Q1. Explain with illustrations the various steps involved in econometric methodology. What are the consequences of omitting a relevant explanatory variable in a regression model?
Key Points:
- Econometric methodology involves seven steps: theory, model specification, data, estimation, testing, forecasting, and policy.
- An econometric model includes a stochastic error term (u) to capture unobserved factors and real-world variability.
- OLS (Ordinary Least Squares) is a common technique used to estimate unknown parameters from collected data.
- Hypothesis testing evaluates the statistical significance and economic validity of estimated coefficients (e.g., MPC between 0 and 1).
Answer: Econometric methodology provides a systematic approach to empirically analyze economic phenomena, test theories, and forecast future trends. It typically involves a series of sequential steps, ensuring a robust and reliable analysis of economic relationships. The first step is the **Statement of Theory or Hypothesis**. This involves clearly formulating an economic theory or hypothesis that can be empirically tested. For instance, Keynesian theory suggests that current consumption (C) is primari...