1. 1. The general linear model All econometric research is based on a set of numerical data relating to certain economic quantities, and makes infer- ences from the data about the ways in which these quanti- ties are related (Malinvaud 1970, p. 3). The linear relation is frequently encountered in applied econometrics. Let y and x denote two economic quantities, then the linear relation between y and x is formalized by: where {31 and {32 are constants. When {31 and {32 are known numbers, the value of y can be calculated for every given value of x. Here y is the dependent variable and x is the explanatory variable. In practical situations {31 and {32 are unknown. We assume that a set of n observations on y and x is available. When plotting the ob- served pairs (x l' YI)' (x ' Y2)' . . ., (x, Y n) into a diagram with x 2 n measured along the horizontal axis and y along the vertical axis it rarely occurs that all points lie on a straight line. Generally, no b 1 and b exist such that Yi = b + b x for i = 1,2, . . ., n. Unless 2 l 2 i the diagram clearly suggests another type of relation, for instance quadratic or exponential, it is customary to adopt linearity in order to keep the analysis as simple as possible.