1.1 What is Econometrics? A set of techniques for measuring economic relationships. 1.What is an economic relationship? It is a relationship among economic variables, where an economic variable is one that measures some aspect of the economy. Examples: –The relationship between economic activity and interest rates –The relationship between savings and tax refunds –The relationship between education and earnings –The relationship between crime and wages –The relationship between advertising expenditures and market share –The relationship between teacher salaries and test scores (student learning)

1.2 What is Econometrics ? (con’t) 2. How do we measure these relationships? We use – economic theory about how economic agents make decisions – data on the economic variables to model and estimate the economic relationship

1.3 Understanding Economic Relationships federal budget Dow-Jones Stock Index trade deficit Federal Reserve Discount Rate capital gains tax rent control laws short term treasury bills power of labor unions crime rate inflation unemployment money supply

1.4 The Consumption Function From economic theory we know that consumption, c, is some function of income, i : c = f(i) For applied econometric analysis this consumption function must be specified more precisely, such as c =  1 +  2 i What is  2 ? Use econometric techniques to estimate  1 and  2

1.5 Demand, q d, for an individual commodity: q d = f( p, p c, p s, i ) If quantity demanded is a linear function: p = own price; p c = price of complements; p s = price of substitutes; i = income Demand Model q d =  1 +  2 p +  3 ps +  4 pc +  5 i

1.6 How Much? If we understand the nature of a relationship between economic variables then we can answer the “how much” question: –Bernanke asks: by how much will economic activity fall if we raise interest rates by a quarter point? –CEO of Pepsi asks: by how much (if any) will market share increase if Pepsi increases advertising expenditures by $100 million? –The Mayor asks: by how much will crime fall if local wages increase by 20%?

1.7 To Answer “How Much” The model is unknown, so … We theorize about it and … We use data to test our theories and to make predictions about “how much”

1.8 Constructing an econometric model Start with c = f(i) but it is too general Use theory to argue for c =  1 +  2 i (linear relshp) –But  1 and  2 are unknown –And there may be other variables that influence c. (The relationship isn’t exact) Econometric Model: c =  1 +  2 i + e (  1 +  2 i) is the average, systematic, deterministic part. e is the random error term that measures all other factors.

1.9 Econometric Model of Consumption Actual = systematic part + random error Systematic part provides prediction, f(i), but the prediction will miss the actual value by a random error, e. Consumption, c, is a function of income, i, with error, e: c = f(i) + e c =  1 +  2 i + e

1.10 Dependent variable, y, is focus of study (predict or explain changes in dependent variable). Explanatory variables, X 2 and X 3, help us explain observed changes in the dependent variable. y =  1 +  2 X 2 +  3 X 3 + e A General Econometric Model

1.11 Econometric model Systematic or Deterministic Portion: (non-random) economic variables and parameters. Error Term: Random variable with a probability distribution. Data observed values of the variables.

1.12 Research Format 1. It all starts with a problem or question 2. Economic theory gives us a way of thinking about the problem: What economic variables are involved and what is the possible direction of the relationship(s)? 3. The working economic model leads to an econometric model. We must choose a functional form and make some assumptions about the nature of the error term. 4. Sample data are obtained, and a desirable method of statistical analysis chosen, based on our initial assumptions, and our understanding of how the data were collected.

Estimates of the unknown parameters are obtained with the help of a statistical software package, predictions are made and hypothesis tests are performed. 6. Model diagnostics are performed to check the validity of assumptions we’ve made. For example, were all of the right- hand-side explanatory variables relevant? Was the correct functional form used? 7. The economic consequences and the implications of the empirical results are analyzed and evaluated. What economic resource allocation and distribution results are implied, and what are their policy-choice implications? What remaining questions might be answered with further study ?

1.14 Note: the textbook uses the following symbol to mark sections with advanced material : “Skippy”