Methodology of Econometrics

Specification of Econometric Models

• The most important and difficult stage of econometric research, where errors are likely to occur
• Common reasons for incorrect specification: • Imperfections and looseness of statements in economic theories • Limitations of knowledge of operative factors in a particular case • Data requirements obstacles in estimating large models

Common Specification Errors

• Omissions of important variables from the function
• Omissions of equations (e.g., in simultaneous equations models)
• Mistaken mathematical form of the functions

Estimation of the Model

• A technical stage requiring knowledge of econometric methods, assumptions, and economic implications
• Activities involved: • Gathering data on variables included in the model • Examining identification conditions of the function (especially for simultaneous equations models) • Examining aggregation problems involved in the variables • Examining correlation between explanatory variables (multicollinearity) • Choosing appropriate econometric techniques for estimation (e.g., OLS, MLM, Logit, Probit)

Methodology of Econometrics

• Concerned with measuring parameters of economic relationships and predicting economic variables
• Proceeds along the following stages: • Specification of the model • Estimation of the model • Evaluation of the estimates • Evaluation of the forecasting power of the estimated model

Specifying the Model

• Expressing relationships between economic variables in mathematical form
• Involves determining: • Dependent and independent variables • A priori theoretical expectations about parameter size and sign • Mathematical form of the model (number of equations, specific form, etc.)
• Specification is based on economic theory and available information related to the phenomenon being studied.