Topic 1

INTRODUCTION TO
ECONOMETRICS
What is Econometrics?

Why Econometrics?

Why econometrics a core

in economics course?
 What is Econometrics?
Econometrics means “economic measurement”
Econometrics may be defined as
◦ the social science in which the tools of economic
theory, mathematics & statistical inference are
applied to the analysis of economic phenomena
Econometrics attempts
◦ to quantify economic reality &
◦ to bridge the gap between economic theory & the real
world.
Econometrics consists of the development &
application of statistical, mathematical &
economic hypothesis that use empirical evidence
for estimating the economic relationship, testing
the validity of economic theories or evaluating
government policy.
Why a Separate Discipline?
 Econometric is an amalgam of economic theory,
mathematical economics, economic statistics, and
mathematical statistics.
1. Economy theory – statements or hypotheses that
are mostly qualitative in nature.

2. Mathematical economics – express theory in

mathematical form (equation) without regard to
measurability or empirical verification of the theory.

3. Economic statistics – concerned with collecting,

processing, and presenting economic data in the form
of charts and tables.

4. Mathematical statistics – provides many tools used

in trade.
 Why Study Econometrics?
Economic theory makes statement or
hypotheses
◦ Theories do not provide
 the necessary measure of strength of relationship
(numerical estimate of the relationship) &
 the proper functional relationship between variables.
◦ Example: Law of Demand
 A reduction in price of a commodity is expected to
increase the quantity demanded of that commodity.
to provide empirical verification of theories
 The Objectives of Econometrics
Formulation of econometrics models for
◦ estimating the economic relationship,
◦ testing the validity of economic theories or
hypothesis
◦ evaluating government policy
Use the models for
◦ prediction, forecasting
◦ assess impacts of certain decisions & policy
recommendation
Economic Model vs Econometric Model
 An economic model is a set of
assumptions that approximately
describes the behaviour of an economy
◦ Example, Law of Demand
 An econometric model consists of the
following:
i. A set of behavioural equations derived
from the economic model
ii. A statement of whether there are errors
of observation in the observed variables
iii. A specification of the probability
distribution of the “disturbances”
What Constitutes a Test of an
Economic Theory
To report
◦ the signs of the estimated coefficients in an
econometric model
◦ the significance test of each variables /
regression
To confirm economic theories
◦ whether the estimated coefficients carried the
expected sign
◦ the statistically significance of the variables
◦ The fitness of the model
Methodology of Econometrics

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
Methodology of Econometrics (cont)

5. Estimation of the parameters

of the econometric model
6. Hypothesis Testing
7. Forecasting and prediction
8. Using the model for control
or policy purpose
1. Statement of theory or hypothesis

Consumption Theory
◦ When disposable income increase,
consumption will also increase and
vice versa
◦ Marginal propensity to consume
(MPC)
 Positive relationship between
consumption & income
2. Specification of the
mathematical model of the theory
C =  + Yd 0< <1

where C = consumption
Yd = Personal Disposable Inco
 = Marginal propensity to consume
 = Autonomous Consumption
Keynesian Consumption Function
3. Specification of the statistical,
or econometric model
C =  + Yd + 

where , known as disturbance, error term

or residual, is a random variable
For econometrician, relationship between
economic variables are generally inexact.

In addition to income, there are other

variables affect consumption expenditure.

Deterministic consumption function

modified:
C =  + Yd + 

Residual term represent all those factors

that affect consumption but are not taken
into account explicitly.
EconometricModel of the Keynesian
Consumption Function
4. Obtaining data
Collect disposable income & consumption
data.
Should we collect time series data, cross
sectional data or pooled data?
3 types of data:
◦ Time Series Data
◦ Cross Sectional Data
◦ Panel Data (Pooled Data)
Obtaining Data
 Data can be obtained through many
sources:
 Government
 Non-government organizations
 Research organizations
 Individual researchers
 Internethttp://rfe.wustl.edu/Data/index.html,
http://www.bnm.gov.my/, http://www.imf.org)
Time Series Data
Time series data is a set of
observations on the values that a
variable takes at different times.
Such data may be collected at regular
time intervals (e.g., daily, weekly,
monthly, quarterly, annually)
Example: Consumption and disposable
income for Malaysia from 1990-1992
Time Series Data
Year C Yd

1990 60 130

1991 64 138

1992 68 148
Cross Sectional Data
Cross Sectional data are data collected on
the same point in time.
Example: Consumption and disposable
income of different Asia countries in 1990
Cross Sectional Data
Country C Yd

Malaysia 60 130

Indonesia 82 120

Thailand 75 100

Singapore 100 230

Panel Data
Panel data (Pooled data) are elements of
both cross sectional and time series data.
Example Consumption and disposable
income among Asian Countries for the
period of 1990-1992
Panel Data
Year Country C Yd
1990 Malaysia 60 130
1991 Malaysia 64 138
1992 Malaysia 68 148
1990 Indonesia 82 120
1991 Indonesia 85 127
1992 Indonesia 92 132
1990 Thailand 75 100
1991 Thailand 85 130
1992 Thailand 94 135
1990 Singapore 100 230
1991 Singapore 103 237
1992 Singapore 116 250
5. Estimation of the parameters
of the econometric model
Regression analysis – numerical
estimated of the parameters:
Ŷt = -299.5913 + 0.7218Xt

MPC = 0.72, increase in real income of

one dollar led, on average, to an
increase of about 72 cents in real
consumption expenditure.
PCE in relation to GDP
6.Hypothesis Testing
 Confirmation or refutation of economic
theories on the basis of sample evidence
based on a branch of statistical theory
known as statistical inference.

Y = β1 + β2X + u

Ŷt = -299.5913 + 0.7218Xt
Hypothesis Testing
 Autonomous consumption > 0
H0: β1 = 0 H1: β1 ≠ 0

 0 < MPC < 1

H0: β2 = 0 H1: β2 > 0 or H2: β2 < 1
7.Forecasting or Prediction
 If the chosen model does not refute
the hypothesis or theory, we may use
it to predict the future value(s) of the
dependent variable.

 Values of the explanatory variable was

known. E.g. X2006 = 11319.4 billion
dollars.

Ŷ2006 = -299.5913 + 0.7218(11319.4)

= 8469.3942
Forecasting or Prediction

 Question: If government propose a

reduction in income tax, what will be the
effect of such policy on income and
thereby on consumption expenditure?
Forecasting or Prediction
  Answer: Income tax reduction may result
increases in investment expenditure.

 Income multiplier:

 MPC = 0.72, hence M = 3.57. This

indicates an increase of a dollar in
investment will
Basedon our objectives , you can study eventually lead to more
the income.

than a threefold increase in income.

8. Use of the Model for Control or
Policy Purposes
An estimated model may be used for
control, or policy, purposes

Government can manipulate the control

variable X to produce the desired level of
the target variable Y.
- Goverment control variable X then use to
get the level of target variable Y.
 E.g. Fiscal policy or monetary policy.
 Government believes that consumer
expenditure of about 8750 billion
dollars will keep unemployment rate at
it current level of about 4.2 percent
(early 2006).
 Hence,

8750 = -299.5913 + 0.7218 (GDP2006)

GDP2006 = 11707 billion dollars
Anatomy of Econometric Modeling
Economic theory Explain the time series
and come out with each
data set.

Mathematical model of theory Eg: 8 STEPS with

Econometric model of theory
traditional economic
methodology that you
would take in your
analysist. (Pass year
paper)

Data
Estimation of econometric model
run out parameter
Hypothesis testing
Ho /H1
Forecasting or prediction
Using the model for
control or policy purposes
-Come out with any policy purpose