Econometrics combines economic theory, mathematics, and statistical methods to analyze economic data and test hypotheses about economic relationships. It is a distinct discipline that enables economists to quantify relationships and make predictions, particularly regarding consumption and income as exemplified by the Keynesian consumption function. The methodology involves hypothesis formation, model specification, data collection, estimation, hypothesis testing, and application for policy-making.

1. ECONOMETRICS
WHAT IS ECONOMETRICS?
WHY WE STUDY?

2. WHAT IS ECONOMETRICS?
• ECONOMETRICS – ECONOMIC MEASUREMENT
• Econometrics may be defined as the social science in
which the tools of economic theory, mathematics, and
statistical inference are applied to the analysis of
economic phenomena.
Statistical inference means to “infer” something about the
real world by analyzing a sample of data.
Estimating
economic
parameters
Predicting
economic
outcomes
Testing
economic
hypothesis

3. WHY A SEPARATE DISCIPLINE?
• Fills gap between “being a student of economics” and
“being a practicing economist”
• Economic theory is mostly qualitative in nature.
Example: Law of Demand which shows an inverse
relationship between the price and quantity demanded of that
commodity. But there is no numerical measure of the
relationship.
Economists use economic data to: Estimate economic
relationships, test economic hypothesis and predict economic
outcomes.
Econometrics is all about answering “how much” type
questions.

4. WHY A SEPARATE DISCIPLINE?
• Mathematical economics expresses economic theory in mathematical
form without regard to measurability or empirical verification of the
theory.
Example: Keynesian consumption function (mathematical form)
Y = β1 + β2X where 0 <β2 < 1 , Y= consumption expenditure and
X= disposable income
Keynesian consumption function (econometric form)
Y = β1 + β2X + u where u = the disturbance, or error term.
• Economic statistics is concerned with collecting, processing and
presenting economic data but is not concerned with using the data to
test economic theories.
One who does that becomes an econometrician!

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6. METHODOLOGY OF ECONOMETRICS
- GARIMA GUPTA

7. METHODOLOGY
1. Statement of theory or hypothesis.
2. Specification of the mathematical
model of the theory
3. Specification of the statistical, or
econometric, model
4. Obtaining the data
5. Estimation of the parameters of the
econometric model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or
policy purposes.

8. 1. Statement of Theory or Hypothesis
• Keynes stated “The fundamental psychological law”
Consumption of a person increases as his/her income
increases, but not as much as the increase in his/her income.
In short, Keynes postulated that the marginal propensity to
consume (MPC), the rate of change of consumption for a
unit change in income, is greater than zero but less than 1.

9. 2. Specification of the Mathematical
Model of Consumption
• Although Keynes postulated a positive relationship between consumption and
income, he did not specify the precise form of the functional relationship between
the two.
• Mathematical form of the Keynesian consumption function:
Y = β1 +β2X 0 < β2 < 1 (1)
where Y= consumption expenditure and X=income
β1 and β2 are, respectively, the intercept and slope coefficients
β2 measures the MPC

10. 3. Specification of the Econometric
Model of Consumption
• Econometric model: Y = β1 +β2X+u (2)
where u, known as the disturbance, or error, term, is a
random (stochastic) variable that represent all those factors
that affect consumption but are not taken into account
explicitly.
It is an example of a linear regression model.

11. 4. Obtaining Data
To estimate the econometric model, that is, to obtain the
numerical values of β1 and β2, we need data.
Y- Aggregate personal consumption
expenditure
X- GDP, a measure of aggregate
income
Year Y X (BOTH IN BILLIONS OF DOLLARS)
1982 3081.5 4620.3
1983 3240.6 4803.7
1984 3407.6 5140.1
1985 3566.5 5323.5
1986 3708.7 5487.7
1987 3822.3 5649.5
1988 3972.7 5865.2
1989 4064.6 6062.0
1990 4132.2 6136.3
1991 4105.8 6079.4
1992 4219.8 6244.4
1993 4343.6 6389.6
1994 4486.0 6610.7
1995 4595.3 6742.1
1996 4714.1 6928.4
Source: Economic Report of the President,
1998, Table B–2, p. 282.

12. 5. Estimation of the Econometric Model
• Now, estimate the parameters of the consumption
function. The numerical estimates of the parameters give
empirical content to the consumption function.
• The statistical technique to obtain the estimates:
regression analysis
The estimated consumption function is:
𝒀= −184.08 + 0.7064 Xi - (3)

13. Regression Line

14. 6. Hypothesis Testing
• To develop suitable criteria to find out whether the
estimates obtained are in accord with the expectations of
the theory that is being tested
• In other words, is 0.70 statistically less than 1? If it is, it
may support Keynes’ theory. Such confirmation or
refutation of economic theories on the basis of sample
evidence is based on a branch of statistical theory known
as statistical inference (hypothesis testing).

15. 7. Forecasting or Prediction
• Suppose we want to predict the mean consumption expenditure for 1997. The
GDP value for 1997 was 7269.8 billion dollars.
Putting this GDP figure in (3), we obtain:
𝒀 1997 = −184.0779 + 0.7064(7269.8) = 4951.3167 (4)
The actual value reported in 1997 was 4913.5 billion dollars. The estimated model
(3) thus over-predicted the actual consumption expenditure by about 37.82 billion
dollars.
We could say the forecast error is about 37.82 billion dollars.
A quantitative estimate of MPC provides valuable information for policy purposes.
Knowing MPC, one can predict the future course of income, consumption
expenditure, and employment following a change in the government’s fiscal policies.

16. 8. Use of the Model for Control or Policy
Purposes
• Suppose further the government believes that consumer expenditure of about
4900 (billions of 1992 dollars) will keep the unemployment rate at its current
level of about 4.2 percent (early 2000). What level of income will guarantee
the target amount of consumption expenditure?
4900= −184.0779 + 0.7064X (6)
which gives X = 7197 i.e., an income level of about 7197 (billion) dollars, given
an MPC of about 0.70, will produce an expenditure of about 4900 billion dollars.
• An estimated model may be used for control, or policy, purposes. By
appropriate fiscal and monetary policy mix, the government can manipulate
the control variable X to produce the desired level of the target variable Y.