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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
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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.
Davide Cafaro (Queen Mary University of London) Data Analysis for Research 05/03/2013 2 / 22
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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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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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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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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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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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.
Davide Cafaro (Queen Mary University of London) Data Analysis for Research 05/03/2013 10 / 22
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.
Davide Cafaro (Queen Mary University of London) Data Analysis for Research 05/03/2013 11 / 22
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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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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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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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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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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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.
Davide Cafaro (Queen Mary University of London) Data Analysis for Research 05/03/2013 18 / 22
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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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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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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