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Chapter One
1. Introduction
1.1 Definition and scope of econometrics
The economic theories we learn in various economics courses suggest many relationships among
economic variables. For instance, in microeconomics we learn demand and supply models in
which the quantities demanded and supplied of a good depend on its price. In macroeconomics,
we study „investment function‟ to explain the amount of aggregate investment in the economy as
the rate of interest changes; and „consumption function‟ that relates aggregate consumption to
the level of aggregate disposable income.
Each of such specifications involves a relationship among economic variables. As economists,
we may be interested in questions such as: If one variable changes in a certain magnitude, by
how much will another variable change? Also, given that we know the value of one variable;
can we forecast or predict the corresponding value of another? The purpose of studying the
relationships among economic variables and attempting to answer questions of the type raised
here is to help us understood the real economic world we live in.

However, economic theories that postulate the relationships between economic variables have to
be checked against data obtained from the real world. If empirical data verify the relationship
proposed by economic theory, we accept the theory as valid. If the theory is incompatible with
the observed behavior, we either reject the theory or in the light of the empirical evidence of the
data, modify the theory. To provide a better understanding of economic relationships and a
better guidance for economic policy making we also need to know the quantitative relationships
between the different economic variables. We obtain these quantitative measurements taken
from the real world. The field of knowledge which helps us to carryout such an evaluation of
economic theories in empirical terms is econometrics.
WHAT IS ECONOMETRICS?
Literally interpreted, econometrics means “economic measurement”, but the scope of
econometrics is much broader as described by leading econometricians. Various econometricians
used different ways of wordings to define econometrics. But if we distill the fundamental
features/concepts of all the definitions, we may obtain the following definition.

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“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. 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. Starting from the relationships of economic theory, we
express them in mathematical terms so that they can be measured. We then use specific methods,
called econometric methods in order to obtain numerical estimates of the coefficients of the
economic relationships.”
Measurement is an important aspect of econometrics. However, the scope of econometrics is
much broader than measurement. As D.Intriligator rightly stated the “metric” part of the word
econometrics signifies „measurement‟, and hence econometrics is basically concerned with
measuring of economic relationships. In short, econometrics may be considered as the
integration of economics, mathematics, and statistics for the purpose of providing numerical
values for the parameters of economic relationships and verifying economic theories.
1.2 Econometrics vs. mathematical economics
Mathematical economics states economic theory in terms of mathematical symbols. There is no
essential difference between mathematical economics and economic theory. Both state the same
relationships, but while economic theory use verbal exposition, mathematical uses symbols.
Both 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. Econometrics differs from mathematical economics in that, although
econometrics presupposes, the economic relationships to be expressed in mathematical forms, it
does not assume exact or deterministic relationship. Econometrics assumes random relationships
among economic variables. Econometric methods are designed to take into account random
disturbances which relate deviations from exact behavioral patterns suggested by economic
theory and mathematical economics. Further more, econometric methods provide numerical
values of the coefficients of economic relationships.
1.3 Econometrics vs. Statistics
Econometrics differs from both mathematical statistics and economic statistics. An economic
statistician gathers empirical data, records them, tabulates them or charts them, and attempts to

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describe the pattern in their development over time and perhaps detect some relationship
between various economic magnitudes. Economic statistics is mainly a descriptive aspect of
economics. It does not provide explanations of the development of the various variables and it
does not provide measurements of the coefficients of economic relationships. Mathematical (or
inferential) statistics deals with the method of measurement which are developed on the basis of
controlled experiments. But statistical methods of measurement are not appropriate for a number
of economic relationships because for most economic relationships controlled or carefully
planned experiments cannot be designed due to the fact that the nature of relationships among
economic variables are stochastic or random. Yet the fundamental ideas of inferential statistics
are applicable in econometrics, but they must be adapted to the problem of economic life.
Econometric methods are adjusted so that they may become appropriate for the measurement of
economic relationships which are stochastic. The adjustment consists primarily in specifying the
stochastic (random) elements that are supposed to operate in the real world and enter into the
determination of the observed data.
1.4 Economic models vs. econometric models
i) Economic models:
Any economic theory is an observation from the real world. For one reason, the immense
complexity of the real world economy makes it impossible for us to understand all
interrelationships at once. Another reason is that all the interrelationships are not equally
important as such for the understanding of the economic phenomenon under study. The sensible
procedure is therefore, to pick up the important factors and relationships relevant to our problem
and to focus our attention on these alone. Such a deliberately simplified analytical framework 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. All economic reasoning is ultimately
based on models. Economic models consist of the following three basic structural elements.
1. A set of variables
2. A list of fundamental relationships and
3. A number of strategic coefficients

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ii) Econometric models:

The most important characteristic of economic relationships is that they contain a random
element which is ignored by mathematical economic models which postulate exact relationships
between economic variables.
Example: Economic theory postulates that the demand for a commodity depends on its price, on
the prices of other related commodities, on consumers‟ income and on tastes. This is an exact
relationship which can be written mathematically as:
Q  b0  b1 P  b2 P0  b3Y  b4 t

The above demand equation is exact. How ever, many more factors may affect demand. In
econometrics the influence of these „other‟ factors is taken into account by the introduction into
the economic relationships of random variable. In our example, the demand function studied
with the tools of econometrics would be of the stochastic form:
Q  b0  b1 P  b2 P0  b3Y  b4 t  u

where u stands for the random factors which affect the quantity demanded.
1.5. Methodology of econometrics
Econometric research is concerned with the measurement of the parameters of economic
relationships and with the prediction of the values of economic variables. The relationships of
economic theory which can be measured with econometric techniques are relationships in which
some variables are postulated as causes of the variation of other variables. Starting with the
postulated theoretical relationships among economic variables, econometric research or inquiry
generally proceeds along the following lines/stages.
1. Specification the model
2. Estimation of the model
3. Evaluation of the estimates
4. Evaluation of the forecasting power of the estimated model
1. Specification of the model
In this step the econometrician has to express the relationships between economic variables in
mathematical form. This step involves the determination of three important tasks:
i. .the dependent and independent (explanatory) variables which will be included in the model.
ii. the a priori theoretical expectations about the size and sign of the parameters of the function.
iii. the mathematical form of the model (number of equations, specific form of the equations, etc.

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Note: The specification of the econometric model will be based on economic theory and on any
available information related to the phenomena under investigation. Thus, specification of the
econometric model presupposes knowledge of economic theory and familiarity with the
particular phenomenon being studied.

Specification of the model is the most important and the most difficult stage of any econometric
research. It is often the weakest point of most econometric applications. In this stage there
exists enormous degree of likelihood of committing errors or incorrectly specifying the model.
Some of the common reasons for incorrect specification of the econometric models are:
1. the imperfections, looseness of statements in economic theories.
2. the limitation of our knowledge of the factors which are operative in any particular case.
3. the formidable obstacles presented by data requirements in the estimation of large models.
The most common errors of specification are:
a. Omissions of some important variables from the function.
b. The omissions of some equations (for example, in simultaneous equations model).
c. The mistaken mathematical form of the functions.

2. Estimation of the model

This is purely a technical stage which requires knowledge of the various econometric methods,
their assumptions and the economic implications for the estimates of the parameters. This stage
includes the following activities.
a. Gathering of the data on the variables included in the model.
b. Examination of the identification conditions of the function (especially for simultaneous
equations models).
c. Examination of the aggregations problems involved in the variables of the function.
d. Examination of the degree of correlation between the explanatory variables (i.e.
examination of the problem of multicollinearity).
e. Choice of appropriate economic techniques for estimation, i.e. to decide a specific
econometric method to be applied in estimation; such as, OLS, MLM, Logit, and Probit.

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3. Evaluation of the estimates

This stage consists of deciding whether the estimates of the parameters are theoretically
meaningful and statistically satisfactory. This stage enables the econometrician to evaluate the
results of calculations and determine the reliability of the results. For this purpose we use
various criteria which may be classified into three groups:
i. Economic a priori criteria: These criteria are determined by economic theory and refer to the
size and sign of the parameters of economic relationships.
ii. Statistical criteria (first-order tests): These are determined by statistical theory and aim at the
evaluation of the statistical reliability of the estimates of the parameters of the model.
Correlation coefficient test, standard error test, t-test, F-test, and R2-test are some of the most
commonly used statistical tests.
iii. Econometric criteria (second-order tests): These are set by the theory of econometrics and
aim at the investigation of whether the assumptions of the econometric method employed are
satisfied or not in any particular case. The econometric criteria serve as a second order test (as
test of the statistical tests) i.e. they determine the reliability of the statistical criteria; they help us
establish whether the estimates have the desirable properties of unbiasedness, consistency etc.
Econometric criteria aim at the detection of the violation or validity of the assumptions of the
various econometric techniques.
4. Evaluation of the forecasting power of the model:
Forecasting is one of the aims of econometric research. However, before using an estimated
model for forecasting by some way or another the predictive power of the model. It is possible
that the model may be economically meaningful and statistically and econometrically correct for
the sample period for which the model has been estimated; yet it may not be suitable for
forecasting due to various factors (reasons). Therefore, this stage involves the investigation of
the stability of the estimates and their sensitivity to changes in the size of the sample.
Consequently, we must establish whether the estimated function performs adequately outside the
sample of data. i.e. we must test an extra sample performance the model.

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1.6 Desirable properties of an econometric model

An econometric model is a model whose parameters have been estimated with some appropriate
econometric technique. The„goodness‟ of an econometric model is judged customarily according
to the following desirable properties.
1. Theoretical plausibility. The model should be compatible with the postulates of economic
theory. It must describe adequately the economic phenomena to which it relates.
2. Explanatory ability. The model should be able to explain the observations of the actual
world. It must be consistent with the observed behaviour of the economic variables whose
relationship it determines.
3. Accuracy of the estimates of the parameters. The estimates of the coefficients should be
accurate in the sense that they should approximate as best as possible the true parameters of the
structural model. The estimates should if possible possess the desirable properties of
unbiasedness, consistency and efficiency.
4. Forecasting ability. The model should produce satisfactory predictions of future values of the
dependent (endogenous) variables.
5. Simplicity. The model should represent the economic relationships with maximum simplicity.
The fewer the equations and the simpler their mathematical form, the better the model is
considered, ceteris paribus (that is to say provided that the other desirable properties are not
affected by the simplifications of the model).
1.7. Goals of Econometrics
Three main goals of Econometrics are identified:
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.
1.8 Type and nature of data (Economic data)
As we have seen, an empirical analysis uses data to test a theory or to estimate a relationship. It is
important to stress that in Econometrics we use non-experimental data. Non experimental or
observational data are collected by observing the real world in a passive way. In this case, data are
not the outcome of controlled experiments.

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Experimental data are often collected in laboratory environments in the same way as in natural
sciences. Now, we are going to see three types of data which can be used in the estimation of an
econometric model: time series, cross sectional data, and panel data.

a. Time Series data:

In time series, data are observations on a variable over time. For example: magnitudes from national
accounts such as consumption, imports, income, etc. The chronological ordering of observations
provides potentially important information. Consequently, ordering matters.

b. Cross Sectional Data:

Cross sectional data sets have one observation per individual and data are referred to a determined
point in time. In most studies, the individuals surveyed are individuals (for example, in the Labor
Force Survey (EPA) more than 100000 individuals are interviewed every quarter), households (for
example, the Household Budget Survey), firms (for example, industrial firm survey) or other
economic agents. Surveys are a typical source for cross-sectional data. In many contemporary
econometric cross sectional studies the sample size is quite large.

c. Panel Data:
Panel data (or longitudinal data) are time series for each cross sectional member in a data set. The
key feature is that the same cross sectional units are followed over a given time period. Panel data
combines elements of cross sectional and time series data. These data sets consist of a set of
individuals (typically people, households, or corporations) surveyed repeatedly over time. The
common modeling assumption is that the individuals are mutually independent of one another, but
for a given individual, observations are mutually dependent. Thus, the ordering in the cross section of
a panel data set does not matter, but the ordering in the time dimension matters a great deal. If we do
not take into account the time in panel data, we say that we are using pooled cross sectional data.