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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

魔術師靠群眾智慧「「計出「「計出計出計出」」六合彩」」六合彩六合彩六合彩

魔術師靠群眾智慧魔術師靠群眾智慧魔術師靠群眾智慧

六合彩的攪珠結果 ,真的可以計算嗎?英國魔術師布朗( Derren Brown)上周三在鏡頭前,即場猜中英 國六合彩「樂透」( Lotto)的六個中獎號碼,震動全國,人人都追問怎樣做得到?前晚(周五)他拆解 「魔法」,卻叫觀眾大失所望:他聲稱是運用群眾力量,算出號碼,結果網民大喝倒采,數學家群起炮 轟,指摘他胡說八道。

專家炮轟布朗專家炮轟布朗專家炮轟布朗專家炮轟布朗「「吹牛「「吹牛吹牛吹牛」」」」

專家認為布朗其實是用了分鏡技術,將鏡頭分割成兩邊,左邊透明架的鏡頭是預錄,右邊攪珠情景卻是

直播的。互聯網

布朗所說的「群眾智慧」( Wisdom of Crowds),是 19至 20世紀英國統計學家高爾頓( Francis Galton) 的發現:某次他到園遊會,約 800人參加公牛體重競猜遊戲,沒人猜中正確的「 1,198磅」,但高爾頓發 現, 800個競猜答案的平均數,竟然是「 1,197磅」,與正確答案只差 1磅。

布朗前晚在電視節目《如何中樂透》中聲稱,他猜攪珠結果用的正是類似方法:請 24名男女,完全摒棄 追求中獎的想法,然後寫下六個號碼;把號碼相加,除以 24,就「算出」攪珠結果云云。他解釋後也補 充說:「可能有許多人會不相信。」不少人指布朗把觀眾當儍子,數學家也炮轟他「胡謅」、「吹牛」、 「垃圾」:事關猜牛的重量有根有據,大家可以看到公牛大小,但六合彩攪珠卻是隨機,根本是兩回事。 布朗上周三晚在第四頻道電視台個錄影廠,把前「算」出的六個號碼寫在乒乓球上,在架上,號 碼背向鏡頭;現場放着的電視直播台的「樂透」彩情架子亦一直在鏡頭。攪珠後,布朗把 乒乓球轉過來攪珠結果樣。

布朗表演的視覺效果專家韋伯,直指 90%肯定布朗用了分鏡技術或同類方法,即把畫面左右割,左面影着乒乓球放在架上的畫面,是預;右布朗站着看攪珠是直播。攪珠期間助手把寫有攪出號碼的乒乓球放到架上;攪珠結,就把錄影畫面停止回現場直播,這時布朗才走

到架前開估

英國《每日郵報/衞報

開估 。 英國《 每日郵報 》 / 《 衞報 》 • Facts tell nothing . We are

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:

X 3 is held constant, the model can be represented as: Reference:

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”

Residual plot

600 400 200 0 200 400 600 70 75 80 85 90 95 00 Residual
600
400
200
0
200
400
600
70
75
80
85
90
95
00
Residual
Actual
Fitted

2000

1500

1000

500

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 2000 1500 300 200
Estimated Q = 1158.5 + 0.0047 (Real Income) – 2.96 Price
2000
1500
300
200
1000
100
0
500
-100
-200
70
75
80
85
90
95
00
Residual
Actual
Fitted

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