Basic Econometrics

1. Statement of Theory or Hypothesis

Keynes stated:

The fundamental psychological law ... is that men [women] are disposed, as a rule and on average, to increase their consumption as their income increases, but not as much as the increase in their income.10

In short, Keynes postulated that the marginal propensity to consume (MPC), the rate of change of consumption for a unit (say, a dollar) change in income, is greater than zero but less than 1.

2. Specification of the Mathematical Model of Consumption

Although Keynes postulated a positive relationship between consumption and income, he did not specify the precise form of the functional relationship between the two. For simplicity, a mathematical economist might suggest the following form of the Keynesian consumption function:

where Y = consumption expenditure and X = income, and where 01 and 02, known as the parameters of the model, are, respectively, the intercept and slope coefficients.

The slope coefficient 02 measures the MPC. Geometrically, Eq. (I.3.1) is as shown in Figure I.1. This equation, which states that consumption is linY

Income

FIGURE I.1 Keynesian consumption function.

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