WHAT IS ECONOMETRICS?

Literally interpreted, econometrics means “economic measurement.” Although measurement is

an important part of econometrics, the scope of econometrics is much broader, as can be seen

from the following quotations:

Econometrics, the result of a certain outlook on the role of economics, consists of the application

of mathematical statistics to economic data to lend empirical support to the models constructed

by mathematical economics and to obtain numerical results.

Econometrics may be defined as the quantitative analysis of actual economic phenomena based

on the concurrent development of theory and observation, related by appropriate methods of

inference

Econometrics may be defined as the social science in which the tools of economic theory,

mathematics, and statistical inference are applied to the analysis of economic phenomena.

Econometrics is concerned with the empirical determination of economic laws.

The art of the econometrician consists in finding the set of assumptions that are both sufficiently

specific and sufficiently realistic to allow him to take the best possible advantage of the data

available to him.

Econometricians are a positive help in trying to dispel the poor public image of economics

(quantitative or otherwise) as a subject in which empty boxes are opened by assuming the

existence of can-openers to reveal contents which any ten economists will interpret in 11 ways.

The method of econometric research aims, essentially, at a conjunction of economic theory and

actual measurements, using the theory and technique of statistical inference as a bridge pier.
WHY A SEPARATE DISCIPLINE?

As the preceding definitions suggest, econometrics is an amalgam of economic theory,

mathematical economics, economic statistics, and mathematical statistics. Yet the subject

deserves to be studied in its own right for the following reasons. Economic theory makes

statements or hypotheses that are mostly qualitative in nature. For example, 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.

Thus, economic theory postulates a negative or inverse relationship between the price and

quantity demanded of a 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

the econometrician to provide such numerical estimates. Stated differently, econometrics gives

empirical content to most economic theory.

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.

Econometrics, as noted previously, is mainly interested in the empirical verification of economic

theory. As we shall see, the econometrician often uses the mathematical equations proposed by

the mathematical economist but puts these equations in such a form that they lend themselves to

empirical testing. And this conversion of mathematical into econometric equations requires a

great deal of ingenuity and practical skill.

Economic statistics is mainly concerned with collecting, processing, and presenting economic

data in the form of charts and tables. These are the jobs of the economic statistician. It is he or
she who is primarily responsible for collecting data on gross national product (GNP),

employment, unemployment, prices, etc. The data thus collected constitute the raw data for

econometric work. But the economic statistician does not go any further, not being concerned

with using the collected data to test economic theories. Of course, one who does that becomes an

econometrician.

Although mathematical statistics provides many tools used in the trade, the econometrician often

needs special methods in view of the unique nature of most economic data, namely, that the data

are not generated as the result of a controlled experiment. The econometrician, like the

meteorologist, generally depends on data that cannot be controlled directly. As Spanoscorrectly

observes:

In econometrics the modeler is often faced with observational as opposed to experimental data.

This has two important implications for empirical modeling in econometrics. First, the modeler

is required to master very different skills than those needed for analyzing experimental data. . . .

Second, the separation of the data collector and the data analyst requires the modeler to

familiarize himself/herself thoroughly with the nature and structure of data in question.

METHODOLOGY OF ECONOMETRICS

How do econometricians proceed in their analysis of an economic problem? That is, what is their

methodology? Although there are several schools of thought on econometric methodology, we

present here the traditional or classical methodology, which still dominates empirical research in

economics and other social and behavioral sciences.

Broadly speaking, traditional econometric methodology proceeds along the following lines:
1. Statement of theory or hypothesis.
2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric, model
4. Obtaining the data
5. Estimation of the parameters of the econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purposes.
To illustrate the preceding steps, let us consider the well-known Keynesian theory of

consumption

1. Statement of Theory or Hypothesis

Keynes stated: The fundamental psychological law is that men [women] are disposed, as

a rule and on average, to increase their consumption as their income increases, but not as

much as the increase in their income.

In short, Keynes postulated that the marginal propensity to consume (MPC), the rate of

change of consumption for a unit (say, a dollar) change in income, is greater than zero but

less than 1.

2. Specification of the Mathematical Model of Consumption

Although Keynes postulated a positive relationship between consumption and income, he

did not specify the precise form of the functional relationship between the two. For

simplicity, a mathematical economist might suggest the following form of the Keynesian

consumption function:

Equation 1
where Y = consumption expenditure and X = income, and where β1 and β2, known as the

parameters of the model, are, respectively, the intercept and slope coefficients.

The slope coefficient β2 measures the MPC. Geometrically, Eq. (1) is as shown in Figure

I.1. This equation, which states that consumption, is lintionship between consumption

and income that is called the consumption function in economics. A model is simply a set

of mathematical equations. If the model has only one equation, as in the preceding

example, it is called a single-equation model, whereas if it has more than one equation, it

is known as a multiple-equation model.

In Equation (1) the variable appearing on the left side of the equality sign is called the

dependent variable and the variable(s) on the right side are called the independent, or

explanatory, variable(s). Thus, in the Keynesian consumption function, Equation (1),

consumption (expenditure) is the dependent variable and income is the explanatory

variable.

Specification of the Econometric Model of Consumption. The purely mathematical

model of the consumption function given in Equation (1) is of limited interest to the
econometrician, for it assumes that there is an exact or deterministic relationship between

consumption and income. But relationships between economic variables are generally

inexact. Thus, if we were to obtain data on consumption expenditure and disposable (i.e.,

after tax) income of a sample of, say, 500 American families and plot these data on a

graph paper with consumption expenditure on the vertical axis and disposable income on

the horizontal axis, we would not expect all 500 observations to lie exactly on the straight

line of Equation (1) because, in addition to income, other variables affect consumption

expenditure. For example, size of family, ages of the members in the family, family

religion, etc., are likely to exert some influence on consumption.

To allow for the inexact relationships between economic variables, the econometrician

would modify the deterministic consumption Equation (1) as follows:

Equation (2)

where u, known as the disturbance, or error, term, is a random (stochastic) variable that

has well-defined probabilistic properties. The disturbance term u may well represent all

those factors that affect consumption but are not taken into account explicitly. Equation

(2) is an example of an econometric model. More technically, it is an example of a linear

regression model, which is the major concern of this book. The econometric consumption

function hypothesizes that the dependent variable Y (consumption) is linearly related to

the explanatory variable X (income) but that the relationship between the two is not

exact; it is subject to individual variation. The econometric model of the consumption

function can be depicted as shown in Figure I.2.

Obtaining Data

To estimate the econometric model given in Equation (2), that is, to obtain the numerical

values of β1 and β2, we need data. Although we will have more to say about the crucial

importance of data for economic analysis in the next chapter, for now let us look at the

data given in Table I.1, which relate to

the U.S. economy for the period 1981–1996. The Y variable in this table is the aggregate

(for the economy as a whole) personal consumption expenditure (PCE) and the X

variable is gross domestic product (GDP), a measure of aggregate income, both measured

in billions of 1992 dollars. Therefore, the data are in “real” terms; that is, they are

measured in constant (1992) prices. The data are plotted in Figure I.3 (cf. Figure I.2). For

the time being neglect the line drawn in the figure.

Estimation of the Econometric Model

Now that we have the data, our next task is to estimate the parameters of the consumption

function. The numerical estimates of the parameters give empirical content to the

consumption function. The actual mechanics of estimating the parameters will be

discussed later. For now, note that the statistical technique of regression analysis is the

main tool used to obtain the estimates. Using this technique and the data given in Table
I.1, we obtain the following estimates of β1 and β2, namely, −184.08 and 0.7064. Thus,

the estimated consumption function is:

Equation (3)

The hat on the Y indicates that it is an estimate. The estimated consumption function (i.e.,

regression line) is shown in Figure I.3

As Figure I.3 shows, the regression line fits the data quite well in that the data points are

very close to the regression line. From this figure we see that for the period 1982–1996

the slope coefficient (i.e., the MPC) was about 0.70, suggesting that for the sample period

an increase in real income of 1 dollar led, on average, to an increase of about 70 cents in

real consumption expenditure. We say on average because the relationship between

consumption and income is inexact; as is clear from Figure I.3; not all the data points lie

exactly on the regression line. In simple terms we can say that, according to our data, the

average, or mean, consumption expenditure went up by about 70 cents for a dollar’s

increase in real income.

Hypothesis Testing

Assuming that the fitted model is a reasonably good approximation of reality, we have to

develop suitable criteria to find out whether the estimates obtained in, say, Eq. (I.3) are in

accord with the expectations of the theory that is being tested. According to “positive”

economists like Milton Friedman, a theory or hypothesis that is not verifiable by appeal

to empirical evidence may not be admissible as a part of scientific enquiry.

As noted earlier, Keynes expected the MPC to be positive but less than 1. In our example

we found the MPC to be about 0.70. But before we accept this finding as confirmation of

Keynesian consumption theory, we must en quire whether this estimate is sufficiently

below unity to convince us that this is not a chance occurrence or peculiarity of the

particular data we have used. In other words, is 0.70 statistically less than 1? If it is, it

may support Keynes’ theory.

Such confirmation or refutation of economic theories on the basis of sample evidence is

based on a branch of statistical theory known as statistical inference (hypothesis testing).

Forecasting or Prediction

If the chosen model does not refute the hypothesis or theory under consideration, we may

use it to predict the future value(s) of the dependent, or forecast, variable Y on the basis

of known or expected future value(s) of the explanatory, or predictor, variable X. To

illustrate, suppose we want to predict the mean consumption expenditure for 1997. The

GDP value for 1997 was 7269.8 billion dollars. Putting this GDP figure on the right-hand

side of Equation (3) we obtain:

or about 4951 billion dollars. Thus, given the value of the GDP, the mean, or average,

forecast consumption expenditure is about 4951 billion dol lars. The actual value of the

consumption expenditure reported in 1997 was 4913.5 billion dollars. The estimated

model (I.3.3) thus overpredicted the actual consumption expenditure by about 37.82
billion dollars. We could say the forecast error is about 37.82 billion dollars, which is

about 0.76 percent of the actual GDP value for 1997. When we fully discuss the linear

regression model in subsequent chapters, we will try to find out if such an error is “small”

or “large.” But what is important for now is to note that such forecast errors are inevitable

given the statistical nature of our analysis. There is another use of the estimated model

(I.3.3). Suppose the Presi dent decides to propose a reduction in the income tax. What

will be the ef fect of such a policy on income and thereby on consumption expenditure

and ultimately on employment? Suppose that, as a result of the proposed policy change,

investment ex penditure increases. What will be the effect on the economy? As

macroeconomic theory shows, the change in income following, say, a dollar’s worth of

change in investment expenditure is given by the income multiplier M, which is defined

as

If we use the MPC of 0.70 obtained in Equation (3), this multiplier becomes about M =

3.33. That is, an increase (decrease) of a dollar in investment will eventually lead to more

than a threefold increase (decrease) in income; note that it takes time for the multiplier to

work. The critical value in this computation is MPC, for the multiplier depends on it. And

this estimate of the MPC can be obtained from regression models such as Equation (3).

Thus, a quantitative estimate of MPC provides valuable information for policy purposes.

Knowing MPC, one can predict the future course of income, consumption expenditure,

and employment following a change in the government’s fiscal policies

Use of the Model for Control or Policy Purposes

Suppose we have the estimated consumption function given in Equation (3). Suppose

further the government believes that consumer expenditure of about 4900 (billions of

1992 dollars) will keep the unemployment rate at its current level of about 4.2 percent

(early 2000). What level of income will guarantee the target amount of consumption

expenditure? If the regression results given in Equation (3) seem reasonable, simple

arithmetic will show that

which gives X = 7197, approximately. That is, an income level of about 7197 (billion)

dollars, given an MPC of about 0.70, will produce an expenditure of about 4900 billion

dollars. As these calculations suggest, an estimated model may be used for control, or

policy, purposes. By appropriate fiscal and monetary policy mix, the government can

manipulate the control variable X to produce the desired level of the target variable Y.

Figure I.4 summarizes the anatomy of classical econometric modeling.

 TYPES OF ECONOMETRICS

As the classificatory scheme in Figure I.5 suggests, econometrics may be divided into

two broad categories: theoretical econometrics and applied econometrics. In each

category, one can approach the subject in the classical or Bayesian tradition. In this book

the emphasis is on the classical approach. For the Bayesian approach, the reader may

consult the references given at the end of the chapter. 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 methods used extensively in this book

is least squares. Theoretical econometrics must 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 and business, such as the

production function, investment function, demand and supply functions, portfolio theory,

etc. This book is concerned largely with the development of econometric methods, their

assumptions, their uses, their limitations. These methods are illustrated with examples

from various areas of economics and business. But this is not a book of applied
econometrics in the sense that it delves deeply into any particular field of economic

application.