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# Short-run and Long-run relationship between Producer Price Index (PPI) and Consumer Price Index (CPI) (An

Individual Assignment)

## Semester III First Half January 2011

Course: Lecturer:

## MBAFI 616 - Financial Econometrics Dr. Prabath Jayasinghe

Postgraduate & Mid-Career Development Unit Faculty of Management & Finance University of Colombo

Time Series Consumer Price Index (CPI) for all urban consumers and Producer Price Index (PPI) for all commodities in U.S.A, have been used for analyze the long-run and short-run relationship between the two variables. The source for above data is U.S. Department of Labor: Bureau of Labor Statistics and I have used monthly data from year 1913 to year 2010 for perform this analysis. Augmented Dickey Fuller (ADF) test as a Stationery Test Unit root test for CPI With 0 differences, no trend and no intercept

Null Hypothesis: CPI has a unit root Exogenous: Constant Lag Length: 11 (Automatic - based on SIC, maxlag=22) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(CPI) Method: Least Squares Sample (adjusted): 1914M01 2010M01 Included observations: 1153 after adjustments R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 0.421991 0.415907 0.290256 96.04362 -203.2491 69.35730 0.000000 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat 0.179260 0.379788 0.375107 0.432047 0.396598 2.018762 4.072955 -3.435806 -2.863837 -2.568044 Prob.* 1.0000

Figure: 1 ADF test EViews output for the regression Since the computed ADF test-statistics (4.072955) is greater than the critical values at 1%, 5%, 10% significant level), we cannot reject Ho and conclude unit root exists. Hence CPI is a nonstationary series. Figure: 2 Graph for the regression

By introducing trend and intercept also the series did not become stationary with 0 differences. Further now Durbin-Watson Stat is 2.018762 and it is approximately equal to 2 and hence we can trust the regression results. Unit root test for PPI With 0 differences, no trend and no intercept According to figure 3(Refer Annexure 2) we can observe that computed ADF test-statistics ( 4.773238) is greater than the critical values at 1%, 5% and 10% significant level, respectively, we cannot reject Ho . Hence conclude unit root exists and PPI is a non-stationary series. By introducing trend and intercept also the series did not become stationary with 0 differences. . Further now Durbin-Watson Stat is 1.981003 and it is approximately equal to 2 and hence we can trust the regression results. Figure: 4 Transforming from non-stationary to stationary Difference-Stationery Process (DSP) has been used to transform above non stationary data series to stationary data series. Transforming from non-stationary to stationary CPI By using level one difference and introducing trend and intercept the CPI series become stationary
240 200 160 120 80 40 0 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

PPI

Null Hypothesis: D(CPI) has a unit root Exogenous: Constant Lag Length: 11 (Automatic - based on SIC, maxlag=22) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. -4.463067 -3.435811 -2.863840 -2.568045 Prob.* 0.0002

Figure: 5

Augmented Dickey-Fuller Test Equation Dependent Variable: D(CPI,2) Method: Least Squares Sample (adjusted): 1914M02 2010M01 Included observations: 1152 after adjustments

The computed ADF teststatistic (4.463067) is smaller than the critical values at 10%, 5%, 1% significant level, respectively, therefore we reject Ho. It means the CPI series is a stationary series at 1%, 10% and 5% significant level and it is an I (1) series. Figure: 6 Stationary Graphs Transforming from non-stationary to stationary PPI As per the figure 7(Refer annexure 3) the computed ADF test-statistic (-15.24086) is smaller than the critical values at 10%, 5%, 1% significant level, respectively, therefore we reject Ho. It means the Wages series is a stationary series at 1%, 10% and 5% significant level and it is a I (1) series.
R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic 0.293248 0.285802 0.291508 96.78872 -208.0240 39.38317 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat 0.000641 0.344938 0.383722 0.440702 0.405229 1.993260

Therefore it can be concluded that both series are in same order as they become stationary at first difference.

## Figure 8 Stationary Graphs

Regression Analysis Regression analysis is performed for observe the relationship between two series PPI and CPI.
Dependent Variable: PPI Method: Least Squares Sample: 1913M01 2010M01 Included observations: 1165 Variable CPI C R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 0.785172 7.437830 0.980743 0.980726 6.866729 54837.74 -3896.654 59230.66 0.000000 Std. Error 0.003226 0.288092 t-Statistic 243.3735 25.81759 Prob. 0.0000 0.0000 57.62412 49.46171 6.692968 6.701656 6.696245 0.010407

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

Figure 9 As shown in below EViews output the residuals are non stationary at level 0.
Null Hypothesis: RESID01 has a unit root Exogenous: None Lag Length: 5 (Automatic - based on SIC, maxlag=22) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(RESID01) Method: Least Squares Sample (adjusted): 1913M07 2010M01 Included observations: 1159 after adjustments R-squared Adjusted R-squared S.E. of regression Sum squared resid 0.171635 0.168043 0.640295 472.7047 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion 0.006521 0.701988 1.951389 1.977560 -2.457178 -2.566959 -1.941097 -1.616515 Prob.* 0.0136

## Log likelihood Durbin-Watson stat

-1124.830 1.986633

Hannan-Quinn criter.

1.961264

Figure 10 The computed ADF test-statistic (-2.457178) is greater than the critical values (-4.07 -3.37 -3.03) according to EG tables, we dont reject Ho. It means the residual series is a non stationary series at 1%, 10% and 5% significant level which is not I (0). However series become stationary at level 1. Since the residuals are not stationary at level 0, there is no long term relationship between two series PPI and CPI. However we can observe a short run relationship between two variables. The regression line PPI= 1.69CPI -0.15 According to the regression line, for every unit increase in CPI will increase 1.69 units in PPI. At the same time PPI=(-0.15), even the CPI is 0. As R- squared is a 0.98 we can say that 98% of the changes PPI can be described by the CPI.

## References & Bibliography

Gujarati, D.N, & Sangetha. (2010). Basic Econometrics: McGraw Hill Hirschey, M (2009), Managerial Economics: An integrative Approach, Cengage Learning, India. Lipsey, R.G. (1968), An Introduction to Positive Economics,LPE India edition Lipsey, R.G. & Cheristal,K.A. (2009) Economics, Oxford university press, Oxford.

Annexure:1

Two hypotheses used are: Null Hypothesis Alternative Hypothesis : Unit root exists; and : Unit root does not exist.

Annexure:2
Null Hypothesis: DPPI has a unit root Exogenous: Constant Lag Length: 4 (Automatic - based on SIC, maxlag=22) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. -15.24086 -3.435777 -2.863824 -2.568037 Prob.* 0.0000

Augmented Dickey-Fuller Test Equation Dependent Variable: D(DPPI) Method: Least Squares Sample (adjusted): 1913M07 2010M01 Included observations: 1159 after adjustments R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 0.336401 0.333523 0.782157 705.3712 -1356.777 116.8989 0.000000 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat 0.003279 0.958080 2.351642 2.377813 2.361517 1.976273

## Figure: 3 ADF test EViews output for the regression

Annexure:3

Null Hypothesis: PPI has a unit root Exogenous: None Lag Length: 5 (Automatic - based on SIC, maxlag=22) t-Statistic Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(PPI) Method: Least Squares Sample (adjusted): 1913M07 2010M01 Included observations: 1159 after adjustments R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.230367 0.227029 0.779474 700.5394 -1352.793 1.981003 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. 0.146678 0.886584 2.344769 2.370939 2.354644 4.773238 -2.566959 -1.941097 -1.616515 Prob.* 1.0000

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