When natural scientists such as molecular biologists or particle physicists want to see how good their theories are, they conduct experiments. Economists and other social scientists have much less ability to carry out experiments—certainly at the level of the macroeconomy. The Kennedy tax cut, however, is like a “natural” experiment in that there was a major policy change that we can think of as a change in an exogenous variable. It is not, in truth, completely exogenous. We already explained that the tax cut was enacted in response to the poor performance of the economy. We are not badly misled by thinking of it as an exogenous event, however. We can therefore use it to see how well our theory performs. Specifically, we can look to see whether disposable income and consumption do behave as we have predicted. Empirical Evidence on Consumption Before we turn to those specific questions, let us examine some data on consumption.Figure 12.7 “Consumption and Income” shows the behavior of consumption and disposable income from 1962 to 2010. The measures of both income and consumption are in year 2005 dollars. This means that the nominal (money) levels of income and consumption for each of the years have been corrected for inflation, so that we can see how the real level of consumption relates to the real level of income.
The charts show consumption and personal disposable income (in billions of year 2005 dollars) from 1962 to 2010. Consumption and disposable income grew substantially over this time (a) and there is a close relationship between consumption and income (b). Source: Economic Report of the President (Washington, DC: GPO, 2011), table B-31, accessed September 20, 2011, http://www.gpoaccess.gov/eop/tables11.html. Toolkit: Section 16.5 “Correcting for Inflation” You can review how to correct for inflation in the toolkit. The first thing we see in Figure 12.7 “Consumption and Income” is that both consumption and disposable income grew substantially over the 1962–2010 period. This should come as no surprise. We know that the US economy grew over this period, so we would expect that disposable income and consumption would also grow. Figure 12.7 “Consumption and Income” reveals that, as a consequence, there is a close relationship between consumption and income, and consumption expenditures are, on average, about 91 percent of disposable income. Although Figure 12.7 “Consumption and Income” looks something like a consumption function, we should not take this relationship as strong evidence for our theory because it is primarily caused by the fact that both variables grew over time. Consumption Response to the Kennedy Tax Cut Now we return to the Kennedy tax cut. How well does our model perform in predicting the effects of the tax changes on consumption? Superficially, this seems like an easy question.
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