ETW2410

Introductory Econometrics
Lecture Slides
Week 1

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 In this Unit:
 Many of the topics have already been introduced in
1st year

 Deepen your understanding of the regression model

as a tool for modelling economic and financial
relationships

 Develop a thorough and intuitive understanding of

the linear regression model

2
 Learning Objectives of topic 1

To provide students with an overview of

 what econometrics entails
 the models and techniques that are widely used in
modern applied econometrics.

At the end of this chapter students should have an

appreciation of data types and how recognising the
type of data is important in econometric analysis.
What is Econometrics

Econometrics -the application of

statistical and mathematical methods to
the analysis of economic data, with a
purpose of giving empirical content to
economic theories and verifying them or
refuting them.
 The first task an econometrician faces is that of
formulating an econometric model.

 What is a model?

 A model is a simplified representation of the real

world process.

 An economic model is a set of assumptions that

approximately describes the behavior of an
economy.
 An econometric model consists of :
 A set of behavior equations derived from the
economic model. These equations involve some
observed variables and some ‘disturbances’(which
are all variables considered irrelevant for the
purpose of this model as well as all unforeseen
events.

 A statement of whether there are errors of

observation in the observed variables.

 A specification of the probability distribution of the

‘disturbances’ (and errors of measurement)
Econometrics uses data and
statistical methods to analyze:
 the properties of economic variables
 the behavior of economic variables
 the relationship between economic
variables
Examples of economic variables:
 production (GDP),employment, income, taxes,
investment, prices, inflation, consumption, money,
government spending, interest rates, trade,
exchange rates etc.
Econometric analysis includes:

 estimation
 hypothesis testing
 Prediction
Description of the steps involved in an Econometric analysis
Economic theory

Econometric model Data

Estimation
Specification testing &
Diagnostic testing

Is the model
Adequate?

No Yes
Test of any hypothesis

Using the model for predictions

and policy
 Why study Econometrics?
 Rare in business & economics (and many
other areas without labs!) to have
experimental data

 Need to use nonexperimental, or

observational, data to make inferences
eg. Data about firms, economies and
individuals etc

 Important to be able to apply economic

theory to real world data

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Why study Econometrics?
 An empirical analysis uses data to test a
theory or to estimate a relationship

 A formal economic model can be tested

 Theory may be ambiguous as to the

effect of some policy change – can use
econometrics to evaluate the program

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Why study Econometrics?
Econometrics provides an objective
approach to making decisions, for
example on:
 public economic policy
 investment policy
 the choice of a profit maximizing price
Econometrics provides a means by which
. relationships can be examined and
quantified.
This lets us answer questions like:
 Does the level of economic well-being
have an impact on crime patterns across
cities?
 how will GST affect consumption
 have the recent recessions in Asia affected
Australian income?
 How does advertising affect sales?
 What effect will raising interest rates by
15 have on the housing market
Types of Data – Cross Sectional
1. Define the question
2. What kind of data do I need in order to address
the question? (Type of question)

 Cross-sectional data is a random sample

 Each observation is a new individual, firm, etc.
with information at a point in time
 If the data is not a random sample, we have a
sample-selection problem

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Types of Data – Time Series

 Time series data has a separate observation for

each time period – e.g. stock prices

 Since not a random sample, different problems to

consider –trend, seasonality, autocorelation

 Trends and seasonality will be important

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Types of Data – Panel

 Can pool random cross sections and treat

similar to a normal cross section. Will
just need to account for time differences.

 Can follow the same random individual

observations over time – known as panel
data or longitudinal data

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The type of data

 Quantitative versus qualitative data

 Time-series versus cross-section data

(Panel Data)

 Micro versus macro data

Nature of data

 Degrees of freedom
 Multicollinearity

 Serial correlation
 Nomality

 Structural change
 Non-stationary
 The Question of Causality
y=f(x ) Does this mean x y
 Simply establishing a relationship between variables
is rarely sufficient
 Want the effect to be considered causal
 If we’ve truly controlled for enough other variables,
then the estimated ceteris paribus effect can often
be considered to be causal
 Can be difficult to establish causality
other things being equal

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 Example: Returns to Education
 A model of human capital investment implies getting
more education should lead to higher earnings

 In the simplest case, this implies an equation like

 Private return to education

Earnings   0  1education  u

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 Example: (continued)
 The estimate of 1, is the return to education, but
can it be considered causal?

 While the error term, u, includes other factors

affecting earnings, want to control for as much as
possible eg. Innate motivation to work/earn money

 Some things are still unobserved, which can be

problematic-education variable captures real
education effects plus indirect effects of other
unobserved variables that are correlated with
education.
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