Scribd
Upload
36 views2 pages

Stages of Development

The document outlines the four stages of econometric development: proposing a theory, specifying a statistical model, estimating parameters using data, and testing the hypothesis for economic validity. It emphasizes the importance of economic theory in formulating hypotheses and the necessity of sound judgment in model specification. Ultimately, successful econometric analysis can aid policymakers in making informed decisions regarding economic policies.

Uploaded by

Tesfaye
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
36 views2 pages

Stages of Development

The document outlines the four stages of econometric development: proposing a theory, specifying a statistical model, estimating parameters using data, and testing the hypothesis for economic validity. It emphasizes the importance of economic theory in formulating hypotheses and the necessity of sound judgment in model specification. Ultimately, successful econometric analysis can aid policymakers in making informed decisions regarding economic policies.

Uploaded by

Tesfaye
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 2

Stages of development

The methodology of econometrics is fairly straightforward.

The first step is to suggest a theory or hypothesis to explain the data being examined. The
explanatory variables in the model are specified, and the sign and/or magnitude of the
relationship between each explanatory variable and the dependent variable are clearly stated. At
this stage of the analysis, applied econometricians rely heavily on economic theory to formulate
the hypothesis. For example, a tenet of international economics is that prices across open borders
move together after allowing for nominal exchange rate movements (purchasing power parity).
The empirical relationship between domestic prices and foreign prices (adjusted for nominal
exchange rate movements) should be positive, and they should move together approximately one
for one.

The second step is the specification of a statistical model that captures the essence of the theory
the economist is testing. The model proposes a specific mathematical relationship between the
dependent variable and the explanatory variables—on which, unfortunately, economic theory is
usually silent. By far the most common approach is to assume linearity—meaning that any
change in an explanatory variable will always produce the same change in the dependent variable
(that is, a straight-line relationship).

Because it is impossible to account for every influence on the dependent variable, a catchall
variable is added to the statistical model to complete its specification. The role of the catchall is
to represent all the determinants of the dependent variable that cannot be accounted for—because
of either the complexity of the data or its absence. Economists usually assume that this “error”
term averages to zero and is unpredictable, simply to be consistent with the premise that the
statistical model accounts for all the important explanatory variables.

The third step involves using an appropriate statistical procedure and an econometric software
package to estimate the unknown parameters (coefficients) of the model using economic data.
This is often the easiest part of the analysis thanks to readily available economic data and
excellent econometric software. Still, the famous GIGO (garbage in, garbage out) principle of
computing also applies to econometrics. Just because something can be computed doesn’t mean
it makes economic sense to do so.

The fourth step is by far the most important: administering the smell test. Does the estimated
model make economic sense—that is, yield meaningful economic predictions? For example, are
the signs of the estimated parameters that connect the dependent variable to the explanatory
variables consistent with the predictions of the underlying economic theory? (In the household
consumption example, for instance, the validity of the statistical model would be in question if it
predicted a decline in consumer spending when income increased). If the estimated parameters
do not make sense, how should the econometrician change the statistical model to yield sensible
estimates? And does a more sensible estimate imply an economically significant effect? This
step, in particular, calls on and tests the applied econometrician’s skill and experience.

Testing the hypothesis


The main tool of the fourth stage is hypothesis testing, a formal statistical procedure during
which the researcher makes a specific statement about the true value of an economic parameter,
and a statistical test determines whether the estimated parameter is consistent with that
hypothesis. If it is not, the researcher must either reject the hypothesis or make new
specifications in the statistical model and start over.

If all four stages proceed well, the result is a tool that can be used to assess the empirical validity
of an abstract economic model. The empirical model may also be used to construct a way to
forecast the dependent variable, potentially helping policymakers make decisions about changes
in monetary and/or fiscal policy to keep the economy on an even keel.

Students of econometrics are often fascinated by the ability of linear multiple regression to
estimate economic relationships. Three fundamentals of econometrics are worth remembering.

• First, the quality of the parameter estimates depends on the validity of the underlying economic
model.

• Second, if a relevant explanatory variable is excluded, the most likely outcome is poor
parameter estimates.

• Third, even if the econometrician identifies the process that actually generated the data, the
parameter estimates have only a slim chance of being equal to the actual parameter values that
generated the data. Nevertheless, the estimates will be used because, statistically speaking, they
will become precise as more data become available.

Econometrics, by design, can yield correct predictions on average, but only with the help of
sound economics to guide the specification of the empirical model. Even though it is a science,
with well-established rules and procedures for fitting models to economic data, in practice
econometrics is an art that requires considerable judgment to obtain estimates useful for
policymaking. ■

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy