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405 ECONOMETRICS

Chapter # 0: Introduction

By: Domodar N. Gujarati

Prof.

Prof. M.

M. El-Sakka

El-Sakka

Dept ofof Economics:

Dept

Economics: Kuwait

Kuwait University

University

WHAT IS ECONOMETRICS?

Econometrics

Econometrics means

means ““economic

economic measurement

measurement.

. the

the scope

scope ofof

econometrics isis much

econometrics

much broader,

broader, asas can

can bebe seen

seen from

from the

the following

following

definitions:

definitions:

““Consists

Consists ofof the

the application

application ofof mathematical

mathematical statistics

statistics toto economic

economic

data toto lend

data

lend empirical

empirical support

support toto the

the models

models constructed

constructed byby

mathematical economics

mathematical

economics and

and toto obtain

obtain numerical

numerical results

results (Gerhard

(Gerhard

1968).

1968).

““Econometrics

Econometrics may

may bebe defined

defined asas the

the social

social science

science inin which

which the

the tools

tools

ofof economic

economic theory,

theory, mathematics,

mathematics, and

and statistical

statistical inference

inference are

are applied

applied

toto the

the analysis

analysis ofof economic

economic phenomena

phenomena (Goldberger

(Goldberger 1964).

1964).

““Econometrics

Econometrics isis concerned

concerned with

with the

the empirical

empirical determination

determination ofof

economic

economic laws

laws”” (Theil

(Theil 1971).

1971).

WHY ECONOMETRICS IS A SEPARATE DISCIPLINE?

the subject

the

subject deserves

deserves toto bebe studied

studied inin itsits own

own right

right for

for the

the following

following

reasons:

reasons:

Economic

Economic theory

theory makes

makes statements

statements oror hypotheses

hypotheses that

that are

are mostly

mostly

qualitative inin nature

qualitative

nature (the

(the lawlaw ofof demand),

demand), the

the lawlaw does

does not

not provide

provide any

any

numerical

numerical measure

measure ofof the

the relationship.

relationship. This

This isis the

the job

job ofof the

the

econometrician.

econometrician.

The main

The

main concern

concern ofof mathematical

mathematical economics

economics isis toto express

express economic

economic

theory inin mathematical

theory

mathematical form

form without

without regard

regard toto measurability

measurability oror

empirical verification

empirical

verification ofof the

the theory.

theory. Econometrics

Econometrics isis mainly

mainly interested

interested

inin the

the empirical

empirical verification

verification ofof economic

economic theory.

theory.

Economic statistics

Economic

statistics isis mainly

mainly concerned

concerned with

with collecting,

collecting, processing,

processing,

and presenting

and

presenting economic

economic data

data inin the

the form

form ofof charts

charts and

and tables.

tables. ItIt does

does

not

not gogo any

any further

further..

The

The one

one who

who does

does that

that isis the

the econometrician.

econometrician.

METHODOLOGY OF ECONOMETRICS

Broadly speaking,

Broadly

speaking, traditional

traditional econometric

econometric methodology

methodology proceeds

proceeds

along the

along

the following

following lines:

lines:

  • 1. 1. Statement

Statement ofof theory

theory oror hypothesis

hypothesis..

  • 2. 2. Specification

Specification ofof the

the mathematical

mathematical model

model ofof the

the theory

theory

  • 3. 3. Specification

Specification ofof the

the statistical,

statistical, oror econometric

econometric,, model

model

  • 4. 4. Collecting

Collecting the

the data

data

  • 5. 5. Estimation

Estimation ofof the

the parameters

parameters ofof the

the econometric

econometric model

model

  • 6. 6. Hypothesis

Hypothesis testing

testing

  • 7. 7. Forecasting

Forecasting oror prediction

prediction

  • 8. 8. Using

Using the

the model

model for

for control

control oror policy

policy purposes.

purposes.

ToTo illustrate

illustrate the

the preceding

preceding steps,

steps, let

let usus consider

consider the

the well-known

well-known

Keynesian

Keynesian theory

theory ofof consumption.

consumption.

  • 1. 1. Statement

Statement ofof Theory

Theory oror Hypothesis

Hypothesis

Keynes

Keynes states

states that

that onon average,

average, consumers

consumers increase

increase their

their consumption

consumption asas

their income

their

income increases,

increases, but

but not

not asas much

much asas the

the increase

increase inin their

their income

income

(MPC << 1).

(MPC

1).

2. Specification

2.

Specification ofof the

the Mathematical

Mathematical Model

Model ofof Consumption

Consumption (single-

(single-

equation

equation model)

model)

YY == ββ 11 ++ ββ 22 XX

00 << ββ 22 << 11

(I.3.1)

(I.3.1)

YY == consumption

consumption expenditure

expenditure and

and ((dependent

dependent variable)

variable)

XX == income,

income, (independent,

(independent, oror explanatory

explanatory variable)

variable)

ββ 11

== the

the intercept

intercept

ββ 22 == the

the slope

slope coefficient

coefficient

The slope

The

slope coefficient

coefficient ββ 22 measures

measures the

the MPC.

MPC.

Geometrically Geometrically,,

  • 3. 3. Specification

Specification of

of the

the Econometric

Econometric Model

Model of

of Consumption

Consumption

The

The relationships

relationships between

between economic

economic variables

variables are

are generally

generally inexact

InIn

addition toto income,

addition

income, other

other variables

variables affect

affect consumption

consumption expenditure.

expenditure. For

For

example, size

example,

size of

of family,

family, ages

ages of

of the

the members

members inin the

the family,

family, family

family religion

religion,,

etc.,

etc., are

are likely

likely toto exert

exert some

some influence

influence onon consumption.

consumption.

ToTo allow

allow for

for the

the inexact

inexact relationships

relationships between

between economic

economic variables,

variables, (I.3.1)

(I.3.1) isis

modified

modified asas follows:

follows:

YY == ββ 11 ++ ββ 22 XX ++ uu

(I.3.2)

(I.3.2)

where

where u,

u, known

known asas the

the disturbance,

disturbance, oror error,

error, term

term,, isis aa random

random ((stochastic

stochastic))

variable

variable that

that has

has well-defined

well-defined probabilistic

probabilistic properties

The disturbance

The

disturbance term

term

uu may

may well

well represent

represent all

all those

those factors

factors that

that affect

affect consumption

consumption but

but are

are not

not

taken into

taken

into account

account explicitly.

explicitly.

(I.3.2) isis anan example

(I.3.2)

example of

of aa linear

linear regression

regression model,

model, i.e.,

i.e., itit hypothesizes

hypothesizes that

that YY

isis linearly

linearly related

related toto XX,, but

but that

that the

the relationship

relationship between

between the

the two

two isis not

not exact

exact;;

itit isis subject

subject toto individual

individual variation.

variation. The

The econometric

econometric model

model of

of (I.3.2)

(I.3.2) can

can bebe

depicted

depicted asas shown

shown inin Figure

Figure I.2.

I.2.

• isis anan example (I.3.2) of aa linear regression model, i.e., itit hypothesizes that Y Y
  • 4. 4. Obtaining

Obtaining Data

Data

ToTo obtain

obtain the

the numerical

numerical values

values ofof β1β1 and

and β2,

β2, we

we need

need data.

data. Look

Look atat Table

Table

I.1, which

I.1,

which relate

relate toto the

the personal

personal consumption

consumption expenditure

expenditure (PCE)

(PCE) and

and the

the

gross domestic

gross

domestic product

product (GDP)

(GDP)..

The data

The

data are

are inin “real”

real terms.

terms.

4. 4. Obtaining Obtaining Data Data • ToTo obtain the numerical values ofof β1β1 and β2,

The data are plotted in Figure I.3

The data are plotted in Figure I.3
  • 5. 5. Estimation

Estimation of

of the

the Econometric

Econometric Model

Model

Regression analysis

Regression

analysis isis the

the main

main tool

tool used

used toto obtain

obtain the

the estimates.

estimates. Using

Using this

this

technique

technique and

and the

the data

data given

given inin Table

Table I.1,

I.1, we

we obtain

obtain the

the following

following estimates

estimates

of ββ 11 and

of

and ββ 22 ,, namely,

namely, −184.08

184.08 and

and 0.7064

Thus, the

Thus,

the estimated

estimated consumption

consumption

function is:

function

is:

Yˆ == −184.08

184.08 ++ 0.7064X

0.7064X ii

(I.3.3)

(I.3.3)

The estimated

The

estimated regression

regression line

line isis shown

shown inin Figure

Figure I.3.

I.3. The

The regression

regression line

line fits

fits

the data

the

data quite

quite well.

well. The

The slope

slope coefficient

coefficient (i.e.,

(i.e., the

the MPC)

MPC) was

was about

about 0.70,

0.70, anan

increase inin real

increase

real income

income of

of 11 dollar

dollar led,

led, onon average,

average, toto anan increase

increase of

of about

about 7070

cents inin real

cents

real consumption

consumption..

  • 6. 6. Hypothesis

Hypothesis Testing

Testing

That isis toto find

That

find out

out whether

whether the

the estimates

estimates obtained

obtained in,

in, Eq.

Eq. (I.3.3)

(I.3.3) are

are inin

accord with

accord

with the

the expectations

expectations ofof the

the theory

theory that

that isis being

being tested

Keynes

Keynes

expected the

expected

the MPC

MPC toto bebe positive

positive but

but less

less than

than

InIn our

our example

example we

we found

found the

the

MPC

MPC toto bebe about

about 0.70.

0.70. But

But before

before we

we accept

accept this

this finding

finding asas confirmation

confirmation of

of

Keynesian consumption

Keynesian

consumption theory,

theory, we

we must

must enquire

enquire whether

whether this

this estimate

estimate isis

sufficiently

sufficiently below

below unity.

unity. InIn other

other words,

words, isis 0.70

0.70 statistically

statistically less

less than

than 1?1? IfIf itit

is, itit may

is,

may support

support Keynes’

Keynes theory.

theory.

Such confirmation

Such

confirmation oror refutation

refutation of

of economic

economic theories

theories onon the

the basis

basis of

of sample

sample

evidence isis based

evidence

based onon aa branch

branch of

of statistical

statistical theory

theory known

known asas statistical

statistical

inference (hypothesis

inference

(hypothesis testing).

testing).

  • 7. 7. Forecasting

Forecasting oror Prediction

Prediction

ToTo illustrate,

illustrate, suppose

suppose we

we want

want toto predict

predict the

the mean

mean consumption

consumption

expenditure

expenditure for

for 1997.

1997. The

The GDP

GDP value

value for

for 1997

1997 was

was 7269.8

7269.8 billion

billion dollars

dollars

consumption

consumption would

would be:

be:

Yˆ1997 == −184.0779

Yˆ1997

184.0779 ++ 0.7064

0.7064 (7269.8)

(7269.8) == 4951

4951.3.3

(I.3.4)

(I.3.4)

The actual

The

actual value

value of

of the

the consumption

consumption expenditure

expenditure reported

reported inin 1997

1997 was

was

  • 4913.5 4913.5 billion

billion dollars.

dollars. The

The estimated

estimated model

model (I.3.3)

(I.3.3) thus

thus over-predicted

over-predicted the

the

actual consumption

actual

consumption expenditure

expenditure byby about

about 37.82

37.82 billion

billion dollars.

dollars. We

We could

could

say the

say

the forecast

forecast error

error isis about

about 37.8

37.8 billion

billion dollars,

dollars, which

which isis about

about 0.76

0.76

percent of

percent

of the

the actual

actual GDP

GDP value

value for

for 1997.

1997.

Now

Now suppose

suppose the

the government

government decides

decides toto propose

propose aa reduction

reduction inin the

the income

income

tax

What will

What

will bebe the

the effect

effect of

of such

such aa policy

policy onon income

income and

and thereby

thereby onon

consumption expenditure

consumption

expenditure and

and ultimately

ultimately onon employment?

employment?

Suppose

Suppose that,

that, asas aa result

result of

of the

the proposed

expenditure increases

expenditure

What will

What

will bebe the

macroeconomic

macroeconomic theory

theory shows,

shows, the

the change

worth of

worth

of change

change inin investment

investment expenditure

M, which

M,

which isis defined

defined as:

as:

MM == 1/(1

1/(1 MPC)

MPC)

The multiplier

The

multiplier isis about

about MM == 3.33

That is,

That

inin investment

investment will

will eventually

eventually lead

lead toto more

(decrease) inin income;

(decrease)

income; note

note that

that itit takes

The critical

The

critical value

value inin this

this computation

computation isis MPC

of MPC

of

MPC provides

provides valuable

valuable information

information for

proposed policy

policy change,

change, investment

investment

the effect

effect onon the

the economy?

economy? As

As

change inin income

income following,

following, aa dollar’s

dollars

expenditure isis given

given byby the

the income

income multiplier

multiplier

(I.3.5)

(I.3.5)

is, anan increase

increase (decrease)

(decrease) of

of aa dollar

dollar

more than

than aa threefold

threefold increase

increase

takes time

time for

for the

the multiplier

multiplier toto work.

work.

Thus, aa quantitative

Thus,

quantitative estimate

estimate

for policy

policy purposes.

purposes. Knowing

Knowing MPC,

MPC,

one can

one

can predict

predict the

the future

future course

course of

of income,

income, consumption

consumption expenditure,

expenditure, and

and

employment following

employment

following aa change

change inin the

the government’s

governments fiscal

fiscal policies.

policies.

  • 8. 8. Use

Use ofof the

the Model

Model for

for Control

Control oror Policy

Policy Purposes

Purposes

Suppose

Suppose we

we have

have the

the estimated

Suppose further

Suppose

further the

the government

about 4900

about

4900 will

will keep

keep the

estimated consumption

consumption function

function given

given inin (I.3.3).

(I.3.3).

government believes

believes that

that consumer

consumer expenditure

expenditure of

of

the unemployment

unemployment rate

rate at

at itsits current

current level

level of

of about

about

4.2%

What level

What

level of

of income

income will

will guarantee

guarantee the

the target

target amount

amount of

of

consumption expenditure?

consumption

expenditure?

IfIf the

the regression

regression results

results given

given inin (I.3.3)

(I.3.3) seem

seem reasonable,

reasonable, simple

simple arithmetic

arithmetic

will

will show

show that:

that:

4900 == −184

4900

−184.0779

.0779 ++ 0.7064X

0.7064X

(I.3.6)

(I.3.6)

which gives

which

gives XX == 7197

7197,, approximately.

approximately. That

That is,

is, anan income

income level

level of

of about

about 7197

7197

(billion)

(billion) dollars,

dollars, given

given anan MPC

MPC of

of about

about 0.70,

0.70, will

will produce

produce anan expenditure

expenditure

of

of about

about 4900

4900 billion

billion dollars.

dollars. As

As these

these calculations

calculations suggest,

suggest, anan estimated

estimated

model

model may

may bebe used

used for

for control,

control, oror policy,

policy, purposes.

purposes. ByBy appropriate

appropriate fiscal

fiscal

and

and monetary

monetary policy

policy mix,

mix, the

the government

government can

can manipulate

manipulate the

the control

control

variable XX toto produce

variable

produce the

the desired

desired level

level of

of the

the target

target variable

variable Y.

Y.

Figure I.4I.4 summarizes

Figure

summarizes the

the anatomy

anatomy of

of classical

classical econometric

econometric modeling.

modeling.

Choosing

Choosing among

among Competing

Competing Models

Models

When aa governmental

When

governmental agency

agency (e.g.,

(e.g., the

the U.S.

U.S. Department

Department of

of Commerce)

Commerce)

collects economic

collects

economic data,

data, such

such asas that

that shown

shown inin Table

Table I.1,

I.1, itit does

does not

not

necessarily have

necessarily

have any

any economic

economic theory

theory inin mind

How then

How

then does

does one

one know

know that

that

the data

the

data really

really support

support the

the Keynesian

Keynesian theory

theory of

of consumption?

consumption? IsIs itit because

because

the Keynesian

the

Keynesian consumption

consumption function

function (i.e.,

(i.e., the

the regression

regression line)

line) shown

shown inin

Figure I.3I.3 isis extremely

Figure

extremely close

close toto the

the actual

actual data

data points?

points? IsIs itit possible

possible that

that

another consumption

another

consumption model

model (theory)

(theory) might

might equally

equally fit

fit the

the data

data asas well?

well? For

For

example, Milton

example,

Milton Friedman

Friedman has

has developed

developed aa model

model of

of consumption,

consumption, called

called

the

the permanent

permanent income

income hypothesis

Robert Hall

Robert

Hall has

has also

also developed

developed aa model

model ofof

consumption,