Definition of Econometrics

literally interpreted econometrics means "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(variable). Econometrics can also be defined as

"statistical observation of theoretically formed concepts OR alternatively as mathematical economics

working with measured data. so economic theory attempts to defined the relationship among different

economic variables.

Methodology of Econometrics
Following are the main steps in methodology of econometrics

1. Specify mathematical equation to describe the relationship between economic variables.

2. Design methods and procedures based on statistical theory to obtain representative sample

from the real world.

3. Development of methods for estimating the parameters of the specified relationships

4. Development of methods of making economic forecast for policy implications based on

estimated parameters.

What are the goals of econometrics?

Econometrics help us to achieves the following three goals:
1. Judge the validity of the economic theories.
2. Supply the numerical estimates of the co-efficient of the economic relationships which may be
then used for some sound economic policies.
3. Forecast the future values of the economic magnitude with certain degree of probability.

The Nature of Econometrics Approach

The first step of every econometrics research is the specification of the model, a model is simply a set of
mathematical equations. If the model has only one equation it is called a single-equation model.
Whereas if it has more than one equation it is called a multi-equation model. Now let us consider the
following model.
Y=β0 + β1X
where
Y= Consumption expenditure
β0 = Intercept
β1= Slope or co-efficient of regression
X= income
This is a deterministic model showing the relationship between consumption and
income.
The non-deterministic or stochastic models can be written as:
Yi=β0 + β1Xi+i
where "i " is known as the disturbance or residual term, and hence it is a random
variable. It is also

called probabilistic model. The disturbance or error term represent all those factors that
affect

consumption but not taken into account. This equation is an example of an

"Econometric Model".

In other words it is an example of a "linear regression Model". In this case the response
variable 'Y' is

linearly related to the predictor variable 'X' but the relationship between the two is not
exact. The

second step is the estimation of model by appropriate econometric method, this will
include the

following steps.

1. Collection of Data for the variables included in the model.

2. Choice of appropriate econometric technique for the estimation of technique used is

Regression

Analysis in Statistics).

3. The third step is to develop the suitable criteria to find out whether estimates
obtained are

in agreement with the expectations of the theory that has been tested, that is to decide
whether

the estimates of the parameters of the theoretically meaning full and statistically
significant.

4. The final step is to use the estimated model to predict the future value of the response variable.

Deterministic and Stochastic Models

A relation between X and Y is said to be deterministic if for each value of predictor variable X,

there is one and only one corresponding values of response variable Y. On the other hand the

relation between X and Y is said to be stochastic or probabilistic if for a predictor value of X 4

there is a whole probability distribution of values of Y, that is 'Y' is a random variable and 'X' is a

fixed mathematical variable measured without error.

Types of Econometrics
Econometrics can be divided into two main braches

1. Theoretical

2. Applied
1. Theoretical econometrics:
It is concerned with development of the appropriate methods for measuring the economic relationship

specified by the econometrics models. This type of econometrics depends much on mathematical

statistics, single equation and simultaneous equations techniques, the methods used for measuring

economic relationships.

Y a bx →simple

Y a bx0 bx2 →Simul tan eous
Y a bx1 bx2 →simula tan eous

2. Applied econometrics:
Applied econometrics Describe the practical value of economic research. It deals with the applications of

econometric methods developed in the theoretical econometrics to the different fields of economics

such as the consumption functions, demand and supply, fraction etc. The applied econometrics has

made it possible to obtained numerical results from these studies which are of great importance to the

planners.

The Role of Econometrics:

The important role of econometric is the estimation and testing of economics models. The first step in

the process is the specification of the model in the mathematical form. The 2nd step is the to convert

the relevant data from the economy. The thirdly use the data to estimate the parameters of the

models and finally we will carry out tests on the estimated model in an attempt to judge whether it

constitutes a sufficiently realistic picture of the economy being studied or whether somewhat different

specification is to be estimated.
Definition of Regression
Regression analysis is statistical technique for investigating and modeling the relationship
between variables. The term regression was first time introduced by "Francis Galton". In his
paper Galton found that the height of the children of unusually tall or unusually short parents
tends to move towards the average height of the population. Galton law of universal regression
was confirmed by his friend Karl Pearson, more than a thousand records of heights of members
of family groups. He found that the average height of sons of a group of tall fathers was less than
their father height and the average height of sons of a group of tall fathers was less than their
fathers height and the average height of sons of a group of short fathers was greater than their
fathers height, thus "regressing tall and short sons alike toward the average height of all men. In
the world of Galton this was "regression to mediocrity".

WHAT IS REGRESSION ANALYSIS

Under single regression model one variable, called the dependent variable is expressed as a linear
function of one or more other variable, called explanatory variable.

TWO VARIABLE REGRESSION MODEL ANALYSIS:

That means a function has only one dependent variable and only one independent variable.
Two variable or bivariate
Means regression in which the dependent variable (the regressand) is related to a single explanatory
variable (the regression).
When mean values depend upon conditioning (variable X) is called conditional expected value.
Regression analysis is largely concerned with estimating and/or predicting the (population) mean
value of the dependent variable on the basis of the known or fixed values of the explanatory
variable (s).

Concept of Population Regression function (PRF) Or Conditional Expectation function

2.3.2 ESTIMATION THROUGH OLS
Properties of OLS:
1) Our estimation are expressed solely in term of observatory can be easily complete.
2) They are point estimation.
3) Once OLS estimation is obtained from the sample data. The sample regression line can be easily
obtained.

Assumptions of Model
SUM IT UP
In the concluding remarks, we can say that regression analysis is concerned with the study of the
dependence of one variable, the dependent variable, on one or more other variables, the
explanatory variables, with a view to estimating and/or predicting the (population) mean or average
value of the former in terms of the known or fixed (in repeated sampling values of the latter. If we
are studying the dependence of a variable on only a single explanatory variable, such as that of
consumption expenditure on real income, such a study is known as simple, or two-variable,
regression analysis. However, if we are studying the dependence of one variable on more than one
explanatory variable, as in the crop-yield, rainfall, temperature, sunshine, and fertilizer examples, it
is known as multiple regression analysis. In other words, in two-variable regression there is only
one explanatory variable, whereas in multiple regression there is more than one explanatory
variable.

Modern Interpretation of Regression

Regression analysis is the study of the dependence of one variable the dependent variable, on
one or more other variables, the explanatory variable.

Objective of Regression
The objective of regression analysis is to estimate or predict the average value of the response
variable on the basis of the known or fixed values of the predictor variable.

The Simple Linear Regression Model

Simple linear regression is the most commonly used technique for determining how one variable
of interest(the response variable)is affected by changes in another variable(the explanatory
variable)The terms "response" and "explanatory" mean the same thing as "dependent" and
"independent", but the former terminology is preferred because the "independent" variable may
actually be interdependent with many other variables as well.
Simple linear regression is used for three main purposes:
1. To describe the linear dependence of one variable on another.
2. To predict values of one variable from values of another, for which more data are available.
3. To correct for the linear dependence of one variable on another, in order to clarify other
features of its variability. Linear regression determines the best-fit line through a scatter plot of
data, such that the sum of squared residuals is minimized; equivalently, it minimizes the error
variance. The fit is "best" in precisely that sense: the sum of squared errors is as small as
possible. That is why it is also termed "Ordinary Least Squares" regression. Model of the simple
linear regression is given by:
Yi=β0 + β1Xi+i
Where
β0 = Intercept
β1= Slope or co-efficient of regression
i =random error
An important objective of regression analysis is to estimate the unknown parameters β0 and β1
in the regression model. This process is also called fitting the model to the data, The parameters
β0 and β1 are usually called regression coefficients. The slope β1 is the change in the mean of
the distribution of Y
producing a unit change in X. The intercept β0 is the mean of the distribution of the response
variable Y when X=0.
Estimation of the parameters by OLS (ordinary least squares)
Ordinary least squares (OLS) or linear least squares is a method for estimating the unknown
parameters
in a linear regression model. This method minimizes the sum of squared error or residual.

These are called normal equations.

From equation (ii) we get:
Multiple Linear Regression Model
Definition
A linear regression model that involves more than one predictor variable is called
multiple linear regression model. In this case the response variable is a linear function of
two or more than two predictor variables. A multiple linear regression model with "p"
predictor variables is given by:

Standardized coefficients:
In statistics, standardized coefficients or beta coefficients are the estimates resulting from an
analysis carried out on independent variables that have been standardized so that their variances
are. Therefore, standardized coefficients refer to how many standard deviations a dependent
variable will change, per standard deviation increase in the predictor variable. Standardization of
the coefficient is usually done to answer the question of which of the independent variables have
a greater effect on the dependent variable in a multiple regression analysis, when the variables
are measured in different units of (for example, income measured in dollars and familysize
measured in number of individuals). A regression carried out on original (unstandardized)
variables produces unstandardized coefficients. A regression carried out on standardized
variables produces standardized coefficients.
Values for standardized and unstandardized coefficients can also be derived subsequent to either
type of analysis. Before solving a multiple regression problem, all variables (independent and
dependent) can be standardized. Each variable can be standardized by subtracting its mean from
each of its values and then dividing these new values by the standard deviation of the variable.
Standardizing all variables in a multiple regression yields standardized regression coefficients
that show the change in the dependent variable measured in standard deviations.
Advantages
Standard coefficients' advocates note that the coefficients ignore the independent variable's scale
of units, which makes comparisons easy.
Disadvantages
Critics voice concerns that such a standardization can be misleading; a change of one standard
deviation in one variable has no reason to be equivalent to a similar change in another predictor.
Some variables are easy to affect externally, e.g., the amount of time spent on an action. Weight
or cholesterol level are more difficult, and some, like height or age, are impossible to affect
externally.
Goodness of Fit (R2)
The Coefficient of Determination, also known as R Squared, is interpreted as the goodness of fit
of a regression. The higher the coefficient of determination, the better the variance that the
dependent variable is explained by the independent variable. The coefficient of determination is
the overall measure of the usefulness of a regression. For example, if R 2 is 0.95. This means that
the variation in the regression is 95% explained by the independent variable. That is a good
regression. Now, if the Coefficient of Determination, or R 2 ,is 0.50. Its means that the variation
in the regression is 50% explained by the independent variable. This is not a good regression.
Note that R2 lies between '0' and '1'. If R2 =1, it means that the fitted model explains 100% of the
variation in response variable 'Y'. On the other hand if R 2 =0, the model does not explain any of
the variation of 'Y'. The Coefficient of Determination can be calculated as the Regression sum of
squares, RSS, divided by the total sum of squares, SST
Coefficient of Determination = TSS
RSS
Mathematical formula of the coefficient of Determination is given as under:

Problems with the coefficient of Determination

First, let's consider that the Coefficient of Determination will increase as more independent
variables are added. It does not matter if those independent variables help to explain the variation
of the dependent variable, the R Square (Coefficient of Determination) will increase as more
independent variables are added. This brings us to the concept of Adjusted R Squared. The
adjusted R Squared takes into account only the independent variables that assist in explaining the
variation of the dependent variable.
The adjusted R Squared is different than the Coefficient of Determination, because the adjusted
R Squared will only increase if the independent variables are helpful in an explanatory nature.
The adjusted R Squared may be negative and must be lower than the original R Square (original
Coefficient of Determination).