EED 401: ECONOMETRICS

1. EED 401: ECONOMETRICS • COURSE OUTLINE • Meaning and purpose of econometrics • Methodology of econometric research • Correlation analysis and single equation models; simple linear & multiple linear regression models • Functional forms of the regression model • Special models in regression analysis; dummy variables, RTO.

2. COURSE OUTLINE CONT’D • Problems of single equation models; autocorrelation, heteroscedasticity, multicolinearity, errors in variables • Simultaneous equation models and estimation • Qualitative choice models • Time series analysis

3. SOME REFRENCES • A. KOUTSOYIANNIS (2003). THEORY OF ECONOMETRICS. 2ND EDITION. PELGRAVE • JEFFREY M. WOOLDRIDGE. INTRODUCTORY ECONOMICS- A MODERN APPROACH • DAMODAR N. GUJIRATI. BASIC ECONOMETRICS. FOURTH EDITION. • ETC, ETC.

4. WHAT IS ECONOMETRICS? • The word ‘econometrics’ is derived from two Greek words, oikovoμia (economy), and μetpov(measure) • Definition: the social science in which the tools of economic theory, mathematics and statistical inference are applied to the analysis of economic phenomena (Arthur Goldburger, 1964).

5. WHAT IS ECONOMETRICS? CONT’D • Thus, econometrics is an amalgam of economics, mathematics and statistics • The uniqueness of econometrics lies in the inclusion of a random element in models ILLUSTRATION (economic model of crime) • Based on economic reasoning (theory) time spent on criminal activity by an individual will depend on, hourly ‘criminal wage’ ( ),

6. WHAT IS ECONOMETRICS? CONT’D • Hourly wage in legal employment, • Income other than from crime or employment, • Probability of getting caught, • Probability of being convicted if caught, • Expected sentence if convicted, • Age,

7. WHAT IS ECONOMETRICS? CONT’D • The above depicts an exact relationship ie the time spent on crime is completely dependent on 7 factors • This is stated mathematically as: • Or

8. WHAT IS ECONOMETRICS? CONT’D • This still leaves us with a deterministic relationship • But there are other factors that influence crime apart from the 7. eg. health, vengeance, religion, etc. • Econometrics introduces a random factor (stochastic term) which takes care of these ‘other’ factors

9. Econometric representation of the crime model

10. Econometric representation of the crime model CONT’D. • U is the random factor encapsulating all other random factors that affect time spent on crime • PROCEDURE FOR TESTING ECONOMIC THEORY

12. Reading assignment • Establish the superiority of econometrics to mathematical economics and statistics

13. Branches of econometrics • Two main branches: -Theoretical econometrics –dev’t. of appropriate methods for the measurement of economic relationships -Applied econometrics: application of econometrics to specific fields of economic theory ( demand, supply, investment, production) for the analysis of economic phenomena and forecasting economic behaviour

14. Purpose of econometrics • Policy-making: Provide numerical values for the parameters of economic relationships (elasticities, propensities, marginal values) for decision making • Analysis: Empirical verification of economic laws/theories • Forecasting: determining future values of economic magnitudes based on numerical estimates

15. METHODOLOGY OF ECONOMETRIC RESEARCH Generally, econometric research involves 4 stages: 1. Formulation of the maintained hypothesis: ie. The specification of the model 2.Testing of maintained hypothesis: estimation of the model by appropriate econometric method 3. Evaluation of estimates: decide on the basis of certain criteria whether the estimates are satisfactory & reliable.

16. METHODOLOGY OF ECONOMETRIC RESEARCH CONT’D. 4. Testing the forecasting validity of the model 1&3 are the most important for any econometric research. Require strong knowledge in the functioning of economic systems 2&4 are technical & require a deep understanding of econometrics

17. Formulation of the maintained hypothesis • It involves determining • Dependent and explanatory variables • The a priori theoretical expectations about the signs & the size of the parameters of the function to form the basis for the evaluation of the model • The mathematical form of the model: single vs. simultaneous equation; linear vs. nonlinear functional forms

18. Reasons for incorrect specification of economic models • Looseness/ imperfection of statements in economic theories • Limitation of our knowledge about factors which are operative in a particular situation • Problems associated with large data requirements of large models. Errors of specification- omission of variables, equations, & wrong mathematical form of functions

19. 2. Estimation of the model The estimation process involves the ff. Stages: • Gathering data-: cross-sectional, time series & panel data • Examination of the identification condition of the function • Examination of the aggregation problems of the function (aggregation over individuals, commodities, time,& space) • Examination of the degree of correlation among the explanatory variables

20. 5. Choice of the appropriate econometric technique:- i. Single equation techniques:- Classical Least Squares (CLS) OR ordinary Least Squares(OLS) method, Indirect Least Squares (ILS) or reduced-form technique, 2SLS, Limited information maximum likelihood method,etc. ii. Simultaneous equation techniques:- 3SLS, FIML

21. 3. Evaluation of estimates Are the parameters theoretically meaningful and statistically satisfactory? We use 3 criteria for the evaluation; • Economic ‘a priori’ criteria: are the parameters of the correct signs and the right size? • Statistical criteria: first-order tests- usually by using the correlation coefficient & the standard deviation (error)

22. 3. Econometric criteria: second-order test (test of the statistical tests). This may involve tests of consistency, efficiency, unbiasedness, assumptions, identification, etc.

23. 4. Evaluation of the Forecasting Power of the Model • Forecasting is one of the major objectives of econometrics. • Given data on personal consumption (Y) and GDP (X) from 1982-1996 in billions of dollars the estimated consumption function is given by: • We can forecast the mean consumption expenditure for 1997 given GDP=7269.8 billion dollars as

24. Actual consumption for 1997 was 4913.3 billion dollars • Forecast error is 37.81 billion dollars • Question is: is the error large or small?

25. Properties of econometric models • Econometric models are judged based on • Theoretical plausibility • Explanatory ability • Accuracy of the estimates of the parameters • Predictive power • simplicity

26. GOD BLESS YOU!