principles of econometrics

MAE356: Analytical Methods in Economics

and FinanceTrimester 1, 2014

Lecture 1, Week 1Geelong

Dr. IKM Mokhtarul Wadud

• 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.

Teaching Staff and Academic QueriesGeelong, Off-campus Coordinator and Unit chairDr. IKM Mokhtarul WadudGeelong, ad3.127; Tel. 03 522 72051mokhtarul.wadud@deakin.edu.au

Burwood CoordinatorsDr. Aydogan UlkerBurwood, lb4.421; Tel 03 92443040aydogan.ulker@deakin.edu.au

Dr. Cahit GuvenBurwood, lb4.410; Tel. 92445087cahit.guven@deakin.edu.au

Warrnambool CoordinatorDr Scott SalzmanWarrnambool, J429; Tel. 03 55 633 070scotts@deakin.edu.au

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

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

• 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 cQ f P P P INC

( , , )s c fQ f P P P

• 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

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

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

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

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

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

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.

Table 1.1 Annual GDP of Real 2005 Dollars

Figure 1.1 Real U.S. GDP, 1980–2008

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.

Table 1.2 Cross Section Data: CPS August 2009

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

Table 1.3 Panel Data from Two Rice Farms

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

Rules of Summation, Probability and Random Variables: Preliminaries

Summation

Example using summations:

∑𝑖=1

4

𝑥 𝑖=𝑥1+𝑥2+𝑥3+𝑥4

∑𝑖=1

3

𝑥 𝑖 𝑦 𝑖=𝑥1 𝑦1+𝑥2 𝑦2+𝑥3 𝑦3

∑𝑖=3

5

𝑥 𝑖 𝑦 𝑖+1=𝑥3 𝑦4 +𝑥4 𝑦5+𝑥5 𝑦6

∑𝑖=3

5

(𝑥𝑖+𝑦 𝑖 )=∑𝑖=3

5

𝑥 𝑖+∑𝑖=3

5

𝑦 𝑖=𝑥3+𝑥4 +𝑥5+𝑦3+𝑦4+𝑦5

∑𝑖=1

3

5 𝑖=5+5+5=3∗5=15

∑𝑖=1

2

6 𝑥𝑖=6∑𝑖=1

2

𝑥 𝑖=6(¿ 𝑥1+𝑥2)¿

∑𝑖= 2

4

∑𝑗=1

2

𝑥 𝑖 𝑦 𝑗=¿ 𝑥2 𝑦1+𝑥2 𝑦 2+𝑥3 𝑦1+𝑥3 𝑦2+𝑥4 𝑦1+𝑥4 𝑦2 ¿

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) = 1X = 4 and y = 1

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.