WHAT IS ECONOMETRICS?

Yet the subject deserves to be studied in its own right for the following
Literally interpreted, econometrics means economic measurement. reasons.
Although measurement is an important part of econometrics, the scope of
econometrics is much broader, as can be seen from the following Economic theory makes statements or hypotheses that are
quotations: mostly qualitative in nature. For example, law of demand,
microeconomic theory states that, other things remaining the same, a
Econometrics, the result of a certain outlook on the role of economics, reduction in the price of a commodity is expected to increase the quantity
consists of the application of mathematical statistics to economic data demanded of that commodity. Thus, economic theory postulates a
negative or inverse relationship between the price and quantity
to lend empirical support to the models constructed by mathematical
demanded of a commodity. But the theory itself does not provide
economics and to obtain numerical results. (Gerhard 1968)
any numerical measure of the relationship between the two;
that is, it does not tell by how much the quantity will go up or down as a
. . . Econometrics may be defined as the quantitative analysis of actual
result of a certain change in the price of the commodity. It is the job of
economic phenomena based on the concurrent development of theory and
the econometrician to provide such numerical estimates.
observation, related by appropriate methods of inference. (Koopmans) Stated differently, econometrics gives empirical content to most
economic theory.
Econometrics may be defined as the social science in which the tools of
economic theory, mathematics, and statistical inference are applied to the The main concern of mathematical economics is to express
analysis of economic phenomena. (Goldberger 1964). economic theory in mathematical form (equations) without regard
to measurability or empirical verification of the theory.
Econometrics is concerned with the empirical determination of Econometrics, as noted previously, is mainly interested in the
economic Law. (Theil 1971). empirical verification of economic theory.
The art of the econometrician consists in finding the set of assumptions As we shall see, the econometrician often uses the mathematical
that are both sufficiently specific and sufficiently realistic to allow him to equations proposed by the mathematical economist but puts these
take the best possible advantage of the data available to him. equations in such a form that they lend themselves to empirical testing.
And this conversion of mathematical into econometric equations requires
Econometricians . . . are a positive help in trying to dispel the poor public a great deal of ingenuity and practical skill.
image of economics (quantitative or otherwise) as a subject in which
empty boxes are opened by assuming the existence of can-openers to Economic statistics is mainly concerned with collecting,
reveal contents which any ten economists will interpret in 11 ways. processing, and presenting economic data in the form of charts and
tables. These are the jobs of the economic statistician. It is he or she
The method of econometric research aims, essentially, at a conjunction
who is primarily responsible for collecting data on gross national product
of economic theory and actual measurements, using the theory and
(GNP), employment, unemployment, prices, etc. The data thus collected
technique of statistical inference as a bridge pier.
constitute the raw data for econometric work. But the economic
statistician does not go any further, not being concerned with
WHY ECONOMETRICS IS A SEPARATE DISCIPLINE? using the collected data to test economic theories.
Of course, one who does that becomes an econometrician.
As the preceding definitions suggest, econometrics is an amalgam of economic
theory, mathematical economics, economic statistics, and mathematical statistics.
Although mathematical statistics provides many tools used in the trade, the (MPC), the rate of change of consumption for a unit (say, a dollar) change
econometrician often needs special methods in view of the unique nature of most in income, is greater than zero but less than 1.
economic data, namely, that the data are not generated as the result of a controlled Keynes states that on average, consumers increase their consumption as
experiment. The econometrician, like the meteorologist, generally depends on their income increases, but not as much as the increase in their income.
data that cannot be controlled directly. As Spanos correctly observes: (MPC<1).
In econometrics the modeler is often faced with observational as opposed to
experimental data. This has two important implications for empirical modeling in 2. Specification of the Mathematical Model of Consumption (single-
econometrics. First, the modeler is required to master very different skills than
equation model)
those needed for analyzing experimental data. . . . Second, the separation of the
data collector and the data analyst requires the modeler to familiarize himself/ Although Keynes postulated a positive relationship between consumption
herself thoroughly with the nature and structure of data in question. and income, he did not specify the precise form of the functional relationship
between the two. For simplicity, a mathematical economist might suggest
the following form of the Keynesian consumption function:
METHODOLOGY OF ECONOMETRICS
Y = 1 + 2X 0 < 2 < 1 Equation (I)
How do econometricians proceed in their analysis of an economic problem?
Y = consumption expenditure and (dependent variable)
That is, what is their methodology? Although there are several schools of thought
on econometric methodology, we present here the traditional or classical X = income, (independent, or explanatory variable)
methodology, which still dominates empirical research in economics and other
social and behavioral sciences. PARAMETERS
1 = the intercept
Broadly speaking, traditional econometric methodology proceeds along the 2 = the slope coefficient
following lines:
The slope coefficient 2 measures the MPC. Geometrically,
1. Statement of theory or hypothesis.
2. Specification of the mathematical model of the theory
3. Specification of the statistical, or econometric, model
4. Obtaining 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.

1. Statement of Theory or Hypothesis

Keynes stated:
The fundamental psychological law . . . is that men [women] are This equation, which states that consumption is linearly related to
disposed, as a rule and on average, to increase their consumption as their income, is an example of a mathematical model of the relationship
income increases, but not as much as the increase in their income. between consumption and income that is called the consumption
function in economics.
In short, Keynes postulated that the marginal propensity to consume
 A model is simply a set of mathematical equations. If the model has only dependent variable Y (consumption) is linearly related to the explanatory
one equation, as in the preceding example, it is called a single-equation variable X (income) but that the relationship between the two is not exact;
model, whereas if it has more than one equation, it is known as a it is subject to individual variation.
multiple-equation model. The econometric model of the consumption function can be depicted as
In Equation I, the variable appearing on the left side of the equality sign shown in Figure.
is called the dependent variable and the variable(s) on the right side are
called the independent, or explanatory, variable(s). Thus, in the
Keynesian consumption function, consumption (expenditure) is the
dependent variable and income is the explanatory variable.

3. Specification of the Econometric Model of Consumption

The purely mathematical model of the consumption function given in

Equation I is of limited interest to the econometrician, for it assumes that
there is an exact or deterministic relationship between consumption and
income. But relationships between economic variables are generally 4. Obtaining Data
To estimate the econometric model given in (I), that is, to obtain the numerical
inexact. Thus, if we were to obtain data on consumption expenditure and
values of 1 and 2, we need data. Although we will have more to say about
disposable the crucial importance of data for economic analysis in the next chapter, for now
(i.e., aftertax) income of a sample of, say, 500 American families and plot let us look at the data given in Table II, which relate to which relate to the
these data on a graph paper with consumption expenditure on the vertical personal consumption expenditure (PCE) and the gross domestic product
axis and disposable income on the horizontal axis, we would not expect all (GDP). The data are in real terms.
500 observations to lie exactly on the straight line of Eq. (I) because, in
TABLE I. DATA ON Y (PERSONAL CONSUMPTION EXPENDITURE) AND X (GROSS
addition to income, other variables affect consumption expenditure. For DOMESTIC PRODUCT, 19821996), BOTH IN 1992 BILLIONS OF DOLLARS
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, the
econometrician would modify the deterministic consumption function
(I) as follows:

Y = 1 + 2X + u

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.

Equation (I) is an example of an econometric model. More technically, it

is an example of a linear regression model, which is the major concern of
this book. The econometric consumption function hypothesizes that the
The data are plotted in Figure I
The hat on the Y indicates that it is an estimate. The estimated consumption
function (i.e., regression line) is shown in Figure II.
As Figure II shows, the regression line fits the data quite well in that the
data points are very close to the regression line. From this figure we see
that for the period 19821996 the slope coefficient (i.e., the MPC) was
about 0.70, suggesting that for the sample period an increase in real income
of 1 dollar led, on average, to an increase of about 70 cents in real
consumption expenditure. We say on average because the relationship
between consumption and income is inexact; as is clear from Figure I.3; not
all the data points lie exactly on the regression line. In simple terms we can
say that, according to our data, the average, or mean, consumption
expenditure went up by about 70 cents for a dollars increase in real income.

6. Hypothesis Testing

Assuming that the fitted model is a reasonably good approximation of

reality, we have to develop suitable criteria to find out whether the estimates
The U.S. economy for the period 19811996. The Y variable in this table is obtained in, say, Eq. (II) are in accord with the expectations of the theory
the aggregate (for the economy as a whole) personal consumption that is being tested. According to positive economists like Milton
expenditure (PCE) and the X variable is gross domestic product (GDP), a Friedman, a theory or hypothesis that is not verifiable by appeal to empirical
measure of aggregate income, both measured in billions of 1992 dollars. evidence may not be admissible as a part of scientific enquiry.
As noted earlier, Keynes expected the MPC to be positive but less than
Therefore, the data are in real terms; that is, they are measured in
1. In our example we found the MPC to be about 0.70. But before we accept
constant (1992) prices. The data are plotted in Figure I for the time being
this finding as confirmation of Keynesian consumption theory, we must
neglect the line drawn in the figure. enquire whether this estimate is sufficiently below unity to convince us that
5. Estimation of the Econometric Model this is not a chance occurrence or peculiarity of the particular data we have
used. In other words, is 0.70 statistically less than 1? If it is, it may support
Now that we have the data, our next task is to estimate the parameters of Keynes theory.
the consumption function. The numerical estimates of the parameters give Such confirmation or refutation of economic theories on the basis of sample
empirical content to the consumption function. The actual mechanics of evidence is based on a branch of statistical theory known as statistical
estimating the parameters will be discussed in Chapter 3. For now, note inference (hypothesis testing). Throughout this book we shall see how
that the statistical technique of regression analysis is the main tool used this inference process is actually conducted.
to obtain the estimates. Using this technique and the data given in Table I,
we obtain the following estimates of 1 and 2, namely, 184.08 and 7. Forecasting or Prediction
0.7064. Thus, the estimated consumption function is: If the chosen model does not refute the hypothesis or theory under
consideration, we may use it to predict the future value(s) of the dependent,
= 184.08 + 0.7064Xi (EQUATION II) or forecast, variable Y on the basis of known or expected future value(s)
of the explanatory, or predictor, variable X.
 To illustrate, suppose we want to predict the mean consumption valuable information for policy purposes. Knowing MPC, one can predict
expenditure for 1997. The GDP value for 1997 was 7269.8 billion the future course of income, consumption expenditure, and employment
dollars. Putting this GDP figure on the right-hand side of following a change in the governments fiscal policies.
(EQUATION II), we obtain:
8. Use of the Model for Control or Policy Purposes
1997 = 184.0779 + 0.7064 (7269.8) = 4951.3167 Suppose we have the estimated consumption function given in
(EQUATION II). Suppose further the government believes that
consumer expenditure of about 4900 will keep the unemployment
or about 4951 billion dollars. Thus, given the value of the GDP, the mean,
rate at its current level of about 4.2%. What level of income will
or average, forecast consumption expenditure is about 4951 billion dollars.
guarantee the target amount of consumption expenditure?
The actual value of the consumption expenditure reported in 1997 was
If the regression results given in (EQUATION II) seem reasonable,
4913.5 billion dollars. The estimated model (EQUATION II) thus
simple arithmetic will show that:
overpredicted the actual consumption expenditure by about 37.82 billion
dollars. We could say the forecast error is about 37.82 billion dollars, which
4900 = 184.0779 + 0.7064X (EQUATION IV)
is about
0.76 percent of the actual GDP value for 1997. When we fully discuss the Which gives X = 7197, approximately. That is, an income level of about 7197
linear regression model in subsequent chapters, we will try to find out if such (billion) dollars, given an MPC of about 0.70, will produce an expenditure of
an error is small or large. But what is important for now is to note that about 4900 billion dollars. As these calculations suggest, an estimated model
such forecast errors are inevitable given the statistical nature of our may be used for control, or policy, purposes. By appropriate fiscal and
analysis. monetary policy mix, the government can manipulate the control variable X to
There is another use of the estimated model (EQUATION II). Suppose the produce the desired level of the target variable Y.
President decides to propose a reduction in the income tax. What will be FIGURE II. Summarizes the anatomy of classical econometric
the effect of such a policy on income and thereby on consumption modeling
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, say, a
dollars worth of change in investment expenditure is given by the income
multiplier M, which is defined as

M= () (EQUATION III)

If we use the MPC of 0.70 obtained in (EQUATION II), this multiplier

becomes 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, for the multiplier depends on
it. And this estimate of the MPC can be obtained from regression models
such as (EQUATION II). Thus, a quantitative estimate of MPC provides
Choosing among Competing Models
The eight-step classical econometric methodology discussed
When a governmental agency (e.g., the U.S. Department of above is neutral in the sense that it can be used to test any of these
Commerce) collects economic data, such as that shown in Table I, rival hypotheses. Is it possible to develop a methodology that is
it does not necessarily have any economic theory in mind. How comprehensive enough to include competing hypotheses? This is
then does one know that the data really support the Keynesian an involved and controversial topic.
theory of consumption? Is it because the Keynesian consumption
function (i.e., the regression line) shown in Figure I.3 is extremely CATEGORIES OF ECONOMETRICS
close to the actual data points? Is it possible that another
consumption model (theory) might equally fit the data as well? For
example, Milton Friedman has developed a model of consumption,
called the permanent income hypothesis. Robert Hall has also
developed a model of consumption, called the life-cycle permanent
income hypothesis. Could one or both of these models also fit the
TYPES OF ECONOMETRICS
data in Table I?
As the classificatory scheme in Figure I.5 suggests, econometrics may be
In short, the question facing a researcher in practice is how to
divided into two broad categories: theoretical econometrics and applied
choose among competing hypotheses or models of a given
econometrics. In each category, one can approach the subject in the
phenomenon, such as the consumptionincome relationship.
classical or Bayesian tradition. In this book the emphasis is on the
How then does one choose among competing models or hypotheses?
classical approach. For the Bayesian approach, the reader may consult the
Here the advice given by Clive Granger is worth keeping in mind: I references given at the end of the chapter.
would like to suggest that in the future, when you are presented with a Theoretical econometrics is concerned with the development of appropriate
new piece of theory or empirical model, you ask these questions: methods for measuring economic relationships specified by econometric
(i) What purpose does it have? What economic decisions does models. In this aspect, econometrics leans heavily on mathematical
it help with? and; statistics. For example, one of the methods used extensively in this book is
(ii) Is there any evidence being presented that allows me to least squares. Theoretical econometrics must spell out the assumptions of
evaluate its quality compared to alternative theories or this method, its properties, and what happens to these properties when one
models? or more of the assumptions of the method are not fulfilled.
I think attention to such questions will strengthen economic research In applied econometrics we use the tools of theoretical econometrics to
study some special field(s) of economics and business, such as the
and discussion.
production function, investment function, demand and supply functions,
As we progress through this book, we will come across several competing portfolio theory, etc.
hypotheses trying to explain various economic phenomena. For example, This book is concerned largely with the development of econometric
students of economics are familiar with the concept of the production methods, their assumptions, their uses, their limitations. These methods are
function, which is basically a relationship between output and inputs (say, illustrated with examples from various areas of economics and business.
capital and labor). In the literature, two of the best known are the Cobb But this is not a book of applied econometrics in the sense that it delves
Douglas and the constant elasticity of substitution production functions. deeply into any particular field of economic application. That job is best left
Given the data on output and inputs, we will have to find out which of the to books written specifically for this purpose. References to some of these
two production functions, if any, fits the data well. books are provided at the end of this book