NIAGARA UNIVERSITY

HOLZSCHUH COLLEGE OF BUSINESS ADMINISTRATION, MBA Program.

EC0 640 – ECONOMETRICS
Assignment 5
In this Assignment you’ll expand on Assignment 2 by estimating an aggregate consumption function for
the U.S. economy for the period 1945-2006, testing your equation for serial correlation, and, if
appropriate, taking corrective action. (Assignment 2 used a sample for the period 1945-2014). We end the
sample with 2006 to avoid the (admittedly interesting) complications introduced by the Great Recession
in 2007-2008).

Step 1: State the Variables and the Expected Signs of the Coefficients
As in Assignment 2, our goal is to model U.S. aggregate consumption as a function of disposable personal
income and the real interest rate. Once again, the data are from the St. Louis Federal Reserve FRED
database and the Economic Report of the President. Descriptions of the variables are in Table 1, along
with the hypothesized signs for the coefficients.
Table 1 Variable Defini ons
Variable Description Expected Sign
cont The real personal consumption expenditures in year t, in billions of NA
2009 dollars
pydt The real disposable personal income in year t, in billions of 2009 +
dollars
aaat the real interest rate on Aaa corporate bonds in year t -
yeart Year t NA

Step 2: Estimate the Aggregate Consumption Function

Now estimate the consumption function, using disposable personal income and the real interest rate as the
independent variables.
Step 3: Examine the Residuals
Generate the residuals from the regression in Step 2 and plot them as a line graph against year t (year t
should be on the x-axis). Does the plot look entirely random? Explain.

Step 4: Run the Durbin-Watson Test

Conduct a Durbin-Watson test for positive serial correlation.
a. Carefully write the null and alternative hypotheses.
 b. Run a Durbin-Watson test for positive serial correlation at the 5-percent level. What can you
conclude?

Step 5: Run the Lagrange Multiplier Serial Correlation Test

Let’s see if our Durbin-Watson results can be confirmed with the Lagrange Multiplier test.
a. Are the null and alternative hypotheses for the Lagrange Multiplier test the same as for
the Durbin-Watson test? Why or why not?
b. Conduct a Lagrange Multiplier test for serial correlation at the 5-percent level. What can
you conclude? Explain.

Step 6: Calculate Newey-West Standard Errors

a. Estimate the aggregate consumption model using the Newey-West method with a lag of 1.
b. After the Newey-West calculation, are the coefficients the same as the OLS coefficients? Explain.
c. Why are the Newey-West t-statistics different from the OLS t-statistics? Which do you prefer?
Why?