SSRIC Teaching Resources Depository
James Gerber, San Diego State University

Macroeconomics Chapter 5: Correlation

© The Author, 1998; Last Modified 14 August 1998
Chapter 5 examines the relationship between pairs of variables. Correlation and regression are both statistical techniques for doing this, and in this chapter we focus on some examples of correlation; Chapter 6 examines simple regression techniques. Correlation measures the strength of a linear relationship and determines whether it is positive or negative. Is an increase in disposable income associated with an increase in consumption? Is an increase in economic growth associated with a fall in the unemployment rate (Okunís Law)? Is a fall in the unemployment rate associated with a rise in inflation (Phillips curve)? Measures of correlation indicate whether changes in the value of one variable is associated with changes in the value of another.

Correlation does not tell us anything about causation. In fact, some variables move together due to randomness, or because they are both caused by something else. For example, the number of police in a community is correlated with the crime rate and, Iíve been told, the number of teachers in a given population is correlated with rates of alcoholism. The naive researcher incorrectly concludes that (1) police cause crime, and (2) teachers cause alcoholism. In the first case, the direction of causation is probably from crime to police, not vice versa. In the second case, the association of the two variables is due to pure chance (I hope). In no case do measures of correlation tell us about causation. For that, we must rely on some form of social theory (e.g., economics or sociology or political science, etc.) to explain association.

It is helpful to have notation for correlation. Define the correlation measure for two populations as r (the Greek letter rho) and the sample measure as r. The formula for the sample correlation of variables X and Y is:
Sample correlation = rXY = [Covariance of (X,Y)] / Ö (sXsY),

where sX and sY are the standard deviations of X and Y.

The value of the correlation coefficient, r, must lie between -1 and 1:

1 ³ r ³ -1.

Correlation coefficients of minus one and one imply that X and Y are perfectly correlated. Minus one indicates a perfect negative correlation (X up, Y down), and +1 a perfect positive correlation (X up, Y up). Any variables that are perfectly correlated are measuring the same thing, for example degrees centigrade and degrees Fahrenheit, or dollars and pesos. Every degree centigrade equals 9/5 degrees Fahrenheit, and every dollar equals (about) 8 Mexican pesos. Temperature and money values can be measured using different scales, but in the final analysis, its the same thing.

Consider the relationship between consumption and disposable income. Economists have known for several decades that these two variables are associated with each other. If fact, they have about as close an association as possible without being perfectly correlated. Let's use SPSS to construct the scatter plot of the two variables consumption (c in the dataset) and disposable personal income (dp1).

    1. Choose Graphs from the menu bar, then select Scatter . . .;
    2. Make sure the Simple box is selected, and then click Define;
    3. Highlight c in the variable list box and use the arrow to move it to the Y Axis box;
    4. Do the same for dp1 and move it into the X Axis box;
    5. Click OK.
After editing, your graph should look like Chart 10.
Chart 10

Note the close relationship between the two; they practically lie on a straight line with a positive slope. Now, calculate the correlation coefficient:

    1. Choose Statistics from the menu bar, then select Correlate;
    2. Select Bivariate . . .;
    3. Highlight c in the variable list box and move it into the Variables box;
    4. Do the same for dp1, and click OK.
SPSS puts correlation coefficients, r, in a matrix. The diagonal elements are the correlation of a variable with itself (it must be 1.00), and the off-diagonals are the correlation of the row and column variables. Due to symmetry, you really only need to look at the top triangular part of the matrix. Each entry has 3 numbers, the correlation coefficient, the number of observations in parentheses, and the p-value, which is a measure of the statistical significance of the correlation coefficient.

Consumption and disposable personal income are as correlated as two variables can be without being the same thing (0.9998). There are 68 observations, and the p-value is zero to the nearest 4 decimal places. The p-value is actually a statistical test: H0: r = 0, H1: r¹ 0.

The p-value is the probability of observing the actual sample outcome (r = 0.9998) if the null hypothesis (H0: r = 0) is true. The usual procedure is to reject the null hypothesis if the p-value is less than 0.05 (meaning we have less than a 5% chance of getting our data if the null hypothesis is true; better to reject the null hypothesis if we observe something rare.)

Let's compare this result to others where the correlation is not so strong. In each of the following, we create a graph and the correlation. You will see that as the scatter plot points disintegrate from a straight line into a random jumble, the correlation statistic gets closer to zero. Consider first the relationship between wages and inflation. In an earlier exercise we computed inflation as the percentage change in the CPI, inflation = p = [(cpi - lag(cpi))/lag(cpi)] * 100.

If you have not done this yet, use the Transform, Compute functions in SPSS to do it now. We use inflation in the following exercises. Also, calculate the percentage change in average hourly earnings (ahe) in the same way.

The question is whether wages keep up with inflation. When inflation rises, does the nominal wage too? If so, then the purchasing power of wages stays constant, which is to say that real wages do not change. Chart 11 shows this relationship.

Chart 11

Calculate the correlation coefficient. Are changes in wages and prices perfectly correlated? How correlated are they?

The Phillips curve is the scatter plot relationship between inflation and unemployment. Chart 12 plots these variables.
Chart 12

Note that the scatter plot shows a predominantly negative relationship whereas the other two (inflation/wages, and consumption/income) were positive. Calculate the correlation between inflation and unemployment and note that it is negative. Is inflation more or less correlated with unemployment than it is with changes in wages? Can you see the difference in the tightness of the scatter in Charts 10, 11, and 12?

Letís tell a story about the economy that relates inflation to the federal budget deficit. When the government runs a deficit, it injects new purchases into the economy which are greater than what it takes out with taxes. This increases total spending (aggregate demand) and causes shortages of some goods because spending is greater than production. Firms respond by raising prices and we get inflation. So, deficits cause inflation. If we compute the correlation statistic, it should show a significant positive relationship. That is, we expect to find r > 0, and to reject the null hypothesis, H0: r = 0.

Chart 13 is the scatter plot between inflation and a new variable which we computed as (deficit/gdp). (We computed this new variable last chapter; do so now if you have not done it yet).

Chart 13

It is the deficit, measured as a percentage of GDP.) The correlation statistic turns out to be -0.0383. This is the wrong sign, and the p-value says that there is a high probability of observing this correlation if the null hypothesis is true. We reject the null hypothesis. It looks like we have to either tell a different story, or probe deeper for a connection between inflation and deficits. The latter may not uncover anything, but it definitely requires more statistics.

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