Econometrics ECM712s

P. Nangula
Tel: 2072492
pnangula@nust.na
 What is Econometrics?
Literally interpreted econometrics means “economics
measurements”. Econometrics may be defined as the
social science in which the tools of economic theory,
mathematics, and statistical inference are applied to the
analysis of economic variable. Econometrics can also be
defined as “statistical observation of theoretically formed
concepts or alternatively as mathematical economics
working with measured data”
We know very well that economic theory attempts to
defined the relationship among different economic
variables.
 WHY A SEPARATE DISCIPLINE?
Economic theory makes statements or hypotheses that are
mostly qualitative in nature. For example, microeconomic
theory states that, other things remaining the same, a
reduction in the price of a commodity is expected to
increase the quantity demanded of that commodity.
It is the job of the econometrician to provide such
numerical estimates.
The main concern of mathematical economics is to express
economic theory in mathematical form (equations)
without regard to measurability or empirical verification of
the theory.
 WHY A SEPARATE DISCIPLINE?
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.
 METHODOLOGY OF ECONOMETRICS
How do econometricians proceed in their analysis of an
economic problem?
Following are the main steps in 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
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.
 METHODOLOGY OF ECONOMETRICS
How do econometricians proceed in their analysis of an economic
problem?
1. Statement of theory or hypothesis.
Men or women increase their consumption as their income
increases, but not as much as the increase in their income.
2. Specification of the mathematical model of the theory

where 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.
This is a single equation model
Y is dependent variable and X is independent or explanatory
 METHODOLOGY OF ECONOMETRICS

2. Specification of the mathematical model of

the theory

Consumption

=MPC

Income
 METHODOLOGY OF ECONOMETRICS
3. Specification of the statistical, or econometric, model
, The purely mathematical model of the consumption function
given above is of limited interest to the econometrician, for it
assumes that there is an exact or deterministic relationship
between consumption and income.
, 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.
 METHODOLOGY OF ECONOMETRICS
4. Obtaining the data
Year Y X
1982 3081.5 4620.3
1983 3240.6 4803.7
1984 3407.6 5140.1
1985 3566.5 5323.5
1986 3708.7 5487.7
1987 3822.3 5649.5
1988 3972.7 5865.2
1989 4064.6 6062.0
1990 4132.2 6136.3
1991 4105.8 6079.4
1992 4219.8 6244.4
1993 4343.6 6389.6
1994 4486.0 6610.7
1995 4595.3 6742.1
Source: Economic Report of the President, 1998, Table B–2, p. 282
 METHODOLOGY OF ECONOMETRICS
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 hat on the Y indicates that it is an estimate. The
estimated consumption function.
Interpretation?
6. Hypothesis Testing
Is 0.70 statistically less than 1?
 METHODOLOGY OF ECONOMETRICS
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.
 Review of probability distributions

 The normal distribution

 The t-distribution
 The Chi-square distribution
 The F-distribution
 Regression Analysis

The term regression was introduced by Francis

Galton
Regression analysis is concerned with the study
of the dependence of one variable, the dependent
variable, on one or more other variables, the
explanatory variables, with a view to estimating
and/or predicting the (population) mean or average
value of the former in terms of the known or fixed
(in repeated sampling) values of the latter.
 Regression Analysis

Regression Analysis is a technique of studying

the dependence of one variable (called
dependant variable), on one or more variables
(called explanatory variable), with a view to
estimate or predict the average value of the
dependent variables in terms of the known or
fixed values of the independent variables.
 Regression Analysis

THE REGRESSION TECHNIQUE IS PRIMARILY USED TO :

• Estimate the relationship that exists, on the
average, between the dependent variable and the
explanatory variable
• Determine the effect of each of the explanatory
variables on the dependent variable, controlling the
effects of all other explanatory variables
• Predict the value of dependent variable for a given
value of the explanatory variable
 STATISTICAL VERSUS DETERMINISTIC
RELATIONSHIPS
In regression analysis we are concerned with what is
known as the statistical, not deterministic, dependence
among variables, such as those of classical physics.
In statistical relationships among variables we essentially
deal with random or stochastic variables, that is,
variables that have probability distributions.
In deterministic dependency, on the other hand, we also
deal with variables, but these variables are not random
or stochastic.
 REGRESSION VERSUS CAUSATION
Although regression analysis deals with the
dependence of one variable on other variables,
it does not necessarily imply causation.
Causation indicates that one event is the result
of the occurrence of the other event; i.e. there is
a causal relationship between the two events.
A statistical relationship in itself cannot
logically imply causation.
 REGRESSION VERSUS CORRELATION
Closely related to but conceptually very much different from
regression analysis is correlation analysis.
The primary objective of correlation is to measure the strength or
degree of linear association between two variables. The correlation
coefficient measures this strength of (linear) association. For
example, we may be interested in finding the correlation
(coefficient) between smoking and lung cancer, between scores on
statistics and mathematics examinations, between high school
grades and college grades, and so on. In regression analysis, as
already noted, we are not primarily interested in such a measure.
Instead, we try to estimate or predict the average value of one
variable on the basis of the fixed values of other variables.
 REGRESSION VERSUS CORRELATION
Regression and correlation have some fundamental
differences that are worth mentioning.
• In regression analysis there is an asymmetry in the
way the dependent and explanatory variables are
treated.
• The dependent variable is assumed to be statistical,
random, or stochastic, that is, to have a probability
distribution.
• The explanatory variables, on the other hand, are
assumed to have fixed values
 REGRESSION VERSUS CORRELATION
Regression and correlation have some fundamental differences that are
worth mentioning.
In correlation analysis, on the other hand, we treat any (two) variables
symmetrically; there is no distinction between the dependent and
explanatory variables. After all, the correlation between scores on
mathematics and statistics examinations is the same as that between
scores on statistics and mathematics examinations.
Moreover, both variables are assumed to be random. As we shall see,
most of the correlation theory is based on the assumption of
randomness of variables, whereas most of the regression theory to be
expounded in this book is conditional upon the assumption that the
dependent variable is stochastic but the explanatory variables are fixed
or nonstochastic.
 CAUSATION VERSUS CORRELATION
Unfortunately, intuition can lead us astray when it comes to
distinguishing between the two. For example, eating
breakfast has long been correlated with success in school
for elementary school children. It would be easy to conclude
that eating breakfast causes students to be better learners.
Is this a causal relationship—does breakfast by itself create
better students? Or is it only a correlation: perhaps not
having breakfast correlates highly with other challenges in
kids’ lives that make them poorer students, such as less
educated parents, worse socio-economic status, less focus
on school at home, and lower expectations.
Stochastic Specification of PRF
 Normal distribution
• What is a normal distribution curve?
• All normal distributions are symmetric and
have bell-shaped density curves with a single
peak. To speak specifically of any normal
distribution, two quantities have to be
specified: the mean , where the peak of the
density occurs, and the standard deviation ,
which indicates the spread or girth of the bell
curve.
 Normal distribution
• What is the mean of the standard normal
distribution?
• This is the "bell-shaped" curve of the Standard
Normal Distribution. It is a Normal Distribution
with mean 0 and standard deviation 1. It
shows you the percent of population:
between 0 and Z (option "0 to Z")
 Normal distribution
• What is the first quartile of the standard
normal distribution?
• Quartiles. It is readily calculated that for the
standard normal distribution the first quartile
is -.67 (using .2514 for .25) and the third
quartile is .67. This means that for normally
distributed data, one-half of the data is within
2/3 of a standard deviation unit of the mean.
 T distribution
• What is a t distribution?
• In probability and statistics, Student's t-
distribution (or simply the t-distribution) is any
member of a family of continuous probability
distributions that arises when estimating the
mean of a normally distributed population in
situations where the sample size is small and
population standard deviation is unknown.
 T distribution
• Why is it called Student's t distribution?
• The t distributions were discovered by William
S. Gosset in 1908. Gosset was a statistician
employed by the Guinness brewing company
which had stipulated that he not publish
under his own name. He therefore wrote
under the pen name ``Student.''
 T distribution
• What is at stat?
• The test statistic in the t-test is known as the t-
statistic. The t-test looks at the t-statistic, t-
distribution and degrees of freedom to
determine a p value (probability) that can be
used to determine whether the population
means differ. The t-test is one of a number of
hypothesis tests.
 Chi square distribution
• What is the shape of the chi square
distribution?
• The mean of a Chi Square distribution is its
degrees of freedom. Chi Square distributions
are positively skewed, with the degree of skew
decreasing with increasing degrees of
freedom. As the degrees of freedom
increases, the Chi Square distribution
approaches a normal distribution.
 Chi square distribution
• What does DF mean in Chi Square?
• Since two scores are sampled, the answer can
be found using the Chi Square distribution
with two degrees of freedom. A Chi Square
calculator can be used to find that the
probability of a Chi Square (with 2 df) being six
or higher is 0.050. The mean of a Chi Square
distribution is its degrees of freedom.
 Chi square distribution
• What is a chi square test in statistics?
• A chi square (X2) statistic is used to investigate
whether distributions of categorical variables
differ from one another. Basically categorical
variable yield data in the categories and
numerical variables yield data in numerical
form.
 F distribution
• What is the mean of the F distribution?
• The F distribution is a right-skewed
distribution used most commonly in Analysis
of Variance. When referencing the F
distribution, the numerator degrees of
freedom are always given first, as switching
the order of degrees of freedom changes the
distribution (e.g., F(10,12) does not equal
F(12,10) ).
 F distribution
• What is the F ratio?
• The F ratio is the ratio of the variance between
groups to the variance within groups i.e. the
ratio of the explained variance to the
unexplained variance. The F ratio is used to
test whether or not two variances are equal.
The F ratio is calculated as follows:
• What is the f value in an ANOVA?
• The F ratio is the ratio of two mean square
values. If the null hypothesis is true, you
expect F to have a value close to 1.0 most of
the time. A large F ratio means that the
variation among group means is more than
you'd expect to see by chance.