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Keynes in the General Theory said a $1 increase in income will lead to less than
a $1 increase in overall consumption.
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Although Keynes didnt specify the exact nature of the relationship. Might
suggest a simple linear relationship.
C = 0 + 1 DI
0 < 1< 1
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4.
Only way to estimate the parameters of interest in this model, is to obtain the
necessary data. Data source could involve time series, cross-sectional or panel
data.
Time series data are collected over time for the same country or other single
aggregate economic unit (e.g., aggregate C and DI could be obtained for
Singapore from 1950 -2000). In this case, wed normally re-write the equation
with a t subscript on the variables and disturbance term to denote time.
C t = 0 + 1 DI t + t
Finally, panel data contains elements of both time series and cross-sectional data
(e.g., C and DI could be obtained for all countries in the OECD during the period
1950-2000). Note that we have variation across countries at any single point in
time, as well as variation across time. In this case, wed normally re-write the
equation with both an i and t subscript on the variables and disturbance term to
denote country and time.
C it = 0 + 1 DI it + it
Time series or cross sectional data could be plotted as a scatter diagram below:
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5.
Now its time to estimate the coefficients in the model. The basic idea is to come
up with a line that best fits the data points. Imagine that this regression
analysis yields the following consumption function.
C = 336.9 + 0.820DI
These are the estimates of the 2 coefficients. The hat on C indicates that this is
an estimated consumption function or regression model.
6.
Recall that we wanted to test Keynes hypothesis that the MPC was between zero
and 1. Looks reasonable, but unsure whether there is any statistical evidence
that its below 1.
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7.
One of the other uses of this model if for forecasting or predicting future economic
behaviour. To predict C, however, need to know future values of DI. Suppose
you know that DI is going to be $65,000 (millions).
C = 336.9 + 0.820(65,000) = 53,636.9
This also allows you to predict savings of $11,363.1. This is just the difference
between DI and C.
8.
Can also be used for control purposes. Suppose that C of 53.6 billion is
insufficient to maintain full-employment. Not enough spending by households.
Government could consider increasing DI through tax cuts to achieve a higher
target. Suppose 62 billion is needed.
62,000 = 336.9 + 0.820DI
DI = 75,198.9
Thus, need to cut taxes by just over $10 billion from forecasted levels.
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When K=1, the regression model is Simple Linear Regression (SLR) model.
When K>1, the regression model is Multiple Linear Regression (MLR) model.
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Individual Food
Expenditures (Y)
Average Food
Expenditures
250
87.50
300
93.00
350
90.50, 106.50
98.50
400
104.00
Plot these data points on the following diagram. This is often known as a Scatter
Diagram. The solid dots are the actual observations. Now the Conditional
Mean or Conditional Expectation is
E(Y | X = X i )
The circles are the conditional means. Clearly, food expenditures on average
increase with disposable income.
This can be seen even more clearly by connecting these conditional means with
a straight line. This is the True (or Population) Regression Line. Note that it
could also be a True (or Population) Regression Curve.
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The second possibility is that the PRF is nonlinear in terms of the coefficients.
E(Y | X i ) = 0 +
1 X i
Such regressions functions will not be considered in this paper, but the one given
above will be. From now on, linear regression models should be read as linear
(in terms of the parameters).
where i is a random variable with mean 0. Lot's of reasons why i might exist.
Measurement Error on Y or X.
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Y i = 0 + 1 X i
Of course, we can replace the actual value of the dependent variable ( Y i ) with its
fitted value ( Y i ).
The LHS is no longer an estimator, its the actual value. The RHS now includes
the Residual term e i .
Y i = 0 + 1 X i + ei
This means that the actual dependent variable can be decomposed into its fitted
value and the residual.
Y i = Y i + ei
This residual, like the disturbance can be either positive or negative. We can
either overestimate:
Y i - Y i = ei < 0
if Y i < Y i
if Y i > Y i