Classical Econometric

Methodology
Course Instructor: Dr. Zahoor Khan

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Classical Econometric
Methodology
Classical Econometric Methodology is based
on several Steps….
1. Statement of the theory/ Problem
1. Any traditional theory of economics or finance
you are willing to test empirically.
2. Write the theory in the form of a testable
statement
1. Example; Keynesian psychological theory
“ If income of the consumer increases by $1 the
consumer would like to spend by < $1”
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 Classical Econometric
Methodology……..
There are two important things to be noted;
1. There is a positive dependent relationship
between Income (X) and Consumption
(Y).
2. An increase in consumption resulting from
increase in income will be smaller.

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 Classical Econometric
Methodology……..
2. Specification of Mathematical Model
To develop the theory in the form of a testable
statement we need to write the theory in
mathematical form
Example:
“Consumption (Y) is a function of Income
(X)”

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 Classical Econometric
Methodology……..
More specifically:
Consumption = f (Income) OR
Y =f (X) OR
Y = α +βX
However, this is a deterministic relationship.
It shows an exact relationship between
Income and consumption which is not
possible because there might be other
variables which can also influence this r/s. 5
 Classical Econometric
Methodology……..
3. Specification of Econometric Model
We need to specify Econometric model based
on mathematical model.
Y = α +βX+ei
Where α &β are parameters and ei is residual
or random error or stochastic error term.

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 Classical Econometric
Methodology……..
Within this example α represents autonomous
consumption, which is assumed to be positive
such as α >o
β is slope parameter and represents Marginal
Propensity to Consume (MPC).
Moreover, MPC (β) >0 but β <1
So 0 < β <1.

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 Classical Econometric
Methodology……..
Once we have specified the model the next
step is to collect the data.
4. Collection of data
• It may quantitative or qualitative
• It may be Primary or secondary
• Types of quantitative data
• Cross sectional
• Time series
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• Panel
 Classical Econometric
Methodology……..
5. Estimation of Parameters
There are several econometric techniques
which help us in estimating parameters of the
model.
The most commonly regression estimates are
obtained through Ordinary Least Square
(OLS).
However, there are also well-known
techniques such GLS, MM, Maximum
likelihood, FGLS etc… 9
 Classical Econometric
Methodology……..
5. Estimation of Parameters
The estimated model can be obtained as:
Ŷ = α̂ = β̂ X
Estimated Parameters are outcome of OLS
• Interpretation of result

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 Classical Econometric
Methodology……..
6. Hypothesis Testing
For checking statistical significance, slope
parameter/s are hypothesized as ‘not
statistically significant relationship’ against
alternative hypothesis as ‘statistically
significant relationship’
Hypothesis: A supposition or proposed
explanation made on the basis of limited
evidence as a starting point for further
investigation 11
 Classical Econometric
Methodology……..
6. Hypothesis Testing
A statistical hypothesis is an assumption
about a population parameter. This assumption
may or may not be true. Hypothesis testing
refers to the formal procedures used by
statisticians to accept or reject statistical
hypotheses.
The null hypothesis (H0) is a hypothesis which
the researcher tries to disprove, reject or nullify.

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 Classical Econometric
Methodology……..
7. Forecasting or Prediction
• The estimated model can be used for
forecasting or prediction.
• How accurate the model is depend on its
forecasting.
• The estimated information can be used for
policy purpose…

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