University of Gondar

College of Business and Economics

Department of Accounting and Finance

Assignment

Student name: Eid Awil

ID. NO: 05253/12

Course: Econometrics

Instructor: Dr osman Date: 14\12\2020

 Assignment
1. What is a model? A model is a simplified representation of actual phenomena. for
saying that ‘the quantity demanded of oranges depends on the price of oranges’ is a
simplified representation because there are a host of other variables that one can think
of that determine the demand for oranges. For example, the price of related goods such
as apples and income of the consumer, taste and preference of the consumer, etc are
determinants of the demand for orange. However, there is no end to this stream of
other variables. In a remote sense even the price of gasoline can affect the demand for
oranges. Economic theory or economic model is constructed. An economic model
consists of mathematical equations that describe various relationships. Economists are
well known for their building of models to describe a vast array of behaviors. For
example, in intermediate microeconomics, individual consumption decisions, subject to
a budget constraint, are described by mathematical models. The basic premise
underlying these models is utility maximization. The assumption that individuals make
choices to maximize their well-being, subject to resource constraints, gives us a very
powerful framework for creating tractable economic models and making clear
predictions. In the context of consumption decisions, utility maximization leads to a set
of demand equations. In a demand equation, the quantity demanded of each
commodity depends on the price of the goods, the price of substitute and
complementary goods, the consumer’s income, and the individual’s characteristics that
affect taste. These equations can form the basis of an econometric analysis of
consumer demand. Mathematical model: that it shows a unique exact relationship
between the dependent and independent variables. The value of the dependent
variable is determined based the value of the independent variable. For example
consumption functions: Y = β0 + β1X, or econometric model that is the econometric
model includes a random or error term in addition into the mathematical model. The
econometric model presumes that the relationship between economic variables is not
exact because there are random factors that affect the relationship between dependent
and independent variables. These random factors are not captured by mathematical
model. Stochastic relationship between the two variables could be expressed as:
Yi = β0 + β1Xi + ui
2. The main steps that the investigator should follow when conducting empirical study
in econometrics are following
1. Statement of theory or hypothesis.
2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric, model
4. Obtaining the data
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purposes.
To illustrate the preceding steps, let us consider the well-known Keynesian Theory of
consumption
1. Statement of Theory or Hypothesis
The fundamental psychological law is that men [women] are disposed, as a rule and on
average, to increase their consumption as their income increases, but not as much as
the increase in their income. In short, Keynes postulated that the marginal propensity
to consume (MPC), the rate of change of consumption for a unit (say, a dollar) change
in income, is greater than zero but less than.
2. Specification of the Mathematical Model of Consumption
Although Keynes postulated a positive relationship between consumption and income,
he did not specify the precise form of the functional relationship between the two. For
simplicity, a mathematical economist might suggest the following form of the Keynesian
consumption function Y = β1 + β2X 0 < β2 < 1
Early related to income, is an example of a mathematical model of the relationship
between consumption and income that is called the consumption function in economics.
A model is simply a set of mathematical equations. If the model has only one equation,
as in the preceding example, it is called a single-equation model, whereas if it has more
than one equation, it is known as a multiple equation model
The variable appearing on the left side of the equality sign is called the dependent
variable and the variable(s) on the right side are called the independent, or
explanatory, variable(s). Thus, in the Keynesian consumption function example
consumption (expenditure) is the dependent variable and income is the explanatory
variable.
3. Specification of the Econometric Model of Consumption
The purely mathematical model of the consumption function given in
Example is of limited interest to the econometrician, for it assumes that there is an
exact or deterministic relationship between consumption and income. But relationships
between economic variables are generally inexact. Thus, if we were to obtain data on
consumption expenditure and disposable
i.e., after tax income of a sample of, say, 500 American families and plot these data on
a graph paper with consumption expenditure on the vertical axis and disposable income
on the horizontal axis, we would not expect all 500 observations to lie exactly on the
straight line of because, in addition to income, other variables affect consumption
expenditure. For example, size of family, ages of the members in the family, family
religion, etc., are likely to exert some influence on consumption.
To allow for the inexact relationships between economic variables, the econometrician
would modify the deterministic consumption function: Y = β1 + β2X + u
Where u, known as the disturbance, or error, term, is a random (stochastic) variable
that has well-defined probabilistic properties the disturbance term u may well represent
all those factors that affect consumption but are not taken into account explicitly
4. Obtaining Data
To estimate the econometric model given in that is, to obtain the numerical values of
β1 and β2, we need data. Although we will have more to say about the crucial
importance of data for economic analysis
5. Estimation of the Econometric Model
Now that we have the data, our next task is to estimate the parameters of the
consumption function. The numerical estimates of the parameters give empirical
content to the consumption function. The actual mechanics of estimating the
parameters for now, note that the statistical technique of regression analysis is the
main tool used to obtain the estimates. Using this technique and the data given we
obtain the following estimates of β1 and β2, namely, −184.08 and 0.7064.
Thus, the estimated consumption function is:ˆY= −184.08 + 0.7064Xi
6. Hypothesis Testing
Assuming that the fitted model is a reasonably good approximation of reality, we have
to develop suitable criteria to find out whether the estimates obtained in, say, example
are in accord with the expectations of the theory that is being tested. According to
“positive” economists like Milton Friedman, a theory or hypothesis that is not verifiable
by appeal to empirical evidence may not be admissible as a part of scientific enquiry. As
noted earlier, Keynes expected the MPC to be positive but less than 1. In our example
we found the MPC to be about 0.70. But before we accept this finding as confirmation
of Keynesian consumption theory, we must enquire whether this estimate is sufficiently
below unity to convince us that this is not a chance occurrence or peculiarity of the
particular data we have used. In other words, is 0.70 statistically less than 1? If it is, it
may support Keynes’ theory. Such confirmation or refutation of economic theories on
the basis of sample evidence is based on a branch of statistical theory known as
statistical inference (hypothesis testing). Throughout this book we shall see how this
inference process is actually conducted.
7. Forecasting or Prediction
If the chosen model does not refute the hypothesis or theory under consideration, we
may use it to predict the future value(s) of the dependent, or forecast, variable Y on
the basis of known or expected future value(s) of the explanatory, or predictor, variable
X.
8. Use of the Model for Control or Policy Purposes
Suppose we have the estimated consumption function given in Suppose further the
government believes that consumer expenditure of about 4900 (billions of 1992 dollars)
will keep the unemployment rate at its current level of about 4.2 percent (early 2000).
What level of income will guarantee the target amount of consumption expenditure? If
the regression results given in seem reasonable, simple arithmetic will show that
4900 = −184.0779 + 0.7064X
3. The population regression function (PRF) is a description of the model that is
thought to be generating the actual data and it represents the true relationship
between the variables. The population regression function is also known as the data
generating process (DGP). The PRF embodies the true values of α and β, and is
expressed as yt = α + βxt + ut .
 The Population Regression Function (PRF) which shows the Conditional Expected value
of the dependent variable (conditional upon X, the independent variable) and
Population Regression Function (PRF) It tells us how the expected value of the
distribution of Y is related functionally to the value of x in some way, The function form
of the Population Regression Function is both an empirical and theoretical question. For
instance, economist assumed that expenditure on consumption and income are linearly
related. For simplicity sake and as a initial working hypothesis we assume that the
Population Regression Function E(Y/Xt) is a linear function of Xt
The sample regression function, SRF, is the relationship that has been estimated
using the sample observations, and is often written as, yˆt = αˆ + βˆxt , That there is
no error or residual term in all this equation states is that given a particular value of x,
multiplying it by βˆ and adding ˆα will give the model fitted or expected value for y,
denoted ˆy. It is also possible to write, yt = αˆ + βˆxt + ˆut, Equation splits the
observed value of y into two components: the fitted value from the model, and a
residual term.The SRF is used to infer likely values of the PRF. That is, the estimates αˆ
and βˆ are constructed, for the sample of data at hand, but what is really of interest is
the true relationship between x and y -- in other words, the PRF is what is really
wanted, but all that is ever available is the SRF! However, what can be said is how
likely it is, given the figures calculated for αˆ and βˆ that the corresponding population
parameters take on certain values.
4. The role of the stochastic error term u i in regression analysis and difference between
the stochastic error term and the residual, u i is Stochastic error term: where the u’ are
the stochastic error terms, called impulses or innovations or shocks in the language of
VAR. random, nonsystematic term, a random “disturbance,” the effect of the variables
that were omitted from the equation, assumed to have a mean value of zero, and to be
uncorrelated with the independent variable, x, assumed to have a constant variance,
and to be uncorrelated with its own past values and the stochastic error term ui in this
production function, there is no way to make it a linear (in parameter) regression
model. It is intrinsically a nonlinear regression model.
Residual estimated error, the vertical distance between the actual value of the
dependent variable, yi, and the fitted value of x, in statistics and
optimization, errors and residuals are two closely related and easily confused measures
of the deviation of an observed value of an element of a statistical sample from its
"theoretical value". The error (or disturbance) of an observed value is the deviation of
the observed value from the (unobservable) true value of a quantity of interest (for
example, a population mean), and the residual of an observed value is the difference
between the observed value and the estimated value of the quantity of interest (for
example, a sample mean). The distinction is most important in regression analysis,
where the concepts are sometimes called the regression errors and regression
residuals and where they lead to the concept of studentized residuals.

5. A. E ( ui )=E[ui|Xi]=0 and E (Yi) = βi + β2Xi .

B.cov ( ui , u j ) = cov (ui, uj |Xi, Xj) = E{[ui − E(ui)] | Xi }{[uj − E(uj)] | Xj }
And Cov(Yi, Yj ) = Cov(εi, εj) = 0

6. The assumptions of the classical linear regression model, the least-squares

estimates possess some ideal or optimum properties. These properties are contained in
the well-known Gauss–Markov theorem. To understand this theorem, we need to
consider the best linear unbiasedness property of an estimator. An estimator, say
the OLS estimator ˆ β2, is said to be a best linear unbiased estimator (BLUE) of β2 if
the following hold:
1. It is linear, that is, a linear function of a random variable, such as the dependent
variable Y in the regression model.
2. It is unbiased, that is, its average or expected value, E( ˆ β2), is equal to the true
value, β2.
3. It has minimum variance in the class of all such linear unbiased estimators; an
unbiased estimator with the least variance is known as an efficient estimator.
In the regression context it can be proved that the OLS estimators are
BLUE. This is the gist of the famous Gauss–Markov theorem, which can be stated as
follows: Gauss–Markov Theorem: Given the assumptions of the classical linear
regression model, the least-squares estimators, in the class of unbiased linear
estimators, have minimum variance, that is, they are BLUE.
 7. Σ yi=123 Σ Xi=276 Σ yi2=2051 Σ Xi2=9206 y~=12.3
x~=27.6 Σ yi Xi=4309
β1= Σ yi Xi - n y x ~/ Σ Xi2 - n x ~2 =
4309-(10)(12.3)(27.6)/9206-(10)(27.6)2=914.2/1588.4=0.58
β0=12.3-.058(27.6) =-3.708
A. Qs=-3.708+0.58 Pi
B. Where β0 -3.708 and β1 0.58 are Point Estimates of the true parameters. The value
for β1 (.58) interpreted as the marginal product of price for a one unit increase in
quantity supply, total output will decrease by 0.58 unit.
C. R2=ESS/TSS= 3096.89/538.1=5.8 or R= 2.408
D. Interpretation: R2= 5.8 means that about 5.8% of the variation in output(Y) is
explained by the variation in product price input, If R2= 0; the model doesn’t explain
anything; the explanatory variable doesn’t explain the changes on the dependent
variable.

8. This question is false because the OLS estimators are linear and unbiased, and in
the class of all linear unbiased estimators they have minimum variance (the Gauss–
Markov property). In short, the OLS estimators are best linear unbiased estimators
(BLUE). This property extends to the entire ˆβ vector; that is, ˆβ is linear (each of its
elements is a linear function of Y, the dependent variable). E(ˆ β) = ˆβ, that is, the
expected value of each element of ˆβ is equal to the corresponding element of the true
β, and in the class of all linear unbiased estimators of β, the OLS estimator ˆβ has
minimum variance.

9. The following regression results of Yi = β0 + β1Xi + ui as:

A.
Y^ i= -261.09 + 0.2453Xi
(31.327) ( 0.0147)
t= (-8.334) 16.616
r2 = 0.9388 n=20
B. Would you reject that β1= 0 at ɑ= 0.05
The report above, we can directly conclude that both coefficients are statistically
significantly different from zero at 0.05 level of significant and the claim of the null
hypothesis is rejected

10. The following estimated regression line

Y^ i= 2.6911 – 0.4795Xi
(0.122) (0.114)
σ^ 2= 0.01656 n= 11 r2= 0.6628
A. = (2.6911)-(2.201)(0.122)<Bo<(2.6911)+(2.201)(0.122)=95%
(2.42<Bo<2.96) Therefore, the 95% confidence interval for Bo is (2.42, 2.96)

B. = (0.4795)-(2.201)(0.114)<Bo<(0.4795)+(2.201)(0.114)=95%
(0.23<Bo<0.73) Therefore, the 95% confidence interval for Bo is (0.23, 0.73)

C. the null hypothesis is rejected. Similarly, a test is said to be statistically insignificant if

the value of the test statistic lies in the acceptance region. In such case, the null
hypothesis can’t be rejected. Note that Test significance of a coefficient is a two tail
test. Significance of a coefficient is tested under the following hypothesis:
H0: β1= 0 (The coefficient is statistically zero, insignificant)
H1: β1≠ 0 (The coefficient is significantly different from zero, statistically
Significant)
Reference
Amemiya, T. (1983) Nonlinear Regression Models, in Z. Griliches and M.D. Intriligator
(eds) Handbook of Econometrics, Vol. 1, Amsterdam: North-Holland, 333‒389.
Anderson, R.G., Hoffman, D.L. and Rasche, R.H. (2002) A Vector Autoregression
Forecasting Model of the US Economy, Journal of Macroeconomics, 24, 569‒598.
Anderson, T.W. and Rubin, H. (1949) Estimation of the Parameters of a Single Equation
in a Complete System of Stochastic Equations, Annals of Mathematical Statistics, 20,
46‒63.
Andreou, E., Ghyles, E. and Kourtellos, A. (2010) Regression Models with Mixed
Sampling Frequencies, Journal of Econometrics, 158, 246‒261.