Applied Econometrics

Introduction to Econometrics

General information
Basic information
• Instructor:
– Luca Trapin (first module)
– Giovanni Guastella (second module)
• Contact:
– luca.trapin@unicatt.it
– giovanni.guastella@unicatt.it
• Office hours: Send an email. We can schedule a skype meeting.
• Materials: On blackboard. You will get notified when there are updates.

What is this course about?

• Example. Imagine that you are hired by your state government to evaluate the effectiveness of a publicly
funded job training program on the worker’s subsequent hourly wage.
• Example. Imagine that you work as analyst for a large manufacturing company that asks you to forecast
the energy price over the next six months for his budgeting.
• Answering these economic questions requires using math to define the problem, collecting data, and
performing statistical analysis to reach conclusions. In sum econometrics.
• If you like math and statistics but feel like you don’t have the necessary background no problem. If
you don’t like maths and statistics probably you’re in the wrong class.

What you will learn?

• Estimate causal effects and make prediction using observational data.
• Model time series data and and make forecasts.
• Reproduce econometric analysis of others.
• Be familiar with basic econometric theory.
• Use and manage the R software for regression analysis.

What do I expect from you?

• Listen to the lectures.
• Do the excercises.
• Study the book after class.
• Make questions.

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 • Have critical thinking.

Details of the course

Schedule and topics
• First Module
– Review of probability and statistics (Ch.1-3 S&W)
– Simple linear regression (Ch. 4-5 S&W)
– Time series regression and forecasts (Ch. 14-15 S&W)
• Second module
– Multiple linear regression (Ch. 6-7 S&W)
– Non-linear regression (Ch. 8 S&W)
– Causality in regression (Ch. 9 S&W)
– Regression with panel data (Ch. 10 S&W)
– Regression with a binary dependent variable (Ch. 11 S&W)

Exam
• Final Exam: Written exam on both Modules.
– Questions on the theory (True/False or Multiple choice).
– Excercises requiring to state null hypotheses, compute test statistics and discuss the results.
– Excercises requiring to interpret the output of R.
• Sample exams will be provided to see what to expect.

Materials
• Slides cover all the aspects of the course and all the materials you need to prepare the exam.
– Remember: the slides are for me, not for you!
• Course book: Introduction to Econometrics, 3rd version, by James H. Stock and Mark W. Watson.
• R material: www.econometrics-with-r.org
• Suggested books:
– Introductory Econometrics by Jeffrey Wooldridge
– Using R for Introductory Econometrics by Florian Heiss

Econometric analysis with R

• R is a programming language well-suited for statistical analyses and the creation of graphics
– Powerful for the advanced user and easy for a beginner
– Completely free and available for most operating systems
• R can be downloaded from http://cran.mirror.garr.it/mirrors/CRAN/
• An elegant and freely available IDE for R is RStudio
– You can download the desktop version from https://www.rstudio.com/products/rstudio/download/

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Introduction to econometrics
What is econometrics?
• Econometrics uses statistical methods to confute a well-specified economic theory with economic
data.
• This requires defining an econometric model to assess the existence of the hypothetical relationships
implied by the economic theory, understand the type of relationship and measure the extent of such
relationship.
• The ultimate goal of an econometric analysis is:
– Structural analysis: empirical assessment of the economic hypothesis.
– Forecast: possible future outcome implied by the economic relationship.
– Policy evaluation: analyze the impact of political choices.

What is econometrics?
• Econometric is important in all fields of applied economics. Some examples where econometric models
are applied:
– Macroeconomics. What are the drivers of the growth of a country? To what extent are the
inflation and unemployment related (Phillips Curve)?
– Labour Economics. Is the business cycle a determinant of the number of informal jobs?
– Health Economics. How the level of income affect healthcare expenditure?
– Education Economics. Does four-year high school reduce the level of education?
– Financial Economics. How is financial risk linked to macroeconomics variables?
– Industrial Economics. Does the creation of an industrial district have an effect on the manu-
facturer internationalization decisions?

Economic Theory
• Any econometric analysis starts from the economic theory, with the careful formulation of the
question of interest.
• Economic theory often requires the formulation of an economic model.
• An economic model is a simplified representation of an economic phenomenon through a set of
assumptions and mathematical relationships of the type
y = f (x; θ)
where x are the variables of the model, and θ the model parameters.
– In microeconomics, these relationships are typically the results of utility-maximizing agents subject
to resource constraints.
• Example. In a 1974 article of the Journal of Political Economy, Gary Becker postulated a utility
maximization framework to describe an individual’s participation in crime. Crimes have clear economic
rewards, but most criminal behaviors have costs.
• Under general assumptions, we can derive an equation describing the amount of time spent in criminal
activity as a function of various factors
y = f (x1 , x2 , x3 , x4 , x5 ; θ),
where

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 – y: hours spent in criminal activities
– x1: “wage” for an hour spent in criminal activity
– x2: hourly wage in legal employment
– x3: probability of getting caught
– x4: probability of being convicted if caught
– x5: expected sentence if convicted
• Econometrics is often used to empirically validate the implication of a formal economic model. Sometimes
is convenient to use economic theory less formally and rely on intuition.
• Example. Even wihtout utility maximization, we can all agree that the quantity demanded of a good
depends on its price, the price of substitute and complementary goods, the consumer’s income, and the
individual’s characteristics that affect taste.
• Reasoning based on common sense is sometimes enough to formulate a specific economic question.
There are cases where formal derivations provide insights that intuition can overlook.
• Example. It is natural to expect that a model of consumption implies that the demand of a good
decreases as it price increases. It might not so natural understand how transaction volume affect the
price of an asset in a model of price formation.

What is an econometric model?

• Once we have formalized an economic relationship and a question of interest, we provide an answer
with an econometric model.
• An econometric model consists of a set of equations that tie the economic model to real life.
– To obtain the equations, it is necessary to specify the function f (·).
– The equations involve some observed variables and some error terms.
• Example. For the economic model of crime, we can specify the following econometric model:

y = β0 + β1 x1 + β2 x2 + β3 x3 + β4 x4 + β5 x5 + 

where
– y is some measure of the frequency of criminal activity.
– x1 is the wage that can be earned in legal employment.
– x2 is the income from other sources.
– x3 is the frequency of arrests for prior infractions.
– x4 is the frequency of conviction.
– x5 is the average sentence length after conviction.
–  is an error term.
• The variables are classified into two types:
– Endogenous variables (y). Variables explained by the model. In a model there are as many
endogenous variables as the equations of the model.
– Exogenous variables (x). Variables used in the equations of the model to explain the endogenous
variables.
• The parameters of the econometric model describe the directions and strengths of the relationship
between exogenous and endogenous variables.

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 • The error term () is a random variable and have the scope to fill the discrepancy between the model
and the economic reality. This discrepancy is due to different factors:
– The incompleteness of the economic theory underlying the model.
– The simplifications assumed in the model specification.
– Measurement error in collecting the data.
• Once an econometric model has been specified, the hypotheses of interest can be stated in terms of the
unknown parameters.
• Example. We might hypothesize that the wage that can be earned in legal employment, has no effect
on criminal behavior. In the context of this particular econometric model, the hypothesis is equivalent
to β1 = 0.
• After data on the relevant variables have been collected, statistical methods are used to estimate the
parameters in the econometric model and to formally test hypotheses of interest or make predictions.

Data in econometrics
• Providing a meaningful answer to an economic question requires careful collection of economic data.
• Example. The ministry of economic development hires you to study the impact of industrial innovation
on occupation. How do you measure innovation?
• Example. You are the analyst of an investment bank and are asked to study the impact of macroeconomic
announcements on asset volatility. How do you measure volatility? Assume you are able to do so, can
you just take the pre- and post-announcement volatility observations?
• There are three major data structures in econometrics:
– Cross sectional data
– Time series data
– Panel data
• Cross sectional data. Measurements for individual observations (people, households, firms, states,
ecc) at a given point of the time. For example, the income collected for N individuals in 2018.
• An important feature of cross-sectional data is that we can often assume that they have been obtained
by random sampling from the underlying population. When this is not the case, we have a sample
selection problem.
• Example A cross-sectional data set on wages and other individual characteristics.
id wage educ exper female married
1 1 3.10 11 2 1 0
2 2 3.24 12 22 1 1
3 3 3.01 11 2 0 0
4 4 6.05 8 44 0 1
5 5 5.24 12 7 0 1
• Time series data. Measurements of one (or more) variables over time. For example, the GDP of a
country from 1990 to 2002.
• Because past events can influence future events and lags in behavior are prevalent in the social sciences,
time is an important dimension in a time series data set. Unlike cross-sectional data, the chronological
ordering of observations in a time series conveys potentially important information.
• A key feature of time series data that makes it more difficult to analyze than cross-sectional data is the
fact that economic observations can rarely, if ever, be assumed to be independent across time.

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 • Example. Minimum wage, unemployment, gross national product for Puerto Rico.
year minwage unemp gnp
1 1950 0.20 15.4 878.7
2 1951 0.21 16.0 925.0
3 1952 0.23 14.2 1015.9
• Panel or longitudinal data. Time series measurement for each cross-sectional member in the dataset.
For example, cross-sectional information on US firms, such as size, ROE, book-to-market ratio, from
2001 to 2003.
• The use of more than one observation can facilitate causal inference in situations where inferring
causality would be very difficult if only a single cross section were available.
• Example. A two-year panel dataset on city crime statistics.
city year murders population unemp police
1 1 1950 5 350000 8.7 440
2 1 1955 8 359200 7.2 471
3 2 1950 2 64300 5.4 75
4 2 1955 1 65100 5.5 75
5 3 1950 10 260700 9.6 286
6 3 1955 6 245000 9.8 330

Abuses in econometrics
• An econometric analysis is no alchemy. It’s not about finding relationships among variables with
fancy statistical tools.
• An econometric analysis is grounded in the economic theory, and uses appropriate mathematical and
statistical tools to analyze the data.
– The economic theory selects the variables and the relationships.
– The mathematics formalizes the economic relationships.
– The statistics allows to assign values to the unknown parameters of the mathematical relationships.
– The data provides the information required to quantify the relationships and validate the model.

Causality in econometrics
• In testing economic theory and evaluating public policy, the goal is to infer the causal effect that one
variable has on another variable.
– Simply finding an association between two or more variables do not entail causality.
– Causal effects are identified only under the condition of other factors being equal (ceteris paribus).
• An ideal setting to identify causal effects is the randomized controlled experimenent.
– Individual with equal characteristics are randomly assigned to a treated group and to a control
group.
– The only systematic difference between the two groups is the treatment effect.
• In practice:
– Experiments are costly or difficult to implement seriously (randomised sampling).
– Sometimes they’re contrary to ethics (increase the price of cigarettes only for some people).
– Clearly we cannot treat some circumstances (black/white).

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 – We collect the observations ex-post.
• As a result, the treatment effect could also be the result of other factors we need to control for.
• Econometrics is also about facing the challenges posed by a nonexperimental setup.

Forecast and causality

• It is not necessary to have a causal relation for a good forecast.
– Silly example. You can look outside and see if people walk around with open umbrellas to forecast
that it is raining. However, open umbrellas do not cause rain.
– Note however that economic theory is likely to provide relationship that can lead to a meaningful
forecast.