1. MAE356:
Analytical Methods in Economics and
Finance
Trimester 1, 2014
Lecture 1, Week 1
Geelong
Dr. IKM Mokhtarul Wadud

2. • Welcome to MAE356: Analytical Methods in
Economics and Finance
• This unit is designed to prepare you as graduates
with analytical skills
• Analysis – scientific and precise and hence should
be objective.
• Based on logical reasoning, rules, calculations.
• Analysis in Finance and Economics involve
understanding, interpreting and predicting various
aspects of the business world – mostly
quantitative.

3. Teaching Staff and Academic Queries
Geelong, Off-campus Coordinator and Unit
chair
Dr. IKM Mokhtarul Wadud
Geelong, ad3.127; Tel. 03 522 72051
mokhtarul.wadud@deakin.edu.au
Burwood Coordinators
Dr. Aydogan Ulker
Burwood, lb4.421; Tel 03 92443040
aydogan.ulker@deakin.edu.au
Dr. Cahit Guven
Burwood, lb4.410; Tel. 92445087
cahit.guven@deakin.edu.au
Warrnambool Coordinator
Dr Scott Salzman
Warrnambool, J429; Tel. 03 55 633 070
scotts@deakin.edu.au

6. Important Note:
– Quiz : Only One (not three)
– Comprises 10% marks
– Mode: Online
– Time: 29 March Saturday – 30 March
Sunday (End of Week 3).
– Coverage: Topic 1 & 2

8. Econometrics fills a gap between being a “student
of economics” and being a “practicing economist”
– It lets you tell your employer:
• “I can predict the sales of your product”
• “I can estimate the effect on your sales if
your competition lowers its price by $1 per
unit”
• “I can test whether your new ad campaign is
actually increasing your sales”
– Helps you develop “intuition” about how things
work and is invaluable if you go to graduate
school
Topic 1. The role of statistical data analysis and
econometrics in economics and finance
Textbook Reading: Chap 1

9. • Econometrics is about how we can use theory and data from
economics, business and the social sciences, along with tools from
statistics, to answer “how much” type questions.
• CONSUMPTION = f(INCOME)
• Where Qd and Qs are quantity demanded and quantity supplied,
respectively. Ps represents price of substitutes, Pc represents price
of complements.
• Clearly, the above D and S functions conforms to what you learnt
in year 1 microeconomics.
( , , , )d s c
Q f P P P INC
( , , )s c f
Q f P P P

10. • Geelong city council ponders the question of how
much violent crime will be reduced if an
additional million dollars is spent putting
uniformed police on the street.
• The owner of a local Pizza Hut franchise must
decide how much advertising space to purchase in
the local newspaper, and thus must estimate the
relationship between advertising and sales.
• Deakin University must estimate how much
enrollment will fall if tuition is raised by $100 per
semester, and thus whether its revenue from
tuition will rise or fall.
Example of Econometric applications

11. Every day, decision-makers face „„how much‟‟ questions
(Continued):
– You must decide how much of your savings will go into
a stock fund, and how much into the money market.
This requires you to make predictions of the level of
economic activity, the rate of inflation, and interest
rates over your planning horizon
– A public transportation council in Melbourne, Australia,
must decide how an increase in fares for public
transportation (trams, trains, and buses) will affect the
number of travelers who switch to car or bike, and the
effect of this switch on revenue going to public
transportation

12. An econometric model consists of a systematic
part and a random and unpredictable component e
that we will call a random error
1 2 3 4 5
1 2 3 4 5
, , ,
, , , β β β β β
β β β β β
d s c
s c s c
d s c
Q f P P P INC e
f P P P INC P P P INC
Q P P P INC e

13. The coefficients β1, β2, …, β5 are unknown parameters of the
model that we estimate using economic data and an econometric
technique
– The functional form represents a hypothesis about the
relationship between the variables
– In any particular problem, one challenge is to determine a
functional form that is compatible with economic theory and
the data
The systematic portion is the part we obtain from
economic theory, and includes an assumption about
the functional form
The random component represents a „„noise‟‟
component, which obscures our understanding of the
relationship among variables, and which we represent
using the random variable e

14. We use the econometric model as a basis for
statistical inference
The ways in which statistical inference are carried
out include:
1. Estimating economic parameters, such as
elasticities, using econometric methods
2. Predicting economic outcomes, such as the
enrollment in two-year colleges in the United
States for the next ten years
3. Testing economic hypotheses, such as the
question of whether newspaper advertising is
better than store displays for increasing sales

15. Economic data comes in a variety of „„flavors.”
– Data may be collected at various levels of
aggregation: Micro or Macro
– Data may also represent a flow or a stock:
• Flow: measured over a period of time
• Stock: measured at a particular point in time
– Data may be quantitative or qualitative:
• Quantitative: expressed as numbers
• Qualitative: expressed as an „„either-or‟‟
situation
Economic Data Types

16. A time-series is data collected over discrete
intervals of time
– The key feature of time-series data is that the
same economic quantity is recorded at a regular
time interval. For example, the annual price of
wheat in the US from 1880 to 2007, or the daily
price of General Electric stock from 1980 to
2007.

17. Table 1.1 Annual GDP of Real 2005 Dollars
Figure 1.1 Real U.S. GDP, 1980–2008

18. A cross-section of data is collected across sample
units in a particular time period
– The „„sample units‟‟ are individual entities and
may be firms, persons, households, states, or
countries. For example, income by counties in
California during 2006, or high school
graduation rates by state in 2006.

19. Table 1.2 Cross Section Data: CPS August 2009

20. A „„panel‟‟ of data, also known as „„longitudinal‟‟
data, has observations on individual micro-units
who are followed over time
– The key aspect of panel data is that we observe
each micro-unit for a number of time periods
– If we have the same number of time period
observations for each micro-unit, we have a
balanced panel
– Usually the number of time series observations
is small relative to the number of micro-units,
but not always

21. Table 1.3 Panel Data from Two Rice Farms

22. Economic/ financial data are much easier to obtain
since the development of the World Wide Web
Resources for Economists (RFE)
Australian Bureau of Statistics (ABS)
Reserve Bank of Australia (RBA)
Australian Bureau of Agriculture and Resource
Economics (ABARE)
Productivity Commission
IMF, World Bank
Various databases such as DataStream, BankScope etc.
National Bureau of Economic Research (NBER)
Economagic
Data Sources

23. Rules of Summation, Probability and Random Variables: Preliminaries
Summation

27. Example using summations:

28. Basic Math Review:
(xm)n= xm*n e.g., (x4)3 = x12
xm * xn = xm+n e.g., (x4)(x3) = x7
xm/ xn = xm-n e.g., x5/ x2 = x5-2 = x3
xm * x-n e.g., (x2)(x-3 )= x2/ x3 = 1/ x
Equation: (i) 4x + 3 = 9; => 4x= 9-3; x = 6/4 = 1.5
(ii) 6y+3(3-4y)=4+7/2; => 6y +9-12y = (8+7)/2; => -6y = 15/2 - 9; => -
6y = (15-18)/2; => - 6y= -3/2; => y = (-3/2)/-6= 1/4
Equation system: 5x+ y = 21
2x – 4y = 4
Multiply the first equation by 4 and add the second equation to the
first to obtain:
• 20x+ 4y = 84
• 2x – 4y = 4
• ---------------------------------
• 22x = 88; Hence x = 88/22 = 4
Putting this value x = 4 in any one equation: 2(4) – 4y=4; => - 4y = 4-8 = -
4; => y = (- 4/- 4) = 1
X = 4 and y = 1

29. Equation system (another example):
Use substitution method:
x2 + y2 = 1 (1)
x + y = 0 (2)
We cannot apply the elimination method here because we can eliminate
neither x2 nor y2 by subtracting (2) from (1).
From (2) we get x = -y. Substituting x into the first equation to get:
y2+y2=1
=> 2y2=(1) ; => y2 = (1/2); => y = (1/2)1/2.
Thus, x= - (1/2) 1/2.
Note:
Class attendance is very important for on campus students.
Make the best use of Staff consultation services (both on campus and online).
make sure that you have access to all learning materials including the textbook.
Start planning and preparing for the online quiz due at the end of week 3.