UNDERSTANDINGMODERNECONOMETRICSYongmiaoHongDepartmentofEconomicsandDepartmentofStatisticalScienceCornellUniversity,U.S.A.andWangYananInstituteforStudiesinEconomics,XiamenUniversity,ChinaEmail:yh20@cornell.eduFebruary2006ThispaperiswrittenbasedonmyteachingexperiencesatCornellUniversity,HongKongUniversityofScienceandTechnology,RenminUniversityofChina,ShandongUniversity,ShanghaiJiaoTongUniversity,TsinghuaUniversityandXiamenUniversity.IthankYingFangandBaoliangLiforhelpfulcommentsandsuggestions.FinancialsupportsfromtheChangjiangScholarshipoftheChineseMinistryofEducationandfromtheNationalScienceFoundationofChinaareacknowledged.ABSTRACTEconometricshasbecomeanintegralpartoftraininginmoderneconomicsandbusiness.Togetherwithmicroeconomicsandmacroeconomics,econometricshasbeentaughtasoneofthethreecorecoursesinmostundergraduateandgraduateeconomicprogramsinNorthAmerica.InChina,theimportanceofeconometricshasbeenincreasinglyrecognizedandeconometrictoolsandmethodshavebeenwidelyemployedinempiricalstudiesonChineseeconomy.However,thereisasubstantialgapbetweenChineseeconometricsandmoderneconometrics.TherestillexistsconceptualmisunderstandingofeconometricsamongChineseeconomicprofession,andthereexistsomeproblemsinChineseeconometricteachingandresearch.Thispaperdiscussesthephilosophyandmethodologyofeconometrics,therolesandlimitationsofeconometrics,andthedi¤erencesbetweeneconometricsandmathematicaleconomicsaswellasmathematicalstatistics.Avarietyofillustrativeeconometricexamplesaregiven,whichcovervarious eldsofeconomicsand nanceThepaperalsosuggestshowtoimproveandstrengtheneconometricteachingandresearchinChina.KeyWords:Econometrics,mathematicalEconomics,Mathematicalstatistics,Quantitativeanalysis,Science,Uncertainty.1IntroductionEconometricshasbecomeanintegratedpartofteachingandresearchinmoderneconomicsandbusiness.TheimportanceofeconometricshasbeenincreasinglyrecognizedinChina.Inthisreviewarticle,Iwilldiscussthephilosophyandmethodologyofeconometricsineconomicresearch.First,Iwilldiscussthequalitativefeatureofmoderneconomics,andthedi¤erencesbetweeneconometricsandmathematicaleconomicsaswellasmathematicalstatistics.ThenIwillfocusontheimportantrolesofeconometricsasafundamentalmethodologyineconomicresearchviaavarietyofillustrativeeconomicexamplesincludingtheconsumptionfunction,marginalpropensitytoconsumeandmultipliers,rationalexpectationsmodelsanddynamicassetpricing,theconstantreturntoscaleandregulations,evaluationofe¤ectsofeconomicreformsinatransitionaleconomy,thee¢cientmarkethypothesis,modelinguncertaintyandvolatility,anddurationanalysisinlaboreconomicsand nance.Theseexamplesrangefromeconometricanalysisoftheconditionalmeantotheconditionalvariancetotheconditionaldistributionofeconomicvariablesofinterest.Iwillalsodiscussthelimitationsofeconometrics,duetothenonexperimentalnatureofeconomicdataandthetime-varyingnatureofeconometricstructures.Finally,problemsincurrenteconometricteachingandresearchinChinaarepointedout,andpossiblesolutionsareproposed.2QuantitativeFeaturesofModernEconomicsModernmarketeconomiesarefullofuncertaintiesandrisk.Wheneconomicagentsmakeadeci-sion,theoutcomeisusuallyunknowninadvanceandeconomicagentswilltakethisuncertaintyintoaccountintheirdecision-making.Moderneconomicsisastudyonscarceresourcealloca-tionsinanuncertainmarketenvironment.Generallyspeaking,moderneconomicscanberoughlyclassi edintofourcategories:macroeconomics,microeconomics, nancialeconomics,andecono-metrics.Ofthem,macroeconomics,microeconomicsandeconometricsnowconstitutethecorecoursesformosteconomicdoctoralprogramsinNorthAmerica,while nancialeconomicsisnowmainlybeingtaughtinbusinessandmanagementschools.MostdoctoralprogramsineconomicsintheU.S.emphasizequantitativeanalysis.Quantita-tiveanalysisconsistsofmathematicalmodelingandempiricalstudies.Tounderstandtherolesofquantitativeanalysis,itmaybeusefulto rstdescribethegeneralprocessofmoderneconomicresearch.Likemostnaturalscience,thegeneralmethodologyofmoderneconomicresearchcanberoughlysummarizedasfollows:Step1:Datacollectionandsummaryofempiricalstylizedfacts.Theso-calledstylizedfactsareoftensummarizedfromobservedeconomicdata.Forexample,inmicroeconomics,1awell-knownstylizedfactistheEngelscurve,whichcharacterizesthattheshareofacon-sumersexpenditureonacommodityoutofherorhistotalincomewilleventuallydeclineastheincomeincreases;inmacroeconomics,awell-knownstylizedfactisthePhillipsCurve,whichcharacterizesanegativecorrelationbetweentheinationrateandtheunemploymentrateinanaggregateeconomy;andin nance,awell-knownstylizedfactabout nancialmarketsisvolatilityclustering,thatis,ahighvolatilitytodaytendstobefollowedbyanotherhighvolatilitytomorrow,alowvolatilitytodaytendstobefollowedbyanotherlowvolatilitytomorrow,andbothalternateovertime.Theempiricalstylizedfactsoftenserveasastartingpointforeconomicresearch.Forexample,thedevelopmentofunitrootandcointegrationeconometricswasmainlymotivatedbytheempiricalstudyofNelsonandPlossor(1982)whofoundthatmostmacroeconomictimeseriesareunitrootprocesses.Step2:Developmentofeconomictheories/models.