For this econometrics project, I'm going to calculate the marginal propensity to consume (MPC) in the United States. (If you're more interested in doing a simpler, univariate econometrics project, please see "How to Do a Painless Econometrics Project") The marginal propensity to consume is defined as how much an agent spends when given an extra dollar from an additional dollar's personal disposable income. My theory is that consumers keep a set amount of money aside for investment and emergency, and spend the rest of their disposable income on consumption goods. Therefore my null hypothesis is that MPC = 1.
I'm also interested in seeing how changes in the prime rate influence consumption habits. Many believe that when the interest rate rises, people save more and spend less. If this is true, we should expect that there is a negative relationship between interest rates such as the prime rate, and consumption. My theory, however, is that there is no link between the two, so all else being equal, we should see no change in the level of the propensity to consume as the prime rate changes.
In order to test my hypotheses, I need to create an econometric model. First we'll define our variables:
Yt is the nominal personal consumption expenditure (PCE) in the United States.
X2t is the nominal disposable after-tax income in the United States. X3t is the prime rate in the U.S.
Our model is then:
Yt = b1 + b2X2t + b3X3tWhere b1, b2, and b3 are the parameters we will be estimating via linear regression. These parameters represent the following:
- b1 is the amount the level of PCE when nominal disposable after-tax income (X2t) and the prime rate (X3t) are both zero. We do not have a theory about what the "true" value of this parameter should be, as it holds little interest to us.
- b2 represents the amount PCE rises when the nominal disposable after-tax income in the United States rises by a dollar. Note that this is the definition of the marginal propensity to consume (MPC), so b2 is simply the MPC. Our theory is that MPC = 1, so our null hypothesis for this parameter is b2 = 1.
- b3 represents the amount PCE rises when the prime rate increases by a full percent (say from 4% to 5% or from 8% to 9%). Our theory is that changes in the prime rate do not influence consumption habits, so our null hypothesis for this parameter is b2 = 0.
Yt = b1 + b2X2t + b3X3tto the hypothesized relationship:
Yt = b1 + 1*X2t + 0*X3twhere b1 is a value that does not particularly interest us. To be able to estimate our parameters, we'll need data. The excel spreadsheet "Personal Consumption Expenditure" contains quarterly American Data from the 1st quarter of 1959 to the 3rd quarter of 2003. Right click here to download the data. Make sure to note what directory you saved the file in. All data comes from FRED II - The St. Louis Federal Reserve. It's the first place you should go for U.S. economic data. After you've downloaded the data, open up Excel, and load the file called "aboutpce" (full name "aboutpce.xls") in whatever directory you saved it in. Then continue to the next page.
Be Sure to Continue to Page 2 of "How to Do a Painless Multivariate Econometrics Project"