Econometric%20Methodology

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Econometric Methodology

• Chapter 3

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Step 1

• Review the literature and develop a theoretical
  model
• Keyword Search Databases (EBSCO, EconLit)
• Journal of Economic Literature (JEL)

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Sample Model

• Y Erie Mfg Employment
• X1 Total Employment
• X2 Exchange Rate
• X3 Economic Activity
• X4 Stock Market Activity

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Step 2

• Specify the models variables and functional form
• Measurement issues for Y and X
• Dummy variables
• Determine appropriate functional form

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Example Choosing Y

• Measuring Erie Manufacturing Employment (Y)
• Number of Manufacturing Employees
• Manufacturing/Total Employment
• Change in Manufacturing Employment
• Change in Manufacturing/Total Employment

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Options for the Dependent Variable
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Options for the X Variables
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Total Employment X1
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Expressed as Differences
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Exchange Rate X2

• U.S. versus a particular currency?
• Broad exchange rate index?
• Major currencies exchange rate index?
• Values in levels or differences?

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Economic Activity X3

• Level or Difference in
• PA Manufacturing Employment
• U.S. Manufacturing Employment
• Regional or National Unemployment Rate
• Index of Industrial Production
• Capacity Utilization Rate
• Real GDP (quarterly)

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Stock Market X4

• Level or Difference in
• SP 500 Stock Index
• Dow Jones 30 Stock Index
• Price/Earnings Ratio (SP500)
• NASDAQ Stock Index

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Dummy Variables

• Measure qualitative characteristics or events

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Dummy Example

• To measure the impact of the 9/11/2001
  attacks, use a dummy for September through
  November of 2001.

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Determining if there is a Relationship between Y
and X

• Scatter Plots

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Determining if there is a Relationship between Y
and X

• Correlation Coefficient

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Correlation Coefficient

• r 0 (no relationship between Y and X)
• r gt 0 (positive relationship)
• r lt 0 (negative relationship)
• r ? 1.0 (strong relationship)

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Example from EViews
ERMFG SP500 USTOT XCHBRD
ERMFG 1.000000 -0.562928 -0.737109 -0.579849
SP500 -0.562928 1.000000 0.943997 0.873023
USTOT -0.737109 0.943997 1.000000 0.925830
XCHBRD -0.579849 0.873023 0.925830 1.000000
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Functional Form of Equation

• Linear
• Quadratic

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Step 3

• Hypothesize the expected signs of the variable
  relationships
• Base the decision on theory
• Assists in validating the model

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Example

• Y Erie Mfg Employment
• X1 Total Employment
• X2 Exchange Rate
• X3 Economic Activity
• X4 Stock Market Activity

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Step 4

• Collect the data
• Use sufficient data to maximize degrees of
  freedom (d.f.) for the model
• d.f. n-k-1
• Larger data sets allow and (-) errors to offset
  maximizing model accuracy

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Special Considerations with Time-Series Data

• More data the better not necessarily true for
  T-S data
• Data far in the past may no longer be relevant
• The issue of spurious regression
• Two variables may trend together over time
  because they are both affected by a third
  variable
• Consider use of real instead of nominal
  variables when possible

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Step 5

• Estimate evaluate the regression model
• Estimate ß values using OLS or other method
• Validate the model to determine usefulness

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Forms of Validation

• Testing sign of slope coefficients
• Goodness-of-Fit (sy,x, R2, Adj-R2)
• Testing for significance of relationship (t)
• Testing model (OLS) assumptions
• Testing for correct functional form

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Step 6

• Documenting the results
• Make results clear to the non-technical reader
• Include sufficient statistical evidence of model
  usefulness
• Thoroughly document variable definitions and data
  sources