Regression Tools - Introduction to Econometrics

Regression ToolsPart I

“Introduction to”Econometrics

BySameh Al-Anani

●What is Econometrics?●Why Econometrics?

●Econometrics means “economic measurement”

●Econometrics may be defined as

○ The social science in which the tools of economic theory, mathematics & statistical inference are applied to the analysis of economic phenomena

?What is Econometrics

?What is in Econometrics

●Econometrics attempts

○ to quantify economic reality &

○ to bridge the gap between economic theory & the real world.

What is in Econometrics?

●Econometrics consists of

○ The development & application of statistical, mathematical & economic hypothesis that use empirical evidence for estimating the economic relationship,

○ Testing the validity of economic theories or evaluating government policy.

?Why Econometrics

●Economic theory makes statement or hypotheses ○ Theories do not provide

■ the necessary measure of strength of relationship (numerical estimate of the relationship) &

■ the proper functional relationship between variables.

○ Example: Law of Demand ■ A reduction in price of a commodity is expected to increase

the quantity demanded of that commodity.

●To provide empirical verification of theories

The Objectives of Econometrics

●Formulation of econometrics models for ○ Estimating the economic relationship, ○ Testing the validity of economic theories or hypothesis○ Evaluating government policy

●Use the models for ○ Prediction, forecasting ○ Assessing the impacts of certain decisions & policy

recommendations

Economic Model vs. EconometricModel● An economic model is a set of assumptions that

approximately describes the behavior of an economy○ Example, Law of Demand

● An econometric model consists of the following:○ A set of behavioral equations derived from the

economic model○ A statement of whether there are errors of observation

in the observed variables○ A specification of the probability distribution of the

“disturbances”

What Constitutes a Test of anEconomic Theory

●To report ○ The signs of the estimated coefficients in an

econometric model○ The significance test of each variables / regression

●To confirm economic theories○ Whether the estimated coefficients carried the

expected sign ○ The statistical significance of the variables○ The fitness of the model

Methodology of Econometrics

1. Statement of theory or hypothesis2. Specification of the mathematical model of the theory3. Specification of the statistical, or econometric model4. Obtaining the data

Methodology of Econometrics (cont)

5. Data Transformations (Refining)6. Estimation of the parameters of the econometric model7. Hypothesis Testing8. Forecasting and prediction9. Using the model for control or policy purpose

1. Statement of theory or hypothesis

●Consumption Theory

○ When disposable income increase, consumption will also increase and vice versa

■ Disposable income the amount of income left to an individual after taxes have been paid, available for spending and saving.

○ Marginal propensity to consume (MPC)■ Positive relationship between consumption & income

2. Specification of the mathematical model of the theory

C = � + �Yd 0 < � < 1

where C = consumptionYd = income� = Marginal propensity to consume

MPC - the proportion of an aggregate raise in pay that is spent on the consumption of goods and services, as opposed to being saved.

3. Specification of the statistical, or econometric model

C = � + �Yd + �

where �, known as disturbance, error term or residual, is a random variable

4. Obtaining data

●Collect disposable income & consumption data.●Should we collect time series data, cross sectional

data or pooled data? ●3 types of data:

○ Time Series Data ○ Cross Sectional Data ○ Panel Data (Pooled Data)

The Structure of Economic Data

Cross Sectional Data

●Cross Sectional data are data collected on the same point in time.

●Example: Consumption and disposable income of different Asian countries in 1990

Cross Sectional Data

Time Series Data

●Time series data is a set of observations on the values that a variable takes at different times.

●Such data may be collected at regular time intervals (e.g., daily, weekly, monthly, quarterly, annually)

●Example: Consumption and disposable income for Malaysia from 1990-1992

Time Series Data

Panel Data

●Panel data (Pooled data) are elements of both cross sectional and time series data.

●Example Consumption and disposable income among Asian Countries for the period of 1990-1992

Panel Data

5. Data Transformations (Refining)

● Changing the frequency (only for time series data)

● Nominal vs. real data○ Using indices such as CPI or PPI as price deflators

● Logs

● Differencing

● Growth rates

6. Estimation of the parameters of the econometric model● The numerical estimates of the parameters give empirical

content

● MPC = 0.7● Is this model valid or correct?

7. Hypothesis Testing

●Confirmation or refutation of economic theories on the basis of sample evidence

●C = � + �Yd

●Autonomous consumption > 0H0: � = 0 H1: � > 0●0 < MPC < 1H0: � = 0 H1: � > 0 or H2: � < 1

8. Forecasting or Prediction

● If the chosen model does not refute the hypothesis or theory, we may use it to predict the value(s) of the dependent variable○ values of the explanatory variable was known

9. Use of the Model for Control or Policy Purposes

●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 Yd to produce the desired level of the target variable C

Anatomy of Econometric Modeling

Economic theory

Mathematical model of theory

Econometric model of theory

Forecasting or prediction

Hypothesis testing

Estimation of econometric model

Data

Using the model for control or policy purposes