FUNDAMENTALS OF

ECONOMETRICS
DR ABDUL WAHEED
PhD Econometrics
FUNDAMENTALS OF
ECONOMETRICS
Week 2
Lecture 3
 ECONOMETRICS
 Literarily meaning: “economic measurement”.
 It is the use of statistical methods to analyze economic data (no
single definition).
 typically analyze non-experimental data.
 ….. started as a part of economics sciences.
 …..gradually emerged as a separate discipline with wide
applications in other fields such as finance, management,
sociology, HR, etc.
 not a very old science.
ECONOMETRICS
 ECONOMETRICS
Theoretical econometrics
It is concerned with the development of appropriate methods for
measuring economic relationships specified by econometric models.
In this aspect, econometrics leans heavily on mathematical statistics.
For example, one of the methods is least squares.
Applied econometrics
In it we use the tools of theoretical econometrics to study some special
field(s) of economics and business, such as the production function,
investment function, demand and supply functions, portfolio theory, etc.
 ECONOMETRICS
Broadly speaking, traditional econometric methodology proceeds along the
following lines:
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.
 ECONOMETRICS
Explanation with Example:
1. Statement of Theory or Hypothesis
Keynes stated:
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 1.

𝟎 < 𝑴𝑷𝑪 < 𝟏

 ECONOMETRICS
2. Specification of the Mathematical Model of Consumption
Keynes postulated a positive relationship between consumption and
income.
But he did not specify the precise form of the functional relationship
between the two.
A mathematical economist might suggest the following form of the
Keynesian consumption function:
𝑌 = 𝛽1 + 𝛽2 𝑋 0 < 𝛽2 < 1
Y = consumption expenditure and X = income, and
where 𝜷𝟏 and 𝜷𝟐 , known as the parameters of the model, are,
respectively, the intercept and slope coefficients.
 ECONOMETRICS
Keynesian consumption function
 ECONOMETRICS
3. Specification of the Econometric Model of Consumption
The purely mathematical model of the consumption function assumes that there is
an exact or deterministic relationship between consumption and income.
But relationships between economic variables are generally inexact.
To allow for the inexact relationships between economic variables, the
econometrician would modify the deterministic consumption function as follows:
𝒀 = 𝜷 𝟏 + 𝜷𝟐 𝑿 + 𝒖
where 𝒖, known as the disturbance, or error, or stochastic or residual, term, is a
random 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.
 ECONOMETRICS
Econometric model of the Keynesian consumption function
 ECONOMETRICS
4. Obtaining Data
Data is required to estimate the econometric model, that is, to obtain
the numerical values of 𝜷𝟏 and 𝜷𝟐 .
(Detailed discussion on the crucial importance of data for economic
analysis will be later),
for now let us look at the data given in Table, which relate to the U.S.
economy for the period 1960–2005.
The Y variable in this table is the aggregate (for the economy as a whole)
personal consumption expenditure (PCE) and
the X variable is gross domestic product (GDP), a measure of aggregate
income, both measured in billions of 2000 dollars.
ECONOMETRICS
 ECONOMETRICS
5. Estimation of the Econometric Model
The numerical estimates of the parameters give empirical content to the
consumption function. Note that the statistical technique of regression
analysis is the main tool used to obtain the estimates.
(Regression analysis will discussed in detail later).
Using this technique and the data given in Table we obtain the following
estimates of 𝜷𝟏 and 𝜷𝟐 , namely, −299.5913 and 0.7218. Thus, the
estimated consumption function is:

𝒀𝒕 = −299.5913 + 0.7218𝑿𝒕
The hat on the Y indicates that it is an estimate.
ECONOMETRICS
 ECONOMETRICS
6. Hypothesis Testing
Keynes expected the MPC to be positive but less than 1.
In our example we found the MPC to be about 0.72.
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 0.72 statistically less than 1?
If it is, it may support Keynes’s theory.
 ECONOMETRICS
7. Forecasting or Prediction
If the chosen model does not reject 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 the known or
expected future value(s) of the explanatory, or predictor, variable X.
To illustrate, suppose we want to predict the mean consumption
expenditure for 2006. The GDP value for 2006 was 11319.4 billion, we
obtain:
𝒀𝟐𝟎𝟎𝟔 = −299.5913 + 0.7218(11319.4)
= 𝟕𝟖𝟕𝟎. 𝟕𝟓𝟏𝟔
 ECONOMETRICS
8. Use of the Model for Control or Policy Purposes
An estimated model may be used for control, or policy, purposes. By appropriate
fiscal and monetary policy mix, the government can manipulate the control
variable X to produce the desired level of the target variable Y.
Suppose the government believes that consumer expenditure of about 8750
(billions of 2000 dollars) will keep the unemployment rate at its current level of
about 4.2 percent (early 2006). What level of income will guarantee the target
amount of consumption expenditure?
𝟖𝟕𝟓𝟎 = −299.5913 + 0.7218𝑮𝑫𝑷𝟐𝟎𝟎𝟔
𝑮𝑫𝑷𝟐𝟎𝟎𝟔 = 𝟏𝟐𝟓𝟑𝟕 𝒂𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆𝒍𝒚
That is, an income level of about 12537 (billion) dollars, given an MPC of about
0.72, will produce an expenditure of about 8750 billion dollars.
ECONOMETRICS
 ECONOMIC MODELS
An economic model refers to the simplified version of real world
complex economic theories.
It could be....
✓ micro- or macro models.
✓ Often use optimizing behavior, equilibrium modeling.
✓ Establish relationships between economic variables.
 ECONOMIC MODELS
Example: Economic model of crime (Becker (1968))
▪ Derives equation for criminal activity based on utility maximization

𝒚 = 𝒇 𝒙𝟏 , 𝒙𝟐 , 𝒙𝟑 , 𝒙𝟒 , 𝒙𝟓 , 𝒙𝟔 , 𝒙𝟕

𝑦= hours spent in criminal activities, 𝑥1 = “wage” for an hour spent in criminal activity,
𝑥2 = hourly wage in legal employment, 𝑥3 = income other than from crime or employment,
𝑥4 = probability of getting caught, 𝑥5 = probability of being convicted if caught,
𝑥6 = expected sentence if convicted, and 𝑥7 = age.

▪ Functional form of relationship not specified

▪ Equation could have been postulated without economic modeling
 ECONOMETRIC MODELS
Econometric model of criminal activity
▪ The functional form has to be specified.
▪ Variables may have to be approximated by other quantities.
𝑪𝒓𝒊𝒎𝒆 = 𝜷𝟎 + 𝜷𝟏 𝒘𝒂𝒈𝒆𝒎 + 𝜷𝟐 𝒐𝒕𝒉𝒊𝒏𝒄 + 𝜷𝟑 𝒇𝒓𝒆𝒒𝒂𝒓𝒓
+𝜷𝟒 𝒇𝒓𝒆𝒒𝒄𝒐𝒏𝒗 + 𝜷𝟓 𝒂𝒗𝒈𝒔𝒆𝒏 + 𝜷𝟔 𝒂𝒈𝒆 + 𝒖
some measure of the frequency of criminal activity,
𝐶𝑟𝑖𝑚𝑒 = Measure of criminal activity
𝑤𝑎𝑔𝑒𝑚 =the wage that can be earned in legal employment,
𝑜𝑡ℎ𝑖𝑛𝑐 =the income from other sources (assets, inheritance, and so on),
𝑓𝑟𝑒𝑞𝑎𝑟𝑟 =the frequency of prior arrests (to approximate the probability of arrest),
𝑓𝑟𝑒𝑞𝑐𝑜𝑛𝑣 =the frequency of conviction, and
𝑎𝑣𝑔𝑠𝑒𝑛 =the average sentence length after conviction.
The term 𝒖 contains unobserved factors, such as the wage for criminal activity, moral character,
family background, and errors in measuring things like criminal activity and the probability of arrest.
 The Linear Regression Model (LRM)
The general form of the LRM model is:

𝒀𝒊 = 𝜷𝟏 + 𝜷𝟐 𝑿𝟐𝒊 + 𝜷𝟑 𝑿𝟑𝒊 + ⋯ + 𝜷𝒌 𝑿𝒌𝒊 + 𝒖𝒊

Or, as written in short form:

𝒀𝒊 = β𝑿 + 𝒖𝒊

Y is the regressand,
X is a vector of regressors, and
u is an error term.
 The Linear Regression Model (LRM)
𝒀𝒊 = 𝜷𝟏 + 𝜷𝟐 𝑿𝟐𝒊 + 𝜷𝟑 𝑿𝟑𝒊 + ⋯ + 𝜷𝒌 𝑿𝒌𝒊 + 𝒖𝒊
It consists of two components:
1- A deterministic component, BX (the conditional mean of 𝒀, or 𝐄(𝒀/
𝑿)
2- A nonsystematic, or random component, 𝒖𝒊 .
𝜷𝟏 is the intercept.
𝜷𝟐 to 𝜷𝒌 are the slope coefficients. Collectively, they are the regression
coefficients or regression parameters.
Each slope coefficient measures the (partial) rate of change in the mean
value of 𝒀 for a unit change in the value of a regressor, ceteris paribus.
The Linear Regression
Terminology for Simple Regression
Y X
Dependent variable Independent variable
Explained variable Explanatory variable
Response variable Control variable
Predicted variable Predictor variable
Regressand Regressor
 Measurement of Variables in
Regression Models
Measurement Scales
• Nominal Scale
• Ordinal Scale
• Interval Scale
• Ratio Scale
 Measurement of Variables in
Regression Models
Nominal Scale
➢ When the classification or grouping of the observations are made
into mutually exclusive qualitative categories or classes it is said to
constitute a nominal scale (only group formation)
➢ For example, students are classified as male and female. Number 1
and 2 may also be used to identify these two categories
➢ Please note that the numbers when they are used only to identify
the categories of the given scale, carry no numerical significance
and there is no particular order for the grouping.
 Measurement of Variables in
Regression Models
Ordinal or Ranking Scale
➢ This scale includes the characteristic of a nominal scale and in
addition has the property of ordering or ranking of measurements.
(group formation plus ranking but no constant interval)
➢ For example, the performance of students (or players) is rated as
excellent, good, fair or poor, etc. Number 1, 2, 3, 4 etc. are also
used to indicate ranks.
➢ The only relation that holds between any pair of categories is that
of “greater than” (or more preferred).
 Measurement of Variables in
Regression Models
Interval Scale
➢ A measurement scale possessing a constant interval size(distance)
but not a true zero point, is called an interval scale.(group formation
plus ranking plus constant interval).
➢ Temperature measured on either the Celsius or the Fahrenheit scale is
an outstanding example of interval scale because the same difference
exists between 20𝑜 𝐶 (68𝑜 𝐹) and 30𝑜 𝐶 (86𝑜 𝐹) as between 5𝑜 𝐶(41𝑜 𝐹)
and 15𝑜 𝐶 (59𝑜 𝐹).
➢ But it cannot be said that a temperature of 40 degrees is twice as
hot as a temperature of 20 degree, i.e. the ratio 40/20 has no meaning.
The arithmetic operation of addition, subtraction, etc. are meaningful.
 Measurement of Variables in
Regression Models
Ratio Scale
➢ It is a special kind of an interval scale where the sale of
measurement has a true zero point as its origin. (group formation
plus ranking plus constant interval plus a true zero)
➢ The ratio scale is used to measure weight, volume, distance,
money, etc. The, key to differentiating interval and ratio scale is
that the zero point is meaningful for ratio scale.
Measurement of Variables in
Regression Models