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Chapter one
Introduction

1.1 Definition of Econometrics

The economic theories you have learnt in various economics courses suggest that the existence
of many relationships among economic variables. For instance, in microeconomics you have
learnt demand and supply models in which the quantities demanded and supplied of a good
depend on its price (i.e. quantity of X is depends on price of X). In macroeconomics, you have
studied ‗investment function‘ to explain the amount of aggregate investment in the economy as
the rate of interest changes; and ‗consumption function‘ that relates aggregate consumption to
the level of aggregate disposable income.

Each of such specifications involves a relationship among two or more variables in the economy.
As economists, we might be interested in questions such as: If price of one commodity changes
by certain magnitude, by how much would quantity demanded for a commodity changes? Also,
given that we know the value of one variable; can we forecast or predict the corresponding value
of another? The purpose of studying the relationships among economic variables and attempting
to answer questions of the type raised here help us to understand the real economic world we live
in. The field of knowledge which helps us to carry out such measurement and evaluation of
economic theories in empirical terms is known as econometrics.

What is Econometrics?
Different scholars defined econometrics in slightly different ways:
Gujarati (2003): 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. Thus, it is concerned with empirical determination of economic laws.
Maddala (1992) defined econometrics as 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 them or refuting them.
According to Woodridge (2004) econometrics is based upon statistical methods for estimating
economic relationships, testing economic theories, and evaluating and implementing government

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and business policy. On the other hand, Verbeek (2008) explained econometrics as the
interaction of economic theory, observed data and statistical methods. However, William H.
Greene (2003) stated that econometrics is a unification of the theoretical-quantitative and the
empirical-quantitative approach to economic problems. But there are several aspects of the
quantitative approach to economics, and no single one of these aspects taken by itself, and
should be confounded with econometrics. Thus, econometrics is by no means the same as
economic statistics; nor is it identical with what we call general economic theory, although a
considerable portion of this theory has definitely quantitative character. Nor should econometrics
be taken as synonymous with the application of mathematics to economics.

In general, econometrics is concerned with ―economics measurement‖ and quantitative analysis

of economic phenomenon. 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.
Why Econometrics a separate discipline?
As the preceding definitions suggest, econometrics is an amalgam of economic theory,
mathematical economics, economic statistics, and mathematical statistics. Yet, the subject
deserves to be studied in its own right for the following reasons:
Economic theory makes statements or hypotheses that are mostly qualitative in nature, while
econometrics gives empirical content to most economic theory (it helps us to quantify economic
theory). For instance, economic theory postulates, ceteris paribus, a negative relationship
between price and quantity demanded or price and quantity demanded of a commodity is
inversely related keeping other things constant. But the theory by itself doesn‘t provide any
numerical measures.
Economic statistics is concerned with descriptive statistics such as collecting, processing, and
presenting economic data in the form of charts and tables but doesn‘t go further to test economic
theory.
Mathematical statistics deals with statistics from mathematical point of view using probability
theory but econometricians‘ needs special method of data generating process.
Mathematical economics is to express economic theory in mathematical form without empirical
verification of the theory, while econometrics is mainly interested in the later. Econometricians

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 Department of Economics, Econometrics for Management for 3rd year management
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often use mathematical equations proposed by mathematical economists in a way that they lend
themselves to empirical testing. Ex.
Econometrics is an amalgam of economic theory, mathematical economics, economic statistics,
and mathematical statistics. It borrows methods from statistical and mathematics for estimating
economic relationships, testing economic theories, and evaluating and implementing government
and business policy whenever possible.
Econometrics is mainly concerned with:
 Estimation of relationships from sample data
 Hypotheses testing about how variables are related
 the existence of relationships between variables
 the direction of the relationships between the dependent variable and its
hypothesized observable determinants
 the magnitude of the relationships between a dependent variable and the
independent variables thought to determine it

Thus, the main task of econometrics is estimation and hypothesis testing.

1.2 Models
A model is a simplified representation of a real-world process. For instance, saying that the
quantity demanded of oranges depends on the price of oranges keeping other things being
constant is a simplified representation. Because, there are other variable that determine demand
for oranges. In other words, demand for orange is negatively related with price of orange holding
other factors constant. Why we hold other factors constant? Model helps us to easily understand,
communicate, and test empirically with data. It is important to explain complex real-world
phenomena.

An economic model is a set of assumptions that approximately describes the behavior of an

economy. While an econometric model consists of a set of behavioral equations derived from the
economic model. These equations involve some observed variables and some unobserved
variable (disturbances). It uses 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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 Department of Economics, Econometrics for Management for 3rd year management
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1.3 Methodology of Econometrics

Econometric methods are relevant in virtually every branch of applied economics. They come
into play either when we have an economic theory to test or when we have a relationship in mind
that has some importance for business decisions or policy analysis. An empirical analysis uses
data to test a theory or to estimate a relationship.
How do econometricians proceed in their analysis of an economic problem? Or what is their
methodology? The classical econometrics methodology which dominates empirical research in
econometrics and other social and behavioral science proceeds along the following steps:
i. Statement of theory or hypothesis
ii. Specification of the mathematical model of the theory
iii. Specification of the econometric/Statistical model of the theory
iv. Obtaining Data
v. Estimating the parameters of the Econometric Model
vi. Hypothesis Testing
vii. Forecasting or Prediction
viii. Using model for control or policy purposes
1. Statement of theory or hypothesis

Example a. Keynes stated that ―Consumption increases as income increases, but not as much as
the increase in income‖. It means that ―The marginal propensity to consume (MPC)
for a unit change in income is greater than zero but less than unit‖
b. The law of demand states that there is an inverse relationship between quantity
demanded and own price. In other words demand curve is negatively sloped keeping
other factors constant.
c. the law of supply describes that as price of a particular commodity increase, ceteris
paribus, quantity supplied of that particular commodity increase.
2. Specification of the mathematical model
Although, Keynesian consumption theory postulates positive relationship between consumption
and disposable income, it doesn‘t specify precise form of functional relationship between them.
Mathematical economists might suggest the following consumption function:

(1.1)

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Where, Y= consumption expenditure
X= disposable income
and are unknown parameters; is intercept, and is slope coefficient which
measures the MPC.
Equation (1.1) shows that consumption expenditure (Y), dependent variable, linearly related with
income (X), independent variable. This equation is known as mathematical or deterministic
model of consumption function.

Figure 1.1 Keynesian consumption function

3. Specification of the econometric/Statistical model

Mathematical model in (1.1) is of limited interest to Econometricians since it assumes that the
existence of an exact or deterministic relationship between variables. However, the relationships
between economic variables are generally inexact. To allow for the inexact relationships between
economic variables, the econometrician would modify the deterministic consumption function in
(1.1) as follows:
(1.2)
Where, U is unobservable disturbance term or error term which is a random or stochastic
variable. The disturbance term (U) may capture all unobservable factors (variables not included
in the model) that can affect consumption. Equation (1.2) is an example of econometric model
technically it is linear regression model. The econometric model hypothesize that dependent

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variable (Y) related to the explanatory variable (X) but the relationship between variables is not
exact. The econometrics model can be depicted as shown in figure 1.2

Y .
. .
. . .
.
U . .
. .
..
. .
.
.

Figure 1.2 econometric model of Keynesian consumption function

4. Obtaining Data
To estimate parameters of econometric model in (1.2) we need data. For example, data in billion
dollar on Y (personal consumption expenditure) and X (gross domestic product) of hypothetical
country from 1980 to 1991are presented in the following table.
Table 1.1 personal consumption expenditure and gross domestic product in Billion USD
Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
2447.1 2476.9 2503.7 2619.4 2746.1 2865.8 2969.1 3052.2 3162.4 3223.3 3260.4 3240.8
Y
3776.3 3843.1 3760.3 3906.6 4148.5 4279.8 4404.5 4539.9 4718.6 4838 4877.5 4821
X

5. Estimating the Econometric Model

Now we have the data and we can estimate parameters of the econometric model of consumption
function. This gives empirical content to our consumption function. In the next chapters we will
discuss statistical techniques of regression analysis to estimate parameters. Using this technique
and the data give in (4) above we obtain the following estimates of , namely,
respectively. Thus, the estimated consumption function is:
̂ (1.3)
MPC was about 0.72, and it means that for the sample period when real income increased by 1
USD on average real consumption expenditure increased by about 72 cents
Note: A hat symbol (^) on Y variable will signify an estimator of the relevant population value

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 Department of Economics, Econometrics for Management for 3rd year management
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6. Hypothesis Testing
Assuming that the estimated 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
expectation of the theory.
 Are the estimates accords with the expectations of the theory that is being tested? That is,
is MPC < 1 statistically significant? If so, it may support Keynes‘ theory.

 Confirmation or refutation of economic theories based on sample evidence is the

objective of Statistical Inference (hypothesis testing)

7. Forecasting or Prediction
If the estimated model does not refute the hypothesis or theory under consideration, we may use
it to predict the future value(s ) of the dependent variable (Y) given future value(s) of
explanatory or predictor variable (X).
 With given future value(s) of X, what is the future value(s) of Y?

 Example, given X=$6000Bill in 1994, what is the forecasted consumption expenditure?

Y^= - 231.8+0.7196(6000) = 4085.8

Suppose the government decided to reduce income tax. What will be the effect of such a policy
on income and consumption expenditure and ultimately on employment? Assume that due to the
proposed policy change investment expenditure increased. What will be its effect on the
economy?
The critical value in this computation is MPC, for the multiplier depends on it. And this estimate
of the MPC can be obtained from regression models. Thus, 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.
Income Multiplier M = 1/(1 – MPC) (=3.57). Decrease (increase) of $1 in investment will
eventually lead to $3.57 decrease (increase) in income.

8. Using model for control or policy purposes

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Suppose that the government believes that 5000 level of consumption keeps inflation rate at
10%. Thus, Y=5000= -231.8+0.7194 X  X  7266
MPC = 0.72, an income of $7266 Bill will produce an expenditure of $5000 Bill. By fiscal and
monetary policy, Government can manipulate the control variable X to get the desired level of
target variable Y
Economic Theory

Mathematical model

Econometric Model

Data

Estimation of the Econometric Model with the

refined data using Econometric Techniques

Hypothesis testing

Is the Model adequate ?

YES
NO
Forecasting and prediction

Using the model for forecasting or

prediction and policy purposes

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 Department of Economics, Econometrics for Management for 3rd year management
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1.4 The structure of economic data

Economic data sets come in a variety of types which are the most important data structures
encountered in applied work.
A. Cross-section data: A cross-sectional data set consists of a sample of individuals, households,
firms, cities, states, countries, or a variety of other units, taken at a given point in time. 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. In economics, the analysis of
cross-sectional data is closely aligned with the applied microeconomics fields, such as labor
economics, state and local public finance, industrial organization, urban economics,
demography, and health economics. These types of data are important for testing microeconomic
hypotheses and evaluating economic policies.
Example,

Table 1.2 Partial List of hypothetical cross sectional data collected at one period.
Person Wage Educ Exper female married

1 3.1 11 2 1 0
2 3.24 12 22 1 1
3 3.00 11 2 0 0
4 6.00 8 44 0 1
5 5.30 12 7 0 1
……… ……… ……… ……… ……… ………
.
B. Time-series data: A time series data set consists of observations on a variable or several
variables over time at certain regular time interval. Examples of time series data include stock
prices, money supply, consumer price index, gross domestic product, annual homicide rates, and
automobile sales figures. Because past events can influence future events and lags in behaviour
are prevalent in the social sciences, time is an important dimension in a time series data set.
Unlike the arrangement of cross-sectional data, the chronological ordering of observations in a
time series conveys potentially important information.
Example,

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Table 1.3 Ethiopian Money supply and consumer price index (CPI) from 2005 to 2014

Observation Year Money supply CPI

1 2005 46968.2 44.84

2 2006 56358.9 50.36
3 2007 68877.7 59.04
4 2008 84988.0 85.26
5 2009 102084.0 92.48
6 2010 125088.4 100.00
7 2011 142161.7 133.22
8 2012 141584.3 163.56
9 2013 167567.0 176.77
10 2014 193053.5 189.84

C. A panel or longitudinal data: consists of a time series for each cross-sectional member in the
data set. A panel data set contains repeated observations over the same units (individuals,
households, firms), collected over a number of periods. Data sets that have both cross-sectional
and time series dimensions are being used more and more often in empirical research. Multiple
regression methods can still be used on such data sets. In fact, data with cross-sectional and time
series aspects can often shed light on important policy questions.
Consider having data on n units —individuals, firms, countries, or whatever —over T periods. The
data might be income and other characteristics of n persons surveyed each of T years, the output
and costs of n firms collected over T months, or the health and behavioral characteristics of n
patients collected over T years. In panel datasets, we write for the value of x for unit i at time t.
To collect panel data sometimes called longitudinal data we follow the same individuals, families,
firms, cities, states, or whatever, across time. For example, a panel data set on individual wages,
hours, education, and other factors is collected by randomly selecting people from a population at a
given point in time. Then, these same people are interviewed at several subsequent points in time.
This gives us data on wages, hours, education, and so on, for the same group of people in different
years.

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Example,
Table 1.4 A Two-Year Panel Data Set on City Crime Statistics
obs city year murders population unem polic
1 1 2003 5 350000 8.7 440
2 1 2007 8 359200 7.2 471
3 2 2003 2 64300 5.4 75
4 2 2007 1 65100 5.5 75
’’ ‘’ ‘’ ‘’ ‘’ ‘’ ‘’
‘’ ‘’ ‘’ ‘’ ‘’ ‘’ ‘’
97 49 2003 10 260700 9.6 286
98 49 2007 6 245000 9.8 334
99 50 2003 25 543000 4.3 520
100 50 2007 32 546200 5.2 493

D. Pooled Cross Section data: Is a randomly sampled cross sections of individuals at different
points in time For example, suppose that two cross-sectional household surveys are taken in the
Ethiopia, one in 2005 and one in 2008. In 2005, a random sample of households is surveyed for
variables such as income, savings, family size, and so on. In 2008, a new random sample of
households is taken using the same survey questions. In order to increase our sample size, we can
form a pooled cross section by combining the two years survey. Because random samples are
taken in each year, it would be a fluke if the same household appeared in the sample during both
years.
E. Non-experimental vs. experimental data
a. Non-experimental data are obtained from observations of a system that is not subject to
experimental control
b. experimental data are obtained from controlled experiments in laboratory
F. Qualitative versus quantitative data

The data may be quantitative (e.g. exchange rates, stock prices, number of shares outstanding,
GDP, inflation,..,) or qualitative (e.g. gender, color, race, religion, etc).

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Review questions
 How would you define econometrics?
 How does it differ from mathematical economics and statistics?
 Describe the main steps involved in any econometrics research.
 Differentiate between economic and econometric model.
 What are the goals of econometrics?
 Describe the structure of economic data.
 What are the sources of economic data?
 Explain problems associated with economic data
 What is the difference among panel data, pooled cross-sectional data and time
series data?
 What does mean by random sample? Why we are interested in it?
 Suppose you want to investigate student class attendance on their performance in
final exam for econometrics course. How do you collect data to achieve your
goal? Are there any other factors that can affect student performance? Do you
think ceteris paribus assumption is important in this investigation? Why?

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