Academic journal article Federal Reserve Bank of St. Louis Review

Assessing Applied Econometric Results

Academic journal article Federal Reserve Bank of St. Louis Review

Assessing Applied Econometric Results

Article excerpt

IT IS A GREAT HONOR to be asked to participate in this conference to celebrate the work of Ted Balbach, who has long upheld the standard of relevant, independent, intelligible economic studies at the Federal Reserve Bank of St. Louis.

My invitation to this conference asked for a philosophical paper about good econometric practice. I have organized my views as follows. Part I of the paper defines the concept of an ideal econometric model and argues that to tell whether a model is ideal, we must test it against new data--data that were not available when the model was formulated. Such testing suggests that econometric models are not ideal, but are approximations to a changing reality. Part I closes with a list of desirable properties that we can realistically seek in econometric models. Part II is a loosely connected set of comments and criticisms about several econometric techniques. Part III discusses methods of evaluating economietric models by means of their forecasts and summarizes some results of such evaluations, as proposed in part I. Part IV resurrects an old, plain-vanilla equation relating monetary velocity to an interest rate and tests it with more recent data. The rather remarkable result is that it still does about as well today as it did nearly 40 years ago. Part V is a brief conclusion.

HOW TO RECOGNIZE AN IDEAL MODEL IF YOU MEET ONE

The Goal of Research and the Concept of an Ideal Model

The goal of economic research is to improve knowledge and understanding of the economy, either for their own sake, or for practical use. We want to know how to control what is controllable, how to adapt to what is uncontrollable, and how to tell which is which. The goal of economic research is analogous to the prayer of Alcoholics Anonymous (I do not suggest that economics is exactly like alcoholism)--"God grant me the serenity to accept the things I cannot change; the courage to change the things I can; and the wisdom to know the difference."

The goal of applied econometrics is quantitative knowledge expressed in the form of mathematical equations.

I invite you to think of an ideal econometric model, by which I mean a set of equations, complete or incomplete, with numerically estimated parameters, that describes some interesting set of past data, closely but not perfectly, and that will continue to describe all future data of that type.

The Need for Testing Against New Data

How can we tell whether we have found an ideal econometric model? We can certainly tell how well a model describes a given set of past data. (We will discuss what is meant by a good description later). Suppose we have a model in 1992, with estimated parameters, that closely describes past data for 1950--91. To tell whether it is the ideal model we seek, we must try it with future data. Suppose that after three years we try the model with data for 1992--94, and it describes them closely also. Still, in 1995 all we will be sure of is that it describes data closely for a past period, this time from 1950 through 1994. In principle we can never be sure we have found an ideal model because there will always be more future data to come, so we will never be able to say that a model is ideal. The longer the string of future data that a model describes closely, however, the more confidence we have in it.

Is this only a matter of the amount of data that the model describes, or is there something else involved? I argue that something else is involved.

Suppose again that in 1992 we have a model that closely describes an interesting data set for the past period 1950--91. Consider the following three methods, shown in figure 1, by which this model might have been obtained and by which its ability to describe data for 1950 through 1991 might have been assessed:

[CHART OMITTED]

1. It was formulated in 1992, and fitted to data

for the entire period 1950--91. …

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