ARBAMINCH UNIVERSITY(AMU)

Course: Introduction to Econometrics for

Finance (Econ-611)

Cr Hr: 3

Instructor: Alemayehu A. (Ass. Professor)

JANUARY, 2021

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 Lecture 1: Introduction to Econometrics

Welcome to Economics
What is Econometrics?

Wooldridge, Jeffrey M. (2010). Econometric Analysis of Cross Section and Panel

Data (2nd ed.). The MIT Press. Comprehensive, and formal as well as intuitive.

Angrist and Pischke (2009). Mostly Harmless Econometrics. Jazzy exposition,

reflects the new way of thinking about econometrics, based on the experimentalist
paradigm and the potential outcomes framework.

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 1: Introduction to Econometrics
1.1 : The Purpose and application of Econometrics
What is Econometrics?
Definition:
e·con·o·met·rics [i kònnə méttriks] noun
mathematics in economics: the application of mathematical
and statistical techniques to economic data and problems
(takes a singular verb) Microsoft® Encarta® 2009.

Literal meaning is “measurement in economics”.

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 1: Introduction to Econometrics
In economics, we are interested in r/nships b/n d/nt variables, for
e.g., “What is the impact of an additional years of schooling on
earnings?”
In Econometrics, we learn the skill how to quantify these r/nships
on the basis of available data, use statistical techniques, and
interpret, use or exploit the resulting outcomes appropriately.

Econometrics therefore is the interaction of economic theory,

observed data and statistical methods.
The interaction of these three makes econometrics interesting,
challenging, and perhaps, difficult!
Traditionally econometrics has focused upon aggregate economic
r/nships.
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Introduction..Contd..
• Generally, econometrics means the merger of
mathematics, statistics and economic theory.
Therefore, econometrics utilizes –
• 1. Economic theory, as embodied in an
econometric Model;
• 2. Facts, as summarized by relevant data, and
• 3. Statistical theory, as refined into
econometric techniques

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 1.2. What are the major roles of econometric analysis?

• Econometrics usually deals with:

• Estimating economic r/nships from sample
data.
• Testing hypothesis about how the economic
variables are related.
• The existence of r/nships b/n variables.
• The direction of r/nships b/n the dependent or
outcome variable & its hypotheses observable
determinants.
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1.3. What is the main task of econometrics?

• The main task of econometrics is to generate estimates of the

unknown parameters!

1.4. Why should econometrics be a separate discipline?

• As the definition suggests econometrics is an amalgamation of

economic theory, mathematics and statistics.
• But, a distinction has to be made b/n Econometrics, & economic
theory, statistics & mathematics.
• 1. Economic theory makes statements or hypotheses that are
mostly of qualitative nature.

• EXAMPLE: Other things remaining constant (ceteris paribus) a

reduction in the price of a commodity is expected to increase the
quantity demanded. 7
Introduction…Contd
• Theory postulates an inverse r/nship b/n price
and quantity demanded of a commodity.

• But, the theory does not provide numerical

value as the measure of the r/nship b/n the two.

• Hence, it is the task of the econometrician to

provide the numerical value by w/c the
quantity will go up or down b/c of changes in
the price of the commodity.

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 Contd…

1. Statistics is concerned with collecting, processing and presenting

economic data.
• EXAMPLE: collecting and refining data on national accounts, index
numbers, employment, prices, wages, import, export, etc.

2. Mathematics does provide much of the tools used in Econometrics.

• Econometrics needs special methods to deal with economic data,
which are never experimental data.
• EXAMPLES: Errors of measurement, problem of multicollinearity,
problem of serial correlation are only econometric problems and are
not concerns of mathematical statistics.
3. Econometrics utilizes data to estimate quantitative economic
relationships and to test hypothesis about them.
• The Econometrician is called upon to develop special methods of
analysis and deal with such kinds of Econometric problems. 9
 1.6. What are the goals of econometrics?

Econometrics helps to achieve the following goals:

1. Judge the validity of economic theory
• No theory can stand on its own without empirical testing.
• Econometrics enables us to make such empirical testing.
• Econometrics aims at the verification of economic theories and
thereby helps us to know how well economic theories developed to
explain the actual behavior of the economic units.
• 2. Supply the numerical estimates of the coefficients of the
economic relationships, which may then be used for the formulation
of sound economic policies.
• Econometrics is concerned with the analysis of measures of
economic activity.
• It is constantly expanded into areas of applications wider than
statistics and economics themselves. 10
1B. CLASIFICATION OF ECONOMETRICS
1.7. Discuss classification of econometrics
• Econometrics may be divided into two main categories:
• a) Theoretical Econometrics
• b) Applied Econometrics

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Contd….
1) Theoretical Econometrics - is concerned with the dev’t of
appropriate methods for measuring economic r/nships specified by
econometric models.
• The methods of estimation can be classified into two groups:
• The single equation techniques, w/c are applied to one r/nship at a
time.
• The simultaneous equation techniques, which are applied to all the
r/nships of the model simultaneously.
• Choice depends on the nature of r/nship & identification
considerations, the properties of the estimates of the coefficient
obtained from each technique such as consistency, sufficiency, time,
cost, simplicity, etc.
• It is also concerned with the spelling out of the assumptions of the
models, their properties and what happens to these properties
when one or more of the assumptions of the model are not
satisfied. 12
 Contd…

2) Applied Econometrics - is concerned with the measurement

of the parameters of economic r/nships and with the prediction
of the value of economic r/nship.
• The tools of theoretical Econometrics are used to study some
special fields such as:
– The production function,
– The consumption function,
– The investment function,
– The demand and supply function, etc.
2.7. What is the Nature of the Econometric Approach?
• As discussed earlier there are at least two basic ingredients in
any econometric study, namely, Economic theory and Data
(facts).
• Therefore, the major task of the econometrician is to
combine these two ingredients. 13
Cont’d
Methodology of econometric research
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.

Schematic description of the steps involved in econometric

analysis (research)
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15
16
 Contd…
• a) The theory should be developed into a useable form.
• The most useable form for the purposes of econometrics is
the Econometric model.
• The model is the most convenient way of summarizing the
theory for empirical measurement and testing.
• The most important aspect of this step is the specification of
the appropriate econometric model that appropriately
represents the phenomena to be studied.
• EXAMPLE: The Cobb - Douglas production function is given as:

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Contd….
• b) The other basic ingredients in an econometric
study is a set of facts (data).
• The data have to be refined (massaged) in a
variety of ways to make them suitable for use in
an econometric study.
• The next step is to combine these two sources or
basic ingredients – Estimation.
• This step requires the use of a set of econometric
techniques to enter certain characteristics of a
population.
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Contd…

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Contd…

• Step 3: Statistical design to obtain data

Representative samples from the "real world“
- Time series
- Cross-section
- Panel data (repeated survey of a single sample in
different time periods)
- Engineering data (information on methods of
production and output data, production function,
input output relationship).
- Legislation and other regulations - data constructed by
the econometrician (Dummy variables, e.g. sex)

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 Contd….

• Step 4: Estimation of the model by means of appropriate

econometric method
• 1) Examination of the identification condition
• 2) Examination of the aggregation problems (aggregate over
individuals, commodities, time periods, space).
• 3) Examination of the degree of correlation among explanatory
variables
• 4) Choice of appropriate econometric technique.(single equation or
simultaneous equation techniques)

• Requirements: Estimators posses following properties: - unbiasedness

- consistency, and - efficiency Possible Errors: estimators do not
possess the desired characteristics due to autocorrelation,
heteroscedasticity, multicollinearity, etc. in the sample
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Contd…
Step 5: Verification
• 1) Economic "a priori" criteria - determined by the
principles of economic theory.

• If estimates of the parameters turn up with sign and

size not conforming to "a priori" criteria, they
should be rejected unless there is a good reason to
believe that in the particular instance the principles
of economic theory do not hold.
• In such cases the reasons for accepting the estimates
with the (from economic theory) different sing and
size must be stated clearly 22
Contd…
•2) Statistical criteria (first order tests) - tests are determined by statistical
theory
•- R² and standard errors of the estimates (describes the dispersion of the
estimates around the true parameters).
•Hence, the larger the standard error, the less reliable it is.

•3) Econometric criteria (second-order tests)

These tests are given by the theory of econometrics.
They will help to establish whether the estimates have the
desirable properties of unbiasedness, consistency, sufficiency, etc.
The assumptions of the various econometric techniques differ and
hence there are various econometric criteria for each method.
The researcher must use all the above criteria; economic, statistical
and econometric, before accepting or rejecting the estimates.

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Contd…
• Requirements:
 economic interpretation of the results obtained in
Step 3.
 Evaluation of economic theory or hypothesis.
 Rejection of economic theory if theory is not validated
and then creation of new hypothesis to re-start from
Step1.
• Possible Errors: Wrong and irrelevant tests to verify
the validity of the hypothesis.

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 Contd…
• Step 6: Application Requirements:
 The ultimate goal of econometrics is to obtain reliable
predictions for the application to economic policy decision.
• Possible Errors: biased forecasts; this leads to losses in
welfare of the society when used for policy purposes.
 Forecasting is closely related to policy choice and policy
evaluation.
 Most methods of policy evaluation rely upon a specific
type of forecast.
 It is also essential to examine the forecasting power of the
model.
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 1C. MODELS AND DATA
1.9. What is a model ?
• A model is any representation of an actual phenomenon.
• The real world system is represented by the model in order to explain it, to
predict it, and to control it.
• Any model represents a compromise b/n reality and manageability.
• (1) It must be a “reasonable“ representation of the real world system and
in that sense it should be realistic.
• (2) On the other hand it must be “manageable“ in the sense that it yields
certain insights or conclusions.
• So, a good model is both realistic and manageable.
• A highly realistic but too complicated model is a “bad“ model in the sense
it is not manageable.
• Also a model that is highly manageable but so idealized that it is unrealistic
in the real world system is a “bad“ model.
• In general, to find the proper balance between realism and manageability
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is the essence of good Modeling.
1.10. Discuss types of models
• There are many types of models exist in each of the different fields
to which models have been applied. Among the most important
types of models are:
• the verbal/ logical models
• the physical models
• the geometric models
• the algebraic models
• the Econometric model
• The verbal/ logical model - is the simplest type of model and uses
verbal analogies.
• The physical model - in certain cases the real-world system is
physical and a model is obtained by appropriate scaling up or down.

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Contd..
• The geometric model - represents the relationships of
economic variables geometrically. A geometric model uses
a diagram to indicate the relationship between variables.
• The algebraic model - represents the real-world system by
a system of equations. This is the most important type of
model for the purposes of econometric study.
C = f (Y)
• Econometric model - is a special type of algebraic model,
namely a stochastic one that includes one or more random
variables. It represents a system by a set of stochastic
relations among the variables of the system.

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29
Contd…….

• One could use a combination of the features of one

or more of the econometric models.
• For example, we could have a multiple regression
model in which the dependent variable is in logs
form and some of the X variables are also in log
forms, but some are in linear forms.
• In choosing among the competing models the
overriding objective should be economic relevance
of the various models and not merely the statistics.

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 Contd…

• But, model building requires a proper balance of

– Theory
– Availability of appropriate data
– A good understanding of the statistical properties of the various models
– One’s own judgment

• Since theory underlying a topic is never perfect, there is no such

thing as a perfect model. Some criteria for choosing a functional
form include:
– Theoretical consistency
– Flexibility
– Computational facility
– Factual conformant
– Etc.
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 1.11. Discuss datum or data.

• An econometric model requires, for its estimation, data on all the

variables included in the model.
• Values taken by endogenous, exogenous, etc. are necessary in order to
estimate the parameters of the model.
• It is relatively easy to construct models of all types.
• But: Finding the data relevant to a particular model is not always easy.
• Often data are either not available or not available in the form wanted.
• Hence, proxies are used for certain variables of the model.
 Quantitative Vs Qualitative data:
 Dummy variables
 Time series Vs cross-section data
 pooling
 panel data (or longitudinal data)
 Non experimental vs experimental data.
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Contd…
Problems with data
– degrees of freedom
– multicollinearity problems
– serial correlation problems
– errors in measurement
– problem of data stationary (time series data),
etc.
• Sources of Economic data - primary sources
and/or secondary sources
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Some Points to Consider when reading papers in the academic
literature

o Does the paper involve the development of a theoretical

model

o Is the data of “good quality”? Is it from a reliable source? Is

the size of the sample sufficiently large for asymptotic
theory to be invoked?

o Have the techniques been validly applied? Have diagnostic

tests for violations of been conducted for any assumptions
made in the estimation of the model?
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Cont’d

Have the results been interpreted sensibly?

Do the results actually address the questions posed by the

authors?

Are the conclusions drawn appropriate given the results, or

has the importance of the results of the paper been
overstated?

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 MENTAL GYMNASTICS CHAPTER ONE
• 1. Distinguish between pairs of the following terms.
– a) Econometrics and Economic theory
– b) Data and Statistics
– c) Theoretical and Applied Econometrics
– d) Stochastic and Deterministic models
• 2. True, False or Uncertain. Support your answer.
– a) Deterministic model does not contain disturbance term.
– b) A static model involves explicit independence on time.
– c) Stochastic model can be dynamic model.
• 3. Discuss model is „realistic‟ and „manageable‟.
• 4. Why is theoretical model important before engaging applied
model?
• 5. Discuss the various stages of econometrics approach.
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