What is 'Econometrics'

Econometrics is the application of statistical and mathematical theories in economics for the purpose of testing hypotheses and forecasting future trends. It takes economic models, tests them through statistical trials and then compare and contrast the results against real-life examples. Econometrics can therefore be subdivided into two major categories: theoretical and applied.

BREAKING DOWN 'Econometrics'

Econometrics uses a combination of economic theory, math and statistical inferences to quantify and analyze economic theories by leveraging tools such as frequency distributions, probability and probability distributions, statistical inference, simple and multiple regression analysis, simultaneous equations models and time series methods.

An example of a real-life application of econometrics would be to study the income effect. An economist may hypothesize that as a person increases his income, his spending will also increase. The hypothesis can be tested and proven using econometric tools like frequency distributions or multiple regression analysis.

Econometrics was pioneered by Lawrence Klein, Ragnar Frisch and Simon Kuznets. All three won the Nobel Prize in economics for their contributions.

The Methodology of Econometrics

Econometrics uses a fairly straightforward approach to economic analysis. The first step to econometric methodology is to look at a set of data and define a specific hypothesis that explains the nature and shape of the set. The explanatory variables being analyzed are specified during this step; the relationship between the dependent and independent variables are also specified. This stage of econometrics relies heavily on economic theory that will be tested for validity in the later stages.

The second step in the methodology is to choose the specific statistical tool or model that will test the hypothesis being posed. An effective model outlines a specific mathematical relationship between the explanatory variable and the dependent variable being tested. The most common relationship is linear, meaning that any change in the explanatory variable will have a positive correlated with the dependent variable. This is why the multiple linear regression model is the most used tool in econometrics, because it expresses relationships linearly.

The third step is the most passive in that all the data is imputed into a econometric software program. The program then uses the statistical model of choice to estimate the results, using the economic data provided.

The fourth and final step is the most important in proving the validity of a hypothesis. Economists will take the results from the program and conduct a small test. The test will help the economist understand whether or not the model resulted in good predictions or not. If the economist finds what he expected than he may safely assume that the hypothesis is true. If, however, the economist does not find what he expected, new hypotheses or inferences are needed.

  1. Mathematical Economics

    Mathematical economics is a form of economics that relies on ...
  2. Lawrence Klein

    An American economist and winner of the 1980 Nobel Memorial Prize ...
  3. Ragnar Frisch

    A Norwegian economist and joint winner in 1969 of the very first ...
  4. Hypothesis Testing

    A process by which an analyst tests a statistical hypothesis. ...
  5. Trygve Haavelmo

    A Norwegian economist who won the 1989 Nobel Memorial Prize in ...
  6. Error Term

    A variable in a statistical and/or mathematical model, which ...
Related Articles
  1. Investing

    The Basics Of Business Forecasting

    Discover the methods behind financial forecasts and the risks inherent when we seek to predict the future.
  2. Financial Advisor

    How Do Companies Forecast Oil Prices?

    Read about the different forecasting methods that businesses use to predict future crude oil prices, and why it's so difficult to guess correctly.
  3. Trading

    4 Ways To Forecast Currency Changes

    Whether you are a business or a trader, having an exchange rate forecast to guide your decisions helps to minimize risks and maximize returns.
  4. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  5. Trading

    The Linear Regression Of Time and Price

    This investment strategy can help investors be successful by identifying price trends while eliminating human bias.
  6. Insights

    Why Can't Economists Agree?

    There are many reasons why economists can be given the same data and come up with entirely different conclusions.
  7. Investing

    7 controversial investing theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  8. Trading

    Build a Profitable Trading Model In 7 Easy Steps

    Trading models can provide a powerful tool for building profit. Traders can use and customize existing trading models or build an original model. This article provides seven steps to building ...
  9. Personal Finance

    Jump Start Your Financial Career With The BAT

    The BAT is quickly becoming known in the job market as a tool to provide a window into the minds of those seeking financial jobs.
  10. Investing

    The Difference Between Finance And Economics

    Learn the differences between these closely related disciplines and how they inform and influence each other.
  1. What are some of the more common types of regressions investors can use?

    Learn about the most common types of regressions investors use to model asset prices including linear regressions and multiple ... Read Answer >>
  2. How can I create a linear regression in Excel?

    Learn the steps involved in creating a linear regression chart in Microsoft Excel. Read Answer >>
  3. How can I use a regression to see the correlation between prices and interest rates?

    Learn how to use linear regression to calculate the correlation between stock prices and interest rates by taking the square ... Read Answer >>
  4. What does a strong null hypothesis mean?

    Find out what null hypothesis is and why it is important to the scientific method. See how statisticians and economists use ... Read Answer >>
  5. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  6. How can you calculate correlation using Excel?

    Find out how to calculate the Pearson correlation coefficient between two data arrays in Microsoft Excel through the CORREL ... Read Answer >>
Hot Definitions
  1. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  2. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  3. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  4. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  5. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
  6. Restricted Stock Unit - RSU

    A restricted stock unit is a compensation issued by an employer to an employee in the form of company stock.
Trading Center