Specifying a Regression Model: Estimating the Marginal Propensity to Consume A model begins with a theoretical proposition about some

aspect of the economy.1 The theory specifies a set of relationships among variables. Familiar examples are demand equations, production functions and macroeconomic models. The empirical investigation provides estimates of unknown parameters in the model, such as elasticities or the marginal propensity to consume. The model often attempts to measure the validity of the propositions against what is observed in the data. An Example In 1936, Keynes wrote in his General Theory: We shall therefore define what we shall call the propensity to consume as the functional relationship between a given level of income and the expenditure on consumption out of that level of income. The amount that the community spends on consumption depends (i) partly on the amount of its income, (ii) partly on other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it The fundamental psychological law upon which we are entitled to depend with great confidence, both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income. (That is: dPCE/dDPI is positive and less than one). The theory postulates a stable relationship between personal consumption expenditure and real disposable income: PCE = f(DPI) and claims that the marginal propensity to consume is between 0 and 1: The model is
PCE = 0 + 1 DPI +

0<

dPCE <1 dDPI

Monthly data on real disposable personal income (Keynes Income Variablethe independent variable) and personal consumption expenditures (Keynes' Consumption Variablethe dependent variable) in 1996 dollars was obtained from the Federal Reserve Bank of St. Louis.2 The data are saved as simple regression data in www.fordham.edu/economics/combs. There are three variables in this data set. Variable Name DATE DPI PCE Definition the year and the month. real disposable income in billions of dollars, in 1996 dollars (independent variable, x) real personal consumption expenditures in billions of dollars, in 1996 dollars (dependent variable, y)

The DATE variable ranges from 1959.1 to 2000.4. The first four digits represent the year, the digit following the decimal place refers to the quarter. For example the first quarter of 2000 is 2000.1.
1

This project is based on William H. Greene, Econometric Analysis (New York: MacMillan Publishing Co.) pp. 141-142. These notes were obtained from Professor Linda Leightons notes. 2 http://www.stls.frb.org/fred/data/gdp.html

1. Go to http://www.stls.frb.org/fred/data/gdp.html and check out the data sources. 2. Go to www.fordham.edu/economics/combs, and select simple regression data. Save this data set to your floppy disk in drive A. 3. In this example the dependent variable (Y) is the personal consumption variable (PCE), and the independent variable (X) is the disposable income variable (DPI). 4. Obtain summary statistics for your sample. Select Tools/Data Analysis/Descriptive Statistics. Select (highlight) the DPI values for your time period for the Input range and select the expenditure values for your time period as well. Check the option Labels in first row. Place a check mark for the Summary Statistics option. Press OK. 5. Obtain a plot of your two variables. Highlight the values for DPI and for PCE. Select Insert/Chart from the menu. For Chart type, select scatter. Click on Next. In Step 2, press Next. In Step 3, enter a title for your chart, and appropriate labels for the x and y-axes. Still in Step 3, click on Legend and remove the check for a legend. Press Next. In Step 4 select the option to have the chart placed on a new sheet and in the textbox for the sheet name, enter Chart. Press Finish. 6. A line can be fitted through the data of a chart. Select Chart/Add line from the menu. The default regression is a simple linear regression line. Click on the Option tab and place checks before the options to display the equation on a chart and display the r-squared value on the chart. Press OK. If it is difficult to see your equation, click on the equation and then place the cursor arrow on the box, click on the mouse key and drag the box to a more visible position. 7. We would like to have more statistics to judge the merits of our regression line. Click on the worksheet tab for the data (Keynes). Select Tools/Data Analysis/Regression. Your consumption variable, PCE, is the dependent variable (Y) and the disposable personal income variable, DPI, is the independent variable, (X) measuring income. Enter the Input Y range (PCE) and the Input X range (DPI). Press OK. Click on the new worksheet for the regression results. Widen the columns where necessary. (note: ANOVA results appear with your regression results). 8. Find the correlation between DPI and PCE. Use Tools/Data Analysis/Correlation. 9. Save the workbook and print the summary statistics, the chart, and the regression output. Answer the following questions. 1. Based on the plot, does there appear to be a linear relationship between the variables? 2. Write the sample regression line. 3. Use the mean value for the DPI variable to predict the mean value of the dependent variable. 4. Interpret the slope of the sample regression line in terms of your particular problem. Does your data support Keyness theory that the marginal propensity to consume is between zero and one? 5. What is the R2 value for the regression? What does it mean in terms of your regression? 6. What is the standard error of the estimate and what are its units? 7. Test the null hypothesis that is zero. Is your explanatory variable significant?