INTRODUCTION TO ECONOMETRICS
Definition and scope of econometrics
It is the quantitative analysis of actual economic phenomena based on the concurrent
development of theory and observation, related by appropriate methods of inference.
It is a social science in which the tools of economic theory, mathematics and statistical
inference are applied to the analysis of economic phenomena.
It is the integration of economics, mathematics and statistics for purpose of providing
numerical values for the parameters of economic relationships and verifying economic
theories.
Relationship between economic theory, mathematics and statistics
Economic theory makes statements or hypothesis that are mostly qualitative or verbal
exposition in nature e.g. micro-economic theory postulates that a reduction in the price of a
commodity is expected to increase the quantity demanded of that commodity. Economic
theory states a negative or inverse relationship between the price and quantity demanded but
it does not provide any numerical measure of the relationship between the two i.e. it does not
tell by how much the quantity change as a result of a certain change in the price of the
commodity.
Mathematical economists express economic theory in mathematical form (equations) without
regard to measurability or empirical verification of the theory. They assume economic
relationship is exact and do not allow for random disturbances.
Economics statistics is mainly concerned with collecting, processing and presenting
economic data in the form of diagrams and tables.
Economic theory Mathematical economics Econometrics
It indicates verbal It states economic It states economic
explanation and statements relationships / theory in terms relationships / theory in terms
of mathematical symbols of mathematical symbols
It expresses the various It expresses the various Assumes that relationships
relationships in an exact form relationships in an exact form are not exact ( stochastic)
It does not allow for random It does not allow for random Takes into account random
element and the relationship element and the relationship disturbances
are of non-stochastic form are of non-stochastic form
It does not provide numerical It provides numerical values It provides numerical values
values of the coefficients of of the coefficients of the of the coefficients of the
the economic phenomena economic phenomena economic phenomena
It does not make any It 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
, Model Building in Econometrics
A model consists of a number of elements abstracted from reality and some statements about the
relationships, which exist between them. An economic model is a logical (usually mathematical)
representation of whatever a prior or theoretical knowledge of economic analysis suggests is
most relevant for treating a particular problem. Usually a model takes the form of a system of
equations embodying certain assumed independencies among more or less operationally defined
variables. A model can be described by a list of endogenous variables, a list of exogenous
variables and a list of specifications as to which variables are present in each equation. In
econometric modeling process, a number of concepts and terms are used which include
variables, equations, data and graphs.
Variables
A requirement of good model construction is ensuring that all the variables an econometrician
seeks to explain are consistent with an underlying model. A variable may be defined as a
quantity that can assume any value from a given set of numbers. In economics, a variable is a
quantity or magnitude, which varies from one individual observation to another or over a period
of time under consideration. A variable can be quantitative or qualitative. The simultaneous
equation model is a complete and systematic approach to estimation. To develop a complete
model, it is necessary to describe the variables that are used in the models. They are endogenous,
exogenous variables and lagged endogenous variables.
Endogenous variables: they are variables whose values are required to be explained or
predicted or generated by the model. They are determined within the system of equations
Exogenous variables: they are variables whose values are not to be determined within the
system but they are assumed to be given or known or known in advance independently.
Lagged endogenous variable: these are lagged values of the endogenous variables e.g.
demand may depend not only on current period price (P t) but also on price of the previous
period (Pt-1). Pt is the endogenous variable in period t and Pt-1 is the lagged endogenous
variable.
Equations
An equation is a statement of equality between two mathematical arguments. An equation
contains one or more variables, the coefficients and exponents associated with these variables,
and a constant term giving the value of the equation. A set of equations has to be devised to
express correctly the relationship between the variables. Economic equations contain the
following types:-
Behavioural equation: It describes the actions of individuals or groups or firms in the
economy. It may express a function of one independent variable or several independent
variables e.g. demand function, consumption function, investment function etc
Identities or Definitional equations: These equations assume that the relationship between
variables is true by its definition e.g. Disposable income = Consumption + Savings
Technological equations: they are the descriptions of the production process in the
economy.
Definition and scope of econometrics
It is the quantitative analysis of actual economic phenomena based on the concurrent
development of theory and observation, related by appropriate methods of inference.
It is a social science in which the tools of economic theory, mathematics and statistical
inference are applied to the analysis of economic phenomena.
It is the integration of economics, mathematics and statistics for purpose of providing
numerical values for the parameters of economic relationships and verifying economic
theories.
Relationship between economic theory, mathematics and statistics
Economic theory makes statements or hypothesis that are mostly qualitative or verbal
exposition in nature e.g. micro-economic theory postulates that a reduction in the price of a
commodity is expected to increase the quantity demanded of that commodity. Economic
theory states a negative or inverse relationship between the price and quantity demanded but
it does not provide any numerical measure of the relationship between the two i.e. it does not
tell by how much the quantity change as a result of a certain change in the price of the
commodity.
Mathematical economists express economic theory in mathematical form (equations) without
regard to measurability or empirical verification of the theory. They assume economic
relationship is exact and do not allow for random disturbances.
Economics statistics is mainly concerned with collecting, processing and presenting
economic data in the form of diagrams and tables.
Economic theory Mathematical economics Econometrics
It indicates verbal It states economic It states economic
explanation and statements relationships / theory in terms relationships / theory in terms
of mathematical symbols of mathematical symbols
It expresses the various It expresses the various Assumes that relationships
relationships in an exact form relationships in an exact form are not exact ( stochastic)
It does not allow for random It does not allow for random Takes into account random
element and the relationship element and the relationship disturbances
are of non-stochastic form are of non-stochastic form
It does not provide numerical It provides numerical values It provides numerical values
values of the coefficients of of the coefficients of the of the coefficients of the
the economic phenomena economic phenomena economic phenomena
It does not make any It 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
, Model Building in Econometrics
A model consists of a number of elements abstracted from reality and some statements about the
relationships, which exist between them. An economic model is a logical (usually mathematical)
representation of whatever a prior or theoretical knowledge of economic analysis suggests is
most relevant for treating a particular problem. Usually a model takes the form of a system of
equations embodying certain assumed independencies among more or less operationally defined
variables. A model can be described by a list of endogenous variables, a list of exogenous
variables and a list of specifications as to which variables are present in each equation. In
econometric modeling process, a number of concepts and terms are used which include
variables, equations, data and graphs.
Variables
A requirement of good model construction is ensuring that all the variables an econometrician
seeks to explain are consistent with an underlying model. A variable may be defined as a
quantity that can assume any value from a given set of numbers. In economics, a variable is a
quantity or magnitude, which varies from one individual observation to another or over a period
of time under consideration. A variable can be quantitative or qualitative. The simultaneous
equation model is a complete and systematic approach to estimation. To develop a complete
model, it is necessary to describe the variables that are used in the models. They are endogenous,
exogenous variables and lagged endogenous variables.
Endogenous variables: they are variables whose values are required to be explained or
predicted or generated by the model. They are determined within the system of equations
Exogenous variables: they are variables whose values are not to be determined within the
system but they are assumed to be given or known or known in advance independently.
Lagged endogenous variable: these are lagged values of the endogenous variables e.g.
demand may depend not only on current period price (P t) but also on price of the previous
period (Pt-1). Pt is the endogenous variable in period t and Pt-1 is the lagged endogenous
variable.
Equations
An equation is a statement of equality between two mathematical arguments. An equation
contains one or more variables, the coefficients and exponents associated with these variables,
and a constant term giving the value of the equation. A set of equations has to be devised to
express correctly the relationship between the variables. Economic equations contain the
following types:-
Behavioural equation: It describes the actions of individuals or groups or firms in the
economy. It may express a function of one independent variable or several independent
variables e.g. demand function, consumption function, investment function etc
Identities or Definitional equations: These equations assume that the relationship between
variables is true by its definition e.g. Disposable income = Consumption + Savings
Technological equations: they are the descriptions of the production process in the
economy.
