ECONOMETRICS FOR FINANCE

Course Code [AcFn3131]

Contact Hrs: 4
By
Megerssa (MSc)

1
 Course Contents

1. Introduction
1.1. Definition and Scope of Econometrics
1.2. Models: Economic models and Econometric models
1.3. Methodology of Econometrics
1.4. The Sources, Types and Nature of Data
1.5 Goal of econometrics
 Assessment/Evaluation method
1. Assignment (Individual)………………………..10%
2. Attendance …………………………………….10%
3. Assignment (Group)………………….....…..….10%
4. Mid Exam……………………….......…………30%
5. Final Exam…………………………..........…....40%
 REFERENCES:
1. Gujarati, D. N. (2004). Basic Econometrics, 4th edition, McGraw-Hill.
2. Maddala, G. S. (1992). Introduction to Econometrics, 2nd edition, Macmillan.
3. Wooldridge, J. (2004). Introductory Econometrics: A Modern Approach, 2nd
ed.
4. Enders, W. (2004). Applied Econometric Time Series, John Wiley & Sons:
Singapore.
5. Koutsoyiannis, A. (2001). Theory of Econometrics, Palgrave: New York.
6. Johnston, J., Econometric Methods, 3rd edition.
7. Kmenta, J. Elements of Econometrics, 2nd edition.
8. Intrilligator M.D, R.G. Bodkin, and D. Hsiao (1996). Econometric Models,
Techniques and Applications.
 CHAPTER 1:
INTRODUCTION TO ECONOMETRICS

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After completing this chapter, you will be able to:
 Understand the definition of econometrics
 Differentiate econometrics from other disciplines
 Distinguish the three main goals of econometrics
 Understand the methodology of Econometrics
 Know the types and sources of data

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 1.1 Definition of Econometrics
o The term econometrics is derived from two Greek words:
“Oikonomia Metron”
o Oikonomia ……Meaning Economics
o Metron……….. Meaning measure

o Simply stated Econometric means economic measurement.

o Econometrics is concerned with the measuring of economic

relationships.

o It is the method of using sample data on observable variables to

learn about economic relationships.

 1.1 Definition Econometrics
• It is a social science in which the tools of economic theory,
mathematics, statistics & Computing are applied to the
analysis of economic phenomena.

• In a nutshell, econometrics means the amalgamation of

mathematics, statistics, computing & economic theory.
Therefore, econometrics utilizes
o Economic theory, as embodied in an econometric Model;

o Facts, as summarized by relevant data, &

o Statistical Theory, as refined into econometric techniques

1.1.1 Definition and scope of Econometrics
 1.1.2 Scope of Econometrics

Econometrics also decomposed in to two branches:-

1. Theoretical econometrics

2. Applied econometrics

1. Theoretical Econometrics: It is the development of appropriate

econometric methods for measuring economic relationship between
variables.
 In theoretical Econometrics :

i. The data used for measurement purpose are observations from

the real world but are not derived from controlled experiments

ii. Econometric relation ships are not exact,

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 1.1.2 Scope of Econometrics
• The econometrics method that will be used in theoretical Econometrics may be
classified in to two :
A. Single - equation techniques i.e. one side relationship between variables at a
time. Example : 1
Qd   iPi  ui
• Means quantity demanded depends up on the price of the commodity but not
price depends up on quantity. Then we have only one side causations. Then we
can apply. Econometrics techniques only for this equation.
A. Simultaneous equation model :- When there is two sided action.
• Ex. Equation 1 explains that quantity demand depends on the price of the
commodity but if the price of the commodity is in turn depends on the quantity
of commodity supplied. Then we will have two side action.
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 1.1.2 Scope of Econometrics

Pi   iQSi  ui

• Econometrics techniques will applied for three equations

Qd   iPi  ui
Pi   iQSi  ui
•
Qd QS
Then in this case we applied Econometrics techniques
simultaneously for all equations at a time.

Numerical example: Given market demand: Qd= 100-2P, and

market supply: P =( Qs /2) + 10

A. Calculate the market equilibrium price and quantity

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 Solution
P= Q/2 +10= (QS+20)/2 = 2 P = QS+20 = QS= 2P-20 then,
Qd =QS
100-2P = 2P-20,
100+20 = 2P+2P ,
4P= 120,
P= 30
 1.1.2 Scope of Econometrics
2. Applied Econometrics
o It is concerned with the measurement of the parameters of
economic relationships & with the prediction of the value of
economic relationship.
o The tools of applied Econometrics are used to study some special
fields such as:
o the production function,

o the consumption function,

o the investment function,

o the demand & supply function, etc.

 1.2 Models: Economic models and Econometric models

o A model : It is a simplified representation of a real world

process. It should be representative in the sense that it should
contain the salient features of the phenomena under study.

Used
o The obtained models are used for forecasting and policy
formulation which is an essential part in any policy decision.
Such forecasts help the policy makers to judge the goodness of
fitted model and take necessary measures to re-adjust the
relevant economic variables.
 1.2 Models: Economic models and Econometric models

1. Economic models : It is an organized set of relationships that

describes the functioning of an economic entity under a set of
simplifying assumptions.
o All economic reasoning is ultimately based on models.
Economic models consist of the following three basic structural
elements.
o A set of variables
o A list of fundamental relationships and
o A number of strategic coefficients
 1.2 Models: Economic models and Econometric models
2. Econometrics models are also known as statistical analytical tools that

estimates the probability of an event occurring based on past historical data.

o Econometrics model are mathematical representation of economic theories with

the residual phenomena.

o Unlike the economic model, the stochastic or econometric model includes the

elements of randomness.

o This model is likely to produce different result even with the same initial

condition. There is always an element of uncertainty involved which implies

that there are possible alternative solution.

o Thus, Econometrics model include both Economic model and randomness of

the life.
 The Difference Between Economic and Econometric Model

Economic Model Econometrics Model

o It shows economic relation ship o It measures the value of parameters in the

between different economic variables. economic relation ship.

o An Econometrics model is the combination

o The Economic model is the theoretical
of mathematical, statistics and economic
construct that represent the complex
concept that represent the mathematical
economic process or association estimates of the variables or parameters
between economic variables. there in the identified model.

o Economic model are qualitative but by o Econometrics models are extensively

nature they are based on mathematical statistical or future forecast oriented

model as they ignore residual variables. and thus based on statistical model.
 Economic Model Econometrics Model
o Economic model attempt to exhibit the logical o Econometrics model focuses on calculating

relation ship between different variables the numerical value and direction of variables
considered in the model.
consider in the model,

o The econometrics model is directly linked

o The economic model is directly linked with
with the mathematical model but it is used for
the mathematical model as it in mathematical
further empirical forecasting and extension of
economics all the economic model are applied
an economic model or mathematical model
to express to them in to quantitative form.

o The econometrics model include the residual

o The outcome of economic model is almost variables/ uncertainty so the outcome is not
certain and exact. It means all economic fixed and unknown, unlike the economic
models all developed with a set of fixed model. So the outcome of econometrics
assumption /conditions so the outcome is also model may be certain but not exact.
almost fixed.
 Economic Model Econometrics Model
o Economic model is deterministic model. o All the econometrics are stochastic and
Deterministic model do not include the econometrics assumes all the economic models
error term. as stochastic by including the error term.

o Economic model forecast the future values o Econometrics models forecast the future value
of economic variables regardless of their
of economic magnitude with a certain degree of
uncertainty or degree of probability.
probability.

o Y= B1+B2X Keynes consumption function

o Y= B1+B2X + U stochastic relation is an example
is an example of Economic Model. This
of the Econometrics model
relation is deterministic.

o Economic models do not have any thing to

do with significance testing of the variables o Econometrics model requires significant testing
and parameters. of their parameters
 Economic Model Econometrics Model
o There is no uncertainty in the value of o There is linear as well as nonlinear
variables in the model at any point in the relation ship in econometrics so there is
time in the case of economic model. possibilities of uncertainty in the value of
variables in any particular instant of time.

o o Econometrics model takes randomness as

Economic model allows for random
an essential elements of the model. So all
element which might affect the exact
the economic model in the econometrics
relation ship and the tender it in
model as probabilistic models.
stochastic characters.

o Econometrics models are more power

o Economic models are less power full to
full to predict the future
predict the future
 1.3. Methodology of Econometrics

• Starting from the relationships of economic theory, econometric

inquiry generally proceeds along the following lines:
• Step 1: Economic Theory
• Step 2: Specification
• Step 3: Statistical design to obtain data
• Step 4: Estimation
• Step 5: Verification
• Step 6: Application
 1.3. Methodology of Econometrics

Step 1: Economic Theory

o What economic theory says about the inter-dependence of
economic variables
o What does economic theory tells you about the relationship b/n
two or more variables
For Instance
o Economic theory says that there is an inverse relationship
between the price of a commodity & its quantity demanded, citrus
paribus.

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 1.3. Methodology of Econometrics
Step 2: Specification
o Specify the mathematical equation to describe the relationship
between economic variables as proposed by economic theory.
o What are other factor apart from dependent variables affect
independent variables?
o Variables to the model Qs = f(Po, Y, T,Pz)
o Signs & magnitude of the parameters
o Mathematical form of the model (i.e. linear vs. non-
linear)

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 1.3. Methodology of Econometrics

Step 3: Statistical design to obtain data

o Representative samples from the "real world“
o What types of data required?
o Cross-section
o Time-series
o Panel data (repeated survey of a single sample in
different time periods)

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 1.3. Methodology of Econometrics

Step 4: Estimation
o Estimation of the model by means of appropriate econometric
method
1. examination of the identification condition
2. examination of the degree of correlation among explanatory
variables
3. choice of appropriate econometric technique.
o Forecasting & prediction

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 1.3. Methodology of Econometrics

Step 5: Verification
o are the estimates accords with the expectation of the theory that
is being tested?
o Comparing the estimation of the model result with economic “
a priory” criteria
o Statistical criteria (first order tests)
o These tests are determined by statistical theory
o Econometric criteria (second-order tests)
o These tests are given by the theory of econometrics
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 1.3. Methodology of Econometrics

Step 6: Application

o The ultimate goal of econometrics is to obtain reliable

predictions for the application to economic policy
decision or policy purpose.

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 1.4 The Sources, Types and Nature of Data

• Data are raw, unorganized facts, statistics, figures, numbers,

symbols, characters, images etc that represent conditions, ideas or
known events/objects.
• Data are raw material from which information is generated by
human or machine through some sort of structuring, processing,
evaluation, analysis and aggregation.
Example : number of students in the class, each student’s test score
etc.

10/25/2024 MWU 29
 Sources of Data
• Different sources

1. Reference books encyclopedia

2. Univ. publications thesis dissertations
3. Co publications financial reports prod. Specification etc
4. Professional and other associations publications eg research report
proceedings
5. Personal documents historical studies)
The data that is compiled can be classified as statistical or non statistical data.
Government documents and company and association publications are often
statistical natures while periodicals and books tend to be non statistical
Example of statistical data: trade statistics, survey of manufacturing industries
quarterly bulletins etc.
10/25/2024 MWU 30
 1.4 The Sources, Types and Nature of Data

There are three type of data . These are

1. Time series data
2. Cross-sectional data
2. Pooled data

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 [Link] Series Data

• Time series data has a separate observation for each time period
– e.g. stock prices
• Since not a random sample, different problems to consider
• Trends and seasonality will be important
• Examples of time series data
Series Frequency
GNP or unemployment monthly, or quarterly
government budget deficit annually
money supply weekly
value of a stock market index as transactions occur

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• This is a set of observations on the values that a variable takes at
different times.
• Such data may be collected at regular time intervals:
o Daily,
o Weekly,
o Monthly,
o Quarterly,
o Annually etc.

• Example. data on stock prices, unemployment rate, GDP etc

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 Example of time series dataset:
observation
year month Exchange Interest
rate rate
1 1990 1 1.32 7.35
2 1990 2 1.30 7.30
3 1990 3 1.29 7.32
. . . . .
. . . . .
. . . . .
191 2005 11 1.11 4.26
192 2005 12 1.10 4.31 34
 [Link]-Section data:
• These data give information on the variables concerning
individual agents (consumers or producers) at a given point of
time.
Or
• The data is collected at single time-period or takes a snap shot
approach to social world.
• Each observation is a new individual, firm, etc. with
information at a point in time
• If the data is not a random sample, we have a sample-selection
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problem
  Example of cross-section data
Observn wage education experience female married

1 3.10 11 2 1 0
2 3.24 12 22 1 1
3 3.00 11 2 0 0
. . . . . .
. . . . . .
. . . . . .
499 11.56 16 5 0 1
500 3.50 14 5 1 0
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 [Link] /pooled Data
• These are repeated surveys of a single (cross-section) or more
than one time sample in different periods of time.
o It is more powerful especially with respect to social
changes.
• They record the behavior of the same set of individual
microeconomic units over time.
• There are elements of both time series and cross sectional data.
Examples : Interviewing and collecting the data from the same
people in 1991, 1995, 1999 etc and observe the change

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• The panel or longitudinal data also called micro panel data, is a
special type of pooled data in which the same cross-sectional
unit is surveyed over time.
• Can pool random cross sections and treat similar to a normal
cross section.
• Will just need to account for time differences.
• Can follow the same random individual observations over time
– known as panel data or longitudinal data

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  Example of panel dataset: 150 cities over 2 years

obsn city Year murders populatio police

n
1 1 1999 5 350,000 440
2 1 2000 8 359,200 471
3 2 1999 2 64.300 75
4 2 2000 1 65,100 75
. . . . . .
. . . . . .
299 150 1999 25 543,000 520
300 150 2000 32 546,200 493
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 1.7.2 Source of Data 4
0
There are two types of data source:

a) Primary Data
 Data collected by the investigator directly from
the source. Example: observing signs, measure
characteristics, record symptoms and interview
respondents, etc.

b) Secondary Data
 Data gathered or compiled from published and
unpublished sources or files. Example: Hospital
records, vital statistics and registers, etc.
 1.8. Measurement Scales 4
1
 The variables that we will generally
encounter fall into four broad categories:
 ratio scale,
 interval scale,
 ordinal scale, and
 nominal scale.
Cont’d 4
2
1. Ratio Scale

 For a variable X, taking two values, X1 and X2, the

ratio X1/X2 and the distance (X2 − X1) are meaningful
quantities.

 Also, there is a natural ordering (ascending or

descending) of the values along the scale.
Therefore, comparisons such as X2 ≤ X1 or X2 ≥ X1
are meaningful.

 Most economic variables belong to this category.

Thus, it is meaningful to ask how big this year’s
GDP is compared with the previous year’s GDP.

 Personal income, measured in dollars, is a ratio

 Cont’d 4
3
2. Interval Scale
 An interval scale variable satisfies the last two
properties of the ratio scale variable but not the
first.

 Thus, the distance between two time periods, say

(2000–1995) is meaningful, but not the ratio of two
time periods (2000/1995).

 Interval scales can have an arbitrary zero, but it is

not possible to determine for them what may be
called an absolute zero or the unique origin.

 The primary limitation of the interval scale is the

lack of a true zero; it does not have the capacity
Cont’d 4
4
 The Fahrenheit scale is an example of an
interval scale and shows similarities in what one
can and cannot do with it.
 One can say that an increase in temperature from
30° to 40° involves the same increase in
temperature as an increase from 60° to 70°, but
one cannot say that the temperature of 60° is
twice as warm as the temperature of 30°
because both numbers are dependent on
the fact that the zero on the scale is set
arbitrarily at the temperature of the freezing
point of water.
 The ratio of the two temperatures, 30° and 60°,
 Cont’d 4
5
3. Ordinal Scale
 The lowest level of the ordered scale that is commonly
used is the ordinal scale.
 The ordinal scale places events in order, but there is
no attempt to make the intervals of the scale equal in
terms of some rule.
 A variable belongs to this category only if it satisfies
the third property of the ratio scale (i.e., natural
ordering).
 Examples are grading systems (A, B, C grades) or
income class (upper, middle, lower).
 For these variables the ordering exists but the
distances between the categories cannot be
 Cont’d
4
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4. Nominal Scale
 Nominal scale are commonly used to refer to data
that can only be classified into categories.

 The lowest level of data measurement is nominal

level data. Numbers representing nominal data can
be used only to classify or categorize.

 Variables in this category have none of the features

of the ratio scale variables.

 Variables such as gender (male, female) and marital

status (married, unmarried, divorced, separated)
simply denote categories.
1.5 Goals of Econometrics 4
 Basically there are three main goals of Econometrics. They are:
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1. Analysis: - Testing Economic Theory
 2. Policy-Making
 3. Forecasting

[Link] Megeressa M. OCT, 2023

 Megerssa (MSc).

THANK YOU!
2023 ECONOMETRICS FOR FINANCE 48