Applied Econometrics

A Short-sighted view of the Relationship between Inflation, Investment, Unemployment,

Literacy and GDP

Date

Tuesday January 15, 2013

Table of Contents

Introduction.................................................................................................................................................2
Data regression and Interpretation.............................................................................................................4
Stability tests.............................................................................................................................................12
Multicolinearity.........................................................................................................................................14
Conclusion.................................................................................................................................................15
References.................................................................................................................................................15

List of Tables

Table 1 - Array of Selected Countries versus Data to Analyze.....................................................................5

List of Figures

Figure 1 - PCI Regressed on Independent Variables....................................................................................5

Figure 2 - Residual.......................................................................................................................................6

Figure 3 - Regression Result after Deletion of Outliers................................................................................7

Figure 4 – Heteroscedasticity Test...............................................................................................................8

Figure 5 - Jarque Bera Normality Test.......................................................................................................10

Figure 6 - Ramsey RESET Test....................................................................................................................11

Figure 7 - CUSUM and CUSUMQ Tests.......................................................................................................12

Figure 8 - Recurcive Residual Test.............................................................................................................13

Figure 9 - Chow Test..................................................................................................................................14

Figure 10 - Correlation Matrix...................................................................................................................15

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Introduction

This paper aims to analyze, by means of econometric models, the relationship between inflation,
investment, unemployment, literacy and GDP -the latter of which is the dependent variable -across
selected countries some of which are developed and the rest developing.

Inflation is a rise in the general level of prices over time. It may also refer to a rise in the prices of a
specific set of goods and services. In either case, it is measured as the percentage rate of change of a
price index.

Mainstream economists believe that high rates of inflation are caused by high rates of growth of the
money supply. Views on the factors that’s determine moderate rates of inflation are more varied:
changes in inflation are sometimes attributed to fluctuations in real demand for goods and services or in
available supplies (i.e. changes in scarcity), and sometimes to changes in the supply or demand for
money.

In fact, “inflation not only reduces the level of business investment, but also the efficiency with which
productive factors are put to use.”

Investment ratio: in our analysis we have taken investment ratios as a percentage of GDP. Generally it is
lower in poor countries than in rich ones, but tends to level off as income rises. Growing economies
which are poor in terms of per capita income (PCI) have high investment ratios.

Literacy Rates: we have taken adult literacy rate (%) which means the percentage of the total population
which is literate. Literacy rates differ widely from country to country and generally this is also lower in
poor countries than in rich ones.

Unemployment: it is universally recognized that unemployment is a bad thing; economists make

convincing arguments that there is a certain natural level of unemployment that can’t be erased.
Although inflation consequences could be dealt with, unemployment can have destructive effects on
businesses and the economic health of the country, where these effects are long lasting both on the
businesses and workers especially the confidence in building and developing future set of skills.

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Data regression and Interpretation

This cross-sectional data is collected for different countries with different types of economy for the year
2011.

Table 1 - Array of Selected Countries versus Data to Analyze

Source:

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Figure 1 - PCI Regressed on Independent Variables

Source: E Views

From the above regression result of the data, we can see that the result for R-squared is 80% with a
prob(f-statistic) 0.000072 which means that the model is significant; whereas the adjusted R-square of
75% means that most of the independent variables explain the dependent variable GDP per capita.
Consequently the model is a good fit.

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Figure 2 - Residual

The residual table and graph shows some outliers, the observations 4,9,12, & 15 have higher residuals
than the other countries. These countries are Ecuador, Japan, Mexico, and Sri Lanka respectively.
Though analyzing the residuals is not a very good indicator of outliers but by looking at the observations
individually, one can note that Ecuador and Sri Lanka are outliers because they have high literacy with
normal investment level in spite of being among low per capita income countries and the same applies
to Mexico which has a high literacy and investment rate; whereas Japan has a very high income per
capita compared to other countries.

The following figure (Figure 3) is the result for running the regression on the data after deleting the
outliers indicated above.

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Figure 3 - Regression Result after Deletion of Outliers

As we can see that the value of the R-squared is higher in the new model as compared to the original
which means that the new model has a better fit that the previous one, which justifies the deletion of
the outliers from our data.

Estimated Equation:

PCI = -4202 – 1275*INF – 830*INV + 607*LIT – 118*UNEM

Thus while inflation, investment and unemployment are inversely related to the PCI, literacy rate is
positively related to PCI.

Now we check the validity of the OLS estimates of our model, so we carry some tests on our CLM
standards to see if any is violated.

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Figure 4 – Heteroscedasticity Test

The white test statistics gave us T*R-squared=12.85495 which follows a X-squared(8) under the null
hypothesis. The 5% critical value for the X-squared table is 15.507. The test statistic is therefore less
than the critical value and hence the null hypothesis is not rejected. So it would be concluded that there
is a significant evidence of Homoscedasticity, so that it would be plausible to assume that the variance
of the errors is constant; but the white test has a very low power of proof of the results so we shall use
another test which is Goldfeld-Quandt test.

We sort our sample in the ascending order of Unemployment rate and split and we run a regression on
both separate samples taking the first and last 6 observations, so we divide the entire set of 15
observations into 3 groups consisting of the first 6, next 3, and the last six observations respectively.

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We then run two separate regressions corresponding to the first 6 observations to get an RSS of
220,000,000 and a regression on the last six observations to have an RSS of 143,000,000.

We use the GQ formula GQ=(s^2)/(s’^2) where GQ=220,000,000 /143,000,000=1.53 from the statistical
table under F-distribution, we see that F(1,1,5%)=161 & F(1,1,1%)=4052.

The value of the F-test obtained is less than the tabular values for both 5% and 1% level of significance.
We therefore accept the null hypothesis of homoscedasticity at both 5% and 1% level of significance;
therefore we have no problem of heteroscedasticity in our data set collected.

Bera-Jarque normality tests is to check for normality of the disturbance terms. Where the null hypotheis
of the test is that the error terms are normally distributed. Under the null hypothesis the test statistic
involved has a X-squared distribution.

Figure 5 - Jarque Bera Normality Test

We can see that the p-value at the bottom of the normality test screen is greater that 0.05, so we do not
reject the null of normality at 5% level, but since our sample size is only 15 so this is not an accurate test.
We should therefore carry other tests on our samples.

We now conduct the Ramsey Reset Test to test functional specification, it checks for any functional mis-
specification.

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Figure 6 - Ramsey RESET Test

From the above figure we can see that the coefficients of higher powers are indeed zero as suggested by
the probability value, and it can be seen that there is no apparent non-linearity in the regression
equation and so it would be concluded that the linear model for the GDP per capita is appropriate.

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Stability tests

Figure 7 - CUSUM and CUSUMQ Tests

From CUSUM we can say that the cumulative sum of the residuals are within the area between the two
critical lines, so we can say that the parameters are constant in terms of intercept; and as for the
CUSUMSQ test we can say that the parameters are constant in terms of variance.

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Figure 8 - Recurcive Residual Test

We can see from the above Recursive residual test that most of the observed residuals are within the
standard error bands, where it suggests that the parameters to a great extent are stable.

Chow Test

One of the most important criteria for an estimated equation is that it should have relevance for data
outside the sample data used in the estimation i.e. parameter constancy. To examine this we use the
Chow Forecast Test which is the one of the most useful as a test of predictive accuracy. The procedure is
to divide the data set into n 1 observations to be used for estimation & n 2 observations for testing. The
null hypothesis for this test is parameter constancy. We use an F-statistic with degrees of freedom n 2 &
(n 1 – k).

In the model under consideration--- n 1 =12 ; n 2 =3

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Figure 9 - Chow Test

From the F-test statistical table we can see that: F(3,7,5%)=4.35 ; F(3,7,1%)=8.45 and as we can see from
Chow Forecast Test, F-Statistic= 0.906935, to conclude we see that the F-test result from Chow test is
less than the critical values obtained from 5% and 1% level of significance. We therefore accept the null
hypothesis of parameter constancy at both 5% and 1% level of significance.

Multicolinearity
In order to check whether or not there is any problem of correlation among the explanatory variables,
i.e., whether or not our model suffers from the problem of multicollinearity , we use the Variance
Inflating Factor (VIF) where, we regress each explanatory variable on the others referred to as Auxiliary
Regressions. R-squared is the squared multiple correlation coefficients obtained from each of these
regressions. If the VIF corresponding to any auxiliary regression is greater than 10 we say that the model
has a severe multicollinearity problem and VIF between 2 and 10 implies moderate multicollinearity. The
general solution suggested is to drop the corresponding regressor .

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Figure 10 - Correlation Matrix

From the obtained results above we can see that our model is free from multicollinearity and that our
explanatory variables used are uncorrelated.

Conclusion
The behavior of GDP per capita (Per Capita Income) can be expressed in the model of explanatory
variables of annual rates of investment, inflation, unemployment, & literacy.

The result of the above analysis not only corroborates the negative relationship between inflation,
unemployment and per capita income but also shows the significance of literacy in the development of
an economy regardless of affluence (considering recent data of the selection of developed and
developing economies).

In addition, the reason why inflation has a much greater effect on PCI compared to the other variables
could be explained in that the responses taken to improve GDP are mostly usually linked to the level of
inflation within an economy.

There are many other factors that affect PCI; including them, spreading the data over a number of years
as well as increasing the sample size to include more countries would enable to generalize the results.

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References

Theoretical:

Class noted of Doctor Charbel Bassil

Brooks, C. (2008). Introductory Econometrics for Finance. Cambridge University Press.

Software:

Eviews 5

Data:

UNDP 2011 < http://www.undp.org/content/undp/en/home/librarypage.html>

World bank 2011 < http://data.worldbank.org/>

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