Supplemental Material for Real Expenditure Model - Estimation of Consumption Function, as part of a Macro Model
In order to eliminate output gap and achieve full employment, one needs to estimate aggregate demand, and to estimate impact of fiscal and monetary policy on aggregate demand. One important part of the aggregate demand is generated by the consumption function. Estimation of the consumption function is therefore an important part of what is needed for good monetary policy, and much effort has been devoted to this topic by econometricians.
The DHSY (Davidson, Hendry, Srba, Yeo) paper was a landmark contribution in the study of methodologies for estimating the consumption function. This explained why conventional econometric methodology gave conflicting results for the consumption function, and did not provide any tools to decide which among a variety of different models was correct. They created a new methodology with the goal to reconcile all existing models within the compass of a single model, and to come to decision as to which among a collection of models was the best one. They called this the "Encompassing Approach". It has also been called the Hendry Methodology, as well as the LSE (London School of Economics) approach. This has become very popular, and dominant approach in Europe, but has not been widely accepted in the USA. Nonetheless, it is very much superior to the standard USA approach taught in conventional textbooks.
Below I provide links to some lecture on Estimation of the Consumption Function and also the DHSY paper and the Hendry Methodology. Please read/view the lectures as a preliminary. I will try to provide a lecture on estimation of the Consumption Function for Pakistan later in the course.
The textbook "Introductory Econometrics" by R L Thomas can be accessed by members of the AZ Research Group only.
Final Exam Questions:
Prior to DHSY, anyone could use his own favorite variables to estimate the consumption function, and come up with a new equation. Everyone who estimated consumption function came up with very different results regarding key parameters like the marginal propensity to consume, and the multiplier.
1. Explain the encompassing methodology and how it can avoid the problem that every model leads to different results.
2. Explain the Error Correction model and how this model incorporates the idea of a gradual adjustment to a long run equilibrium
L14 Estimating the Consumption Function — RL Thomas Introductory Econometric, Chapter 10 on Consumption Function provides the best state of art introductory summary of the topic. Charemza & Deadman provide more advanced treatment based on Hendry.