CHAPTER ONE

1.INTRODUCTION
1.1. Definition and Scope of Econometrics Models:
1.2. Economic models and Econometric models
1.3. Methodology of Econometrics
1.4. The Sources, Types and Nature of Data
What is Econometrics?
How we know whether economic theory is valid or not ?
How policy maker understand econ variable r/ship ?
The field of knowledge which helps us to carry out such an
evaluation of economic theories in empirical terms is
econometrics.
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Definition 1: Economic Measurement (D.Intriligator )
Definition 2: Application of the mathematical
statistics to economic data in order to lend empirical
support to the economic models and obtain numerical
results (Gerhard Tintner, 1968)
Definition 3: The quantitative analysis of actual
economic phenomena based on concurrent
development of theory and observation, related by
appropriate methods of inference (P.A.Samuelson, et.al

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 Definition 4: Econometrics is the science which
integrates economic theory, economic statistics,
and mathematical economics to investigate the
empirical support of the general schematic law
established by economic theory.
Definition 5: Application of statistical and
mathematical method to the analysis of economic
data, with the purpose of giving empirical content
to economic theories and verify them or refuting
them to the models constructed by mathematical
economics and to obtain numerical results

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 In short, econometrics considered as the
integration of economics, mathematics,
and statistics for the purpose of providing
numerical values for the parameters of
economic r/ships and verifying economic
theories.
 I.e. it is an amalgam of economic theory,
mathematical economics, economic
statistics, and mathematical statistics.

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 Economic theory: is a simplified representation
of economic reality as the world
Economic theory makes statements that are
mostly qualitative in nature. E.g demand theory.
Economic theory uses verbal exposition
while econometrics gives empirical content to
most economic theory. Therefore econometrics is a
field of study which used to evaluate and verify
economic theories in empirical terms.

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 Mathematical Economics: express economic
theory in mathematical form without empirical
verification of the theory, (use mathematical
symbols).
While econometrics is mainly interested in the
empirical verification of the theory
Economic Statistics is mainly concerned with
collecting, processing and presenting economic
data. It does not being concerned with using the
collected data to test economic theories
 Mathematical statistics provides many of tools
for economic studies, but econometrics supplies
the economic studies with many special methods
of quantitative analysis based on economic data
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 In short Both mathematical economics and
economic theory express economic relationships
in an exact or deterministic form. Neither
mathematical economics nor economic theory
allows for random elements which might affect
the relationship and make it stochastic.
Furthermore, they do not provide numerical
values for the coefficients of economic
relationships.
 However, Econometrics differs from other
discipline in that; it does not assume exact or
deterministic relationship.
 Furthermore, econometric methods provide
numerical values of the coefficients of economic
relationships
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Economic Mathematical
Theory Economics

Econometrics

Economic Mathematic
Statistics Statistics

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 In general Econometrics:
 use economic theories, mathematical economics and
economic statistics
 empirical measure
 presuppose economic relationship can be deterministic
and random
 provide empirical value of the coefficient of the
relationship
 can be used to infer relationship among variables

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1.2. Economic Models vs. Econometric Models
 A model is a simplified representation of an actual
phenomenon, such as an actual system or process.
 The actual phenomenon is represented by the model
in order to explain it, to predict it, and to control it.
 A simplified analytical framework of economic
variable r/ship is called on economic model.
 It is an organized set of relationships that describes
the functioning of an economic entity under a set of
simplifying assumptions. Q= b1+b2P1+b3P2+b4T
 But Econometrics model consider random,
stockastic, or error term. Q= b1+b2P1+b3P2+b4T+u

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How do Econometricians proceed in their analysis
of an economic problem?
1) Economic Theory/ Statement of theory/
Hypothesis
2) Mathematical Model of Theory
3) Econometric Model of Theory
4) Data
5) Estimation of Econometric Model
6) Hypothesis Testing
7) Forecasting or Prediction
8) Using the Model for control or policy purposes
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Economic Theory

Mathematic Model Econometric Model Data Collection

Estimation

Hypothesis Testing
Application
in control or
Forecasting policy
studies

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(1) Statement of theory or hypothesis:
Keynes stated: ”Consumption increases as
income increases, but not as much as the
increase in income”. It means that “The marginal
propensity to consume (MPC) for a unit change
in income is grater than zero but less than unit”
(2) Specification of the mathematical model of the
theory
Y = ß1+ ß2X ; 0 < ß2< 1
Y= consumption expenditure
X= income
ß1 and ß2 are parameters;
ß1 is intercept, and ß2 is slope coefficients

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(3) Specification of the econometric model of the
theory
Y = ß1+ ß2X + u ; 0 < ß2< 1;
Y = consumption expenditure;
X = income;
ß1 and ß2 are parameters;
ß1is intercept and ß2 is slope coefficients;
u is disturbance term or error term; random or
stochastic

(4) Obtaining Data (look below table)

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(5) Estimating the Econometric Model
Y^ = - 231.8 + 0.7194 X
MPC was about 0.72 and it means that for the
sample period when real income increases 1 USD,
led (on average) real consumption expenditure
increases of about 72 cents. Note: A hat symbol (^)
signify an estimator of the relevant population
value
(6) Hypothesis Testing
Are the estimates accord with the expectations of
the theory that is being tested?
Is MPC < 1 statistically? If so, it may support Keynes’
theory. Confirmation or refutation of economic
theories based on sample evidence is object of
Statistical Inference (hypothesis testing)
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(7) Forecasting or Prediction
 With given future value(s) of X, what is the future
value(s) of Y? GDP=$6000Bill in 1994,
 what is the forecast consumption expenditure? Y^= -
231.8+0.7196(6000) = 4084.6
 Income Multiplier M = 1/(1 – MPC) (=3.57).
 decrease (increase) of $1 in investment will eventually
lead to $3.57 decrease (increase) in income
(8) Using model for control or policy purposes
Y=4000= -231.8+0.7194 X  X  5882
MPC = 0.72, an income of $5882 Bill will produce an
expenditure of $4000 Bill.
By fiscal and monetary policy, Government can
manipulate the control variable X to get the desired
level of target variable Y 17
 Goals of Econometrics
Three main goals of Econometrics are
i) Analysis i.e. testing economic theory
ii) Policy making i.e. Obtaining numerical estimates of the
coefficients of economic relationships for policy
simulations.
iii)Forecasting i.e. using the numerical estimates of the
coefficients in order to forecast the future values of
economic magnitudes

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1.4. The Source and Type of Economic Data
 Why need to study types of data?
 Applications of econometric model differ depend on
data.
A. sources of data
 The data used in empirical analysis may be collected by
a governmental agency, an international agency (e.g.,
(IMF), a private organization or an individual.
Household (utility, consumption, saving etc.)
firms( production , profit, costs, etc)
government( government expenditure, public finance,
etc) things like commodities Export and import
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 B. Types of Data
 Cross-Sectional Data
 Time Series Data
 Pooled Data
 Panel Data
1. Cross sectional Data
Cross-section data are data on variables collected at the
same point in time. For example:
 The census of population conducted by the Census
Bureau every 10 years;
 random sampling used to draw sample.
Applications of Cross-sectional data is closely aligned
with the applied microeconomics fields, such as labor
economics, state and local public finance, industrial
organization, demography, and health economics. 20
The structure of economic data
 2.Time Series Data
 A time series data set consists of observations
on a variable or several variables over time.
 Time is an important dimension.
 Chronological ordering of observations is
important
 Example: Stock prices, money supply,
consumer price index, gross domestic product,
and automobile sales
 One feature is more difficult to analyze than
cross sectional data; and second data collection
frequency is important (daily, weekly, monthly
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 3. Pooled Cross Sections
 Pooled cross sections have both cross-sectional and time
series features.
 E.g cross section data of hh survey are collected two year,
one 1985, second 1990. if you bring together these two
years data to increase sample size, you will get pooled
cross section data.
 Pooling cross sections is an effective way of analyzing the
effects of a new government policy.

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The structure of economic data
 Review questions
 How would you define econometrics?
 How does it differ from mathematical economics and
statistics?
 Describe the main steps involved in any econometrics
research.
 Differentiate between economic and econometric model.
 What are the goals of econometrics?