ECON301_Handout_01_1213_02

6 sources of disturbance term the existence of the

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6. Sources of Disturbance Term The existence of the disturbance term is justified in three main ways. Instructor: Dr. Ozan ERUYGUR e-mail: [email protected] Lecture Notes 5
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ECON 301 (01) - Introduction to Econometrics I March , 2012 METU - Department of Economics (l) Omission of the influence of chance events [Not Omitted Variable Case!] Although income might be the major determinant of the level of consumption, it is not the only determinant. Other variables, such as the interest rate or liquid asset holdings may have a systematic influence on consumption. Their omission constitutes one type of specification error: the nature of the economic relationship is not correctly specified. In addition to these systematic influences, however, are innumerable less systematic influences (chance events) such as weather variations , taste changes , earthquakes , epidemics , strikes , etc. . Although some of these variables may have a significant impact on consumption and thus should definitely be included in the specified relationship, many have only a very slight, irregular influence: the disturbance is often viewed as representing the net influence of a large number of such small and independent causes (Kennedy, p.3). In any economic model, we want to include all the important and relevant explanatory variables in the model, so the error term u is a ‘‘ storage bin ’’ for unobservable and/or unimportant factors affecting level of consumption. As such, it adds noise that masks the relationship between X (income) and Y (consumption) (Griffith and Hill, p. 48). Note that, if we have omitted some important factor, made any other serious specification error (omitted variable case), then the assumption of ()0 t Eu = that we will see in the next section will be violated, which will have serious consequences (Griffith and Hill, p. 48) (2) Measurement error in Y [not in X !] It may be the case that the dependent variable Y cannot be measured accurately, either because of data collection difficulties or because it is inherently unmeasurable and a proxy variable must be used in its stead. The disturbance term can in these circumstances be thought of as representing this measurement error. Instructor: Dr. Ozan ERUYGUR e-mail: [email protected] Lecture Notes 6
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ECON 301 (01) - Introduction to Econometrics I March , 2012 METU - Department of Economics On the other hand, errors in measuring the independent variable(s) X (as opposed to the dependent variable Y) create a serious econometric problem and hence this situation cannot be stated as a source of the existence of the disturbance term. For example: (1) It may be that dependent variable Z is exactly related to X: 01 t ZX ββ = + but we observe t tt YZu = + , where t u denotes the measurement error. Thus: t Y Xu = ++ However, note that, this justification is less satisfactory since (as we will see later) measurement error in X, as stated above, can cause considerable problems.
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6 Sources of Disturbance Term The existence of the...

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