Econometrics – 18KP3EC11 Dr. S. Manonmani Assistant Professor of Economics KNGAC for Women Thanjavur UNIT – I Introduction • Econometrics is formed from two Greek words economy and measure. • Econometrics deals with measurement of economic relationships. • Origin of Econometrics • Prof. Irving Fisher – Quantity theory of money- with the help of data. • Ragner Frish – Father of econometrics and he is one of the founders of econometric society. • Definition of econometrics • Prof. G. Tintner defined “Econometrics consists of the application of mathematical economic theory and statistical procedures to economic data in order to establish numerical results in the field of economics and to verify economic theorems. • Econometrics is a combination of economic theory, mathematical economics and statistics. • Economics + Mathematics – Mathematical Economics • Mathematical Economics + Statistics = Econometrics • Econometrics is usually described as the application of statistical techniques to economic data. • Economists use econometrics to quantify economic relationships. eg. To estimate how demand for a product varies with its price. To estimate trends in a nation’s imports over a given period of time. • Economic theory and mathematical economics postulates exact relationship between various economic magnitude. • Whereas econometrics deals with random component of economic relationships. eg. Economic theory says that the demand for a commodity depends on its price, on the prices of other commodities, on consumer’s income and on tastes. Q = b0 + b1P + b2PO + b3Y + b4t Where Q – Quantity demanded for a particular commodity P – price of the commodity PO - prices of other commodities Y – consumer’s income t – consumer’s tastes b0, b1, b2, b3, b4 – coefficients of the demand equation . In Econometrics the influence of other factors such as Psychological and sociological factors. These other factors are taken into account by introduction of random variable. Q = b0 + b1P + b2PO + b3Y + b4t + u Where u stands for random factors. • Relationship between Econometrics, mathematical economics and statistics. Mathematical economics states economic theory in terms of mathematical symbols. Eg. Q = f (P) It describes the economic relationships in exact form. It never allows random elements. • Econometrics assumes that relationships are not exact. This methods are take into account the random variables. Further, econometric provides numerical values of the coefficients of economic phenomena. • Econometrics and Statistics • Mathematical statistics and economic statistics. • Economic statistics – empirical data – record the data- tabulate and chart it. • Mathematical statistics deals with methods of measurement, which are developed on the basis of controlled experiments in laboratories. • Econometrics uses statistical methods after adapting them to the problems of economic life. These adopted statistical methods are called Econometric methods. • Raw materials of econometrics Econometrics deals with statistical estimation of economic relationships which can be formulated economically. Data have prime importance for econometricians – quantitative and qualitative The statistics of income, consumption, production, price, employment, government expenditure, private expenditure, exports imports etc., provides raw material to econometricians. • Econometrician is free to collect his data from primary sources and secondary sources. • The primary and secondary data can be classified into two category Time series- Data from same entity (universe) for several periods of time. Cross-section data – Data which describe the activities of individual persons, firms or other units at a given point of time. Objectives or uses of econometrics 1. Econometrics is giving numerical estimates to economic parameters. We have economic parameters like marginal values, propensities, growth rates and elasticity. We derive numerical values for these parameters by estimating economic models. 2. Econometrics is verifying economic theories. Using the fitted demand function D = 45 – 3P we get (-3) as the price effect. It verifies Marshall’s theory of demand. 3. Econometrics is forecasting economic variables. eg. Decisions made to purchase of raw materials by forecasting future sales. 4. Econometrics is suggesting economic policies. Production and Trade policy – estimated demand and elasticity of demand for a commodity. Income policy and Investment policy - Keynes linear consumption function. Tax and subsidy policy – Cobb-Douglass production function. • Characteristics of Econometrics Economic theory is mainly concerned with quantitative relationships among economic variables. Such quantitative statements are usually expressed in the form of equations with specified numerical coefficients. According to Prof. Carl F. Christ, these equations must have some desirable characteristics. 1. Relevance: since our study is based on equations, an economic equation should be relevant to the phenomenon being studied. – the model should be relevant to objective and area of study. For eg. If we want estimate production function for manufacturing sector, Cobb-Douglas production function is to be considered. 2. Simplicity: the economic model should be simple and easy to estimate. – The simple linear model satisfies this criteria. 3. Theoretical acceptability: constructing economic theory specifies the econometric model. For eg. Harrod – Domar growth model is suitable for developing countries and it should be considered to get growth rate of national income. 4. Explanatory ability: The estimated econometric model should have greater explanatory power. Using the Co- efficient of determination (R2) the explanatory power of the model can be derived. Eg. If consumption expenditure has a multiple relation with income, wealth, family size and age of the head, then a multiple linear consumption function is to be estimated instead of a simple linear consumption function. 5. Accuracy: The model should give accurate value for economic parameters. Eg. Price elasticity of demand can be estimated more accurately with the use of Engal’s demand function than Marshall’s demand function. 6. Forecasting power: The estimated model should have forecasting ability. The Econometric study is not concerned with present only but it is also to forecast future. eg,. If we know the population in 2016 with accurate coefficient, the probable population in 2020 can be forecast. • Scope of Econometrics Scope and areas of application of econometrics is expanding constantly. It plays a service role to economic analysis. It is now being widely used in policy formation by governments, businessmen and other economic thinkers. For eg. Govt. wants to devaluate its currency to correct the balance of payment position. For estimating the consequences of devaluation, the government is immediately concerned with price elasticity of imports and exports.. If exports and imports are inelastic the devaluation will ruin the economy, if it is elastic then it is advantages to the country, these price elasticity are to be estimated with the help of demand functions of import and export commodities, here econometric tool will be applied. The problem of planned economy have been effectively solved by econometrics. It is an outstanding method for verification of economic theories. • Limitations of Econometrics According to Tintner, “The case for econometrics has sometimes been overstated by enthusiastic econometricians” as it has the limitations. 1. Econometrics is applicable only for quantifiable economic behaviour. 2. Estimation of econometric model is based on certain assumptions, which are not true with economic data. 3. Mathematical models are inadequate to explain economic model. 4. Econometric models are time consuming and complex. 5. Estimation of econometric model is biased due to specification errors and measurement errors. • Tools and methods of study Econometrics is a scientific method which has a systematic way of studying the phenomena. There are some important tools of econometrics Mathematics Statistics • Econometrics and mathematics Econometrics transforms economic theory into mathematical terms and utilizes statistical methods to derive economic relationships under certain assumptions. In mathematics we study different types of equations. Economic model refers to a set of equations which describes the relationships among the economic variables. for eg. While constructing national income model, the set of equations are, Y = C + I C = f(Y) or C = α + βY + u Where, Y = National Income, C = Consumption, I = Investment, u = disturbance term, and α, β are the parameters or the coefficients. The above model consists of two types of variables 1. Endogenous variable or dependent variable 2. Exogenous variable or independent variable Endogenous variable: The variable which are determined inside the model. (Y and C) Exogenous variable: The variable which are determined outside the model. (I) • Econometrics and statistics The second important tool is statistical inference. There are two different approaches in Statistics are used in econometrics. they are, 1. descriptive statistics – measurement of central tendency, measurement of dispersion etc. 2. technique of statistical inference – it includes the theory of probability. Some of the statistical tools are part of econometrics. They are, 1. Statistical data – The economic parameters are estimated on the basis of statistical data available to an investigator. 2. Statistical methods of sampling – In