Data Analysis for Research

M.Sc. Accounting and Finance, Banking and Finance, Finance, Finance and Investment, Law and Finance Davide Cafaro
Queen Mary University of London

05/03/2013

Davide Cafaro (Queen Mary University of London)

Data Analysis for Research

05/03/2013

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Estimating the simple Taylor rule

In this exercise, we want to test whether there exists a relationship between the way in which monetary policy is detemined and stock market volatility. We use the Taylor rule as the estimation framework and make use of UK data ranging from 1990:1Q to 2010:3Q. The variables contained in the dataset are: RGDP, which is the UK real GDP, CPI, which is the consumer price index, ftse, i.e. the stock market value and interest is the interest rate, set by the Bank of England. We start our analysis by estimating the following simple Taylor rule: it = + ( t t ) + (yt yt ) + t (1)

where it is the log of interest rate, t is the actual ination, t is the desired level of ination, yt is the actual output and yt is the potential one. Note that for convenience, we set t = 0. Therefore the interest rate depends by the actual ination level and output gap only.
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Estimating the simple Taylor rule

Note that the variables, which we need for our analysis have been already calculated and included in the dataset. More specically, we generated it as the log of interest rate, t as the year-on-year ination percentage rate and the output gap (yt yt ). In all cases we used the command Quck/Generate Series. Remember that:
1

The year-on-year percentage change requires rst that you take the log CPI (pt ) and, secondly, that you generate ination using the following formula (to be written in EViews): ination = 100 [pt p (t 4)]

In order to generate the ouput gap, we need to calculate the potential output, yt . First, we take the log of RGDP (we call this variable rt ). Double click on this variable and when the spreadsheet opens, click Proc/Hodrick-Prescott. Generate the potential output (yt ) and, nally, the output gap as (yt yt ).
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Davide Cafaro (Queen Mary University of London)

Estimating the simple Taylor rule - Visual inspection

Our rst step consists of a graphical inspection of our data. Plotting the variables of interest yields:

Ination and output gaps show a similar behavior. The interest rate remains stable over the period until the 2008, when we may assist to a large decrease in it. It could be the consequence of the nancial crisis.
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Davide Cafaro (Queen Mary University of London)

Estimating the simple Taylor rule - OLS analysis

The further step consists of estimating equation (1) employing the OLS estimator. Remember that we expect that both and be positive. Results are reported in the following table:

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Estimating the simple Taylor rule - OLS analysis

As expected, the coe cients associated to ination and output are positive and signicant. A 1% increase in ination leads to a 0.15% increase in the interest rate. Moreover a unitary increase in the output gap raises the interest rate by 0.17%. Overall we may note that the R 2 indicates that our model can explain about the 24% of the variability of dependent variable. Moreover the F-statistic argues in favor of the correctness of our model, since its associated probability is smaller than 0.05. Finally, the DW statistics is about 0.06. This indicates that our specication may suer from a problem of serial correlation. Taylor (1993) suggests that for conducive monetary policy should set both and equal to 0.5. This implies that the output and the ination gap own an equal weight in shaping monetary policy. A more severe ination-targetting monetary policy is such that the weight for ination is considerably larger compared to the one for output gap.
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Estimating the simple Taylor rule - OLS analysis

To test the aforementioned restriction, we set a Wald test (from the ouput window, click on View/Coe cient diagnostics/Wald Test Coe cient restriction). The null is: H0 : = 0.5 and = 0.5 HA : 6= 0.5 and 6= 0.5 The result of the Wald test is reported below:

We may note that the Wald test is extremely signcant. Therefore we cannot accept the null hypothesis stated above. This implies that ination and output gap weight dierently in shaping monetary policy.
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Davide Cafaro (Queen Mary University of London)

Estimating the simple Taylor rule - OLS analysis

To have a visual impression regarding our model, we may consider how it is performs in predicting the variability of the dependent variable. To accomplish this objective, we plot the actual values along with the tted ones (from the ouput window, click on View/Actual, Fitted, Residuals/Actual, Fitted, Residuals Graph):

The immediate impression is that our model (green line) underestimate the actual data (red line) at the beginning of our series while consistently overestimate it from the 2008 onwards.
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Davide Cafaro (Queen Mary University of London)

Estimating the simple Taylor rule - OLS analysis

According to the above graph, we may conclude that our model may be misspecied and/or aected by a problem of omitted variables. However, before addressing the above issues, we may want to check the stability of the relationship under investigation. More specically, the presence of some shocks may aect it. For instance, the dotcom bubble at the beginning of 2001 may had some consequences on the way in which the monetary authority shaped monetary policy. In order to disclose the presence of a structural break, we set up a Chow break test (from the window output, select View/Stability Diagnostics/Chow Break test. In the window, which appears, write 2001 : 1, to underline that you suspect that a break occurred at that point).

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Estimating the simple Taylor rule - OLS analysis

The null hypothesis for this test is the following: H0 : there is not a break HA : thre is a break at 2001:Q1

The result of the test is the following:

We may note that all the reported statistics argue against the acceptance of the null hypothesis. Therefore, we should conclude that the dotcom bubble played a role in the way in which the monetary policy was set.
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Estimating the augmented Taylor rule - OLS analysis

According to the main literature, there exists the possibility that asset price volatility aects the monetary policy by bringing more information to the monetary authority. If we want to test this possibility, we need to slightly change the equation to be estimated as follows: it = + ( t t ) + (yt yt ) +

k =1

k st

+ t

(2)

where st k is the year-to-year S&P500 index change, which we use as a proxy of the stock market volatility. The hurdle of the above estimation is to correctly set k , i.e. the number of lagged values, which we should include in our model. To accomplish this task, we adopt a specic to general approach. We start by including the rst lag. If it is signicant, we include the second lag. If both the rst and the second lags are signicant, we include the third lags and so on. We stop when some of the included lags are not signicant.
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Estimating the augmented Taylor rule - OLS analysis

The results from our rst estimations are the following:

The inclusion of the rst lag of s improves the goodness of t of our model. Instead of focusing on the R 2 , we look at the adjusted R 2 , since the latter is sensitive only to the inclusion of meaningful regressors. We may note that it slightly increased from 0.21 to 0.22, this suggesting that our model can explain better the variability of the dependent variable.
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Davide Cafaro (Queen Mary University of London)

Estimating the augmented Taylor rule - OLS analysis

As far as the coe cient associated to s ( 1) is concerned , we may note that the associate t-statistic is equal to 1.84, with a p-value of 0.07. This means that we have only a mild evidence of signicance. Nonetheless, this is enough to claim that asset price volatility brings some more information into the model. Note that consistently with the theory, as the asset price volatility increases, the interest rate goes up as well. Given this result, we re-estimate our model by including the second lag of s . The results are the following:

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Estimating the augmented Taylor rule - OLS analysis

By including the second lag, we may note that s ( 1) loses its signicance. Moreover, it displays a change in the sign. Moreover, the coe cient associated with s ( 2) is much more closer to the rejection region. Therefore, we may conclude that only the rst lag should be included in our model. A second source of misspecication may come from the fact that our model does not satisfy the man assumptions of the classical regression model. More specically, it may suer from heteroskedasticity and serial correlation of the residuals and at a small extent from normality of the residuals. Therefore, we carry out some tests to check our model.

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Estimating the augmented Taylor rule - Diagnostic tests

The rst test is the normality one (in the output window select View/Residual Diagnostic/Histogram - Normality test). Remember that the Jarque Bera test has the null of normality distribution in the residuals. The result is reported below:

We may easily note that the Jarque Bera test strongly reject the hypothesis of normality in the distribution of the residuals. Actually, we could reach the same result by looking at the graph reported along with the statistic.
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Estimating the augmented Taylor rule - Diagnostic tests

The second test is the White test for heteroskedasticity (in the output window select View/Residual Diagnostic/Histogram - Normality test). Remember that the test has the null of homoskedasticity in the residuals. The result is the following:

The reported statistics indicate a clear rejection of the null hypothesis. Therefore, our residuals are heteroskedastic.

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Estimating the augmented Taylor rule - Diagnostic tests

The third test, which we carry out, is the LM test for serial correlation (View/Residual Diagnostic/Histogram - Serial correlation LM test. Remember to select 1 lag). The null hypothesis for this test is that the residuals are not serially correlated. The results are the following:

Also in this case, we have enough evidence to reject the null hypothesis. Actually, this result is consistent with the interpretation of the DW statistic reported in the estimation table. It is equal to 0.11, this denoting the existence of positive serial correlation.
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Estimating the augmented Taylor rule - Robust S. E.

We may conclude by saying that our model suers from both serial correlation and heteroskedasticity. We may overcome this problem, by re-estimate our model using the Newey-West option to obtain robust standard errors:

We may note that after re-estimating our model by using robust standard errors, none of the variables enter the model signicantly, although they show the expected sign.
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Estimating the augmented Taylor rule - GMM

However, the previous results may be determined by the fact that the asset price volatility aects monetary policy indirectly. Someone argued that the asset price volatility may aect both the output gap and the ination rate. Therefore, we may consider the following auxiliary regressions:

(yt

= t yt ) = t
t

+ (yt 1 + (yt
1

1 1

+ t yt 1 ) + st 1 + t
yt

1 ) + st 1

The results from the above regressions are reported in the following slide.

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Estimating the augmented Taylor rule - GMM

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Estimating the augmented Taylor rule - GMM

According to the previous tables, it seems that stock market variability may aect both ination and output gap. Therefore, it might be more appropriate to estimate our model using an IV procedure, namely a GMM estimator:

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Estimating the augmented Taylor rule - GMM

Right from the beginning, we may note that the probability associated with the J-statistic support the choice of our instruments. We may note that the coe cient associated with s ( 1) is positive, although not statistically signicant. This may be an evidence that the asset price volatility aects the interest rate only indirectly. We based our conclusion on the results that we obtained in the previous two tables.

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