ECONOMETRICS

WHAT IS ECONOMETRICS?
WHY WE STUDY?
• ECONOMETRICS – ECONOMIC MEASUREMENT
• Econometrics may be defined as the social science in
which the tools of economic theory, mathematics, and
statistical inference are applied to the analysis of
economic phenomena.

Statistical inference means to “infer” something about the

real world by analyzing a sample of data.

Estimating Predicting Testing

economic economic economic
parameters outcomes hypothesis

WHAT IS ECONOMETRICS?
• Fills gap between “being a student of economics” and
“being a practicing economist”
• Economic theory is mostly qualitative in nature.
Example: Law of Demand which shows an inverse
relationship between the price and quantity demanded of that
commodity. But there is no numerical measure of the
relationship.
Economists use economic data to: Estimate economic
relationships, test economic hypothesis and predict economic
outcomes.
Econometrics is all about answering “how much” type
questions.

WHY A SEPARATE DISCIPLINE?

• Mathematical economics expresses economic theory in mathematical
form without regard to measurability or empirical verification of the
theory.
Example: Keynesian consumption function (mathematical form)
Y = β1 + β2X where 0 <β2 < 1 , Y= consumption expenditure and
X= disposable income
Keynesian consumption function (econometric form)
Y = β1 + β2X + u where u = the disturbance, or error term.

• Economic statistics is concerned with collecting, processing and

presenting economic data but is not concerned with using the data to
test economic theories.
One who does that becomes an econometrician!

WHY A SEPARATE DISCIPLINE?

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METHODOLOGY OF ECONOMETRICS
- GARIMA GUPTA
 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.

METHODOLOGY
• Keynes stated “The fundamental psychological law”
Consumption of a person increases as his/her income
increases, but not as much as the increase in his/her income.

In short, Keynes postulated that the marginal propensity to

consume (MPC), the rate of change of consumption for a
unit change in income, is greater than zero but less than 1.

1. Statement of Theory or Hypothesis

 • Although Keynes postulated a positive relationship between consumption and
income, he did not specify the precise form of the functional relationship between
the two.
• Mathematical form of the Keynesian consumption function:
Y = β1 +β2X 0 < β2 < 1 (1)

where Y= consumption expenditure and X=income

β1 and β2 are, respectively, the intercept and slope coefficients
β2 measures the MPC

2. Specification of the Mathematical

Model of Consumption
• Econometric model: Y = β1 +β2X+u (2)
where u, known as the disturbance, or error, term, is a
random (stochastic) variable that represent all those factors
that affect consumption but are not taken into account
explicitly.

It is an example of a linear regression model.

3. Specification of the Econometric

Model of Consumption
To estimate the econometric model, that is, to obtain the
numerical values of β1 and β2, we need data.
Year Y X (BOTH IN BILLIONS OF DOLLARS)
1982 3081.5 4620.3
1983 3240.6 4803.7
1984 3407.6 5140.1
1985 3566.5 5323.5
Y- Aggregate personal consumption 1986 3708.7 5487.7
expenditure 1987 3822.3 5649.5
X- GDP, a measure of aggregate 1988 3972.7 5865.2
income 1989 4064.6 6062.0
1990 4132.2 6136.3
1991 4105.8 6079.4
1992 4219.8 6244.4
1993 4343.6 6389.6
1994 4486.0 6610.7
1995 4595.3 6742.1

4. Obtaining Data
1996 4714.1 6928.4
Source: Economic Report of the President,
1998, Table B–2, p. 282.
 • Now, estimate the parameters of the consumption
function. The numerical estimates of the parameters give
empirical content to the consumption function.
• The statistical technique to obtain the estimates:
regression analysis

The estimated consumption function is:

𝒀= −184.08 + 0.7064 Xi - (3)

5. Estimation of the Econometric Model

Regression Line
• To develop suitable criteria to find out whether the
estimates obtained are in accord with the expectations of
the theory that is being tested
• In other words, is 0.70 statistically less than 1? If it is, it
may support Keynes’ theory. Such confirmation or
refutation of economic theories on the basis of sample
evidence is based on a branch of statistical theory known
as statistical inference (hypothesis testing).

6. Hypothesis Testing
• Suppose we want to predict the mean consumption expenditure for 1997. The
GDP value for 1997 was 7269.8 billion dollars.
Putting this GDP figure in (3), we obtain:

𝒀 1997 = −184.0779 + 0.7064(7269.8) = 4951.3167 (4)

The actual value reported in 1997 was 4913.5 billion dollars. The estimated model
(3) thus over-predicted the actual consumption expenditure by about 37.82 billion
dollars.
We could say the forecast error is about 37.82 billion dollars.

A quantitative estimate of MPC provides valuable information for policy purposes.

Knowing MPC, one can predict the future course of income, consumption
expenditure, and employment following a change in the government’s fiscal policies.

7. Forecasting or Prediction
• Suppose further the government believes that consumer expenditure of about
4900 (billions of 1992 dollars) will keep the unemployment rate at its current
level of about 4.2 percent (early 2000). What level of income will guarantee
the target amount of consumption expenditure?
4900= −184.0779 + 0.7064X (6)
which gives X = 7197 i.e., an income level of about 7197 (billion) dollars, given
an MPC of about 0.70, will produce an expenditure of about 4900 billion dollars.
• An estimated model may be used for control, or policy, purposes. 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.

8. Use of the Model for Control or Policy

Purposes