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Econometric Modeling: Model Specification and Diagnostic Testing

This document discusses econometric model specification and diagnostic testing. It outlines criteria for selecting the correct model, including that the model be data admissible, consistent with theory, have weakly exogenous regressors, exhibit parameter constancy, and data coherency. It also describes types of specification errors like omitting relevant variables, including unnecessary variables, using the wrong functional form, and measurement errors. Consequences of errors are discussed, such as underfitting models resulting in omitted variable bias and overfitting models reducing power and distorting inferences. Diagnostic tools to detect errors are also mentioned.

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Yeasar Ahmed Ushan
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104 views11 pages

Econometric Modeling: Model Specification and Diagnostic Testing

This document discusses econometric model specification and diagnostic testing. It outlines criteria for selecting the correct model, including that the model be data admissible, consistent with theory, have weakly exogenous regressors, exhibit parameter constancy, and data coherency. It also describes types of specification errors like omitting relevant variables, including unnecessary variables, using the wrong functional form, and measurement errors. Consequences of errors are discussed, such as underfitting models resulting in omitted variable bias and overfitting models reducing power and distorting inferences. Diagnostic tools to detect errors are also mentioned.

Uploaded by

Yeasar Ahmed Ushan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Econometric Modeling: Model

Specification and Diagnostic


Testing
[Based on ”Basic Econometrics” by Gujarati (Fifth version)
Topics to be discussed
We examine:
• How does one go about finding the “correct” model? In other words, what
are the criteria in choosing a model for empirical analysis?
• What types of model specification errors is one likely to encounter in
practice?
• What are the consequences of specification errors?
• How does one detect specification errors? In other words, what are some
of the diagnostic tools that one can use?
• Having detected specification errors, what remedies can one adopt and
with what benefits?
• How does one evaluate the performance of competing models?
Model Selection Criteria
According to Hendry and Richard, a model chosen for empirical analysis should satisfy the following criteria
• Be data admissible
• predictions made from the model must be logically possible.

• Be consistent with theory


• it must make good economic sense.

• Have weakly exogenous regressors


• the explanatory variables, or regressors, must be uncorrelated with the error term.

• Exhibit parameter constancy


• the values of the parameters should be stable. Otherwise, forecasting will be difficult.

• Exhibit data coherency


• the residuals estimated from the model must be purely random (technically, white noise).

• Be encompassing
• the model should encompass or include all the rival models in the sense that it is capable of explaining
their results.
Types of Specification errors
1. Omission of a relevant variable(s)
2. Inclusion of an unnecessary variable(s)
3. Adopting the wrong functional form
4. Errors of measurement
5. Incorrect specification of the stochastic error term
Consequences of model specification error
• Underfitting a Model (Omitting a Relevant Variable)
Consequences of model specification error
• Underfitting a Model (Omitting a Relevant Variable)
Consequences of model specification error
• Inclusion of an Irrelevant Variable (Overfitting a Model)
Consequences of model specification error
• Inclusion of an Irrelevant Variable (Overfitting a Model)
Consequences of model specification error

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