How do we pick the right model?
For now, we will focus on the issue of picking the regressors. The whole of econometrics considers other issues like functional form.
There are two ways to decide which regressors to include in a model.
- Economic Theory
- Testing
As we will see, the second criterion is not conclusive so models end up being judged (much like ice skaters) on a combination of technical merit and artistic impression. In the end, after exhaustive application of testing (technical merit), the result is often judged relative to economic theory (artistic impression). In particular, economic theory sometimes motivates modeling choices that are pretty much immune to testing results. (For example, including the price in a demand function.)
Level 2
Simulation Exercise