Basic Econometrics

As Figure I.3 shows, the regression line fits the data quite well in that the data points are very close to the regression line. From this figure we see that for the period 1982-1996 the slope coefficient (i.e., the MPC) was about 0.70, suggesting that for the sample period an increase in real income of 1 dollar led, on average, to an increase of about 70 cents in real consumption expenditure.12 We say on average because the relationship between consumption and income is inexact; as is clear from Figure I.3; not all the data points lie exactly on the regression line. In simple terms we can say that, according to our data, the average, or mean, consumption expenditure went up by about 70 cents for a dollar's increase in real income.

6. Hypothesis Testing

Assuming that the fitted model is a reasonably good approximation of reality, we have to develop suitable criteria to find out whether the estimates obtained in, say, Eq. (I.3.3) are in accord with the expectations of the theory that is being tested. According to "positive" economists like Milton Friedman, a theory or hypothesis that is not verifiable by appeal to empirical evidence may not be admissible as a part of scientific enquiry.13

As noted earlier, Keynes expected the MPC to be positive but less than 1. In our example we found the MPC to be about 0.70. But before we accept this finding as confirmation of Keynesian consumption theory, we must enquire whether this estimate is sufficiently below unity to convince us that this is not a chance occurrence or peculiarity of the particular data we have used. In other words, is 0.70 statistically less than 1? If it is, it may support Keynes' theory.

Such confirmation or refutation of economic theories on the basis of sample evidence is based on a branch of statistical theory known as statistical inference (hypothesis testing). Throughout this book we shall see how this inference process is actually conducted.

7. Forecasting or Prediction

If the chosen model does not refute the hypothesis or theory under consideration, we may use it to predict the future value(s) of the dependent, or forecast, variable Y on the basis of known or expected future value(s) of the explanatory, or predictor, variable X.

To illustrate, suppose we want to predict the mean consumption expenditure for 1997. The GDP value for 1997 was 7269.8 billion dollars.14 Putting

12Do not worry now about how these values were obtained. As we show in Chap. 3, the statistical method of least squares has produced these estimates. Also, for now do not worry about the negative value of the intercept.

13See Milton Friedman, "The Methodology of Positive Economics," Essays in Positive Economics, University of Chicago Press, Chicago, 1953.

14Data on PCE and GDP were available for 1997 but we purposely left them out to illustrate the topic discussed in this section. As we will discuss in subsequent chapters, it is a good idea to save a portion of the data to find out how well the fitted model predicts the out-of-sample observations.

this GDP figure on the right-hand side of (I.3.3), we obtain:

or about 4951 billion dollars. Thus, given the value of the GDP, the mean, or average, forecast consumption expenditure is about 4951 billion dollars. The actual value of the consumption expenditure reported in 1997 was 4913.5 billion dollars. The estimated model (I.3.3) thus overpredicted the actual consumption expenditure by about 37.82 billion dollars. We could say the forecast error is about 37.82 billion dollars, which is about 0.76 percent of the actual GDP value for 1997. When we fully discuss the linear regression model in subsequent chapters, we will try to find out if such an error is "small" or "large." But what is important for now is to note that such forecast errors are inevitable given the statistical nature of our analysis.

There is another use of the estimated model (I.3.3). Suppose the President decides to propose a reduction in the income tax. What will be the effect of such a policy on income and thereby on consumption expenditure and ultimately on employment?

Suppose that, as a result of the proposed policy change, investment expenditure increases. What will be the effect on the economy? As macroeco-nomic theory shows, the change in income following, say, a dollar's worth of change in investment expenditure is given by the income multiplier M, which is defined as

If we use the MPC of 0.70 obtained in (I.3.3), this multiplier becomes about M = 3.33. That is, an increase (decrease) of a dollar in investment will eventually lead to more than a threefold increase (decrease) in income; note that it takes time for the multiplier to work.

The critical value in this computation is MPC, for the multiplier depends on it. And this estimate of the MPC can be obtained from regression models such as (I.3.3). Thus, a quantitative estimate of MPC provides valuable information for policy purposes. Knowing MPC, one can predict the future course of income, consumption expenditure, and employment following a change in the government's fiscal policies.

8. Use of the Model for Control or Policy Purposes

Suppose we have the estimated consumption function given in (I.3.3). Suppose further the government believes that consumer expenditure of about 4900 (billions of 1992 dollars) will keep the unemployment rate at its

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