such qualitative information is usually quantified by what are known as
dummy variables .

The Structure of Economic Data
Economic data sets come in a variety of types.

Whereas some econometric methods can be applied with little or no
modification to many different kinds of data sets, the special features
of some data sets must be accounted for or should be exploited.
The most important data structures encountered in applied work
include the following:
1 Cross-Sectional Data
2 Time Series Data
3 Pooled Cross Sections
4 Panel or Longitudinal Data

Cross-Sectional Data
1. Cross-Sectional Data
Sample of individuals, households, firms, cities, states, countries, or
other units of interest at a given point of time/in a given period.
Cross-sectional observations are more or less independent.
For example, pure random sampling from a population.
Sometimes pure random sampling is violated, e.g. units refuse to
respond in surveys, or if sampling is characterized by clustering
Cross-sectional data typically encountered in applied microeconomics

Cross-Sectional Data (Continued)
Example

Time Series Data
Observations of a variable or several variables over time.

For example, stock prices, money supply, consumer price index, gross
domestic product, annual homicide rates, automobile sales, etc.
Time series observations are typically serially correlated.
Ordering of observations conveys important information.
Data frequency: daily, weekly, monthly, quarterly, annually, etc.
Typical features of time series: trends and seasonality.
Typical applications: applied macroeconomics and finance.

Time Series Data (Continued)
Example

Pooled Cross Sections
Two or more cross sections are combined in one data set

Cross sections are drawn independently of each other
Pooled cross sections often used to evaluate policy changes
Example:
I Evaluate effect of change in property taxes on house prices.
I Random sample of house prices for the year 1993
I A new random sample of house prices for the year 1995.
I Compare before/after (1993: before reform, 1995: after reform).

Pooled Cross Sections (Continued)
Example

Panel or Longitudinal Data
The same cross-sectional units are followed over time.

Panel data have a cross-sectional and a time series dimension.
Panel data can be used to account for time-invariant unobservables.
Panel data can be used to model lagged responses.
Example:
I City crime statistics; each city is observed in two years.
I Time-invariant unobserved city characteristics may be modeled.
I Effect of police on crime rates may exhibit time lag.

Panel or Longitudinal Data (Continued)
Example

Causality and the Notion of Ceteris Paribus
Definition of causal effect of x on y:
How does variable y change if variable x is changed but all other relevant
factors are held constant?
Most economic questions are ceteris paribus questions.
It is important to define which causal effect one is interested in
It is useful to describe how an experiment would have to be designed
to infer the causal effect in question

Example (Effects of Fertilizer on Crop Yield)

Q: "By how much will the production of soybeans increase if one
increases the amount of fertilizer applied to the ground?"
Implicit assumption: all other factors that influence crop yield such as
quality of land, rainfall, presence of parasites etc. are held fixed
Experiment:
Choose several one-acre plots of land; randomly assign different
amounts of fertilizer to the different plots; compare yields
Experiment works because amount of fertilizer applied is unrelated to
other factors influencing crop yields

Example (Effect of Education on Earnings)

Q: "If a person is chosen from the population and given another year
of education, by how much will his or her wage increase?"
Implicit assumption: all other factors that influence wages such as
experience, family background, intelligence etc. are held fixed
Experiment:
Choose a group of people; randomly assign different amounts of
eduction to them (infeasable!); compare wage outcomes
Problem without random assignment: amount of education is related
to other factors that influence wages (e.g. intelligence)

Reading Assignment:
I Wooldridge (2019). Introductory Econometrics: A Modern Approach.
Ch. 1

************* End of Chapter One *************

CH 1. The Nature of Econometrics and Economic Data

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Econ 3044: Introduction to Econometrics

Chapter-1: The Nature of Econometrics and Economic

Addis Ababa University

March 25, 2021

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 1 / 30

Econometrics = use of statistical methods to analyze economic data

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 2 / 30

Typical goals of econometric analysis

Estimating relationships between economic variables

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 3 / 30

Steps in an econometric analysis

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 4 / 30

Steps in an econometric analysis

An econometric model consists of a set of behavioral equations

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 5 / 30

Economic vs. Econometric Models

An econometric model would be of the stochastic form:

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 6 / 30

Economic vs. Econometric Models

Example (Job Training and Worker productivity)

wage = f (educ, exper, training),

A complete econometric model might be

wage = β0 + β1 educ + β2 exper + β3 training + u,

where the term u contains factors such as “innate ability,” quality of

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 7 / 30

Broadly speaking, traditional econometric methodology proceeds along

1 Statement of theory or hypothesis.

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 8 / 30

To illustrate the preceding steps, let us consider the well-known

1. Statement of theory or hypothesis

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 9 / 30

2. Specification of the Mathematical Model of Consumption

where Y = consumption expenditure and X = income, and where β1

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 10 / 30

3. Specification of the Econometric Model of Consumption

where u is disturbance term or error term. It is a random or stochastic

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 11 / 30

Figure: Data on Y (Personal Consumption Expenditure) and X (Gross

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 12 / 30

5. Estimation of the Econometric Model

Ŷt = −299.5913 + 0.7218Xt

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 13 / 30

Ŷ = −299.5913 + 0.7218(6000) ≈ 4031.21

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 14 / 30

8. Use of the Model for Control or Policy Purposes

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 15 / 30

Types of Data for Econometric Analysis

Data based on sources is classified in to primary and secondary.

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 16 / 30

The Structure of Economic Data

Economic data sets come in a variety of types.

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 17 / 30

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 18 / 30

Cross-Sectional Data (Continued)

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 19 / 30

Time Series Data

Observations of a variable or several variables over time.

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 20 / 30

Time Series Data (Continued)

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 21 / 30

Pooled Cross Sections

Two or more cross sections are combined in one data set

Lemi Taye (AAUSC) Ch 1: Introduction March 25, 2021 22 / 30

* End of Chapter One *