First Note

In the recent times, Mathematical Economics and Econometrics have attracted attention of
engineering students. Two of the important reasons are need to understand of economic forces
and develop models at Micro level and secondly, understanding economic environment at Macro
level. Some of them like to explore other disciplines where they can use their basic analytical
reasoning and vast knowledge of mathematics, statistics and other similar subjects.
1. Mathematical Economics
Mathematical economics is not any branch of Economics as Monetary Economics
and International Economics but just application of Mathematics to the purely
theoretical aspects of economic analysis. It mainly expresses economic theory in
mathematical form. It does not deal with measurement.
2. Econometrics
As the word Metric refers to measurement, Econometrics in simple words means
measurement of economic date to verify an Economic Theory. It deals with the
study of empirical observations for estimation, inference and forecasting.
Econometrics may be defined as the quantitative analysis of actual economic
phenomena based on the concurrent development of theory and observation,
related by appropriate methods of inference (P.A. Samuelson T.C. Koopmans and
J.R.N. Stone, Report of the Evaluation Committee for Econometrica, Econometrica,
22(2)1954 pp. 141-146).
Econometrics may be defined as the social science in which the tools of economic
theory, mathematics, and statistical inferences are applied to the analysis of
economic phenomena ( Arthur S. Golberger, Econometric Theory, John Wiley &
Sons, New York, 1964, p.1).
As empirical studies and theoretical analysis are often complementary and mutual
reinforcing, knowledge of both Mathematical Economics and Econometrics are
important but knowledge of Mathematical Economics may be considered as the
more basic of the two to undertake Econometrics study. Hence, knowledge of
Mathematical Economics is useful not only for those who are interested in
theoretical Economics, but also for those seeking a foundation for the pursuit of
Econometric studies.
In the beginning, statistics was used for Econometric studies. However, over the
years other similar branches as operational research game theory, fuzzy logic etc.
are being used for Mathematical and Econometrics studies.

3. Deterministic and stochastic Relationship

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In Mathematics and Physics, a deterministic system has no randomness, is involved

in the development of future state of system. A deterministic model will produce the
same output. In economics, a production function is a deterministic model. Or when
you calculate price elasticity of demand that is deterministic relationship. The
Ramsay-Cass-Koopmans model is deterministic model.
But in stochastic relationship, Randomness is involved.
Significance of Stochastic Disturbance Term
The disturbance term, represents all those variables that are omitted from the
model but that collectively affect, Y.
Assumption of Ceritus Paribus (when other variables remain same)
As we have studied that D inversely related to Price of the product when
other things as taste, fashion, price of the substitute goods, complimentary goods
remain same. But due to paucity of time or data, we may not study that all other
variables to remain same or not. So, we cannot say that
4.

Ingredients of an Econometric Model:

Broadly, traditional econometric methodology proceeds along with the following

lines:
i.

Statement of theory
It is very important to discuss what the exiting information/ theory says.

As Keynes stated:
The fundamental psychological law.is that men (women) are disposed, as a rule
and on average, to increase their consumption as their income increases, but not as
much as the increase in their income (John Maynard Keynes, The general Theory of
Employment, Interst and Money, Harcourt Brace Jovanovich, New York, 1936, p. 36).
In short, Keynes postulated that the marginal propensity to consume (MPC), the rate
of change of consumption for a unit change in come is greater than zero but less
than one.

John Maynard Keynes

5 June 1883 21 April 1946 (aged 62)
Nationality - British
Field- political economy, probability
School of thought Keynesian economics
Contributions MACROECONOMICS
Liquidity preference theory
Spending multiplier
ADAS model
Deficit spending
The general Theory of Employment, Interest and
Money, 1936

ii.

Specification of the Mathematical Model of the theory

Though Keynes did not discuss its Mathematical form, but that can be discussed
as a
Y= +X ;

0<<1

Where
Y = consumption expenditure and X = income
and are parameters of the model; the intercept and slope coefficients.
The slope coefficient measures the MPC. The equation is called consumption
function in Economics and it states that consumption is linearly related to
income.

iii.

Specification of the statistical, or econometric model

The purely mathematical model of consumption Function is of limited e to the

Econometricians because it is an exact or deterministic relationship between
consumption and income. But relationships between economic variables are
generally inexact. To allow for the inexact relationships between economic
variables, the econometrician would modify the deterministic consumption
function
Y= + X +
Where is known as disturbance, or error, the term is a stochastic variable that
has well defined probabilistic properties. The disturbance term may well
represented all those factors that affect consumption but are not taken into
account explicitly.
iv.

Obtaining the data

To estimate the Econometric model, numerical value of and need to be

obtained. For which we need to collect data
v.

Estimation of the Parameters of the Econometric model

As we have data, the next task would to estimate the parameters of the
consumption function. The numerical estimates of the parameters give empirical
content to the consumption function. Through statistical technique of regression
analysis is used to estimate.
V (hat)= 103736.0493 + 0.6303 X1
The hat on the Y indicates that it is an estimate. Value of is .63, suggest that
for the given data during the sample period, an increase in real income of one
rupee led, led on average, to an increase of about 63 paisa in real consumption
expenditure. We say on average because the relationship between consumption
and income is inexact.
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vi.

Hypothesis testing

Assuming that the fitted model is reasonably good approximation of reality, we

have to develop theory or hypothesis that is not verifiable by appeal to
empirical evidence may not be admissible as part of scientific enquiry (Milton
Friedman, The Methodology of Positive Economics, Essay in Positive
Economics, University of Chicago Press, Chicago, 1953).
vii.

Forecasting or Prediction

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 or
forecast, Y on the basis of the known or expected future value(s) of the
explanatory, or predictor, variable X.
viii.

Using the model for Control or Policy purposes.

Suppose we have estimated consumption function. Suppose further that the

government believes that consumer expenditure of about 2500 thousand crore
rupees (in 1999-2000 prices) will increase the required employment level in the
country. Through MPC calculated, the government will be able to find out that
income need to be increased by what rate.
Choosing among Competing Model
Advice given by Clive Granger is worth keeping in mind:
i.
ii.

What purpose does it have? What economic decision does it help with?
Is there any evidence being presented that allows me to evaluate its
quality compared to alternative theories or models?

PERMANENT INCOME HYPOTHESIS OF MILTON FRIEDMAN

The permanent income hypothesis was formulated by the Nobel Prize winning economist Milton
Friedman in 1957. The hypothesis implies that changes in consumption behavior are not
predictable, because they are based on individual expectations. This has broad implications
concerning economic policy. Under this theory, even if economic policies are successful in
increasing income in the economy, the policies may not kick off a multiplier effect from
increased consumer spending. Rather, the theory predicts there will not be an uptick in consumer
spending until workers reform expectations about their future incomes.
(source: http://www.investopedia.com/terms/p/permanent-income-hypothesis.asp dated
22/2/2016)
Milton Friedman was an American economist who received the 1976 Nobel Memorial
Prize in Economic Sciences for his research on consumption analysis, monetary
history and theory and the complexity of stabilization policy. Wikipedia
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Born: July 31, 1912, Brooklyn, New York City, New York, United States
Died: November 16, 2006, San Francisco, California, United States
Influenced by: John Maynard Keynes, Friedrich Hayek, more
Influenced: Margaret Thatcher, Gary Becker, Mart Laar, more

Life Cycle permanent Income Hypothesis by Robert Hall

(Source_ Hall Robert E. (1978), Stochastic Implications of the Life Cycle

Permanent Income Hypothesis: Theory and evidence Journal of Political Economy,
vol86, no. 6 pp 971-987)

Robert Ernest "Bob" Hall (born August 13, 1943) is an American economist and a Robert and
Carole McNeil Senior Fellow at Stanford University's Hoover Institution. He is generally
considered a macroeconomist, but he describes himself as an "applied economist".[1]
Bob Hall received a BA in Economics at the University of California, Berkeley and a PhD in
Economics from MIT for thesis titled Essays on the Theory of Wealth under the supervision of
Robert Solow. He is a member of the Hoover Institution, the National Academy of Sciences, a
fellow at both American Academy of Arts and Sciences and the Econometric Society, and a
member of the NBER, where he is the program director of the business cycle dating committee.
Hall served as President of the American Economic Association in 2010.
Variable can be categorical or continuous
i.
ii.

Categorical variable are also called as discrete variable

Continuous variable are also called as quantitative variable

Categorical variables can be further categorized as either nominal, ordinal or dichotomous.

Nominal variables are variables that have two or more categories, but which do not have
an intrinsic order. For example, a real estate agent could classify their types of property
into distinct categories such as houses, condos, co-ops or bungalows. So "type of
property" is a nominal variable with 4 categories called houses, condos, co-ops and
bungalows. Of note, the different categories of a nominal variable can also be referred to
as groups or levels of the nominal variable. Another example of a nominal variable would
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be classifying where people live in the USA by state. In this case there will be many more
levels of the nominal variable (50 in fact).

Dichotomous variables are nominal variables which have only two categories or levels.
For example, if we were looking at gender, we would most probably categorize
somebody as either "male" or "female". This is an example of a dichotomous variable
(and also a nominal variable). Another example might be if we asked a person if they
owned a mobile phone. Here, we may categorise mobile phone ownership as either "Yes"
or "No". In the real estate agent example, if type of property had been classified as either
residential or commercial then "type of property" would be a dichotomous variable.

Ordinal variables are variables that have two or more categories just like nominal
variables only the categories can also be ordered or ranked. So if you asked someone if
they liked the policies of the Democratic Party and they could answer either "Not very
much", "They are OK" or "Yes, a lot" then you have an ordinal variable. Why? Because
you have 3 categories, namely "Not very much", "They are OK" and "Yes, a lot" and you
can rank them from the most positive (Yes, a lot), to the middle response (They are OK),
to the least positive (Not very much). However, whilst we can rank the levels, we cannot
place a "value" to them; we cannot say that "They are OK" is twice as positive as "Not
very much" for example.

Continuous variables can be further categorized as either interval or ratio variables.

Interval variables are variables for which their central characteristic is that they can be
measured along a continuum and they have a numerical value (for example, temperature
measured in degrees Celsius or Fahrenheit). So the difference between 20C and 30C is
the same as 30C to 40C. However, temperature measured in degrees Celsius or
Fahrenheit is NOT a ratio variable.

Ratio variables are interval variables, but with the added condition that 0 (zero) of the
measurement indicates that there is none of that variable. So, temperature measured in
degrees Celsius or Fahrenheit is not a ratio variable because 0C does not mean there is no
temperature. However, temperature measured in Kelvin is a ratio variable as 0 Kelvin
(often called absolute zero) indicates that there is no temperature whatsoever. Other
examples of ratio variables include height, mass, distance and many more. The name
"ratio" reflects the fact that you can use the ratio of measurements. So, for example, a
distance of ten metres is twice the distance of 5 metres.

Data series
Secondary vs. primary data
If someone else has collected, it is called secondary data. Must give source of the
data.
If data is not available than collect data which is called as primary data
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 Cross Sectional Data: In medical or social research information is collected from a

population or sample.
Time Series Data: It is sequence of data points, typically consisting of successive
measurements made over a time interval.

Pooled Data: Both cross-sectional and time series but sample is different

Panel data: With same sample a cross sectional as well as time series data