Econometric Analysis

What is Econometrics?

Econometrics literally means Metrics of Economics. In Econometrics, measurements of economic variables are analyzed using advanced statistical techniques to test economic principles, or to aid economic policy making.

Economic theory makes hypotheses that are qualitative in nature. For example, one can hypotesise that the sales of a particular commodity will increase if the price of that commodity decrease. Here no quantitative relationship is presented between the commodity demand and the commodity price.

Mathematical Economics builds a model for the proposed economic theory using equations. For example, mathematics can be used to build a regression relationship between the commodity demand and the commodity price - known as Economic Models.

Mathematicians provide solutions to the Economic Models, but Econometricians not only find solutions but also interpret the model results. For example, the mathematicians may be able to find a significant regression relationship between two economic variables, but it is the job of the Econometricians to verify the relationship between the variables to establish the cause and effect relationship.

Econometrics differs from statistics in one important aspect. In traditional statistical applications, analyses are performed using the data obtained from controlled experiments (e.g., Clinical Trials). However, in Econometrics the data to be analyzed are observed in real-world situations.

The datasets available to Econometricians may be of three types: cross-sectional data; timeseries data; and panel data. Cross-sectional datasets represent one moment in time and the observations generally relate to households, individuals, enterprises, or geographical areas. It is usually observed using a sample drawn from the population.

Time series datasets consist of repeated observations of a set of variables over a period of time. Normally the interval between the observations is fixed. The interval could be a year, a quarter, or a month. The frequency may be higher, for example hours or minutes, if the study involved the analysis of stock market indices.

Panel datasets include both cross-sectional and timeseries components. This involves repeating cross-sectional observations over a period of time at fixed intervals. For example, Observing socio-economic status of several thousand people living in a town over 10 years on annual basis. Analysis of this type of data to understand the economic relationships require a special type of regression analysis.

Processes in Econometrics

An Econometrician will have to follow a series of processes or methods to address an economic problem, to test an economic principle or to inform economic policy making. Typically the steps involved in the Econometric Analysis are:

1) State Economic Theory or Hypothesis.
2) Build a Mathematical Model of the theory.
3) Specify Statistical or Econometric Model.
4) Conduct surveys and gather data to fit the model.
5) Estimate parameters of the Econometric Model.
6) Conduct Tests of Hypotheses.
7) Use the model to Forecast the future.
8) Use the model for Policy Making.

We shall explain each step described above using an example Econometrics Project. It is very important that the graduate students understand these steps, as these steps are essential components of any Econometrics Project.