AIS 4204: Introduction to

Econometrics

Md. Roni Hossain

Assistant Professor
Department of Economics
Jahangirnagar University
Lecture 1
Introduction
 Introduction

 Contents
 Definition of Econometrics.
 Why do we study it?
 Methodology of Econometrics
 Introduction

 Definition of Econometrics
 Econometrics means “economic measurement”.

 “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 phenomena” .

 Econometrics may be defined as the quantitative analysis of actual

economic phenomena based on the concurrent development of theory
and observation, related by appropriate methods of inference.

 Econometrics is concerned with the empirical determination of economic

laws.
 Introduction

 Definition of Econometrics

Economic Mathematical
Theory Economics

Econometrics

Economic Mathematic
Statistics Statistics
 Introduction

 Why do we study it/Why econometrics is a separate

discipline?
 Economic theory makes statements or hypotheses that are mostly
qualitative in nature (the law of demand), the law does not provide any
numerical measure of the relationship. This is the job of the
econometrician.

 The main concern of mathematical economics is to express economic

theory in mathematical form without regard to measurability or empirical
verification of the theory. Econometrics is mainly interested in the
empirical verification of economic theory models.

 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.
 Introduction

 Methodology of Econometrics
1. Statement of Economic theory or hypothesis.
2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric, model
4. Collecting 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.
 Introduction

 Methodology of Econometrics
1. Statement of Economic Theory or Hypothesis
 Keynes states that on average, consumers increase their consumption as
their income increases, but not as much as the increase in their income.
(MPC < 1).

 MPC = Rate of change consumption( say in $) by change in income.

 Introduction

 Methodology of Econometrics
2. Specification of the Mathematical Model of Consumption (single-
equation model)
Y = ß1+ ß2X ; 0 < ß2< 1

Y = consumption expenditure and (dependent variable)

X = income, (independent, or explanatory variable)
ß1 = the intercept
ß2 = the slope coefficient

 The slope coefficient ß2 measures the MPC.

 Introduction

 Methodology of Econometrics
2. Specification of the Mathematical Model of Consumption (single-
equation model)
 Introduction

 Methodology of Econometrics
3. Specification of the Econometric Model of Consumption
 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.

 To allow for the inexact relationships between economic variables, is

modified as follows:
Y = ß1+ ß2X + u

 where u, known as the disturbance, or error, term, is a random (stochastic)

variable. The disturbance term u may well represent all those factors that
affect consumption but are not taken into account explicitly.
 Introduction

 Methodology of Econometrics
3. Specification of the Econometric Model of Consumption
 Introduction

 Methodology of Econometrics
4. Obtaining Data
 To obtain the numerical values of β1 and ß2, we need data. Look at Table I.1,
which relate to the personal consumption expenditure (PCE) and the gross
domestic product (GDP). The data are in “real” terms.
 Introduction

 Methodology of Econometrics
5. Estimation of the Econometric Model
 Regression analysis is the main tool used to obtain the estimates. Using this
technique and the data given in Table 1.1, we obtain the following estimates of
β1 and ß2, namely, −184.08 and 0.7064. Thus, the estimated consumption
function is:
෠ −184.08 + 0.7064Xi
𝑌=

 The estimated regression line is shown in Figure I.3. The regression line fits the
data quite well. The slope coefficient (i.e., the MPC) was about 0.70, an increase
in real income of 1 dollar led, on average, to an increase of about 70 cents in
real consumption.
 Introduction

 Methodology of Econometrics
5. Estimation of the Econometric Model
 Introduction

 Methodology of Econometrics
6. Hypothesis Testing
 That is to find out whether the estimates obtained in, Eq. (I.3.3) are in

accord with the expectations of the theory that is being tested. Keynes
expected the MPC to be positive but less than 1.

 In our example we found the MPC to be about 0.70. But before we accept

this finding as confirmation of Keynesian consumption theory, we must

enquire whether this estimate is sufficiently below unity. In other words, is
0.70 statistically less than 1? If it is, it may support Keynes’ theory.
 Introduction

 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.

 To illustrate, suppose we want to predict the mean consumption expenditure

for 1997. The GDP value for 1997 was 7269.8 billion dollars consumption
would be:

𝑌෠ 1997
= −184.0779 + 0.7064 (7269.8) = 4951.3 (I.3.4)

 Thus, given the value of the GDP, the mean, or average, forecast
consumption expenditure is about 4951 billion dollars.
 Introduction

 Methodology of Econometrics
7. Forecasting or Prediction
 The actual value of the consumption expenditure reported in 1997
was 4913.5 billion dollars. The estimated model (I.3.3) thus
overpredicted the actual consumption expenditure by about 37.82
billion dollars.

 We could say the forecast error is about 37.82 billion dollars, which
is about 0.76 percent of the actual GDP value for 1997.

 Alternatively, suppose the government decides to propose a

reduction in the income tax. What will be the effect of such a policy
on income and thereby on consumption expenditure and ultimately
on employment?
 Introduction

 Methodology of Econometrics
7. Forecasting or Prediction
 Suppose that, as a result of the proposed policy change, investment
expenditure increases. What will be the effect on the economy?

 As macroeconomic theory shows, the change in income following, a

dollar’s worth of change in investment expenditure is given by the income
multiplier M, which is defined as:

M = 1/(1 − MPC) (I.3.5)

 Introduction

 Methodology of Econometrics
7. Forecasting or Prediction
 The multiplier is about M = 3.33. That is, an increase (decrease) of a dollar
in investment will eventually lead to more than a threefold increase
(decrease) in income; note that it takes time for the multiplier to work.

 The critical value in this computation is MPC. Thus, a quantitative estimate

of MPC provides valuable information for policy purposes.

 Knowing MPC, one can predict the future course of income, consumption
expenditure, and employment following a change in the government’s fiscal
policies.
 Introduction

 Methodology of Econometrics
8. Use of the Model for Control or Policy Purposes
 Suppose we have the estimated consumption function given in (I.3.3).
Suppose further the government believes that consumer expenditure of
about 4900 will keep the unemployment rate at its current level of about
4.2%. What level of income will guarantee the target amount of
consumption expenditure?

 If the regression results given in (I.3.3) seem reasonable, simple arithmetic

will show that:

4900 = −184.0779 + 0.7064X (I.3.6)

 which gives X = 7197, approximately. That is, an income level of about

7197 (billion) dollars, given an MPC of about 0.70, will produce an
expenditure of about 4900 billion dollars.
 Introduction

 Methodology of Econometrics
8. Use of the Model for Control or Policy Purposes
 As these calculations suggest, 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.
 Introduction

 Methodology of Econometrics
 Introduction

 Discussion Questions
1. What do you mean by Econometrics?
2. Why do you study Econometrics as a separate discipline?
3. What are the steps in the traditional methodology of
econometrics? Illustrate it with an example.
 Reference

 Basic Econometrics, Damodar N. Gujrati, 4th Ed., Chapter

Introduction.
Thank You