Consumption Function – I

1. Consumption Function – I ECN Data Analysis Lawlor

2. Macroeconomic Time Series • Data issue is to consider the nature of economic series that move through time • These are typically “dated” • Annually, quarterly, monthly • In economics these are often Macroeconomic data • History only happened once

3. Consumption Function • Our example of this will be the estimation of a “Consumption Function” • For the United States in the post-war period • Only years for which we have data • Requires a very little bit of background in Macroeconomic theory

4. Formal Theory of the Cons. Fn. • Specifies the nature of the determinants of real aggregate household consumption (C). • Asserts the major determinant of this in short-run data (say quarterly or monthly) is contemporaneous real income (Y) • Describes this in the form of a general function: • C = f(Y,…)

5. Many attempts to estimate in many data contexts • 1st. step is to linearize the relation • So we can use simple regression • C = a + b*Y • Where, • a = intercept of cons function, sometimes interpreted as “autonomous consumption” • that part of C not caused by changes in Y • “b” = the slope of the consumption function • sometimes interpreted as “induced consumption” • that part caused by changes in Y

6. Data derived Cons. Fn. • If you were to display the contemporaneous data on C and Y on a scatterplot… • Do so on Gretl • Show on board • Derive: MPC, MPS, a • One of the most stable relationships in economics

7. Show how data implies “the fundamental psychological law: • This form of the “fundamental psychological law” • 0 < a • 0 < b, or MPC < 1 • Says that, in the short-run, “when household income increases, so does household consumption, but not by as much” • Again, 0 < MPC < 1

8. Now look at origin of Cons. Fn. • JMK, writing in the Great Depression • Reading Keynes: • Choice of units • Discussion of the precision with which macroeconomic time series data are measured • Can we really rely on aggregate P and Y the over long-period? Think how we define real C and real Y. • JMK says no, reason we should confine macroeconomics, an macroeconomics to the short-run- say a decade, or the time span between usual business cycles

9. JMK on the “Propensity to Consume” • pp. 12-14 in text selection • States a verbal form of “fundamental psychological law” • namely that people are disposed to “increase their consumption as their income increases, but not by as much as the increase in their income.” • Says the MPC is “positive and less than unity” • Note, for us, this importantly corresponds to the data of repeated attempts to estimate the cons. fn.

10. Two additional hints from JMK, worth storing away for later study • 1. He suggests that many other factors may co-determine the consumption levels of different countries • Seen today in wildly different MPC’s across the globe • His choice for the most important measurable variable is “windfall changes in capital values” • 2. He suggest MPC may fall at as Y drifts higher

11. Keynes and the Data • Use Gretl – “Browse Databases” • Explore and install various series from the St. Louis Federal Reserve • Want to find and open variables that measure C and Y • In series “find” window search for “consumption” and “income” • Looking for “real” personal consumption and disposable income of households

12. Plot and explore the Data • Note first the nature of the data: monthly, real, seasonally adjusted, from 1959:01 to 2007:06 • Highlight both and display as “time series plot” • Note how good it fits our conception of “fund. psych. law” • Note we can use the mouse to figure out what year we are looking at • Note it is over “long-run” data from 1959 to present – should this be a problem?

13. Explore, contd. • Note you can “zoom” in on a particular time period in the “edit” menu • Show it in a “scatterplot” • Comment on the “line of best fit” • Note the value of the intercept, pos., neg, O • Select “Model” and estimate an “OLS” regression • Interpret the coefficients and output

14. The Cons. Fn. And the U.S. “Great Depression” • Think of the historical context • Great uncertainty about employment, extreme frugality • Why? As seen in figs. on 4, a collapse of Y and C and I • Fig. 11 on p. 5, shows the stability of spending on consumption versus the excessive volatility of investment

15. Estimate a Cons. Fn. For these years • Last page shows this • First figure is the material out of which a consumption function is made • notice C > Y in 1932-1934 • Think about that and annual data (all available) • Now run the regression: results graphically displayed in second figure • Note the very high MPS, = .76