Introduction

to
Econometrics

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 What is econometrics?

• Econometrics is a set of research tools employed in various

economic fields (accounting, finance, marketing and
management) and also in history, political science, and
sociology.

• Econometrics means ”economic measurement” –> from the

Greek words: „eikonomia” – economy and „metren” – measure.

• It plays a special role in the training of the economists by:

– quantifying the economic reality
– bridging the gap between economic theory and the real
world.
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Econometrics may be defined as the social science that applies
the tools of economic theory, mathematics and statistics for
estimating economic relationships, testing the validity of
economic theories and validating the government policies.

Example.
The Central Bank rises the discount rate by 3%
⇒ economic theory suggests this will influence the interest rates of
the commercial banks, the credits, the investments, the inflation
…
⇒ but how much?
Only econometrics can answer this question by combining
economic theory, statistical data and mathematical tools!

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 Why study econometrics?

Economic theory makes statements about how important

variables are related to one another, but:
– does not provide the necessary measure of strength of the
relationship or
– the magnitudes involved (how much a change in one
variable affects another).

Example
The law of demand: a reduction in price of a commodity is
expected to increase the quantity demanded of that
commodity (but how much?).

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 Economic model vs econometric model

• An economic model is a set of assumptions that aproximately

describes the behaviour of an economy.

• An econometric model gives:

– the form of the algebraic relationships among the economic
variables involved and
– a specification of the errors (due to the factors omitted from
the model)

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 The economic model
(describes the way in which economic variables are interrelated).
1.Quantity demanded, qd, for an individual commodity (Ford cars):

qd = f( p, pc, ps, i ) demand

p = price of the car; pc = price of complements (like gasoline);
ps = price of substitutes (other similar cars); i = income

2. Quantity supplied, qs (beef):

qs = f( p, pc, pf, ps ) supply

p = price of beef; pc = price of complements ;
ps = price of substitutes (pork); pf = price of inputs (e.g. corn) 6
 The econometric model
qd = f( p, pc, ps, i ) + e The random
(the unpred error
ictable par
t)

The systematic part

(the average behavior)

• The random error accounts for the many factors that affect
sales and miss from this model; it is a “noise” component that
obscures our understanding of the relationships.

• Assuming quantity demanded is a linear function of prices, the

econometric model of the demand for Ford cars is :
qd = β1+ β2p+ β3pc+ β4ps+ β5i + e,
where βi are unknown parameters to be estimated using
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a sample of economic data.
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 Limits of econometrics

• any econometric model can capture only a part of the

real economic world => a simplified image of the reality;

• qualitative variables (like motivation, satisfaction,

management) are difficult to incorporate in an
econometric model;

• imperfect identification of the contribution of each factor

of influence (because factors interact and influences are
difficult to separate);

• forecasting based on past trends is uncertain.

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 β1 β2 β2

β2

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 parameters

β1 β2 e
dependent
(endogeneous)
explanatory (exogeneous) variable
variable
e

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β1 β2

β1 β1

β2 β2 β2

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 “ God created the econometricians to make t
weather forecasts look good .“

The value of the explanatory variable (Yd) is known

Estimated values of the parameters

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 Economic Empirical Study
(anatomy of econometric modeling)
Economic Theory; Past Experience, studies
C = f(Y) ==>
Formulating a model: Cause - effect Ct = β 1 + β 2 Y + e t

Gathering data: Statistics monthly, quarterly, yearly data

Estimating the model: Simple OLS method or other advances

H0: β2>0,
Testing the hypothesis:
positive relationship or not If not true

Interpreting the results:

Forecasting Policy implication and decisions

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 Types of econometric models
1. Considering the number of influence factors
– simple models are based on the assumption of a single
decisive factor of influence X, all the others having
random or fixed effects captured by the error term e.
y = f(x)+e
– multiple models: use two or more factors of influence;
better but more complicated => the number of factors
have to be limited.
y = f(x1,x2,...,xp)+e

2. Considering the form of the relationship between

the dependent variable y and the factors of
influence
– linear models
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– non-linear models: exponential, parabolic, etc.
 Types of econometric models (cont’d)

3. Considering the time factor

- static models: the factors influence the dependent
variable y over the same period of time:
y = f(x1t,...,xjt,...,xkt) + et
- dynamic models include the time variable:
– the time variable is one of the factors
y = f(xt,t) + et
– autoregressive models: the lagged dependent variable
becomes a factor of influence itself
y = f(xt,yt-k) + et
– lagged models: the factor x influences y over several
periods of time:
y = f(xt,xt-1,... xt-k) + et
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 Types of econometric models (cont’d)
4. Considering the number of equations
- models having a single equation
- multiple equation models: consist of a system of
equations
-> structural form:
b11Y1 + b12Y2 + ... + b1nYn + c11 X 1 + c12 X 2 + ... + c1m X m = U1
 b Y + Y + ... + b Y + c X + c X + ... + c X = U
 21 1 2 2n n 21 1 22 2 2m m 2

 
 bn1Y1 + bn 2Y2 + ... + Yn + cn1 X 1 + cn 2 X 2 + ... + cnm X m = U n

Yi , i = 1, n dependent (endogenous) variabiles

X j , j = 1, m
independent (exogenous) variabiles
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