Study Notes

Econometric Methods
Econometric Methods

Introduction

 Econometrics is that branch of economics which is concerned with the use of

mathematical methods (especially statistics) in describing economic systems.
 It is the application of statistical and mathematical theories in economics for the purpose
of testing hypotheses and forecasting future trends.
 Econometrics = Econo + Metrics. It means economic measurement.
 Consists of application of mathematical statistics to economic data to lend empirical
support to the models constructed by mathematical economics and to obtain
numerical results.
 Its an amalgam of economic theory, mathematical economics, economic statistics
and mathematical statistics.

ECONOMIC THEORY, MATHEMATICAL ECONOMICS AND ECONOMETRICS

S. ECONOMIC THEORY MATHEMATICAL ECONOMETRICS

No. ECONOMICS

1. Postulates Expresses economic Mainly interested in the

relationships. For e.g., theory in mathematical empirical verification of
an inverse relationship form (equations) without economic theory. For
between price and regard to measurability or e.g.; if a firm changes its
quantity demanded of a empirical verification of the price by ∆P then by how
commodity or inverse theory. For e.g.; much will it impact its
relationship between demand. This relationship
unemployment and Law of demand: Dt = α - βPt can be different for
inflation (Phillips curve). different commodities and
However, it does not different reasons also.
provide any numerical
measure of the It can also be used for
relationship between the forecasting.
two.

2
Econometric Methods

2. It indicates verbal It states economic It also states economic

explanation and relationships/theory in terms relationships/theory in
statements. of mathematical symbols. terms of mathematical
symbols.

3. It expresses the various It also expresses the various It does not assume that
relationships in an exact relationships in an exact economic relationships
form. form. are exact → relationships
are not exact (stochastic)

4. It does not allow for It also does not allow for Econometric methods are
random element, which random element, and the designed to take into
might affect the relationships are of non- account random
relationships and make stochastic form. disturbances, which
them stochastic. The create deviations from the
relationships are of non- exact behavioural
stochastic form. patterns suggested by
economic theory and
mathematical economics.

5. It does not provide It provides numerical values Econometric methods

numerical values of the of the coefficients of the provide numerical values
coefficients of the economic phenomena. of the coefficients of the
economic phenomena. economic phenomena.

6. It does not make any It also does not make any It makes the empirical
empirical verification of empirical verification of verification of economic
economic relationships/ economic relationships/ relationships/ theory.
theory. theory.

Econometrician often needs special tools methods in view of the unique nature of most
economic data. (Observational Vs. Experimental)

Experimental Data: Researcher has generated for his / her specific use. For e.g.; Randomized
Control Trials

Observational Data:

Econometric Models

3
Econometric Methods

 A model is a simplified representation of a real-world process.

 In practice, generally, all the variables which the experimenter thinks are relevant to
explain the phenomenon are included in the model. Rest of the variables are dumped in
a basket called “disturbances” where the disturbances are random variables. This is the
main difference between economic modeling and econometric modeling.
 An econometric model consists of
o a set of equations describing the behaviour. These equations are derived from
the economic model and have two parts – observed variables and
disturbances.
o a statement about the errors in the observed values of variables.
o a specification of the probability distribution of disturbances.
 This is also the main difference between mathematical modeling and statistical modeling.
The mathematical modeling is exact in nature, whereas the statistical modeling contains a
stochastic term also.

Scope of Econometrics

 Developing statistical methods for the estimation of economic relationships.

 Testing economic theory and hypothesis
 Evaluating and applying economic policies
 Forecasting the future trends
 Collecting and analyzing experimental and observational data
 Empirical application of Economic theory using data to know whether theory is true or
false
 Graphical representation has a limitation of two dimension, i.e., two variables can easily
be represented but for more than 2 variables we need equation and that’s where
Econometrics comes into picture. E.g.- Consumption depends on income but,
consumption also depends upon income, wealth, tastes and preferences, price of other
goods, etc

Y i=β 0 + β 1 X i 1+ β 2 X i 2 +…+ β n−1 X i ,n−1 +ε i

4
Econometric Methods

Relevance of econometrics in management and economics

 Econometric applications have become an integral part of training in modern economics

and business management.
 Modern managers are increasingly incorporating econometric applications into their
businesses to establish healthy economic strategies, to develop insights, create value,
optimized solutions and outperform competition. Econometric application can serve the
development of business and enhance performance of a firm by helping it to go ahead of
its competitors.
 Financial stability of the economy by creating virtual situation that presumes the real-life
situation
 Prediction of economic growth
 Prediction of future outcomes, future production, diversification, future planning,
transforming economic policies, future risks by seeing market situations.

Steps of an econometric analysis

1. Hypothesizing a causal relationship

2. Formulating a mathematical model
3. Formulating a statistical model
4. Collecting data
5. Estimation of parameters of the model
6. Hypothesis testing
7. Forecasting or Prediction
8. Using the model for control or policy
purposes

Nature and Sources of Data

To conduct econometric analysis, we need data. There are generally four types of data that are
available for analysis:

 time series,
 cross-sectional, and
 pooled
o panel (a special kind of pooled data)
 dummy variable data
1) Time series data

5
Econometric Methods

A time series is a set of observations that a variable takes at different times, such as daily
(e.g. stock prices, weather reports), weekly (e.g. money supply), monthly (e.g. the
unemployment rate, the consumer price index CPI), quarter

ly (e.g. GDP), annually (e.g. government budgets), quinquennial or every five years (e.g. the
census of manufacturers), or decennially or every ten years (e.g. the census of population).

2) Cross-sectional data
Cross-sectional data are data on one or more variables collected at the same point in time.
Examples are the census of population conducted by the Census Bureau every 10 years,
opinion polls conducted by various polling organizations and temperature at a given time in
several places.

3) Pooled data
Pooled data combines features of both cross-section and timeseries data. For example, to
estimate a production function we may have data on several firms (the cross-sectional
aspect) over a period of time (the time series aspect).

 Panel, Longitudinal or micro-panel data

It is a special type of pooled data where the same cross-sectional unit is surveyed over time.

4) Dummy Variable Data

When the variables are qualitative in nature, then the data is recorded in the form of the
indicator function. The values of the variables do not reflect the magnitude of the data. They
reflect only the presence/absence of a characteristic. For example, variables like religion,
sex, taste, etc. are qualitative variables. The variable `sex’ takes two values – male or
female, the variable `taste’ takes values-like or dislike etc. Such values are denoted by the
dummy variable. For example, these values can be represented as ‘1’ represents male and
‘0’ represents female. Similarly, ‘1’ represents the liking of taste, and ‘0’ represents the
disliking of taste.