ECONOMETRICS-I Eco-537

Dr. Adnan Haider

Assistant Professor Department of Economics and Finance IBA, Karachi. E-Mail: ahaider@iba.edu.pk

Week 1: Introduction

Aims and Objectives

To explain some of the basic methods in econometrics (the application of statistical methods to economic problems)
To provide an overview of how to carry out and interpret empirical research
useful for your dissertations & Research Projects

What is Econometrics?
The Students Perspective

Econometrics is too mathematical; its the reason my best friend isnt majoring in economics!!!

The Lecturers Perspective

Econometrics allows the measurement and analysis of economic phenomena and the prediction of future economic trends

Why Study Econometrics?

Economic Theory deals with the question why?, Econometrics answers how much?
Econometrics: The practice of combining economic theory with data to make statistical inferences and predictions

How do you decide how much to charge for a good or your professional services?
How does the Monetary Policy Committee decide how to set interest rates (policy discount rate)?

Will theory alone provide an answer?

Its clear that data issues are very important in Econometrics You will, sooner or later, be asked to use data in your jobs, in order to support a decision

What is Econometrics?

Historical Context
Econometricians wear many different hats
Are often criticised for ..using sledgehammers to crack open peanuts while turning a blind eye to data deficiencies and the many questionable assumptions required for the successful application of these techniques (Kennedy,1998: p.2)

Econometrics as Art or Science?

Economic Decisions
To use information effectively:

economic theory economic data

economic decisions

*Econometrics* helps us combine economic theory and economic data .

Economic Data
Economic data are Uncertainty! incomplete and far from perfect

Economic variables should, in general, be treated as random variables, since we have imperfect knowledge of the actual data generating mechanism On the other hand, we usually work with samples, not the entire population we infer population features by analysing samples: statistical inference as a tool for drawing conclusions from limited sets of information, i.e., quantifying uncertainty Different samples will lead to different results we need to account for sampling variability

Types of Economic Data

Cross-sectional Panel/longitudinal Time series Each type is suited for a different purpose and will have associated problems Cross-sectional data Consists of a sample of individuals, households, firms, regions, countries or other units taken at a given point in time Often the information comes from government surveys e.g. LFS or PSLM in the Paksitan These data have to be obtained by random sampling from the underlying population (apart from Census) Random sampling often suffers from the problem of non-response => can create biases

 Problems could also occur if units are sampled from units that are large relative to the population e.g. geographical areas
Survey data is also widely analysed in other social sciences e.g. sociology and geography Used to test micro-economic hypotheses and evaluating economic policies Mainly used in the fields of financial economics, labour economics, public economics, industrial economics and health economics

Time series data Consists of observations on a variable or series of variables over a period of time

Chronological ordering of observations conveys potentially important information

More difficult to analyse than cross-sectional data because economic observations are rarely independent over time Most time series are related to their recent histories

 Modifications to standard econometric techniques have been developed to account for and exploit the dependent nature of economic time series and address other issues, e.g. variables have trends The frequency of the data is also important most common frequencies are daily, weekly, monthly, quarterly and annually

Many weekly, monthly and quarterly time series display a strong seasonal pattern
Mainly used to analyse macroeconomic issues and test macroeconomic theories

Panel or Longitudinal Data

Consists of a time series for each cross-sectional unit in the data set Quite difficult to collect this type of data as need information on the same units over time Can be obtained either from surveys or collected over time for regions, industries etc

But biases if the household/individual drops out of the sample => attrition

 The main advantage is the ability to control for unobserved characteristics of individuals/firms
Also contains the best features of cross section and time series Disaggregated data e.g. individuals/firms Allows for the inclusion of dynamics But some of the econometric techniques needed to analyse panel data are quite complex => covered in Econometrics

Pooled cross sections are similar but do not have repeated observations on the same units

The Modelling Process

8 STAGE PROCESS
(1) Statement of theory/hypothesis (2) Specification of mathematical model (3) Specification of the econometric model (4) Obtaining the data / conduct preliminary data analysis (5) Estimation of the econometric model and interpretation of regression results (6) Diagnostic Analysis (7) Hypothesis testing (8) Prediction/forecasting

EXAMPLE: 1

Degree Performance in Economics

Number of factors determine performance: Ability Family background Effort Let us look at this from the perspective of ability only and analyse this using a simple bivariate (2 variable) model

Student Performance
STAGE 1- Statement of Theory /Hypothesis
Student Performance Function: Student degree performance is determined by ability

Student Performance
STAGE 2 - Mathematical Model Performance, P, is some function of ability, A :

P = f(A)
In linear form:

(1)

Y = 1 + 2X

(2)

where Y = performance and X = ability

Student Performance
STAGE 3 - Econometric Model

Y = 1 + 2X + U

(3)

Y = Performance - the dependent variable X = Ability - explanatory variable U = Disturbance (random error) term
For this particular example we will collect data on year 2 average and final year average

Student Performance
STAGE 4a - Obtaining the data Observed values of Y (yr 3 average) and X (yr 2 average) STAGE 4b Preliminary Data Analysis

Descriptive Statistics, graphical charts (initial identification of possible errors: outliers, influential observations and lurking variables)

Student Performance
Year 3 Average Against Year 2 Average
80

70

60

50
Year 3 Average

40

30

20

10

0 10 20 30 40 50 Year 2 Average 60 70 80 90

What can we say about the relationship between year 3 average and year 2 average? Subjective judgement

Student Performance
STAGE 5a - Estimation of the Parameters Y and X are the variables - known 1, 2 are the parameters and U both: unknown Estimators versus Estimates
The least squares (OLS) regression line is the line that minimises the sum of square deviations of the data points

Student Performance
Year 3 Average Against Year 2 Average
80

70

60

50
Year 3 Average

40

30

20

10

0 10 20 30 40 50 Year 2 Average 60 70 80 90

Student Performance
STAGE 5b Interpreting the regression results

Check the coefficient sign against expectations (hypothesis) (e.g. do we expect year 2 average to be positively related to year 3 average?) Check coefficient magnitude against expectations (if any) (e.g. are there any prior expectations on the possible magnitude of the effect of year 2 average?)

Student Performance
STAGE 6 - Diagnostic Analysis Is the model correctly specified?
- Correct functional form - Omitted variables (or unnecessary ones) - Is the regression spurious?

Has the model got good diagnostic properties?

(validity of the probability distribution of the disturbance term) - Is the disturbance term uncorrelated with the regressors? - Are the values of the disturbance term independently and normally distributed with mean 2 zero and variance

Student Performance
STAGE 7 - Hypothesis Testing Are the estimates statistically significant? Do they conform with economic theory? STAGE 8 - Forecasting/Prediction For example, predicting the level of performance for a particular ability level. Possible policy implications?

Student Performance
Excel Regression Output: Bivariate Case
SUMMARY OUTPUT Regression Statistics Multiple R 0.599443 R Square 0.359332 Adjusted R Square 0.356338 Standard Error 4.617821 Observations 216 ANOVA df Regression Residual Total SS MS F Significance F 1 2559.477 2559.477 120.0265 1.84E-22 214 4563.393 21.32427 215 7122.87

Correlation coefficient

36% of the variation in year 3 is explained by variation in year 2

Coefficient of determination

Intercept Y2AV

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 29.4029 2.799513 10.50286 4.45E-21 23.88475 34.92106 23.88475 34.92106 0.538088 0.049115 10.95566 1.84E-22 0.441277 0.6349 0.441277 0.6349

1 t statistic

P-value

Student Performance
MicroFit Regression Output: Bivariate Case
Ordinary Least Squares Estimation ****************************************************************************** Dependent variable is Y3AV 216 observations used for estimation from 1 to 216 ****************************************************************************** Regressor Coefficient Standard Error T-Ratio[Prob] CONSTANT 29.4029 2.7995 10.5029[.000] Y2AV .53809 .049115 10.9557[.000] ****************************************************************************** R-Squared .35933 R-Bar-Squared .35634 S.E. of Regression 4.6178 F-stat. F( 1, 214) 120.0265[.000] Mean of Dependent Variable 59.8796 S.D. of Dependent Variable 5.7558 Residual Sum of Squares 4563.4 Equation Log-likelihood -635.9494 Akaike Info. Criterion -637.9494 Schwarz Bayesian Criterion -641.3247 DW-statistic 1.6939 ******************************************************************************

Basic Regression (similar to results reported in Excel

Regression diagnostics

Diagnostic Tests ****************************************************************************** * Test Statistics * LM Version * F Version ****************************************************************************** * * * * A:Serial Correlation*CHSQ( 1)= 4.8159[.028]*F( 1, 213)= 4.8573[.029] * * * * B:Functional Form *CHSQ( 1)= .0080270[.929]*F( 1, 213)= .0079158[.929] * * * * C:Normality *CHSQ( 2)= 1394.7[.000]* Not applicable * * * * D:Heteroscedasticity*CHSQ( 1)= 3.1753[.075]*F( 1, 214)= 3.1928[.075] ****************************************************************************** A:Lagrange multiplier test of residual serial correlation B:Ramsey's RESET test using the square of the fitted values C:Based on a test of skewness and kurtosis of residuals D:Based on the regression of squared residuals on squared fitted values

Example: 2 Keynesian theory of consumption

Statement of economic theory or hypothesis e.g. Keynesian consumption function C = f (Y), Marginal propensity to consume (MPC 0<MPC<1
Specification of mathematical model C = a + bY 0 < b < 1
C=Consumption Expenditure; Y=Income

This is a precise mathematical representation of the economic theory it may make additional assumptions e.g. a linear functional form (as here) it is exact or deterministic

Econometric Methodology:

Keynesian Consumption Theory

Y

=MPC 1 X

Econometric Methodology:

Keynesian Consumption Theory

Specification of econometric model C = a + bY + u
u is a disturbance or error term it is a random variable with well-defined properties this model is probabilistic or stochastic Obtaining data involves making further assumptions e.g. which measures of C and Y to use and whether the variables should be in real or nominal terms a plot of the data shows that usually no exact relationship holds between the variables

Econometric Methodology:

Keynesian Consumption Theory

Data on C (personal consumption expenditure) and Y (Gross Domestic Product), 1980-1991 in 1987 Billions of $US
Year C Y 1980 2447.1 3776.3 1981 2476.9 3843.1 1982 2503.7 3760.3 1983 2619.4 3906.6 1984 2746.1 4148.5 1985 2865.8 4279.8 1986 2969.1 4404.5 1987 3052.2 4539.9 1988 3162.4 4718.6 1989 3223.3 4838.0 1990 3260.4 4877.5 1991 3240.8 4821.0 Source: Gujarati, p 6. Reproduced from Economic Report of the President, 1993, Table B -2, p. 350.

Econometric Methodology: Keynesian Consumption Theory

Estimation of parameters of the model Basically, we will study how to draw a line through a set of points But our set of points is just a sample, and we want to know a and b in the population usually these estimates are denoted using hats i.e. a and b Quantifying uncertainty: Use statistical theory to assign a std. error to the parameter estimates and interpret those estimates as random variables in a probability distribution. Then we can draw confidence intervals for a and b Hypothesis testing Having estimated a and b we can test statistical hypotheses about them, e.g. is the MPC different from unity?

Econometric Methodology: Keynesian Consumption Theory

Forecasting and Prediction
Estimation of a and b also allows us to use the model for prediction or the forecasting of C for a given value of Y given the Y equation: c a b

Using the model for policy analysis

The model can be used to policy questions e.g. what is the effect on C of cutting taxes (and thereby raising disposable income) by 5%?

Econometric Methodology: Keynesian Consumption Theory

Estimation of the model
regression analysis OLS estimates (details next lecture)

On average, a US$1 increase in real income led to an increase of about US72c in consumption expenditure Hypothesis testing
theory: 0<MPC<1 Is 0.72 statistically less than 1?

Forecasting or prediction
Suppose GDP is expected to be $6000 billion, what will consumption expenditure be? 231.8 0.7194(6000) C 4084.6 C

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Econometric Methodology: Keynesian Consumption Theory

Can also work out the Income Multiplier (M)
M
M=1/(1-0.72)=3.57

1 1 MPC

Using the model for control or policy purposes

Govt believe expenditure of US$4000 will lead to unchanged unemployment

Using the model for control or policy purposes

Govt believe expenditure of US$4000 will lead to unchanged unemployment What level of income leads to the target consumption expenditure?
4000 231 .8 0.7194 X Control variable X X; target 5882 variable Y

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Economic theory

Econometric model Data

Estimation

Specification testing and diagnostic testing

Yes

Is the model adequate?

No

Hypothesis testing Policy: prediction and forecasting

The Practice of Econometrics

Econometric Analysis

Theory

Facts
Statistical Theory

Model

Data

Econometric Model

Refined Data

Econometric Techniques

Estimation of Econometric Model with the Refined Data Using Econometric Techniques

Structural Analysis

Forecasting

Policy Evaluation

Summary
Three stages of research
Specification of model
relevant variables, mathematical form, signs and magnitudes of parameters, error terms

Estimation
Data requirements (time series, cross section, panel), level of aggregation (households, regional, national), estimation techniques (OLS, etc)

Model evaluation
a priori beliefs (signs and magnitudes etc), significance of coefficients, degree of fit within sample, forecasting ability beyond sample, nature of residuals