Regression, like correlation, does not determine causation. Its strength is that unlike correlation, it measures the parameters of the association. That is, correlation can show that disposable income and household consumption move together, but regression measures the amount by which consumption will increase when disposable income rises by a dollar. Because regression goes beyond correlation to a measurement of the size of the affect of one variable on another, it is the favorite statistical technique in empirical economics.In the example of regression just cited there is an implicit assumption about causation, even though neither regression nor correlation can prove it. Economists assume that changes in disposable income cause changes in consumption (although we allow that the reverse is true as well, at least in the aggregate). In the regression statistical procedure, is assumed that one variable is dependent (consumption) and the other is independent (disposable income). This assumption tells us about the researcher’s intuition, or the theory in use, but it cannot be validated or invalidated with the regression procedure. To repeat, whatever we think we know about causation must come from theories and histories and other pieces of information besides regression.
61 The consumption function
Chart 10 in Chapter 5 plotted the pairs of values for consumption and disposable income for each year, 19291996. In the economics literature, this is known as the consumption function. Economists theorize that consumption is largely determined by disposable income (after tax income). Algebraically, we can write the consumption function in general functional notation:C = f(Y^{d}), where C is consumption and Y^{d} is disposable income. The plot of c and dp1 in Chart 10 revealed that the relationship was linear, so we can convert the general functional notation into a specific, linear functional form:
C = c_{0} + c_{1} Y^{d}. In this form, the consumption function is a straight line, with intercept c_{0} and slope c_{1}. In economics, the intercept, c_{0}, is called autonomous consumption since it is independent of (autonomous from) disposable income. The slope, c_{1}, measures the rate of change in consumption given a change in Y^{d}. For example, if Y^{d} increases by $1, then C changes by (c_{1} )*($1) = c_{1}.
Let D stand for the change in a variable, so D Y^{d} is read as "the change in disposable income." Then, if Y^{d} changes by D Y^{d}, the change in C (D C) is c_{1} D Y^{d}:
C = c_{0} + c_{1} Y^{d}_{,}, and D C = c_{1}D Y^{d},
so that c_{1 }= D C /_{ }D Y^{d} = the marginal propensity to consume = MPCAutonomous consumption and the marginal propensity to consume are the parametersof the linear consumption function. Mathematically, they are the intercept and slope of a line that describes the relationship between disposable income and consumption. Regression analysis is an exercise in estimating their values, but before we do regression, we have to take into account one more element of every regression model.
The linear consumption function, C = c_{0} + c_{1} Y^{d}, is a deterministic model. It allows no room for variation away from the relationship. Once Y^{d} is known, C is completely determined (given the parameters c_{0} and c_{1}). In fact, the consumption function describes a tendency, not a mathematically fixed relationship. The relationship between consumption and disposable income is probabilistic, or to say the same thing with a 5 dollar word, it is a stochastic relationship. Stochastic relationships are not fixed like deterministic relationships, there is always margin for variation away from the general tendency. Therefore, if the consumption function describes the deterministic relationship, we need to add a term to let the actual behavior of consumption in the actual economy deviate from the value predicted by disposable income:
C = c_{0} + c_{1} Y^{d} + e, where e is a random error term. On average, e is zero, so C = c_{0} + c_{1} Y^{d}, but in any given year, C could be more than predicted (e > 0), or less than predicted (e < 0). Graphically, the inclusion of a random error terms allows for the possibility that the scatter points of the consumption function do not fall on a straight line.
With the regression procedure in SPSS we can compute the values of the parameters c_{0} and c_{1}.
The results are in Table 6 where I have divided them into 3 parts. In each part, the most important numbers are in bold. Part 1 has 1 number (Adj. R Square =.99964), Part 2 has none, and Part 3 has several. One of the keys to using SPSS or any statistical package, is to not become overwhelmed by the amount of output it generates; the trick to that is to know what you can ignore, at least initially. As you become more skilled, you will find uses for the things we are going to ignore for now.
 Select Statistics from the menu bar, choose Regression, then select Linear . . .;
 Highlight c in the variable list, and click the arrow to put it into the Dependent box;
 Highlight dp1 in the variable list, and click the arrow to put it into the Independent(s) box;
 Click OK.
Table 6
Elements of Regression OutputPart 1 provides 4 measures of goodness of fit. These are statistics that tell how well the data fits the model. R Square and its adjustment, Adj. R Square, can be interpreted as the percentage of the variation in the dependent variable that is explained by the independent variable. In our model, C is the dependent variable and Y^{d} is independent, so movements in Y^{d} explain nearly all (>99%) of the movement in C. There is no threshold for the R squared or adjusted R squared where they go from bad to good, but by any criteria, our model explains nearly all the variation in C.
Part 1 Multiple R 0.99982 R Square 0.99965 Adj. R Square 0.99964 Standard Error 27.4352 Part 2 Analysis of Variance DF Sum of Squares Mean Square Regression 1 141122061.6 141122061.6 Residual 66 49677.6 752.7 F=187489.9 Signif F=0.000 Part 3 Variable B SE B Beta T Sig T DP1 0.918815 0.002122 0.99984 433.001 0.000 (Constant) 12.33177 4.243069 2.906 0.0050 Adjusted R square is an adjustment to R square (duh!) that takes into account the number of independent variables. Since we only have one, Y^{d}, the two are close in value. The adjusted R squared of 0.99964 looks too good to be true and it probably is; for various technical reasons, some statistical, some economic, it makes the model look better than it is. (Two reasons: autocorrelation, and nominal data.) It pays to be skeptical, even (especially) when things look great.
Part 2 provides a number of statistics that are grouped together under the subject of analysis of variance. Basically, Part 2 provides measures that break down the variation in C and attribute the different parts to the deterministic part of the model (c_{0} + c_{1} Y^{d} ) and the stochastic part (e). These are useful measures in more advanced routines, but they are unnecessary at this point.
Part 3 is the core of the output. Part 3 has the estimated values of c_{0} (12.33) and c_{1} (0.9188). These are in the column labeled B. The next column, SE B, is the standard error of the estimates (0.002122 for c_{1}, and 4.243069 for c_{0}.) These are measures of the precision of our estimates of c_{0} and c_{1}. The smaller the standard errors, the more precise are our estimates. The column labeled Beta can be ignored, but the following column, T, has important information. T is the value of the tstatistic that is constructed to test the hypothesis that the "true" values of c_{0} and c_{1} are zero. Let the unobserved true values be symbolized with Greek letters, b_{0} and b_{1}. We want to test the hypotheses:
H_{0}: b_{0} = 0 versus H_{1}: b_{0} ¹ 0, and
H_{0}: b_{1} = 0 versus H_{1}: b_{1} ¹ 0.If we accept the second null, then it means that disposable income has no affect on consumption. Since this is one of the primary reasons for doing regression (i.e., to see if disposable income affects consumption, and if so, how much), every statistical package automatically turns out a tstatistic to test this hypothesis. The formula for the tstatistic is:
tvalue = (c_{1}  value in null hypothesis)/(standard error of the estimate) =
(B  0)/(SE B) = (0.9188  0)/(0.002122) = 433.The last column of the SPSS printout in Part 3 is labeled Sig T. It is the probability of the tstatistic, which is also the probability of getting the data in the dataset when the null hypothesis is true (H_{0}: b_{1} = 0). Since the probability (to four decimal places) of getting a sample value, c_{1} , that is 0.9188 with a standard error of 0.002122, is 0, we should reject the null hypothesis.
62 Okun’s Law
Let’s try another regression. (This section and the following borrow heavily from Blanchard, 1997.) Economists have long known that increases in the rate of growth of GDP enables more unemployed people to finds jobs. It was not until the 1960s and the work of Arthur Okun that that this general relationship between unemployment and GDP growth was estimated empirically. The question is simple and basic: If GDP falls by 1%, how much does the unemployment rate change? In order to answer this, we have to compute the change in the unemployment rate, ur  lag(ur). We will call this variable Dur, where the Greek letter delta, D , indicates change. We also have to compute the percent change in real GDP, which requires two steps (you may already have done this). First, use the GDP deflator (gdpdef) and GDP to compute real GDP. Second, compute the percentage change in real GDP, and give it a name. Then you are ready to run the regression.The estimated equation is
Dur = 1.274321  0.361428(Percent change in real GDP). The interpretation of this relationship is that, on average, each 1% increase in the rate of growth of real GDP, reduces the unemployment rate by 0.36 percent. You should check the goodness of fit statistics, R square and adjusted R square, and the tstatistics for the slope and the intercept. Follow the procedure outlined for the consumption function.
The implications of Okun’s Law are that output must grow by about 3.5% per year (1.27/0.36) just to keep unemployment from rising. Why? The answer is that the labor force grows about 1% a year (check this), so output has to grow at about the same speed to provide enough new jobs. Second, labor productivity (output per hour worked, prod1 in the dataset) grows at about 2.3 percent a year (check this) so even if no new jobs are created, output goes up 2.3 percent. Put these two forces together, and real GDP has to grow over 3 percent a year on average just to keep the unemployment rate from going up. Because of this relationship, many economists view "normal" economic growth as approximately 33.5%.
Okun’s Law has also been used to try to measure the costs of unemployment to the national economy. When unemployment holds constant (Dur = 0), real GDP grows about 3.5%. Now solve for the percent change in real GDP if unemployment rises by 1 percentage point (D ur = 1):
1 = 1.2743  0.36142(Percent change in real GDP)
Þ Percent change in real GDP = 0.75.When GDP growth falls from 3.5% to 0.75%, we lose about 2.75 percent of potential GDP. Given that our GDP is roughly 8,000 billion in nominal terms, a loss of 2.75 percent represents a loss of about $220 billion (0.0275*8,000). In other words, each 1% increase of unemployment costs the US economy around $220 billion in lost output.
63 The Phillips curve, then and now
The Phillips curve was one of the key economic discoveries of postWorld War II macroeconomics. Recall that the curve showed a regular relationship between inflation and unemployment. This seemed to give policymakers a set of inflationunemployment tradeoffs they could choose. If inflation was too high, then use Keynesian policies to slowdown the economy unemployment would rise, but the amount was predictable and did not vary. If unemployment was too high, then do the oppositeinflation would rise, but again it was predictable and invariant.To see the Phillips relationship that economists in the 1950s and 1960s worked with, we should omit the data from the 1930s and World War II. In addition, since the relationship broke down in the 1970s, we will work with data limited to 19481969. Algebraically, the relationship can be expressed as
p_{t} = b_{0} + b_{1}u_{t} + e_{t}, where p_{t} is inflation in year t, b_{0} is the intercept of the regression line, b_{1} is the slope parameter which is expected to be negative, u_{t} is the unemployment rate in year t, and e_{t} is the random error terms that measures deviations from the average relationship.
In the data set, the unemployment rate is variable ur, and the inflation rate is a computed variable that is the percentage change in the CPI. We calculated this in several earlier exercises.
Now run the regression using your inflation variable as the dependent variable and ur for the independent variable. You should get
 Select Data from the menu bar, then Select Cases. . .;
 Click the button for Based on time or case range, then click Range;
 In the boxes type 1948 and 1969;
 Click OK.
p_{t} = 6.917  0.987u_{t} + e_{t}, This is the relationship that broke down during the 1970s. To see this, change Select Cases to the years 1970 to 1996 and rerun the regression. Look at the R squared. Does u_{t} explain anything about inflation? Is the sign on u_{t} what you expected (i.e., is your estimate of b_{1} negative)? Is it significantly different from zero? That is, do you accept or reject the null hypothesis H_{0}: b_{1} = 0?
Needless to say, most economists were puzzled by this. As early as the mid1970s it was apparent that the Phillips relation no longer worked. What could have gone wrong? The answer was waiting in the wings in the form of a earlier prediction made by Milton Friedman. Friedman had argued that as soon as people changed their expectations about inflation, the Phillips curve would breakdown. Friedman’s point was that inflation partly depended on what people expected it to be. If everyone thought it was going to be high, then workers would demand wage increases, and businesses would expect higher costs, so they would raise their prices. The net result would be inflationin part because everyone expected it and acted to protect themselves by raising their wage demands and their prices.
Until the late 1960s, prices seemed to have no trend; they were about as likely to fall as they were to rise. Consequently, it made sense to expect zero inflation since that was close to the long term average. In the late 1960s and early 1970s, this changed. Inflation was ratcheted up by a combination of eventsthe Vietnam War, domestic spending for the War on Poverty, bad harvests in the early 1970s, and, in 1973, the first oil crisis. Households and businesses began to expect that inflation would not be zero, facts bore out the correctness of this view, and the inflation rate rose. Friedman’s arguments led economists to the "expectations augmented" Phillips curve, which is just the old Phillips curve with another variable, expected inflation, on the right hand side:
p_{t} = b_{0} + p^{e} + b_{1}u_{t} + e_{t}, where p^{e} is the expected rate of inflation. The old Phillips curve is a variety of this one in which p^{e} is zero. Here, p^{e} is expected to be positive, so that for a given unemployment rate, inflation is higher by that amount.
The obvious question is whether or not this can be measured. That is, how do we know (measure) the expected rate of inflation? Friedman’s answer was to point out that most of us use the recent past to form our expectations about the future. For example, will it be hot or cold today? When my kids ask me that in the morning, I always tell them that it will be just like yesterday. (Of course, I could look it up in the weather section of the morning paper, and sometimes I do if there is reason to believe the weather might be changing. Looking it upseeking additional informationis the rational thing to do and conforms to the economic idea of rational expectations. It is forward looking and incorporates all readily available information that is not too costly to obtain. Friedman’s ideatoday is like yesterdayis called adaptive expectations.)
For the sake of simplicity, we assume that our expectation of inflation today is that it will be like last period’s rate. Algebraically,
p^{e} = p_{t1}, where p_{t1} is the inflation rate in year t1 (i.e., last year if this is year t). Using this notation, we can rewrite the expectations augmented Phillips curve as
p_{t} = b_{0} + p_{t1} + b_{1}u_{t} + e_{t}, or, moving the expected inflation term to the left:
p_{t}  p_{t1} = b_{0} + b_{1}u_{t} + e_{t}, which we can easily estimate for 1970 to 1996. After selecting the years 1970 to 1996, and computing a new variable p_{t}  p_{t1}, rerun the regression. You should get
p_{t}  p_{t1} = 7.078  1.085u_{t} + e_{t.} Notice the similarity to the regression for 1948 to 1969.
This regression has many uses in policy making. For example, it implies that if unemployment is too low, the left hand side will be positive and inflation will be accelerating (p_{t} > p_{t1}). Economists have a special fondness the rate of unemployment that keeps inflation from rising. Note that this is not the same thing as zero inflation. The unemployment rate that prevails when p_{t}  p_{t1} equals 0 is known as (get ready!) the nonaccelerating inflation rate of unemployment, or the NAIRU. A prettier but misleading name for it is the natural rate of unemployment.
What is the natural rate? Set the above equation equal to zero, and solve:
0 = 7.078  1.085u_{t}, or u_{t} = 6.5. Anything less, and inflation is supposed to increase; anything more and it decreases. Unemployment is currently less than 5%, so you can guess why the Federal Reserve and inflation hawks are nervous. Inflation should be ratcheting up, but it is not. We don’t know why, and the debate rages on among economists. It is clear, however, that the natural rate of unemployment, or the NAIRU, changes over time. It seems to have fallen in the 1990s, but no one can say how low. The data is not loud and clear enough for us to be certain.
64 Sources
A full treatment of the Phillips curve and Okun’s Law in a more theoretical framework can be found in Blanchard, Olivier. Macroeconomics. New Jersey: Prentice Hall. 1997.





