Question
Explain with illustrations the various steps involved in econometric methodology. What are the consequences of omitting a relevant explanatory variable in a regression model?
Answer :
Word Count : 1063
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Econometric methodology provides a systematic framework for using economic theory, mathematical models, and statistical techniques to analyze economic relationships using real-world data. The process begins with the formulation of an economic theory or hypothesis based on established principles or observed behavior. At this stage, the researcher specifies the nature of the relationship between variables in qualitative terms. For example, economic theory may suggest that consumption expenditure depends positively on disposable income and negatively on interest rates. This theoretical reasoning does not yet involve data but offers a logical structure that guides the entire analysis. The next step is the specification of an econometric model that translates the theoretical relationship into a mathematical form. This involves selecting the dependent variable, explanatory variables, and the functional form of the relationship. Continuing the earlier illustration, consumption may be expressed as a linear function of income and interest rate, along with a stochastic error term that captures unobserved influences such as preferences or measurement errors. The inclusion of the error term is crucial, as it acknowledges that economic relationships are rarely exact and are influenced by random and unmeasured factors. Once the model is specified, the third step involves the collection of relevant data. Data may be time-series, cross-sectional, or panel in nature, depending on the research question. For instance, a study on inflation and unemployment may use annual time-series data for a country, while an analysis of wage determination may rely on cross-sectional data from a household survey. The quality, reliability, and appropriateness of data are vital, as poor data can lead to misleading results even if the model is well specified. After data collection, the parameters of the econometric model are estimated using suitable statistical techniques. The most commonly used method is Ordinary Least Squares (OLS), which estimates the coefficients
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