178.280 Research Methods in Financial Economics Lecture 2- Estimating the OLS Model

Introduction Tough guys don’t do math. Tough guys fry chicken for a living. -- Jaime Escalante (Stand and Deliver, 1988).

Outline Administration Readings: Simple OLS Model Office Hours Computer Labs Readings: Chapter 1, 2 Simple OLS Model Objectives this week- Find Eviews on the computer system Practice working with data. Estimate a simple OLS Model

Administration Tutorials and Labs start this week. Web site: Signup sheets are still available. Note: Labs are compulsory Web site: http://www.massey.ac.nz/~bjmoyle/mu/teach.html WebCT Office hours will be announced this week.

Basic Stats We use statistical tools in this paper. but it is not a course in statistics. We estimate the value of certain parameters. E.g. mean, regression-coefficient. We signal our uncertainty about the parameter with ‘spreads’. Examples Variance Standard Deviation Standard error This forms basis of hypothesis tests.

Recap The main difference between statistics and other maths, is answers will have 2 dimensions In normal algebra, variables combine to produce an explicit solution. In statistics, we think in 2 dimensions What we think the value of something is How confident we are in that estimate

The OLS Regression The OLS regression measures the relationship between 2 (or more) variables. One variable is the dependent variable (Y). One variable is the explanatory variable (X). We estimate the relationship with the coefficient B1. We measure the uncertainty about this estimate with its standard-error.

Aside OLS uses a least squares method. It minimises the sum of the square of the residuals. The estimate of Y consists of Constant Slope (beta)

Analysing the OLS Model The model has a deterministic part. That part of the value of Y we can successfully predict Stochastic part That part of Y we can’t explain or predict. The stochastic part contains Measurement errors Missing variables Genuine random effects Non-linearities in the relationship.

Deterministic portion General Equation Dependent Variable Explanatory Variable Constant Stochastic portion Deterministic portion

What is B1? How much Y changes, if we change X (all other things constant). It is also the slope of the regression line. Hence, it is dY/dX Note The slope changes if the units we measure X and Y change. The slope approximates a derivative.

Eviews The Eviews window has: Tool bar Top-pane (for manipulating variables) Lower Scroll-bar (output may appear there) Top Pane Scroll Bar

Data New pane opens

Lab Introduction The data file is trade.wf1 We will estimate an ‘Absorption Model’ for NZ. This uses National Income Accounting procedures. Y=C+I+G+X-M Hence Y-C-I-G=X-M Add/Substract TX from both sides (Y-TX-C)-I+(TX-G)=(X-M)+TX-TX

Absorption Model Note- Y-TX-C equals Savings (S) So (S-I)+(TX-G)=(X-M) Net Private Savings + Net Public Savings = Current Account Balance Net National Savings (NNS) = CAB Implication: Economies with low savings rates (deficits) will run trade deficits.

Definitions C- Household consumption on final goods and services I- Investment G- Government Spending on goods and services TX- Taxes X- Exports M- Imports (removed for double-counting purposes). S- Household Income, less Consumption