ECON410: Econometrics

 Lecturers: Assist. Prof. Dr. Derviş Kırıkkaleli

Department of Economics
Room TO104
Course Components:

 Lectures: Tuesday 12pm-3pm MISLAB

Econometrics means “economic measurement”. The scope of
econometrics is much broader, as can be seen from the following
definitions:
“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” (Gerhard
1968).
“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” (Goldberger
1964).
“Econometrics is concerned with the empirical determination of
economic laws” (Theil 1971).

WHAT IS ECONOMETRICS?
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 (the law of demand), the law does not provide any numerical
measure of the relationship. This is the job of the econometrician.
The main concern of mathematical economics is to express economic theory
in mathematical form without regard to measurability or empirical
verification of the theory. Econometrics is mainly interested in the empirical
verification of economic theory.
Economic statistics is mainly concerned with collecting, processing, and
presenting economic data in the form of charts and tables. It does not go any
further. The one who does that is the econometrician.

WHY ECONOMETRICS IS A
SEPARATE DISCIPLINE?
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. Collecting 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.

METHODOLOGY OF
ECONOMETRICS
1. Statement of Theory or Hypothesis
Keynes states that on average, consumers increase their consumption as their
income increases, but not as much as the increase in their income (MPC < 1).

2. Specification of the Mathematical Model of Consumption (single-

equation model)
Y = β1 + β2X 0 < β2 < 1 (I.3.1)

Y = consumption expenditure and (dependent variable)

X = income, (independent, or explanatory variable)
β1 = the intercept
β2 = the slope coefficient

The slope coefficient β2 measures the MPC.

Geometrically,
3. Specification of the Econometric Model of Consumption
The relationships between economic variables are generally inexact. 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, (I.3.1) is

modified as follows:

Y = β1 + β2X + u (I.3.2)

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.
(I.3.2) is an example of a linear regression model, i.e., it hypothesizes that Y is
linearly related to X, but that the relationship between the two is not exact; it is
subject to individual variation. The econometric model of (I.3.2) can be depicted
as shown in Figure I.2.
4. Obtaining Data
To obtain the numerical values of β1 and β2, we need data. Look at Table I.1, which
relate to the personal consumption expenditure (PCE) and the gross domestic product
(GDP). The data are in “real” terms.
The data are plotted in Figure I.3
5. Estimation of the Econometric Model

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:

Yˆ = −184.08 + 0.7064Xi (I.3.3)

The estimated regression line is shown in Figure I.3. The regression line fits the
data quite well. The slope coefficient (i.e., the MPC) was about 0.70, an increase in
real income of 1 dollar led, on average, to an increase of about 70 cents in real
consumption.
6. Hypothesis Testing

That is to find out whether the estimates obtained in, Eq. (I.3.3) are in accord with
the expectations of the theory that is being tested. 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 enquire whether this estimate is sufficiently below unity. 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).
7. Forecasting or Prediction
To illustrate, suppose we want to predict the mean consumption expenditure for
1997. The GDP value for 1997 was 7269.8 billion dollars consumption would be:

Yˆ1997 = −184.0779 + 0.7064 (7269.8) = 4951.3 (I.3.4)

The actual value of the consumption expenditure reported in 1997 was 4913.5
billion dollars. The estimated model (I.3.3) thus over-predicted the actual
consumption expenditure by about 37.82 billion dollars. We could say the forecast
error is about 37.8 billion dollars, which is about 0.76 percent of the actual GDP
value for 1997.
Now suppose the government decides to propose a reduction in the income tax.
What will be the effect 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 expenditure
increases. What will be the effect on the economy? As macroeconomic theory shows,
the change in income following, a dollar’s worth of change in investment
expenditure is given by the income multiplier M, which is defined as:

M = 1/(1 − MPC) (I.3.5)

The multiplier is 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. 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.
Suppose we have the estimated consumption function given in (I.3.3). Suppose further
the government believes that consumer expenditure of about 4900 will keep the
unemployment rate at its current level of about 4.2%. What level of income will
guarantee the target amount of consumption expenditure?
If the regression results given in (I.3.3) seem reasonable, simple arithmetic will show
that:

4900 = −184.0779 + 0.7064X (I.3.6)

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.

8. USE OF THE MODEL FOR CONTROL OR

POLICY PURPOSES
Kinds of data
 Time Series: A time series is a sequence of
observations which are ordered in time
 Cross-section: is a type data collected by observing
many subjects (such as individuals, firms, countries,
or regions) at the same point of time, or without
regard to differences in time.
 Panel: Data on an economic variable that include
both multiple economic units and multiple time
periods
Time Series Graph:
The Baltic Dry Index
 Scatter Diagram:
Changes in GDP and Unemployment
12 Estonia
Increase in Unemployment Rate June 09 - May

Latvia
10 Lithuania

Spain
8

Ireland
6
08

Turkey USA
4 Sweden
Hungary Denmark
Finland Euro AreaRepublic
Czech
UK France Poland
2 Japan Belgium Greece
Norway
Italy
Germany Austria
New Zealand
Netherlands

0
-20 -15 -10 -5 0 5

-2
Latest Year-on-Year Change in GDP
Combined Time Series:
Timing of the Recession USA
Combined Time Series:
Timing of the Recession UK
Introduction to Probability:
What is a Random Variable?

 The outcome of an event that cannot be known

with certainty before it occurs
 The toss of a coin
 The outcome of a soccer match

 The price of a share

 The rate of economic growth

What is a Probability Distribution?
 It describes the probabilities associated with
random variables

 The set of possible outcomes is known as the

range of the random variable

 The range for the toss of a coin is

 Heads and tails

 The range for the throw of a die is

 1, 2, 3, 4, 5, and 6
Notation
 X, Y – random variables
 A, B, Xi, Yi - possible values of random variables
 SX – the set of all possible values of X
 P(X) – the probability that X occurs
 Or P(X=Xi) – the probability that X takes the
particular value Xi
Basic Rules of Probability

 For single events (X)

SX
0 < P(X) < 1
P(Sx) = 1
X not X
 P(not X) = 1 – P(X)

 For combinations of events (XY ∈ SXY)

0 < P(XY) < 1
P(SXY) = 1

Combinations of events have a joint probability distribution

Probability distribution of throw of a die

X P(X)
1 1/6
2 1/6
3 1/6
4 1/6
5 1/6
6 1/6
Total 1
Mutually Exclusive Events
 Two events that cannot occur together
 P(X and Y) = 0
 P(X or Y) = P(X) + P(Y)
 P(X=3) or (X=6) in throw of a die = ?

X Y
Non-Mutually Exclusive Events
 P(X or Y) = P(X) + P(Y) – P(X and Y)
 The general addition rule for probabilities

X X and Y Y
Joint probability distributions
The values that go on the inside portion of the table are the
intersections or "and"s of each pair of events). "Marginal" is
another word for totals -- it's called marginal because they
appear in the margins.

Probabilities X Not X Marginal

Y 0.00 0.20 0.20
Not Y 0.70 0.10 0.80
Marginal 0.70 0.30 1.00

P(X) = 0.7 P(Y) = 0.2

P(X or Y) = 0.2 + 0.7 – 0.0 = 0.9

P(not X or not Y) = 0.8 + 0.3 – 0.1 = 1

Conditional Probability
 Is the probability of Y occurring affected by the
probability of X occurring?

 The probability of Y conditional on X is represented

as: P(Y|X)
Conditional probability very important
for finance

 Is the rate of inflation conditional on the growth of

the money supply?

 Is the price of a share today conditional on

yesterday’s price?
Independent Events
Two events are independent if the occurrence of
one does not influence the occurrence of the other

P(Y|X) = P(Y)

P(Y and X) = P(Y) * P(X)

Probability Rules
 Prob(X and Y) = P(X)*P(Y)

if X and Y independent

 Prob(X or Y) = P(X) + P(Y)

if X and Y are mutually exclusive

Combined Events - Counting Rule

If X has nX possible outcomes, Y has nY possible

outcomes, then the number of possible outcomes
for the joint event XY is nX * nY

This can be generalised to events described by 3

or more possible outcomes
N = nX * nY * nz ….
 Example of Combined Event: Stock Classifications

3 . . . .
Short-term
growth 2 . . . .

1 . . . .

1 2 3 4
Long-term growth

Each of the combinations of short-term growth and

long-term growth is equally likely
 What is the probability that sum of short-
term and long-term growth assessments = 5?

3 . . . .
Short-term
growth 2 . . . .

1 . . . .

1 2 3 4
Long-term growth

Answer = 3/12
 Discrete and continuous random variables

There are two kinds of random variables:

 Discrete – countable number of outcomes

 What if we flipped a fair coin two times? What are the possible
outcomes and what is the probability of each?

 Continuous – infinite number of possible outcomes

 They are used to model physical characteristics such as time,
length, position, etc. if we let X denote the height (in meters) of a
randomly selected maple tree, then X is a continuous random
variable
Probability Density Function and Cumulative
Distribution Functions

 The area under the probability density function

between any two points is the probability that the
random variable falls between these points.
 The cumulative distribution function shows the
probability that an outcome less than a selected value
occurs.
 The pdf and cdf contain the same information – they
just present it differently.
Cumulative Distribution Function
Cumulative Distribution Function

1.2

0.8

0.6

0.4

0.2

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Probability Density Function
Density Function

0.25

0.2

0.15

0.1

0.05

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
Reading for Lecture 1
 S&W Chapter 1
 Section 1.2, 1.3,
 S&W Chapter 2
 Section 2.1