Econometrics is a powerful tool. Through econometrics you can get quantitative estimates of the underlying behavioral relations in the economy. For example, policy makers need to know the size of the propensity to consume (the proportion of additional disposable income spent on consumption goods) because this is an ingredient in the determination of the multiplier (the effect of policy on output). To get a feel for the relationship between disposable income and consumption, you can look at a scatter plot of the two variables shown in this exercise. (The numbers are not realistic.)

  1. Is an increase in disposable income associated with an increase or decrease in consumption ?

Policy makers need to know how much consumption, C, is likely to rise if disposable income, Y, rises by 1. To obtain this type of information, economists use econometrics to estimate the intercept and slope of the consumption function:

  1. Ct = intercept + (propensity to consume) Yt

Currently the consumption function has an intercept of 2.0 and a propensity to consume of 0.0.

  1. What does a propensity to consume equal to 0.0 imply about the relationship between Y and C ?

Basically, econometrics is the process of choosing the intercept and slope of a line that gets as close as possible to the data points in the graph. You can do this by grabbing the handle on the right end of the line and moving up and down.

  1. How does the propensity to consume in the consumption function change as you move the right handle up ?
  2. Does the intercept of the consumption function change as you move the left handle up ?

Move the right and left handles up and down, to sort of jiggle the line, to try and get the consumption function (the red line) to get as close to as many of the data points as possible.

  1. What is the propensity to consume in your consumption function ?
  2. What is the propensity to consume in the consumption function estimated by econometrics ?
  3. What would you tell policymakers would happen to consumption if disposable income rises by $1000 ?