Question:

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Expert answer:

Step: 1

Consumer Price Index measures the weighted average of

prices of consumer goods and services purchased in an
economy. Table 12.1 gives data on Consumer Price index of 7
countries during period of 1980-2005, with 100 as the base of
index during 1982-84.

Step: 2

a.

Plot CPI of country U against CPI of country C, using data

from table 12.1.

It can be seen from the graph 12.1 that CPI of country U is

positively related to country C. This means inflation in
Country C move in the same direction as with inflation in
country U.

Step: 3

b.

To develop a model to predict CPI of country U (Y) on the

basis of CPI of country C (X), obtain OLS regression of Y on
X. Regression of Y on X can be represented by simple linear
regression model (as in (1.1)). u is residual term.

………..(1.1)

Step: 4

Find slope coefficient β2 and intercept β1 of regression using

data from table 12.2.

Estimated regression equation for regression of Y on X,

………..(1.2)

The above regression model (1.2) can be used to predict CPI

of country Y given CPI of country C.

Step: 5

Find estimated Y and residual term for regression of Y on X

using data from table 12.2 and expression (1.2).

Step: 6

Find homoscedastic variance σ2 of model (1.2) using

following formula. Substitute value of sum of squares of
residual term from table 12.3,

Homoscedastic variance σ2 of model (1.2) is 23.4692

Step: 7

Find standard error se of slope coefficient B2 of model (1.2).

Substitute value of homoscedastic variance σ2 and sum of
squares of mean adjusted X from table 12.2 in below formula,

Standard error se of slope coefficient B2 of model (1) is

0.03157

Step: 8

c.

Use t test to check whether there is relationship between CPI

of country U and CPI of country C. If there is no relation
between then then slope coefficient is zero. Null hypothesis
states that slope coefficient β2 is zero.

Calculate t value using following relationship,

Substituting values in expression,

Degree of freedom is n-k. n (number of observations) is 26

and k (number of parameters to be estimated) is 2. Hence,
degree of freedom is 24 df. At 5% significance and 28 df, find
critical t value from t-table for two tail test,

Absolute estimated t value is 33.95, which exceeds critical t

value of 2.048 and p value of obtaining such t value 0.00001,
which is low. Therefore, reject the null hypothesis that β2 is
equal to zero. There is relationship between CPI of country U
and CPI of country C.