Addis Ababa University

School of Commerce
Economics Program Unit

Introduction to Econometrics
Econ 3044

Mulat G.
20202
May 2014 Econometrics
Course Objectives:
 The main objective of this course is to enable students have a good background knowledge on
cross-sectional econometric models. More specifically, after the completion of the course,
students are expected to:
 Distinguish between economic and econometric models;
 Do simple and multiple regression with economic data ( in business area)
 Interpret regression results (like coefficients and R2) and test hypotheses (both manually and
using statistical packages); and
 Detect (in) existence of problems of multicollinearity, heteroscedasticity and autocorrelation as
well as suggest how to rectify such problems (both manually and using statistical packages).
 Course Contents for Lecture:
 Introduction
◦ Definition and Scope of Econometrics
◦ Models: Economic models and Econometric models
◦ Methodology of Econometrics
◦ The Sources, Types and Nature of Data
 Simple Linear Regression
◦ Concept of Regression Function
◦ Properties of OLS Estimates and Gauss-Markov Theore
◦ Confidence Intervals and Hypothesis Testing
◦ Predictions using Simple Linear Regression Model

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Cont....
 3. Multiple Linear Regressions
 3.1. Method of Ordinary Least Squares revised
 3.2. Partial Correlation Coefficients & their Interpretation
 3.3. Coefficient of Multiple Determination
 3.4. Properties of Least Squares and Gauss-Markov Theorem
 3.5. Hypothesis Testing in Multiple Linear Regression
 4. Violations of the Assumptions of the Classical Model
 4.1. Multicollinearity
 4.2. Heteroscedasticity
 4.3. Autocorrelation
 4.4. Specification Errors: Omission of Variables
 5. Multiple Regression Analysis: Qualitative Information

 REFERENCES:
 1. Gujarati, D. N. (2004). Basic Econometrics, 4th edition, McGraw-Hill.
 2. Wooldridge, J. (2004). Introductory Econometrics: A Modern Approach, 2nd ed.

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Chapter One - Introduction
1.1 What is Econometrics?
 Economic theories suggest many
relationships among economic variables.
 These, however, have to be checked
against data obtained from the real world.
 We use econometrics, to provide a better
understanding of economic relationships
and a better guidance for economic policy
making.

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 Different scholars defined econometrics
as:
 Definition 1: econometrics simply means
“economic measurement”. The “metric” part
of the word indicates measurement and hence it is
a branch of economics concerned with measuring
the empirical estimation of economic relationships
among economic variables. (Gujarati, 2003)
 Definition 2: econometrics is the
application of statistical and mathematical
methods to the analysis of economic data,
with a purpose of giving empirical content to
economic theories and verifying them or
refuting them. (Maddala,1992)

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 Definition 3: Econometrics is the interaction
of economic theory, observed data and
statistical methods. These interactions make
econometrics interesting, challenging and
difficult. But “econometrics is much easier
without data”. (Verbeek, 2008)
 Definition 4: Econometrics is based upon
the development of statistical methods for
estimating economic relationships, testing
economic theories, and evaluating and
implementing government and business
policy. (Woodridge, 2004)
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Why a separate discipline?
 Economic theory makes statements
that are mostly qualitative in nature, while
econometrics gives empirical content to
most economic theory.
 Mathematical economics is to
express economic theory in mathematical
form without empirical verification of the
theory, while econometrics is mainly
interested in the later
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 Economic statistics is mainly
concerned with collecting, processing,
and presenting economic data in the
form of charts and tables. It does not go
any further. The one who does that is the
econometrician.
 Mathematical statistics provides
many of tools for economic studies, but
econometrics supplies the later with
many special methods of quantitative
analysis based on economic data.
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Economic Mathematical
Theory Economics

Econometrics

Economic Mathematic
Statistics Statistics

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1.2 Models and their types
 A model is the simplified representation
of actual/real phenomena.
 Modelling is an integral part of most
scientific inquiry.
 A model is a compromise between reality
and manageability.
Types of models
1. Verbal/logical models - uses verbal
analogies
1
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2. Physical models - scaling down or up of
the item investigated.
3. Geometric models - Geometric models
are used to represent relationships
geometrically.
4.Algebraic models - verbal and
geometric models have to be expressed
algebraically before they can be
transformed into an econometric model.

1
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 Econometric models - stochastic model
that includes one or more random
variables.
◦ An econometric model will either be linear or
non-linear in parameters and variables.
◦ Econometric models can be either static or
dynamic

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Economic vs. econometric models
 Economic models: Any economic theory
is an observation from the real world. A
deliberately simplified analytical framework
is called an economic model.
 Economic models consist of the following
three basic structural elements.
◦ A set of variables
◦ A list of fundamental relationships and
◦ A number of strategic coefficients

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Example
 Model of job training and worker productivity
◦ What is effect of additional training on worker productivity?
◦ Formal economic theory not really needed to derive equation:

Hourly wage

Years of formal
education Weeks spent
Years of work- in job training
force experience
◦ Other factors may be relevant, but these are the most important (?)

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 Econometric models: contain a random
element.
◦ Mathematical economic models

◦ Econometric model would be of the stochastic

form:

 where u stands for the random factors which affect

the quantity demanded.

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 Example
 Econometric model of job training and worker productivity

Unobserved deter-
minants of the wage

e.g. innate ability,

Hourly wage Years of formal Years of work- Weeks spent quality of education,
education force experience in job training family background …

 Most of econometrics deals with the specification of the error

 Econometric models may be used for hypothesis testing

◦ For example, the parameter represents effect of training on wage

◦ How large is this effect? Is it different from zero?

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1.3. Methodology of Econometrics
 The traditional/classical econometric
methodology includes:
(1) Statement of theory or hypothesis:
Keynes stated: ”Consumption increases as income
increases, but not as much as the increase in
income”. It means that “The marginal propensity to
consume (MPC) for a unit change in income is
grater than zero but less than unit”

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(2) Specification of the mathematical
model of the theory
Y = ß1+ ß2X ; 0 < ß2< 1
Y= consumption expenditure and X= income
ß1 and ß2 are parameters; ß1 is intercept, and ß2 is slope
coefficients
(3) Specification of the econometric
model of the theory
◦ The relationships between economic variables are
generally inexact. 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.
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 To allow for the inexact relationships between
economic variables, the mathematical
equation is modified as follows:
Y = ß1+ ß2X + u ; 0 < ß2< 1;
u is disturbance term or error term. It is a random
or stochastic variable.

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Example
 A deterministic relationship
P Qd
25 1
20 3
15 5
10 7
5 9
0 11

 A random relationship
f( ) P Qd E(Qd)
25 2 or1or 0 1
1 0.25
20 4 or 3or 2 3
0 0.5 15 6 or 5 or 4 5
-1 0.25 10 8 or 7 or 6 7
5 10 or 9 or 8 9
0 12 or 11or 10 11

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(4) Obtaining Data
 An econometric model requires data on
all the variables in the model.
Year X Y

1980 2447.1 3776.3

1981 2476.9 3843.1
1982 2503.7 3760.3
1983 2619.4 3906.6
1984 2746.1 4148.5
1985 2865.8 4279.8
1986 2969.1 4404.5
1987 3052.2 4539.9
1988 3162.4 4718.6
1989 3223.3 4838.0
1990 3260.4 4877.5
1991 3240.8 4821.0

(5) Estimating the Econometric Model

Y^ = - 231.8 + 0.7194 X
MPC was about 0.72
Note: A hat symbol (^) above one variable will signify
an estimator of the relevant population value
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(6) Hypothesis Testing
 Are the estimates accord with the
expectations of the theory that is being
tested? Is MPC < 1 statistically?
(7) Forecasting or Prediction
 With given future value(s) of X, what is the
future value(s) of Y?
 Example: if GDP=$6000Bill in 1994, what is
the forecast consumption expenditure?
Y^= - 231.8+0.7196(6000) = 4084.6

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(8) Using model for control or
policy purposes

Y=4000= -231.8+0.7194 X  X  5882

 MPC = 0.72, an income of $5882 Bill will

produce an expenditure of $4000 Bill. By fiscal
and monetary policy, Government can
manipulate the control variable X to get the
desired level of target variable Y

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The purpose of econometrics
 The principal purposes of econometrics
are:
◦ structural analysis,
◦ forecasting and
◦ policy evaluation.

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1.4.Types of Data for Econometrics
Analysis
 Data based on sources is classified in to
primary and secondary.
 Data types can also be classified as:
Non experimental Vs experimental data
 Non-experimental data are obtained from
observations of a system that is not subject
to experimental control, while experimental
data are obtained from controlled
experiments in laboratory.
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Qualitative versus quantitative data
 Data, as a matter of definition, is
quantitative. Thus facts, which are already
expressed as numbers.
 There are also variables, which are
qualitative by nature and variables which
show qualitative shifts over time or space.
◦ Such qualitative information is usually
quantified by what are known as dummy
variables.

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Time series versus cross section data
◦ Cross-section data
◦ Time-series data
◦ Pooled cross-sections
◦ A panel data (or longitudinal data) set
 Econometric methods depend on the
nature of the data used
◦ Use of inappropriate methods may lead to
misleading results

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 Cross-sectional data sets
◦ Sample of individuals, households, firms, cities, states,
countries, or other units of interest at a given point of
time/in a given period
◦ Cross-sectional observations are more or less
independent
◦ For example, pure random sampling from a
population
◦ Sometimes pure random sampling is violated, e.g. units
refuse to respond in surveys, or if sampling is
characterized by clustering
◦ Cross-sectional data typically encountered in applied
microeconomics
Cross-sectional data set on wages and other
characteristics

Indicator variables
(1=yes, 0=no)

Observation number Hourly wage

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 Time series data
◦ Observations of a variable or several variables over time
◦ For example, stock prices, money supply, consumer price
index, gross domestic product, annual homicide rates,
automobile sales, …
◦ Time series observations are typically serially
correlated
◦ Ordering of observations conveys important
information
◦ Data frequency: daily, weekly, monthly, quarterly, annually,
…
◦ Typical features of time series: trends and seasonality
◦ Typical applications: applied macroeconomics and finance

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  Time series data on minimum wages and related
variables

Average minimum Average Unemployment Gross national

wage for given year coverage rate rate product

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 Pooled cross sections
◦ Two or more cross sections are combined in one data
set
◦ Cross sections are drawn independently of each other
◦ Pooled cross sections often used to evaluate policy
changes
◦ Example:
 Evaluate effect of change in property taxes on
house prices
 Random sample of house prices for the year 1993
 A new random sample of house prices for the year
1995
 Compare before/after (1993: before reform, 1995:
after reform) 32
 Pooled cross sections on housing prices

Property tax
Size of house
in square feet

Number of bathrooms

Before reform

After reform

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 Panel or longitudinal data
◦ The same cross-sectional units are followed over time
◦ Panel data have a cross-sectional and a time series
dimension
◦ Panel data can be used to account for time-invariant
unobservables
◦ Panel data can be used to model lagged responses
◦ Example:
 City crime statistics; each city is observed in two
years
 Time-invariant unobserved city characteristics may
be modeled
 Effect of police on crime rates may exhibit time lag
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 Two-year panel data on city crime
statistics

Each city has two time

series observations

Number of
police in 1986

Number of
police in 1990

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End of Chapter One

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