Lecture 1

The Nature of Econometrics and the Modelling Process

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Aims and Learning Objectives

By the end of this session students should be able to: Appreciate that the study of econometrics is important Appreciate that there are different types of data and different types of variables Understand the nature of the modelling process

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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

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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?
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Economic Decisions
To use information effectively: economic theory economic data

economic decisions

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

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Types of Data Cross Sectional

Cross-sectional data is a random sample
Each observation is an individual, firm, etc. with information at a point in time If the data is not a random sample, we have a sample-selection problem

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Types of Data Panel

Can pool random cross sections and treat

similar to a normal cross section. Will just need to account for time differences. Can follow the same random individual observations over time known as panel data or longitudinal data

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Types of Data Time Series Time series data has a separate observation for
each time period e.g. stock prices Since not a random sample, different problems to consider These problems will be addressed in EC20019

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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
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EXAMPLE 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
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Student Performance

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

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

P = f(A)
In linear form:

(1)

Y = 1 + 2X
where Y = performance and X = ability

(2)
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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 have data on year 2 average and final year average
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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)
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Student Performance
Year 3 Average Against Year 2 Average
80

70

60

50
Y e ar 3 Av era ge

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

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Student Performance STAGE 5a - Estimation of the Parameters Y and X are the variables - known 1, 2 and U are the parameters unknown Estimators versus Estimates
The least squares (OLS) regression line is the line that minimises the sum of square deviations of the data points
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Student Performance
Year 3 Average Against Year 2 Average
80

70

60

50 Y e ar 3 Av era ge

40

30

20

10

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

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

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 zero and constant variance
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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?
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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 2559.477 120.0264807 1.83942E-22 214 4563.393 21.32427 215 7122.87 P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 4.44707E-21 23.88475288 34.92106 23.88475 34.92106 1.83942E-22 0.441276987 0.6349 0.441277 0.6349

Correlation coefficient

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

Coefficient of determination

Intercept Y2AV

Coefficientstandard Erro t Stat 29.4029 2.799513 10.50286 0.538088 0.049115 10.95566

1 t statistic

P-value

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Student Performance
EViews Regression Output: Bivariate Case
Dependent Variable: Y3AV Method: Least Squares Date: 09/24/05 Time: 20:28 Sample: 1 216 Included observations: 216

1 2

Variable C Y2AV R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient 29.40290 0.538088 0.359332 0.356338 4.617821 4563.393 -635.9494 1.693922

Std. Error 2.799513 0.049115

t-Statistic 10.50286 10.95566

Prob. 0.0000 0.0000 59.87963 5.755834 5.906939 5.938192 120.0265 0.000000

P-value

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Greater number of regression statistics

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The Practice of Econometrics

Economic theory

Econometric model Data Estimation Specification testing and diagnostic testing Is the model adequate? No

Yes Hypothesis testing

Policy: prediction and forecasting

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Summary

In this session we have: Outlined what econometrics is all about Outlined the methodology of econometrics and illustrated the process using a simple economic model

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