Homework 5 answers

Nathaniel Higgins nhiggins@umd.edu, nhiggins@ers.usda.gov

Assignment
The assignment was to do the following book problems: 10.1, 10.2, 10.7 C10.1

10.1
Decide if you agree or disagree with each of the following statements and give a brief explanation of your decision: (i) Like cross-sectional observations, we can assume that most time series observations are independently distributed. Disagree. Time series processes are often identically but not independently distributed. Things that happen in one period tend to inuence things that happen in the next which is another way of saying that most time series processes are correlated over time, which is a violation of the independence assumption. (ii) The OLS estimator in a time series regression is unbiased under the rst three GuassMarkov assumptions. Agree. If the rst three GM assumptions are met, then the estimator is unbiased. (iii) A trending variable cannot be used as the dependent variable in multiple regression analysis. Disagree. We must take care to remove trends that might cause spurious correlation, but there is no reason why we cannot use a trending variable as a dependent variable. (iv) Seasonality is not an issue when using annual time series observations. Agree. Mostly. Seasonality usually refers to inter-annual variations, but really, the phenomenon is simply one of repeated patterns, which could occur over any period of time. So technically, I think the best answer is yes, seasonality is not an issue when using annual time series observations, but we still need to be aware of regular patterns that could exist in the data. If you answered disagree but gave this as a reason, I give you full credit.

10.2
Let gGDPt denote the annual percentage change in gross domestic product and let intt denote a short-term interest rate. Suppose that gGDPt is related to interest rates by gGDPt = 0 + 0 intt + 1 intt1 + ut , where ut is uncorrelated with intt , intt1 , and all other past values of interest rates. Suppose that the Federal Reserve follows the policy rule: intt = 0 + 1 (gGDPt1 3) + vt , where 1 > 0. (When last years GDP growth is above 3%, the Fed increases interest rates to prevent an overheated economy.) If vt is uncorrelated with all past values of intt and ut , aruge that intt must be correlated with ut1 . (Hint: Lag the rst equation for one time period and substitute for gGDPt in the second equation.) Which GuassMarkov assumption does this violate? Following the hint, we lag the rst equation one time period to obtain gGDPt1 = 0 + 0 intt1 + 1 intt2 + ut1 , which can then be substituted into the second equation to obtain intt = 0 + 1 (0 + 0 intt1 + 1 intt2 + ut1 3) + vt . This makes pretty clear that intt must be correlated with ut1 the latter causes the former. This violates the exogeneity assumption for the rst equation. ut in the rst equation is correlated with intt+1 , i.e. the unobservables in the rst equation are not exogenous to all periods of all explanatory variables (Assumption TS.2).

10.7
In Example 10.4, we wrote the model that explicitly contains the long-run propensity 0 , as gf rt = 0 + 0 pet + 1 (pet1 pet ) + 2 (pet2 pet ) + ut , where we omit the other explanatory variables for simplicity. As always with multiple regression analysis, 0 should have a ceteris paribus interpretation. Namely, if pet increases by one (dollar) holding (pet1 pet ) and (pet2 pet ) xed, gf rt should change by 0 . (i) If (pet1 pet ) and (pet2 pet ) are held xed but pet is increasing, what must be true about changes in pet1 and pet2 ? The only way that pet can increase while the dierence terms stay the same is if pet1 and pet2 increase by the exact same amount that pet increases. (ii) How does your answer in part (i) help you to interpret 0 in the above equation as the LRP? In order for 0 to be the eect of pet , holding all other regressors constant, it must be the case that pet1 and pet2 are also increasing at the same rate. This enables us to interpret 0 as the total eect of a long-term (permanent) increase in pet . 2

C10.1
In October 1979, the Federal Reserve changed its policy of targeting the money supply and instead began to focus directly on short-term interest rates. Using the data in INTDEF, dene a dummy variable equal to 1 for years after 1979. Include this dummy in equation (10.15) to see if there is a shift in the interest rate equation after 1979. What do you conclude? Including a dummy variable post79 in the regression results in a large and statistically signicant coecient, leading us to conclude that the interest rate equation shifts higher after 1979.