1
The Methodology of Empirical
Econometric Modeling:
Applied Econometrics Through
the Looking-Glass
David F. Hendry
Abstract
This chapter considers the methodology of empirical econometric modeling. The historical back-
ground is reviewed from before the Cowles Foundation to the rise of economic theory-based
econometrics and the decline of data concerns. A theory for “Applied Econometrics” suggests
reinterpreting the role of economic theory given that the intrinsic non-stationarity of economic
data vitiates analyses of incomplete specifications based onceteris paribus. Instead, the many steps
from the data-generation process (DGP) through the local DGP (LDGP) and general unrestricted
model to a specific representation allow an evaluation of the main extant approaches. The poten-
tial pitfalls confronting empirical research include inadequate theory, data inaccuracy, hidden
dependencies, invalid conditioning, inappropriate functional form, non-identification, parameter
non-constancy, dependent, heteroskedastic errors, wrong expectations formation, misestimation
and incorrect model selection. Recent automatic methods help resolve many of these difficulties.
Suggestions on the teaching of “Applied Econometrics” are followed by revisiting and updating the
“experiment in applied econometrics” and by automatic modeling of a four-dimensional vector
autoregression (VAR) with 25 lags for the numbers of bankruptcies and patents, industrial output
per capita and real equity prices over 1757–1989.
1.1 Introduction 4
1.2 What is “Applied Econometrics”? 6
1.3 Historical background 7
1.3.1 Pre-Cowles 7
1.3.2 War and post-war 8
1.3.3 The rise of economic theory-based econometrics 10
1.3.4 The decline of data concerns 11
1.4 A theory of Applied Econometrics 12
1.4.1 Economic theory 14
1.4.1.1 Non-stationarity andceteris paribus 16
1.4.1.2 Long-run change 18
1.4.2 Incomplete specifications 21
1.4.2.1 From DGP to LDGP 22
1.4.2.2 From LDGP to general unrestricted model 24
1.4.2.3 From the general to the specific 25
1.4.2.4 Implications 26
1.4.2.5 Evaluating the three main approaches 28
3