STUDY OF THE RELATIONSHIP BETWEEN GDP AND THE MONETARY VARIABLES

Pelayo Esparza Sola, 72832033-A Econometrics, 3rd course LE

INDEX OF CONTENTS

SECTION

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1. Background 2. Data used and sources of information 3. Elaboration of the model 3.1. Obtaining and analyzing the initial model (a linear static model) 3.2. Estimation of the original model with robust (Newey-West) standard errors 3.3. Estimation using a dynamic model 3.4.Comparison between the estimation methods that are appropriate for the model: 4. Conclusions 5. Bibliography

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1. Background The main goal of this project is to evaluate if real GDP can be determined as a function of the main monetary macroeconomic variables (price level, the interest rate and money supply). Economic theory suggests that the response of an endogenous variable to the changes in the exogenous variables usually occurs at a different moment of time in a macroeconomic model. When this happens, we say there is a dynamic relationship, and it is not unusual to find that a shock in an independent variable has a different effect on the explained variable depending of the number of periods that have passed since that shock. The fact that in many cases some exogenous variables have an effect on the short run in the explained one while others affect it only on the long run is also remarkable. As a consequence of these ideas, it would be of interest to find a suitable model that could explain the real GDP in a moment of time as a function of our independent variables on that period and the previous ones.

2. Data used and sources of information The variable to be determined in the model is the real GDP (Yt), which will be measured in billions of United States dollars. We will use the following variables to explain it: the price level (Pricet), measured with the GDP deflator; the interest rate (Intratet), regarded as the monthly treasury bill rate in percentage; as well as the money supply (Moneyt), M2, measured in billions of dollars. All the data has been gathered during 184 periods, each period being a quarter of a year between 1947 and 1992 (46 years). Hence, the conclusions we shall reach from our estimations would be representative for the behavior of the variables in the last decades. The data clearly shows a time-series structure. Consequently, we will probably have to specify a dynamic model at some stage of our analysis, and we will have to face and solve some problems regarding autocorrelation.

3. Elaboration of the model 3.1. Obtaining and analyzing the initial model (a linear static model) We will start by introducing the initial regression model. As economic theory states that all the three independent variables (price, interest rate and money supply) have an effect on the production, we will compute a static linear model that will relate Y with Price, Intrate and Money: Yt = 0 + 1Pricet + 2Intratet + 3Moneyt + ut

We compute the model by OLS, and we obtain the following sample regression function, and the next statistics for the model: Yhatt = 1772.03 - 2187.37Pricet + 125.194Intratet + 1.47804Moneyt
(std.errors) (133.857) (975.812) (12.7922) (0.2843)

(Model 1)

Number of observations: 184; R-squared = 0.9391; F-statistic = 925.8111; P-value(F) = 4.1e-109; rho = 0.9478; Durbin-Watson = 0.0999 The model has a nice goodness of fit, because the R^2 is close to 1 (0.9391), and therefore the combination of the independent variables will explain a great part of the value of Y. If this model was consistent and asymptotically normal, inference would be valid and we could also tell that all the variables in it would be significant (|t-ratio of a variable| = |coefficient of the variable/std. error of the variable| > tT-K = t184 4 = t180 = 1.9732), and that the model would be overly significant as well [F-statistic = 925.8111 > F(K -1, T-K) = F(3, 180) = 2.6548)] In order to be able to know if this model is appropriate, we will proceed to study if the assumptions of the disturbances on the General Linear Regression Model hold. To do so, we will check the variability of the regression residuals, as well as their relationship with the other residuals over time. Plot.1: Plot of residuals against time:
Regression residuals (= observed - fitted Y) 600

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Most residuals are followed by other residuals of the same sign. This is an indication of possible positive autocorrelation.

Plot.2: Plot of actual versus fitted values of Yt:

Actual and fitted Y 5500 fitted actual

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The fitted values remain over the actual ones for some consecutive periods, and after that they stay some other consecutive periods under the actual ones. This alternation is repeated over time. As the residuals equal the actual values minus the fitted ones, we arrive to the same conclusion than before (there might be positive autocorrelation).

Plot.3: Plot of residuals against Yt:

Regression residuals (= observed - fitted Y) 600

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residual

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-800 1500 2000 2500 3000 Y 3500 4000 4500 5000

The variability of the residuals seems approximately constant for any value of the dependent variable. Hence, there will probably not be heteroskedasticity. Testing for autocorrelation It is quite common for the variables in macroeconomic models to have some relationship between the value in one period and the value in the previous one. Hence, we can perform the Durbin-Watson test in order to check the possibility of 1st order AR(1) autocorrelation: Durbin-Watson test for autocorrelation: Ho: null 1st order AR(1) autocorrelation for the disturbances (rho = 0) Ha: 1st order AR(1) autocorrelation for the disturbances (rho 0; rho > 0 in this case) Durbin-Watson statistic = 0.0999149 5% critical values for Durbin-Watson statistic, n = 184, k = 3 dL (T=184, K=3) = 1.7257 dU T=184, K=3) = 1.7920 DW = 0.0999149 < dL = 1.7257 We reject H0: theres evidence of positive AR(1) autocorrelation at a 5% significance level. Since the residuals are autocorrelated, the disturbances will not be spherical, and hatOLS will no longer be the linear unbiased estimator of minimum variance (it will be inefficient), and it will neither be asymptotically normally distributed nor asymptotically efficient. Therefore, it will not be valid for inference. We should look for another estimator, at least valid for asymptotical inference.

3.2. Estimation of the original model with robust (Newey-West) standard errors If we want to stick to the OLS estimation from the original regression in order to perform some hypothesis testing, it is possible to find a consistent estimator under autocorrelation for the covariance matrix of the OLS estimator, the Newey-West estimator. Hence, we will be able to estimate correctly the standard error of the estimated betas. As a result of that, the inference will be asymptotically normal (|t-ratio| N(0,1)) and consequently valid for estimation, even if it is inefficient: Yhatt = 1772.03 + -2187.37Pricet + 125.194Intratet + 1.47804Moneyt (Model 2)

(N-W std.errors)

(246.587)

(1630.06)

(22.943)

(0.4748)

Number of observations: 184; R-squared = 0.9391; F-statistic = 385.9143; P-value(F) = 3.99e-78; rho = 0.9478; Durbin-Watson = 0.0999 The model has a nice goodness of fit, because the R^2 is close to 1 (0.9391), and the model is overly significant as well [F-statistic = 385.9143 > F(K -1, T-K) = F(3, 180) = 2.6548)] Since the variable price is not significant (|t-ratio of price| = |coefficient/std. error| = 0.1813 < z/2 = 1.96), we will omit it from our model. We will estimate the model without the variable price by OLS: Yhatt = 1485.22 + 102.92Intratet + 0.843136Moneyt
(std.errors) (39.7654) (8.1459) (0.0246)

(Model 3)

Number of observations: 184; R-squared = 0.9374; F-statistic = 1356.051; P-value(F) = 1.2e-109; rho = 0.9633; Durbin-Watson = 0.0661 D-W test D-W = 0.066115 < dL( T = 184, K = 2) = 1.7368 We reject Ho: theres still autocorrelation. Since theres still autocorrelation, we reestimate Model 3 using Newey-West standard errors: Yhatt = 1485.22 + 102.92Intratet + 0.8431Moneyt
(N-W std.errors) (95.2198) (21.1343) (0.0346)

(Model 4)

Number of observations: 184; R-squared = 0.9374; F-statistic = 669.6988; P-value(F) = 2.25e-84; rho = 0.9633; Durbin-Watson = 0.0661 The model has a nice goodness of fit, because the R^2 is close to 1 (0.9374), and the model is overly significant as well [F-statistic = 669.6988 > F(K -1, T-K) = F(2, 181) = 3.0459)]. All the variables in it are also significant (|t-ratio of a variable| = |coefficient of the variable/std. error of the variable| > z/2 = 1.96).

3.3. Estimation using a dynamic model Autocorrelation can be due to a misspecification of the model. This happens because the residuals in a model where a significant variable has been omitted will be autocorrelated if the consecutive observations of the omitted variable are autocorrelated. The dependent variable, (Yt or real GDP) could actually depend on the past values for the independent variables (Price, Intrate and Money), as well than on the past values for itself.

We could start by specifying and estimating by OLS a model where Yt could depend on the last six lags for every dependent variable, as well than on the last six lags of itself: Yhatt = -45.9688 + 816.501Pricet 584.045Pricet-1 1319.51Pricet-2 + 1603.85Pricet-3 + + 1491.49Pricet-4 5204.58Pricet-5 + 3514.88Pricet-6 + 11.5856Intratet7 10.8222Intratet-1 11.8927Intratet-2 + 6.6442Intratet-3 8.880112Intratet-4 + + 3.6076Intratet-5 + 4.5375Intratet-6 + 0.3435Moneyt 0.2562Moneyt-1 0.1928Moneyt-2 0.1236Moneyt-3 + 0.1719Moneyt-4 0.0987Moneyt-5 + + 0.0591Moneyt-6 + 1.0892Yt-1 0.0213Yt-2 0.14Yt-3 + 0.1397Yt-4 0.013Yt-5 0.0399Yt-6 (Model 5) Number of observations: 178; R-squared: 0.9997; F-statistic: 16263.94; P-value(F): 4.6e-246 Since we are introducing some endogenous variables as regressors, the lags of Yt, which are random variables, we will not be able to perform the D-W test to check first order AR(1) autocorrelation. However, we could still check the Breusch-Godfrey test to check 1st order AR(1) or MA(1) autocorrelation: Breusch Godfrey test for 1st order AR(1) or MA(1) autocorrelation: Ho: no autocorrelation Ha: autocorrelation of order p = 1 (ut = p1ut-1 + t - AR(1) - or either ut = t + 1t-1 MA(1)) If TR^2(auxiliary regression) > X^2(p), we reject Ho in favor of Ha If TR^2(auxiliary regression) < X^2(p), we dont reject Ho Since TR^2(auxiliary regression) = 0.757596 < X^2(p) = X^2(1) = 3.84, we dont reject Ho theres no AR(1) nor MA(1) autocorrelation. Since theres no longer autocorrelation, hatOLS is now consistent and asymptotically normal. Therefore, we can start omitting from the model the variables that are not significant, beginning with the ones that have the highest p-value (the less significant ones). The model is overly significant [F-statistic = 16263.94 > F(K -1, T-K) = F(27, 150) = = 1.6971)]. However, there are some variables that are not significant (|t-ratio of a not significant variable| = |coefficient of the variable/std. error of the variable| < z/2 = 1.96). Hence, we will start omitting the least significant one, Yt-5 (|t-ratio| = 0.113 < z/2 = 1.96), and we will check if the condition of no autocorrelation still holds, by checking the value for the B-G(1) test again: Since TR^2(auxiliary regression of Model 5 when we omit Yt-5) = 0.728238 < X^2(1) = 3.84, we dont reject Ho theres no AR(1) nor MA(1) autocorrelation.

When we omit the variable Yt-5 from Model 5, theres neither autocorrelation. Therefore, we can omit the less significant variable in this new model, Yt-2. We will check BG(1) = TR^2 again and if it is smaller than X^2(1) = 3.84 (as it is), the model will still be consistent and asymptotically normal. Therefore, we will be able to omit the least significant variable one more time. We will repeat the same procedure as long as there is no 1st order autocorrelation until we find a model where all the variables are significant at a 5 % significance level. We will obtain the following results: Lets omit Yt-2: TR^2 = 0.034000 < X^2(1) = 3.84 Lets omit Moneyt-5: TR^2 = 0.038293 < X^2(1) = 3.84 Lets omit Moneyt-6: TR^2 = 0.036705 < 3.84 Lets omit Moneyt-3: TR^2 = 0.040813 < 3.84 Lets omit Pricet-1: TR^2 = 0.016537 < 3.84 Lets omit Moneyt-1: TR^2 = 0.016537 < 3.84 Lets omit Intratet-5: TR^2 = 0.029065 < 3.84 Lets omit Moneyt-4: TR^2 = 0.000009 < 3.84 Lets omit Yt-6: TR^2 = 0.003981 < 3.84 Lets omit Pricet: TR^2 = 0.006368 < 3.84 Lets omit Pricet-2: TR^2 = 0.006461 < 3.84 Lets omit Pricet-3: TR^2 = 0.010843 < 3.84 Lets omit Intratet-3: TR^2 = 0.081521 < 3.84 Lets omit Yt-4: TR^2 = 0.051598 < 3.84 Lets omit Yt-3: TR^2 = 0.298927 < 3.84 Lets omit Intratet-4: TR^2 = 0.329517 < 3.84 We arrive to the following model: Yhatt = -45.9346 + 1793.59Pricet-4 4806.47Pricet-5 + 3314.59Pricet-6 + 12.2164Intratet 12.1375Intratet-1 9.306Intratet-2 + 3.8929Intratet-6 + 0.2067Moneyt 0.3014Moneyt-2 + 1.018Yt-1 (Model 6) Number of observations: 178; R-squared: 0.9996; F-statistic: 46391.04; P-value(F): 6.2e-282; We proceed to check that we have also solved autocorrelation for every order up to 6: B-G(2) = TR^2 = 0.782575 < X^2(2) = 5.99 theres no AR(2) nor MA(2) autocorrelation B-G(3) = TR^2 = 3.665253 < X^2(3) = 7.81 theres no AR(3) nor MA(3) autocorrelation B-G(4) = TR^2 = 4.291702 < X^2(4) = 9.49 theres no AR(4) nor MA(4) autocorrelation B-G(5) = TR^2 = 4.335580 < X^2(5) = 11.07 theres no AR(5) nor MA(5) autocorrelation B-G(6) = TR^2 = 4.626915 < X^2(6) = 12.59 theres no AR(6) nor MA(6) autocorrelation There is no autocorrelation of any order up to 6. Since Model 6 has a stochastic regressor, this model will not be linear, and then it wont be valid for small samples. On

the other hand, the model is not autocorrelated and we will be able to find consistent, asymptotically efficient and asymptotically normal estimators for the betas with it. The model has a nice goodness of fit, because the R^2 is close to 1 (0.9374), and the model is overly significant as well [F-statistic = 46391.04 > F(K -1, T-K) = F(10, 167) = 1.8878)]. All the variables in it are also significant (|t-ratio of a variable| = |coefficient of the variable/std. error of the variable| > z/2 = 1.96).

3.4. Comparison between the estimation methods that are appropriate for the model: We have obtained two different models that have been simplified as much as possible in order to perform asymptotic inference with them. In order to decide which of them is more appropriate for that task, we will consider some of its qualities and properties: Chart.1: Comparison between models 4 and 6: Variable Constant Pricet Pricet-4 Pricet-5 Pricet-6 Intratet Intratet-1 Intratet-2 Intratet-6 Moneyt Moneyt-2 Yt-1 Number of explanatory variables (K-1) Sample size R2 Overall significance value P-Value for F Model 4 1485.22 Model 6 -45.9346 1793.59 -4806.47 3314.59 12.2164 -12.1375 -9.306 3.8929 0.2067 -0.3014 1.018 10 178 0.9996 46391.04 6.2e-282

102.92

0.8431

2 184 0.9374 669.6988 2.25e-84

As we have seen before, Model 4 will provide asymptotically normal estimators for the OLS regression model. Even if Model 6 is not linear and consequently it will not follow a normal distribution and it will neither be useful for small sample inference, it has better large sample properties, because it is not only asymptotically normal, but also consistent (because there is not autocorrelation) and asymptotically efficient. As our sample size is large enough (we can make use of 184 observations in the case of Model 4 and of 178 observations in the case of Model 6), the asymptotic inference will be equivalent to the small sample inference (if the latter was possible).

Model 6 has a sample size, because we lose 6 observations due to the lags. However, the model is very representative, since 6 observations are a small proportion from a sample of 184. The goodness of fit is higher for Model 6, l of as well as the level of overall significance (P-ValueModel6 = 6.2e-282 < P-ValueModel4= 2.25e-84). As a result of these observations, we can conclude that Model 6 would be the most appropriate model for hypothesis testing and prediction.

4. Conclusions We have arrived to the conclusion that all three dependent variables have an effect on the real GDP, even if that effect does not necessarily occur at the same moment of time, because there is a dynamic relationship between real GDP and the main monetary macroeconomic variables. In fact, some of the independent variables have a short run impact on real GDP. That is the case of the money supply, and for the most part of the interest rate (except for the influence of the previous sixth period). However, the price level only affects real GDP in the long run (it has an impact on real GDP after a years four periods- time), concretely four, five and six periods after the initial change on the price level. We should also take into account the strong significance of the value of the real GDP in the last period when we determine the real GDP in a certain moment of time.

5. Bibliography In order to perform this report, the following works have been analyzed: Wooldridge, J. M. (2006), Introductory Econometrics: A modern Approach, South-Western, 3rd edition Boone, K. (2010), How to write a technical report (available at http://kevinboone.net/howto_report.html) The Econometrics course class notes

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