Econometrics Theory and

Application
By Dagmawe T.
(dagymanta@[Link])
 Course Contents to be Covered
 Introduction
 Regression Analysis
 Simple regression Model
 Multiple regression Model
 Violations of the Assumptions of the Classical Model
 Regression Analysis with Qualitative Information:
Binary (Dummy Variables)
 Introduction to Basic Regression Analysis with Time Series Data
 Introduction to Panel Data Regression Models 2
 Introduction
Definition and Scope of Econometrics

 Models: Economic models and Econometric models

 Aim and Methodology of Econometrics

 The Sources and Types of Data

3
 Definition & Scope of Econometrics
What is Econometrics?
Oikovomia Economy
Econo-metrics
Metopov Measure
 Econometrics means economic measurement. ---measuring
unknown values of theoretically defined parameters
 It was coined in 1930s following the foundation of econometric
society
 Ragnar Frisch and Jan Tinbergen--- founders of econometrics
4
Econometrics is:
 A conjunction of economic theory and actual measurements, using the
theory and technique of statistical inference as a bridge pier
([Link], 1944)
 The Application of the mathematical statistics to economic data in order to
lend empirical support to the economic mathematical models and obtain
numerical results (Gerhard Tintner, 1968)

 The quantitative analysis of actual economic phenomena based on

concurrent development of theory and observation, related by appropriate
methods of inference ([Link], [Link] and [Link], 1954)

 A social science which applies economics, mathematics and statistical

inference to the analysis of economic phenomena (By Arthur S. Goldberger,
1964). 5
Econometrics:
 It is a special type of economic analysis and research in which the
general economic theories, formulated in mathematical terms, is
combined with empirical measurements of economic phenomena.

 It is a systematic study of economic phenomena using observed

data.

 It is a field of knowledge which helps us evaluating economic

theories in empirical terms.

 It is a set of research tools employed in the various business

disciplines and social sciences.
6
 Econometrics converts qualitative statements into quantitative
statements.
 Econometrics is about how we can use economic, business or social
science theory, data and tools from statistics, to answer “how
much” type questions.

 It is the application of statistical and mathematical techniques to

the analysis of empirical data with the purpose of verifying or
refuting theories.

 Studying econometrics fills a gap between being “a student of

economics” and being “a practicing economist.
7
Econometrics is defined as a science that deals with
measurements of economic relationship through statistical
techniques.
Example:
 Relationship b/n demand for a good & price of a good
 Relationship b/n job performance & leadership style
 Relationship b/n tuition fee & number of students enrolled
 Relationship b/n advertising expenditure & market share
 Relationship b/n education and earnings
Relationship b/n CGPA and hours of studying

The scope of econometrics is much broader than measurement.

8
Economic Mathematical
Theory Economics

Scope of
Econometrics

Statistics
9
 Economic Mathematical Mathematical
Economics
Theory Economics

Economics Mathematics Econometrics

Scope of
Econometrics

Economic Mathematical
Statistics
Statistics Statistics
statistics
10
Econometrics is an integration of economic theory, statistical
inference, and mathematical economics
 Economic theory: makes statements that are qualitative in
nature (verbal exposition).
 Mathematical economics: expressing economic theory in
mathematical forms and symbols without verification of the
theory (without empirical testing)
 Statistics: Economic and mathematical (inferential)
 deals with collecting, processing, and presenting data.

They do not provide numerical values (measurements) for

economic relationships. 11
Economic theory, mathematical economics and statistics are
necessary, but not by itself sufficient conditions for understanding
the real situations.

It is the unification of the three that is powerful and that

constitutes econometrics ([Link], 1933).

Differences
No essential difference between economic theory and
mathematical economics: way of expression
Both state economic relationships in exact form.
They do not allow for random elements.
12
Econometrics differs from mathematical economics in that it
assumes random (stochastic) relationships among economic
variables.
Econometric methods provide numerical values of coefficients of
economic phenomena.
Econometrics differs from economic statistics in that the later does
not concern with testing economic theories.
 Econometrics differs from mathematical statistics in that the later
deals with statistical methods of measurement based on
controlled experiments. Experimental data
Econometrics uses adapted statistical methods, which are adjusted
to become appropriate for economic relationships.
Econometrics involves non-experimental (observational) data 13
 Economic Models Vs. Econometric Models

Models are simplified representations of the real world.

Economic Model
is an organized set of relationships that describes the functioning
of an economic entity under a set of simplifying assumptions.

consists of three structural elements:

1. A set of variables
2. A list of fundamental relationships
3. A number of coefficients
It postulates exact (deterministic) relationships among variables.
14
An Econometric model:
consists of behavioral equation derived from economic models and
specification of probability distribution of errors.
contains a random element which is ignored by economic models.
has two parts: observed variables and disturbances
postulates stochastic (random) relationships among variables.
Example: Economic theory postulates that demand for a good
depends on its price, on the prices of other related commodities, on
consumers’ income and on tastes.

15
Economic Model:

Econometric Model:

where u stands for the error term.

𝒖 makes the distinction between economic and econometric
models.
 The main difference between the economic modeling and
econometric modeling is economic modeling is exact in nature
whereas the later contains a stochastic term also.

Why we include the error term in the model??? 16

 Aims and Methodology of Econometrics
Three main goals of Econometrics
Analysis - testing the implication of a theory
 verifying how well economic theories explain the observed behavior of
economic units.

Policy making - Obtaining numerical estimates of the coefficients

of economic relationships for policy simulations.

Forecasting- using the numerical estimates of the coefficients in

order to forecast the future values of economic magnitudes – for
planning of economic development
17
Methodology of Econometrics
Econometric research is concerned with the measurement of
parameters of economic relationships and prediction of values of
variables.
Starting with the postulated theoretical relationships among economic
variables, the following steps/stages are involved in econometric
research methodology.

• Specification the model

• Estimation of the model
• Evaluation of the estimates
• Evaluation of the forecasting power of the estimated model
18
1. Specification of the Model
• Formulation of maintained hypothesis.
• It is about expressing the relationships between economic variables in
mathematical form.
• It Involves the determination of:
 variables included in the model: Dependent and independent variables
 the size and sign of the parameters of the model (priori theoretical
expectation)
 The mathematical form of the model: number of equations, specific
functional form of the equations (linear or non-linear)
• It presupposes the knowledge of theory and familiarity with the
particular phenomenon being studied.
• It should be theory-inspired and data-centered. 19
• It is the most important and difficult stage of any econometric
research.
• It is often the weakest point of most econometric applications.
• Almost all econometric models are sensitive to specification errors.
Why?
• Common reasons:
 imperfections and looseness statements in theories
 Limitation of our knowledge
 obstacles in data requirements
• The most common errors of model specification are:
a) Omissions of important variables from model.
b) Inclusion of irrelevant variables in the model.
c) Wrong mathematical form & measurement errors.
20
Note: our econometric models are mis-specified to some extent.
Hence, we seek our models to be reasonably well specified - keep
our errors relatively modest.
2. Estimation of the Model: Testing maintained hypothesis
• It is about providing numerical estimates of parameters of the model.
• It is purely a technical stage, which requires knowledge of:
 the various econometric methods and their assumptions,
 the economic implications for estimates
• This is stage involves:
 Data collection: Gathering of the data on the variables included in
the model.
Examining the aggregations problems of the model: examining the
possibility of aggregation errors in the estimates of coefficients. 21
Examining of the identification conditions of the model:
checking whether the parameters are the true coefficients and to
determine whether a relationship can be statistically estimated or
not.
Examining of the degree of multicollinearity : the degree of
correlation between explanatory variables.
Choice of appropriate econometric techniques for estimation: OLS,
Logit, probit, VEC, ARDL…..
single equation techniques- applied to one equation at a time
Simultaneous-equation techniques- applied to all equations
of a system.
22
 Some important criteria for choice of appropriate estimation
technique:
– the nature of relationship and its identification condition
– desirable properties of estimates obtained: unbiasedness,
efficiency, consistency and sufficiency
– the purpose of econometric research: analysis, forecasting, policy
making
– simplicity of the technique: easy computation and less-data
requirements
– time and cost requirements

23
3. Evaluation of Estimates
• It is about the determining of the reliability of estimates (results of the model)
• It consists of deciding whether the estimates are theoretically meaningful,
statistically satisfactory and econometrically correct.
Economic criteria
• Evaluation criteria involves: Statistical Criteria
Econometric criteria
I. Economic a priori criteria:
 refer to the size (magnitude) & sign of the parameters
 are determined by economic theory
 Estimates with wrong signs or size should be rejected unless there is a good
reason to believe the result.
24
II. Statistical criteria: First order test
 aim at evaluating statistical reliability of estimates
 are determined by statistical theory
 Correlation coefficient test, standard error test, t-test, F-test, & R2-test
are some of the most commonly used statistical tests.
III. Econometric criteria: second order tests Post-estimation tests

Aim at the detecting the violation or validity of the assumptions of the

econometric technique employed.
are determined by econometric theory
determine the reliability of statistical criteria
help us establish whether the estimates have desirable properties of
unbiasedness, efficiency and consistency…….
25
4. Evaluation of forecasting power of the model:
• This stage involves the investigation of the stability of the estimates
and their sensitivity to changes in the size of the sample. The
ability of the model to predict the future values of dep. Var.

• Extra-sample performance of the model: outside sample data

• Some of ways of establishing the forecasting power of the model are:
Using estimates of the model for a period not included in the sample.
re-estimating the model with an expanded sample (sample including
additional observations)

• Conducting test of statistical significance for the difference between the

actual (original) and new (forecast) values to check the forecasting power of
the model. 26
 Summary of Econometric Modeling

Economic theory Using a model for

policy purpose

Mathematical model Forecasting or

of the theory prediction

Specification of Hypothesis Testing

Econometric model

Collecting Estimation of
Data econometric model
27
Desirable properties of an econometric model
• The ‘goodness’ of an econometric model is judged according to the
following desirable properties.
1. Theoretical plausibility: The model should be compatible
(consistent) with the postulates of economic theory.
2. Explanatory ability: The model should be able to explain the
observations of the actual world.
3. Accuracy of the estimates of the parameters: the model should
approximate as best as possible the true parameters of the model.
4. Forecasting ability: The model should produce satisfactory
predictions of future values of the dependent variable.
5. Simplicity: the fewer the equations and the simpler their
mathematical form, the better the model is considered, ceteris
paribus 28
 The Sources and Types of Data

Econometrics in absence of data would not exist.

different types datasets have their own advantages and

limitations.
Data can be qualitative or quantitative.

There are three types of statistical datasets

1. cross-sectional data
2. Time series data
3. Panel data
29
1. Cross-sectional data: data collected from different parties or entities
at a given point in time.
e.g. survey of consumer expenditures in 2010

2. Times series data: a set of observations on a variable or several

variables over time.
• collected at regular intervals: daily, weekly, monthly, quarterly,
annually, quinquenially, decennially
E.g. data on weather reports, money supply, inflation, GDP, government
budget, Population Census

3. Panel or longitudinal data: data in which the same cross-sectional unit

(an individuals, households, firms or countries) is surveyed over time
• combination of time series and cross-sectional data
30
 Example of cross sectional data
individuals Consumption income age sex
1 6000 7000 38 Male
2 2000 4000 32 Male
3 3000 4000 32 Female
4 520 700 70 Male
5 400 200 35 Female
6 1100 1500 24 Female
7 3500 4000 36 Male
8 2300 5000 24 Male
9 2000 3000 38 Female
10 1000 2000 25 Female 31
 Example of Time series data
year RGDPpc Inflation FD Investment Govt. Exp GDS

2007 4215.8 15.10 32.69 45441.75 21077.95 8810.00

2008 4548.02 55.20 27.25 64007.59 27432.23 12671.81

2009 4819.093 2.70 24.41 86908.68 33205.86 22640.61
2010 5282.513 7.30 27.06 106170.11 36081.07 29291.39
2011 5720.123 38.00 28.22 165380.00 53147.10 88842.90
2012 6053.615 20.80 25.34 277243.70 62044.50 143745.70

2013 7.40 27.14 295456.40 77636.90 152382.90

6521.836

2014 7007.728 8.50 28.07 403042.90 98115.20 217848.20

2015 7541.87 10.40 29.00 485888.40 111301.10 269229.7032

 Example of Panel data
year country HDI EC FDI FD URB
2011 RWANDA 0.458 396.772 2.06155 21.9664 42.256
2012 RWANDA 0.466 399.68 3.4537 20.6267 42.667
2013 RWANDA 0.475 406.254 3.93416 21.469 43.086
2014 RWANDA 0.481 416.796 4.1741 21.5041 43.514
2015 RWANDA 0.485 428.171 1.80488 21.0418 43.95
2011 ETHIOPIA 0.422 489.682 1.96074 17.7101 17.735
2012 ETHIOPIA 0.427 490.69 0.64317 17.7101 18.16
2013 ETHIOPIA 0.435 494.728 2.82041 17.7101 18.59
2014 ETHIOPIA 0.441 496.815 3.33569 17.7101 19.028
2015 ETHIOPIA 0.448 498.31 4.07436 17.7101 19.472
2011 KENYA 0.536 468.976 3.45734 30.5726 23.967
2012 KENYA 0.541 462.097 2.73775 29.5362 24.37
2013 KENYA 0.546 475.883 2.03063 31.7127 24.78
2014 KENYA 0.55 513.426 1.33605 34.1352 25.197
2015 KENYA 0.555 521.52 0.97185 34.3752 25.62233