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# Introductory Econometrics â Building an Investment model

ECN 221

Stage A: Specification of the model or maintained hypothesis Economic theory postulates, ceteris paribus, that investment in an economy is sa id to be influenced by the real interest rate, level of Gross Domestic Product, Marginal Propensity to Save, political climate, available natural resources of t he country and expansionary fiscal and monetary policies. On a priori grounds the researcher knows that not all the variables stated above have a positive effect on investment. In almost all instances investment is pos itively related to GDP, MPS, a positive political climate, an abundance of natur al resources and expansionary monetary policies. Conversely the real interest ra te and expansionary fiscal policies negatively influence investment. In this investment function, the core regressors that impact investment are the real interest rate and the level of GDP. The real interest rate has an inverse r elationship with investment since it is the opportunity cost of doing something instead of investment; as the interest rate increases the benefit of doing somet hing other than investment increases. GDP, which can be used as a measure of national income, impacts investment posit ively since as income increases the amount of savings you have will increase and thus investment increases since investment is equal to savings. Mathematical form of the model I= f(i, GDP, MPS, Pc, Nr, Fp, Mp) Where I= investment, i= real interest rate, GDP= Gross Domestic Product, MPS= Ma rginal Propensity to Save, Pc= political climate, Nr= available natural resource s of the country, Fp= fiscal policies, Mp= monetary policies. The above function states that investment is a function the real interest rate, Gross Domestic Product, Marginal Propensity to Save, political climate, availabl e natural resources of the country, fiscal policies, monetary policies. To refine the function we have I= f(i, GDP) Y= b0-b1X1+b2X2 Y represents investment which is the dependent variable, while X1 and XÂ¬Â¬2 which repr esent the real interest rate and GDP respectively are the independent variables. b0, b1 and b2 are the parameters of the model with b0 being the Y intercept and b1 and b2 the slope of the explanatory variables real interest rate and GDP resp ectively. The mathematical form of the model assumes that all economic variables display a constant pattern and are never random. Econometric form of the model Y= b0-b1X1+b2X2+u The econometric form is similar to the mathematical form the only difference bei ng the stochastic term being added to the econometric form. The stochastic term u was added to take into account random disturbances which create variations fro m the exact behavioral model suggested by economic theory and mathematical econo mics. The model above can also be described as a linear regression model. Stage B: Estimation of the model Gathering data for the estimation of the model Time series data will be used from the Bureau of Statistics and Bank of Guyana r eports on their respective websites. Examination of aggregation problems of the function In computing the level of GDP, aggregation problems may arise and this may be tr ansferred from the reports to the model. If this occurs the model may have aggre gation bias in the estimates of the coefficients and the model or the aggregate variables will have to be adjusted.

Examination of the degree of correlation among the explanatory variables In most instances economic variables display a degree of multicollinearity due t o growth and technological patterns. If multicollinearity is high it must be tre ated for it will not be computationally possible to separate the influence of th e real interest rate and GDP on investment. Choice of appropriate econometric technique The single equation technique of Ordinary Least Squares will be used since the m odel is a simple linear one and the distribution is expected to be a normal one. In this instance we are concerned with using the model for forecasting, because of this we want the model to have the property of minimum variance. Stage C: Evaluation of estimators Economic a priori criteria If when the estimates are done and we find that the sign or size of the paramete rs did not confirm to economic theory we nay attribute this to deficiencies of t he empirical data employed for the estimation of the model. If the a priori theo retical criteria are not satisfied, the estimate should be considered unsatisfac tory. Â¬Â¬Statistical criteria: first-order tests First order tests such as the correlation coefficient and the standard deviation of the estimates should be carried out to see how significant the estimates are statistically. While these tests are important they are secondary to a priori t heoretical criteria. If the signs or size of the parameters do not confirm to ec onomic theory the parameters will be rejected. Econometric criteria: second-order tests Second order tests serve the purpose of establishing whether the estimates have the desirable properties of an OLS estimator, which is if they are BLUE (best li near unbiased estimators). If the estimates are not â BLUEâ they cannot be used to give r eliable forecasting results. Stage D: Evaluation of the forecasting power of the estimated model. The forecasting ability of the model can be tested by using the model to forecas t parameters not included in the sample. The difference between the actual and t he forecasted value would be tested for statistical significance. If the value i s statistically significant we can then deem the model fit to be used for foreca sting.