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 deviations, variances, maxima/minima: Distribution of data kurtosis: Number of observations, number of missing observations

Standard

Skewness,

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* Forecasting

IV. Why is econometrics important?

Facts tell nothing. We are usually concerned with explaining one variable using

another (hypothesis/ theory)

* Testing theory

* Policy analysis

Note: correlation causation.

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

correlations (covariances)

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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).

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2.

Specifying the mathematical model From theory Q = f(Price,...) Specify the mathematical form Linear: Q = 1 + 2.Price Loglinear: ln(Q) = 1 + 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 = 1 + 2.Price + e The Mathematical Interpretation: The Meaning of the Regression Parameters 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) 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.

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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. Researchers desire to keep specification simple/parsimonious g. Wrong functional form e.g. linear vs. quadratic or loglinear
4. 5. Collecting data 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 C 2222.171 253.3745 8.770304 Real_price -2.242878 0.697891 -3.213796 R-squared 0.262621 Mean dependent var Adjusted R-squared 0.237194 S.D. dependent var S.E. of regression 308.1887 Akaike info criterion Sum squared resid 2754428. Schwarz criterion Log likelihood -220.6055 F-statistic Durbin-Watson stat 0.050316 Prob(F-statistic) Estimated Q = 2222.17 2.24 Price Interpretation of the estimates: 2222.17 & -2.24

Prob. 0.0000 0.0032 1427.546 352.8659 14.36164 14.45416 10.32849 0.003203

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Interpretation of the Multi-Variable Equation & its Coefficients Partial regression coefficients: In a 2 variable model: Yi = 1 + 2Xi + ui; 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 2 In the 3 variable model: Yi = 1+ 2X2i + 3X3i + ui, a change in Y can be caused by: 1) a change in X2i alone 2) a change in X3i alone or 3) a simultaneous change in both X2i and X3i 2 and 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. 2 = Y/X2 with X3= 0= change in Y as X2 changes while X3 is constant 3 = Y/X3 with X2= 0= change in Y as X3changes while X2is constant 1 is still called the intercept term and measures the value that Y takes when both X2 & X3 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 X3 is held constant, the model can be represented as:

Reference: http://www.washjeff.edu/users/kswint/ECN340/LectureNotes/L06StudentNotes.pdf

Note: Loglinear: ln (Q) = 1 + 2.ln (Price) + u What is the meaning of 1 and 2 ?

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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 R2 and F statistics Durbin-Watson statistic Chow tests Ramseys 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
2000

1500

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

1000

500

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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 C 1158.552 67.97038 17.04496 Real_price -2.962742 0.149211 -19.85605 Real_income 0.004687 0.000187 25.11414 R-squared 0.968656 Mean dependent var Adjusted R-squared 0.966418 S.D. dependent var S.E. of regression 64.66442 Akaike info criterion Sum squared resid 117081.6 Schwarz criterion Log likelihood -171.6550 F-statistic Durbin-Watson stat 1.325191 Prob(F-statistic) Estimated Q = 1158.5 + 0.0047 (Real Income) 2.96 Price
2000

Prob. 0.0000 0.0000 0.0000 1427.546 352.8659 11.26806 11.40684 432.6630 0.000000

1500 300 200 1000 100 0 -100 -200 70 75 80 Residual 85 90 Actual 95 Fitted 00 500

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

2003 2004 2005

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?

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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

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