Applied Economics

Lecture Week 1

Review of OLS and hypothesis

testing
Key references

• Wooldridge, Introductory Econometrics 4th

Edition

• Stock and Watson

An economic model

Origin of an economic model

• Use of a set of assumptions (on behaviour, mathematic
structure, etc.)
• Real world situation
• “Economics” simplification
Purpose
• Draw a set of conclusions/ relationship/ influence of core
factors
• Make predictions, policy recommendations
Statistical testing of a hypothesis

Hypothesis testing
• Under those assumptions, are the conclusions correct in the real
world?
• Do we accept or reject the estimated relationship (from
regression)?

The results from the test

• Revise the original assumptions or models
• Policy recommendation
What is Econometrics

Statistical methods for

• Estimating economic relationship

• Testing economic theories

• Evaluating policy impact

• Forecast economic policies

Setting up an econometric model

• Mostly, motivated by an economic model; economic reasoning;

common sense

• Selection of a functional form

• Dealing with unattainable, unobservable variables

• The variable choices are determined by economic models, as well as

data considerations.

• Dealing with the error terms.

• Hypothesis testing- back to economic models, reasoning and common

sense to come up with hypotheses
In sum

Econometric models

• Use the data

• To “estimate” the value of the “parameters”

• Conduct hypotheses testing on these parameters to test if make sense

• Reliability

• Validity: external and internal

Data structures
Types of data (I)
• Non-experimental, Observational data
• Experimental data

Types of data (II)

• Cross-sectional
• Time-series
• Panel data: Balanced, Unbalanced, Longitudinal, Pooled cross-
section

Sampling method
• Random sampling
• Convenient sampling
• Snowball sampling
𝑦𝑖 = 𝛼 + 𝛽1 𝑥𝑖 + 𝜀𝑖 𝑦𝑖 = 𝛼 + 𝛽1 𝑥𝑖 + 𝛽1 𝑥𝑖2 + 𝜀𝑖
Comparing two specifications of the same question:

Model 1

Model 2
Omitted variable bias:
Single Linear Regression: only 𝑋1 may influence Y
When we regress Y on X1 :

Multiple Linear Regression: 𝑋1 and 𝑋2 may influence Y:

An omitted variable bias from using SLR can be calculated by:

෪1 is the slope parameter when we regression X1 on X2

where 𝛿
Omitted variable bias:

෪1 is biased when using SLR (NOT including 𝛽2 ) happens when one

𝛽
of these two cases happen:

(1) The partial effect of 𝑋2 on 𝑌෠ is NOT zero.

෢2 ≠ 0.
That is 𝛽

(2) 𝑋1 and 𝑋2 are correlated in the sample.

෪1 ≠ 0.
That is 𝛿
Source: Wooldridge 4th edition
Example
OLS Functional forms & beta interpretations
Causal interpretation?

Check more here: https://www.tylervigen.com/spurious-correlations

 We use hypothesis testing to
• ‘Reject H0’ if p-value is very low (near zero)
• ‘Do not reject H0’ if p-value is high (> 0.1)