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Ch1: An Overview of Econometrics

I. What is economics?

"Economics" comes from the Greek ‘oikos’, meaning "house," and ‘nemein’, meaning "to manage." "Economics" means "house stewardship"

Economics is the social science that studies how people manage their resources

The scientific method consists of:

The observation of facts (real data).

 The formulations of explanations of cause and effect relationships (hypotheses) based upon the facts. The testing of the hypotheses. The acceptance, rejection, or modification of the hypotheses. Continued testing of a hypothesis, leading to determination of a theory, law, principle, or model.

II. What is econometrics?

Econometrics is a connection of two Greek words, ‘oikonomia’ (administration, or economics) and ‘metron’ (measure)

Literally means ‘Economic measurement’

Use economic theory, mathematics and statistical inference to measure size of economic relationships, i.e. obtain empirical estimates

Explain the behaviour of an economic variable. Note that ‘facts tell nothing’.

III. Basic Data Analysis

Descriptive statistics: Average level of variable

Mean, median, mode: Variability around this central tendency

Standard deviations, variances, maxima/minima: Distribution of data

Skewness, kurtosis: Number of observations, number of missing observations Facts tell nothing. We are usually concerned with explaining one variable using

another

(hypothesis/ theory)

E.g., “consumption depends positively on income” relationships between variables are important

correlations (covariances)

Note: correlation causation.

IV. Why is econometrics important?

* Forecasting

* Testing theory

* Policy analysis

V. How do we go about doing applied econometrics?

Steps:

1. Create a statement of theory or hypothesis

2. Specify a mathematical model of the theory

3. Specify a statistical or econometric model of the theory Importance of the disturbance term

4. Obtain data Distinguish between time-series and cross-sectional data

5. Estimate the econometric model

6. Hypothesis testing: testing the “adequacy” of the model

7. Forecasting and prediction

8. Using the model for control or policy purposes

IV. Practical application of this methodology

1. Create a statement of theory or hypothesis

Can the government reduce cigarette consumption by increasing the tax on cigarettes?

Factors to consider:

Addictiveness of tobacco: Demand inelastic? Does the consumer bear the whole tax?

Cause-effect model

Q = f (Price, other determinants)

The fundamental question: Is Price a statistically significant determinant of Quantity?

Regression Analysis:

Statistical procedure for estimating the average relationship between the dependent variable (Y) and one or more independent variables (X).

2.

Specifying the mathematical model

From theory Q = f(Price,

Specify the mathematical form

)

Linear: Q = β 1 + β 2 .Price

Loglinear: ln(Q) = β 1 + β 2 .ln(Price)

3. Specifying the econometric model

The mathematical model assumes a deterministic/exact relationship between the variables

Reality: relationship may hold on average, but it is inexact

Changing a mathematical model into an econometric model:

Linear: Q = β 1 + β 2 .Price + e

The Mathematical Interpretation: The Meaning of the Regression Parameters

β 1 = the intercept the point where the line crosses the Y-axis. (the value of the dependent variable when all of the independent variables = 0)

β 2 = the slope the increase in the dependent variable per unit change in the independent variable. (also known as the 'rise over the run')

Importance of the error (disturbance) term, e Such models do not predict behavior perfectly. So we must add a component to adjust or compensate for the errors in prediction.

It is a random (stochastic) variable that has well-defined probabilistic properties. u may well represent all those factors that affect Q (quantity demanded) but are not taken into account explicitly.

“stochastic” comes from the Greek word stokhos meaning “a bull's eye”

Econometrics mainly deals with the error term.

Why are there error terms? – No one knows the truth

a. Vagueness of theory: Ignorance about other determinants

b. Unavailability of data - serious practical problem!

c. Core variables vs. peripheral variables

d. “Intrinsic randomness”: Economics is not an exact science

e. Poor proxy variables e.g., Price: real price vs. nominal price Income: current income vs. permanent income Interest rate: real vs. nominal

f. Researcher’s desire to keep specification simple/parsimonious

g. Wrong functional form e.g. linear vs. quadratic or loglinear

4. Collecting data

5. Estimating the parameters of the chosen econometric model

Least squares: What does it mean?

Dependent Variable: Real_Consumption (Q) Method: Least Squares Sample(adjusted): 1970 2000 Included observations: 31 after adjusting endpoints

 Variable Coefficient Std. Error t-Statistic Prob. C 2222.171 253.3745 8.770304 0.0000 Real_price -2.242878 0.697891 -3.213796 0.0032 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.262621 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) 1427.546 0.237194 352.8659 308.1887 14.36164 2754428. 14.45416 -220.6055 10.32849 0.050316 0.003203

Estimated Q = 2222.17 – 2.24 Price

Interpretation of the estimates: 2222.17 & -2.24

Interpretation of the Multi-Variable Equation & its Coefficients

Partial regression coefficients:

In a 2 variable model:

Y i = β 1 + β 2 X i + u i ;

the only factor that can cause a change in Y is a change in the single independent variable X and the rate of that change is measured by β 2

In the 3 variable model:

Y i = β 1 + β 2 X 2i + β 3 X 3i + u i, a change in Y can be caused by:

1) a change in X 2i alone

2) a change in X 3i alone or

3) a simultaneous change in both X 2i and X 3i

β 2 and β 3 are called partial regression coefficients because each measures the rate that Y changes given a change in their respective variable when the other variable is held constant.

β 2 = Y/X 2 with X 3 = 0= change in Y as X 2 changes while X 3 is constant

β 3 = Y/X 3 with X 2 = 0= change in Y as X 3 changes while X 2 is constant

β 1 is still called the intercept term and measures the value that Y takes when both X 2 & X 3 are equal to 0.

Holding one of the variables constant is using the ‘ceteris paribus’ assumption. When this is done, the variable(s) that are held constant become part of the intercept term. The variable that is allowed to change can then be interpreted as the slope coefficient. If X 3 is held constant, the model can be represented as: Reference: http://www.washjeff.edu/users/kswint/ECN340/LectureNotes/L06StudentNotes.pdf

Note:

Loglinear: ln (Q) = β 1 + β 2 .ln (Price) + u

What is the meaning of β 1 and β 2 ?

6.

Hypothesis testing: testing for model adequacy

Is the relationship between Price and Quantity statistically significant?

Or is the non-zero estimate taken from a population whose population parameter is zero?

Statistical inference: drawing conclusions about a population, based on a sample of the population

Some other tests:

* t – statistics

* R 2 and F statistics

* Durbin-Watson statistic

* Chow tests

* Ramsey’s regression specification error test (RESET)

Role of the error term

The quality of the regression results depend crucially on the error terms

If error terms do not meet certain requirements, the estimated coefficients are “wrong”

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Practical issue: Should income be included in the model?

Dependent Variable: Real_Consumption (Q) Method: Least Squares Sample(adjusted): 1970 2000 Included observations: 31 after adjusting endpoints

 Variable Coefficient Std. Error t-Statistic Prob. C 1158.552 67.97038 17.04496 0.0000 Real_price -2.962742 0.149211 -19.85605 0.0000 Real_income 0.004687 0.000187 25.11414 0.0000 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.968656 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) 1427.546 0.966418 352.8659 64.66442 11.26806 117081.6 11.40684 -171.6550 432.6630 1.325191 0.000000 Estimated Q = 1158.5 + 0.0047 (Real Income) – 2.96 Price
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7.

Forecasting or prediction

Request: Make a forecast of cigarette consumption for 2003 to 2005

Required:

An adequate regression equation Estimates of the independent variables in each year (The forecasts are conditional on the independent variables)

Regression equation:

Estimated Q = 1158.5 + 0.0047 (Real_Income) – 2.96 Real_Price Estimates of independent variables and forecasted variable:

 Year Real income Price (1995 base) (cents per pack) Estimated Q (millions of packs) (in millions) 2003 440 000 630 1361.7 2004 451 000 660 1324.6 (2.5% growth) (4.8% growth) (-2.7% growth) 2005 464 530 690 1299.4 (3% growth) (4.5% growth) (-1.9% growth)

Alternative request:

By how much is cigarette consumption likely to decrease given a 34-cents/pack increase in the real price, cause by an increase in the tax rate, ceteris paribus?

Appendix: Short history of econometrics

The early years:

 Developed as a separate discipline during the 1930s and 1940s Early practitioners: Laurence Klein and Jan Tinbergen Early practical application constrained by lack of computing power Cowles Commission methodology developed during 1950s and 1960s:
 o Starting point: CLRM; focus on assumptions about error term o What to do if the assumptions are broken ……. o Focus on fixing the regression results; underlying approach was not questioned

The 1960s and 1970s: era of the large macro-models

 e.g. Wharton model in US – 2000 equations BER and Department of Finance models in SA Uses of these models: policy analysis and forecasting Economic instability of the 1970s discredited large econometric models’ forecasting ability

o Extrapolation techniques of the B-J sort proved equally good

The 1980s and 1990s: a rethink of econometric theory and methodology

 Problem with traditional econometrics: spurious correlation/regression Solution: cointegration
 o Is there an equilibrium (and equilibrium-returning) relationship between variables? o If so, there is cointegration; if not, the relationship might be spurious o Two basic approaches:
 Engle-Granger: two variables Johansen: more than two variables