The Engle-Granger Methodology

Application on the Austrian Economy Data

Martin Fuka (martin.fukac@cerge-ei.cz)

Abstract
In this paper I test for two theoretical relationships using the cointegration approach. First, I test whether growth of nominal wages is a function of the growth of aggregate price level. I find there is a quite close relationship. This fact suggests that the inflation phenomenon is anticipated in the wage policy. Second relationship I test for is the relationship given by the Friedmans rule, i.e., in equilibrium inflation grows at the same rate as the real output does. I find that this is not the case of Austrian economy, although there is certain causality between inflation and output growth.

Introduction
I focus in this paper on testing two causal relationships expected by the economic theory. Testing is done on the quarterly economic data of the Austrian economy. In the first case, a microeconomic one, I try to find out whether the nominal wage adjusts for the aggregate price level changes. In other words, I try to test, whether there is a tendency in the economy to keep real wage at least non-decreasing. In the second case, a macroeconomic one, I try to indirectly check whether there is a tendency of the monetary policy to follow the Friedmans rule. The employed testing procedure is based on the Engle-Granger methodology described in Enders (1995). The paper proceeds as follows. In the next part I describe the data sources and the relevant data transformation for testing. In the second section I briefly sketch the hypothesis to be tested. The methodology of is in the third part. The fourth part presents results and the discussion about them, and the fifth part concludes.

Data description

The source of data is the Osterreichisches Institut fur Wirtschaftsforschung (www.wifo.ac.at). The description of quarterly time series I use for this paper is contained in the following Table 1.
Table 1 Original time series Time series of Real Gross Domestic Product Consumer price index Average Nominal Wage Denotation GDPr CPI W Units mill. of ATS (base year 1985) % (base year 1995) ATS Data span 1980:Iq 1999:IVq 1980:Iq 1999:IVq 1980:Iq 1999:IVq Note seasonally unadjusted seasonally unadjusted seasonally unadjusted

For the testing purposes I have to transform the original data. The transformation and the new variables are described in the Table 2.

Table 2

Transformed time series (relevant for testing) Time series of Denotation g Units % % % Data span 1981:Iq 1999:IVq 1981:Iq 1999:IVq 1981:Iq 1999:IVq Transformation form

Year-to-Year Real GDP growth Year-to-Year CPI inflation Year-to-Year Nominal Wage growth
Note:

GDPr t GDPr t 4 100 GDPr t 4 CPI t CPI t 4 100 CPI t 4 Wt Wt 4 100 Wt 4

Using the described transformation none of the series exhibits a seasonal pattern.

In the following figures, I plot the graphs of transformed time series which will be used for testing later on. The Figure 1 shows the real GDP growth, Figure 2 shows the yearly inflation path, and the Figure 3 presents the growth of nominal wages.

Figure 1

Year-to-Year growth of Real GDP

Figure 2

Year-to-Year inflation of CPI

Figure 3

Year-to-Year growth of Average Nominal Wage

Test Hypothesis

Hypothesis H1:

The inflation rate is anticipated in wage contracts

The first hypothesis to be tested expects that if economic agents are rational they adjust their wage appropriately to the changes in product prices, i.e., they will tend to keep their real earnings at least constant.1 If this is actually true I should be able to find cointegration in the growth of nominal wage and aggregate price level inflation. I assume the following long-run relationship between price inflation and the growth of nominal wage:
wt = b0 + b1 t + et ,

(1)

where w is the growth rate of the aggregate nominal wage, is the aggregate price level inflation, and e is iid process.

Hypothesis H2:
1

The monetary policy follows the Friedmans rule

Because I have not seen an empirical study concerning the labour productivity development in Austria, I assume that the development is non-decreasing. From here, I conclude that a rational agent should tend to keep her real earnings at least constant.

This hypothesis is monetary policy oriented. I would like to test whether the monetary policy was conducted under the Friedmans rule that monetary theory suggests and which was actually employed in many developed market economies, including Austria. The Friedmans rule says that in order to maintain the aggregate price level stabile (keep inflation constant), the real money supply (m) should growth at the same rate as the long-term real output (g). The same theory implies that if the rule is followed, in equilibrium, the inflation rate ( ) should be equal to the growth rate of money supply. Hence, if in the equilibrium the theory implies m = and m = g, one should be able to observe = g. Utilizing this fact, I indirectly test whether the last implication holds, i.e., there is really an equilibrium relationship between the inflation growth and real output growth. To formalize this, I estimate

t = b0 + b1 g t + et ,
where g is the growth rate of real output.

(2)

Methodology
In order to test for the hypothesis discuss above I utilize the methodology suggested by Engle and Granger (1987). In testing I proceed as follows.
1.) I test whether the assumed time series are I(1) which is a necessary condition for the further

testing procedure. To do that I employ the very standard Augmented Dickey-Fuller test (ADFt). First, I test for the unit roots in the cases when intercept and trend is present in the regression, then when there is the intercept only, and finally without intercept and trend. If I am not able to reject the null hypothesis about the unit root I run the ADFt on the first differences of the original time series, i.e., g, w, . In this step, I should be already able to reject the null hypothesis about the unit root in order to be able to conclude that the original time series (g, w, . ) are I(1). 2.) Estimate the long-run relationships, i.e., run regression on the equations (1) and (2). Save regression residuals. 3.) Test whether the residuals are stationary using again the standard ADFt. The procedure is the same as in the step 1.). If I am able to reject the null hypothesis about the unit root, I can conclude that the variables in (1) and (2), respectively, are cointegrated of the orders CI(1,1). 4.) If I conclude cointegration in relation (1) and (2) I estimate the error-correction model (ECM). For the theory I refer to Enders (1995), pp. 365-373. Basically, I utilize the VAR approach. In the case of equation (1) I estimate the following system of equations:

wt = 1 + w et 1 + 11 (i ) wt i + 12 (i ) t i + tw
i =1 i =1

(3)

 t = 2 + et 1 + 21 (i ) wt i + 22 (i ) t i + t
i =1 i =1

(4)

Estimating (3) and (4) I have to take into account two objectives, (i) maintain the models parsimonious, and (ii) at the same time receive as a white noise. Clearly, to fulfil both objectives at a time is in practice almost impossible. My prior criterion is, hence, to make a white noise. I control for this objective by checking the residuals for serial correlation. This I consider as a sufficient check. The most important outcome from the ECM are, however, the parameters w and ,. Those will be discussed in the section with results. Next result is the check of causality between the variables. 5.) If I do not conclude cointegration in the relationships of (1) and (2) I examine them by the simple Granger causality test. But one must be aware that the Granger causality test must be ran on I(0) series, in our case, g, w, . Basically, I test the hypothesis whether helps predict w, and g helps predict , respectively. This is done by a simple F-test where I compare restricted (R) and unrestricted model (UR). In the case of relation (2), the models look as (R): (UR):

t = 1 + i t i + e t , t = 1 + i t i + i g t i + t .
i =1 i =1 i =1 m m

(5) (6)

Results
Testing whether g, w,
Table 3

are I(1)

ADF-test results for g, w, .

n

y t = y t 1 + i y t i + et
i =1

Time series g w

Parameter gamma beta(n) gamma beta(n) gamma beta(n)

n

Estimate -0.0869 -0.3293 -0.0394 -0.3187 -0.0168 0.1833

t-test -1.60 -3.46 -1.59 -3.24 -1.10 1.76

Critical value -1.61b 1.66b -1.61b 1.99a -1.61b 1.99a

R^2 0.234 0.308 0.158

F-test (p-value) 6.26 (0.00) 9.18 (0.00) 5.02 (0.015)

Durbin-h 1.51 0.97 1.11

n/ observations 5 / 84 4 / 85 5 / 84

y t = a 0 + y t 1 + i y t i + et
i =1

Time series g

Parameter a0

Estimate 0.0098

t-test 3.31

Critical value 1.66b

R^2 0.320

F-test (p-value) 7.62

Durbin-h 1.56

n/ Observations 5 / 84

gamma beta(n) a0 gamma beta(n) a0 gamma beta(n)

-0.4424 -0.1739 0.0055 -0.1364 -0.2889 0.0019 -0.0636 0.2155

n

-2.75 -2.49 1.20 -1.62 -2.87 1.42 -1.75 2.04

-2.93a 1.99a 1.66b -2.60b 1.99a 1.66b -2.60b 1.99a

(0.00) 0.323 0.20 7.75 (0.00) 4.05 (0.001) 1.50 1.44 4 / 85 5 / 84

y t = a 0 + a1t + y t 1 + i y t i + et
i =1

Time series

Parameter a0 a1 gamma beta(n) a0 a1 gamma beta(n) a0 a1 gamma beta(n)

Estimate 0.2605 -0.0001 -0.448 0.2650 1.3319 -0.0007 -0.3451 -0.2226 0.6548 -0.0003 -0.1617 0.2630

t-test 0.64 -0.62 -3.03 2.53 2.20 -2.18 -2.74 -2.17 2.66 -2.65 -3.17 2.56

Critical value 1.99a 1.99a -3.18b 1.99a 1.99a 1.99a -3.18b 1.99a 1.99a 1.99a -3.18b 1.99a

R^2

F-test (p-value) 6.36 (0.00) 7.47 (0.00) 4.34 (0.0019)

Durbin-h

n/ Observations

0.323

1.45

5 / 84

0.36

1.37

4 / 85

0.246

0.98

5 / 84

Note:

The estimates in bold are statistically significant. In terms of parameter gamma it means that the null hypothesis about unit root is rejected. (a) are critical values for 5% level of significance, (b) are critical values for 10%. The critical value for the Durbins h at 5% level of significance in 1.645. (I test the Durbins h, which is approximately distributed as standard normal distribution, by a one-tailed test).

Table 4

ADF-test results for g, w, .

n

y t = y t 1 + i y t i + et
i =1

Time series g w

Parameter gamma beta(n) gamma beta(n) gamma beta(n)

n

Estimate -1.7970 0.5325 -1.9947 0.3172 -0.9650 0.2794

t-test -6.54 3.48 -7.08 3.20 -5.89 2.75

Critical value -1.95a 1.99a -1.61b 1.99a -1.95a 1.99a

R^2 0.67 0.75 0.47

F-test (p-value) 42.56 (0.00) 84.66 (0.00) 24.93 (0.015)

Durbin-h 1.51 0.97 1.11

n/ observations 3 / 83 4 / 84 3 / 83

y t = a 0 + y t 1 + i y t i + et
i =1

Time series g w

Parameter a0 gamma beta(n) a0 gamma beta(n)

Estimate -0.0001 -1.7979 0.5331 -0.0016 -2.0513 0.3272

t-test -0.10 -6.54 3.48 -1.26 -7.19 3.29

Critical value 1.66b -2.93a 1.99a 1.66b -2.60b 1.99a

R^2 0.67 0.76

F-test (p-value) 33.62 (0.00) 64.07 (0.00)

Durbin-h 1.56 1.50

n/ Observations 3 / 83 4 / 84


Note:

a0 gamma beta(n)

-0.0003 -0.9814 0.2841

-0.59 -5.91 2.79

1.66b -2.93a 1.99a

0.48

18.72 (0.001)

1.44

3 / 83

The estimates in bold are statistically significant. In terms of parameter gamma it means that the null hypothesis about unit root is rejected. (a) are critical values for 5% level of significance, (b) are critical values for 10%. The critical value for the Durbins h at 5% level of significance in 1.645. (I test the Durbins h, which is approximately distributed as standard normal distribution, by a one-tailed test).

From the ADF test follows that all time series under consideration, i.e., g, w, , can be handled as integrated of the first order, although, the I(1) is not so clear for the growth of real output where the test statistic was on the margin of significance (see the table 3, the first model parameter gamma for g). Yet to be able to continue in the analysis, I consider g as I(1).

Testing the long-run relationship

In this section I present the results of the relationships expressed by (1) and (2). The table 5 shows the estimation results and the table 6 shows the results on testing the regression residuals for a unit root. The residuals were subject to the ADF test.
Table 5 Estimation results of the long-run relationships

Equation
(1) (2)
Note:

b0 (t-stat.)
0.0257 (8.2738) 0.0352 (11.675)

b1 (t-stat.)
0.8155 (9.7178) -0.1079 (-1.6162)

R^2
0.51 0.15

F (p-value)
93.40 (0.00) 3.02 (0.21)

DW
1.98 1.25

The parameters in bold are significant at 5% level. The DW statistic is compared with the critical values in Pindyck and Rubinfeld (1996). DWL = 1.635, DWU = 1.679.

Table 6

Testing for the unit roots in regeression residuals

 et = et 1 + i et i + t
i =1

Equation (1) (2)

Note:

Parameter gamma beta(n) gamma beta(n)

Estimate -0.5189 -0.2402 -0.0435 -0.2317

t-test -3.53 -2.37 -1.21 -2.29

Critical value -3.17a 1.99a -2.19b 1.99a

R^2 0.41 0.12

F-test (p-value) 14.03 (0.00) 2.80 (0.03)

Durbin-h 1.47 1.11

n/ #obs. 4 / 84 4 / 85

The critical values for the parameters gamma are taken from Enders (1996), p.383. (a) stands for the 5% significance, (b) stands for 10% significance.

The test results in the table 6 suggest that the long-run relationship (1) holds, while, the relationship (2) does not because I cannot reject the null hypothesis about the unit root in the case of the equation (2) residuals. I can conclude that and w are CI(1,1), and I do not identify any cointegration between g and . From the economic view, I find a positive realtionship between price and wage inflation, which in fact meets my prior expectations. In contrast, and what surprising is, I identify negative relation between inflation and the real output growth. However, this cannot be taken too seriously because a detailed analysis of residuals proved them not to be a white noise but rather an unspecified process.

The Error-Correction model for the long-run relation (1)

In this section I present the results of the error-correction model estimation. The model is of the form (3) and (4), where m = 2. I employ traditional methods of estimating VAR models to obtain the results. The results follow in the Table 7.

Table 7 Equation

Estimation results of the error-correction model Parameter alpha(1) alpha(w) alpha(11)(1) alpha(11)(2) alpha(12)(1) alpha(12)(2) Estimate -0.0013 -0.5139* 0.7093* -0.0780 -0.5387* 0.2571** t-test 1.00 -4.14 6.30 -0.73 -2.27 1.76 R^2 F-test (p-value) 19.10 (0.00) Durbin-h

(3)

0.65

1.34

(4)

alpha(2) alpha( ) alpha(21)(1) alpha(21)(2) alpha(22)(1) alpha(22)(2)

-0.0003 0.0627 -0.0387 -0.0508 -0.1501** -0.1324

-0.50 1.46 -0.74 -1.04 -1.68 -1.20

0.15

2.80 (0.15)

1.67

Note:

The estimates in bold are statistically significant. (*) are critical values for 5% level of significance, **) are critical values for 10%. The critical value for the Durbins h at 5% level of significance in 1.645. (I test the Durbins h, which is approximately distributed as standard normal distribution, by a one-tailed test).

As one can notice, there is a quit strong one-sided relationship between inflation and the growth in nominal wages. Having these results, I can conclude that the hypothesis H1 stated in the part 2 can be accepted, i.e., it seems that the price inflation is anticipated in the contract policy when negotiating wages.

Testing Granger causality between

and g

Because I did not identify cointegration between and g of the form (2), in this section I am going to test for the one-sided causality between and g. More precisely, I test whether g Granger causes . To do that I run regression on the restricted model (5) and unrestricted model (6) and evaluate the causality by the standard F-test procedure. Here, I present the results only on the relation ( g G.C. ) because the opposite causality was even less significant. The results of the first causality test are stated in the Table 8 below.
Table 8 Model (R) Granger causality test results Parameter alpha(1) beta(1) Estimate -0.0039* -0.1981** t-test 2.01 -1.91 R^2 0.37 F-test (p-value) 5.12 (0.01) Durbin-h 0.99

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(UR)
Note:

alpha(1) beta(1) gamma(1)

-0.0031* -0.2141* 0.0965*

2.19 -2.06 2.41

0.42

3.20 (0.01)

1.56

The estimates in bold are statistically significant. (*) are critical values for 5% level of significance, **) are critical values for 10%. The critical value for the Durbins h at 5% level of significance in 1.645. (I test the Durbins h, which is approximately distributed as standard normal distribution, by a one-tailed test).

The test statistic for the Granger causality test is of the value of 2.97 while the critical value was 3.85 (for the F-stat. with (2,88) degrees of freedom, 5% significance level), hence, I have to reject the hypothesis that g Granger causes at the 5% level of significance.

Conclusion
Employing the Engle-Granger methodology I was able to accept the hypothesis that the changes in nominal wages reflect the changes in aggregate price level inflation. In other words, my initial hypothesis that rational economic agents have to take into account inflation when negotiating for wages has shown to hold. The analysis of the error-correction model supports this conclusion. I found there is a strong one-sided causality from price inflation to wage inflation but not other way round. By the same means of analysis I was not able to find any support for the hypothesis that the monetary policy probably follows the Friedmans rule. The prior expectation that there is a long-term relationship between inflation and the growth rate of real product were not met. I was not able to find a long-run relation between these two variables. Even more, which is surprising, I did not find a causal relation between these two variables. Although there were certain time periods (beginning of 90s) when the changes in real output growth helped predicting changes in inflation, there was no overall statistically significant improvement.

References
Enders, W. (1995), Applied econometric time series, John Wiley&sons.,Inc., New York Engle, R.F. and C.W.J. Granger (1987), Cointegration and Error-Correction: Representation, Estimation, and Testing, Econometrica 55 (March), pp. 251-276 Pindyck, R.S. and D.L. Rubinfeld (1996), Econometric models and Economic Forecast, Fourth edition, McGraw-Hill, New York

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Appendix
The Matlab code created to run testing done in this paper
%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% % HW4: COINTEGRATION

%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% % I examine the relationship between % i.) GDPr vs. CPI % ii.) Wn vs. CPI clear all close all

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format short load austria % Model data: % ^^^^^^^^^^^ % yearly inflation dCPI_year = (CPI(5:end)-CPI(1:end-4))./CPI(1:end-4); dWn_I_year = (Wn_I(5:end)-Wn_I(1:end-4))./Wn_I(1:end-4); dOIL_year = (OIL(5:end)-OIL(1:end-4))./OIL(1:end-4); % yearly GDP growth GDPr(end) = GDPr(end-4); %GDPn(end) = mean(GDPn(end-6:end-1)); dGDPr_year = (GDPr(5:end)-GDPr(1:end-4))./GDPr(1:end-4); %dGDPr_year = (GDPn(5:end)-GDPn(1:end-4))./GDPn(1:end-4); dt = t(5:end); %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% % THE ENGLE-GRANGER METHODOLOGY % ***************************** % Testing % ^^^^^^^^ set(0,'DefaultLineLineWidth',1.5); figure plot(dt,dCPI_year.*100) hold on xlabel('[quarters]') ylabel('[%]') figure plot(dt,dWn_I_year.*100) hold on xlabel('[quarters]') ylabel('[%]') figure plot(dt,dGDPr_year.*100) hold on xlabel('[quarters]') ylabel('[%]') figure plot(dt,dCPI_year,dt,dWn_I_year) legend('CPI inflation','yearly growth of nomina wage') figure plot(dt,dCPI_year,dt,dGDPr_year) legend('CPI inflation','yearly growth of GDPr') figure plot(dt,dCPI_year,dt,dOIL_year) legend('CPI inflation','yearly growth of OIL') %adf(diff(dGDPr_year),dt(2:end),4)

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figure plot(dt,dGDPr_year,'r') hold on plot(dt,mean(dGDPr_year)*ones(size(dt)),'k'); %wwwwwwwwwww %adf(diff(dCPI_year),dt(2:end),3); % >>====>>> dCPI_year ~ I(1) %wwwwwwwww adf(diff(dWn_I_year),dt(2:end),3); % >>====>>> dWn_I_year ~I(1) %wwwwwwwww disp(' i.) CPI(t) = b0 + b1*GDPr(t) + e(t)') disp(' =====================================') const = ones(size(dGDPr_year)); X = [const dGDPr_year]; [b bint e_1 eint STATS] = regress(dCPI_year,X,.05); e_std = sqrt(inv(X'*X)*var(e_1)); disp(' Parameters (t-stat) ') disp([b,b./diag(e_std)]) %wwwwwwwwwww % Testing stationarity of e: lag_1 = 4; [par t_test] = adf(e_1,dt,lag_1); %wwwwwwwwwww

% >>>====> "e" is stationary

disp(' ii.) dw(t) = b0 + b1*dCPI(t) + e(t)') disp(' =====================================') const = ones(size(dt)); X = [const dCPI_year]; [b bint e_2 eint STATS] = regress(dWn_I_year,X,.05); e_std = sqrt(inv(X'*X)*var(e_2)); disp(' Parameters (t-stat) ') disp([b,b./diag(e_std)]) %wwwwwwwwwwwwwwwww % Testing stationarity of e: lag_2 = 4; [par t_test] = adf(e_2,dt,lag_2);

% >>>====> "e" is stationary

% Error-correction model: (VAR models) % ^^^^^^^^^^^^^^^^^^^^^^ disp(' i.) The Error Correction model for dCPI vs. dWn') disp(' ===========================================') na = [2 2;2 2]; nb = [1 1;1 1]; nk = [1 1;1 1]; ORDERS = [na nb nk]; M_1 = arx([diff(dWn_I_year) diff(dCPI_year) ones(size(e_1(2:end)))],ORDERS); present(M_1) %wwwwwwwwwwwwww disp(' Granger causality test') % ======================= % Testing dX ---> dY % ^^^^^^^^^^^^^^^^^^^ disp(' i.) dGDPr ---> dCPI') [F F_krit] = granger(diff(dCPI_year),diff(dGDPr_year),[2 2 1])

e_2(1:end-1)

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% Identifying the long run-relationship % ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ disp(' i.) CPI(t) = b0 + b1*GDPr(t) + e(t)') disp(' =====================================') const = ones(size(GDPr_s)); X = [const GDPr_s]; [b bint e_1 eint STATS] = regress(CPI,X,.05); % Testing stationarity of e: lag_1 = 4; [par t_test] = adf(e_1,t,lag_1);

% >>>====> "e" is stationary

disp(' ii.) CPI(t) = b0 + b1*OIL(t) + e(t)') disp(' =====================================') const = ones(size(R)); X = [const R]; [b bint e_2 eint STATS] = regress(CPI,X,.05); b STATS % Testing stationarity of e: lag_2 = 1; [par t_test] = adf(e_2,t,lag_2);

% >>>====> "e" is stationary

%WWWWWWWWWWWWWWWW % Error-correction model: (VAR models) % ^^^^^^^^^^^^^^^^^^^^^^ disp(' i.) The Error Correction model for CPI vs.GDPr') disp(' ==========================================') na = [2 2;2 2]; nb = [1 1;1 1]; nk = [1 1;1 1]; ORDERS = [na nb nk]; M_1 = arx([diff(CPI) diff(GDPr_s) e_1(2:end) ones(size(e_1(2:end)))],ORDERS); present(M_1) %wwwwwwwwwwwwww disp(' ii.) The Error Correction model for CPI vs.OIL') disp(' ==========================================') i = 2; j = 1; na = [i j;j i]; nb = [1 1;1 1]; nk = [1 1;1 1]; ORDERS = [na nb nk]; %M_2 = arx([diff(CPI) diff(R) e_2(2:end) ones(size(e_2(2:end)))],ORDERS); %present(M_2) disp(' GRANGER CAUSALITY TEST') % ********************** % Stationarizing time series dt dGDPr dCPI dOIL = = = = t(2:end); diff(GDPr_s); % quarterly growth rate of output diff(CPI); % quarterly inflation rate diff(R); % quarterly changes in the oil price

% Testing dX ---> dY % ^^^^^^^^^^^^^^^^^^^ disp(' i.) dGDPr ---> dCPI') [F F_krit] = granger(dCPI,dGDPr,[2 1 1])

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disp(' ii.) dOIL ---> dCPI') [F F_krit] = granger(dCPI,dOIL,[2 3 0])

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