Phillips

Estimating the Phillips curve relationship for US 1970:01-2015:12
Ramberto Jr. Sosa Cueto
Submitted in Partial Fulfilment

Of the Course Requirements
For Applied Econometrics
ECO 524
Master of Arts in Applied Economics
Spring 2016
Table of Contents
Introduction ................................................................................................................................... 3
Review of Literature ..................................................................................................................... 4
Development of the Theoretical Model ....................................................................................... 7
Specification of Model ................................................................................................................ 10
The data ....................................................................................................................................... 12
Estimated Results, Documentation, and Evaluation ............................................................... 13
nonstationarity tests ................................................................................................................ 13
ARDL (1,0) with OLS ............................................................................................................. 14
Residual Analysis .................................................................................................................... 16
Heteroscedasticity test ............................................................................................................ 19
Newey-West standard errors ................................................................................................. 19
Multicollinearity Test ............................................................................................................. 20
Conclusion ................................................................................................................................... 21
Bibliography ................................................................................................................................ 23
Appendix I ................................................................................................................................... 25
Appendix II .................................................................................................................................. 26
Appendix III ................................................................................................................................ 27
SAS results I ................................................................................................................................ 28
SAS results II ............................................................................................................................... 32
SAS results III ............................................................................................................................. 34
SAS results IV ............................................................................................................................. 36
SAS results V ............................................................................................................................... 37
SAS results VI ............................................................................................................................. 38
2
Introduction
How stable is the relationship between unemployment rate and the inflation rate for the
past decades in the United States? The relation between employment and inflation is called Phillips
Curve.1Many students in Macroeconomics have been taught that unemployment and inflation are
negatively correlated. If this relationship is steady or even existing, there would be an incentive
for policymakers to forgo inflation in order to achieve lower unemployment. In 1960, Paul
Samuelson and Robert Solow applied the Phillips Curve study to The United States, at that time
the relation appeared to be solid. Considering the results, they proposed that the price level should
increase between 4% and 5% in a year. For the unemployment rate to be not more than 3%, this
estimation was subject to a moderate GDP growth.2
What motivates me to investigate this issue is the desire to understand under what
economic circumstances is the relationship between inflation and unemployment manipulable by
policy makers. Is full employment possible at a given economic setting? If yes, could this
conditions be quantitatively determined? This work probably does not clarify these doubts. Yet, I
hope to objectively determine how statistically significant the relationship between unemployment
and inflation is for the sample chosen, with the aids of econometric analysis.
Particularly, the concern is the statically relationship between The inflation rate and the
unemployment rate for United States sample in the period 1970:01-2015:12. Does it provide
empirical evidence for the Phillips curve? Applying appropriate statistical techniques. I will test
the following hypothesis: the unemployment rate is negatively correlated with the rate of inflation.
1
Rudiger Dornbusch, Stanley Fischer, and Richard Startz, Macroeconomics, 9th ed. (Boston: McGraw-Hill/Irwin,
©2004), 120.
2
José E. De Gregorio Rebeco, Macroeconomía: Teoría y Políticas, 1a ed. (México: Pearson Educación de México,
2012), 608.
3
Review of Literature
In its core, the Phillips curve is a relation signifying that the level of the employment is
systematically related to the temporary variation of inflation from its equilibrium level.3 Stated in
simple words, any decrease or increase in the levels of employment in an economy will be related
to temporary changes in inflation. Specifically, temporary means that the tradeoff between
unemployment and inflation can only be observed in the short-run. While in long-run, inflationary
arrangements will not decrease unemployment. Regardless, The international evidence of a stable
short-run tradeoff between the rate of price change and unemployment is rather compelling. 4
Yet, a common concern may be identified in must of the literature. How should the
inflation and unemployment be estimated? According to Jaejoon Lee, “ If the slope of the Phillips
curve is not uniquely identified, but rather depends on the model of forecast horizon”.5 Some
papers seek to answer why do the estimates for the Phillips curve vary so widely from one model
to another. While others are concerned with forecasting inflation, developing a new form of the
Phillips curve; Keynesian Phillips Curve, Sticky Price Phillips curve, Backward Bending,
Expectations-augmented Phillips curve, and the list goes on.
Nonetheless, the Phillips curve in its origin is simple. The Phillips curve first appears in
a journal article published in 1958. Its developer Arthur W. Phillips studied the association
between unemployment and inflation in Great Britain using annual data for the period 1861-1957.
He concluded that it was possible to find an inflation rate that could lead to a certain type of desire
3
Jaejoon Lee, “Expectation Horizon and the Phillips Curve: The Solution to an Empirical Puzzle,” Journal of Applied
Econometrics 22, no. 1 (2007): 163, accessed February 8, 2016,http://www.jstor.org/stable/25146509.
4
Marina J. Malinov, Paul, M. Sommers, “A New Line On the Phillips Curve,” Social Science Quarterly 78, no. 3
(1997): 740-46, accessed February 9, 2016,http://www.jstor.org/stable/42863564.
5
Jaejoon Lee, “Expectation Horizon and the Phillips Curve: The Solution to an Empirical Puzzle,” Journal of Applied
Econometrics 22, no. 1 (2007): 176, accessed February 8, 2016,http://www.jstor.org/stable/25146509.
4
level of unemployment. In the 60s, the Phillips curve was a central concept in Macroeconomics.
Yet, the theoretical analysis, driven by Milton Friedman and later by Robert Lucas, as the 70s
experience with high rates of inflation and unemployment, started a distrust in the stable relation
between the inflation and unemployment.6“…the likely explanation was that the Phillips curve
shifted outward during these stagflationary episodes as a result of supply-side shocks such as
higher oil prices. The empirical results of this study indicate that the position of the Phillips curve
is very sensitive to such shocks”.7
By the 1980s, the existence of a ‘natural rate of unemployment’ became increasingly
doubtful as a result of the research regarding the Phillips curve.8 Even more, “Cottrell and Myatt,
both argue that a natural unemployment does not exist, in part because of the downward
inflexibility of nominal wages which prevents the unemployment rate from remaining at or near
the ‘natural’ level when product demands decrease.”9 The Data from the 70s and 80s simply did
not fit with the simple explanation of the Phillips curve (See Appendix I for Illustration). Something
was missing in the Phillips curve and it was expected inflation.10 Thus, “The expected inflation
rate is included because workers will negotiate wage increases to cover increasing costs from
expected inflation, and these wage increases will be transmitted into actual inflation.”11
6
2012), 608.
7
David G. Hula, “The Phillips Curve and the Natural Rate of Inflation,” Policy Sciences 24, no. 4 (1991): 364,
accessed February 9, 2016, http://www.jstor.org/stable/4532234.
8
9
10
R. & Fischer, S. & Startz, R. Dornbusch, Macroeconomics (International Edition), 9th ed. (Bostom: McGraw-
Hill, 2004), 125.R. & Fischer, S. & Startz, R. Dornbusch, Macroeconomics (International Edition), 9th ed. (Bostom:
McGraw-Hill, 2004), 125.
11
R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley,
©2011), 351.
5
In the present, The Phillips Curve in its modern version continues to be a great tool in
macroeconomics models, as it enacts the aggregate supply. In fact, The Phillips curve is the
relation between inflation, unemployment, and the aggregate supply is the relation between
inflation and product. 12 “The assessments of the rate of unemployment that is consistent with
holding inflation stable (at a low rate) represent an integral part of the monetary policy framework
in most industrial countries.” Although the rate of unemployment that is consistent with inflation
stability is not directly observable, it can be estimated observing the state of the economy”.13
12
2012), 609.
13
Guy Debelle and Douglas Laxton, “Is the Phillips Curve Really a Curve? Some Evidence for Canada, the United
Kingdom, and the United States,” Palgrave Macmillan Journals 44, no. 2 (1997): 249, accessed February 9,
2016, http://www.jstor.org/stable/3867544.
6
Development of the Theoretical Model
The original Phillips curve was concerned with the inverse relation between the
unemployment rate and the rate of increase of money wages (See appendix II for illustration). And
the trade-off between inflation in wages and the unemployment. Supposing that Wt is present wage
and Wt+1 the wage in the next period, the wage inflation rate, gw, is defined as follows: 14
𝑔𝑤 = (𝑊𝑡 + 𝑊𝑡−1 )/𝑊𝑡
Further, assume in the mathematical model that u* represents the natural unemployment rate, the
Phillips curve can be formulated in the following form:
𝑔𝑤 = −𝜖(𝑢 − 𝑢∗ )
where  measures the sensitivity of wages to unemployment. The equation establishes that wages
decrease when u (unemployment rate) is greater than u* (natural rate of unemployment), u>u*.
Inversely, if u<u*, the wages increases.
Although the original Phillips curve relates wage inflation rate and unemployment it gradually
evolved in time into another relation; inflation rate and unemployment rate. 15
As for the modern Phillips curve, which includes rational expectations; it is formulated in
the following form:
𝜋 = 𝜋 𝑒 − 𝜖(𝑢 − 𝑢∗ )
14
15
7
where πt stands for inflation and πte denotes inflationary expectations. In view of, a good
model assumes that economic agents behave in a wise manner, so the intellectual appeal of
rational expectations is absolutely irresistible.16
Being that, the height of the Phillips curve in the short-run, the level of inflationary
expectations, moves in ascending or descending with the responses in the changes of the firm’s
and worker’s expectations of inflation. If so, when economic agent’s expectations increase the
Phillips curve in the short-run moves upwards. On the other hand, in the long run the Phillips
curve is simply vertical and inflation is not related (See Appendix III for illustration). 17
As an illustration of the theoretical framework in the modern Phillips curve, we observe some
fundamental points:18
1. The inflationary expectations are reflected in the effective inflation.
2. The unemployment is in its natural rate when the effective inflation is equal to expected
inflation.
3. The Phillips curve states that inflation is greater to expect inflation when the effective
unemployment is lower than full employment.
4. There is stagflation when there is a recession along the Phillips curve in the short-run based
on an increased inflationary expectation.
5. Adjustments to expected inflation add another automatic mechanism to adjust supply
curve.
6. In the short-run Phillips curve, it is fairly flat.
16
R. & Fischer, S. & Startz, R. Dornbusch, Macroeconomics (International Edition), 9th ed. (Bostom: McGraw-Hill,
2004), 134.
17
18
R. & Fischer, S. & Startz, R. Dornbusch, Macroeconomics (International Edition), 9th ed. (Bostom: McGraw-Hill,
2004), 132-133.
8
However, the Phillips curve with expectations has a dilemma. Such as, we are predicting
that effective inflation will increase with respect to inflationary expectations when unemployment
rate decreases and it is below the natural rate of unemployment (u<u*). Then, why do not
economic agents adjust their expectations rapidly to take into account the prediction? The Phillips
curve relationship precisely depends on the miscalculation of the expected inflation in a
predictable manner.19 Under those circumstances, what makes this a problem is the assumption
that economic agents are rational and take decisions base on possible outcomes.
19
Hill, 2004), 133.
9
Specification of Model
The model used for the paper is the Phillips curve model with inflationary expectations. It
is the short-run model which takes into account inflationary expectations. And it is a tool for
analyzing the relation between inflation and unemployment.
Population regression function:
𝜋 𝑡 = 𝜋𝑡𝑒 − 𝛾(𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡𝑡 – 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡𝑡−1 ) + 𝑢𝑡
Where:
πt: the inflation in period t, derived from the CPI (1982-84=100) 12-month percent change.
πet: the inflationary expectations for period t
Unemploymentt – Unemploymentt-1: is the change in the unemployment from period t-1 to period t.
: the coefficient slope, a parameter which indicates the change in inflation given an increase in
Unemployment
ut : Error term, represent all the model can not explain, as well as omitted variables affecting the model. It
is assumed to be random with well define probabilistic distribution.
The model implies that when Unemploymentt – Unemploymentt-1<0, the inflation rate
increases. Contrarily, when unemployment increases (Unemploymentt – Unemploymentt-1>0)
inflation rate decreases. Further, what this mean from the theory point of view is that and increase
demand for labor drives wages up, as result prices. On the other hand, expected inflation is
included because workers negotiate their wages given their expectations of inflation, and at some
point this became inflation. Assuming that this expectation is conditional to past inflation, the
10
inflationet is equal to 𝛾̂0 + 𝛾̂1 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑡−1 . Now rewriting the model as the sample regression
function:20
Sample Regression Function
𝜋𝑡 = 𝛾̂0 + 𝛾̂1 𝜋𝑡−1 − 𝛾̂2 𝐷. 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡𝑡 + ̂

𝑢𝑡
Then, the hypothesis test for the model is the following:
H0: 𝛾̂1≤0, case it is not statically significant. H0: 𝛾̂2≥0, case it is not statically significant.
H1: 𝛾̂1＞0, case it is statically significant. H1: 𝛾̂2＜0, case it is statically significant.
In the model 𝛾̂2 is the estimated coefficient slope and represents the change in inflation given the
change in unemploymentt (Unemploymentt – Unemploymentt-1). Therefore, if statically it is “zero” it
means unemployment does not affect inflation for the given sample. Also, it means we reject the
null hypothesis.
Further, "𝛾̂0 + 𝛾̂1 𝜋𝑡−1” is the inflationary expectations. It is conditional to previous rates
of inflation since individual’s future expectations are subject to actual or previous events. The
expectations in the model are measured by “𝛾̂0 " the estimated intercept and "𝛾̂1” the estimated
slope of the previous inflation rate.
We expect the model estimators to be significantly different from “zero” at a confidence
level of 95%. Thus, hypothesis testing for the estimators will be base on a p-value of 5 %.
Consequently, for the results to be statistically significantly different from “0” the p-value must be
less than 5%. Due to, the probability of committing a Type-I error will be 5% (A Type-I error
occurs when a true hypothesis is rejected).
20R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley,
©2011), 351 and 364.
11
The data
The data utilized in this paper are quantitative in nature; and are ratio scale variables. In
particular, the data collected is a monthly time series for the unemployment rate and the inflation
rate, the sample data covers the period 1970:01- 2015:12. For the purpose of analyzing the Phillips
curve in an extended horizon. The source for the data collected was the U.S. Bureau of Labor
Statistics.
Further, the data arrayed for unemployment rate have the following specification: it counts
every person unemployed in the age of 16 years and over. In addition, Unemployment refers to
that labor force (economically active population) that wants to work, but does not get employed.21
In other words, it does not count does who are unwilling to work although they are old enough.
The unemployment rate, in general, is an important economic indicator, high rates of
unemployment is associated with low levels of economic activities. This can be illustrated in the
neoclassical production function (𝑌 = 𝑓(𝐾, 𝐿).22
On the other hand, the data collected for inflation have the following specifications:
 It is a U.S. city average.
 The base period is 1982-84=100.
Also, the inflation rate use in this paper it’s the 12-month percent change in the consumer
price index for all urban consumers. Indeed, this is the common way to observe percentage change
in prices. Inflation is an important indicator because it affects the purchasing power of individuals.
21 José E. De Gregorio Rebeco, Macroeconomía: Teoría y Políticas, 1a ed. (México: Pearson Educación de México,
2012), 24.
22 Jose E. De Gregorio Rebeco, Macroeconomía: Teoria y Políticas, 1a ed. (Mexico: Pearson Educacion de México,
́ ́ ́ ́
2012), 24.
12
Estimated Results, Documentation, and Evaluation
nonstationarity tests
For instance, a time series is stationary if its mean and variance are constant over time, and
if the covariance between two values from the series depends only on the length of time separating
the two values. The main reason we prefer times series to be stationary before any regression
analysis is to avoid any significant regression results from unrelated data. A possible scenario
when utilizing nonstationary series. Such cases are often called spurious. In other words, any
significant result may be subject to mere coincidence.23
For the purpose of testing stationarity, we may use the Augmented-Dickey-Fuller Test
(ADF). The unit root tests based on its variants (intercept excluded or trend included). The null
hypothesis is that the series is nonstationary, equally, it means the existence of unit root.
According to the ADF test, the inflation rate is a nonstationary series. While the
unemployment rate differential is stationary. At a 5% significance level, the test indicates that
unemployment rate differential’s tau/s and rho/s are all statically significant. On the other hand,
the inflation rate’s tau/s and rho/s are statically equal to zero. (See results at SAS Results I)
Consequently, there is a danger of obtaining apparently significant regression results from
unrelated data. Unless the inflation rate, and unemployment rate are cointegrated, the regression
analysis might not be reliable. Cointegration implies that both series share similar stochastic
trends. Thus, the spurious relation is discarded.24
23 R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley,
©2011), 477 and 483.
24 R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley,
©2011), 488.
13
ARDL (1,0) with OLS
For instance, by using this ARDL (1, 0) model, it is possible to avoid the outcome of the
residuals serial correlation. An alternative to the method is the AR model, modeling lags through
auto-correlated error, but the same dynamic effects may be captured adding lagged variables.25
Particularly, the ARDL (1, 0) Augmented-Phillips curve assumes that inflationary expectations
have the following functional form: “𝛾̂0 + 𝛾̂1 𝜋𝑡−1 ". Overall, autoregressive models and ARDL
models are good time series predictors. However, for this case, it extends the analysis by including
an additional estimator to the model. According to SAS the estimated model ARDL using the
ordinary least square method is the following:
𝜋
̂𝑡 = 0.0110 + 0.9951(𝜋) − .02817(𝐷. 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡𝑡 )
𝑠𝑒(𝛽̂
𝑖 ) = (0.0301) (0.005890) (0.0985)
𝑡= (0.37) (168.95) (−2.86)
𝑅 − 𝑠𝑞𝑢𝑎𝑟𝑒 = 0.9819 𝑛 = 552 𝐹 − 𝑣𝑎𝑙𝑢𝑒 = 14838.2 𝑎𝑑𝑗 𝑅 − 𝑠𝑞𝑢𝑎𝑟𝑒 = 0.9818
Notably, the estimated slope coefficient for the estimated inflation shows a negative
relationship with the change in unemployment; for each additional unit in D. unemploymentt
(Unemploymentt – Unemploymentt-1) the estimated inflation decrease by “.0287”. Accordingly, the
Phillips curve theoretical model states that inflation and unemployment are negatively correlated;
when unemployment increases (Unemploymentt – Unemploymentt-1>0) the inflation rate
decreases.
On the other hand, the inflationary expectation in the model is equal to "0.0110 +
0.9951(𝜋𝑡−1 )", it is composed by estimated intercept, "0.0110, and the previous inflation times
the its estimated slope. According to the estimated model, when 𝜋𝑡−1 is equal “1”, the inflationary
©2011), 363.
14
expectations is equal to "1.0061" (= 0.0110 + 0.9951 ∗ 1) . Accordingly, the inflation
expectations have a positive relation with the estimated inflation. Further, the model implies that
it has a greater impact relative to unemployment in the overall estimation.
More importantly, the p-values at a 5% significance level indicate that both estimated
slopes, for the change in unemployment and the inflation rate lag, are statically different from
“zero” as previously hypothesize. But, the estimated intercept is not statically significant,
contrarily to our expectations.
In particular, The standard errors (𝑠𝑒(𝛽𝑖) ) are used to calculate the “t”. And using the test
statistics, the p-value is calculated. For instance, the measure of precision for the change in
unemployment is “0.0985”, 𝑠𝑒(𝛽̂

3 ), on the other hand, the standard error for the lagged inflation
is “0.005890". It is relevant in the estimation of the confidence coefficient and the hypothesis test
result. Since biased estimators leads to unreliable hypothesis testing.
Further, the adjusted coefficient of determination from the estimated model is 0.9818.
Under those circumstances, it may be interpreted that most of the variation in the inflation rate are
explained by the estimated model. Also, the estimated F-value (14838.2) is greater than the
critical value of F0.05(551,549), “1.150740380847686”, as a result, the Adj. R-square is significant at
5% significance level. Both Adj. R-square and R-square, give an idea of the goodness of fit of the
estimated model. But, the R-square assumes that every single variable explains the variation in the
dependent variable. While adjusted R-square adjusts for the number of terms in a model. If you
add useless variables to a model, adjusted r-squared will decrease. If you add more useful variables,
adjusted r-squared will increase.
(See results at SAS Results II)
15
Residual Analysis
Even though the model presents a high Adj. R-square. these results are only reliable if
Gauss-Markov theorem is not violated. That being the case, a residuals analysis must be made to
test the overall model. On the graph below, “the height of each bar gives estimated correlation
between observations k period apart and the shaded area gives the 95% confidence bounds”.26 The
results indicate, serially correlated residuals for the 3 first observations and other above or below
the shaded area; the assumption cov(et,es) = 0 for t different that s is violated.
Additionally, according to the Godfrey's Serial Correlation Test (LM test), the LM for all
the AR, 1-12, are greater than 3.84, which is the 5% critical value for a chi-distribution, leading us
26
R Carter Hill and Randall C. Campbell, Using Sas for Econometrics (New York: Wiley, ©2012), 273.
16
to reject the null of no correlation. In contrast to Durbin-Watson test, the LM test is sensitive to
correlations between disturbances that are not adjacent to one another, and to correlations
between adjacent disturbances. Thus, by adding AR, 1-12, we may analyze correlation k periods
apart, as suggested by LM test.27 Similarly, the conducted Durbin h test detects a serial correlation.
The test null hypothesis is no autocorrelation. Accordingly, the results Durbin h statistics is
insignificant with a p-value of “0.0001”.
The h statistic is an alternative test for serial correlation in the presence of lagged variable.
Since the standard Durbin-Watson d statistic is biased when it comes to detecting first order serial
correlation in ADRL models. However, the suggested test in ARDL model is the Lagrange
multiplier test (LM), it has been suggested to be statistically more powerful in a large and small
28
sample, it is preferred relative to the h test.
Furthermore, the test normality in the residuals suggests there is sufficient evidence to
reject the null hypothesis of normal distribution at the 5% level of significance. Failing the
normality test implies that at 95% confidence, the data does not fit the normal distribution.
Observing the distribution below it can be inferred that our data presents excess kurtosis.
As a result, the confidence interval and hypothesis test are unreliable. Given the serial
correlation and the no normality in the residuals, the OLS is no longer a minimum variance
estimator.
27
Michael P. Murray, Econometrics: A Modern Introduction, The Addison-Wesley Series in Economics. (Boston:
Pearson Addison Wesley, ©2006), 452.
28
Damodar N. Gujarati and Dawn C. Porter, Basic Econometrics, 4th ed., The Mcgraw-Hill Series, Economics
(Boston: McGraw-Hill Irwin, ©2004), 667,668-681.
17
On the other hand, the KPSS test for the residuals indicates that the residual is stationary
at a 5% significance level. A stationary time series is a variable with constant mean, variance,
autocorrelation over time. If the residuals are stationary, then Inflationt and D. Unemploymentt are
said to be cointegrated; and there is a long-run relationship between both variables. In other words,
the relationship between them is not spurious. Otherwise, the results are merely a coincidence.
This test differs from those in common use by having a null hypothesis of stationarity. The test
may be conducted under the null of either trend stationarity (the default) or level stationarity.
Accordingly, the estimated eta/s are statically equals to zero (p-value>5%).
18
Even more, the Phillips-Perron test rejects the null hypothesis of a unit root test.
Consequently, there is evidence that for the given sample the residuals are stationary. Accordingly,
the estimated Rho/s and Tau/s are statically significant.
(See results at SAS Results III.)
Heteroscedasticity test
According to the White test, we accept the null hypothesis of no heteroskedasticity at a
95% confidence level. However, The Breusch-Pagan test rejects the null hypothesis of no
heteroscedasticity, at the same level of significance. The heteroskedasticity implies that the
standard errors of the parameter estimates are incorrect and, thus, any inferences derived from
them may be misleading. Both White and Breusch-Pagan test are based on the residuals of the
fitted model. However, White’s test is a general test, it makes no assumptions about the
heteroskedasticity structure or form. Consequently, it may identify specification errors.
(See results at SAS Results IV.)
Newey-West standard errors
Given the estimated model presents serial correlation and heteroskedasticity, “the least
squares estimator is still a linear unbiased estimator, but it is no longer best.”29 With this in mind,
I used the HAC (Heteroscedasticity-consistent) standards errors with least square, this allows
estimating standards errors given the serially correlated residuals and the condition of no normality
in the residuals.
Thus, the confidence intervals are more reliable. However, according to the results the
parameters remained statistically different from zero. Yet, “this technique does not address the
29
R Carter Hill, William E. Griffiths, and G C. Lim, Principles of Econometrics, 4th ed. (Hoboken, NJ: Wiley,
©2011), 357.
19
issue of finding an estimator that is more efficient than ordinary least squares”. 30 Indeed, the
estimation of the parameters remains unchanged the only difference is in the standard errors, in
the precision. Consequently, the p-value for the estimations is more reliable. For illustration,
observe the following model and the newly calculated standard errors.
̂ 𝑡 = 0.0110 +
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 0.9951(𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑡−1 ) − .02817(𝐷. 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡𝑡 )
𝑠𝑒(𝛽̂
𝑖) = (0.0448) (0.0121) (0.1258)
𝑡= (0.25) (82,58.95) (−2.24)
𝑅 − 𝑠𝑞𝑢𝑎𝑟𝑒 = 0.9819 𝑛 = 552 𝐹 − 𝑣𝑎𝑙𝑢𝑒 = 14838.2 𝑎𝑑𝑗 𝑅 − 𝑠𝑞𝑢𝑎𝑟𝑒 = 0.9818
Previously, in the first estimation with the OLS, the standard errors were smaller. But, by
taking in account the problem of autocorrelation and heteroscedasticity. And applying an adequate
method to estimate standard errors. It is concluded, that the standard errors are greater than initially
estimated, for both slopes. In other words, the parameters are less precise, however, the estimates
are more reliable.
(See results at SAS Results VI)
Multicollinearity Test
Besides, applying the rules of thumb, there is no sign of multicollinearity problem
between the change in unemployment and the lagged variable of the inflation rate. None of the
estimated correlation coefficients are above 0.8. Also, the parameter estimated tolerance is
greater that “0.2” and the variance inflation is less than “5.0”. The presence of multicollinearity
lead to unreliable separate effects of the independent variable and high standard errors.
Consequently, low t-scores.
(See results at SAS Results V.)
30 R Carter Hill and Randall C. Campbell, Using Sas for Econometrics (New York: Wiley, ©2012), 278.
20
Conclusion
In Summary, The Phillips curve is a great macroeconomic tool observe the relation
between inflation and unemployment. Yet, it is a tool for short-run analysis. In the long-run, the
relation ceases to exist. According to the estimated results and evaluation of this paper, the relation
between unemployment and inflation is statically significant when using an Augmented-Phillips
curve model for United State sample data, period 1970:01-2015:12. But, the least squares method
violates Gauss-Markov theorem of serially correlated data according to a series of test. As a
consequence, the estimators are an inefficient even when correcting the parameters standard error
with the HAC or Newey–West estimator technique. Although the method makes the model more
reliable it still not the best estimator.
Additionally, “nonstationary time-series variables should not be used in regression
models, to avoid the problem of spurious regression”. Although this paper does not stress upon
this possible conflict, it relies on the exception to the rule. That is the case when the independent
variable and dependent variable are cointegrated.31
However, the model presents some good features. Such as a stationary residual, high
adjusted R-square, and no multicollinearity. Being that, it would be a good idea to test the model
prediction capabilities. Overall, models that are able to predict and explain economic phenomena
are useful for control policies. In other words, by the relative stimulus of a variable, reach the
desired level of another variable.
Lastly, in future papers, I recommend not to rely on this exception to the rule. Also, it
would be interesting to try other models to address the issue of serially correlated errors. And
©2011), 488.
21
analyze which models are more capable of prediction. Or even, be good enough to do economic
policy.
22
Bibliography
Dornbusch, Rudiger, Stanley Fischer, and Richard Startz. Macroeconomics. 9th ed. Boston:
McGraw-Hill/Irwin, ©2004.
De Gregorio Rebeco, José E. Macroeconomía: Teoría y Polit́ icas. 1a ed. México: Pearson
Educación de México, 2007.
Hill, R Carter, William E. Griffiths, and G C. Lim. Principles of Econometrics. 4th ed. Hoboken,
NJ: Wiley, ©2011.
Gujarati, Damodar N., and Dawn C. Porter. Basic Econometrics. 4th ed. The Mcgraw-Hill Series,
Economics. Boston: McGraw-Hill Irwin, ©2004.
Lee, Jaejoon. “Expectation Horizon and the Phillips Curve: The Solution to an Empirical
Puzzle.” Journal of Applied Econometrics 22, no. 1 (2007): 161-78. Accessed February 8,
2016.http://www.jstor.org/stable/25146509.
Malinov, Marina J. and Sommers, Paul M. “A New Line On the Phillips Curve.”Social Science
Quarterly 78, no. 3 (1997): 740-46. Accessed February 9,
Hula, David G. “The Phillips Curve and the Natural Rate of Inflation.” Policy Sciences 24, no. 4
(1991): 357-366. Accessed February 9, 2016.http://www.jstor.org/stable/4532234.
Önder, Özlem A. “Forecasting Inflation in Emerging Markets by Using the Phillips Curve and
Alternative Time Series Models.” Emerging Markets Finance and Trade (2004): 71-82. Accessed
February 9, 2016.http://www.jstor.org/stable/27750383.
Nason, James M. and Smith, Gregor W. “Identifying the New Keynesian Phillips Curve.” Journal
of Applied Econometrics 23, no. 5 (2008): 525-51. Accessed February 9,
2016. http://www.jstor.org/stable/25144566.
Debelle, Guy and Laxton, Douglas. “Is the Phillips Curve Really a Curve? Some Evidence for
Canada, the United Kingdom, and the United States.”Palgrave Macmillan Journals 44, no. 22
(1997): 249-82. Accessed 08-02-2016. http://www.jstor.org/stable/3867544.
Smith, Gregor W. “Japan's Phillips Curve Looks Like Japan.” Journal of Money, Credit and
Banking 40, no. 6 (2008): 1. Accessed February 9, 2016.http://www.jstor.org/stable/25096308.
Econometrica. “Phillips Curve.” Econometric Society 38, no. 4 (1970): 190-93. Accessed
February 9, 2016. http://www.jstor.org/stable/1911622.
Coibion, Olivier. “Testing the Sticky Information Phillips Curve.” The Review of Economics and
Statistics 92, no. 1 (2010): 87-101. Accessed February 9,
2016. http://www.jstor.org/stable/25651392.
Palley, Thomas I. “The Backward Bending Phillips Curves: Competing Micro-Foundations and
the Role of Conflict.” Investigación Económica 68, no. 270 (2009): 13-36. Accessed February 9,
23
Bureau of Labor Statistics.” Accessed February 18, 2016. http://www.bls.gov/data/.
Hill, R Carter, and Randall C. Campbell. Using Sas for Econometrics. New York: Wiley, ©2012.
Murray, Michael P. Econometrics: A Modern Introduction. The Addison-Wesley Series in

Economics. Boston: Pearson Addison Wesley, ©2006.
24
Appendix I
The Phillips Curve: Rate of Inflation in relation to Unemployment Rate.
Source: De Gregorio Rebeco, José E. Macroeconomiá : Teoriá y Polit́ icas. 1a ed. México: Pearson
Educación de México, 2007.
25
Appendix II
The Original Hypothetical Phillips curve: Rate of Change of Money Wage in relation to
Unemployment Rate.
Source: Gujarati, Damodar N., and Dawn C. Porter. Basic Econometrics. 5th ed. The Mcgraw-Hill
Series, Economics. Boston: McGraw-Hill Irwin, ©2009.
26
Appendix III
Expectations-augmented Phillips curve: Rate of Inflation in relation to Unemployment Rate
Source: Polieconomics. “New Classical Macroeconomics: Ncm’s Phillips Curve.” Accessed

February 12, 2016. ht
27
SAS results I
Dickey-Fuller Non Stationarity test for the US Inflation rate
The AUTOREG Procedure

Ordinary Least Squares Estimates
SSE 4999.29911 DFE 551
MSE 9.07314 Root MSE 3.01217
SBC 2789.15643 AIC 2784.84288
MAE 2.21104679 AICC 2784.85015
MAPE 122.100546 HQC 2786.52827
Durbin-Watson 0.0185 Regress R-Square 0.0000
Total R-Square 0.0000
Augmented Dickey-Fuller Unit Root Tests on Inflation Rate
Type Lags Rho Pr < Rho Tau Pr < Tau F Pr > F
Zero Mean 12 -2.6924 0.2597 -1.2723 0.1877
Single Mean 12 -6.8793 0.2821 -1.7014 0.4299 1.5284 0.6792
Trend 12 -16.9725 0.1245 -2.7157 0.2306 3.7320 0.4257
Parameter Estimates
Standard Approx
Variable DF Estimate Error t Value Pr > |t|
Intercept 1 4.1846 0.1282 32.64 <.0001
28
Source: Bureau of Labor Statistics.” Accessed February 18, 2016. http://www.bls.gov/data/
Copyright (c) 2016 Ramberto Jr. Sosa Cueto. All rights reserved.
29
Dickey-Fuller Non Stationarity test for the US Unemployment rate differential

SSE 17.827804 DFE 550
MSE 0.03241 Root MSE 0.18004
SBC -320.48553 AIC -324.79726
MAE 0.13039087 AICC -324.78998
MAPE 100.127856 HQC -323.11244
Augmented Dickey-Fuller Unit Root Tests on Unemployment rate differential
Type Lags Rho Pr < Rho Tau Pr < Tau F Pr > F
Zero Mean 12 -148.8217 <.0001 -5.4105 <.0001
Single Mean 12 -148.6615 <.0001 -5.4047 <.0001 14.6135 <.0010
Trend 12 -151.6256 <.0001 -5.4150 <.0001 14.6632 <.0010
Parameter Estimates
Standard Approx
Intercept 1 0.001996 0.007670 0.26 0.7947
30
31
SAS results II
Phillips curve ARDL(1,0) with ODS graphics

SSE 90.5688255 DFE 548
MSE 0.16527 Root MSE 0.40654
SBC 587.706234 AIC 574.771029
MAE 0.2948925 AICC 574.814905
MAPE 14.7724069 HQC 579.825493
Regress R-Square 0.9819
Parameter Estimates
Standard Approx
Intercept 1 0.0110 0.0301 0.37 0.7145
inf1 1 0.9951 0.005890 168.95 <.0001
du 1 -0.2817 0.0985 -2.86 0.0044
32
Estimated Phillips Curve and Inflation
Overall Fitness

33
SAS results III
Residual Analysis
Godfrey's Serial Correlation Durbin h statistic

Test
Statistic Value Prob Label
Alternative LM Pr > LM
Durbin h 8.9162 0.0001 Pr > h
AR(1) 71.8443 <.0001
AR(2) 71.9579 <.0001
AR(3) 73.1370 <.0001
AR(4) 76.2154 <.0001
AR(5) 76.3142 <.0001
AR(6) 78.6785 <.0001
AR(7) 82.7837 <.0001
AR(8) 83.6809 <.0001
AR(9) 93.0647 <.0001
AR(10) 94.1994 <.0001
AR(11) 95.1052 <.0001
AR(12) 188.3132 <.0001

Normality Test on the Residuals
The CAPABILITY Procedure

Fitted Normal Distribution for ehat
Parameters for Normal Distribution
Parameter Symbol Estimate
Mean Mu 0
Std Dev Sigma 0.405796
Goodness-of-Fit Tests for Normal Distribution
Test Statistic DF p Value
Kolmogorov-Smirnov D 0.0496 Pr > D <0.010
Cramer-von Mises W-Sq 0.4638 Pr > W-Sq <0.005
Anderson-Darling A-Sq 2.7527 Pr > A-Sq <0.005
Chi-Square Chi-Sq 61967.7086 9 Pr > Chi-Sq <0.001
Quantiles for Normal Distribution
Quantile
Percent Observed Estimated
1.0 -0.95760 -0.94402
5.0 -0.60786 -0.66748
10.0 -0.47249 -0.52005
25.0 -0.22456 -0.27371
50.0 0.00312 0.00000
75.0 0.22739 0.27371
90.0 0.46142 0.52005
95.0 0.66299 0.66748
99.0 1.13470 0.94402
34
Phillips-Perron Unit Root Test for Residuals
Type Lags Rho Pr < Rho Tau Pr < Tau
Zero Mean 12 -382.5311 <.0001 -16.4798 <.0001
Single Mean 12 -382.5321 0.0018 -16.4659 <.0001
Trend 12 -381.3573 0.0007 -16.4498 <.0001
34
KPSS test for Residuals

SSE 90.5688255 DFE 550
MSE 0.16467 Root MSE 0.40580
SBC 575.082764 AIC 570.771029
MAE 0.2948925 AICC 570.778315
MAPE 100 HQC 572.455851
KPSS Stationarity Test
Type Lags Eta Pr > Eta
Single Mean 18 0.0691 0.7573
Trend 18 0.0315 0.8510
KERNEL=QS, SCHW=12
Parameter Estimates
Standard Approx
Intercept 1 5.65E-16 0.0173 0.00 1.0000
35
SAS results IV
Heteroscedasticity test
The MODEL Procedure

Nonlinear OLS Summary of Residual Errors
Equation DF Model DF Error SSE MSE Root MSE R-Square Adj R-Sq Label
Inf 3 548 90.5688 0.1653 0.4065 0.9819 0.9818 Inf
Nonlinear OLS Parameter Estimates
Approx
Parameter Estimate Approx Std Err t Value Pr > |t|
B0 0.011022 0.0301 0.37 0.7145
B1 0.995122 0.00589 168.95 <.0001
B2 -0.28166 0.0985 -2.86 0.0044
Number of Observations Statistics for System
Used 551 Objective 0.1644
Missing 61 Objective*N 90.5688
Heteroscedasticity Test
Equation Test Statistic DF Pr > ChiSq Variables
Inf White's Test 9.61 5 0.0871 Cross of all vars
Breusch-Pagan 7.18 2 0.0276 1, inf1, du
36
SAS results V
Phillips curve with HAC standard errors
The MODEL Procedure

Nonlinear GMM Summary of Residual Errors
Equation DF Model DF Error SSE MSE Root MSE R-Square Adj R-Sq Label
Inf 3 548 90.5688 0.1653 0.4065 0.9819 0.9818 Inf
Nonlinear GMM Parameter Estimates
Approx
Parameter Estimate Approx Std Err t Value Pr > |t| Label
B0 0.011022 0.0448 0.25 0.8060 intercept
B1 0.995122 0.0121 82.58 <.0001 inf1
B2 -0.28166 0.1258 -2.24 0.0256 du
Number of Observations Statistics for System
Used 551 Objective 1.986E-27
Missing 61 Objective*N 1.094E-24
GMM Test Statistics
Test DF Statistic Prob
Overidentifying Restrictions 0 0.00 .
37
SAS results VI
Tests for Multicollinearity
The REG Procedure

Model: MODEL1
Dependent Variable: Inf Inf
Analysis of Variance
Sum of Mean
Source DF Squares Square F Value Pr > F
Model 2 4904.66108 2452.33054 14838.2 <.0001
Error 548 90.56883 0.16527
Corrected Total 550 4995.22991
Root MSE 0.40654 R-Square 0.9819
Dependent Mean 4.18094 Adj R-Sq 0.9818
Coeff Var 9.72355
Parameter Estimates
Parameter Standard Variance

Variable Label DF Estimate Error t Value Pr > |t| Tolerance Inflation
Intercept Intercept 1 0.01102 0.03012 0.37 0.7145 . 0
inf1 1 0.99512 0.00589 168.95 <.0001 0.95526 1.04684
du 1 -0.28166 0.09851 -2.86 0.0044 0.95526 1.04684
Correlation of Estimates
Variable Label Intercept inf1 du
Intercept Intercept 1.0000 -0.8181 0.1668
inf1 -0.8181 1.0000 -0.2115
du 0.1668 -0.2115 1.0000
38
Tests for Multicollinearity
The REG Procedure

Model: MODEL1
Dependent Variable: Inf Inf
Test of First and Second
Moment Specification
DF Chi-Square Pr > ChiSq
5 10.99 0.0515
Durbin-Watson D 1.286
Number of Observations 551
1st Order Autocorrelation 0.357
39

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Estimating the Phillips curve relationship for US 1970:01-2015:12

Ramberto Jr. Sosa Cueto

Submitted in Partial Fulfilment

Master of Arts in Applied Economics

estimation was subject to a moderate GDP growth.2

economic circumstances is the relationship between inflation and unemployment manipulable by

Expectations-augmented Phillips curve, and the list goes on.

is very sensitive to such shocks”.7

By the 1980s, the existence of a ‘natural rate of unemployment’ became increasingly

𝑔𝑤 = (𝑊𝑡 + 𝑊𝑡−1 )/𝑊𝑡

Phillips curve can be formulated in the following form:

Inversely, if u<u*, the wages increases.

the following form:

rational expectations is absolutely irresistible.16

1. The inflationary expectations are reflected in the effective inflation.

unemployment is lower than full employment.

on an increased inflationary expectation.

5. Adjustments to expected inflation add another automatic mechanism to adjust supply

6. In the short-run Phillips curve, it is fairly flat.

curve relationship precisely depends on the miscalculation of the expected inflation in a

analyzing the relation between inflation and unemployment.

Population regression function:

𝜋 𝑡 = 𝜋𝑡𝑒 − 𝛾(𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡𝑡 – 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡𝑡−1 ) + 𝑢𝑡

πet: the inflationary expectations for period t

is assumed to be random with well define probabilistic distribution.

increases. Contrarily, when unemployment increases (Unemploymentt – Unemploymentt-1>0)

Sample Regression Function

𝜋𝑡 = 𝛾̂0 + 𝛾̂1 𝜋𝑡−1 − 𝛾̂2 𝐷. 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡𝑡 + ̂

Then, the hypothesis test for the model is the following:

change in unemploymentt (Unemploymentt – Unemploymentt-1). Therefore, if statically it is “zero” it

slope of the previous inflation rate.

We expect the model estimators to be significantly different from “zero” at a confidence

occurs when a true hypothesis is rejected).

The unemployment rate, in general, is an important economic indicator, high rates of

neoclassical production function (𝑌 = 𝑓(𝐾, 𝐿).22

 It is a U.S. city average.

 The base period is 1982-84=100.

significant result may be subject to mere coincidence.23

Consequently, there is a danger of obtaining apparently significant regression results from

trends. Thus, the spurious relation is discarded.24

ordinary least square method is the following:

(Unemploymentt – Unemploymentt-1) the estimated inflation decrease by “.0287”. Accordingly, the

when unemployment increases (Unemploymentt – Unemploymentt-1>0) the inflation rate

it has a greater impact relative to unemployment in the overall estimation.

contrarily to our expectations.

unemployment is “0.0985”, 𝑠𝑒(𝛽̂

result. Since biased estimators leads to unreliable hypothesis testing.

critical value of F0.05(551,549), “1.150740380847686”, as a result, the Adj. R-square is significant at

adjusted r-squared will increase.

(See results at SAS Results II)

insignificant with a p-value of “0.0001”.

Accordingly, the estimated eta/s are statically equals to zero (p-value>5%).

the estimated Rho/s and Tau/s are statically significant.

(See results at SAS Results III.)

According to the White test, we accept the null hypothesis of no heteroskedasticity at a

heteroskedasticity structure or form. Consequently, it may identify specification errors.

(See results at SAS Results IV.)

Newey-West standard errors

are more reliable.

(See results at SAS Results VI)

Besides, applying the rules of thumb, there is no sign of multicollinearity problem

Consequently, low t-scores.

(See results at SAS Results V.)