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## Econometric

#### Definition

“Econometric means economic measurement. Econometrics is social science in which tools of mathematics, statistics, and economics theory apply to analyze the economic phenomena. It is the application of mathematics, statistics, and economics”.

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### Methodology of Econometrics

How we study the econometric to analyze the economic theory. What is needed is a methodology, i.e. a step-by-step procedure. The details are given below.

1. Statement of the theory / Economic Problem

2. Convert this into a mathematical model.

3. Transform into a statistical model.

4. Data requirement

5. Estimation

6. Hypothesis testing

7. Forecasting/Prediction

8. Use for Policy recommendation.

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Statement of the theory / Economic Problem

A theory should have a prediction. In statistics and econometrics, we also speak of the hypothesis. One example is the marginal propensity to consume (MPC) proposed by Keynes.

Y = F(X)

Where

Y =Consumption and X = Income

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### Specification of the Mathematical Model

This is where the algebra enters. We need to use mathematical skills to produce an equation. Assume a theory predicting that income increases consumption. In economic terms, there is a positive relationship b/w income and consumption.

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The equation is:

Where Y is the variable for consumption and is a constant and is the coefficient of income, and X is a measurement of income. We also call intercept and a slope coefficient. Normally, we would expect both and to be positive.

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### Specification of the Econometric Model

Here, we assume that the mathematical model is correct but we need to account for the fact that it may not be so. We add an error term, u to the equation above. It is also called a random (stochastic) variable. It represents other nonquantifiable or unknown factors that affect Y. It also represents miss measurements that may have entered the data. The econometric equation is: (Economic Books PDF)

The error term is assumed to follow some sort of statistical distribution. This will be important later on. Economic Books PDF

### Obtain Data

We need data for the variables above. This can be obtained from government statistical agencies and other sources. A lot of data can also be collected on the Internet these days. But we need to learn the art of finding appropriate data from the ever-increasing huge loads of data

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### Estimation of the model

Here, we quantify and, i.e. we obtain numerical estimates. This is done by a statistical technique called regression analysis. (Economic Books PDF)

### Hypothesis Testing

Now we go back to the part where we had an economic theory. The prediction was that income is good for consumption. Does the econometric model support this hypothesis? What we do here is called statistical inference (hypothesis testing). Technically speaking, the coefficient should be greater than 0. (Economic Books PDF)

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### Forecasting

If the hypothesis testing was positive, i.e. the theory was concluded to be correct, we forecast the values of the wage by predicting the values of education. For example, how much would someone earn for an additional year of schooling? If the X variable is the years of schooling, the coefficient gives the answer to the question.

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