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You are on page 1of 13

Steps 1-4

1. Decide on what it is you want to explain or

predict.

2. Identify the variables that you believe are

important to what you want to explain or

predict.

3. State the assumptions of the theory.

Ceteris Paribus - A Latin term meaning “all things

held constant.”

4. State the hypothesis

Building and Testing a Theory

Steps 5-6

5. Test the theory by comparing its predictions

against real-world events.

6. If the evidence supports the theory, then no

further actions is generally taken. If the evidence

rejects the theory, then

a. you can conclude the theory is incorrect.

b. you can conclude the data is inadequate.

Step 6 teaches a valuable lesson – We do not

learn the “truth” via econometrics.

Econometrics Defined

Econometrics - the social science in which the

tools of economic theory, mathematics, and

statistical inference are applied to the analysis of

economic phenomena.

Econometrics is defined literally as “economic

measurement”

Quantitative analysis of actual economic

phenomena.

Uses of Econometrics

1. Describing Economic Reality

2. Testing Hypothesis about Economic Theory

3. Forecasting Future Economic Activity

Regression Analysis Defined

A statistical technique that attempts to “explain”

movements in one variable as a function of

movements in a set of other variables.

Dependent variable – what we wish to explain.

Independent variable – what we believe explains

movements in the dependent variable.

Correlation vs .Causation

Regression analysis tells us that variables move

together.

In other words, it tells us about correlation.

Regression analysis does not “prove” causation.

Causation is “established” via the combination of

regression analysis and economic theory.

Hypothesis Testing

Hypothesis Testing – Statistical experiment used to

measure the reasonableness of a given theory or

premise

NOTE: WE DO NOT “PROVE” A THEORY

Type I Error – Incorrect rejection of a „true‟

hypothesis.

Type II Error – Failure to reject a „false‟ hypothesis.

Deterministic Relations vs.

Statistical Relations

Deterministic Relation = An identity

A relationship that is known with

certainty.

Statistical Relation – An inexact

relation

Regression Analysis

Types of Data

Time series – A daily, weekly, monthly, or annual sequence of data.

i.e. GDP data for the United States from 1950 to 2005

Cross-section – Data from a common point in time. i.e. GDP data

for OECD nations in 1995.

Panel data – Data that combines both cross-section and time-series

data. i.e. GDP data for OECD nations from 1960 to 2000.

Regression Math

E(Y|X

i

) = α + βX

i

In words…. the expected value of Y for given values of X

i

is equal to a

linear function of X.

OR….

Y = Β

0

+ Β

1

X

1

Where

Y = The Dependent Variable, or what you are trying to explain (or

predict).

X = The Independent Variable, or what you believe explains Y.

Β

0

= the y-intercept or constant term.

Β

1

= the slope coefficient

Linear vs. Non-linear equations

Y = Β

0

+ Β

1

X

1

+ ε

Stochastic error term (ε) = disturbance term = a term that is added

to a regression equation to introduce all of the variation in Y that

cannot be explained by the included Xs.

Stochastic = Random

Sources of error term

1. Omitted variables

2. Measurement error

3. Incorrect functional form

4. Unpredictable or purely random variation

Interpreting a regression coefficient

the impact of a one unit change in X on the dependent

variable Y, holding constant the other included

independent variables.

This is how we do controlled experimentation in

economics

If a variable is not included, then we have not controlled

for this factor.

Population Regression Function (PRF) vs. a

Sample Regression Function (SRF)

True regression coefficients vs. Estimated

regression coefficients.

Residual – difference between the observed

Y and the estimated regression line.

Error term – difference between the

observed Y and the true regression equation.

Error term is theoretical and never observed.

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