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David Ortuño Jeremi Fosse Yuliya Kulikova

Monetary policy Problem set #1 Long-run correlations. Notes.
John Taylor have suggested that: “…about which there is now little disagreement, . . . that there is no long-run trade-off between the rate of inflation and the rate of unemployment.” a) what does this implies for the Phillips curve? b) can you verify the statement using data for France, Russia, Spain and the UK? c)What about the correlations between money growth inflation and nominal interest rates in the long run in these countries? (Hint: use the Fisher equation here). Data: Russia 1996 – 2009 (we droped observations 1993-1996 because of hyperinflation after Soviet Union crash). For the second part of problem we used data 1999-2009. Spain 1980 – 2009 France, UK 1970-2009 For money growth+Interest rate, Money growth+Inflation Spain, France 1971 – 1998, UK 1987 – 2009, Russia 1996 - 2009 We used different time periods for different countries. This is because we don’t need to compare countries – we need to look only at existence of relations between variables in the same country.

a) In theory Phillips curve imply negative short-run relationship. By

numerous authors, however, it was shown, that Phillips curve in the short-run doesn’t hold. Our objective is to look at Phillips curve in the long-run. If John Taylor is right and there is no trade-off between inflation and unemployment, the Phillips curve will not have a negative slope.

b) Among all papers we read about this problem we distinguish 2 papers:

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Niskanen (2002), Reichel (2004). Niskanen proposed autoregressive distributed lag model: Ut=α+βIt+γIt-1+δUt-1+εt (estimation by OLS) He found out, that there is: small negative relation between unemployment and inflation in the same year, larger positive relation with the inflation rate in the prior year, and unemployment rate adjusts only slowly to the equilibrium rate. But Niskanen’s approach has a problem of non-stationarity. Nonstationary data, while working with it, could provide us with spuriously good results. This problem was considered in the Reichel’s Error Correction model. So, our approach was based on Reichel’s approach. Summary of how do we use methods you can find on the following picture:

ΔUt = μ + β0 * ΔIt + (γ-1) (Ut−1 − θ It−1) + εt Equilibrium relationship between Equilibrium error changes in unemployment rate (deviation from equilibrium) and inflation rate where • Δ Ut = Ut − Ut−1, • Δ It = It − It−1, • θ = −(β0+ β1)/(γ-1) • (γ-1) – loading coefficient, shows degree of adjustment of the error term to equilibrium • β0 – short-run coefficient

θ – long-run coefficient

1.1 Stationarity We begin from checking statistical properties of variables – whether variables are stationary or not. 1) If Ut and It are stationary (I(0)), there is no need for an ECM, and the ARDL model is appropriate. 2) If the variables are nonstationary (I(1), I(2)), there are two alternatives: – In the case of cointegration (i.e., a meaningful Phillips curve between Ut and It), we should obtain a significantly negative loading coefficient (γ-1) as well as a significantly positive θ. – If there is no Phillips curve, the regression will not survive the differencing procedure. Thus, a “significant” level relationship in the ARDL – spurious. Results of stationarity test (Augmented Dickey-Fuller test) Inflation • Spain – I(2) • Spain – I(1) • France-I(1) • France-I(1) • UK-I(2) • UK-I(1) • Russia-I(1) • Russia-I(0) Unemployment We observe the same order unit root only for France. However, in literature there are a lot of discussions about power of stationarity tests (such as ADF). Many scientists consider them of low power in distinguishing number of unit roots. Moreover, different stationarity test can perform different stationarity results. So, Kwiatkowski-Phillips-Schmidt-Shin (KPSS) test, and the ElliotRothenberg-Stock test (ERS) show that unemployment of UK is U(I). So, we assume that we might have been mistaken in order of stationarity (because of low power of the ADF) and will check for cointegration all countries, not only France (as Reichel proposes). 1.2 Johansen’s Cointegration test:
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Test for France detects cointegration Test for Spain, UK, Russia – inflation and unemployment are not cointegrated. That means, that there is no trade off between unemployment and inflation.

The fact that inflation and unemployment are not cointegrated means that we cannot use error-correction model. However, we follow Reichel and check ECM for those countries and if the relation between It and Ut

for these countries exists, then the error-correction model will detect such relation. If not – we conclude that there is no such a trade-off. Error-correction model (bold numbers- significant coefficients): • France: D(UFR) = 0.017*( UFR(-1) + 0.577*IFR(-1) - 10.69 ) + 0.547*D(UFR(-1)) + 0.06*D(IFR(-1)) + 0.05 • Spain: D(USP) = - 0.165*( USP(-1) + 0.21*ISP(-1) - 17.58 ) + 0.88*D(USP(-1)) + 0.087*D(ISP(-1)) + 0.18 • UK: D(UUK) = - 0.074*( UUK(-1) - 0.099*IUK(-1) - 6.639) + 0.702*D(UUK(-1)) + 0.102*D(IUK(-1)) + 0.033 • Russia: D(URU) = 0.034*( URU(-1) - 0.245*IRU(-1) + 4.616 ) + 0.583*D(URU(-1)) - 0.006*D(IRU(-1)) - 0.278 Cointegrating relationship between Ut and It implies a negative sign of loading coefficient. In this case, deviations from the equilibrium will be corrected and, therefore, it will indicate a stable long-run equilibrium. Thus, to detect Phillips curve in the long-run, error-correction model should show significantly negative loading coefficient and significantly positive longrun coefficient. We present our results in a table. Column 1 shows the simple correlation coefficient between the unemployment rate and the inflation rate; column 2 reports the short-run impact of inflation on unemployment—the coefficient β0 of the ECM; column 3 presents the loading coefficient (γ-1)to show the presence of a cointegrating relationship; column 4 reports the long-run θ, which must have a positive sign if the traditional Phillips curve is a valid representation of the U-I relation; column 5 presents the conclusion about the relationship. As we see from the table below, these conditions are not held for any of the countries:

Simple correlation France Spain UK Russia -0,68 0,052 -0,22 -0,37

Loading Short-run PC coefficient (γβ0 1) Long-run θ 0,06 0,87 0,10 -0,06 0,017 -0,165 -0,074 0,034 -0,577 -0,21 0,099 0,245

Conclusion No tradeoff No tradeoff No tradeoff No tradeoff

We used also second method to look at long-run trade-offs. Method of moving averages. We took 5-year moving averages.

As we see from the graphs, for the same level of inflation we can observe different levels of unemployment. This means that there is no trade-off in the long-run between inflation and unemployment for all countries.

II. Long-run correlations between inflation, money growth and interest rate. We used the same error-correction model to detect long-run correlations between variables. Advancing presentation of the results we got, we should say, that this model is not good for detecting long-run correlations between these variables. We detected almost nothing with it. More advanced methods should be applied. The stages for this analysis were the same, as we performed for Phillips curve. 1) Stationarity tests 2) Cointegration tests 3) ECM results Stationarity tests:

Inflation • Spain – I(1) • France-I(1) • UK-I(1) • Russia-I(0)

Money Growth • Spain – I(1) • France – I(1) • UK – I(1) • Russia – I(2)

Interest rate • Spain – I(1) • France – I(1) • UK – I(1) • Russia – I(0)

As we see, for Spain, France, UK variables are of the same order of stationarity. For Russia inflation and interest rate are of the same order (I(0)), but money growth is I(2). II.1 Interest rate + inflation • Fischer equation holds (Hoffman, Crowder): i=r+π • Real interest rate usually assumed stationary • Johansen’s test detect cointegration between inflation and nominal interest rate for all countries. So, we can use ECM for all countries.
•France D(RFR) = 0.149*( IFR(-1) - 0.86*RFR(-1) + 2.08 ) + 0.045*D(IFR(-1)) + 0.13*D(RFR(-1)) - 0.03 •Spain D(RSP) = 0.101*( ISP(-1) - 0.404*RSP(-1) - 1.89) + 0.45*D(ISP(-1)) - 0.031*D(RSP(1)) - 0.25 •UK D(RUK) = - 0.01*( RUK(-1) - 1.14*IUK(-1) - 1.87 ) + 0.16*D(RUK(-1)) + 0.062*D(IUK(1)) - 0.05 •Russia D(RRU) = - 1.17*( RRU(-1) - 0.798*IRU(-1) - 1.65) - 0.03*D(RRU(-1)) 0.09*D(IRU(-1)) - 3.83

Simple correlation France Spain UK Russia 0,825 0,852 0,8 0,975

Short-run coef. β0 0,13 -0,031 0,062 -0,09

Loading coef. (γ-1) 0,149 0,101 -0,01 -1,17

Long-run θ 0,86 0,404 1,14 0,798

Fisher equation tells us, that relation should be positive. So, we should get significant negative loading coefficient (telling us about cointegration) and significantly negative long-run coefficient. However, ECM doesn’t perform such results. We didn’t detect positive relation between interest rate and inflation in the long run for any of the countries. II.2 Money growth + Inflation For Spain, France and UK money growth and inflation are cointegrated – we perform ECM. For Russia these variables are not cointegrated – this method doesn’t suit. However, we perform it. And if there is the relation between money growth and inflation in the long-run, error-correction model should detect it.
• • • France D(DIFR) = - 0.609*( DIFR(-1) + 7.75*MGFR(-1) - 0.003 ) + 0.017*D(DIFR(1)) + 11.35*D(MGFR(-1)) - 0.07 Spain D(DISP) = - 0.96*( DISP(-1) + 4.095*MGSP(-1) + 0.44 ) - 0.037*D(DISP(-1)) + 9.6*D(MGSP(-1)) + 0.04 UK D(DIUK) = - 1.47*( DIUK(-1) - 17.54*MGUK(-1) + 1.47 ) + 0.40*D(DIUK(-1)) + 0.078*D(MGUK(-1)) - 0.07

Russia D(DIRU) = - 2.17*( DIRU(-1) + 153.18*MGRU(-1) - 43.15 ) + 0.40*D(DIRU(-1)) + 53.63*D(MGRU(-1)) - 3.23

Simple correlation Franc e Spain UK Russi a

Short-run coef. Loading coef. Long-run Β0 (γ-1) θ 11,35 9,6 0,078 53,63 -0,609 -0,96 -1,47 -2,17 -7,75 -4,095 17,54 153,18

-0,03 -0,05 0,34 0,009

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Quantitative theory of money says, that MV = PQ. If it holds, there should be positive relationship between money growth and inflation. So, we should get significantly negative loading coefficient (telling us about cointegration) and significantly negative long-run coefficient. We got that correlation in the long-run is significantly positive for France, Spain and Russia and significantly negative for UK. However, we didn’t get neither Walsh’s result about 1 to 1 correspondence, nor positive relationship for all countries We are treating our results about Russia with great doubts, as cointegration test was negative.

II.3 Money growth +Interest rate.
• • • • France D(RFR) = - 0.104*( RFR(-1) - 115.49*MGFR(-1) - 3.85) + 0.36*D(RFR(-1)) 7.73*D(MGFR(-1)) - 0.24 Spain D(RSP) = 0.028*( RSP(-1) + 446.09*MGSP(-1) - 51.37 ) + 0.023*D(RSP(-1)) 5*D(MGSP(-1)) - 0.63 UK D(RUK) = 0.012*( RUK(-1) + 161.4*MGUK(-1) - 20.1) + 0.019*D(RUK(-1)) 0.48*D(MGUK(-1)) - 0.29 Russia D(RRU) = - 0.23*( RRU(-1) - 208.75*MGRU(-1) + 49.36 ) + 0.21*D(RRU(1)) - 13.8*D(MGRU(-1)) - 1.05

Short-run coef. Loading coef. Long-run β0 (γ-1) θ Franc e Spain UK Russi a -7,73 -5 -0,48 -13,8 -0,104 0,028 0,012 -0,23 115,49 -446,09 -161,4 208,75

To see long-run relationship between this parameters we should see significant loading coefficient (telling us about cointegration) and significantly positive θ for negative relation or significantly positive θ for positive relation.

We didn’t find out direct relationship between money growth and interest rate using ECM

However, it is clear: - if Fischer equation holds, - if quantitative theory of money equation holds Money growth should be correlated with interest rate through inflation •