For a policy maker, one objective of econometric models is to forecast the values of economic variables. Suppose, for example, that the head of the Department of Transportation wants to predict the rail petroleum consumption next year. To do so, she looks at petroleum consumption over the past twenty years, takes the average, and uses the average as an estimate of next year’s consumption.
(a) Why is this estimate likely to be an incorrect estimate of next year’s petroleum consumption?
(b) Show that estimating next year’s consumption by the average consumption over the past twenty years is comparable to the following regression model: Rail Petroleum Consumption = a + et (t = 1, … , 20) where ??is estimated by the method of least squares (hint: see footnote 1 in this chapter). According to this model, what impact will a $1 increase in the price of oil have upon rail petroleum consumption?
(c) On the advice of her economic staff, the policy maker revises her model to include price of oil: Rail Petroleum Consumption = a+ b(Price of Oil) + et (t = 1, … , 20)
In this case, what would be the policy head’s prediction of next year’s consumption of oil by railroads? And what effect will a $1 increase in the price of oil have upon rail petroleum consumption?
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