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MEL15701

ECONOMETRICSPROJECT

1. Description of Data and Model


The project is derived from Wooldridges Introductory Econometrics, 5th edition to
test the Permanent Income Hypothesis (PIH). This hypothesis was proposed by Milton
Friedman in 1957 to explain consumer behavior. Friedmans PIH complements
Modiglianis life-cycle hypothesis: both use Irving Fishers theory of the consumer to argue
that consumption should notdepend on current income alone, Mankiw (2015), p.493.
In PIH, individuals decision to consume depend primarily on permanent income because
individuals use the concept of saving and borrowing to re-enforce consumption in response
to changes in income. For instance, if a person received permanent raise of $1,000 a year,
his/her consumption would increase as much as this raise. Yet, if the extra money were
received accidentally, perhaps from lottery, gift, door prize, he/she would not consume it all
in one year. Instead, the extra money would be spread to consume over the rest of his/her life.
Thus, individuals spend their permanent income, but they save rather than spend for
accidentally received income.
The data analyzed in this project had been analyzed by Campbell and Mankiw (1990)
using 1959 through 1995 data which was taken from Economic Report of the President.
However, compared with previous analysis, I extend the data into 2012 to make a
comparison of the model whether extending the data gives different conclusions or not since
the pure form of PIH is strongly rejected subject to estimation result in Wooldridge (example
16.7, p.570). The data can be freely downloaded from US Government Publishing Offices
Website.
Most of my analysis will be conducted based on the Computer Exercise (number C16.4
and C16.5) questions. The model I will analyze in this project is:
gct = 0 + 1gyt + 2r3t + ut,
where
gct=log(ct) = annual growth rate in real per capita consumption (excluding durables)
gyt= real disposable income growth rate

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ECONOMETRICSPROJECT

r3t = the (ex post) real interest rate as measured by the return on three-month T-bill rates:
r3t = i3t - inft, where the inflation rate is based on the Consumer Price Index.
The explanatory variables in this model are endogenous so then the model requires
instrumental variables. The valid instrumental variables for the model are lagged values of gc,
gy, and r3.
The expected value for coefficients 1 and 2are described as follows:
1is expected to have positive sign because as income increases, individuals may prefer to
increase their consumption. This is because people tend to maximize their utility subject to
the budget constraint. As income increases, so does the budget constraint and individuals
preferences. Meanwhile, 2is expected to have negative sign because the value of real interest
rate, as measured by the return of three-month T-bill rates minus the inflation rate, alters
individuals decision to consume. If the real interest rate is high, people will tend to save
rather than to consume because saving (especially in bank) is more profitable. In addition, the
hypothesis for the pure form of PIH where the value of 1 =2= 0 as exampled in Wooldridge
will be re-tested with the new set of data.
2. OLS Estimation of the Model
The following table shows the comparison of descriptive data statistic between original
data and extended data.
Table 1. Descriptive Statistic of the Data
1959-1995
Variable Obs Mean

Std.
Dev.

1959-2012
Min

Max

Variable Obs

Mean

Std.
Dev.

Min

Max

gc

36 .0204738 .0126375

.0402088
.0091066

gc

53 .0242636 .0473737 -.0242 .348636

gy

36 .0217153 .0182399

.061985
.0169735

gy

53 .0252422 .0429182

r3

37 1.423784 2.064335

r3

54 1.077222 2.085458 -3.26

gc_1

35 .0206894 .0127547

.0402088
.0091066

gc_1

52 .0246441 .047754 -.0242 .348636

gy_1

35 .0216098 .0184951

.061985
.0169735

gy_1

52 .0255734 .0432685

-3.26

5.43

.303214
.03719
5.43

.303214
.03719

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r3_1

36 1.388056 2.081984

-3.26

ECONOMETRICSPROJECT

5.43

r3_1

53 1.135472 2.060589 -3.26

5.4

The Following figures show the comparison of OLS Estimation with different
time frame.
Figure 1. 2SLS Regression with 1959-1995 Data
Instrumental variables (2SLS) regression
Source

SS

df

MS

Model
Residual

.003759532
.001786069

2
32

.001879766
.000055815

Total

.005545602

34

.000163106

gc

Coef.

r3
gy
_cons

-.0002698
.5826035
.0081396

Instrumented:
Instruments:

Std. Err.
.0007639
.0747338
.002054

t
-0.35
7.80
3.96

Number of obs
F(2, 32)
Prob > F
R-squared
Adj R-squared
Root MSE

P>|t|
0.726
0.000
0.000

=
=
=
=
=
=

35
33.68
0.0000
0.6779
0.6578
.00747

[95% Conf. Interval]


-.0018258
.4303758
.0039557

.0012861
.7348312
.0123236

r3
gy L.gc L.gy L.r3

Figure 2. 2SLS Regression with 1959-2012 Data

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ECONOMETRICSPROJECT

Instrumental variables (2SLS) regression


SS

Source

df

MS

Model
Residual

.109200546
.007392314

2
49

.054600273
.000150864

Total

.11659286

51

.002286135

gc

Coef.

r3
gy
_cons

-.0014683
1.084533
-.0017636

Instrumented:
Instruments:

Std. Err.

.0011152
.041438
.0021641

-1.32
26.17
-0.81

Number of obs
F(2, 49)
Prob > F
R-squared
Adj R-squared
Root MSE

P>|t|
0.194
0.000
0.419

=
=
=
=
=
=

52
362.45
0.0000
0.9366
0.9340
.01228

[95% Conf. Interval]


-.0037093
1.00126
-.0061125

.0007728
1.167806
.0025853

r3
gy L.gc L.gy L.r3

3. Interpretation of Results
Following the above OLS estimation, the equation can be written as follows:
gct

0.00813

0.00205
gct

-0.00176

0.583

gyt

0.075
+

0.00216

1.084
0.041

0.00027 r3t

(1)

0.00076
gyt

0.00014 r3t

(2)

0.00111

Looking at equation (2) with new set of data, as expected, the expected value of 1is
positive and the expected value of 2is negative. This sign is corresponding with what
expected before. However, compared with the original set of data in equation (1), the
coefficient of 1increases while the coefficient of 2decreases.
a. Statistical Significance
With the new set of data, the following section will convey the significance testing of the
variables. At 1% critical value for a two-tailed test with 49df is 2.660, therefore the null
hypothesis H0: 1= 0 is rejected in favor of alternative hypothesis H1: 1 0. For the latter
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coefficient, at 1% critical value for a one-tailed test with 49 df, is 2.390, the null
hypothesis H0: 2= 0 is rejected in favor of alternative hypothesis H1 = 2< 0.
b. Goodness of fit
The equation (2) gives bigger R2than that of equation (1) where the R2value from
equation (2) is 93.66%. This means that as the data extended, both the explanatory
variables gyand r3 are able to explain the 93.66% variability of gc.
c. Linear Restriction
For this section, the null hypothesis is stated as follows:
H0:1=2, where the alternative is
H1:1 0or/and 2 0
The null hypothesis implies that none of the explanatory variables have any impact on the
dependent variable. The test result by using stata is:
( 1)

- r3 + gy = 0
F(

1,
49) =
Prob > F =

676.10
0.0000

Since the value of F-statistic is zero, we reject the null hypothesis at any percentage
significance level. Therefore, both of the variables have impact on dependent variable gc.

4. Model Specification
a. Heteroskedasticity Testing
The null hypothesis for heteroskedasticity testing is no heteroskedasticity. The result of
the test is:
IV heteroskedasticity test(s) using levels of IVs only
Ho: Disturbance is homoskedastic
Pagan-Hall general test statistic : 4.636 Chi-sq(4) P-value = 0.3267

Looking at the result, we fail to reject the null hypothesis, therefore, no heteroskedasticity
present.
b. Autocorrelation Testing

MEL15701

ECONOMETRICSPROJECT

The null hypothesis for autocorrelation testing is no autocorrelation. The result of the test
is:
Cumby-Huizinga test with H0: errors nonautocorrelated at order 1
Test statistic: 5.6504315
Under H0, Chi-sq(1) with p-value: .01745108

The result implies that no autocorrelation present, therefore, we fail to reject the null
hypothesis.

c. Instruments Validity Testing


The last testing is about to test whether the instruments are valid, the result is as follows:

MEL15701

ECONOMETRICSPROJECT

IV (2SLS) estimation

Total (centered) SS
Total (uncentered) SS
Residual SS

=
=
=

gc

Coef.

r3
gy
_cons

-.0014683
1.084533
-.0017636

Number of obs
F( 2,
49)
Prob > F
Centered R2
Uncentered R2
Root MSE

.1165928599
.147710145
.0073923142

Std. Err.
.0010825
.0402249
.0021007

z
-1.36
26.96
-0.84

=
=
=
=
=
=

52
362.45
0.0000
0.9366
0.9500
.01192

P>|z|

[95% Conf. Interval]

0.175
0.000
0.401

-.00359
1.005694
-.005881

.0006535
1.163373
.0023537

Anderson canon. corr. LR statistic (underidentification test):


Chi-sq(3) P-val =

42.489
0.0000

Cragg-Donald F statistic (weak identification test):


Stock-Yogo weak ID test critical values: 5% maximal IV
10% maximal IV
20% maximal IV
30% maximal IV
10% maximal IV
15% maximal IV
20% maximal IV
25% maximal IV
Source: Stock-Yogo (2005). Reproduced by permission.

19.801
13.91
9.08
6.46
5.39
22.30
12.83
9.54
7.80

relative
relative
relative
relative
size
size
size
size

bias
bias
bias
bias

Sargan statistic (overidentification test of all instruments):


Chi-sq(2) P-val =

5.558
0.0621

Instrumented:
r3
Included instruments: gy
Excluded instruments: L.gc L.gy L.r3

The interpretation of the testing result is described as follows:


1) The Sargan Statistic is used to test the null hypothesis that the instruments are
uncorrelated with the error term. Since the p-value is 0.0621, we do not reject the null
hypothesis at 1% and 5% significance level, yet reject at 10% significance level.
2) The Anderson LR test null hypothesis is that instruments do not verify the rank
condition, which requires the instruments to be correlated with the endogenous
variables. Since the p-value is zero and thus smaller than any significance level, we
reject the null hypothesis. The implication is the IV estimates and standard errors are
reliable.
3) Since we reject the null hypothesis in Anderson LR test, we have to look at the
Cragg-Donald weak identification test. The null hypothesis is that instruments are not
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MEL15701

ECONOMETRICSPROJECT

sufficiently correlated with endogenous regressors. The value of F-Statistic on this


test is 19.801 and relatively bigger than any bias. Therefore, we reject the null
hypothesis.

5. Summary
This project means to test the permanent income hypothesis as it was conducted by
Campbell and Mankiw. Their research concluded that the pure form of the PIH is strongly
rejected because the coefficient on gy is economically large, in Wooldridge (2012), p.571.
After the data are extended until 2012, the result is the same with what Campbell and
Mankiw found:the coefficient for gy becomes larger than the original data.
In term of goodness of fit, the latter estimation gives better result than that of the former.
This is reflected in the value of R2. Therefore, the latter estimation implies that the
explanatory variables in the model are able to explain 93.66% variability of dependent
variable gc.
The model is regressed by using two stage least square method because it has endogenous
variable. The instruments validity testing presents a good conclusion where the instrumental
variables used have reasonable statistic results with an exception on the Sargan statistic, at
10% significance level the null hypothesis is rejected.
Finally, the model has two explanatory variables and also has endogenous variable.
Though the value of R2 increases as the data extended, I think the reliability of this model is
not sufficient. This is because there are some issues related with the nature of time series
estimation. As Campbell and Mankiw stated on their research, they did not distinguish the
consumption expenditure on durables, just nondurables and services. Another problem is that
the data measurement since consumption and income are tallied as quarterly averages rather
than at points in time.

MEL15701

ECONOMETRICSPROJECT

References:
Campbell, J. Y., &Mankiw, N. G. (1990). Permanent Income, current income, and consumption.
Journal of Business & Economic Statistics, 8 (3), 265-279. Retrieved February 3rd, 2016,
from http://scholar.harvard.edu/files/mankiw/files/permanent_income.pdf
Mankiw, N. Gregory. (2015). Macroeconomics (9thed). New York: Worth Publishers
US Government Publishing Office. (2016). Economic report of the president: 2012. Retrieved
February 7th, 2016, from
https://www.gpo.gov/fdsys/browse/collection.action?collectionCode=ERP&browsePath=
2013&isCollapsed=false&leafLevelBrowse=false&isDocumentResults=true&ycord=0
Wooldridge, Jeffery. M. (2012). Introductory Econometrics: A Modern Approach (5thed). USA:
South-Western-Cengage Learning.

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