UNIT 1: INTRODUCTION

Contents
1.0 Aims and Objectives
1.1 Definition of Econometrics
1.2 Goals of Econometrics
1.3 Division of Econometrics
1.4 Methodology of Econometrics
1.5 The Nature and Sources of Data for Econometrics Analysis
1.5.1 Types of Data
1.5.2 The Sources of Data
1.6 Summary
1.7 Answers to Check Your Progress
1.8 References
1.9 Model Examination Questions

1.0 AIMS AND OBJECTIVES

The purpose of this unit is to let you know what econometrics is all about; and to discuss the
scope, goals, division and methodology of econometric analysis.

After completing this unit, you will be able to:

 understand the definition of econometrics
 differentiate econometrics with other disciplines
 distinguish the three main goals of econometrics
 distinguish the two branches of econometrics
 understand the methodology of Econometrics
 know the types and sources of data.

1.1 INTRODUCTION

Definition:
Definition: Econometrics deals with the measurement of economic relationships.

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Econometrics is a combination of economic theory,
theory, mathematical economics and statistics,
statistics, but
it is completely distinct from each one of these three branches of science. The relationships and
differences among these sciences are pointed out below.

A. Economic theory makes statements or hypotheses that are mostly qualitative in nature
Ex.
Ex. 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. But the
theory itself does not provide any numerical measure of the relationship between the two: that
is it does not tell by how much the quantity will go up or down as a result of a certain change in
the price of the commodity. It is the job of econometrician to provide such numerical
statements.

B. 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. Both economic theory and mathematical economics state the same relationships.
Economic theory uses verbal exposition but mathematical economics employs mathematical
symbolism. Neither of them allows for random elements which might affect the relationship
and make it stochastic. Further more, they do not provide numerical values for the coefficients
of the relationships.

Although econometrics presupposes the expression of economic relationships in mathematical

form, like mathematical economics it does not assume that economic relationships are
exact(deterministic).
- It assumes that relationships are not exact
- Econometric methods are designed to take in to account random disturbances which create
deviations from the exact behavioral patterns suggested by economic theory and
mathematical economics.
- Econometrics provide numerical values of the coefficients of economic phenomena.

C. Economic Statistics is mainly concerned with collecting, processing, and presenting

economic data in the form of charts and tables. It is mainly a descriptive aspect of economics. It
does not provide explanations of the development of the various variables and it does not
provide measurement of the parameters of economic relationships.

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The econometrician often needs special methods since the data are not generated as the result of
a controlled experiment. This creates special problems not normally dealt with in mathematical
statistics. Moreover, such data are likely to contain errors of measurement, and the
econometrician may be called up on to develop special methods of analysis to deal with such
errors of measurement.

To Conclude:
Conclude: Econometrics is an amalgam of economic theory, mathematical economics,
economic statistics, and mathematical statistics. Yet, it is a subject that deserves to be studied in
its own right for the above mentioned reasons.

1.2 GOALS OF ECONOMETRICS

Three main goals of econometrics

1. Analysis: - Testing Economic Theory
Economists formulated the basic principles of the functioning of the economic system using
verbal exposition and applying a deductive procedure. Economic theories thus developed in an
abstract level were not tested against economic reality. Econometrics aims primarily at the
verification of economic theories.

2. Policy-Making
In many cases we apply the various econometric techniques in order to obtain reliable estimates
of the individual coefficients of the economic relationships from which we may evaluate
elasticities or other parameters of economic theory (multipliers, technical coefficients of
production, marginal costs, marginal revenues, etc.) The knowledge of the numerical value of
these coefficients is very important for the decisions of firms as well as for the formulation of
the economic policy of the government. It helps to compare the effects of alternative policy
decisions.

3. Forecasting
In formulating policy decisions it is essential to be able to forecast the value of the economic
magnitudes. Such forecasts will enable the policy-maker to judge whether it is necessary to
take any measures in order to influence the relevant economic variables.

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1.3 DIVISION OF ECONOMETRICS

Econometrics

Theoretical Applied

Classical Bayesian Classical Bayesian

Econometrics may be divided in to two broad categories

1. Theoretical Econometrics
2. Applied Econometrics

- Theoretical Econometrics is concerned with the development of appropriate methods for

measuring economic relationships specified by econometric models. In this aspect,
econometrics leans heavily on mathematical statistics. For example, one of the tools that is
used extensively is the method of least squares. It is the concern of theoretical econometrics
to spell out the assumptions of this method, its properties, and what happens to these
properties when one or more of the assumptions of the method are not fulfilled.
- In applied Econometrics we use the tools of theoretical econometrics to study some special
field(s) of economics, such as the production function, consumption function, investment
function, demand and supply functions, etc.
Applied econometrics includes the applications of econometric methods to specific branches of
economic theory. It involves the application of the tools of theoretical econometrics for the
analysis of economic phenomena and forecasting economic behavior.

Check Your Progress 1.1

Distinguish between
A. Mathematical statistics, economic theory and econometrics
B. Theoretical and applied econometrics
C. What are the goals of econometrics

1.4 METHODOLOGY OF ECONOMETRICS

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In any econometric research we may distinguish four stages:

A.Specification
A.Specification of the model
The first, and the most important, step the econometrician has to take in attempting the study
of any relationship between variables, is to express this relationship in mathematical form,
that is to specify the model, with which the economic phenomenon will be explored
empirically. This is called the specification of the model or formulation of the maintained
hypothesis. It involves the determination of:
i) the dependent and explanatory variables which will be included in the model. The
econometrician should be able to make a list of the variables that might influence the
dependent variable.
. General economics theories,
. Previous studies in any particular field and
. Information about individual condition in a particular case, and the actual behavior
of the economic agents may indicate the general factors that affect the dependent
variable.
ii) the a priori theoretical expectations about the sign and the size of the parameters of
the function. These a priori definitions will be the theoretical criteria on the basis of
which the results of the estimation of the model will be evaluated
. Economic theory
. Other applied research
. Information about possible special features of the phenomena being studied will
contain suggestions about the sign and size of the parameters.
Example: Consider the following simple consumption function:
C = B0 + B1Y+ U
Where: C = Consumption function
Y = level of income
In this function the coefficient B1 is the marginal propensity to consume (MPC) and
should be positive with a value less than unity (0<B
(0<B1<1). The constant intercept, Bo of the
function is expected to be positive. This is because when income is zero, consumption will

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 assume a positive value; people will spend past savings, will borrow or find other means
for covering their needs.

iii) the mathematical form of the model (number of equations liner or non-linear form of
these equations, etc).

The specification of the econometric model will be based on economic theory and on any
available information relating to the phenomenon being studied. The econometrics must know
the general laws of economic theory, and further more he must gather any other information
relevant to the particular characteristics of the relationship as well as all studies already
published on the subject by other research workers.
The most common errors of specification are:
- the omission of some variables from the functions
- the omission of some equations
- the mistaken mathematical form of the functions.

B. Estimation of the Model

Having specified the econometric model, the next task of the econometrician is to obtain
estimates (numerical values) of the parameters of the model from the data available; consider
the Keynesian consumption function.
C = o + 1Y+ U
Where C is consumption
Y is income
If 1 = 0.8 this value provides a numerical estimates of the marginal propensity to consume
(MPC). If also supports Keynes’ hypothesis that MPC is less than 1.
The stage of estimation includes the following steps.
- Gathering of statistical observations (data) on the variables included in the
model
- Examination of the identification conditions of the function in which we are
interested.
- Examination of the aggregation problems involved in the variables of the
function.
- Examination of the degree of correlation between the explanatory variables.

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 - Choice of the appropriate econometric technique for the estimation of the
function and critical examination of the assumptions of the chosen technique
and of their economic implications for the estimates of the coefficients.

C.Evaluation
C.Evaluation of Estimates
After the estimation of the model the econometrician must proceed with the evaluation of the
results of the calculations that is with the determination of the reliability of these results. The
evaluation consists of deciding whether the estimates of the parameters are theoretically
meaningful and statistically satisfactory. Various criteria may be used.
- Economic a prior criteria:
criteria: – These are determined by the principles of economic
theory and refer to the sign and the size of the parameters of economic relationships. In
econometric jargon we say that economic theory imposes restrictions on the signs and
values of the parameters of economic relationships.
- Statistical criteria:
criteria: – These are determined by statistical theory and aim at the
evaluation of the statistical reliability of the estimates of the parameters of the model.
The most widely used statistical criteria are the correlation coefficient and the
standard deviation( or the standard error) of the estimates. These concepts will be
discussed in the subsequent units. Note that the statistical criteria are secondary only to
the a priori theoretical criteria. The estimates of the parameters should be rejected in
general if they happen to have the wrong sign or size even though the pass the
statistical criteria.
- Econometric criteria:
criteria: – are determined by econometric theory. It aims at the
investigation of whether the assumptions of the econometric method employed are
satisfied or not in any particular case. When the assumptions of an econometric
technique are not satisfied it is customary to re specify the model.

D.Evaluation
D.Evaluation of the forecasting power of the estimated model
The final stage of any econometric research is concerned with the evaluation of the forecasting
validity of the model. Estimates are useful because they help in decision-making. A model,
after the estimation of its parameters, can be used in forecasting the values of economic
variables. The econometrician must ascertain how good the forecasts are expected to be in other
words he must test the forecasting power of the model.

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It is conceivably possible that the model is economically meaningful and statistically and
econometrically correct for the sample period for which the model has been estimated, yet it
may vary well not be suitable for forecasting due, for example, to rapid change in the structural
parameters of the relationship in the real world.

Therefore, the final stage of any applied econometric research is the investigation of the
stability of the estimates, their sensitivity to changes in the size of the sample.

One way of establishing the forecasting power of a model is to use the estimates of the model
for a period not included in the sample. The estimated value (forecast value) is compared with
the actual (realized) magnitude of the relevant dependent variable. Usually there will be a
difference between the actual and the forecast value of the variable, which is tested with the
aim of establishing whether it is (statistically) significant. If after conducting the relevant test of
significance, we find that the difference between the realized value of the dependent variable
and that estimated from the model is statistically significant, we conclude that the forecasting
power of the model, its extra – sample performance, is poor.

Another way of establishing the stability of the estimates and the performance of the model
outside the sample of data from which it has been estimated, is to re-estimate the function with
an expanded sample, that is a sample including additional observations. The original estimates
will normally differ from the new estimates. The difference is tested for statistical significance
with appropriate methods.

Reasons for a model’s poor forecasting performance

a) The values of the explanatory variables used in the forecast may not be accurate
b) The estimates of the coefficients may be poor, due to deficiencies of the sample
data.
c) The estimates are ‘good’ for the period of the sample, but the structural background
conditions of the model may have changed from the period that was used as the basis for
the estimation of the model, and there fore the old estimates are not ‘good’ for
forecasting. The whole model needs re-estimation before it can be used for prediction.
Example . Suppose that we estimate the demand function for a given commodity with a single
equation model using time-series data for the period 1950 – 68 as follows

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 = 100 + 5Yt – 30Pt
This equation is then used for ‘forecasting’ the demand of the commodity in the year 1970, a
period outside the sample data.
Given Y1970 = 1000 and P1970 = 5
= 100 + 5(1000) – 30(5) = 4, 950 units.
If the actual demand for this commodity in 1970 is 4, 500 there is a difference of 450 between
the estimated from the model and the actual market demand for the product. The difference can
be tested for significance by various methods. If it is found significant, we try to find out what
are the sources of the error in the forecast, in order to improve the forecasting power of our
model.

Check Your Progress 1.2.

1. What types of criteria would you use to evaluate the results of an estimated relationship?
……………………………………………………………………………………………
……………………………………………………………………………………………
2. Distinguish between statistical and econometric criteria.
……………………………………………………………………………………………
……………………………………………………………………………………………
3. What are the most commonly used statistical criteria?
……………………………………………………………………………………………
……………………………………………………………………………………………

1.5 THE NATURE AND SOURCES OF DATA FOR ECONOMETRIC ANALYSIS

The success of any econometric analysis ultimately depends on the availability of the
appropriate data. Let us first discuss the types of data and then we will see the sources and
limitations of the data.

1.5.1 Types of Data

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There are three types of data
a) Time series data
This is a set of observations on the values that a variable takes at different times. Such data may
be collected at regular time intervals: daily, weekly, monthly, quarterly, annually etc.
Example.
Example. data on stock prices, unemployment rate, GDP etc
Data may be qualitative or quantitative
Qualitative data are sometimes called dummy variables or categorical variable. These are
variables that cannot be quantified.
Example: male or female, married or unmarried, religion, etc
Quantitative data are data that can be quantified
Example.
Example. income, prices, money etc.

b) Cross-Section data
These data give information on the variables concerning individual agents (consumers or
producers) at a given point of time.
Example:
Example:
- the census of population conducted by CSA.
-survey of consumer expenditure conducted by Addis Ababa university
Note that due to heterogeneity, cross- sectional data have their own problems.

c) Pooled Data
These are repeated surveys of a single (cross-section) sample in different periods of time. They
record the behavior of the same set of individual microeconomic units over time. There are
elements of both time series and cross sectional data.

The panel or longitudinal data also called micro panel data, is a special type of pooled data in
which the same cross-sectional unit is surveyed over time.

1.5.2 The Sources of Data

A governmental agency, an international agency, a private organization or an individual may

collect the data used in empirical analysis.
Example.
Example. Governmental in Ethiopia: - MEDAC, MOF, CSA, NBE

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 International agencies: - International Monetary Fund (IMF), World Bank (WB)

The individual (researcher) himself may collect data through interviews or using questionnaire.

In the social sciences the data that one generally obtains is non experimental in nature; that is
not subject to the control of the researcher. For example, data on GNP, unemployment, stock
prices etc are not directly under the control of the investigator. This often creates special
problems for the researcher in pinning down the exact cause or causes affecting a particular
situation.

Limitations
Although there is plenty of data available for economic research, the quality of the data is often
not that good. Reasons are:
- Since most social science data are not experimental in nature, there is the possibility of
observational errors.
- Errors of measurement arising from approximations and round offs.
- In questionnaire type surveys, there is the problem of non-response
- Respondents may not answer all the questions correctly
- Sampling methods used in obtaining data
- Economic data is generally available at a highly aggregate level. For example most macro
data like GNP, unemployment, inflation etc are available for the economy as a whole.
- Because of confidentiality, certain data can be published only in highly aggregate form
For example, data on individual tax, production, employment etc at firm level are usually
available in aggregate form.

Because of all these and many other problems, the researcher should always keep in mind that
the results of research are only as good as the quality of the data. Therefore, the results of the
research may be unsatisfactory due to the poor quality of the available data (may not be due to
wrong model)

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Check Your Progress 1.3.
1. Give examples of a time series and cross section data (do not write those mentioned in
the text)
……………………………………………………………………………………………
……………………………………………………………………………………………
2. Distinguish between qualitative and quantitative data
……………………………………………………………………………………………
……………………………………………………………………………………………

1.6. SUMMARY

Definition of Econometrics
Economic theory, mathematical economics and statistics

Econometrics is an amalgam of economic theory, mathematical economics, economic

statistics, and mathematical statistics.
Three main goals of econometrics
i) Analysis: - Testing Economic Theory
ii) Policy-Making
iii) Forecasting
Division of econometrics:
. Theoretical Econometrics
. Applied Econometrics

Methodology of econometrics:

In any econometric research we may distinguish four stages:

A) Specification of the model; which involves the determination of:

i) the dependent and explanatory variables .
ii) the a priori theoretical expectations about the sign and the size of the parameters.
iii) the mathematical form of the model.

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The most common errors of specification are:
B) Estimation of the Model
The stage of estimation
C) Evaluation of Estimates
Criteria for evaluation of the estimates
- Economic a prior criteria:
criteria: – These are determined by the principles of economic
theory and refer to the sign and the size of the parameters of economic relationships.
- Statistical criteria:
criteria: – These are determined by statistical theory
correlation coefficient and the standard deviation( or the standard error) of the
estimates.
- Econometric criteria:
criteria: – are determined by econometric theory.
D) Evaluation of the forecasting power of the estimated model
-Reasons for a model’s poor forecasting performance

Types of Data
There are three types of data
A)Time series data
qualitative or quantitative data
dummy variables or categorical variable.
B)Cross-Section data
C)Pooled Data
. The panel data
The Sources of Data

1.7. ANSWERS TO CHECK YOUR PROGRESS

Check Your Progress 1.1

Answers are explicitly discussed in the text

Check your progress 1.2

Answers are explicitly discussed in the text

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Check your progress 1.3

Answers are explicitly discussed in the text

1.8 REFERENCES

Gujarati, D., Basic Econometrics.

Kmenta, J., Elements of Econometrics, Macmillan, New York, 1971
Koutsoyiannis, A., Theory of Econometrics, 2nd ed. Pal grave, 1977.

1.9 MODEL EXAMINATION QUESTIONS

1. Economic theory postulates exact relationships between economic variables. Consider

the demand function
Qd = 0

Where Qd = Quantity demanded

P = price
Y = income
a) What is the meaning of exact relationship?
b) What is the economic meaning of the coefficients (b0, b1, & b2)
c) What do you expect the sign of the coefficients?
2. Distinguish between stochastic and deterministic relationships.

3. The results of research are only as good as the quality of the data. Explain it.

4. Mention some of the reasons for the poor forecasting power of the estimated model.

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