Chapter 1econometrics New MBA

Grand College
Post graduate studies

Management Department : MBA Program
Course Title: Econometrics and software Application in Research

Year: I ; Semester II: Academic Year : 2022-2023
Level and program of study: MBA
Course Code: MBA 514 ; Credit Hours: 2
Course Instructor : Berhanu Getinet(Ass. Professor )
E-mail: getbre@gmail.com
Econometrics&SW App for MBA: Lecture by

3/21/2023 Berhanu G.(Ass.Professor) 1
COURSE DESCRIPTION
•The course aims at introducing the theory and practice of
econometrics.
•It provides students with the opportunity to develop specialized
quantitative skills and gain an understanding of the recent
advances in applied econometric models
•The course first introduces students with the definition and some
fundamental concepts of econometrics like economic and
econometric modeling as well as types of data employed in
quantitative analysis.
•Then it proceeds to the simple classical linear regression model
with emphasis to the basic concepts, assumptions, estimation
methods, ordinary least squares and maximum likelihood
estimation, inferences and analyses of residuals and interpretations
of the models and their applications in finance are covered.
•This is then built into the multiple linear regressions.
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Berhanu G.(Ass.Professor)
Cont…
• The the multiple linear regression model, is an extension
of the simple linear regression where more multiple
explanatory variables are considered and additional
assumptions are made.
• The second and third chapters will give due emphasis for
the ordinary least squares (OLS) technique of estimation
and the statistical properties of the parameter estimates.
• After making tests of linear restrictions emanating from
economic theory, the course will introduce the concepts of
multicollinearity, heteroskedasticity and autocorrelation.
• The assumptions of the classical linear regression model
will be relaxed or the case of autocorrelation,
heteroskedasticity and multicollinearity will be discussed.
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Cont…
• In addition, the methods to detect the presence of each of
the problems, their consequences and remedial measures
will be dealt.
• Moreover, the course introduces the concepts of
regression analysis with Qualitative Information(dummy
variable) and regression models such as Logit and Probit
Models will be covered.
• Finally, the course introduces time series econometrics
• The course heavily builds upon your previous courses like
introduction to statistics and Statistics for business ,
Economics and thus concepts of sampling distributions,
estimation and hypothesis testing will be of much help.
• These will be applied on Ethiopian/international data
using statistical packages.

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COURSE OBJECTIVE
•The main objective of this course is to;
enable students have a good background knowledge on basic
econometric models.
introduce students with the technique of how a blend of
economic theory, statistical and mathematical methods are used in
the analysis of economic data, with a purpose of giving empirical
content to economic theories and verify or refute them.
acquaint with basic but comprehensive introduction to applied
econometrics.
to enable students to construct an empirical model and apply
statistical techniques to conduct problem solving research in
management by translating theoretical models into an empirically
implementable form,
enhance the practical research skills of graduates to make an
empirical analysis of data and develop a basic knowledge of
econometric modeling used in business administration researches.

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LEARNING OUT COMES: l
• After the completion of the course, students will be able to:
o Distinguish between economic and econometric models;
o Do simple and multiple regression with economic data(both
manually and using statistical packages);
o Interpret regression results (like coefficients and R2) and test
hypotheses (both manually and using statistical packages); and
o Detect (in) existence of problems of multicollinearity,
heteroskedasticity and autocorrelation as well as suggest how
to rectify such problems using statistical packages).
o Understand and apply qualitative response models such as logit
and probit
o Critically understand time series and panel data econometrics
and their applications
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COURSE CONTENTS:
Chapter 1: Introduction
1.1. Definition and Scope of Econometrics
1.2. Models: Economic models and Econometric models
1.3. Methodology of Econometrics
1.4 Desirable properties of an econometric model
1.5 Goals of Econometrics
1.6. The Sources, Types and Nature of Data in econometrics
Chapter 2: Simple Linear Regression
2.1. Concept of Regression Function
2.2. Method of Moments & Method of Least Squares
2.3. Residuals and Goodness-of-fit
2.4. Properties of OLS Estimates and Gauss-Markov Theorem
2.5. Confidence Intervals and Hypothesis Testing
2.6. Predictions using Simple Linear Regression Model
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Cont…
Chapter 3: Multiple Linear Regression
3.1. Method of Ordinary Least Squares revised
3.2. Partial Correlation Coefficients & their Interpretation
3.3. Coefficient of Multiple Determination
3.4. Properties of Least Squares and Gauss-Markov Theorem
3.5. Hypothesis Testing in Multiple Linear Regression
3.6. Predictions using Multiple Linear Regression
Chapter 4 : Violations of the Assumptions of the Classical Model
4.1. Multicollinearity
4.2. Heteroscedasticity
4.3. Autocorrelation
4.4. Specification Errors: Omission of Variables
4.5. Tests of Parameter Stability

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Cont…
Chapter 5 : Regression Analysis with Qualitative Information:
Binary (or Dummy Variables)
5.1.Describing Qualitative Information
5.2.Dummy as Independent Variables
5.3.Dummy as Dependent Variable
5.4.The Linear Probability Model (LPM)
5.5.The Logit and Probit Models
5.6.Interpreting the Probit and Logit Model Estimates

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Cont…
Chapter 6 : Introduction to time series econometrics
6.1. The nature of Time Series Data
6.2. Stationary and non-stationary stochastic Processes
6.3. Trend Stationary and Difference Stationary Stochastic
Processes
6.4. Integrated Stochastic Process
6.5. Tests of Stationarity: The Unit Root Test

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Mode Of Delivery for the course
• The delivery method shall be student-centered.
• In addition to the series of lectures offered in class and the
seminars prepared by students, a series of computer
workshops will be arranged for the course to introduce
students with econometrics packages, particularly SPSS.
• Specifically the course will be delivered through the following
methods:
o Lecture Method sessions with demonstrations
o Computer Lab works (SPSS Application)
o In-class problem solving
o Individual and group Assignments(works)

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Evaluation and Assessment
• In this course, the evaluation and assessment will be made in

the following contents and aspects;
1. Assignment( Individual )---------------------------------- -10 %
2. Assignment(Group) --------------------------------------- -40%
3. Final Examination------------------------------------------ 50 %

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REFERENCES
• Gujarati, Damodar N., Porter, Dawn C. & Gunasekar, Sangeetha.
(2009) Basic Econometrics. 5th ed. McGraw Hill Education.
• Zax, Jeffrey S. (2011), Introductory Econometrics: Intuition, Proof
and Practice. Stanford University Press.
• Brooks, C. (2014), Introductory to Econometrics for Finance. 3rd
ed. Cambridge University Press.
• Hall, R. Carter., Griffiths, William E., Lim, Guay S. (2011). Principles
of Econometrics. 4th ed. John Wiley & Sons, Inc.,

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Chapter 1 : Introduction
1.1Definition and Scope of Econometrics
What is econometrics?
• Literally speaking, the word ‘econometrics’ means measurement
in economics.
• The first four letters of the word suggest correctly that the
origins of econometrics are rooted in economics
• Econometrics, the result of a certain outlook on the role of
economics, consists of the application of mathematical statistics
to economic data to lend empirical support to the models
constructed by mathematical economics and to obtain
numerical results.
• 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.
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Cont…
• Econometrics may be defined as the quantitative analysis of
actual economic phenomena based on the concurrent
development of theory and observation, related by appropriate
methods of inference.
• More specifically, it is concerned with the use of statistical
methods to attach numerical values to the parameters of
economic models and also with the use of these models for
prediction.
• The techniques of econometrics consist of a blend of economic
theory, mathematical modeling and statistical analysis.
• The method of econometric research aims, essentially, at a
conjunction of economic theory and actual measurements, using
the theory and technique of statistical inference as a bridge pier.
• Econometrics is concerned with the empirical determination of
economic laws and principles

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Cont…
• In general, econometrics is the application of statistical and
mathematical methods to the analysis of economic data with a
purpose of giving empirical content to economic theories and
verifying or refuting them.

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Cont…
• The main techniques employed for studying economic problems
are of equal importance in financial and business applications.
• Therefore ,econometrics is defined as the application of statistical
techniques to problems in finance, economics and business
• Econometrics can be useful for;
o testing theories in economics and finance, business
administration
o determining asset prices or returns,
o testing hypotheses concerning the relationships between
variables,
o examining the effect on financial and non financial markets of
changes in economic conditions/variables,
o forecasting future values of financial and related variables and
o financial and managerial decision-making.
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1.2 Economic models and econometric models
• The first task an econometrician faces is that of formulating an
econometric model.
What is a model?
• A model is a simplified representation of a real-world process.
• For instance, ‘the demand for oranges depends on the price of
oranges’ is a simplified representation since there are a host of
other variables that one can think of that determine the demand
for oranges.
• These include:
o Income of consumers
o An increase in diet consciousness (e.g. drinking coffee causes
cancer; so better switch to orange juice)
o Increase or decrease in the price of substitutes (e.g. that of apple)
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Cont…
• However, there is no end to this stream of other variables!
Many have argued in favour of simplicity since simple
models are easier:
To understand
To communicate
To test empirically with data
• In practice we include in our model:
o Variables that we think are relevant for our purpose.
o A ‘disturbance’ or ‘error’ term which accounts for variables
that are omitted as well as all unforeseen forces.
This brings us to the distinction between an economic
model and econometric model.

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Economic models
• Any economic theory is an observation from the real
world.
• For one reason, the immense complexity of the real
world economy makes it impossible for us to
understand all interrelationships at once.
• Another reason is that all the interrelationships are not
equally important as such for the understanding of the
economic phenomenon under study.
• The sensible procedure is therefore, to pick up the
important factors and relationships relevant to our
problem and to focus our attention on these alone.
• Such a deliberately simplified analytical framework is
called on economic model.

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Cont…
• Economic model is an organized set of relationships that
describes the functioning of an economic entity under a set of
simplifying assumptions.
• An economic model is a set of assumptions that approximately
describes the behavior of an economy(or a sector of an
economy).
• Economic models consist of the following three basic structural
elements.
1. A set of variables
2. A list of fundamental relationships and
3. A number of strategic coefficients

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Econometric models
• The most important characteristic of econometric relationships is
that they contain a random element which is ignored by
mathematical economic models which postulate exact
relationships between economic variables.
Example: Economic theory postulates that the demand for a
commodity depends on its price, on the prices of other related
commodities, on consumers’ income and on tastes.
• This is an exact relationship which can be written mathematically
as:
• The above demand equation is exact. How ever, many more

factors may affect demand.

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Cont…
• In econometrics the influence of these ‘other’ factors is taken into
account by the introduction into the economic relationships of
random variable.
• The above demand equation is exact though many more factors
may affect demand.
• In our example, the demand function studied with the tools of
econometrics would be of the stochastic form:
• where ‘’u’’ stands for the random factors which affect the
quantity demanded.

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Cont…
• Therefore, an econometric model consists of the following:
a) A set of behavioural equations derived from the economic
model. These equations involve some observed variables
and some ‘disturbances’.
b) A statement of whether there are errors of observation in
the observed variables.
c) A specification of the probability distribution of the
‘disturbances ‘.
• With these specifications, we can proceed to test the
empirical validity of the economic model and use it to make
forecasts or use it in policy analysis.

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1.3 Methodology of econometrics
• How do econometricians proceed in their analysis of an economic
behavior and problems ?
• What is their methodology?
• Although there are several schools of thought on econometric
methodology, we present here the traditional or classical
methodology, which still dominates empirical research in
economics and other social and behavioral sciences.
The aims of econometrics are:
a) Formulation of econometric models, that is, formulation of
economic models in an empirically testable form (specification
aspect).
b) Estimation and testing of these models with observed data
(inference aspect).
c) Use of these models for prediction and policy purpose.

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Cont…
Fig 1 Schematic description of the steps involved in econometric
analysis(modelling)

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Description of the steps
1. Statement of theory or hypothesis: We begin with an
economic model which is a set of assumptions that describes
the behaviour of an economic phenomenon.
2. Specification of the mathematical model of the theory
3. Formulation (specification) of an econometric model: a set of
equations derived from the economic model that involve some
observed variables and some ‘disturbances’.
4. Collection of relevant data on variables implied by the
econometric model.
5. Estimation of model parameters using mathematical statistics
and probability theory.

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Cont…
6. Hypothesis testing: We conduct tests to verify whether:
• The specification of the model is correct
• Model assumptions are valid
Based on step (6):
• If the model failed to pass the specification testing and
diagnostic checking step, then one has to revise the
specification of the econometric model (or new specification).
• If the model passes the specification testing and diagnostic
checking step, then one has to proceed with testing any
hypothesis of interest (e.g. which of the explanatory variables
significantly affect the response (endogenous) variable?).
7 . Forecasting or prediction
8. We use the estimated model for predictions and policy.

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Cont…
• The steps of econometric modeling can be presented in detail
as follows:
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.
• Theory of demand is an other example, ‘there is an inverse

relationship between the price of a commodity and its
quantity demanded, ceteris paribus’.

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Cont…
2. Specification of the Mathematical Model (of
Consumption)
– a mathematical economist might suggest the following
form of the Keynesian consumption function:
Y = β1 + β2X, 0 < β2 <
– where Y = consumption expenditure and X = income,
and where β11 and β22, known as the parameters of
the model, are, respectively, the intercept and slope
coefficients.
– The slope coefficient β2 measures the MPC (marginal
propensity to consume). Graphically presented on the
next slide.
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Cont…
• Fig. 2 : Keynesian consumption function and MPC

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Cont…
3. Specification of the Econometric Model (of Consumption)
• The purely mathematical model of the consumption function
given in the above equation is of limited interest to the
econometrician, for it assumes that there is an exact or
deterministic relationship between consumption and income.
• But relationships between economic variables are generally
inexact.
• To allow for the inexact relationships between economic
variables, the econometrician would modify the deterministic
consumption function as follows:
Y = β1 + β2X + u
where u, known as the disturbance, or error, term, is a random
(stochastic) variable that has well-defined probabilistic
properties.
3/21/2023 32
Cont…
• The disturbance term u may well represent all those factors
that affect consumption but are not taken into account
explicitly.
• The above equation is an example of an econometric model.
• More technically, it is an example of a linear regression model,
which is the major concerns of this course.
• The econometric consumption function hypothesizes that the
dependent variable Y (consumption) is linearly related to the
explanatory variable X (income)
• but that the relationship between the two is not exact; it is
subject to individual variation.

3/21/2023 33
Cont…

3/21/2023 34
Cont…
4. Obtaining or Collection of relevant data
• To estimate the econometric model given, to obtain the
numerical values of β1 and β2, we need data.
• See the data in the table on the previous slide, used for
illustration .
5. Estimation of the Econometric Model

• Now that we have the data, our next task is to estimate the
parameters of the consumption function.
• The statistical technique of regression analysis is the main
tool used to obtain the estimates. E.g.
Y_hat= −184.08 + 0.7064Xi
• suggesting that 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.
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Cont…
6. Hypothesis Testing
• Assuming that the fitted model is a reasonably good
approximation of reality, we have to develop suitable criteria to
find out whether the estimates obtained are in accord with the
expectations of the theory that is being tested.
• As noted earlier, Keynes expected the MPC to be positive but

less than 1. In our example we found the MPC to be about
0.70. 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).

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Cont…
7. Forecasting or Prediction
• If the chosen model does not refute the hypothesis or
theory under consideration, we may use it to predict the
future value(s) of the dependent, or forecast, variable Y on
the basis of known or expected future value(s) of the
explanatory, or predictor, variable X.
• To illustrate, 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 on the right-hand side, we obtain:
Y_ hat1997 = −184.0779 + 0.7064 (7269.8)

= 4951.3167
or about 4951 billion dollars.
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cont…
• Thus, given the value of the GDP, the mean, or average, forecast
consumption expenditure is about 4951 billion dollars.
• If the actual value of the consumption expenditure reported in
1997 was 4913.5 billion dollars.
• The estimated model 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,
which is about 0.76 percent of the actual GDP value for 1997.
8. Use of the Model for Control or Policy Purposes
• Suppose we have the estimated consumption function given
above.
• 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.

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Cont…
• What level of income will guarantee the target amount of
consumption expenditure?
• If the regression results given above seem reasonable, simple
arithmetic will show that
4900 = −184.0779 + 0.7064X
• which gives X = 7197, approximately.
• That is, an income level of about 7197 (billion) dollars, given an
MPC of about 0.70, will produce an expenditure of about 4900
billion dollars.
• As these calculations suggest, 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.
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1.4 Types of Econometrics
• Econometrics may be divided into two broad categories:
– theoretical econometrics and
– applied econometrics.
• In each category, one can approach the subject in

– the classical or
– Bayesian tradition.
• The emphasis here is on the classical approach
• Theoretical econometrics is concerned with the
development of appropriate methods for measuring
economic relationships specified by econometric models.
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Cont…
Fig 3: Types of econometrics

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cont…
• Econometrics leans heavily on mathematical statistics.
• For example, one of the methods used extensively in this course
is least squares.
• Theoretical econometrics must spell out the assumptions of
this method, its properties, and what happens to these
properties when one or more of the assumptions of the method
are not fulfilled.
• In applied econometrics we use the tools of theoretical
econometrics to study some special field(s) of economics and
business, such as
o the production function,
o investment function,
o demand and supply functions,
o portfolio theory, etc.
3/21/2023 42
1.5 Goals of econometrics
i) Analysis i.e. testing economic/financial theory
ii) Policy making i.e. Obtaining numerical estimates of
the coefficients of economic relationships for policy
simulations.
iii) Forecasting i.e. using the numerical estimates of the
coefficients in order to forecast the future values of
economic magnitudes

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1.6 Types of Data used in econometrics
• Broadly three types of data that can be employed in quantitative
analysis of financial problems: time series data, cross-sectional
data, and panel data
1. Cross-sectional data
• Cross-sectional data are data on one or more variables collected
at a single point in time.
2. Time series data
• Time series data, as the name suggests, are data that have been
collected over a period of time on one or more variables.
• Time series data have associated with them a particular
frequency of observation or collection of data points.

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Cont…
• The frequency is simply a measure of the interval over, or the
regularity with which, the data are collected or recorded.
Example : weekly, annually, quarterly, daily, hourly,etc
3. Panel data
o Panel data have the dimensions of both time series and cross-
sections,
o e.g. the daily prices of a number of blue chip stocks over two
years.

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Types of variables
• Like classifying data as being of the time series or cross-sectional
type, we could also distinguish it as being either continuous or
discrete
1. Continuous
• Continuous data can take on any value and are not confined to
take specific numbers; their values are limited only by precision.
• For example, the rental yield on a property could be 6.2%, 6.24%
or 6.238%, and so on.
2. Discrete
• On the other hand, discrete data can only take on certain values,
which are usually integers (whole numbers), and are often
defined to be count numbers.
• The number of shares traded during a day and in this case
58571/2 shares traded would not make sense.
3/21/2023 46
Types of data measurements
• Some of the types of data measurement scales are:
o Cardinal(continuous)
o Ordinal
o Nominal
o Scale/Ratio

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Desirable properties of an econometric model
• An econometric model is a model whose parameters have
been estimated with some appropriate econometric technique.
• The ‘goodness’ of an econometric model is judged customarily
according to the following desirable properties:
1. Theoretical plausibility.
• The model should be compatible with the postulates of
economic theory.
• It must describe adequately the economic phenomena to
which it relates.

3/21/2023 48
Cont…
2. Explanatory ability
• The model should be able to explain the observations of he
actual world.
• It must be consistent with the observed behaviour of the
economic variables whose relationship it determines.
3. Accuracy of the estimates of the parameters
• The estimates of the coefficients should be accurate in the
sense that they should approximate as best as possible the true
parameters of he structural model.
• The estimates should if possible possess the desirable
properties of unbiasedness, consistency and efficiency.

3/21/2023 49
Cont…
4. Forecasting ability
• The model should produce satisfactory predictions of future
values of he dependent (endogenous) variables.
5. Simplicity
• The model should represent the economic relationships with
maximum simplicity.
• The fewer the equations and the simpler their mathematical
form, the better the model is considered, ceteris paribus (that
is to say provided that the other desirable properties are not
affected by the simplifications of the model).

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End of the chapter
Thank you for your attention!

3/21/2023 51

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Grand College

Post graduate studies

Course Title: Econometrics and software Application in Research

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

• In this course, the evaluation and assessment will be made in

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

• The above demand equation is exact. How ever, many more

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

• Theory of demand is an other example, ‘there is an inverse

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

5. Estimation of the Econometric Model

• As noted earlier, Keynes expected the MPC to be positive but

• Such confirmation or refutation of economic theories on the

Econometrics&SW App for MBA: Lecture by

• To illustrate, suppose we want to predict the mean

Y_ hat1997 = −184.0779 + 0.7064 (7269.8)

Econometrics&SW App for MBA: Lecture by

• In each category, one can approach the subject in

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Econometrics&SW App for MBA: Lecture by

Thank you for your attention!

Econometrics&SW App for MBA: Lecture by

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