Frequently Asked Questions about Econometrics

What is Econometrics?

The term econometrics is made of economics + metrics, which means “economic measurement.” Econometrics is an amalgam of three subjects: mathematics, economics, and statistics. Econometrics is the application of statistical tools to economic data which is expressed in mathematical symbols/models, to give empirical content to economic relationship. Although it is a combination of three subjects, it is completely distinct from each one of these subjects. More precisely, it is a special type of economic analysis and research in which the general economic theory, formulated in a mathematical form, is combined with empirical measurement of economic phenomena through statistical tools.  Statistical methods are specifically adapted to the peculiarities of economic phenomena.

According to Stock and Johnson “econometric methods are used in many branches of economics, including finance, labour economics, macroeconomics, microeconomics, and economic policy.” Economic policy decisions are rarely made without econometric analysis to assess their impact.

Is Econometrics Hard?

This is a million dollar question. Like every other subjects, in the beginning Econometrics is neither easy nor difficult. It’s your professor who has not been able to generate interest for this subject; generation after generation of professors teach it in a mechanical way. You need a basic foundation of three subjects; absence of familiarity in any one subject will keep you in the dark. If you do not have the basic mathematics knowledge you can refer to the appendix section of every econometrics textbook and read Statistics Without Tears (link for the book – ), before picking up any course in Econometrics. Same is for students not having any statistics background. If you are from mathematics and statistics background but economics, you should cover intermediate microeconomics by Hall Varian. You can buy it from here ( ) and Macroeconomics by Gregory Mankiew. Buy it from here ( ).

How many branches of Econometrics are there?

Econometrics is divided into theoretical econometrics and applied econometrics. While theoretical econometrics includes the development of appropriate methods for the measurement economic relationships which are not meant for controlled experiments conducted inside the laboratories, applied econometrics includes the application of econometric method to specific branches of economic theory and problems like demand and supply, production, investment, consumption, etc. It involves data analysis and forecasting.

How different Economics is from Econometrics?

Economics is a broad subject and Econometrics is a part of it. If you are the student of economics you may come across a situation to predict the GDP for the next quarter, or increase in tax revenue due to a change in income-taxation slab. Here, you can use the economics theory about GDP composition, their rate of growth for the last quarters, trend and you look at the macro policy framework, fiscal policy and come up with the forecasting. To forecast you used Economics background and econometric methods. Here, we use Econometrics as the vehicle by which economics theories claim scientific validity.

I am confused about Economics, Economic Theory and Econometrics?

Economics as a social science subject concerns with the study of resource allocation, distribution and consumption; of capital and investment; and of management of the factors of production. In contrast, Economic theory makes statements or hypotheses that are mostly qualitative in nature. For example, law of demand in microeconomic theory states that, other things remaining the same, there is an inverse relationship between quantity demanded of a product and its price. An increase in the price of a commodity is expected to decrease the quantity demanded of that commodity. Thus, economic theory postulates a negative or inverse relationship between the price and quantity demanded of a commodity. But the theory itself does not provide any numerical measure of the relationship between the two; that is, it does not tell by how much the quantity will go up or down as a result of a certain change in the price of the commodity. It is the job of the econometrician to provide such numerical estimates. Stated differently, econometrics gives quantifies most economic theory.

Ok, I got it. But what about Financial Econometrics, Micro Econometrics? Are they branches of Econometrics too?

Just like health economics – you study demand and supply side in health sector, labour economics industrial economics, agricultural economics. – these are all extension of the subject ‘Economics’. Microeconomic tools and principals have been applied to these niches of study. Similarly, econometrics method have invaded the finance subjects just like Economics is in use in Engineering Economics or Managerial Economics.

I see. What do you say about mathematical economics and Econometrics?

Mathematical economics studies economic theory in terms of mathematical symbols. Thus it employs mathematical symbolism to showcase the economic relationship in exact form. Econometrics presupposes the expression of economic relationship in mathematical form but does not assume the exactness of the economic relationships. Econometric methods are in built with the randomness of the behavioural pattern in economic theory.

Financial Economics Vs Financial Econometrics Vs Econometrics?

 “Financial economics is the economics of financial assets such as stocks, bonds, derivatives. Pricing of financial assets, financing of corporations and financial intermediation (banks) are its main focus areas. It doesn’t deal with goods and services that broader economics deals with.

Financial Econometrics basically utilizes Financial Market Data to build mathematical and statistical financial models and later analyse the statistical significance and make predictions. It is generally used by risk managers and economists to predict (forecast) and study the return market characteristics. GARCH Models and other Time Series Models are used to study the pattern of Return Volatility Clusters, Tail Dependence Events, Covariance, Heavy Tails Phenomenon, Serial Correlations, Mean Reversions, Random Walks, White Noise Disturbances, Risk Migrations, Contingent Claim Volatility Smiles, Probability of Defaults, Credit Rating Matrix Volatility, Value at Risk, Deviations from Normality and other prices of asset classes. Model Validation, Cross Validation and Selection are also topics of interest that fall within the domain of Financial Econometrics.”

Thus, we can see the difference between the content of financial econometrics, financial economics. Econometrics methods are applied to financial econometrics. Financial Econometrics as field is more dependent on Time Series (inter-temporal) Analysis using data spread over a look back period. Simulation Models such as Monte Carlo Simulations are also an integral part of the Financial Econometrics Curriculum which is a part of Advanced Econometrics curriculum.

In financial econometrics the mostly used type of data is time series data, while in applied econometrics the mostly used type of data are cross sectional data, panel data and pooled cross sectional data.

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Quantitative Finance Vs Econometrics?

Quantitative Finance (QF) is an application of Quantitative Financial Methods in the fields of Investment Banking, Retail banking, Corporate Finance, Enterprise and Financial Risk Management, Insurance, Asset Management, Model Development and Validation, and Pricing of Transactions.

Although most of the QF graduates study both Econometric Methods and Financial Econometrics separately, but it also focuses more on the stochastic processes, and the computing and programming methods executed with special reference to derivative pricing and hedging models.

Is econometrics same as statistics?

Econometrics is interesting because it provides the tools to enable us to extract useful information about important economic policy issues from the available data.

Statistical methods have been adapted to the problems of economics, which are called econometrics methods. These methods are adjusted so that they become appropriate for the measurement of economic relationships which are random.

Mathematical Statistics Vs Economics Statistics Vs Econometrics

Mathematical statistics deals with methods of measurement, developed on the basis of controlled experiments in laboratories. This controlled experiment is not possible for economic phenomena. We cannot change only income, keeping prices and tastes other factors as income is an endogenous variable having impact on the other factors. In physics, and some other sciences we can see usage of mathematical statistics.

Economics statistics gathers empirical data, records them, tabulates them and describe the pattern in their development over time and detect some relationship between various magnitudes. This explains the descriptive aspect of economics without providing explanations for the development of the various variables.

Econometrics instead uses adapted statistical methods, specify the randomness what are supposed to operate in the real world and enter into the determination of the observed data, so that the latter can be interpreted as a random sample to which methods of statistics can be applied.

What are the goals of econometrics ?

There are three goals of econometrics.

a. analysis of economic theory – obtain empirical evidence to test the explanatory power of economic theories to decide how well they explain the observed behaviour of the economic units

b. supplying numerical estimates of the coefficients of economic relationships for policy decision making – helps to compare the effects of alternative policy decisions.

c. forecasting using the numerical estimates of the coefficients in order to forecast the future values of the economic magnitudes – helps the policy makers judge whether it is necessary to take any measures in order to influence the relevant economic variables.

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